Item 2. Management's Discussion and Analysis or Plan of Operation
Critical Accounting Policies
The accompanying discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("US GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We base our estimates and judgments on historical experience and all available information. However, future events are subject to change, and the best estimates and judgments routinely require adjustment. US GAAP requires us to make estimates and judgments in several areas, including those related to recording various accruals, income taxes, the useful lives of long-lived assets, such as property and equipment and intangible assets, and potential losses from contingencies and litigation. We believe the policies discussed below are the most critical to our financial statements because they are affected significantly by management's judgments, assumptions and estimates.
Income taxes
We account for income taxes using the asset and liability method described in SFAS No. 109, "Accounting For Income Taxes," the objective of which is to establish deferred tax asset and liabilities for the temporary differences between the financial reporting and the tax basis of assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. A valuation allowance related to deferred tax assets is recorded when it is more likely than that some portion or all of the deferred tax assets will not be realized.
We have provided a 100% valuation allowance for deferred tax assets, because the ultimate realization of those assets is uncertain. Utilization of net operating loss carry-forwards is subject to a substantial annual limitation due to the "change in ownership" provisions of the Internal Revenue Code. The annual limitation may result in the expiration of net operating loss carry-forwards before utilization.
Share Based Payment
In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement No. 123R ("SFAS 123R") "Share Based Payment", a revision of Statement No. 123, "Accounting for Stock Based Compensation." This standard requires the Company to measure the cost of employee services received in exchange for equity awards based on grant date fair value of the awards. The Company adopted SFAS 123R, effective January 1, 2006. The standard provides for a prospective application. Under this method, the Company will begin recognizing compensation cost for equity based compensation for all new or modified grants after the date of adoption.
Results of Operations for the three months and nine months ended September 30, 2007 and September 30, 2006.
Net Sales. Net sales for the three and nine months ended September 30, 2007 were $27,939 and $134,675 as compared to $52,607 and $231,347 for the three and nine months ended September 30, 2006. These sales reflect revenues from our ProAlgaZyme product.
We believe that the decrease in our sales was due to the absence during 2007 of national publicity about our product. We now believe that national publicity about our product had a temporary effect on our sales for the first half of 2006. We believe that regulatory limitations on our ability to promote our product, has contributed to a low level of net sales. Although our ProAlgaZyme product is available for sale and we are exploring various potential marketing opportunities, as well as advertising the product on a limited basis, we expect only limited sales revenue for the foreseeable future. We believe that our ability to generate sales of the ProAlgaZyme product will depend upon, among other things, further characterization of the product, identification of its method of action and obtaining further evidence of its efficacy, as well as additional advertising. The testing necessary to further characterizing the product, identifying its method of action and establishing its effectiveness has largely been suspended as we do not currently have the funds needed to continue such testing..
Unless and until we receive further positive test results regarding ProAlgaZyme's method of action and efficacy, we may not have meaningful sales revenue. Even if we receive positive test results, we cannot be sure that they will lead to an increase in our sales revenue, as our ability to promote our product is limited by applicable law.
Cost of Sales. Cost of Sales was $11,204 and $96,006 for the three and nine months ended September 30, 2007, as compared to $64,039 and $203,921 for the comparable periods in 2006. Cost of Sales represents primarily costs related to raw materials, labor and operation of the laboratory and controlled production environment necessary for the growing of the algae cultures that constitute the source of the biological activity of the ProAlgaZyme product, and for conducting the necessary harvesting and production operations in preparing the product for sale. The decrease in cost of sales for 2007 is a direct result of our decreased sales volume.
Gross Profit. Gross Profit was $16,735 and $38,669 for the three and nine months ended September 30, 2007, as compared to $(11,432) and $27,426 for the comparable periods in 2006. The increased gross profit for 2007 is due to streamlining the bottling process and the automation of the labeling process.
Research and Development Expenses. For the three and nine months ended September 30, 2007, we incurred $74,533 and $271,798 on research and development expenses, as compared to $107,338 and $237,899 for the comparable period in 2006. These expenses are comprised of costs associated with internal and external research. The overall increase in our research and development for the nine months ended September 30, 2007 is due primarily to the initiation and completion of external clinical trials concerning our ProAlgaZyme product.
We have completed several studies directed toward determining the product's method of action and efficacy. In May, 2006, we commenced two clinical trials in Cameroon, which were substantially completed in September, 2006. The total cost of these trials was $144,000, of which $50,000 is still owing. One trial explored the possible effects of ProAlgaZyme on HIV. In particular, the trial explored ProAlgaZyme's potential to reduce viral loads in patients with HIV.
The second trial explored ProAlgaZyme's potential effects on C-Reactive Protein (CRP) levels and the inflammation process. A third trial was initiated in the first quarter of 2007 in Minnesota to explore ProAlgaZyme's potential effects on cholesterol levels, CRP levels and the inflammation process. This trial was suspended due to concerns raised by inconsistent results. The trial was terminated after review of preliminary data on ten early finishing subjects, due to concerns arising out of the lack of positive response with respect to either cholesterol or C-reactive protein levels, both key prospective markers of the study. The lack of positive response with respect to these key prospective markers, in light of positive results in the Cameroon trials and extensive anecdotal reports, raised concerns about the status of the ProAlgaZyme test agent, including potential problems associated with freezing and thawing. We initiated animal model tests to facilitate its inquiry into whether there was a problem with the ProAlgaZyme batch used in the Minnesota study. Some of the product used in the MN trial froze during shipment to the laboratory, which raised concerns as to whether the product may have been degraded as a result.
Independent research indicates that, the original clinical product, which had not been frozen, showed the presence of active protein. However, in the same tests, all the returned clinical samples that had been frozen showed signs of loss of active protein. Further testing is needed, for which we do not currently have funding. Subject to the availability of sufficient funding, which we do not currently have, we plan to resume our research and development activities as soon as we are able. We may not be able to raise the funding that we need to undertake further research and development activities. In the event that we are not able to secure sufficient funding to meet our research needs, we will be unable to pursue necessary research activities, in which case our ability to market ProAlgaZyme with objective clinical support for its efficacy will be impeded, thereby hindering our ability to generate sales revenue and impacting negatively our operating results.
Selling and Marketing Expenses. Selling and marketing expenses were $29,772 and $100,018 for the three and nine months ended September 30, 2007, as compared to $51,571 and $180,062 for the comparable period in 2006. The decrease in 2007 was due to a decrease in the use of outside consultants who provided outside marketing support for our product. We intend to direct our in house selling efforts to existing ProAlgaZyme users during 2007. The Company recently engaged a sales and marketing consultant at a cost of $6,000 per month to advise the Company about the promotion of its ProAlgaZyme product. We are currently engaged in limited advertising and marketing related activities. We intend to continue to direct selling efforts to existing ProAlgaZyme users. In addition, we are exploring the establishment of additional distribution channels for ProAlgaZyme. The limit on our ability thus far to advertise our product (due to the need for additional testing and regulatory constraints) has had and, until we are able to advertise our product based upon the results of clinical trials further demonstrating its efficacy, will continue to have, a material adverse effect on our ability to increase our sales revenue and improve our operating results. Subject to the availability of funding, which we do not currently have, we intend to continue to pursue clinical study of our product and, subject to the results of such testing, increase our advertising.
General and Administrative Expenses. General and administrative expense was $604,544 and $1,464,931 for the three and nine months ended September 30, 2007, as compared to $771,104 and $2,690,997 for the comparable period in 2006. The decrease in general and administrative expenses for the nine months ended September 30, 2007 is due primarily to a $940,000 decrease in stock based compensation issued to consultants, and a $150,000 decrease in legal fees.
Financing Costs. We incurred $2,907 and $30,759 in interest expense on our indebtedness to our former CEO for the three and nine months ended September 30, 2007, compared to $17,306 and $51,087 for the comparable period in 2006. This note was paid off in July, 2007.
Liquidity and Capital Resources
The condensed consolidated financial statements contained in this Report have been prepared on a 'going concern' basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.
While we raised an aggregate of approximately $900,000 in July and August, 2007, we currently have an immediate and urgent need for additional capital. As noted below, at October 31, 2007, we had only $35,000 in cash (approximately 30 days of cash based on payment of critical operating expenses, such as payroll, utilities, etc.) For the reasons discussed herein, there is a significant risk that we will be unable to continue as a going concern, in which case, you would suffer a total loss of your investment in our company.
We have had limited revenue ($134,675 for the nine months ended September 30, 2007) and have incurred significant net losses since inception, including a net loss of $1,762,942 during the nine months ended September 30, 2007 and an aggregate net loss of $15,688,979 since inception. We expect only limited revenue for the foreseeable future. Further, since inception, we have incurred negative cash flow from operations. During the nine months ended September 30, 2007, we incurred negative cash flows from operations of $1,195,533. As of October 31, 2007, we had a cash balance of approximately $35,000. As of September 30, 2007, we had a working capital deficiency of $378,646 and a stockholders' deficit of $703,738. We are largely dependent upon external sources for funding and, although we recently raised $900,000, we have in the past had difficulty raising capital from external sources. If we are unable to raise additional funds within the next thirty days, it is highly unlikely we will be able to continue as a going concern. These factors raise substantial doubt about our ability to continue as a going concern.
During the nine months ended September 30, 2007 and 2006, our operating activities used $1,195,533 and $1,704,279 in cash, respectively. The decrease in cash used in our operating activities during the nine months ended September 30, 2007 was due largely to a decrease in executive compensation of approximately $155,000, a decrease in stock based compensation of approximately $140,000, and a decrease in legal fees of approximately $200,000. Our financing activities generated $1,351,886 and $1,515,171 during the nine months ended September 30, 2007 and 2006, respectively. The approximate $150,000 decrease in cash generated by our financing activities is primarily attributable to an increase in proceeds from the sale of securities, offset by net repayments to our former CEO. We received a short term advance of $155,000 from our former CEO, Mr. Howard R. Baer, in February of 2007. This was repaid in April of 2007.
During July and August of 2007, we raised an aggregate of $900,000, $775,000 of which was raised through the issuance of convertible debentures (in the principal amount of $775,000) and warrants to purchase 1,550,000 shares of common stock, and $125,000 of which was received in connection with the exercise of an outstanding warrant to purchase 1,250,000 shares of common stock at an exercise price of $.10 per share.
On February 15, 2005, we entered into a Promissory Note ("Note"), a Security Agreement and a Patent Security Agreement with our former CEO, Mr. Baer (such documents are collectively hereinafter referred to as the "Loan Documents"), under which we were indebted to Mr. Baer in the aggregate amount of $847,359.
On March 25, 2005, we, Mr. Baer, and our wholly owned Subsidiary, Health Enhancement Corporation ("HEC"), executed and delivered a Joinder Agreement and First Amendment, which had the effect of making HEC a party to the Loan Documents, including as a co-maker of the note. As a result of entering into the Joinder Agreement and First Amendment, in addition to being a co-maker under the Note, HEC granted Mr. Baer a security interest in all of its assets related to the ProAlgaZume product. As of June 30, 2007, the Note was in the principal amount of $414,391. The Note bore interest at the rate of 10% per annum. As required by the terms of the convertible note offering described above, this note was paid in full on July 26, 2007, and the related liens on our assets have since been released.
We estimate that we will require approximately $1,000,000 in cash over the next twelve months in order to fund our operations. Based on this cash requirement, we have an immediate and urgent need for additional funding. For the foreseeable future, we do not expect that sales revenues will be sufficient to fund our cash requirements. Historically, we have had difficulty raising funds from external sources; however, we recently were able to raise a limited amount of capital from outside sources. As noted above, if we are unable to raise additional funds within the next thirty days, it is highly unlikely we will be able to continue as a going concern, in which case you will suffer a total loss of your investment in our company.
We have only limited product liability insurance. If a product claim were successfully made against us, there could be a material adverse effect on our financial condition.
Significant elements of income or loss not arising from our continuing operations
We do not expect to experience any significant elements of income or loss other than those arising from our continuing operation.
Seasonality
Our product is directed to the improvement of the health of our consumers, and we do not expect that operating results will be affected materially by seasonal factors. In addition, ProAlgaZyme is cultivated in a climate-controlled laboratory environment, not subject to seasonal growing effects or influences.
Staffing
We have conducted all of our activities since inception with a minimum level of qualified staff. We currently do not expect a significant increase in staff.
Off-Balance Sheet arrangements
We have no off-Balance Sheet arrangements that would create contingent or other forms of liability.
