| SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES | NOTE
2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Use
of Estimates US
GAAP requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities,
revenues and expenses, together with amounts disclosed in the related notes to the consolidated financial statements. Actual results
and outcomes may differ from management’s estimates, judgments and assumptions. Significant estimates, judgments and assumptions
used in these consolidated financial statements include, but are not limited to, those related to revenues, accounts receivable
and related allowances, contingencies, useful lives and recovery of long-term assets, income taxes, and the fair values of stock-based
compensation, warrants, and derivative financial instrument liabilities. These estimates, judgments, and assumptions are reviewed
periodically and the effects of material revisions in estimates are reflected in the financial statements prospectively from the
date of the change in estimate. Revenue
Recognition We
recognize revenues when (a) the price is fixed or determinable, (b) persuasive evidence of a sales arrangement exists, (c) the
service is performed, or delivery has occurred and (d) collectability of the resulting receivable is reasonably assured. We
recognize product revenues when products are shipped to customers. At that time, product ownership and risk have transferred to
the customer and we have no further obligations. We record product sales at net selling prices that are reflective of discounts
and allowances. Shipping and handling costs are recorded as a component of direct costs, as are shipping and handling costs billed
to customers. Revenue
related to licensing agreements is recorded upon substantial performance of the terms of the licensing contract. In the case of
licensing arrangements that involve up-front payments, revenue is recorded when management determines that the appropriate terms
of the contract have been fulfilled. For example, this may occur when technology has been transferred via written documents or,
if training is involved, whenever all contracted training has occurred. In the case of licenses where product delivery is also
embedded in the deliverable, a portion of revenue would be recognized when products are delivered. In
the case of licensing arrangements that involve ongoing royalties based on sales of products produced with our technology, royalty
income is recorded when received or, in the case of minimum royalties due, in the period when due. Grant
contract revenue is recognized over the life of the contracts as the services are performed. Amounts
received in excess of revenues earned are recorded as deferred revenue. Cost
of Products Sold We
use a standard cost system to estimate the direct costs of products sold. Direct costs include estimates of raw material costs,
packaging, freight charges net of those billed to customers, and an allocation for direct labor and manufacturing overhead. Because
of the nature of our production processes, there is a substantial fixed manufacturing expense requirement that represents the
ongoing cost of maintaining production facilities that are not directly related to products sold, so we use a “full capacity”
allocation of overhead based on an estimate of what product costs would be if the manufacturing facilities were operating on a
full-time basis and producing products at the designed capacity. The
remaining costs of operating the Company’s manufacturing facilities are recorded as Unallocated Manufacturing Expenses.
Manufacturing expense includes the costs of operating our manufacturing facilities including personnel costs, rent, utilities,
indirect supplies, depreciation, and related indirect expenses. Manufacturing expenses are expensed as incurred. Research
and Development Research
and development expenses include the compensation costs of research personnel, laboratory rent and utilities, depreciation of
laboratory equipment, travel and laboratory supplies and are expensed as incurred. General
and Administrative Expense General
and administrative expenses include the compensation costs of personnel, rent, utilities, supplies, travel, depreciation of office
equipment, and related expenses not included in other expense categories. General and administrative expenses also include non-cash
compensation expenses related to the Company’s deferred compensation, management incentive bonus, and employee stock option
programs. Sales
and Marketing Expense Sales
and marketing costs include compensation, travel, and business development expenses including free samples provided to customers.
These costs are expensed as incurred. Product marketing allowances are recorded at the estimated out of pocket cost necessary
to produce the product in the period the allowance is granted. Advertising costs are expensed at the time they are incurred and
were not material for the years ended December 31, 2017 and 2016. Income
Taxes It
is our policy to provide for uncertain tax positions and the related interest and penalties based upon management’s assessment
of whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. To the extent that the probable
tax outcome of these uncertain tax position changes, such changes in estimate will impact the income tax provision in the period
in which such determination is made. At December 31, 2017, we believe we have appropriately accounted for any unrecognized tax
benefits. We are not aware of any uncertain tax positions. To the extent we prevail in matters for which a liability for an unrecognized
tax benefit is established or we are required to pay amounts in excess of the liability, our effective tax rate in a given financial
statement period may be affected. We
account for income taxes using an asset and liability approach. The difference between the financial statement and tax basis of
assets and liabilities is determined annually. Deferred income tax assets and liabilities are computed for those differences that
have future tax consequences using the currently enacted tax laws and rates that apply to the periods in which they are expected
to affect taxable income. Income tax expense is the current tax payable or refundable for the period plus or minus the net change
in the deferred tax assets and liabilities. The deferred tax effects of state and local income taxes are considered immaterial
and have not been recorded. Valuation allowances are established, if necessary, to reduce deferred tax assets to the amount that
is estimated to be realized. Because of the uncertainty related to future realization of deferred tax assets (see Note 14), we
have established a valuation allowance equal to one hundred percent of the deferred tax assets. The
Tax Cuts and Jobs Act (the Tax Act) was signed into law on December 22, 2017. The Tax Act changed many aspects of U.S. corporate
income taxation and included reduction of the corporate income tax rate from 35% to 21%. The Company will continue to assess
its provision for income taxes as future guidance is issued but does not currently anticipate significant revisions will be necessary.
Any such revisions will be treated in accordance with the measurement period guidance outlined in Staff Accounting Bulletin No.
118. Net
Income (Loss) Per Common Share We
compute net income or (loss) per share in accordance with Financial Accounting Standards Board (“FASB”) Accountings
Standards Codification (“ASC”) Topic 260: Earnings Per Share. Under the provisions of ASC 260, basic net income (loss)
per share is computed by dividing the net income (loss) available to common stockholders by the weighted average number of common
shares outstanding during the period. Diluted net loss per share is computed using the weighted average number of shares outstanding
during the applicable period, plus the effect of potentially dilutive securities. Potentially dilutive securities consist of shares
potentially issuable pursuant to stock options and warrants as well as shares that would result from full conversion of all outstanding
convertible securities. These potentially dilutive securities were 3,081,487 and 2,699,112 as of December 31, 2017 and 2016
and are excluded from diluted net loss per share calculations because they are anti-dilutive. As a result, for the years ended
December 31, 2017 and 2016, basic and diluted net loss per share was the same. Accounts
Receivable and Allowance for Doubtful Accounts Accounts
receivable are stated at the amount management expects to collect from outstanding balances. Management provides for probable
uncollectible amounts through a provision for bad debt expense and an adjustment to a valuation allowance based on their assessment
of the current status of individual accounts. Balances that are still outstanding after management has used reasonable collection
efforts are written off through a charge to the allowance account and a credit to accounts receivable. Statements
of Cash Flows For
the purposes of the statements of cash flows, we consider all highly liquid investments purchased with an original maturity of
three months or less to be cash equivalents. Fair
Value of Financial Instruments and Concentrations of Credit Risk Financial
instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash and accounts
receivable. The Company places its cash with FDIC insured financial institutions. Although such balances may exceed the federally
insured limits at certain times, in the opinion of management they are subject to minimal risk. The
Company has established policies for extending credit to customers based upon factors including the customers’ credit worthiness,
historical trends and other information. Nonetheless the collectability of accounts receivable is affected by regional economic
conditions and other factors. Inventory Inventory
consists of raw materials, work-in-process and finished goods, all of which are stated at the lower of cost or market. Cost is
determined on a first in, first out basis. Property
and Equipment Property
and equipment are recorded at cost, net of accumulated depreciation and amortization. Property and equipment generally includes
purchases of items with a cost greater than $3,000 and a useful life greater than one year. Depreciation and amortization are
computed on the straight-line basis over the estimated useful lives of the assets. Leasehold improvements are amortized over the
shorter of the related lease terms or their estimated useful lives. We
periodically review the estimated useful lives of property and equipment. Changes to the estimated useful lives are recorded prospectively
from the date of the change. Upon retirement or sale, the cost of the assets disposed of and the related accumulated depreciation
are removed from the accounts and any resulting gain or loss is included in the statement of operations. Repairs and maintenance
costs are expensed as incurred. Recoverability
and Impairment of Long-Lived Assets Land,
buildings and equipment and certain other assets, including definite-lived intangible assets, are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The judgments we make
related to the expected useful lives of long-lived assets, definitions of lease terms and our ability to realize undiscounted
cash flows in excess of the carrying amounts of these assets are affected by factors such as the ongoing maintenance and improvements
of the assets, changes in economic conditions, changes in usage or operating performance, and other factors, such as our ability
to sell our assets held for sale. As we assess the ongoing expected cash flows and carrying amounts of our long-lived assets,
significant adverse changes in these factors could cause us to realize an impairment loss. Based on a review of operating results,
we believe the carrying values of our long-lived assets are recoverable at December 31, 2017 and 2016. Intangible
Assets We
have entered into a license agreement with Michigan State University under which we have licensed certain intellectual property
in the form of patents and patent applications and invention disclosures. We are responsible for managing the patent process and
ongoing filings for this licensed intellectual property and for bearing the cost thereof. We capitalize all costs related to the
acquisition and ongoing administration of this license agreement and we amortize these costs over 15 years or the remaining life
of the license agreement, whichever is shorter. In
addition to the costs of managing in-licensed intellectual property, we also file for patent protection for inventions and other
intellectual property generated by our employees. All patents are evaluated for filing in international markets on a case-by-case
basis and are filed in the United States and in selected international markets as considered appropriate. All external legal and
filing costs related to patent applications, patent filings, ongoing registrations, overseas filings, and legal opinions related
thereto are capitalized as intangible assets at cost and amortized over a period of 15 years from the date incurred, or the remaining
useful life of the associated patent, whichever is shorter. The
cost of royalties or minimum payments specified under the license agreement for in-licensed technology is expensed as incurred. We
have also out-licensed certain of our intellectual property to licensees under terms and conditions of license agreements that
specify the intellectual property licensed, the territory, and the type of license. In exchange for these licenses, we have recorded
revenues associated with the initial granting of the license and expect to receive royalties based on sales of products produced
under these licenses. License revenues are recorded to reflect our performance of requirements under these license agreements.
In addition, we record royalty revenues from licensees at the time they are earned. Incentive
Refund As
of December 31, 2017, and 2016, we had $0 and $165,635 of incentive refunds due from the Michigan Economic Growth Authority under
a five-year agreement signed on January 19, 2011. These incentive payments are awarded annually based on a pre-determined formula
relating to the number of jobs created, average compensation, and total payroll and benefits for jobs created by XG Sciences in
Michigan. These refunds are paid in cash during the year following the refund period. There is no requirement to have taxable
income to receive these incentive payments. The five-year agreement expired December 31, 2016. Stock-Based
Compensation We
recognize compensation expense in our statement of operations for all share-based option and stock awards, based on estimated
grant-date fair values. We
estimate the grant-date fair value of stock-based compensation awards using the Black-Scholes option valuation model. This model
is affected by the estimated value of our common stock on the date of the grant as well as assumptions regarding a number of highly
complex and subjective variables. These variables include the expected term of the option, the exercise price, expected risk-free
rates of return, the expected volatility of our common stock, and expected dividend yield, each of which is more fully described
below. The assumptions for the estimated value of our common stock, expected term and expected volatility are the assumptions
that most significantly affect the grant date fair value. Expected
Term Risk-free
Interest Rate Expected
Stock Price Volatility Dividend
Yield The
grant-date fair value of the award is recognized as expense over the requisite service period using the straight-line method. Fair
Value Measurements FASB
ASC 820: “Fair Value Measurements and Disclosures” 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. ASC 820 also establishes a 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 standard describes three levels of inputs that may be used to measure fair value: Level
1 Level
2 Level
3 A
financial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is significant
to the fair value measurement. Our derivative liabilities are classified as Level 3 within the fair value hierarchy because they
were valued using other unobservable inputs. The valuation technique used to measure fair value of the derivative liabilities
is based on a lattice model with significant assumptions and inputs determined by the Company. A lattice model was used to estimate
the fair value of the derivative liabilities because management believes it reflects all of the assumptions that market participants
would likely consider including early exercise of the warrants. The fair value of the derivative liabilities will be significantly
influenced by the fair value of our common stock, stock price volatility and the risk-free interest components of the lattice
technique. Derivative
Financial Instruments We
do not use derivative instruments to hedge exposures to cash flow, market or foreign currency risk. The terms of convertible preferred
stock and convertible notes that we issue are reviewed to determine whether or not they contain embedded derivative instruments
that are required by ASC 815: “Derivatives and Hedging” to be accounted for separately from the host contract and
recorded at fair value. In addition, freestanding warrants are also reviewed to determine if they achieve equity classification.
Certain stock warrants that we have issued did not meet the conditions for equity classification and are classified as derivative
instrument liabilities measured at fair value. The fair values of these derivative liabilities are revalued at each reporting
date, with the change in fair value recognized in earnings. See Note 9 for additional information. In
July 2017, the FASB issued Accounting Standards Update No. 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities
From Equity (Topic 480), Derivatives and Hedging (Topic 815) (“ASU 2017-11”). This update changes the classification
analysis of certain equity-linked financial instruments with down-round features. When determining whether certain financial instruments
should be classified as liabilities or equity instrument, securities with anti-dilution features no longer preclude equity classification
when assessing whether the instrument is indexed to an entity’s own stock. As a result, freestanding equity-linked financial
instruments (or embedded conversion features) would no longer be accounted for as derivative liabilities at fair value because
of the existence of an anti-dilution feature. For freestanding equity classified financial instruments, ASU 2017-11 requires entities
that present earnings per share in accordance with ASC Topic 260 to recognize the effect of the anti-dilution feature when it
is triggered. That effect is treated as a dividend and as a reduction of income available to common shareholders in basic EPS.
The guidance in this Update is effective for fiscal years, and interim period within those fiscal years, beginning after December
15, 2018, with earlier adoption permitted. When adopted in an interim period, any adjustments are reflected as of the beginning
of the fiscal year that includes that interim period. We elected to early adopt ASU 2017-11 at September 30, 2017 by applying
the standard retrospectively to outstanding financial instruments with a down round feature by means of a cumulative-effect adjustment
to the Company’s beginning accumulated deficit as of January 1, 2017 (see Note 9). There were 972,720, warrants indexed
to Series A Preferred Stock which were originally recorded as derivative liabilities because of their anti-dilution features.
We chose to early adopt ASU 2017-11 because it permitted these warrants to be recorded as equity rather than derivative liabilities.
If ASU 2017-11 had been effective in 2016, it would have resulted in a decrease in the derivative liability and a corresponding
decrease in the accumulated deficit of $7,650,443 as of December 31, 2016. The impact to the financial statements for the year
ended December 31, 2016 is as follows:
Year ended December
31, 2016
As previously As
reported Adjusted
Operating
loss $ (5,522,942 ) $ (5,522,942 )
Other income (expense):
Incentive refund
and interest income 80,259 79,635
Interest expense,
net (298,832 ) (298,208 )
Gain from change
in fair value of derivative warrants 283,496 61,911
Loss
on disposal of equipment and intangible assets (70,143 ) (70,143 )
Total
other income (expense) (5,220 ) (226,805 )
Net
loss $ (5,528,162 ) $ (5,749,747 )
The impact to the
balance sheet as of December 31, 2016 is as follows:
As previously As
reported Adjusted
Derivative
liability-warrants $ 7,900,249 $ 249,807
Total
long-term liabilities $ 9,877,475 $ 2,227,033
Total
liabilities $ 11,117,327 $ 3,466,885
Series
A convertible preferred stock $ 21,634,597 $ 21,574,360
Accumulated
deficit $ (48,899,530 ) $ (41,188,851 )
Total
liabilities and stockholder’s deficit $ 5,990,463 $ 5,990,463 Fair
Value Measurements The
liabilities measured at fair value on a recurring basis using significant unobservable inputs during the year ended December 31,
2017 is as follows:
2017 2016
Balance
at January 1 $ 249,807 $ 8,235,163
(Gain) Loss recognized
in earnings 46,612 (283,496 )
Reclass to equity-Waiver
of Exchange Rights — (51,418 )
Reclass to equity-Adoption
of ASU 2017-11 — (7,650,442 )
Reclass
to equity-Series B Amendment (296,419 ) —
Balance
at December 1 $ — $ 249,807 As
mentioned in further detail in Notes 8 and 9, the warrants issued in connection with the Series B Units were classified as liabilities
until September 30, 2017 when they were reclassified to equity after it was determined they no longer required liability classification. Recent
Accounting Pronouncements In
May 2014, the FASB issued ASU No. 2014-09 (ASC 606), Revenue from Contracts with Customers, which requires an entity to recognize
the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU No.
2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective
for us on January 1, 2018. Early adoption is not permitted. The standard permits the use of either the retrospective or cumulative
effect transition method. We performed an analysis and concluded that the amendment will not have a material impact on our financial
condition or results of operations. ASC
606 will become effective for us beginning with the first quarter of 2018, and we plan to adopt the new accounting standard using
the modified retrospective transition approach. The modified retrospective transition approach will recognize any changes from
the beginning of the year of initial application through retained earnings with no restatement of comparative periods. We will
record revenue under ASC 606 at a single point in time, when control is transferred to the customer, which is consistent with
past practice. We will continue to apply our current business processes, policies, systems and controls to support recognition
and disclosure under the new standard. Based on the results of the evaluation, nothing has come to our attention that would indicate
that adoption of the new standard will have a material impact on our consolidated financial statements. Application of the transition
requirements of the new standard will not have a material impact on opening retained earnings. In
April 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs On
February 24, 2016, the FASB issued ASU No. 2016-02, Leases, requiring lessees to recognize a right-of-use asset and a lease liability
on the balance sheet for all leases with the exception of short-term leases. For lessees, leases will continue to be classified
as either operating or finance leases in the income statement. Lessor accounting is similar to the current model but updated to
align with certain changes to the lessee model. Lessors will continue to classify leases as operating, direct financing or sales-type
leases. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2018 and
interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted using a modified retrospective
transition and requires application of the new guidance at the beginning of the earliest comparative period presented. We are
currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures. On
March 30, 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting, which simplifies various
aspects related to the accounting and presentation of share-based payments. The amendments require entities to record all tax
effects related to share-based payments at settlement or expiration through the income statement and the windfall tax benefit
to be recorded when it arises, subject to normal valuation allowance considerations. All tax-related cash flows resulting from
share-based payments are required to be reported as operating activities in the statement of cash flows. The updates relating
to the income tax effects of the share-based payments including the cash flow presentation must be adopted either prospectively
or retrospectively. Further, the amendments allow the entities to make an accounting policy election to either estimate forfeitures
or recognize forfeitures as they occur. If an election is made, the change to recognize forfeitures as they occur must be adopted
using a modified retrospective approach with a cumulative effect adjustment recorded to opening retained earnings. The effective
date of the new standard for public companies is for fiscal years beginning after December 15, 2016 and interim periods within
those fiscal years. Early adoption is permitted. The adoption of this standard during December 31, 2017 did not have a material
effect on our consolidated statements of financial position, results of operations, or cash flows. In
July 2015, the FASB issued ASU No. 2015-11, (“ASU 2015-11”), Inventory (Topic 330): Simplifying the Measurement of
Inventory. ASU 2015-11 requires an entity to measure in scope inventory at the lower of cost and net realizable value. The amendment
does not apply to inventory that is measured using last-in, first-out or the retail inventory method. For public entities, ASU
2015-11 is effective for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years, and is
to be applied prospectively. The adoption of this standard during the year ended December 31, 2017 did not have a material effect
on our consolidated statements of financial position, results of operations, or cash flows. In
August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230). This update provides clarification regarding how
certain cash receipts and cash payments are presented and classified in the statement of cash flows. This update addresses eight
specific cash flow issues with the objective of reducing the existing diversity in practice. This update is effective for annual
and interim periods beginning after December 15, 2017, which will require us to adopt these provisions in the first quarter of
fiscal 2018 using a retrospective approach. Early adoption is permitted. We do not expect the adoption of this guidance to have
a material impact on our consolidated financial statements. In
July 2017, the FASB issued Accounting Standards Update No. 2017-11, Earnings Per Share (Topic 260), Distinguishing Liabilities
From Equity (Topic 480), Derivatives and Hedging (Topic 815) (“ASU 2017-11”) With
the exception of the standards discussed above, we believe there have been no new accounting pronouncements effective or not yet
effective that have significance, or potential significance, to our Consolidated Financial Statements. JOBS
Act In
April 2012, the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, was enacted. Section 107 of the JOBS Act provides
that an “emerging growth company,” or EGC, can take advantage of the extended transition period for complying with
new or revised accounting standards. Thus, an EGC can delay the adoption of certain accounting standards until those standards
would otherwise apply to private companies. We have irrevocably elected not to avail ourselves of this extended transition period
and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards
is required for other public companies. We
are in the process of evaluating the benefits of relying on other exemptions and reduced reporting requirements under the JOBS
Act. Subject to certain conditions, as an EGC, we intend to rely on certain of these exemptions, including exemptions from the
requirement to provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant
to Section 404(b) of the Sarbanes-Oxley Act and from any requirement that may be adopted by the Public Company Accounting Oversight
Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about
the audit and the financial statements, known as the auditor discussion and analysis. We will remain an EGC until the earlier
of: the last day of the fiscal year in which we have total annual gross revenues of $1.0 billion or more; the last day of the
fiscal year following the fifth anniversary of the date of the completion of our Offering; the date on which we have issued more
than $1.0 billion in nonconvertible debt during the previous three years; or the date on which we are deemed to be a large accelerated
filer under the rules of the SEC. |
