Protea Biosciences 10Q 2013 Q3 Quarterly report

FORM 10-Q

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from ________ to ________

Commission file number 000-51474

PROTEA BIOSCIENCES GROUP, INC.

(Exact name of registrant as specified in its charter)

Delaware		20-2903252
(State or other jurisdiction		(I.R.S. Employer Identification
of incorporation or organization)		Number)

955 Hartman Run Road, Morgantown, West Virginia 26507

(Address of principal executive offices)

(304) 292-2226

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

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

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

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

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨	Smaller reporting company	x
(Do not check if a smaller reporting company)

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

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 57,500,432 shares of common stock, par value $.0001 per share, outstanding as of November 13, 2013.

PROTEA BIOSCIENCES GROUP, INC.

- INDEX -

		Page
PART I – FINANCIAL INFORMATION:

Item 1.	Financial Statements:	1

	Consolidated Balance Sheets	2

	Consolidated Statements of Operations and Total Comprehensive Loss	3

	Consolidated Statements of Stockholders’ Equity (Deficit)	4

	Condensed Consolidated Statements of Cash Flows	5

	Notes to Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	25

Item 4.	Controls and Procedures	25

PART II – OTHER INFORMATION :

Item 1.	Legal Proceedings	25

Item 1A.	Risk Factors	25

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	26

Item 3.	Defaults Upon Senior Securities	27

Item 4.	Mine Safety Disclosures	27

Item 5.	Other Information	27

Item 6.	Exhibits	27

Signatures		29

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements.

The accompanying financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and in accordance with the instructions for Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

In the opinion of management, the financial statements contain all material adjustments, consisting only of normal recurring adjustments necessary to present fairly the financial condition, results of operations, and cash flows of the Company for the interim periods presented.

The results for the period ended September 30, 2013 are not necessarily indicative of the results of operations for the full year. These financial statements and related footnotes should be read in conjunction with the financial statements and footnotes thereto included in the Company’s Form 10-K filed with the Securities and Exchange Commission on March 27, 2013.

	1

PROTEA BIOSCIENCES GROUP, INC.

(A DEVELOPMENT STAGE ENTERPRISE)

Consolidated Balance Sheets

See Accompanying Notes to Financial Statements

	September 30, 2013 (unaudited)		December 31, 2012
ASSETS

Current Assets:
Cash and cash equivalents	$	41,039	$	27,604
Trade accounts receivable		66,596		127,721
Other receivables		27,679		308,934
Inventory		591,404		905,186
Prepaid expenses		103,895		29,567
Total current assets		830,613		1,399,012

Property and equipment, net		2,389,104		2,790,464

Other noncurrent assets		22,939		22,555

Total Assets	$	3,242,656	$	4,212,031

LIABILITIES AND STOCKHOLDERS' EQUITY

Current Liabilities:
Current maturities on short and long-term debt	$	3,037,991	$	1,374,489
Accounts payable		1,662,314		2,270,671
Bank line of credit		2,725,000		2,725,000
Loans payable to stockholders		620,000		2,898,216
Obligation related to the letter of credit		377,695		-
Other payables and accrued expenses		410,701		764,460
Total current liabilities		8,833,701		10,032,836

Long-term debt - net of current portion		1,698,361		2,083,026

Commitments and contingencies (see Notes)		-		-

Stockholders' Equity:
Preferred stock ($.0001 par value; 10,000,000 shares
authorized; none issued or outstanding)		-		-
Common stock ($.0001 par value; 200,000,000 shares
authorized; 49,536,846 and 31,879,247 shares issued
and outstanding at September 30, 2013 and December 31, 2012)		4,954		3,188
Additional paid in capital		47,597,116		39,074,062
Deficit accumulated during development stage		(54,891,560)		(46,974,678)
Accumulated other comprehensive income (loss)		84		(6,403)
Total Stockholders' Equity (Deficit)		(7,289,406)		(7,903,831)
Total Liabilities and Stockholders' Equity	$	3,242,656	$	4,212,031

	2

PROTEA BIOSCIENCES GROUP, INC.

(A DEVELOPMENT STAGE ENTERPRISE)

Consolidated Statements of Operations and Total Comprehensive Loss (Unaudited)

See Accompanying Notes to Financial Statements

	For the Three Months Ended September 30,		For the Three Months Ended September 30,		For the Nine Months Ended September 30,		For the Nine Months Ended September 30,		Period from July 13, 2001 (date of inception) to September 30,
	2013		2012		2013		2012		2013

Gross revenue	$	178,475	$	165,538	$	938,080	$	568,994	$	4,430,935

Selling, general, administrative expenses		(1,943,814)		(1,508,068)		(6,015,077)		(5,205,388)		(28,723,038)
Research and development expense		(658,880)		(722,352)		(2,367,014)		(2,723,129)		(28,128,813)
Loss from operations		(2,424,219)		(2,064,882)		(7,444,011)		(7,359,523)		(52,420,916)

Other income (expense):
Interest and exchange income (expense)		573		(2,369)		6,997		(6,169)		49,915
Interest expense		(131,277)		(138,621)		(464,095)		(367,309)		(2,494,549)
Gain on debt settlement		-		-		-		-		13,834
Loss on asset disposal		-		(25,103)		(15,773)		(25,103)		(39,844)
Total other income (expense)		(130,704)		(166,093)		(472,871)		(398,581)		(2,470,644)

Loss before income taxes		(2,554,923)		(2,230,975)		(7,916,882)		(7,758,104)		(54,891,560)
Income taxes		-		-		-		-		-

Net loss		(2,554,923)		(2,230,975)		(7,916,882)		(7,758,104)		(54,891,560)
Foreign currency translation adjustment		5,797		2,136		6,487		(19,944)		84
Total comprehensive loss	$	(2,549,126)	$	(2,228,839)	$	(7,910,395)	$	(7,778,048)	$	(54,891,476)

Net loss per share - basic and diluted	$	(0.06)	$	(0.08)	$	(0.19)	$	(0.27)	$	(4.33)
Weighted average number of shares
outstanding - basic and diluted		43,952,003		29,245,418		41,122,424		28,442,560		12,675,003

	3

PROTEA BIOSCIENCES GROUP, INC.

(A DEVELOPMENT STAGE ENTERPRISE)

Consolidated Statements of Stockholders' Equity (Deficit) (Unaudited)

See Accompanying Notes to Financial Statements

							Deficit		Accumulated		Total
	Common Stock				Additional		Accumulated		Other		Stockholders'
	Par Value $.0001				Paid in Capital		During		Comprehensive		Equity
	Shares		Amount		Common Stock		Development Stage		Income (Loss)		(Deficit)
December 31, 2012		31,879,247	$	3,188	$	39,074,062	$	(46,974,678)	$	(6,403)	$	(7,903,831)

Issuance of stock for cash at $0.50 per
share (net of issuance costs of $302,675)		10,266,900		1,027		4,829,748		-		-		4,830,775
Issuance of stock upon conversion of
convertible debentures		6,663,199		666		3,330,934		-		-		3,331,600
Issuance of stock for services		200,000		20		99,980		-		-		100,000
Issuance of stock under anti-dilution
provision		527,500		53		(53)		-		-		-
Stock-based compensation expense		-		-		238,495		-		-		238,495
Stock warrants issued as part of
convertible debentures		-		-		23,950		-		-		23,950
Net loss		-		-		-		(7,916,882)		-		(7,916,882)
Foreign currency translation adjustment		-		-		-		-		6,487		6,487
September 30, 2013		49,536,846	$	4,954	$	47,597,116	$	(54,891,560)	$	84	$	(7,289,406)

	4

PROTEA BIOSCIENCES GROUP, INC.

(A DEVELOPMENT STAGE ENTERPRISE)

Consolidated Statements of Cash Flows (Unaudited)

See Accompanying Notes to Financial Statements

	For the Nine Months Ended September 30, 2013		For the Nine Months Ended September 30, 2012		Period from July 13, 2001 (date of inception) to September 30, 2013
Cash flows from operating activities:
Net loss	$	(7,916,882)	$	(7,758,104)	$	(54,891,560)
Adjustments to reconcile net loss to net
cash from operating activities:
Depreciation and amortization		633,535		749,155		5,032,029
Non-cash compensation		238,495		238,484		1,848,705
Issuance of common stock and warrants for services		100,000		-		629,138
Issuance of common stock for accrued interest		228,384		-		689,584
Accretion of convertible debenture discount		17,208		47,686		210,336
Loss on disposal of fixed assets		15,921		25,103		39,992
Bad debt expense		5,000		-		35,032
Net change in assets and liabilities:
Decrease (increase)
Trade accounts receivable		56,125		15,315		(101,628)
Prepaid expenses		(74,328)		18,804		(103,995)
Other receivables		280,870		291,711		351,774
Inventory		313,782		(606,983)		(591,404)
Increase (decrease)
Trade accounts payable		(813,738)		108,698		1,576,441
Other payables and accrued expenses		(353,758)		181,983		410,701
Net cash used in operating activities		(7,269,386)		(6,688,148)		(44,864,855)

Cash flows from investing activities:
Movement in restricted cash		-		49,979		-
Purchase of and deposits on equipment		(42,715)		(390,624)		(4,534,189)
Proceeds from sale of equipment		-		-		47,450
Net cash used in investing activities		(42,715)		(340,645)		(4,486,739)

Cash flows from financing activities:
Net advances on bank line of credit		-		-		2,725,000
Proceeds from sale of common stock		4,830,775		4,406,851		30,598,785
Proceeds from short and long-term debt		1,769,500		1,090,000		13,399,500
Proceeds from shareholder debt		825,000		1,358,216		4,223,216
Repayment of long-term debt		(483,921)		(255,262)		(1,927,260)
Proceeds from Obligation related to the Letter of Credit		600,000		-		600,000
Repayment of Obligation related to the Letter of Credit		(222,305)		-		(222,305)
Financing costs		-		-		(4,387)
Net cash provided by financing activities		7,319,049		6,599,805		49,392,549

Effect of exchange rate changes on cash		6,487		(19,944)		84

Net increase (decrease) in cash		13,435		(448,932)		41,039
Cash, beginning of period		27,604		505,277		-

Cash, end of period	$	41,039	$	56,345	$	41,039

Supplemental disclosure of cash flow information:
Cash paid during the period for interest	$	403,140	$	315,235	$	1,646,253

Supplemental disclosure of non-cash investing and financing activities:
Financed equipment	$	205,381	$	72,635	$	2,996,288
Debt converted to company stock	$	3,331,600	$	-	$	12,960,310
Stock subscription	$	-	$	23,605	$	-

	5

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements – (Unaudited)

Description of Company and Nature of Business

Protea Biosciences Group, Inc. (“Protea” or the “Company”) was incorporated in the state of Delaware on May 24, 2005. Pursuant to an Agreement and Plan of Merger, dated September 2, 2011 (the “Merger Agreement”), by and among the Company, Protea Biosciences, Inc. (“PBI”), and SRKP 5 Acquisition Corp., a wholly-owned subsidiary of the Company (“MergerCo”), PBI was merged with and into MergerCo, with PBI continuing as the surviving entity (the “Merger”). Upon the closing of the Merger, the Company changed its name from “SRKP 5, Inc.” to “Protea Biosciences Group, Inc.” and became the parent company of PBI.

PBI is an emerging biotechnology company incorporated in Delaware in July 2001, and based in Morgantown, West Virginia. The Company is engaged in developing and commercializing proprietary life science technologies, products and services that are used to recover and identify proteins, metabolites and other biomolecules in tissue, cells and biological samples. The interim consolidated financial statements presented herein have been prepared by the Company, are unaudited and, in the opinion of management, reflect all adjustments of a normal recurring nature necessary for a fair statement of the financial position at September 30, 2013, the results of operations for the three and nine month periods ended September 30, 2013 and September 30, 2012, and the cash flows for the nine month periods ended September 30, 2013 and September 30, 2012. Interim results are not necessarily indicative of results for a full year.

The consolidated balance sheet presented as of December 31, 2012, has been derived from the audited consolidated financial statements as of that date. The consolidated financial statements and notes included in this report should be read in conjunction with the financial statements and notes included in the Company’s 2012 year-end audit.

The accompanying financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. The Company has experienced negative cash flows from operations since inception and had an accumulated deficit at September 30, 2013 of approximately $55 million and at December 31, 2012 of approximately $47 million. The Company has funded its activities to date almost exclusively from debt and equity financings. The Company will continue to require substantial funds to advance the research and development of its core technologies, to develop new products and services based upon its proprietary protein recovery and identification technologies, and to continue development of its recombinant pharmaceutical compound.

Management intends to meet its operating cash flow requirements primarily from the sale of equity and debt securities. The Company seeks additional capital through sales of equity securities or convertible debt and, if appropriate, to pursue partnerships to advance various research and development activities. The Company may also consider the sale of certain assets, or entering into a transaction such as a merger with a business complimentary to theirs.

While the Company believes that it will be successful in obtaining the necessary financing to fund its operations, they have no committed sources of funding and are not assured that additional funding will be available to them.

Summary of Significant Accounting Policies

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Protea Biosciences Group, Inc. and all of its wholly-owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.

Development Stage Enterprise

The Company is a development stage enterprise and devotes substantial efforts to establishing new business, raising capital, conducting research and development activities and developing markets. All losses accumulated, since inception, have been considered as part of the Company’s development stage activities.

	6

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

Summary of Significant Accounting Policies (continued)

Estimates and Assumptions

The presentation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Revenue Recognition

The Company derives its revenue from the sale of products and services. LAESI product revenue is recognized upon the transfer of title. Consumable product revenue is recognized upon shipment of the product. Service revenue is recognized upon completion of service contracts that are normally short-term in duration. However, where applicable, service revenue is recorded under proportional performance for projects in process to approximate the amount of revenue earned based on the percentage of effort completed.

Shipping and handling costs are included in selling, general and administrative expenses. Shipping and handling costs charged to customers are recorded as revenue in the period the related product sales revenue is recognized.

Warranty Costs

The Company provides for estimated warranty costs at the time product revenue is recognized. As the Company does not currently have historical data on warranty claims, the Company's estimates of anticipated rates of warranty claims and costs are primarily based on comparable industry metrics. The Company engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its products. During the nine months ended September 30, 2013, the Company recorded accrued warranty expense of $65,000. The Company did not accrue warranty expense for the year ended December 31, 2012.

Reclassification

Certain amounts have been reclassified in the presentation of the Consolidated Financial Statements for the nine months ended September 30, 2012 to be consistent with the presentation in the Consolidated Financial Statements for the nine months ended September 30, 2013. This reclassification had no impact on previously reported net income, cash flow from operations or changes in stockholder equity.

Total Comprehensive Loss

For the period from inception through September 30, 2013, the Company has a translation loss which represents other comprehensive loss and is included in the Statement of Operations and Total Comprehensive Loss in the financial statements.

Other Receivables

Other receivables, which reflect amounts due from non-trade activity, consist of the following at:

	September 30, 2013		December 31, 2012
French government R&D credit	$	-	$	282,036
Employee loan – current		2,400		4,000
Stock subscription and other		25,279		22,898
Other receivables – current	$	27,679	$	308,934

Deposits	$	22,939	$	22,555
Other receivables – noncurrent	$	22,939	$	22,555

	7

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

Summary of Significant Accounting Policies (continued)

Net Loss per Share

Basic and diluted loss per common share is computed based on the weighted average number of common shares outstanding. Common share equivalents (which may consist of options, warrants and convertible debt) are excluded from the computation of diluted loss per share since the effect would be anti-dilutive. Common share equivalents which could potentially dilute basic earnings per share in the future, and which were excluded from the computation of diluted loss per share, totaled approximately 34,958,000 and 18,697,000 at September 30, 2013 and December 31, 2012, respectively.

RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS:

Other Comprehensive Income

In February 2013, the FASB issued new guidance which requires disclosure of information about significant reclassification adjustments from accumulated other comprehensive income in a single note or on the face of the financial statements. This guidance is effective for the Company in 2013. Adoption of this standard, which is related to disclosure only, will not have an impact on the Company’s consolidated financial position, results of operations or cash flows.

In June 2011, the FASB issued new guidance pertaining to the presentation of comprehensive income. The new rule eliminates the previous option to report other comprehensive income and its components in the statement of changes in equity. The standard is intended to provide a more consistent method of presenting non-owner transactions that affect the Company’s equity. Under the new guidance, an entity can present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. The new guidance was effective for the Company on January 1, 2012 and did not have an impact on the Company’s consolidated financial position, results of operations or cash flows.

Bank Line of Credit

In August of 2009, the Company received a line of credit of up to $3,000,000 and is payable on demand. The interest rate is variable and is .75% plus prime with a minimum rate of 5.87%. The line of credit is subject to an annual review and certain covenants. At September 30, 2013 and December 31, 2012, the balance was $2,725,000 with interest payable at 5.87% and all covenants had been met. Borrowings under the line are secured by the personal guarantee of three board members and the estate of a former board member.

Loans Payable to Stockholders

During 2011 and 2012, the Company issued convertible promissory notes in an aggregate principal amount equal to $2,898,216 to various board members, their spouses and other related parties. The notes accrue simple interest at a rate of 10% per annum and were due and payable 60 to 180 days from the date of issue. At the option of the holders, the notes, including the principal and accrued interest, were convertible into common stock of the Company at $2.00 per share. The noteholders signed multiple addendums to the notes agreeing to extend the maturity date. On March 22, 2013, the Company and the noteholders amended the notes to extend the maturity date to May 31, 2013 and reduce the conversion price to $0.50 per share. Prior to June 30, 2013, the Company entered into certain Conversion Agreements, which provided that if the noteholders agreed to convert the entire principal and interest balance due on these notes into common stock on or prior to June 30, 2013, the Company would issue additional five year warrants to purchase 75% of the number of shares of common stock into which the notes are convertible at an exercise price of $1.10 per share. The Company was notified of conversion of all but one note prior to June 30, 2013 and the related warrants and shares were issued in July 2013. On August 6, 2013, the Company along with one board member and his spouse agreed to further extend one note for $20,000 until December 31, 2013.

	8

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

Loans Payable to Stockholders (continued)

On January 3, 2013, the Company issued a convertible promissory note in an aggregate principal amount equal to $125,000 to El Coronado Holdings, Inc., an affiliate of Josiah Austin, a director of the Company. At the option of the holder, the note, including the principal and accrued interest, was convertible into common stock of the Company at $0.50 per share. On May 1, 2013, the Company and El Coronado Holdings, LLC extended the maturity date by 60 days to May 31, 2013. Prior to June 30, 2013, the Company entered into certain Conversion Agreements, which provided that if the noteholder agreed to convert the entire principal and interest balance due on these notes into common stock on or prior to June 30, 2013, the Company would issue additional five year warrants to purchase 75% of the number of shares of common stock into which the notes are convertible at an exercise price of $1.10 per share. The Company was notified of conversion prior to June 30, 2013 and the related warrants and shares were issued on July 23, 2013.

On January 11, 2013, the Company received an advance equal to an aggregate of $100,000 from Summit Resources, Inc., an affiliate of Steve Antoline, a director of the Company. On July 23, 2013, the Company issued 200,000 shares of common stock at $0.50 per share and a warrant to purchase up to 150,000 shares of common stock with an exercise price of $1.10 per share for the advanced funds.

On August 6, 2013, the Company entered into the Note and Warrant Purchase Agreement (the “Summit Agreement”) with Summit Resources, Inc. (“Summit”), an affiliate of Steve Antoline, a director of the Company, pursuant to which Summit acquired (a) a promissory note (the “Summit Note”) in an aggregate principal amount of $600,000 and (b) a five year warrant to purchase up to an aggregate of 250,000 shares of common stock for each $150,000 borrowed of common stock at an exercise price of $1.10 per share for up to a maximum of 1,000,000 shares of common stock as consideration for up to $600,000 in advances made or to be made, which was fully advanced to the Company as of September 30, 2013. In accordance with the terms of the Summit Agreement, up to $150,000 of the gross proceeds received by the Company from the sale of each LAESI instrument, beginning with the sale of the fourth LAESI instrument sold following the effective date, shall be used to repay the principal amounts due under the Summit Note. The Company issued a warrant to purchase up to 1,000,000 shares of common stock at an exercise price of $1.10 in connection with the Summit Agreement as of August 6, 2013.

Obligation Related to the Letter of Credit

On March 6, 2013, the Company entered into that certain Warrant Purchase and Reimbursement Agreement, dated March 6, 2013 (the “Reimbursement Agreement”) with Steve Antoline, a director of the Company, pursuant to which Mr. Antoline agreed to issue a letter of credit, dated February 25, 2013 (the "Letter of Credit") for the benefit of MPR Associates, Inc. ("MPR") for the purpose of guaranteeing an amount equal to $600,000 (the “Purchase Order Amount”) due by the Company to MPR in connection with the production of certain LAESI instruments in exchange for (i) the agreement by the Company to reimburse Mr. Antoline for any amounts paid by him on behalf of the Company pursuant to the Letter of Credit, up to the Purchase Order Amount and (ii) a warrant to purchase up to 1,100,000 shares of the Company’s common stock, issued to an affiliate of Mr. Antoline. The Letter of Credit expired on September 30, 2013. On February 26, 2013, MPR drew $300,000 against the Letter of Credit and on March 15, 2013, it drew an additional $300,000. As of September 30, 2013, $377,695 was due to Steve Antoline in connection with the terms of the Reimbursement Agreement. On June 14, 2013, the Company received $147,860 as payment for one of the LAESI instruments. The Company and Steve Antoline entered into an Addendum to the Warrant Purchase and Reimbursement Agreement whereby the Company could use the funds for up to 80 days or until September 1, 2013. The Addendum was further amended whereby the Company and Mr. Antoline agreed to extend the maturity date until December 31, 2013. For the period the funds are used by the Company, Steve Antoline will receive interest on a 10% per annum basis. In addition, the Company will also issue a five-year warrant to purchase 250,000 shares of common stock at an exercise price of $1.10 per share upon the repayment of the funds. Subsequent to the balance sheet date, the Company remitted an additional $139,000 related to the proceeds from the sale of one LAESI unit to Mr. Antoline and reduced the balance due to $238,695.

Long-term Debt

1) Note Payable to the West Virginia Development Office

In March 2007, the Company obtained an 8-year loan in the amount of $685,000 from the West Virginia Development Office. The note bears interest at 3% providing for 96 monthly principal and interest payments of $8,035 through April 2015, at which time the note is due and payable. The note is secured by equipment costing $1,057,167.

	9

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

Long-term Debt (continued)

2) Note Payable to the West Virginia Economic Development Authority

In August 2009, the Company obtained a 10-year loan in the amount of $242,631 from the West Virginia Economic Development Authority. The note bears interest at 4% providing for 120 monthly principal and interest payments of $2,457 through August 2019, at which time the note is due and payable. The note is secured by 50% of equipment costing $569,812.

3) Note Payable to the West Virginia Infrastructure and Jobs Development Council

In August 2009, the Company obtained a 10-year loan in the amount of $242,630 from the West Virginia Infrastructure and Jobs Development Council. The note bears interest at 3.25% providing for 120 monthly principal and interest payments of $2,371 through August 2019, at which time the note is due and payable. The note is secured by 50% of equipment costing $569,812.

4) Note Payable to the West Virginia Economic Development Authority

In October 2010, the Company issued a 10-year note in the amount of $900,000 from the West Virginia Economic Development Authority. The note bears interest at 3.26% providing for 120 monthly principal and interest payments of $8,802 through October 2020, at which time the note is due and payable. The note is secured by equipment costing $997,248.

5) Note Payable to the West Virginia Infrastructure and Jobs Development Council

In December 2010, the Company issued a 10-year note in the amount of $900,000 from the West Virginia Infrastructure and Jobs Development Council. The note bears interest at 3.25% providing for 120 monthly principal and interest payments of $8,781 through December 2020, at which time the note is due and payable. The note is secured by equipment costing $1,098,249.

6) Convertible Promissory Note Payable to the West Virginia Jobs Investment Trust Board

In March 2012, the Company issued an 18-month note in the amount of $290,000 from the West Virginia Jobs Investment Trust Board. The note bears interest at 6% providing for monthly interest-only payments starting April 2012 through August 2013, then final interest and principal payments due September 2013. The note includes a stock warrant for 72,500 shares (see Note 9, Stock Warrants). On September 3, 2013, the Company and the West Virginia Jobs Investment Trust Board entered into a Loan Modification Agreement whereby the maturity date changed from September 14, 2013 to $100,000 due on December 15, 2013, $100,000 due on March 15, 2014 and the remaining $90,000 due on June 15, 2014. An executive member of the West Virginia Jobs Investment Trust Board is a board member of the Company.

7) Convertible Promissory Note Payable to the West Virginia Jobs Investment Trust Board

In April 2012, the Company issued a 3-month note in the amount of $400,000 from the West Virginia Jobs Investment Trust Board. The note bears interest at 10% providing for monthly interest-only payments starting May 2012 through June 2012, then final interest and principal payments due July 2012. The note includes a stock warrant for 88,889 shares (see Note 9, Stock Warrants). On June 18, 2012, the West Virginia Jobs Investment Trust Board signed an addendum to the note agreeing to extend the maturity date by 90 days to October 15, 2012. On March 11, 2013, the West Virginia Jobs Investment Trust Board approved an additional deferral of principal and interest until May 15, 2013 and reduced the price of converting into common shares to $0.50 per share. The West Virginia Jobs Investment Trust Board further extended the maturity date until October 15, 2013. Subsequent to the balance sheet date, the West Virginia Jobs Investment Trust Board further extended the maturity date until November 29, 2013, with a $100,000 principal payment due on or before November 15, 2013. An executive member of the West Virginia Jobs Investment Trust Board is a board member of the Company.

8) Convertible Promissory Note Payable to the West Virginia High Technology Consortium Foundation

In May 2012, the Company issued a 30-month note in the amount of $200,000 from the West Virginia High Technology Consortium Foundation. The note bears interest at 8% providing for 25 monthly principal and interest payments of $9,001 starting December 2012 through November 2014, then final interest and principal payments due December 2014. The note is secured by 50% of equipment costing $447,320.

9) Note Payable to the West Virginia Economic Development Authority

In June 2012, the Company issued a 10-year note in the amount of $200,000 from the West Virginia Economic Development Authority. The note bears interest at 2% providing for 120 monthly principal and interest payments of $1,840 through June 2022, at which time the note is due and payable. The note is secured by 50% of equipment costing $447,320.

	10

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

Long-term Debt (continued)

10) Capital Leases

From time to time, in the normal course of business, the Company enters into capital leases to finance equipment. As of September 30, 2013, the Company had four capital lease obligations outstanding with imputed interest rates ranging from 2.9% to 8.0%. The leases require 36 monthly payments and begin to expire in March 2013 through May 2015. These leases are secured by equipment with an aggregate cost of $560,195. As of September 30, 2013, the Company was in arrears on all four capital leases.

11) Bridge Notes

In July and September 2013, the Company issued convertible debentures to eighteen (18) accredited investors. The convertible 1-year promissory notes bear simple interest at 10% and are due and payable on the anniversary date on an aggregate principal amount equal to $1,769,500 and include stock warrants in aggregate of 1,327,125 shares (see Note 9, Stock Warrants.) The Bridge Notes and all accrued unpaid interest thereon shall automatically convert into a subsequent offering by the Company at a rate of two shares of the Company’s common stock and a) a 1-year warrant to purchase two shares of common stock at an exercise price of $0.50 per share for each $1 invested and b) a 5-year warrant to purchase one share of common stock exercisable at $0.75 per share for each $1.00 invested or on such other terms and conditions as may be determined by the Company; provided however that such terms shall be consistent with the terms of the subsequent offering. The Company issued three (3) notes to a director of the Company in aggregate of $1,115,000 and stock warrants in aggregate of 836,250 shares. Subsequent to the balance sheet date, the Bridge Notes converted into common stock (see Note 15, Subsequent Events.)

Total debt outstanding as of September 30, 2013 and December 31, 2012 are as follows:

		September 30, 2013		December 31, 2012
1)	Note Payable to the WV Development Office	$	155,967	$	258,497
2)	Note Payable to the WVEDA		155,099		179,728
3)	Note Payable to the WVIJDC		152,935		177,894
4)	Note Payable to the WVEDA		667,128		756,217
5)	Note Payable to the WVIJDC		679,766		768,259
6)	Note Payable to the WVJITB		290,000		275,045
7)	Note Payable to the WVJITB		400,000		400,000
8)	Note Payable to the WVHTCF		128,086		191,373
9)	Note Payable to the WVEDA		177,129		196,983
10)	Capital Leases		182,439		253,519
11)	Bridge Notes		1,747,803		-
	Total		4,736,352		3,457,515
	Less: current portion		(3,037,991)		(1,374,489)
	Long-term portion	$	1,698,361	$	2,083,026

Future required minimum principal repayments over the next five years are as follows:

Year ending December 31:	Future required minimum principal repayments
2012 (payment in arrears)	$	17,296
2013	$	698,226
2014	$	2,440,570
2015	$	289,917
2016	$	253,577
2017	$	262,002
2018 & Thereafter	$	774,764

	11

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

Common Stock

The Company is authorized to issue a total of 210,000,000 shares of stock, of which 200,000,000 shares are designated common stock and 10,000,000 shares are designated preferred stock.

Common Stock – par value of $.0001 per share with one vote in respect of each share held. Holders of common stock do not have cumulative voting rights. The members of the Board of Directors are elected by the affirmative vote of the holders of a majority of the Company’s outstanding common stock.

Common stock issued during the first nine months of 2013 is as follows:

	# Shares Issued		Par Value		Price Per Share		Gross Proceeds		Value of Services Obtained		Par Value		Additional Paid in Capital (4)
December 31, 2012 Balance		31,879,247	$	.0001		Various	$	37,467,400	$	529,138	$	3,188	$	37,993,350
Issuance of stock		10,266,900		.0001		.50		5,133,450		-		1,027		5,132,423
Issuance of stock (1)		200,000						-		100,000		20		99,980
Issuance of stock (2)		527,500						-		-		53		(53)
Issuance of stock (3)		6,663,199						3,103,216		-		666		3,102,550
September 30, 2013 Balance		49,536,846					$	45,704,066	$	629,138	$	4,954	$	46,328,250

	(1) Shares issued for services performed
	(2) Shares issued under anti-dilution provision
	(3) Shares issued upon conversion of convertible debentures
	(4) Activity does not include issuance costs, deferred financing, warrants portion of convertible debentures and stock options.

Preferred Stock

The Company is authorized to issue preferred stock in one or more series and containing such rights, privileges and limitations, including voting rights, dividend rates, conversion privileges, redemption rights and terms, redemption prices and liquidation preferences, as the Board may, from time to time, determine. No shares of the Preferred Stock have been issued.

9. Stock Options and Stock-based Compensation

In 2002, the Board adopted the 2002 Equity Incentive Plan (“the 2002 Plan”) that governed equity awards to employees, directors and consultants of the Company. Under the Plan, 450,000 shares of common stock were reserved for issuance. From 2006 through 2012, the 2002 Plan was amended several times to increase the total number of shares authorized under the 2002 Plan to 4,150,000 shares. During the first quarter 2013, the Board adopted the 2013 Equity Incentive Plan (the “2013 Plan”) and together with the 2002 Plan (the “Plans”) governs the equity awards to employees, directors and consultants of the Company. Under the 2013 Plan, an additional 5,000,000 shares of common stock has been reserved for issuance. On June 18, 2013, the 2013 Plan was approved by holders of a majority of the issued and outstanding shares of common stock of the Company.

The types of awards permitted under the Plans include qualified incentive stock options (ISO), non-qualified stock options (NQO), and restricted stock. Each option shall be exercisable at such times and subject to such terms and conditions as the Board may specify. Stock options generally vest over four years and expire no later than ten years from the date of grant.

	12

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

9. Stock Options and Stock-based Compensation (continued)

A summary of stock option activity is as follows:

	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (in years)
Outstanding at December 31, 2012		3,864,750	$	1.42		4.00
Granted		1,756,000	$	0.55
Exercised		-		-
Cancelled or expired		520,000	$	1.45
Outstanding at September 30, 2013		5,100,750	$	1.12		7.27

Exercisable at December 31, 2012		2,992,417	$	1.39		3.59
Exercisable at September 30, 2013		3,660,959	$	1.25		6.53

The following table summarizes information about stock options at September 30, 2013:

Options Outstanding								Options Exercisable
Exercise Price		Outstanding		Weighted Average Remaining Contractual Life (in years)		Weighted Average Exercise Price		Exercisable		Weighted Average Exercise Price
$	0.50		159,000						102,688
$	0.55		1,681,000						645,833
$	0.80		320,000						320,000
$	1.25		310,000						310,000
$	1.50		2,416,000						2,095,813
$	2.00		214,750						186,625
$	0.50 - $2.00		5,100,750		7.27	$	1.12		3,660,959	$	1.25

At September 30, 2013 and December 31, 2012, the total aggregate intrinsic value for options currently exercisable and options outstanding was $0. These values represent the total pre-tax intrinsic value based on the estimated fair value of the Company’s stock price of $0.50 as of September 30, 2013 and December 31, 2012. During the year ended December 31, 2012, 225,000 options were exercised. During the first nine months of 2013, no additional options were exercised.

The following table summarizes the activity of the Company’s stock options that have not vested for the nine months ended September 30, 2013:

	Shares		Weighted Average Grant-date Fair Value
Nonvested at December 31, 2012		872,333	$	0.441
Granted		1,091,479	$	0.110
Forfeited		103,125	$	0.448
Vested		420,896	$	0.328
Nonvested at September 30, 2013		1,439,791	$	0.290

The fair value of non-vested options to be recognized in future periods is $234,296, which is expected to be recognized over a weighted average period of 1.9 years. The total fair value of options vested during the nine months ended September 30, 2013 was $238,495 compared to $238,484 for the nine months ended September 30, 2012.

	13

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

9. Stock Options and Stock-based Compensation (continued)

Stock-based compensation expense is as follows:

	Nine months Ended
	September 30, 2013		September 30, 2012
Selling, general, and administrative expense	$	220,840	$	180,701
Research and development expense		17,655		57,783
Total stock-based compensation expense	$	238,495	$	238,484

The weighted average grant-date fair value of options granted during the nine months ended September 30, 2013 was $0.111 and for the nine months ended September 30, 2012 was $0.568 per option. The fair value of the option grants was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Nine months Ended
	September 30, 2013			September 30, 2012
Risk-free interest rate		0.35	%		1.04	%
Volatility factor		24.48	%		24.04	%
Weighted average expected life (in years)		7			7
Dividend rate		0.0	%		0.0	%

The Company based its estimate of expected stock price volatility on monthly price observations of the AMEX Biotech Index. Given the Company’s limited history with stock options, the Company’s expected term is based on an average of the contractual term and the vesting period of the options (the SAB 110 “Simplified” method).

10.

Stock Warrants

	From 2008 through 2013, the Company has issued warrants mostly in connection with common stock issuances. The warrants are exercisable for five years from date of issuance. The warrant allows the holder the ability to purchase shares of common stock. The exercise price is $1.10 to $2.25 per share.

	In November 2009, the Company issued stock warrants to four board members in exchange for personal guarantees on a bank line of credit (See Note 3, Bank Line of Credit). The warrants are exercisable for five years from date of issuance. The warrant allows the four holders the ability to purchase 375,000 shares of common stock. The exercise price is $2.00 per share.

	In March 2012, the Company issued stock warrants in connection with the issuance of a Convertible Debenture to the West Virginia Jobs Investment Trust Board (see Note 6, Long-term Debt). The warrant is exercisable for five years from date of issuance. The warrant allows the holder the ability to purchase 72,500 shares of common stock. The exercise price is $2.25 per share.

	In April 2012, the Company issued stock warrants in connection with the issuance of a Convertible Debenture to the West Virginia Jobs Investment Trust Board (see Note 6, Long-term Debt). The warrant is exercisable for five years from date of issuance. The warrant allows the holder the ability to purchase 88,889 shares of common stock. The exercise price is $2.25 per share.

	In March and April 2013, the Company issued stock warrants to a placement agent as commission in connection with the sale of common stock pursuant to two private placement offerings. The warrants are exercisable for five years from date of issuance. The warrant allows the holder the ability to purchase 387,720 shares of common stock. The exercise price is $1.10 to $2.20 per share.

	In March 2013, the Company issued stock warrants in connection with the Reimbursement Agreement with Steve Antoline, a director of the Company (see Note 5, Obligation Related to the Letter of Credit.) The warrants are exercisable for five years from date of issuance. The warrant allows the holder the ability to purchase 1,100,000 shares of common stock. The exercise price is $1.10 per share.

	14

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

10.

Stock Warrants (continued)

	In August 2013, the Company also issued stock warrants in connection with the Note and Warrant Purchase Agreement with Summit Resources, Inc., which is an affiliate of Steve Antoline (see Note 4, Related Party Debt.) The warrants are exercisable for five years from date of issuance. The warrant allows the holder the ability to purchase 1,000,000 shares of common stock. The exercise price is $1.10 per share.

	In July and September 2013, the Company issued stock warrants in connection with Bridge Notes (see Note 6, Bridge Notes.) The warrants are exercisable for five years from date of issuance. The warrants allow the holders the ability to purchase 1,327,125 shares of common stock. The exercise price is $1.10 per share.

	In July 2013, the Company issued stock warrants in connection with the conversion of related party debt. The warrants are exercisable for five years from date of issuance. The warrants allow the holders the ability to purchase 4,997,399 shares of common stock. The exercise price is $1.10 per share.

	As of September 30, 2013, warrants to purchase 31,297,239 shares of common stock were outstanding and exercisable.

11.

Income Taxes

The provision for income taxes, if any, is comprised of current and deferred components. The current component, if any, presents the amount of federal and state income taxes that are currently reportable to the respective tax authorities and is measured by applying statutory rates to the Company’s taxable income as reported in its income tax returns.

The Company adopted ASC 740-10 Income Taxes effective January 1, 2007. The adoption of ASC 740-10 did not require an adjustment to the opening balance of retained earnings as of January 1, 2007. There were no changes to unrecognized tax benefits during 2012 or the first nine months of 2013. The tax years 2009 through 2012 remain open to review by various taxing authorities.

Deferred income taxes are provided for the temporary differences between the carrying values of the Company’s assets and liabilities for financial reporting purposes and their corresponding income tax basis. These temporary differences are primarily attributable to a net operating loss, which, due to income tax laws and regulations, become taxable or deductible in different years than their corresponding treatment for financial reporting purposes. The temporary differences give rise to either a deferred tax asset or liability in the financial statements, which is computed by applying statutory tax rates to taxable or deductible temporary differences based upon the classification (i.e., current or noncurrent) of the asset or liability in the financial statements which relate to the particular temporary difference. Deferred taxes related to differences that are not attributable to a specific asset or liability are classified in accordance with the future period in which they are expected to reverse and be recognized for income tax purposes.

During the development stage of the Company when future benefit of the deferred tax asset is uncertain, the Company provides for a full valuation allowance against the deferred tax asset. Net operating loss carryforwards start to expire beginning 2021 for both federal and state purposes. The net operating tax loss carryforwards total approximately $48,100,000 and $41,500,000 at September 30, 2013 and December 31, 2012, respectively.

	15

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

12.

Lease Commitments

The Company leases its USA facilities under operating leases beginning a) January 2013 on a month to month basis and b) April 2012 through March 2017. Additionally, the Company leases its Europe facility on a three year lease beginning January 2012 through January 2015. The Company also has three equipment operating leases with terms of three to five years. Future required minimum principal repayments over the next five years are as follows:

Year ending December 31:		Future required minimum lease payments
2013	$	208,057
2014	$	260,376
2015	$	173,500
2016	$	167,628
2017	$	41,907

Rent expense totals $108,446 for the three months ended and $325,980 for the nine months ended September 30, 2013, compared to $113,778 for the three months ended and $300,754 for the nine months ended September 30, 2012.

13.

Retirement Plan

The Company provides a 401(k) Profit Sharing Plan (“401(k) Plan”) for elective deferrals whereby participants can defer up to 100% of their wages not to exceed a maximum dollar amount determined by the Federal Government each year. The Company, at its discretion, can make matching contributions to the 401(k) Plan. The Company may also make qualified non-elective contributions to participants who are not highly compensated employees. All employees meeting age and hours of service requirements are eligible to participate in the 401(k) Plan beginning their first full month of service. Participants become vested in employer contributions on a graduated scale with full vesting after five years. No company contributions have yet been made.

14.

Commitments and Contingencies

Legal Proceedings

The Company currently is not a party to any material legal proceeding and has no knowledge of any material legal proceeding contemplated by any governmental authority or third party. The Company may be subject to a number of claims and legal proceedings which, in the opinion of our management, are incidental to normal business operations. In management’s opinion, although final settlement of these claims and suits may impact the financial statements in a particular period, they will not, in the aggregate, have a material adverse effect on the Company’s financial position, cash flows or results of operations.

Warranty Obligations

In the ordinary course of business, the Company warrants to customers that its products will conform to published or agreed specifications. During the nine months ended September 30, 2013, the Company recorded accrued warranty expense of $65,000. The Company did not accrue warranty expense for the year ended December 31, 2012.

Indemnity of Directors and Officers

As permitted under Delaware law and required by corporate by-laws, the Company indemnifies and holds harmless its directors and officers for certain events or occurrences while the director or officer is or was serving in such capacity. The maximum potential amount of future payments that could be required under these indemnification obligations is unlimited; however, the Company maintains a Directors and Officers liability insurance policy that enables it to recover a portion of any future amounts paid with a limit of liability of $5,000,000. The Company may incur an additional liability if indemnity for more than the limit of liability occurred, and such liability may have a material adverse effect on its financial position, cash flows and results of operations. As there were no known or pending claims, the Company has not accrued a liability for such claims as of September 30, 2013.

	16

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

14.

Commitments and Contingencies (continued)

University License Agreements

The Company has agreements with universities related to in-licensed technologies as follows:

AGREEMENT WITH WEST VIRGINIA UNIVERSITY (WVU)

The Company has entered into a License and Exclusive Option to License Agreement with the West Virginia University Research Corporation, a nonprofit West Virginia corporation (“WVURC”) acting for and on behalf of WVU. Under the terms of this Agreement, the WVURC has granted the Company an exclusive option to license technology from the laboratories of certain WVU principal investigators in the field of protein discovery, for therapeutic, diagnostic and all other commercial fields worldwide. Under the terms of this Agreement, the Company pays expenses for the preparation, filing and prosecution of related patent applications, and the Company will pay royalties on the net revenue resulting from the sale of products and services that utilize the WVU subject technology.

AGREEMENT WITH VIRGINIA TECH (VT)

In 2010, the Company entered into an agreement with VT for the exclusive option to license technology in development in the laboratory of Rafael Davalos, PhD., which is intended to enable the separation of specific cell populations, such as cancer cells, in blood and other fluids. It also has an exclusive license to the IRAK-1 compound as a regulator of diseases and disorders in the lab of Liwu Li, PhD. Per the licensing agreements, the Company may be required to pay milestone payments of $12,500 during 2013.

AGREEMENT WITH JOHNS HOPKINS UNIVERSITY (JHU)

In June 2009, the Company entered into an Exclusive License Agreement with Johns Hopkins University for technology developed in the laboratory of Jennifer Van Eyk, Ph.D., Professor of Medicine, Division of Cardiology, Biological Chemistry and Biomedical Engineering. The technology field is albumin-bound protein complexes and their use in the diagnosis of cardiovascular disease. Under the terms of the license agreement, the Company has the exclusive, worldwide rights to commercialize the technology. The Company is obligated to pay expenses for the preparation, filing and prosecution of related patent applications, and the Company will pay royalties on the net revenues resulting from the sale of products and services that utilize the JHU subject technology.

AGREEMENT WITH GEORGE WASHINGTON UNIVERSITY (GWU)

In March 2009, the Company entered into an Exclusive License Agreement with George Washington University (Washington D.C.) for technology developed in the laboratory of Dr. Akos Vertes Ph.D., Professor of Chemistry, Professor of Biochemistry & Molecular Biology, Founder and Co-Director of the W.M. Keck Institute for Proteomics Technology and Applications, the Department of Chemistry, who is a science advisor to the Company. The technology field is LAESI - laser ablation electrospray ionization, a new method of bioanalytical analysis that enables high throughput biomolecule characterization.

Under the terms of the license agreement, the Company has the exclusive, worldwide rights to commercialize the technology. The Company is obligated to pay expenses for the preparation, filing and prosecution of related patent applications, and the Company will pay royalties of 5% on the net revenues resulting from the sale of products and services that utilize the GWU subject technology.

In November 2012, the Company entered into a Patent License Agreement with George Washington University (Washington D.C.) for technology developed in the laboratory of Akos Vertes Ph.D. The technology field is Laser Desorption/Ionization and Peptide Sequencing on Laser-Induced Silicon Microcolumn Arrays (Matrix) and Nanophotonic Production, Modulation and Switching of Ions by Silicon Microcolumn Arrays.

Under the terms of the license agreement, the Company has an exclusive, worldwide license to make, have made, use, import, offer for sale and sell the licensed products. The Company is obligated to pay a license initiation fee of $25,000 and a minimum license diligence resources of $12,500 in year two and $20,000 each year thereafter to develop and commercialize the products, $30,000 milestone payment upon the first sale of a licensed product, and royalties will be 7% of the net sales of licensed products and 5% of the net sales of combination products for combined cumulative net sales up to $50 million. Thereafter, royalties reduce to 6% and 4%, respectively, after taking into account quarterly minimum royalties of $1,500 for the first four quarters after the first sale of a licensed product, $2,500 for the next four quarters, $3,000 for the next four quarters and $6,000 for each succeeding quarter.

	17

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

14.

Commitments and Contingencies (continued)

Joint Pharmaceutical Development Agreement

AGREEMENT WITH LABORATOIRE MAYOLY SPINDLER SAS (Mayoly)

In May 2009, the Company, and its wholly-owned subsidiary, Proteabio Europe SAS, entered into a Joint Research and Development Agreement with Mayoly, a European Pharmaceutical company with headquarters in France, for the joint development of a recombinant lipase biopharmaceutical. Under terms of the agreement, Protea receives the exclusive marketing rights for the therapeutic in the territory of North America; will be responsible for paying 40% of the development expenses (with Mayoly funding the remaining 60%); will pay royalties on net sales of the biopharmaceutical, and a milestone payment of 1 million Euros at the time the Company obtains the first FDA approval for the recombinant Lipase biotherapeutic. The Company also receives a sublicense to certain patents owned by Mayoly and licensed from the Government of France. As of September 30, 2013 and December 31, 2012, based on estimated expenditures by both companies and the anticipated sharing of expenditures, the Company estimates that it owed approximately $36,000 to Mayoly, which is reflected in Trade Accounts Payable on the Consolidated Balance Sheet.

Engineering and Design Services

The Company has approximately $254,000 in outstanding commitments with MPR Associates, Inc. for engineering and design services related to their LAESI (Laser Ablation Electrospray Ionization) technology. These amounts relate to further design enhancements to its instruments and the transfer of manufacturing knowledge to the Company's contract manufacturer, Dynamic Manufacturing, LLC. At September 30, 2013, the Company recorded approximately $7,800 in accrued expenses owed to MPR.

The Company has approximately $3,500 in outstanding commitments with Bridger Photonics for lasers related to the LAESI technology. At September 30, 2013, the Company did not have a related accrual for Bridger.

Contract Manufacturing Services

The Company has approximately $588,000 in outstanding commitments with Dynamic Manufacturing, LLC for contract manufacturing services related to their LAESI technology. These amounts relate to the production of instruments. At September 30, 2013, the Company did not have a related accrual for Dynamic.

15.

Evaluation of Subsequent Events

Issuance of Common Stock

On November 1, 2013 (the “Initial Closing”), the Company received $2,104,965 in aggregate gross cash proceeds from 36 accredited investors in connection with the sale of approximately 21 units (each a “Unit” and collectively, the “Units”) in an offering (the “Offering”) of a minimum of $2,000,000 (the “Minimum Offering Amount”) and up to a maximum of $6,000,000 (the “Maximum Offering Amount”), in Units of securities of the Company pursuant to the terms and conditions of a Subscription Agreement (the “Subscription Agreement”) and Unit Purchase Agreement (the “Purchase Agreement”) by and among the Company and each of the purchasers (the “Purchasers”) thereto. The Maximum Offering Amount excludes up to an additional $2,000,000 (the “Additional Offering Amount”) in Units that may be sold to any existing stockholders, officers, and directors of the Company, including any of their affiliates (the “Company Investors”). Each Unit consists of (i) 200,000 shares of common stock, par value $.0001 per share (the “Common Stock”), (ii) and two warrants, including (a) a 1 year warrant to purchase 200,000 shares of Common Stock at an exercise price of $0.50 per share (the “A Warrants”) and (b) a 5 year warrant to purchase 100,000 shares of Common Stock at an exercise price of $0.75 per share (the “B Warrants” and together with the A Warrants the “Investor Warrants”).

In connection with the Initial Closing of the Offering, the Company also paid to the placement agent (the “Placement Agent”) an aggregate of $314,669 in cash commissions, representing (1) 10% of the gross proceeds raised in the Offering from Purchasers introduced to the Company by the Placement Agent; (2) 2% of the aggregate gross proceeds raised in the offering from Company Investors, including the Conversion Amount and (3) 2% of the aggregate gross proceeds raised in the Offering, including the Conversion Amount, in connection with a non-accountable expense allowance. In addition, the Company agreed to issue warrants (the “Placement Agent Warrants”) to purchase an aggregate of 1,052,483 shares of Common Stock to the Placement Agent (or its designees), representing 10% of the number of shares of Common Stock underlying the Units sold in the Offering, including the shares of Common Stock underlying the Investor Warrants.

	18

PROTEA BIOSCIENCES GROUP, INC. (A DEVELOPMENT STAGE ENTERPRISE)

Notes to Consolidated Financial Statements (unaudited)

15. Evaluation of Subsequent Events (continued)

Conversion of Convertible Debentures

In addition, at the Initial Closing, the Company issued an aggregate of approximately 18.77 in additional Units to certain existing note holders, in connection with the conversion of $1,876,828 (the “Conversion Amount”) in outstanding principal and accrued unpaid interest in convertible promissory notes.

Issuance of Convertible Debentures

Subsequent to the balance sheet date (the “October Note Issue Date”), the Company has issued to three (3) accredited investors (each an “October Noteholder” and collectively, the “October Noteholders”) (1) 10% convertible 1-year promissory notes (each an “October Note” and collectively, the “October Notes”) in an aggregate principal amount equal to $225,000 and (2) warrants (each an “October Noteholder Warrant” and collectively, the “October Noteholder Warrants”) for each investor to purchase the number of shares of the Company’s common stock as is equal to 37.5% of the principal amount of the October Notes purchased by it, divided by $0.50, pursuant to the terms and conditions of those certain Note and Warrant Purchase Agreements (the “Purchase Agreements”).

The October Notes accrue simple interest at a rate of 10% per annum and are due and payable on the one-year anniversary of the October Note Issue Date. The October Notes and all accrued unpaid interest thereon shall automatically convert into units (the (“Units”) issued by the Company in a subsequent offering (the “Subsequent Offering”) at a rate that is equal to (a) two shares (the “Subsequent Offering Shares”) of the Company’s common stock and (b) two warrants including (1) a 1 year warrant (each, an “A Warrant” and collectively, the “A Warrants”) to purchase two shares of common stock at an exercise price of $0.50 per share and (2) a 5 year warrant (each, a “B Warrant” and collectively, the “B Warrants” and together with the A Warrants the “Subsequent Offering Warrants”) to purchase one share of common stock at an exercise price of $0.75 per share for each $1.00 invested in the Subsequent Offering or on such other terms and conditions as may be determined by the Company; provided however that such terms shall be consistent with the terms of the Subsequent Offering. At the Initial Closing, the Company issued an aggregate of approximately 1.36 Units to these note holders, in connection with the conversion of $135,900 (the “Conversion Amount”) in outstanding principal and accrued unpaid interest.

Issuance of Related Party Debt

Subsequent to the balance sheet date, the Company issued Promissory Notes (the “Related Party Notes”) to two (2) board members’ affiliated companies in the aggregate amount of $275,000. The notes mature on October 25, 2014 and accrue simple interest of 10% per annum. The Related Party Notes and all accrued unpaid interest thereon shall automatically convert into a subsequent offering by the Company at a rate of two shares of the Company’s common stock and a) a 1-year warrant to purchase two shares of common stock at an exercise price of $0.50 per share for each $1 invested and b) a 5-year warrant to purchase one share of common stock exercisable at $0.75 per share for each $1.00 invested or on such other terms and conditions as may be determined by the Company; provided however that such terms shall be consistent with the terms of the subsequent offering.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward-Looking Statement Notice

Certain statements made in this Quarterly Report on Form 10-Q are “forward-looking statements” regarding the plans and objectives of management for future operations. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of Protea Biosciences Group, Inc. (“we”, “us”, “our”, “Protea” or the “Company”) to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. The Company's plans and objectives are based, in part, on assumptions involving the continued expansion of business. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of the Company. Although the Company believes its assumptions underlying the forward-looking statements are reasonable, any of the assumptions could prove inaccurate and; therefore, there can be no assurance the forward-looking statements included in this Quarterly Report will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives and plans of the Company will be achieved.

Overview

We were originally incorporated under the name SRKP 5, Inc. in the State of Delaware on May 24, 2005 and were originally organized as a “blank check” shell company to investigate and acquire a target company or business seeking the perceived advantages of being a publicly-held corporation.

On September 2, 2011, we completed a merger in accordance with the terms and conditions of an Agreement and Plan of Merger by and among the Company, Protea Biosciences, Inc., a Delaware corporation ("PBI") and SRKP 5 Acquisition Corp., a Delaware corporation and our wholly-owned subsidiary ("Merger Co"), pursuant to which Merger Co merged with and into PBI (the "Merger"). As a result of the Merger, we (i) became the 100% parent of PBI, (ii) assumed the operations of PBI and (iii) changed our name to "Protea Biosciences Group, Inc."

Protea operates in the field of bioanalytics. Bioanalytics is the identification and characterization of proteins and other biomolecules, which are the products of all living cells and life forms. The Company is applying its technology to the development of a new generation of products and services that enable comprehensive, real-time analysis of living cells, thereby providing data that helps to define normal and disease processes. We believe this will, in turn, support the next generation of medical research and pharmaceutical development. Protea’s technologies seek to enable the discovery and analysis of the proteins and other biomolecules that regulate the biological functions of the human body and all other forms of life. This is a critical area of research, because most biological functions are carried out by proteins, and the discovery of proteins that are associated with specific diseases can lead to the development of new pharmaceuticals, designed to block the proteins’ aberrant biological activities. In 2012, the Company opened a dedicated Mass Spectrometry Imaging Center (MSIC) at their facility in Morgantown, WV. This MSIC offers access to advanced biomolecular imaging capabilities, including ultra-high resolution mass spectrometry coupled with Protea’s revolutionary LAESI platform.

Our Business Strategy and Products

The Company applies its core technologies and expertise to the development of products, instruments and services that seek to improve the discovery and identification of proteins, metabolites and other biomolecules. Our products and services are purchased and used primarily by pharmaceutical and academic/clinical research laboratories, including analytical chemists, translational researchers, oncologists, pathologists and cell biologists.

LAESI DP 1000 Instrument platform, software and consumables

In 2011, Protea completed the development of a novel bioanalytical instrument platform known as “LAESI” (laser ablation electrospray ionization). This technology enables the direct identification of proteins, lipids and metabolites in tissue, cells and biofluids, such as serum and urine, without any sample preparation prior to analysis. By eliminating sample preparation, the biological sample can be analyzed without the possible contamination, bias or sample loss that occurs with the current techniques, which require the introduction of chemicals, or the destruction of the sample itself, in order to enable analysis by mass spectrometry. LAESI then can display the data obtained by mass spectrometry analysis combined with actual images of the tissue and cell samples. Thus, mass spectrometry data can be evaluated in the context of the biology of the sample; this allows the integration of mass spectrometry data with current pathology and microscopic imaging techniques. Data is available in seconds to minutes, allowing rapid time to results and the capacity to analyze thousands of samples in a single work period. As an example, a researcher testing a new drug’s effects on living cells can analyze changes in cells’ metabolism across a specific time course, thereby almost immediately obtaining data as to the activity of the new drug. The Company believes that LAESI technology has the potential to revolutionize bioanalytics in pharmaceutical research, as well as many other fields, including agriculture, pathology, biomarker discovery, biodefense and forensics.

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LAESI is intended to meet the broad need of the biologist for the direct, unbiased identification and characterization of biomolecules in biological samples, which can remain untouched prior to their analysis. By virtue of LAESI’s improved speed and the comprehensive datasets it generates, the Company is pursuing its vision of what it believes will be a new era of human bioanalytics, where the molecular pathways of human disease will be more clearly elucidated, and datasets more rapidly available, thereby accelerating pharmaceutical and life science research.

The Company offers the LAESI DP-1000 instrument as well as software packages developed by the Company (LAESI desktop software and ProteaPlot™). Our software facilitates operating the instrument, and the storage and display of datasets, in a user friendly, intuitive software environment. The LAESI and ProteaPlot software include LAESI datamining and analytic tools to search for new, disease-specific biomarkers, and to elucidate disease-specific biomolecular pathways. In addition, the Company provides an expanding line of LAESI consumables.

Bioanalytical Consumable Products

This product group encompasses consumable products used in bioanalytical mass spectrometry, including a family of proprietary reagents, known as Progenta™ surfactants, that can rapidly remove proteins out of biological samples and into liquid phase, preparing them for analysis by mass spectrometry; single use products, including pipette tips and 96 well plates, that employ a novel chemistry technique, known as monolith chemistry, which enables recovery of proteins from solutions, as well as removal of salts, thereby improving the quality of analysis of the proteins by mass spectrometry; and, an extensive line of protein mass spectrometry standards, which provide defined and characterized proteins representing different protein structures and classes in order to improve the reproducibility of a researcher’s bioanalytical mass spectrometry results.

LAESI Services & Bioinformatics

Protea offers proprietary LAESI bioanalytical services for the rapid identification of both small molecules (e.g. lipids and metabolites) and large molecules (e.g. proteins). The services unit is operated under GLP (Good Laboratory Practices), which are necessary for regulatory submissions and to meet the internal research and development standards of pharmaceutical research clients.

We focus on the unique capability of LAESI technology to image and display the presence of specific biomolecules in cell and tissue samples. We believe that this field, called LAESI mass spectrometry imaging (“LAESI-MSI”), will become a major analytical method for biological investigation of tissues and living cell populations, such as cell cultures and colonies. LAESI-MSI provides new information based on molecule-specific images, without the need for labeling, staining or complex sample preparation protocols. Datasets are automatically generated, and are available in minutes, depending on the complexity of the analysis.

In LAESI-MSI, the chemical identity of biomarkers or other biomolecules present, for example in a tissue, is investigated as a function of spatial distribution. This paradigm allows accurate distribution profiling of chemical species that may help to understand pathologies or metabolic processes present in the specimen. LAESI-MSI has the potential to revolutionize biological investigation using objective chemical data by presenting the distribution of specific molecular structure in situ.

LAESI-MSI eliminates the need for sample preparation and allows the researcher to study the biochemical landscape of a sample as it exists in nature. LAESI-MSI services are available for 2D and 3D tissue biomolecular distribution profiling, high throughput biofluid analysis, biodynamic live cell colony monitoring, and biomaterial characterization.

We are applying LAESI-MSI to create cell-based biomolecular databases that will be specific to disease states and allow the analysis and integration of LAESI biomolecular datasets with the sample-related pathology, gene expression and demographic datasets. We are developing “high resolution” LAESI technology that will enable the analysis of single cells. We believe LAESI-MSI can generate important advances in bioinformatics to help provide time-based, biodynamic datasets for improved disease state assessment and management.

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Emerging Growth Company

We are an “emerging growth company” under the federal securities laws and will be subject to reduced public company reporting requirements. In addition, Section 107 of the JumpStart Our Business Startups Act also provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We are choosing to take advantage of the extended transition period for complying with new or revised accounting standards.

Results of Operations

Three and Nine months Ended September 30, 2013 Compared to Three and Nine months Ended September 30, 2012

For the three months ended September 30, 2013 and September 30, 2012, we earned revenue of $178,475 and $165,538, respectively. This represents an increase of $12,937 or 8% from the prior period. We earned revenue of $938,080 and $568,994 for the nine month period ended September 30, 2013 and September 30, 2012, respectively, an increase of $369,086, or approximately 65%. During the first nine months of 2013, the Company sold four LAESI DP-1000 instruments. These sales represent the largest portion of the increase in revenue.

For the three months ended September 30, 2013 and September 30, 2012, selling, general and administrative expenses totaled $1,943,814 and $1,508,068, respectively. This represents an increase of $435,746 or 29% from prior year. Selling, general and administrative expenses totaled $6,015,077 for the nine months ended September 30, 2013 compared to $5,205,388 for the nine months ended September 30, 2012, an increase of $809,689 or approximately 16%. The increase in selling, general and administrative expenses relates largely to an increase in cost of goods and services sold, consulting fees and outside service expense and a reclassification to the quarter related to LAESI unit costs previously classified as research and development expense, which is partially off-set by a reduction in personnel costs. Cost of goods sold related to LAESI units include the cost to produce the unit, licensing costs, and accrued warranty expense.

For the three months ended September 30, 2013 and September 30, 2012, research and development expense totaled $658,880 and $722,352, respectively. This represents a decrease of $63,472 or 9% from prior year. Research and development expense totaled $2,367,014 for the nine months ended September 30, 2013, compared to research and development expense of $2,723,129 for the nine months ended September 30, 2012, a decrease of $356,115 or approximately 13%. Research and development expenses primarily include costs associated with the development of the LAESI technology. Research and development expenses have decreased as the Company has transitioned from development to production of the LAESI technology.

For the three months ended September 30, 2013 and September 30, 2012, loss from operations totaled $2,424,219 and $2,064,882, respectively. This represents an increase of $359,337 or 17% from prior period. Loss from operations totaled $7,444,011 for the nine months ended September 30, 2013, compared to a loss from operations of $7,359,523 for the nine months ended September 30, 2012, an increase of $84,488 or approximately 1%.

For the three months ended September 30, 2013 and September 30, 2012, other expense was $130,704 and $166,093, respectively. This is a decrease of $35,389 or 21% from the prior period. Other expense was $472,871 for the nine months ended September 30, 2013 compared to $398,581 for the nine months ended September 30, 2012. During 2012, the Company relied on related party debt to fund operations. As a result, other expense increased $74,290 or 19% for the nine months ended September 30, 2013 as compared to prior year due to the rise in related party debt.

After foreign currency translation adjustments of $5,797 and $2,136, respectively, total comprehensive loss was $2,549,126, or ($0.06) per share, for the three months ended September 30, 2013 as compared to a total comprehensive loss of $2,228,839, or ($0.08) per share, for the three months ended September 30, 2012. After foreign currency translation adjustments of $6,487 and ($19,944), respectively, total comprehensive loss was $7,910,395, or ($0.19) per share, for the nine months ended September 30, 2013 as compared to a total comprehensive loss of $7,778,048, or ($0.27) per share, for the nine months ended September 30, 2012.

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Liquidity and Capital Resources

We have experienced negative cash flows from operations since inception. To date, our operations since inception have been funded primarily through proceeds received from the issuance of debt and sale of equity securities in private placement offerings. We have a credit facility of $3,000,000 with United Bank, Inc. with a balance of $2,725,000 outstanding as of September 30, 2013. Interest is payable monthly and the loan is due on demand. In 2009 and 2010, we borrowed a total of $2,285,261 for the purchase of equipment from the West Virginia Economic Development Authority (WVEDA) and the West Virginia Water Development Authority. These loans have 10 year terms and interest rates ranging from 3.25% to 4%. In 2012, we borrowed a total of $400,000 for the purchase of equipment from the WVEDA and the West Virginia High Technology Consortium Foundation (WVHTC Foundation). The WVEDA loan has a 10 year term and an interest rate of 2%. The WVHTC Foundation loan has a 30-month term and an interest rate of 8%. Between 2011 and 2013, we borrowed $3,123,216 from various board members and spouses, of which all but $20,000 was converted into equity in July 2013. The remaining note matures on December 31, 2013 and accrues simple interest at a rate of 10% per annum. In June and August 2013, we borrowed $600,000 from Summit Resources, Inc., an affiliate of one board member, under the Note and Warrant Purchase Agreement. The note matures one year from the anniversary date and accrues simple interest at a rate of 10% per annum. During the 3^rd quarter of 2013, we borrowed $1,769,500 from various accredited investors. The convertible 1-year promissory notes bear simple interest at 10% per annum and are payable on the anniversary.

We will continue to require substantial funds to advance the research and development of our core technologies, to develop new products and services based upon our proprietary protein recovery and identification technologies and to continue development of our recombinant pharmaceutical compound. We intend to meet our operating cash flow requirements by raising additional funds from the sale of equity or issuance of debt and, possibly, pursuing partnerships to advance our drug and technology development activities. We may also consider the sale of certain assets, or entering into a transaction such as a merger with a business complimentary to ours. While we have been successful in raising funds to fund our operations since inception and we believe that we will be successful in obtaining the necessary financing to fund our operations going forward, we do not have any committed sources of funding and there are no assurances that we will be able to secure additional funding.

As of September 30, 2013, we had total current assets equal to $830,613, comprised of $41,039 in cash and cash equivalents, $66,596 in trade accounts receivable, $27,679 in other receivables, $591,404 in inventory and $103,895 in prepaid expenses. This compares with total current assets at December 31, 2012 equal to $1,399,012 comprised of $27,604 in cash and cash equivalents, $127,721 in trade accounts receivable, $308,934 in other receivables, $905,186 in inventory and $29,567 in prepaid expenses. The Company's total current liabilities as of September 30, 2013 were equal to $8,833,701, comprised of $3,037,991 in current maturities on long term debt, $1,662,314 in trade accounts payable, $2,725,000 in connection with the United Bank, Inc. line of credit, $620,000 in loans payable to stockholders $377,695 in the obligation related to the Letter of Credit and $410,701 in other payables and accrued expenses. The Company's total current liabilities as of December 31, 2012 were equal to $10,032,836, comprised of $1,374,489 in current maturities on long term debt, $2,270,671 in trade accounts payable, $2,725,000 in connection with United Bank, Inc. line of credit, $2,898,216 in loans payable to stockholders and $764,460 in other payables and accrued expenses.

Our working capital deficit at September 30, 2013 was $8,003,088 as compared to a working capital deficit of $8,633,824 at December 31, 2012. The decrease in working capital deficit was $630,736 from December 31, 2012 to September 30, 2013.

Operating Activities

Net cash used in operating activities for the nine months ended September 30, 2013 increased $581,238, or 9% from $6,688,148 for the nine months ended September 30, 2012 to $7,269,386. Net cash used in operating activities during the nine months ended September 30, 2013 was primarily the result of a net loss of $7,916,882. Net loss was adjusted for non-cash items such as depreciation and amortization of $633,535, non-cash compensation of $238,495, issuance of stock for services of $100,000, issuance of common stock for accrued interest of $228,384, accretion of convertible debenture discount of $17,208, bad debt expense of $5,000 and loss on disposal of fixed assets of $15,921. We also had a decrease in trade accounts receivable of $56,125, trade inventory of $313,782, in other receivables of $280,871, trade accounts payable of $813,738 and other payables and accrued expenses of $353,759. We also had an increase in prepaid assets of $74,328.

Investing Activities

Net cash used in investing activities during the nine months ended September 30, 2013 was $42,715, which was for equipment purchases. We expect to continue to purchase property and equipment in the normal course of our business. The amount and timing of these purchases and the related cash outflows in future periods is difficult to predict and is dependent on a number of factors including, but not limited to, any increase in the number of our employees and changes related to our development programs. Net cash used in investing activities during the nine month period ended September 30, 2012 was $340,645 and was also used for equipment purchases and partially offset by a movement in restricted cash.

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Financing Activities

Cash provided by financing activities during the nine month period ended September 30, 2013 was $7,319,049, which was the result of net proceeds of $4,830,775 from the sale of our common stock, proceeds of $825,000 from the issuance of related party debt, proceeds of short term debt of $1,769,500, and proceeds of $600,000 from the Obligation related to the Letter of Credit. This was offset by $483,921 used in the repayment of long-term debt and $222,305 used in repayment of the Obligation related to Letter of Credit. Cash provided by financing activities during the nine month period ended September 30, 2012 was $6,599,805, which was the result of the net proceeds of $4,406,851 from the sale of our common stock, proceeds of $1,090,000 from the issuance of short and long-term debt and proceeds of $1,358,216 from the issuance of stockholder debt. This was offset by $255,262 used in the repayment of long-term debt.

Other than as discussed above, we know of no trends, events or uncertainties that are reasonably likely to impact our future liquidity.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet guarantees, interest rate swap transactions or foreign currency contracts. We do not engage in trading activities involving non-exchange traded contracts.

Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses for each period. The following represents a summary of our critical accounting policies, defined as those policies that we believe are the most important to the portrayal of our financial condition and results of operations and that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Revenue Recognition

We derive our revenue from the sale of products and services. Revenue is recognized when all four of the following criteria are met: (1) we have persuasive evidence that an arrangement exists, (2) the price is fixed and determinable, (3) title has passed, and (4) collection is reasonably assured. Product revenue is recognized when title passes, which is typically upon shipment of the product. Service revenue is recognized as the service is performed, generally through short-term contracts. However, where applicable, contract service revenue is earned and recognized according to the provisions of each agreement. As of September 30, 2013, we had deferred revenues of $2,500 compared to no deferred revenue as of September 30, 2012.

Comprehensive Loss

The financial statements of our international subsidiary are translated into U.S. dollars using the exchange rate at each balance sheet date for assets and liabilities, the historical exchange rate for stockholders’ equity and an average exchange rate for each period of revenues, expenses, and gains and losses. The functional currency of our non-U.S. subsidiary is the local currency. Adjustments resulting from the translation of financial statements are reflected in accumulated other comprehensive income. Transactional gains and losses are recorded within operating results.

Research and Development

We follow the policy of charging the costs of research and development to expense as incurred. Research and development expense is $2,367,014 and $2,723,129, respectively, for the nine months ended September 30, 2013 and 2012.

Net Loss per Share

Basic and diluted loss per common share is computed based on the weighted average number of common shares outstanding. Common share equivalents (which may consist of options, warrants and convertible debt) are excluded from the computation of diluted loss per share since the effect would be anti-dilutive. Common share equivalents which could potentially dilute basic earnings per share in the future, and which were excluded from the computation of diluted loss per share, totaled approximately 34,958,000 and 18,697,000 for the nine months ended September 30, 2013 and year ended December 31, 2012, respectively.

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Stock Based Compensation

We follow the provisions of FASB ASC 718, “Stock Based Compensation.” Stock-based compensation expense is estimated as of the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which generally represents the vesting period. Fair value of stock options issued by the Company is estimated using the Black-Scholes option-pricing model. The associated compensation expense is recognized on a straight-line basis over the requisite service period, net of estimated forfeitures.

Estimating the fair value for stock options for each grant requires judgment, including estimating stock-price volatility, expected term, expected dividends and risk-free interest rates. The expected volatility rates are estimated based on the volatility of similar entities whose share information is publicly available. The expected term represents the average time that options are expected to be outstanding and is estimated based on the average of the contractual term and the vesting period of the options as provided in SEC Staff Accounting Bulletin 110 as the “simplified” method. The risk-free interest rate for periods approximating the expected term of the options is based on the U.S. Treasury yield curve in effect at the time of grant. Expected dividends are zero as we have no plans to issue dividends.

Recently Issued Accounting Pronouncements

For a discussion of recently issued accounting pronouncements, please see Note 2 to our financial statements, which are included in this report in Item 1.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

As a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide information required by this Item.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed pursuant to the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules, regulations and related forms, and that such information is accumulated and communicated to our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

As of September 30, 2013, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and our principal financial officer of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, our principal executive officer and our principal financial officer have concluded that as of September 30, 2013, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There have been no changes in our internal controls over financial reporting during the quarter ended September 30, 2013 that have materially affected or are reasonably likely to materially affect our internal controls.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings.

There are presently no pending legal proceedings to which the Company or any of its subsidiaries is a party or to which any of their property is subject and no such proceedings are known to the Company to be threatened or contemplated against it.

Item 1A. Risk Factors.

As a “smaller reporting company” as defined by Item 10 of Regulation S-K, the Company is not required to provide information required by this Item.

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

Common Stock and Warrants

On July 17, 2013, the Company issued an aggregate of 377,500 shares of common stock for no additional consideration to certain stockholders in connection with the anti-dilution rights applicable to such investor’s investments. In addition, the exercise price of the warrants issued to such investors in connection with the anti-dilution rights were reduced from $2.25 to $1.12 per share.

On July 23, 2013, in connection with a private placement offering, the Company issued an aggregate of 300,000 shares of common stock at $0.50 per share and warrants to purchase up to 225,000 shares of common stock at a purchase price of $150,000. The warrants are exercisable for five years from date of issuance at an exercise price of $1.10 per share. The shares and warrants were issued pursuant to the exemption from registration provided by Section 4(2) of the Securities Act in that the investors were the sole offerees, had access to all information concerning the Company and the Company did not engage in any general solicitation. Cash commissions were not paid in connection with the sale of the shares and warrants.

Conversion of Convertible Debentures

As of June 30, 2013, the Company entered into conversion agreements (the "Conversion Agreements") with certain related party holders (the “Existing Noteholders”) of its existing convertible promissory notes with an aggregate principal amount of $3,003,216 (the "Existing Notes") pursuant to which the Company agreed to issue 5 year warrants (the “Conversion Warrants”) to purchase up to 75% of the number of shares of common stock into which the Existing Notes were convertible, at an exercise price of $1.10 per share, provided that the conversion of the Existing Notes was exercised on or prior to June 30, 2013. In accordance with the terms and conditions of the Conversion Agreements, on June 30, 2013 the Existing Noteholders notified the Company of their desire to convert the Existing Notes into an aggregate of 6,663,199 shares (the “Conversion Shares”). On July 23 and 29, 2013, the Company issued the Conversion Shares and Conversion Warrants to purchase up to an aggregate of 4,997,399 shares of common stock. The Conversion Shares and Conversion Warrants were issued pursuant to the exemption from registration provided by Section 4(2) of the Securities Act in that the investors were the sole offerees, had access to all information concerning the Company and the Company did not engage in any general solicitation. Cash commissions were not paid in connection with the sale of the Conversion Shares and Conversion Warrants.

Related Party Debt

On August 6, 2013, the Company and one board member and his spouse agreed to further extend the maturity date of the Convertible Promissory Note dated September 25, 2012 for $20,000 until December 31, 2013.

Issuance of Convertible Debentures

During the 3^rd quarter 2013 (the “July and September Note Issue Dates”), the Company issued to eighteen (18) accredited investors (each a “July and September Noteholder” and collectively, the “July and September Noteholders”) (1) 10% convertible 1-year promissory notes (each a “July and September Note” and collectively, the “July and September Notes”) in an aggregate principal amount equal to $1,769,500 and (2) warrants (each a “July and September Noteholder Warrant” and collectively, the “July and September Noteholder Warrants”) for each investor to purchase the number of shares of the Company’s common stock as is equal to 37.5% of the principal amount of the July and September Notes purchased at $1.10 per share, pursuant to the terms and conditions of those certain Note and Warrant Purchase Agreements (the “Purchase Agreements”).

The July and September Notes accrue simple interest at a rate of 10% per annum and are due and payable on the one-year anniversary of the July and September Note Issue Dates. The July and September Notes and all accrued unpaid interest thereon shall automatically convert into units (the “Units”) issued by the Company in a subsequent offering (the “Subsequent Offering”) at a rate that is equal to (a) two shares (the “Subsequent Offering Shares”) of the Company’s common stock and (b) two warrants including (1) a 1 year warrant (each, an “A Warrant” and collectively, the “A Warrants”) to purchase two shares of common stock at an exercise price of $0.50 per share and (2) a 5 year warrant (each, a “B Warrant” and collectively, the “B Warrants” and together with the A Warrants the “Subsequent Offering Warrants”) to purchase one share of common stock at an exercise price of $0.75 per share for each $1.00 invested in the Subsequent Offering or on such other terms and conditions as may be determined by the Company; provided however that such terms shall be consistent with the terms of the Subsequent Offering.

In the event the Subsequent Offering does not take place within 120 days of the July and September Note Issue Dates, the July and September Notes will be convertible by the July and September Noteholders at their option for the 60 days thereafter. The rate of conversion will be for each $100,000 of principal and interest converted (or portion thereof), the July and September Noteholders will receive 200,000 shares (the “Optional Conversion Shares”) of common stock of the Company and a warrant (the “Optional Conversion Warrant”) to purchase 150,000 shares of common stock, which warrant will be exercisable at $1.10 for a period of five years, subject to proportionate adjustments for stock splits, combinations, stock dividends and other recapitalization events.

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In the event of a Fundamental Transaction (as defined and described in detail in the July and September Notes), the Company shall pay, then upon any subsequent conversion of the July and September Notes, July and September Noteholders shall have the right to receive, for each Subsequent Offering Share, Subsequent Offering Warrant, Optional Conversion Share and/or Optional Conversion Warrant that would have been issuable upon such conversion absent such Fundamental Transaction, the same kind and amount of securities, cash or property as it would have been entitled to receive upon the occurrence of such Fundamental Transaction if it had been, immediately prior to such Fundamental Transaction, the holder of one share of common stock and a warrant to purchase one share of common stock.

The July and September Notes and the July and September Noteholder Warrants were issued to accredited investors in accordance with Rule 506 of Regulation D under the Securities Act in that the Company did not engage in any general advertisement or general solicitation in connection with the offering of the July and September Notes and the July and September Noteholder Warrants, and the Company was available to answer any questions from any purchaser. Cash commissions were not paid in connection with the sale of the July and September Notes and the July and September Noteholder Warrants.

Issuance of Note and Warrant Purchase Agreement

On August 6, 2013, the Company entered into the Note and Warrant Purchase Agreement (the “Summit Agreement”) with Summit Resources, Inc. (“Summit”), an affiliate of Steve Antoline, a director of the Company pursuant to which Summit acquired (a) a promissory note (the “Summit Note”) in an aggregate principal amount of $600,000 and (b) a five year warrant to purchase up to an aggregate of 250,000 shares of common stock for each $150,000 borrowed of common stock at an exercise price of $1.10 per share for up to a maximum of 1,000,000 shares of common stock as consideration for up to $600,000 in advances made or to be made, which was fully advanced to the Company as of September 30, 2013. In accordance with the terms of the Summit Agreement, up to $150,000 of the gross proceeds received by the Company from the sale of each LAESI instrument, beginning with the sale of the fourth LAESI instrument sold following the effective date, shall be used to repay the principal amounts due under the Summit Note.

The Company issued a warrant to purchase up to 1,000,000 shares of common stock in connection with the Summit Agreement as of August 6, 2013. The Summit Note and related warrant were issued pursuant to the exemption from registration provided by Section 4(2) of the Securities Act in that the investor was the sole offeree, had access to all information concerning the Company that was requested and the Company did not engage in any general solicitation. Cash commissions were not paid in connection with the sale of the Summit Note and the related Warrant.

Options

During the quarter ended September 30, 2013, the Company granted options to purchase an aggregate of 252,000 shares of common stock in connection with the Company’s 2013 Equity Incentive Plan at an exercise price of $0.55 per share.

Item 3. Defaults Upon Senior Securities.

Not applicable

Item 4. Mine Safety Disclosure.

Not applicable.

Item 5. Other Information.

Not applicable

Item 6. Exhibits.

(a) Exhibits required by Item 601 of Regulation S-K.

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Exhibit No.		Description
3.1		Certificate of Incorporation (incorporated by reference from Exhibit 3.1 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on June 24, 2013).
3.2		Certificate of Amendment to the Certificate of Incorporation of Protea Biosciences Group, Inc. (incorporated by reference from Exhibit 3.1 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on June 24, 2013).
3.3		Bylaws (incorporated by reference from Exhibit 3.2 to the registrant’s Form 10-SB filed with the Securities and Exchange Commission on August 3, 2005).
3.4		Certificate of Ownership and Merger filed with the Office of Secretary of State of Delaware on September 2, 2011 (incorporated by reference to the registrant's Form 8-K filed with the Securities and Exchange Commission on September 9, 2011).
4.1		Form of Warrants issued to the Existing Noteholders (incorporated by reference from Exhibit 10.2 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on July 23, 2013).
4.2		Form of Note issued to the July and September Noteholders (incorporated by reference from Exhibit 10.4 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on July 23, 2013).
4.3		Form of Warrant issued to the July and September Noteholders (incorporated by reference from Exhibit 10.5 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on July 23, 2013).
4.4		Form of Convertible Promissory Note Addendum No. 3 (incorporate by reference from Exhibit 10.2 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on August 12, 2013).
10.1		Form of Conversion Agreements by and between the Company and the Existing Noteholders (incorporated by reference from Exhibit 10.1 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on July 23, 2013).
10.2		Form of Purchase Agreement issued to the July and September Noteholders (incorporated by reference from Exhibit 10.3 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on July 23, 2013).
31.1		Certification of the Company’s Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, with respect to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013.
31.2		Certification of the Company’s Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, with respect to the registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013.
32.1		Certification of the Company’s Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of the Company’s Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

EX-101.INS		XBRL Instance Document
EX-101.SCH		XBRL Taxonomy Extension Schema
EX-101.CAL		XBRL Taxonomy Extension Calculation Linkbase
EX-101.DEF		XBRL Taxonomy Extension Definition Linkbase
EX-101.LAB		XBRL Taxonomy Extension Label Linkbase
EX-101.PRE		XBRL Taxonomy Extension Presentation Linkbase

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	PROTEA BIOSCIENCES GROUP, INC.

Dated: November 13, 2013	By:	/s/ Stephen Turner
		Stephen Turner
		President and Director
		Principal Executive Officer

	By:	/s/ Edward Hughes
		Edward Hughes
		Chief Financial Officer
		Principal Financial Officer

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Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. junior Avg

Protea Biosciences Inactive 10-Q2013 Q3 Quarterly report

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