Protea Biosciences 10-Q 2014 Q1 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 March 31, 2014

OR

¨ 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 26505

(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. Yesx   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. YesxNo¨

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¨ Nox

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:65,705,083 shares of common stock, par value $.0001 per share, outstanding as of May 9, 2014.

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
	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	23
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	29
Item 4.	Controls and Procedures	29
PART II – OTHER INFORMATION :
Item 1.	Legal Proceedings	30
Item 1A.	Risk Factors	30
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	30
Item 3.	Defaults Upon Senior Securities	31
Item 4.	Mine Safety Disclosures	31
Item 5.	Other Information	31
Item 6.	Exhibits	31
Signatures		32

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 March 31, 2014 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 31, 2014.

1

PROTEA BIOSCIENCES GROUP, INC.

(A DEVELOPMENT STAGE ENTERPRISE)

Consolidated Balance Sheets

See Accompanying Notes to Financial Statements

	March 31, 2014 (unaudited)			December 31, 2013
ASSETS
Current Assets:
Cash and cash equivalents	$	313,286		$	1,086,330
Trade accounts receivable		115,346			216,864
Other receivables		436,871			435,278
Inventory		553,363			465,334
Prepaid expenses		134,622			304,696
Total current assets		1,553,488			2,508,502
Property and equipment, net		3,324,753			2,886,176
Other noncurrent assets		23,231			23,249
Total Assets	$	4,901,472		$	5,417,927
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Current maturities on short and long-term debt	$	1,221,218		$	1,054,053
Accounts payable		1,671,512			759,021
Bank line of credit		3,000,000			2,725,000
Loans payable to stockholders, net of discount		1,070,883			465,883
Obligation related to the letter of credit, net of discount		69,827			151,981
Other payables and accrued expenses		862,500			1,069,167
Total current liabilities		7,895,940			6,225,105
Option fee		300,000			-
Long-term debt - net of current portion		1,754,296			1,580,260
Derivative Liabilities		557,665			623,587
Noncurrent Liabilities		2,311,961			2,203,847
Commitments and contingencies		-			-
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; 65,467,735 and 65,442,735 shares issued and outstanding at March 31, 2014 and December 31, 2013)		6,547			6,545
Additional paid in capital		55,487,576			55,351,613
Deficit accumulated during development stage		(61,124,486	)		(58,392,348	)
Accumulated other comprehensive income (loss)		23,934			23,165
Total Stockholders' Equity (Deficit)		(5,606,429	)		(3,011,025	)
Total Liabilities and Stockholders' Equity	$	4,901,472		$	5,417,927

2

PROTEA BIOSCIENCES GROUP, INC.

(A DEVELOPMENT STAGE ENTERPRISE)

Consolidated Statements of Comprehensive Loss (Unaudited)

See Accompanying Notes to Financial Statements

	For the Three Months Ended March 31,			For the Three Months Ended March 31,			Period from July 13, 2001 (date
	2014			2013			of inception) to March 31, 2014
Gross revenue	$	468,100		$	481,615		$	5,184,447
Selling, general, administrative expenses		(2,353,441	)		(2,047,633	)		(33,836,855	)
Research and development expense		(721,953	)		(863,603	)		(29,256,678	)
Loss from operations		(2,607,294	)		(2,429,621	)		(57,909,086	)
Other income (expense):
Interest and exchange income (expense)		165			(2,178	)		56,212
Interest expense		(166,163	)		(158,255	)		(2,942,776	)
Debt conversion cost		-			-			(724,623	)
Gain on debt settlement		-			-			13,834
Loss on asset disposal		(24,768	)		(15,773	)		(63,955	)
Derivative income		65,922			-			445,908
Total other income (expense)		(124,844	)		(176,206	)		(3,215,400	)
Loss before income taxes		(2,732,138	)		(2,605,827	)		(61,124,486	)
Income taxes		-			-			-
Net loss		(2,732,138	)		(2,605,827	)		(61,124,486	)
Foreign currency translation adjustment		769			(11,520	)		23,934
Total comprehensive loss	$	(2,731,369	)	$	(2,617,347	)	$	(61,100,552	)
Net loss per share - basic and diluted	$	(0.04	)	$	(0.08	)	$	(4.19	)
Weighted average number of shares outstanding - basic and diluted		65,455,791			34,517,601			14,569,103

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, 2013		65,442,735	$	6,545	$	55,351,613		$	(58,392,348	)	$	23,165	$	(3,011,025	)
Issuance costs of $12,500				-		(12,500	)		-			-		(12,500	)
Issuance of stock for services		25,000		2		12,498			-			-		12,500
Stock-based compensation expense		-		-		117,989			-			-		117,989
Stock warrants issued for services		-		-		17,976			-			-		17,976
Net loss		-		-		-			(2,732,138	)		-		(2,732,138	)
Foreign currency translation adjustment		-		-		-			-			769		769
March 31, 2014		65,467,735	$	6,547	$	55,487,576		$	(61,124,486	)	$	23,934	$	(5,606,429	)

4

PROTEA BIOSCIENCES GROUP, INC.

(A DEVELOPMENT STAGE ENTERPRISE)

Consolidated Statements of Cash Flows (Unaudited)

See Accompanying Notes to Financial Statements

	For the Three Months			For the Three Months
	Ended March 31,			Ended March 31,			Period from July 13, 2001 (date
	2014			2013			of inception) to March 31, 2014
Cash flows from operating activities:
Net loss	$	(2,732,138	)	$	(2,605,827	)	$	(61,124,486	)
Adjustments to reconcile net loss to net cash from operating activities:
Depreciation and amortization		206,046			204,752			5,449,428
Non-cash compensation		117,989			76,657			2,517,133
Issuance of common stock and warrants for services		30,476			25,000			905,292
Issuance of common stock for accrued interest		-			-			833,432
Accretion of convertible debenture discount		65,706			5,608			396,386
Debt conversion costs associated with inducement		-			-			724,623
Loss on disposal of fixed assets		24,768			16,100			63,955
Bad debt expense		2,000			-			36,032
(Income) Expense from change in value of derivative		(65,922	)		-			(445,908	)
Net change in assets and liabilities:
Decrease (increase)
Trade accounts receivable		99,518			(276,192	)		(151,378	)
Prepaid expenses		170,074			(20,475	)		(134,622	)
Other receivables		(1,575	)		(3,163	)		26,224
Inventory		(88,029	)		304,473			(553,363	)
Increase (decrease)
Trade accounts payable		657,438			(1,029,659	)		1,058,150
Other payables and accrued expenses		(206,665	)		440,526			862,501
Option fee		300,000			-			300,000
Net cash used in operating activities		(1,420,314	)		(2,862,200	)		(49,236,601	)
Cash flows from investing activities:
Purchase of and deposits on equipment		(51,935	)		(9,500	)		(5,022,308	)
Proceeds from sale of equipment		-			-			48,450
Net cash used in investing activities		(51,935	)		(9,500	)		(4,973,858	)
Cash flows from financing activities:
Net advances on bank line of credit		275,000			-			3,000,000
Proceeds from sale of common stock, net		(12,500	)		2,144,526			35,108,347
Proceeds from short and long-term debt		-			-			13,624,500
Proceeds from shareholder debt		605,000			225,000			5,003,216
Repayment of long-term debt		(21,204	)		(24,832	)		(2,322,700	)
Proceeds from Obligation related to the Letter of Credit		-			600,000			600,000
Repayment of Obligation related to the Letter of Credit		(147,860	)		-			(509,165	)
Financing costs		-			-			(4,387	)
Net cash provided by financing activities		698,436			2,944,694			54,499,811
Effect of exchange rate changes on cash		769			(11,520	)		23,934
Net increase (decrease) in cash		(773,044	)		61,474			313,286
Cash, beginning of period		1,086,330			27,604			-
Cash, end of period	$	313,286		$	89,078		$	313,286
Supplemental disclosure of cash flow information:
Cash paid during the period for interest	$	64,630		$	45,714		$	1,691,031
Supplemental disclosure of non-cash investing and financing activities:
Financed equipment	$	617,457		$	-		$	3,886,181
Debt converted to company stock	$	-		$	-		$	15,273,658

5

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

Notes to Consolidated Financial Statements – (Unaudited)

1. Description of Company and Nature of Business

Protea Biosciences Group, Inc. (referred to as “Protea”, “the Company”, “we”, “us” and “our”) is a commercial stage, molecular information company incorporated in the state of Delaware on May 24, 2005. “Molecular information” is the identification and characterization of the proteins, metabolites and other biomolecules, which are the products of all living cells and life forms. The Company is applying its technology to the development of next generation, “direct molecular imaging” technology and service capabilities that it believes enable more rapid and comprehensive molecular profiling of living cells and biofluids, thereby providing better molecular information that helps to define normal and disease processes. We believe that our proprietary technology is useful to support medical research and pharmaceutical development. The Company’s technologies enable the direct molecular imaging of the proteins, metabolites and other biomolecules that regulate the biological functions of the human body and all other forms of life. Management believes this is a critical area of research, as pharmaceutical research is in need of direct molecular imaging to improve and accelerate the development of new therapeutics and diagnostic tests.

The consolidated balance sheet presented as of December 31, 2013, 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 2013 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 loss from operations since inception had an accumulated deficit at March 31, 2014 of approximately $58 million and at December 31, 2013 of approximately $55 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 and to develop new products and services based upon its proprietary protein recovery and identification technologies.

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. These factors raise substantial doubt about the Company’s ability to continue as a going-concern.

2. Summary of Significant Accounting Policies

The accounting policies underlying the accompanying unaudited consolidated financial statements are those set forth in Note 2 to the consolidated financial statements included in the Company’s 10-K for the year ended December 31, 2013.

Revenue Recognition

We follow the provisions of FASB ASC 605, “Revenue Recognition”. We recognize revenue of products when persuasive evidence of a sale arrangement exists, the price to the buyer is fixed or determinable, delivery has occurred /title has passed, and collectability of the sales price is reasonably assured. The Company recognizes revenue from the sale of its ProteaPlot™ software when bundled with the LAESI platform, which facilitates operating the instrument and storage and display of datasets. The Company also recognizes revenue of standalone sales of ProteaPlot™, which generally consists of additional user licenses.

6

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

Notes to Consolidated Financial Statements (unaudited)

2. Summary of Significant Accounting Policies(continued)

We account for shipping and handling costs in accordance with the provisions of FASB ASC 605-45-45, “Revenue Recognition – Principal Agent Considerations”, which requires all amounts charged to customers for shipping and handling to be classified as revenues. Shipping and handling costs charged to customers are recorded in the period the related product sales revenue is recognized.

Regarding short-term service contracts, the majority of these service contracts involve the processing of imaging and bioanalytical samples for pharmaceutical and academic/clinical research laboratories. These contracts generally provide for a fixed fee for each method developed or sample processed and revenue is recognized when the analysis is complete and a report is delivered.

For longer-term contracts involving multiple elements, the items included in the arrangement (deliverables) are evaluated to determine whether they represent separate units of accounting. We perform this evaluation at the inception of an arrangement and as each item in the arrangement is delivered. Generally, we account for a deliverable (or a group of deliverables) separately if: (i) the delivered item(s) have standalone value to the customer, and the delivery or performance of the service(s) is probable and substantially in our control. Revenue on multiple revenue arrangements is recognized using a proportional method for each separately identified element. All revenue from contracts determined not to have separate units of accounting is recognized based on consideration of the most substantive delivery factor of all the elements in the contract or, if there is no predominant deliverable, upon delivery of the final element of the arrangement.

Revenues from grants are based upon internal costs that are specifically covered by the grants, and where applicable, an additional facilities and administrative rate that provides funding for overhead expenses. These revenues are recognized when expenses have been incurred by the Company that is related to the grants.

The Company has revenue from four major components: molecular information services, LAESI instrument platform, research products, and grants and other collaboration revenues. Revenue by component was as follows:

	Three Months Ended
	March 31, 2014		March 31, 2013
Molecular Information Services	$	170,570	$	70,730
LAESI Instrument Platform		178,000		296,694
Research Products		95,342		114,191
Grants and Other Collaborations		24,188		-
Gross Revenue	$	468,100	$	481,615

Other Receivables

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

	March 31, 2014		December 31, 2013
French government R&D credit	$	399,971	$	400,379
French payroll taxes receivable		36,900		34,899
Other receivables – current	$	436,871	$	435,278
Deposits	$	23,231	$	23,249
Other receivables – noncurrent	$	23,231	$	23,249

7

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

Notes to Consolidated Financial Statements (unaudited)

2. Summary of Significant Accounting Policies(continued)

Other Payables and Accrued Expenses

Other payables and accrued expenses, which reflect amounts due from non-trade activity, consist of the following at:

	March 31, 2014		December 31, 2013
Accrued expenses	$	411,688	$	653,047
Accrued interest		75,738		39,911
Accrued warranties		97,500		81,250
Accrued payroll and benefits		275,374		286,979
Unearned revenue		2,200		7,980
Other payables and accrued expenses	$	862,500	$	1,069,167

Derivative Liabilities

The Company does not use derivative instruments to hedge exposures to cash flow, market or foreign currency risks; however, the Company has certain financial instruments that are embedded derivatives associated with capital raises and common stock purchase warrants. The Company evaluates all its financial instruments to determine if those contracts or any potential embedded components of those contracts qualify as derivatives to be separately accounted for in accordance with FASB ASC 810-10-05-4 and 815-40. This accounting treatment requires that the carrying amount of any embedded derivatives be recorded at fair value at issuance and marked-to-market at each balance sheet date. In the event that the fair value is recorded as a liability, as is the case with the Company, the change in the fair value during the period is recorded as either income or expense. Upon conversion or exercise, the derivative liability is marked to fair value at the conversion date and then the related fair value is reclassified to equity.

Fair value of financial assets and liabilities – Derivative Instruments

We measure the fair value of financial assets and liabilities in accordance with GAAP, which defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements.

GAAP defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. GAAP also establishes the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The three levels of inputs used to measure fair value:

Level 1 – quoted prices in active markets for identical assets or liabilities.

Level 2 – quoted prices for similar assets and liabilities in active markets or inputs that are observable.

Level 3 – inputs that are unobservable (for example, the probability of a capital raise in a “binomial” methodology for valuation of a derivative liability directly related to the issuance of common stock warrants).

The Company has entered into certain financial instruments and contracts such as, equity financing arrangements for the issuance of common stock, which include anti-dilution arrangements and detachable stock warrants that are i) not afforded equity classification, ii) embody risks not clearly and closely related to host contracts, or iii) may be net-cash settled by the counterparty. These instruments are recorded as derivative liabilities, at fair value at the issuance date. Subsequent changes in fair value are recorded through the statement of operations.

8

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

Notes to Consolidated Financial Statements (unaudited)

2. Summary of Significant Accounting Policies(continued)

The Company’s derivative liabilities are related to common stock issuances, detachable common stock purchase warrants (“warrants”) issued in conjunction with debt and common stock, or warrants issued to placement agents for financial instrument issuances. We estimate fair values of the warrants that contain anti-dilution or “Down Round Protections” utilizing valuation models and techniques that have been developed and are widely accepted that take into account the additional value inherent in “Down Round Protection.” These widely accepted techniques include “Modified Binomial”, “Monte Carlo Simulation” and the “Lattice Model.” The “core” assumptions and inputs to the “Binomial” model are the same as for “Black-Scholes”, such as trading volatility, remaining term to maturity, market price, strike price, and risk free rates; all Level 2 inputs.  Fair value measurements are classified according to the lowest level input or value-driver that is significant to the valuation. A measurement may therefore be classified within Level 3 even though there may be significant inputs that are readily observable. However, a key input to a “Binomial” model (in our case, the “Monte Carlo Simulation”, for which we engaged an independent valuation firm to perform) is the probability of a future capital raise.  By definition, this input assumption does not meet the requirements for Level 1 or Level 2 outlined above; therefore, the entire fair value calculation is deemed to be Level 3 under accounting requirements due to this single Level 3 assumption. This input to the Monte Carlo Simulation model was developed with significant input from management based on its knowledge of the business, current financial position and the strategic business plan with its best efforts.

As discussed above, financial liabilities are considered Level 3 when their fair values are determined using pricing models or similar techniques and at least one significant model assumption or input is unobservable.  For the Company, the Level 3 financial liability is the derivative liability related to the common stock and warrants that include “Down Round Protection” and they were valued using the “Monte Carlo Simulation” technique.  This technique, while the majority of inputs are Level 2, necessarily incorporates a Capital Raise Assumption which is unobservable and, therefore, a Level 3 input.  A range of key quantitative assumptions related to the common stock and warrants that include “Down Round Protection” are as follows:

	March 31, 2014
	Expected Life (Years)	Risk Free Rate			Volatility			Probability of a Capital Raise
Derivative liabilities	<1 – 4.75		0.93	%		80.23	%		100	%

Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis

The Company’s derivative liabilities are related to common stock issuances, detachable warrants issued in conjunction with debt and common stock, or warrants issued to the placement agents for financial instrument issuances. The derivative liabilities measured at fair value on a recurring basis are summarized below:

	Fair Value Measurements at March 31, 2014
	Carrying Value		Level 1		Level 2		Level 3
Derivative liabilities – common stock	$	464,506		-		-	$	464,506
Derivative liabilities – warrants		93,159		-		-		93,159
Total	$	557,665		-		-	$	557,665

	Fair Value Measurements at December 31, 2013
	Carrying Value		Level 1		Level 2		Level 3
Derivative liabilities – common stock	$	558,799		-		-	$	558,799
Derivative liabilities – warrants		64,788		-		-		64,788
Total	$	623,587		-		-	$	623,587

9

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

Notes to Consolidated Financial Statements (unaudited)

2. Summary of Significant Accounting Policies(continued)

The table below provides a summary of the changes in fair value of the derivative liabilities measured at fair value on a recurring basis:

	Three Months Ended March 31, 2014
	Derivative Liabilities - Common Stock			Derivative Liabilities - Warrants		Total Fair Value Measurements Using Level 3 Inputs
Balance at January 1, 2014	$	558,799		$	64,788	$	623,587
Issuance of warrants		-			-		-
Unrealized (gain) loss on derivative liabilities		(94,293	)		28,371		(65,922	)
Recognition of derivative liabilities		-			-		-
Balance at March 31, 2014	$	464,506		$	93,159	$	557,665

	Year Ended December 31, 2013
	Derivative Liabilities - Common Stock			Derivative Liabilities - Warrants			Total Fair Value Measurements Using Level 3 Inputs
Beginning balance at January 1, 2013	$	-		$	-		$	-
Issuance of warrants		-			45,685			45,685
Unrealized (gain) loss on derivative liabilities		(257,846	)		(122,140	)		(379,986	)
Recognition of derivative liabilities		816,645			141,243			957,888
Balance at December 31, 2013	$	558,799		$	64,788		$	623,587

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 60,826,000 and 56,711,000 at March 31, 2014 and December 31, 2013, respectively.

RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS:

None

3. Inventory

Inventory represents finished goods and work in progress. Finished goods and work in progress consist primarily of specifically identifiable items that are valued at the lower of cost or fair market value using the first-in, first-out (FIFO) method. Inventory consists of the following at:

Inventory:	March 31, 2014		December 31, 2013
Finished goods	$	217,667	$	360,607
Work in progress		335,696		104,727
Total Inventory	$	553,363	$	465,334

10

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

Notes to Consolidated Financial Statements (unaudited)

4. Property and Equipment

Property and equipment and leasehold improvements are capitalized at cost and depreciated using the straight-line method (the Company used the double-declining balance method for property and equipment placed in service prior to January 2011) over estimated lives as follows:

Equipment	5 - 10 years
Vehicle	5 years
Leasehold improvements	3 years
Software	3 years

Property and equipment consists of the following at:

	March 31, 2014			December 31, 2013
Lab equipment	$	7,222,196		$	6,620,662
Computer equipment		600,318			563,976
Office equipment and vehicle		248,490			248,490
Leasehold improvements		477,682			477,682
		8,548,686			7,910,810
Accumulated depreciation		(5,223,933	)		(5,024,634	)
Property and equipment, net	$	3,324,753		$	2,886,176

For the three months ended March 31, 2014, depreciation expense was $206,046 compared to $204,752 for the three months ended March 31, 2013.

5. Bank Line of Credit

The Company has a line of credit that is authorized to $3,000,000 and 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 March 31, 2014, the balance was $3,000,000 compared to $2,725,000 at December 31, 2013 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.

6. Loans Payable to Stockholders

On August 6, 2013, the Company entered into the Note and Warrant Purchase Agreement (the “Summit Agreement”) with Summit, an affiliate of Steve Antoline, a director of the Company, pursuant to which Summit acquired (a) a promissory note (the “Summit Note”) bearing simple interest at a rate of 10% per annum, in an aggregate principal amount of $600,000 and (b) a five year warrant to purchase 1,000,000 shares of common stock at an exercise price of $1.10 per share. The fair value of these warrants was estimated to be $134,117, which was recorded as a discount to the promissory note, and will be accreted based on the repayment of the obligation. No accretion expense was recognized during the three months ended March 31, 2014 or in 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 shall be used to repay the principal amounts due under the Summit Note.

On March 5, 2014, the Company received advances equal to an aggregate of $30,000 from Stanley Hostler, a director of the Company. No terms of repayment have been specified on the aforementioned advances as of the filing date.

On March 17, 2014, the Company received an advance equal to $175,000 from El Coronado Holdings, Inc. (“El Coronado”). Josiah Austin is the managing member of El Coronado and a director of the Company. On April 2, 2014, in exchange for the advance, the Company entered into a Note Purchase Agreement, and issued a convertible one-year promissory note to El Coronado, in the aggregate principal amount of $175,000 to accrue simple interest at the rate of 10% per annum. Each $100,000 of outstanding principal and accrued unpaid interest underlying the note is automatically convertible into units consisting of 181,818 shares of common stock and warrants to purchase 109,091 shares of common stock at an exercise price of $0.80 per share or such alternate conversion rate as shall be consistent with the terms of a subsequent financing of the Company of at least $2 million in gross proceeds. (See Note 18, Subsequent Events.)

11

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

Notes to Consolidated Financial Statements (unaudited)

6. Loans Payable to Stockholders(continued)

On March 26, 2014 and April 10, 2014, the Company received an advance equal to $400,000 and $200,000 respectively from Summit Resources, Inc. (“Summit”). On April 2 and April 11, 2014, in exchange for advances, the Company entered into a Note and Warrant Purchase Agreement and issued (a) one-year promissory notes to Summit in an aggregate principal amount of up to $600,000 to accrue simple interest at the rate of 10% per annum and (b) five-year warrants to purchase up to 600,000 shares of common stock at an exercise price of $0.80 per share. (See Note 18, Subsequent Events.)

7. Obligation Related to the Letter of Credit

On March 6, 2013, the Company entered into a Warrant Purchase and Reimbursement Agreement, (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 (a) 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 (b) a five-year warrant to purchase up to 1,100,000 shares of common stock, issued to an affiliate of Mr. Antoline. The fair value of these warrants was estimated to be $138,763, which was recorded as a discount to the Reimbursement Agreement balance of $600,000, and has been accreted based on the repayment of the obligation. Accretion expense of $34,196 was recognized during the three months ended March 31, 2014 while $83,559 was recognized in 2013. During the first quarter of 2013, MPR drew $600,000 against the Letter of Credit.

On June 14, 2013, the Company received $147,860 as payment for one of the LAESI instruments. The Company and Mr. Antoline entered into an Addendum to the Reimbursement Agreement whereby the Company could use the funds for up to 80 days or until September 1, 2013. The Addendum was further amended to extend the maturity date until December 31, 2013. For the period the funds were used by the Company, the balance accrued simple interest of 10% per annum. 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. The fair value of these warrants was estimated to be $31,510, which was recorded as a discount to the Addendum balance of $147,860. During the three months ended March 31, 2014, the Addendum was paid in full and $31,510 of accretion expense was recognized. No accretion expense was recognized in 2013. As of March 31, 2014, $90,835 was due in connection with the terms of the Reimbursement Agreement compared to $238,695 as of December 31, 2013. Subsequent to March 31, 2014, the Reimbursement Agreement was paid in full.

8. Long-term Debt

1) Note Payable to the West Virginia Development Office (“WVDO”)

In March 2007, the Company obtained an 8-year loan in the amount of $685,000 from the WVDO. 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. As of March 31, 2014, the Company was in arrears on the note. The repayment terms were modified, whereby the WVDO approved a deferral of principal and interest until June 30, 2014.

2) Note Payable to the West Virginia Economic Development Authority (“WVEDA”)

In August 2009, the Company obtained a 10-year loan in the amount of $242,631 from the WVEDA. 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. As of March 31, 2014, the Company was in arrears on the note. The repayment terms were modified, whereby the WVEDA approved a deferral of principal and interest until May 31, 2014.

3) Note Payable to the West Virginia Infrastructure and Jobs Development Council (“WVIJDC”)

In August 2009, the Company obtained a 10-year loan in the amount of $242,630 from the WVIJDC. 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. As of March 31, 2014, the Company was in arrears on the note. The repayment terms were modified, whereby the WVIJDC approved a deferral of principal and interest until June 30, 2014.

12

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

Notes to Consolidated Financial Statements (unaudited)

8. Long-term Debt(continued)

4) Note Payable to the West Virginia Economic Development Authority (“WVEDA”)

In October 2010, the Company issued a 10-year note in the amount of $900,000 from the WVEDA. 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. As of March 31, 2014, the Company was in arrears on the note. The repayment terms were modified, whereby the WVEDA approved a deferral of principal and interest until May 31, 2014.

5) Note Payable to the West Virginia Infrastructure and Jobs Development Council (“WVIJDC”)

In December 2010, the Company issued a 10-year note in the amount of $900,000 from the WVIJDC. 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. As of March 31, 2014, the Company was in arrears on the note. The repayment terms were modified, whereby the WVIJDC approved a deferral of principal and interest until June 30, 2014.

6) Convertible Promissory Note Payable to the West Virginia Jobs Investment Trust Board (“WVJITB”)

In March 2012, the Company issued an 18-month note in the amount of $290,000 from the WVJITB. 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 has an adjustable conversion price, initially $2.00 per share, and includes a stock warrant for 72,500 shares (see Note 9, Stock Warrants). On December 13, 2013, the Company and the WVJITB entered into a Loan Modification Agreement whereby the maturity date changed from September 14, 2013 to $100,000 due on March 15, 2014 and the remaining $190,000 due on June 15, 2014. The WVJITB and the Company signed two addendums to the note extending the maturity date and deferring interest and principal payments until June 15, 2014. C. Andrew Zulauf, an executive member of the WVJITB, is a board member of the Company.

7) Convertible Promissory Note Payable to the West Virginia Jobs Investment Trust Board (“WVJITB”)

In April 2012, the Company issued a 3-month note in the amount of $400,000 from the WVJITB. 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). The WVJITB and the Company have signed several addendums to the note extending the maturity date and reducing the price of converting into common shares to $0.50 per share. The WVJITB further extended the maturity date until November 29, 2013, with a $100,000 principal payment due on or before November 15, 2013. The Company repaid the $100,000 as agreed, which reduced the principal outstanding balance to $300,000. The WVJITB and the Company signed three addendums to the note extending the maturity date and deferring interest and principal payments until June 15, 2014. C. Andrew Zulauf, an executive member of the WVJITB, is a board member of the Company.

8) Convertible Promissory Note Payable to the West Virginia High Technology Consortium Foundation (“WVHTCF”)

In May 2012, the Company issued a 30-month note in the amount of $200,000 from the WVHTCF. 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. As of March 31, 2014, the Company was in arrears on the note. The repayment terms were modified, whereby the West Virginia High Technology Consortium Foundation approved a deferral of principal and interest until May 31, 2014.

9) Note Payable to the West Virginia Economic Development Authority (“WVEDA”)

In June 2012, the Company issued a 10-year note in the amount of $200,000 from the WVEDA. 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. As of March 31, 2014, the Company was in arrears on the note. The repayment terms were modified, whereby the West Virginia Economic Development Authority approved a deferral of principal and interest until May 31, 2014.

13

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

Notes to Consolidated Financial Statements (unaudited)

8. 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 March 31, 2014, 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 April 2014 through May 2017. These leases are secured by equipment with an aggregate cost of $930,120. As of March 31, 2014, the Company was in arrears on three capital leases. Subsequent to March 31, 2014, one capital lease was paid in full. This lease was secured by equipment costing $95,527.

Total debts outstanding are as follows:

		March 31, 2014			December 31, 2013
1)	Note Payable to the WVDO	$	123,744		$	123,744
2)	Note Payable to the WVEDA		147,306			147,306
3)	Note Payable to the WVIJDC		145,078			145,078
4)	Note Payable to the WVEDA		639,085			639,085
5)	Note Payable to the WVIJDC		651,913			651,913
6)	Note Payable to the WVJITB		290,000			290,000
7)	Note Payable to the WVJITB		300,000			300,000
8)	Note Payable to the WVHTCF		95,178			95,178
9)	Note Payable to the WVEDA		170,932			170,932
10)	Capital leases		412,278			71,077
	Total		2,975,514			2,634,313
	Less: current portion		(1,221,218	)		(1,054,053	)
	Long-term portion	$	1,754,296		$	1,580,260

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

Year Ending December 31:	Future Required Minimum Principal Repayments
2014	$	1,104,334
2015		390,360
2016		360,217
2017		345,839
2018 & Thereafter		774,764
Total	$	2,975,514

9. 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 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 are as follows:

	# Shares Issued		Par Value		Price Per Share		Gross Proceeds		Value of Services Obtained		Par Value		Additional Paid in Capital (1)
Balance at December 31, 2013		65,442,735	$	.0001		Various	$	53,694,771	$	829,132	$	6,545	$	54,517,358
Issuance of stock (2)		25,000		.0001	$	0.50		-		12,500		2		12,498
Balance at March 31, 2014		65,467,735					$	53,694,771	$	841,632	$	6,547	$	54,529,856

(1) Activity does not include issuance costs, deferred financing, warrants portion of convertible debentures and stock options.

(2) Shares issued for services performed and did not contain an anti-dilution provision

14

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

Notes to Consolidated Financial Statements (unaudited)

10. 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.

11. 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.

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, 2013		5,082,750		$	1.11		7.02
Granted		1,304,500		$	0.55
Exercised		-			-
Cancelled or expired		(87,500	)	$	1.50
Outstanding at March 31, 2014		6,299,750		$	1.05		6.95
Exercisable at December 31, 2013		4,005,583		$	1.20		6.52
Exercisable at March 31, 2014		4,400,207		$	1.15		6.35

The following table summarizes information about stock options at March 31, 2014:

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						115,063
$0.55		2,997,500						1,274,582
$0.80		320,000						320,000
$1.25		310,000						310,000
$1.50		2,298,500						2,175,187
$2.00		214,750						205,375
$0.50 - $2.00		6,299,750		6.95	$	1.05		4,400,207	$	1.15

At March 31, 2014 and December 31, 2013, 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 March 31, 2014 and December 31, 2013. In 2014 and 2013, no options were exercised.

15

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

Notes to Consolidated Financial Statements (unaudited)

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

The following table summarizes the activity of the Company’s stock options that have not vested:

	Shares			Weighted Average Grant-date Fair Value
Nonvested at December 31, 2013		1,077,167		$	0.467
Granted		1,122,751		$	0.205
Forfeited		(87,500	)	$	1.027
Vested		(212,875	)	$	0.566
Nonvested at March 31, 2014		1,899,543		$	0.203

The fair value of non-vested options to be recognized in future periods is $296,831, which is expected to be recognized over a weighted average period of 2 years. The total fair value of options vested during the three months ended March 31, 2014 was $117,989 compared to $76,657 for the three months ended March 31, 2013.

Stock-based compensation expense is as follows:

	Three Months Ended
	March 31, 2014		March 31, 2013
Selling, general, and administrative expense	$	111,286	$	70,754
Research and development expense		6,703		5,903
Total stock-based compensation expense	$	117,989	$	76,657

The weighted average grant-date fair value of options granted during the three months ended March 31, 2014 was $0.205 and for the three months ended March 31, 2013 was $0.112 per option. The fair value of the option grants was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Three Months Ended
	March 31, 2014			March 31, 2013
Weighted average risk-free interest rate		2.35	%		0.14	%
Volatility factor		73.56	%		24 - 73%
Weighted average expected life (in years)		7			7
Dividend rate		0.0	%		0.0	%

The Company utilizes a peer group to estimate its expected volatility assumptions used in the Black-Scholes option-pricing model. The Company completed an analysis and identified four similar companies considering their industry, stage of life cycle, size, and financial leverage. 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).

12. Stock Warrants

From 2008 through 2014, the Company has issued warrants to purchase shares of common stock. The warrants are exercisable for five years from date of issuance and are exercisable at exercise prices that range from $0.50 to $2.25 per share.

During 2013, the Company issued warrants mostly in connection with common stock issuances. The warrants are exercisable one or five years from date of issuance. The exercise price is $0.50 to $1.10 per share. The warrant allows the holder to purchase shares of common stock, and contains anti-dilution provisions that adjust the exercise price if certain equity instruments are issued (subject to certain exceptions) at a value below the then-existing exercise price of the warrants. The anti-dilutive provisions have an expiration term of either one or five years from date of issuance. The anti-dilutive provision on 7,592,400 warrants expired on December 31, 2013.

16

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

Notes to Consolidated Financial Statements (unaudited)

12. Stock Warrants(continued)

As of March 31, 2014, warrants to purchase 56,425,937 shares of common stock were outstanding and exercisable. The Company recognized a total of $65,706 in interest expense and $17,976 in consulting services during the three months ended March 31, 2014 and $537,137 in placement agent services as of December 31, 2013 as a result of issuing 3,720,323 warrants earned in 2014.

	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (in years)
Outstanding at December 31, 2013		52,705,614	$	1.30		2.58
Granted		3,720,323	$	0.77		4.84
Exercised		-		-
Cancelled or expired		-		-
Outstanding at March 31, 2014		56,425,937	$	1.28		2.69

The following table summarizes information about stock warrants at March 31, 2014:

Warrants Outstanding
Exercise Price	Outstanding		Weighted Average Remaining Contractual Life (in years)		Weighted Average Exercise Price
$0.50		15,524,642
$0.75		11,065,144
$1.10		18,721,850
$1.12		263,750
$2.00		9,455,842
$2.20		98,320
$2.25		1,296,389
$0.50 - $2.00		56,425,937		2.69	$	1.28

13. 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 has evaluated its income tax positions in accordance with FASB ASC 740. There were no changes to unrecognized tax benefits during 2013. The tax years 2009 through 2012 remain open to review by various taxing authorities.

ASC Topic 740, Income Taxesdefines the confidence level that a tax position must meet in order to be recognized in the financial statements. Accordingly, we have assessed uncertain tax positions in each of the tax jurisdictions in which we have operations and account for the related financial statement implications. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized in the financial statements on a particular tax position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. The amount of unrecognized tax benefits is adjusted as appropriate for changes in facts and circumstances, such as significant amendments to existing tax law, new regulations or interpretations by the taxing authorities, new information obtained during a tax examination, or resolution of an examination. We recognize both accrued interest and penalties, where appropriate, related to unrecognized tax benefits in income tax expense.

17

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

Notes to Consolidated Financial Statements (unaudited)

13. Income Taxes(continued)

Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and any valuation allowance recorded in connection with the deferred tax assets.

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 $51,500,000 and $50,000,000 at March 31, 2014 and December 31, 2013, respectively.

14. Lease Commitments

The Company leases its USA facilities under operating leases beginning a) April 2012 through March 2017 and b) a month-to-month lease. 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
2014	$	183,943
2015	$	167,628
2016	$	167,628
2017	$	41,907

Rent expense totals $94,828 for the three month period ended March 31, 2014, compared to $109,498 for the three month period ended March 31, 2013.

15. 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.

16. 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 managements’ 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.

18

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

Notes to Consolidated Financial Statements (unaudited)

16. Commitments and Contingencies (continued)

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 March 31, 2014.

Warranty Costs

The Company provides for a one year warranty with the sale of its LAESI instrument. All other product warranties are 90 days from the date of delivery of the goods. As the Company does not currently have sufficient 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 product. As of March 31, 2014, the Company recorded accrued warranty expense of $97,500 compared to $81,250 as of December 31, 2013.

Stock Options

The Company has an agreement with one board member for payment of services by stock options. The board member is to receive a stock option for 4,000 shares per month (awarded annually) with an exercise price equal to the current market price. The agreement is cancellable with 90 days’ notice.

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 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.

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

Notes to Consolidated Financial Statements (unaudited)

16. Commitments and Contingencies (continued)

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 GWU subject technology. As of March 31, 2014, the Company accrued approximately $45,800 to GWU for royalties compared to $32,600 as of December 31, 2013.

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.

In January 2014, the Company became a subcontractor to George Washington University in a multi-year project with the Defense Advanced Research Projects Agency (DARPA) to develop new tools and methods to elucidate the mechanism of action of a threat agent, drug, biologic or chemical on living cells within 30 days of exposure.

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.

ACREEMENT WITH OMICS2IMAGE

In 2014, the Company entered into an agreement with Omics2Image related to the “Next Generation Ambient Imaging Mass Spectrometry for (Bio)polymers and Smart Materials” (“COAST Project”). The Company has committed to fund 60,000 Euros related to the COAST Project. Omics2Image agrees to evenly share the value gained from the efforts outlined within the scope of the COAST Project, which may include new intellectual property and the development of a commercial, integrated instrument system.

Joint Pharmaceutical Development Agreement

AGREEMENT WITH LABORATOIRE MAYOLY SPINDLER

In May 2009, the Company, and its wholly-owned subsidiary, Proteabio Europe SAS, entered into a Joint Research and Development Agreement with Laboratories Mayoly Spindler SAS (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 1m 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 December 31, 2013 and December 31, 2012, the Company owed approximately $37,000 and $36,000 to Mayoly, which is reflected in Trade Accounts Payable on the Consolidated Balance Sheet.

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

Notes to Consolidated Financial Statements (unaudited)

16. Commitments and Contingencies (continued)

Engineering and Design Services

The Company has engaged Dynamic Manufacturing LLC, a contract manufacturer to produce ten LAESI units. As of March 31, 2014, the Company had received three LAESI units from Dynamic. As of March 31, 2014, the Company had about $371,438 in outstanding commitments with Dynamic as well as approximately $198,000 in payables due to Dynamic.

The Company has approximately $117,000 in outstanding commitments with Bridger Photonics for lasers related to the LAESI technology. At March 31, 2014, the Company owed approximately $8,000 in payables due to Bridger.

17. Option Fee

Option Agreement with BioPharma d’Azur, Inc.

On March 27, 2014, the Company entered into an Option Agreement by and among, the Company, ProteaBio Europe and BioPharma d’Azur, Inc. (“BioPharma”) pursuant to which BioPharma was granted a 90 day option (the “Option”) to acquire the business of Protea Europe (the “Acquisition”), including an assignment of the Amended and Restated Joint Research Agreement, by and among the Protea Sub, Protea Europe and Laboratoires Mayloy Spindler SAS, dated March 22, 2010, in exchange for a non-refundable fee equal to $300,000 (the “Option Fee”) payable by BioPharma to the Company. The exercise of the Option and the consummation of the acquisition will be conditioned upon BioPharma providing evidence that it has raised gross proceeds from an equity financing of at least an additional $300,000 (the “First Funding Amount”), exclusive of the Option Fee. If the option is not exercised, the Company will issue shares of common stock to BioPharma with an aggregate value of $300,000 determined by dividing the Option Fee by the greater of $0.55 or the 20 day volume weighted average price of the Company’s common stock as reported by Bloomberg L.P. The terms of the Option Agreement provide that the First Funding Amount will be delivered to the Company upon the execution and signing of a definitive agreement with respect to the Acquisition. In addition, upon the consummation of the Acquisition, BioPharma will issue to the Company the number of shares of preferred stock of BioPharma (the “Preferred Shares”) that shall be convertible into no less than 33% of the issued and outstanding common stock of BioPharma following the Acquisition. The Preferred Shares will be subject to certain anti-dilution protection and vote together with the common stock of BioPharma on all matters.

The Option Agreement will terminate upon the earlier of (i) BioPharma providing written notice of its election to terminate the Option Agreement; (ii) at the election of either party, if the other party has (A) breached any of its representations, warranties or covenants contained therein or (B) failed to perform any of its material obligations thereunder and has not cured such breach or failure within twenty (20) days after written notice by the other party thereof; (iii) the expiration of the option period; or (iv) the execution of a definitive agreement with respect to the Acquisition.

18. Evaluation of Subsequent Events

Common Stock

Subsequent to the Balance Sheet date, the Company issued 87,348 shares of common stock to their attorneys for services rendered.

Additionally, the Company issued 150,000 shares of common stock to a consultant for services rendered.

Stock Warrants

Subsequent to March 31, 2014, the Company issued warrants to purchase 600,000 shares of common stock to Summit Resources, Inc., an affiliate of Steve Antoline, a director of the Company, in connection with the April 2, 2014 and April 11, 2014 Promissory Notes. The warrants are exercisable at an exercise price of $0.80 per share for a five year term.

Additionally, the Company issued warrants to purchase 187,500 shares of common stock to a consultant for services rendered. The warrants are exercisable at an exercise price of $1.10 per share for a five year term.

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

Notes to Consolidated Financial Statements (unaudited)

18. Evaluation of Subsequent Events(continued)

Stock Options

Subsequent to March 31, 2014, the Company granted options to purchase an aggregate of 1,042,500 shares of common stock to various employees in connection with the Company’s 2013 Equity Incentive Plan at an exercise price of $0.55 per share.

Advances from Stockholders

Subsequent to March 31, 2014, the Company received advances equal to an aggregate of $20,000 from certain current directors and related parties. No terms of repayment have been specified on the aforementioned advances as of the filing date.

On April 2, 2014, the Board approved an offering of up to $900,000 consisting of (a) one year promissory notes in an aggregate principal amount equal to the amount to be borrowed and disbursed by certain related parties with interest to accrue at a rate of 10% per annum; and (b) five year warrants to purchase up to 900,000 shares of common stock at an exercise price of $0.80 per share. As of the date of this filing, the Company has issued notes in an aggregate principal amount of $650,000 and warrants to purchase up to 650,000 shares of common stock to related parties.

Issuance of Convertible Debentures

In addition, on April 2, 2014, the Board also approved an offering of up to $300,000 in convertible one year promissory notes. Each $100,000 of outstanding principal and accrued unpaid interest underlying the note is automatically convertible upon the final closing of a subsequent financing of at least $2 million in gross proceeds into units consisting of 181,818 shares of common stock and warrants to purchase up to 109,091 shares of common stock at an exercise price of $0.80 per share or such alternate conversion rate as shall be consistent with the terms of a subsequent financing. On April 22, 2014, the Board approved an increase in the total offering amount of convertible notes issuable to $1,100,000. As of the filing date, the Company has issued an aggregate of $426,000 in convertible notes.

Repayment on the Obligation Related to the Letter of Credit

Subsequent to March 31, 2014, the Company made a payment of approximately $90,835 to Steve Antoline. The payment satisfied the Obligation Related to the Letter of Credit.

Repayment on Loans Payable to Stockholders

Subsequent to March 31, 2014, the Company made a payment of approximately $59,165 to Steve Antoline on the August 6, 2013 promissory note. The payment reduced the outstanding balance to $540,835.

Promissory Note

Subsequent to March 31, 2014, the Company issued a 3-month promissory note of $100,000 to BioPharma d’Azur, Inc. The note bears interest at 6% per annum.

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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 of Our Business

Protea Biosciences Group, Inc. (referred to as “Protea”, “the Company”, “we”, “us” and “our”) is a commercial stage, molecular information company incorporated in the state of Delaware on May 24, 2005. “Molecular information” refers to the identification and characterization of the proteins, metabolites and other biomolecules, which are the products of all living cells and life forms. The Company is applying its technology to the development of next generation, “direct molecular imaging” technology and service capabilities that it believes enable more rapid and comprehensive molecular profiling of living cells and biofluids, thereby providing better molecular information that helps to define normal and disease processes. We believe that our proprietary technology is useful to support medical research and pharmaceutical development. The Company’s technologies enable the direct molecular imaging of the proteins, metabolites and other biomolecules that regulate the biological functions of the human body and all other forms of life. Management believes this is a critical area of research, as pharmaceutical research is in need of direct molecular imaging to improve and accelerate the development of new therapeutics and diagnostic tests.

Our Business Strategy and Products

The Company applies its core technologies and expertise to the development of products and services that improve the discovery and identification of proteins, metabolites and other biomolecules produced by living cells. 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 Instrument Platform

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 the 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 significantly improve the availability of molecular information in pharmaceutical research, as well as many other fields, including agriculture, pathology, biomarker discovery, biodefense and forensics.

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 molecular information where the molecular pathways of human disease will be more clearly elucidated, and datasets more rapidly available, thereby accelerating pharmaceutical and life science research.

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The Company offers the LAESI DP-1000, its first generation LAESI instrument, as well as software packages developed by the Company (LAESI Desktop Software and ProteaPlot™). The Company believes that our software facilitates operating the instrument, and the storage and display of molecular information datasets, in a user friendly, intuitive software environment. The LAESI and ProteaPlot™ software generate “ion maps,” which are molecule-specific images that show the location and relative abundance of specific molecules in a sample helping researchers look for new, disease-specific biomarkers, and to elucidate disease-specific pathways.

In addition, the Company offers an expanding line of research products that are used in bioanalytical mass spectrometry, including a family of proprietary reagents. These include 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.

Our commercial offering is organized as follows:

Molecular Information Services

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

The Company provides LAESI mass spectrometry imaging (“LAESI-MSI”) services with the unique capabilities of our proprietary LAESI technology platform, which can directly image and display the presence of specific biomolecules in cell and tissue samples, without sample preparation. The LAESI platform technology is highly disruptive for biological investigation of tissues and living cell cultures and bacterial colonies. LAESI-MSI provides new information based on direct analysis, without the need for labeling, radioisotopes, 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 breakthrough paradigm allows accurate distribution profiling of chemical species that help to elucidate pathologies or metabolic processes underway in the specimen. The Company believes that the LAESI-MSI has the potential to significantly improve biological investigation using objective chemical data by directly visualizing the distribution of specific molecules within a cell’s structure.

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, thereby providing native, unbiased molecular information. LAESI-MSI services are available for both 2D and 3D tissue molecular profiling, high throughput biofluid analysis, and time course studies of live cell colonies.

Molecular Data and Informatics Products

We are applying LAESI-MSI to create comprehensive, cell-based molecular information databases that will be specific to disease states and allow the integration of LAESI biomolecular datasets with the sample-related pathology, gene expression and demographic data. LAESI-MSI generates large bioinformatics datasets for improved disease state assessment and management. Our initial focus is the development of database products for oncology and neurodegenerative disease.

Emerging Growth Company

The Company is an “emerging growth company”, as defined in the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”), and may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not “emerging growth companies” including, but not limited to, not being required to comply with the auditor attestation requirements of section 404(b) of the Sarbanes-Oxley Act, and exemptions from the requirements of Sections 14A(a) and (b) of the Securities Exchange Act of 1934 to hold a nonbinding advisory vote of shareholders on executive compensation and any golden parachute payments not previously approved.

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Results of Operations

Three Months Ended March 31, 2014 Compared to Three Months Ended March 31, 2013

We earned revenue of $468,100 and $481,615 for the three month period ended March 31, 2014 and March 31, 2013, respectively, a decrease of $13,515, or approximately 3%. During the first quarter 2014, the Company sold one LAESI unit compared to two units in 2013. This was offset by increased service revenues during the first quarter 2014 plus initiation of grant revenues in 2014.

Selling, general and administrative expenses totaled $2,353,441 for the three months ended March 31, 2014 compared to $2,047,633 for the three months ended March 31, 2013, an increase of $305,808 or approximately 15%. The increase in selling, general and administrative expenses relates largely to increased salary and personnel costs associated with hiring new staff as well as additional services rendered by outside vendors and consultants in 2014 which was partially offset by lower cost of goods sold year over year.

Research and development expense totaled $721,953 for the three months ended March 31, 2014, compared to research and development expense of $863,603 for the three months ended March 31, 2013, a decrease of $141,650 or approximately 16%. 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 first generation LAESI technology.

Loss from operations totaled $2,607,294 for the three months ended March 31, 2014, compared to a loss from operations of $2,429,621 for the three months ended March 31, 2013, an increase of $177,673 or approximately 7%.

During the three months ended March 31, 2014, we had other expense of $124,844 as compared to other expenses for the three months ended March 31, 2013 of $176,206, a decrease of $51,362 or approximately 29%. Other expenses declined as a result of derivative income recognized in 2014, but not 2013.

After foreign currency translation adjustments of $769 and ($11,520), respectively, we had a total comprehensive loss of $2,731,369, or ($0.04) per share, for the three months ended March 31, 2014 as compared to a total comprehensive loss of 2,617,347, or ($0.08) per share, for the three months ended March 31, 2013.

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 $3,000,000 outstanding as of March 31, 2014. Interest is payable monthly and the loan is due on demand. During the first quarter of 2014, the Company received $605,000 from related parties.

We will continue to require substantial funds to advance the research and development of our core technologies, to continue to develop new products and services based upon our proprietary molecular information technologies. We intend to continue to meet our operating cash flow requirements by raising additional funds from the sale of equity or debt securities and possibly, developing corporate development partnerships to advance our drug and molecular information technology development activities for sharing the costs of development and commercialization.  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, there are no assurances that we will be able to secure additional funding. These factors raise substantial doubt about our ability to continue as a going-concern.

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As of March 31, 2014, we had total current assets equal to $1,553,488, comprised of $313,286 in cash and cash equivalents, $115,346 in trade accounts receivable, $436,871 in other receivables, $553,363 in inventory and $134,622 in prepaid expenses. This compares with total current assets of $2,508,502 at December 31, 2013 comprised of $1,086,330 in cash and cash equivalents, $216,864 in trade accounts receivable, $435,278 in other receivables, $465,334 in inventory and $304,696 in prepaid expenses.  The Company's total current liabilities as of March 31, 2014 were equal to $7,895,940, comprised of $1,221,218 in current maturities on long term debt, $1,671,512 in trade accounts payable, $3,000,000 in connection with the United Bank, Inc. line of credit, $1,070,883 in loans payable to shareholders, net of discount, $69,827 in the obligation related to the Letter of Credit, net of discount and $862,500 in other payables and accrued expenses. The Company's total current liabilities as of December 31, 2013 were equal to $6,225,105, comprised of $1,054,053 in current maturities on long term debt, $759,021 in trade accounts payable, $2,725,000 in connection with the United Bank line of credit, $465,883 in loans payable to shareholders, net of discount, $151,981 in Obligations related to the Letter of Credit, net of discount and $1,069,167 in other payables and accrued expenses.

Our working capital deficit at March 31, 2014 was $6,342,452 as compared to a working capital deficit of $3,716,603 at December 31, 2013.  The increase in working capital deficit was $2,625,849 from December 31, 2013 to March 31, 2014.

Operating Activities

Net cash used in operating activities for the three month period ended March 31, 2014 decreased $1,441,886, or 50% from $2,862,200 for the three month period ended March 31, 2013 to $1,420,314. Net cash used in operating activities during the three month period ended March 31, 2014 was primarily the result of a net loss of $2,732,138. Net loss was adjusted for non-cash items such as depreciation and amortization of $206,046, non-cash compensation of $117,989, issuance of stock for services of $30,476, accretion of convertible debenture discount of $65,706, loss on disposal of fixed assets of $24,768, bad debt expense of $2,000, and income from change in value of derivative of $65,922. We also had a decrease in trade accounts receivable of $99,518, prepaid expenses of $170,074, other payables and accrued expenses of $206,665. We also had an increase in other receivable of $1,575, inventory of $88,029, trade accounts payable of $657,438 and commitments and contingencies of $300,000.

Investing Activities

Net cash used in investing activities during the three month period ended March 31, 2014 was $51,935, 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 three month period ended March 31, 2013 was $9,500 and was also used for equipment purchases.

Financing Activities

Cash provided by financing activities during the three month period ended March 31, 2014 was $698,436, which was the result of net proceeds of ($12,500) from the sale of our common stock and proceeds of $605,000 from advances recorded as related party debt. This was offset by $21,204 used in the repayment of long-term debt and $147,860 used in the repayment of the obligation related to the letter of credit. Cash provided by financing activities during the three month period ended March 31, 2013 was $2,944,694, which was the result of net proceeds of $2,144,526 from the sale of our common stock, proceeds of $225,000 from the issuance of related party debt, and proceeds of $600,000 from the issuance of the obligation related to the letter of credit. This was offset by $24,832 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.

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Revenue Recognition

We follow the provisions of FASB ASC 605, “Revenue Recognition”. We recognize revenue of products when persuasive evidence of a sale arrangement exists, the price to the buyer is fixed or determinable, delivery has occurred /title has passed, and collectability of the sales price is reasonably assured.

We account for shipping and handling fees and costs in accordance with the provisions of FASB ASC 605-45-45, “Revenue Recognition – Principal Agent Considerations”, which requires all amounts charged to customers for shipping and handling to be classified as revenues. Shipping and handling costs charged to customers are recorded in the period the related product sales revenue is recognized.

Regarding short-term service contracts, the majority of these service contracts involve the processing of imaging and bioanalytical samples for pharmaceutical and academic/clinical research laboratories. These contracts generally provide for a fixed fee for each method developed or sample processed and revenue is recognized when the analysis is complete and a report is delivered.

For longer-term contracts involving multiple elements, the items included in the arrangement (deliverables) are evaluated to determine whether they represent separate units of accounting. We perform this evaluation at the inception of an arrangement and as each item in the arrangement is delivered. Generally, we account for a deliverable (or a group of deliverables) separately if: (i) the delivered item(s) have standalone value to the customer, and the delivery or performance of the service(s) is probable and substantially in our control. Revenue on multiple revenue arrangements is recognized using a proportional method for each separately identified element. All revenue from contracts determined not to have separate units of accounting is recognized based on consideration of the most substantive delivery factor of all the elements in the contract or, if there is no predominant deliverable, upon delivery of the final element of the arrangement.

Revenues from grants are based upon internal costs that are specifically covered by the grants, and where applicable, an additional facilities and administrative rate that provides funding for overhead expenses. These revenues are recognized when expenses have been incurred by the Company that is related to the grants.

As of March 31, 2014, we had deferred revenues of $2,200 related to one service customer. As of December 31, 2013, we had deferred revenues of $7,980 related to four service customers.

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 shareholders’ 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.

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 60,826,000 and 56,711,000 at March 31, 2014 and December 31, 2013, respectively.

Derivative Liabilities

The Company does not use derivative instruments to hedge exposures to cash flow, market or foreign currency risks; however, the Company has certain financial instruments that are embedded derivatives associated with capital raises and common stock purchase warrants The Company evaluates all its financial instruments to determine if those contracts or any potential embedded components of those contracts qualify as derivatives to be separately accounted for in accordance with FASB ASC 810-10-05-4 and 815-40.  This accounting treatment requires that the carrying amount of any embedded derivatives be recorded at fair value at issuance and marked-to-market at each balance sheet date.  In the event that the fair value is recorded as a liability, as is the case with the Company, the change in the fair value during the period is recorded as either income or expense. Upon conversion or exercise, the derivative liability is marked to fair value at the conversion date and then the related fair value is reclassified to equity.

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Fair value of financial assets and liabilities – Derivative Instruments

We measure the fair value of financial assets and liabilities in accordance with GAAP, which defines fair value, establishes a framework for measuring fair value, and requires certain disclosures about fair value measurements.

GAAP defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. GAAP also establishes the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs used to measure fair value:

Level 1 – quoted prices in active markets for identical assets or liabilities.

Level 2 – quoted prices for similar assets and liabilities in active markets or inputs that are observable.

Level 3 – inputs that are unobservable (for example, the probability of a capital raise in a “binomial” methodology for valuation of a derivative liability directly related to the issuance of common stock warrants).

The Company has entered into certain financial instruments and contracts; such as, equity financing arrangements for the issuance of common stock, which include anti-dilution arrangements and detachable stock warrants that are i) not afforded equity classification, ii) embody risks not clearly and closely related to host contracts, or iii) may be net-cash settled by the counterparty. These instruments are recorded as derivative liabilities, at fair value at the issuance date. Subsequent changes in fair value are recorded through the statement of operations.

The Company’s derivative liabilities are related to common stock issuances, detachable common stock purchase warrants (“warrants”) issued in conjunction with debt and common stock, or warrants issued to the placement agents for financial instrument issuances. We estimate fair values of the warrants that do contain “Down Round Protections” utilizing valuation models and techniques that have been developed and are widely accepted that take into account the additional value inherent in “Down Round Protection.” These widely accepted techniques include “Modified Binomial”, “Monte Carlo Simulation” and the “Lattice Model.” The “core” assumptions and inputs to the “Binomial” model are the same as for “Black-Scholes”, such as trading volatility, remaining term to maturity, market price, strike price, and risk free rates; all Level 2 inputs.  Fair value measurements are classified according to the lowest level input or value-driver that is significant to the valuation. A measurement may therefore be classified within Level 3 even though there may be significant inputs that are readily observable. However, a key input to a “Binomial” model (in our case, the “Monte Carlo Simulation”, for which we engaged an independent valuation firm to perform) is the probability of a future capital raise.  By definition, this input assumption does not meet the requirements for Level 1 or Level 2 outlined above; therefore, the entire fair value calculation is deemed to be Level 3 under accounting requirements due to this single Level 3 assumption. This input to the Monte Carlo Simulation model was developed with significant input from management based on its knowledge of the business, current financial position and the strategic business plan with its best efforts.

As discussed above, financial liabilities are considered Level 3 when their fair values are determined using pricing models or similar techniques and at least one significant model assumption or input is unobservable.  For the Company, the Level 3 financial liability is the derivative liability related to the common stock and warrants that include “Down Round Protection” and they were valued using the “Monte Carlo Simulation” technique.  This technique, while the majority of inputs are Level 2, necessarily incorporates a Capital Raise Assumption which is unobservable and, therefore, a Level 3 input.

Stock Based Compensation

We follow the provisions of FASB ASC 718,“StockBased 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.

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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 March 31, 2014, 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 March 31, 2014, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

Material Weakness

In connection with our annual audit for the year ended December 31, 2013, it came to management’s attention that certain equity and embedded derivative instruments were not properly recorded during 2013. The derivative liability related to common stock issuances, detachable common stock purchase warrants (“warrants”) issued in conjunction with debt and common stock, warrants issued to the placement agents for financial instrument issuances, and the expense associated with certain equity transactions which were not properly recorded due to their complexity.

As a result of these adjustments, it was determined that a control deficiency that constitutes a material weakness in the design and operation of our internal control over financial reporting in connection with embedded derivatives and certain equity transactions was present.

Remediation

Our management team took immediate action to remediate the material weaknesses disclosed above, including:

· Engaging an independent valuation firm to assist in valuing our derivative liabilities.

· Management will incorporate other resources in addition to its SEC legal counsel when evaluating the accounting implications of issuing future equity and derivative instruments

· Providing additional enhanced local and centralized oversight between accounting and investor relations activities.

· Providing increased training on our internal controls and procedures, including these remedial measures, to our personnel.

· Invested in a web-based accounting research solution, which provides access to research, analysis, discussion, financial interpretation and regulations drawing on various governing bodies, such as the SEC, FASB, IASB, etc.

While certain aspects of these remedial actions have been completed, we continue to actively plan for and implement additional control procedures to improve our overall control environment and expect these efforts to continue throughout 2014.

There have been no changes in our internal controls over financial reporting during the quarter ended March 31, 2014 that have materially affected or are reasonably likely to materially affect our internal controls.

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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.

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

Common Stock and Warrants

During the first quarter of 2014, the Company issued 25,000 shares of common stock at $0.50 per share for services rendered pursuant to the terms of a Consulting Agreement by and between the Company and a consultant, dated February 13, 2014.

On January 28, 2014, the Company issued five year warrants to purchase an aggregate of 3,302,823 shares of common stock to certain designees of a placement agent at an exercise price of $0.75 per share, as commission payable in connection with the purchase of common stock and warrants in the fourth quarter 2013 offering. The warrants include certain anti-dilution provisions that adjust the exercise price if certain equity instruments are issued (subject to certain exceptions) at a value below the then-existing exercise price of the warrants. The anti-dilution provisions have an expiration term five years from warrant issuance date. 

On February 11, 2014, the Company issued warrants to purchase 250,000 shares of common stock to Summit Resources, Inc., an affiliate of Steve Antoline, a director of the Company, in connection with the repayment of the Addendum to the Warrant Purchase and Reimbursement Agreement. The warrant is exercisable for five years from date of issuance at an exercise price of $1.10 per share.

On March 3, 2014, the Company issued warrants to purchase 167,500 shares of common stock in connection with services rendered pursuant to the terms of a Consulting Agreement by and between the Company and a consultant, dated March 3, 2014. The warrants contain an exercise price of $1.10 per share and are exercisable for five years from date of issuance.

Options

During the quarter ended March 31, 2014, the Company granted options to purchase an aggregate of 1,304,500 shares of common stock in connection with the Company’s 2013 Equity Incentive Plan at an exercise price of $0.55 per share.

The securities described above were issued pursuant to the exemption from registration provided by Rule 506 of Regulation D or Section 4(a)(2) of the Securities Act of 1933, as amended.

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Item 3.  Defaults Upon Senior Securities.

Not applicable

Item 4.  Mine Safety Disclosure.

Not applicable.

Item 5.  Other Information.

Option Agreement with BioPharma d’Azur, Inc.

On March 27, 2014, the Company entered into an Option Agreement by and among, the Company, ProteaBio Europe and BioPharma d’Azur, Inc. (“BioPharma”) pursuant to which BioPharma was granted a 90 day option (the “Option”) to acquire the business of Protea Europe (the “Acquisition”), including an assignment of the Amended and Restated Joint Research Agreement, by and among the Protea Sub, Protea Europe and Laboratoires Mayloy Spindler SAS, dated March 22, 2010, in exchange for a non-refundable fee equal to $300,000 (the “Option Fee”) payable by BioPharma to the Company. The exercise of the Option and the consummation of the acquisition will be conditioned upon BioPharma providing evidence that it has raised gross proceeds from an equity financing of at least an additional $300,000 (the “First Funding Amount”), exclusive of the Option Fee. If the option is not exercised, the Company will issue shares of common stock to BioPharma with an aggregate value of $300,000 determined by dividing the Option Fee by the greater of $0.55 or the 20 day volume weighted average price of the Company’s common stock as reported by Bloomberg L.P. The terms of the Option Agreement provide that the First Funding Amount will be delivered to the Company upon the execution and signing of a definitive agreement with respect to the Acquisition. In addition, upon the consummation of the Acquisition, BioPharma will issue to the Company the number of shares of preferred stock of BioPharma (the “Preferred Shares”) that shall be convertible into no less than 33% of the issued and outstanding common stock of BioPharma following the Acquisition. The Preferred Shares will be subject to certain anti-dilution protection and vote together with the common stock of BioPharma on all matters.

The Option Agreement will terminate upon the earlier of (i) BioPharma providing written notice of its election to terminate the Option Agreement; (ii) at the election of either party, if the other party has (A) breached any of its representations, warranties or covenants contained therein or (B) failed to perform any of its material obligations thereunder and has not cured such breach or failure within twenty (20) days after written notice by the other party thereof; (iii) the expiration of the option period; or (iv) the execution of a definitive agreement with respect to the Acquisition.

Item 6.  Exhibits.

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

Exhibit No.	Description
3.1	Certificate of Incorporation (incorporated by reference from Exhibit 3.1 to the registrant’s Form 10-SB filed with the Securities and Exchange Commission on August 3, 2005).
3.2	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).
3.3	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).
10.1*	Memorandum of Understanding by and between the Company and BioPharma d’Azur, Inc.
10.2*	Option Agreement by and between the Company, Proteabio Europe and BioPharma d’Azur, Inc.
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 March 31, 2014.
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 March 31, 2014.
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

* Filed herewith

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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: May 9, 2014	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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