BARFRESH FOOD GROUP INC. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion should be read in conjunction with the financial information included elsewhere in this Quarterly Report on Form 10-Q (this “Report”), including our unaudited condensed consolidated financial statements and the related notes. References in this Management’s Discussion and Analysis of Financial Condition and Results of Operations section to “us”, “we”, “our” and similar terms refer to Barfresh Food Group Inc. This discussion includes forward-looking statements, as that term is defined in the federal securities laws, based upon current expectations that involve risks and uncertainties, such as plans, objectives, expectations and intentions. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors. Words such as “anticipate”, “estimate”, “plan”, “continuing”, “ongoing”, “expect”, “believe”, “intend”, “may”, “will”, “should”, “could” and similar expressions are used to identify forward-looking statements. We caution you that these statements are not guarantees of future performance or events and are subject to a number of uncertainties, risks and other influences, many of which are beyond our control, which may influence the accuracy of the statements and the projections upon which the statements are based. Any one or more of these uncertainties, risks and other influences could materially affect our results of operations and whether forward-looking statements made by us ultimately prove to be accurate. Our actual results, performance and achievements could differ materially from those expressed or implied in these forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether from new information, future events or otherwise. The Company’s products are made in four formats. The first is in portion controlled single serving beverage ingredient packs, suitable for smoothies, shakes and frappes that can also be utilized for cocktails and mocktails. These packs contain all of the ingredients necessary to make a smoothie, shake or frappe, including the ice. Simply add water, empty the packet into a blender, blend and serve. The second format is the bulk “Easy Pour” format. The Company’s bulk “Easy Pour” format also contains all of the solid ingredients necessary to make the beverage, packaged in gallon containers in a concentrated formula that is mixed “one to one” with water. The third format is the Company’s new WHIRLZ 100% Juice Concentrates. These new 5:1 juice concentrates are a perfect complement to the company’s current existing 1:1 bulk Easy Pour products used in beverage dispensing equipment. The fourth format is the Company’s new ready-to-drink bottled smoothie, “Twist & Go”™, This sweet fruit and creamy yogurt smoothie contains four ounces of yogurt and a half-cup of fruit/fruit juice and comes in three different flavors (Peach, Mango and Strawberry/Banana). Domestic and international patents and patents pending are owned by Barfresh, as well as related trademarks for all of the single serve products. Patent rights have been granted in 13 jurisdictions including the United States. In addition, the Company has purchased all of the trademarks related to the patented products. The Company conducts sales through several channels, including National Accounts, Regional Accounts, and Broadline Distributors. Barfresh’s primary broadline distribution arrangement is through an exclusive nationwide agreement with Sysco Corporation (“Sysco”), the U.S.’s largest broadline distributor, which was entered into during July 2014. Pursuant to that agreement, all Barfresh products are included in Sysco’s national core selection of beverage items, making Barfresh its exclusive single-serve, pre-portioned beverage provider. The agreement is mutually exclusive; however, Barfresh may also sell the products to other foodservice distributors, but only to the extent required for such foodservice distributors to service multi-unit chain operators with at least 20 units and where Sysco is not such multi- unit chain operator’s nominated distributor for our products. On October 2, 2019, the exclusive distribution agreement with Sysco expired, opening the possibility to expand distribution with other distributors outside of the Sysco system. During 2016 and 2017, the Company announced that it had signed supply agreements with several of the major global on-site foodservice operators. On March 8, 2018, the Company announced that it had signed a new supply agreement with one of the largest of these foodservice operators, for exclusive distribution of four Barfresh single serve SKUs. On November 14, 2018, the Company announced that it had received approval for multiple products to be rolled out to a national restaurant chain with over 2,500 locations. The Company has multiple SKUs developed and approved by the customer which are awaiting placement on the marketing calendar. 17 On October 26, 2015, Barfresh signed a five-year agreement with PepsiCo North America Beverages, a division of PepsiCo, to become its exclusive sales representative within the food service channel to present the Barfresh line of ready-to-blend smoothies and frozen beverages throughout the United States and Canada. Through this agreement, Barfresh’ products are included as part of PepsiCo’s offerings to its significant customer base. The agreement facilitates access to potential National customer accounts, through introductions provided by PepsiCo’s one thousand plus person foodservice sales team. Barfresh products have become part of PepsiCo’s customer presentations at national trade shows and similar venues. On May 30, 2019, the Company amended its agreement with Pepsi which included a reduction in the commission fee and a clause which allows either party the right to terminate the agreement upon 90 days written notice. Neither party has exercised its right to terminate the agreement. This agreement remains in effect. Barfresh utilizes contract manufacturers to manufacture all of the products in the United States. During November 2016, the Company received an equity investment from Unibel, the majority shareholder of the Bel Group (“Unibel”). The Bel Group is headquartered in Paris, France, with global operations in 33 countries, 30 production sites on 4 continents and nearly 12,000 employees. Its many branded products, including The Laughing Cow®, Mini Babybel® and Boursin®, are sold in over 130 countries around the world. Pursuant to the securities purchase agreement, Unibel purchased 15,625,000 shares of common stock at $0.64 per share (“Shares”) and warrants to purchase 7,812,500 shares of common stock (“Warrants”) for aggregate gross proceeds to Barfresh of $10 million. The Warrants are exercisable for a term of five years at a per share price of $.88 for cash. Pursuant to the Investor Rights agreement, Barfresh has registered the Shares and the Warrants, and Unibel was granted a seat on the Barfresh Board. This strategic investment provided Barfresh with necessary capital while leveraging Unibel’s more than 150 years of industrial expertise, innovative capabilities, world-class marketing and branding expertise to accelerate our growth in new and existing markets and product channels. On February 14, 2018, the Company announced the private placement of convertible notes with gross proceeds of $4.1 million. The closing of the first 60% of this amount occurred between March 12 and 22, 2018, after notice was issued by the Company that it had entered into a material agreement or series of related agreements with a national account for the sale of its products into approximately 1,000 new locations. The remaining 40% of the principal amount was to be received upon achieving a second milestone, which is entering into a material agreement or series of related agreements with a national account for the sale of its products into approximately 2,500 new locations. During November of 2018, the Company and several of the Convertible Note investors agreed to amend the definition of Milestone 2 to allow for the funding the remaining 40% of the principal amount upon the Company receiving approval from a National Restaurant Chain with over 2,500 for the rollout of its products. Such approval was received during the fourth quarter of 2018, and the Company received an additional $1.4 million of convertible note proceeds. The convertible notes were unsecured and had (i) a two-year term, and (ii) a 10% annual coupon to be paid in cash or stock at the Company’s discretion at a conversion price equal to 85% of the average closing bid prices of the Common Stock over the twenty (20) consecutive trading day period immediately preceding the payment date, but in no event lower than sixty cents ($0.60) per share of Common Stock. The investors could elect to convert their principal into common stock at a conversion price equal to the lower of: (i) $0.88 per share of Common Stock, or (ii) 85% of the average closing bid prices of the Common Stock over the twenty (20) consecutive trading day period immediately preceding the date of investor’s election to convert, but in no event lower than $0.60 per share of Common Stock. Investors also received warrant coverage of 25% of the number of shares that would be issuable upon a full conversion of the principal amount at an average of the twenty consecutive trading day period immediately preceding the applicable closing date. If any principal amount were to remain outstanding after the one-year anniversary of the closing, investors would be granted an additional warrant with identical terms. The warrants are exercisable for a period of three years for cash at the greater of 120% of the closing price or $0.70 per share of common stock. After the initial private placement, investors were offered the opportunity to accelerate the issuance of the additional warrant by increasing their convertible note investment by 10% to 20%. After the close of the first quarter 2018, a number of investors took advantage of this acceleration opportunity, resulting in an increase in the amount of the total convertible note by $177,300 and the issuance of 930,332 additional warrants. During the fourth quarter 2018, four of the convertible note investors elected to convert their notes into stock, with a total of $453,000 of convertible debt, plus accrued interest being converted into stock. 18 During the fourth quarter of 2018, one investor exercised 833,333 N warrants for cash, at $0.45 per share. $221,918 of the proceeds of that transaction were used to pay down a short term note payable, held by the same investor, in the amount of $200,000, plus accrued interest. The balance of the proceeds of the N warrant exercise, in the amount of $153,082 were received by the Company. During the first quarter of 2019, the Company completed additional funding, including a Private Placement Offering for common shares priced at $0.60 per share, resulting in the receipt of capital investment in the amount of $2.4 million and the issuance of 4,000,000 shares. In addition, during the first quarter of 2019 the Company offered to reduce the exercise price on its I Warrants from $1 to $0.60, for a limited time. During the time this offer was open, I Warrant holders converted 2,841,454 warrants at $0.60, resulting in the receipt of capital investment in the amount of $1.7 million. In addition, during the first quarter of 2019, one investor exercised G series warrants, resulting in the receipt of capital investment in the amount of $180,000, and the issuance of 300,000 shares. In total, during the first quarter of 2019 the Company raised $4.3 million and issued 7,141,454 shares, and no additional warrants were issued. On March 23, 2020, the Company completed additional funding, including a Private Placement Offering for common shares priced at $0.50 per share (subject to adjustment) resulting in the receipt of proceeds in the amount of $3,825,000 and the issuance of 7,650,000 shares. The investors of this Private Placement Offering were granted O warrants which are eligible to purchase an additional 0.50 shares for every share issued to each purchaser, exercisable for a period of 3 years at an exercise price of $0.60 per share (subject to adjustment). If the volume-weighted average trading price for the 20 consecutive trading days that concluded 6 months after the initial closing (the “Six Month Price”) exceeded or equaled $0.50 per share (the “Target Price”), the per share purchase price would not be adjusted. If the Six Month Price was less than the Target Price, the per share purchase price would be automatically reduced to the Six Month Price, but in no event less than $0.35 per share, in which case the Company would issue to each investor, pro-rata based on such investor’s investment: (a) shares in a quantity that equaled the difference between the number of shares issued to such purchaser at closing and the number of shares that would have been issued to such purchaser at closing at the Six Month Price; and (b) a warrant for a number of shares of common stock equal to 50% of the difference between the number of shares issued to such investor at closing and the number of shares that would have been issued to such investor at closing at the Six Month Price, with an exercise price equal to the sum of $0.10 per share and the Six Month Price, but in no event less than $0.45 per share. The exercise price per share for each warrant would automatically adjust to the sum of $0.10 per share and the Six-Month Price, but in no event less than $0.45 per share. On September 28, 2020, the Company determined the volume-weighted average price was below the $0.35 per share and consequently issued 5,322,868 additional shares in accordance with provisions of the Private Placement Offering. Similarly, the Company issued an additional 2,652,868 Warrants to investors that contributed capital or exercised the conversion of their convertible note. Lastly, the Company issued an additional 459,000 Warrants for convertible noteholders that extended their convertible notes. In addition, the Company obtained a 24 month extension on $1,071,000 in principal, and conversion of $720,000 of principal of the Milestone I Convertible Notes at a conversion price of $0.50 per share. The remaining $110,166 was extended for thirty days. The interest rate on the principal balance of the extended Milestone I Convertible Notes was amended to 15%. Furthermore, the Company obtained a 12 month extension on $168,000 in principal, and conversion of $1,128,000 in principal of the Milestone II Convertible Notes. The Convertible Noteholders of the Milestone I and II Convertible Notes were granted additional interest depending upon their election to convert or extend their Convertible Notes. On June 1, 2021, the Company completed a private placement of 16,666,666 shares of its common stock at $0.36 per share, resulting in gross proceeds of $6,000,000. In addition, holders of debt converted a total of $399,000 in principal and $234,410 in interest into 1,741,873 shares of common stock, debt in the amount of $840,000 was retired, and a PPP loan in the amount of $568,131 was forgiven, leaving the Company with no debt except for a PPP loan in the amount of $568,131. Currently we have 14 employees and 3 consultants. Critical Accounting Policies Our financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). 19 Revenue Recognition In accordance with ASC 606, “Revenue from Contracts with Customers”, revenue is recognized when a customer obtains ownership of promised goods. The amount of revenue recognized reflects the consideration to which the Company expects to be entitled to receive in exchange for these goods. The Company applies the following five steps: 1) Identify the contract with a customer A contract with a customer exists when (i) the Company enters into an enforceable contract with a customer that defines each party’s rights, (ii) the contract has commercial substance and, (iii) the Company determines that collection of substantially all consideration for goods or services that are transferred is probable. For the Company, the contract is the approved sales order, which may also be supplemented by other agreements that formalize various terms and conditions with customers. 2) Identify the performance obligation in the contract Performance obligations promised in a contract are identified based on the goods or that will be transferred to the customer. For the Company, this consists of the delivery of frozen beverages, which provide immediate benefit to the customer. 3) Determine the transaction price The transaction price is determined based on the consideration to which the Company will be entitled in exchange for transferring goods and is generally stated on the approved sales order. Variable consideration, which typically includes volume-based rebates or discounts, are estimated utilizing the most likely amount method. 4) Allocate the transaction price to performance obligations in the contract Since our contracts contain a single performance obligation, delivery of frozen beverages, the transaction price is allocated to that single performance obligation. 5) Recognize Revenue when or as the Company satisfies a performance obligation The Company recognizes revenue from the sale of frozen beverages when title and risk of loss passes and the customer accepts the goods, which generally occurs at the time of delivery to a customer warehouse. Customer sales incentives such as volume-based rebates or discounts are treated as a reduction of sales at the time the sale is recognized. Shipping and handling costs are treated as fulfillment costs and presented in distribution, selling and administrative costs. Stock-based Compensation We account for share-based employee compensation plans under the fair value recognition and measurement provisions in accordance with applicable accounting standards, which require all share-based payments to employees, including grants of stock options and restricted stock units (RSUs), to be measured based on the grant date fair value of the awards, with the resulting expense generally recognized on a straight-line basis over the period during which the employee is required to perform service in exchange for the award. 20 Results of Operations Results of Operation for Three Months Ended September 30, 2021 as Compared to the Three Months Ended September 30, 2020 Revenue and cost of revenue Revenue increased $1,222,936 (173%) from $707,610 in 2020 to $1,930,546 in 2021. The overall revenue for the third quarter 2021 was higher due to growing “Twist & Go”™ revenue and the gradual return of single serve and bulk demand. Cost of revenue for 2021 was $1,209,425 as compared to $423,942 in 2020. Our gross profit was $721,121 (37.4%) and $278,553 (39.4%) for 2021 and 2020, respectively. Gross margin percentages decreased in the third quarter primarily due to higher supply chain costs. We anticipate margins will improve based on improving Twist and Go margins and having a greater mix of higher margin bulk and single serve revenue. As a result, the gross profit percentage for the remainder of 2021 is expected to be approximately 39%. Operating expenses Our operations were primarily directed towards increasing sales and expanding our distribution network. Our general and administrative expenses increased slightly $89,122 (9%) from $976,208 in 2020 to $1,065,330 in 2021. Shipping and storage costs were significantly higher due to higher sales volume due to unprecedented market price and labor shortage, which offset lower research and development, and personnel costs. The following is a breakdown of our general and administrative expenses for the three months ended September 30, 2021 and 2020: three months ended three months ended September 30, 2021 September 30, 2021 Difference Personnel costs $ 349,570 370,010 (20,440 ) Bonus - - - Stock based compensation/options 41,574 45,692 (4,118 ) Legal and professional fees 45,801 29,680 16,121 Travel 15,530 17,331 (1,801 ) Rent 19,818 19,813 5 Marketing and selling 35,571 55,194 (19,623 ) Consulting fees 20,744 9,005 11,739 Director fees 50,000 50,000 - Research and development 34,454 147,738 (113,284 ) Shipping expense and storage 335,414 126,737 208,677 Other expenses 116,854 105,008 11,846 $ 1,065,330 976,208 89,122 21 Personnel cost represents the cost of employees including salaries, bonuses, employee benefits and employment taxes and continues to be one of our largest costs. Personnel cost decreased $20,440 (6%) from $370,010 to $349,570. We had 17 full time employees at the end of the third quarter of 2020, and we currently have 14 full time employees. Stock based compensation is used as an incentive to attract new employees and to compensate existing employees. Stock based compensation includes stock issued and options granted to employees and non-employees. Stock based compensation for the current quarter was $41,574, a decrease of $4,118, or (9%), from the year ago quarter expense of $45,692 The Company issues additional stock options to its employees from time to time under its Equity Compensation Plan. Legal and professional fees increased $16,121 (54%) from $29,680 in 2020 to $45,801 in 2021. The increase was primarily due to legal services for up listing. We anticipate legal fees related to our business and financing activities to decrease as we have renegotiated arrangements with existing service providers. Travel expenses decreased $1,801 (10%) from $17,331 in 2020 to $15,530 in 2021. We anticipate that travel expenses for the remainder of this year will gradually pick up and for the second half of 2021 comparable to 2019 trends. Rent expense remained flat for the three months ended September 30, 2020 compared to the three months ended September 30, 2021. Rent expense is for our location in Los Angeles, California. Rent expense for the Los Angeles office is approximately $6,500 per month. We lease office space at 3600 Wilshire Boulevard, Los Angeles, California pursuant to a new lease that commenced on April 1, 2019 and expires March 31, 2023. Marketing and selling expenses decreased $19,623 (36%) from $55,194 in 2020 to $35,571 in 2021. Lower marketing and selling expenses were primarily due to changes that were made to certain sales commission agreements. Consulting fees were $20,774 in 2021, as compared with $9,005 in 2020, an increase of 130%. Our consulting fees vary based on needs. We engaged consultants in the areas of finance during the quarter due to reduced headcount. The need for future consulting services will be variable. Director fees are flat $50,000 in 2020 to $50,000 in 2021. Annual director fees are anticipated at $50,000 per non-employee director of which six directors will be compensated in 2021. Research and development expenses decreased $113,284 (77%) from $147,738 in 2020 to $34,454 in 2021. These expenses relate to the services performed by our Director of Manufacturing and Product Development, and consultants supporting that employee. The reduction is primarily due to a reduction in labor hours for our development staff. Shipping and storage expense became our largest expense in third quarter 2021, it increased $208,677 (165%) from $126,737 in 2020 to $335,414 in 2021. This is primarily due to higher sales volume, higher fuel costs, and from relocating materials from one location to another. We anticipate that shipping and storage expense as a percentage of sales will reduce during the balance of the year, as the Company is able to take advantage of more efficient distribution arrangements as well as an increased volume per load due to higher sales volume in 2021. Other expenses increased $11,846 (11%) from $105,008 in 2020 to $116,854 in 2021, primarily due to lower insurance expense and the results of the cash and accrued expense reconciliations. Other expenses consist of ordinary operating expenses such as investor relations, office, telephone, insurance, and stock related costs. We anticipate these expenses to be comparable to 2020 for the balance of the year. 22 We had operating losses of $506,660 and $836,384 for the three-month periods ended September 30, 2021 and 2020, respectively. The improvement of $329,724 or (39%), was primarily due to higher sales volume and related product margin. The change in the value of the derivative liability is based upon the Black-Scholes model from one period to another. The loss is a result of the change in components of the Black-Scholes model. Components include the Company’s stock price, conversion price, remaining term, volatility, and current discount rate. The derivative liability was settled upon conversion and repayment of the convertible notes in 2020. We had net losses of $506,660 and $878,257 in the three-month periods ended September 30, 2021 and 2020, respectively. Results of Operation for Nine Months Ended September 30, 2021 as Compared to the Nine Months Ended September 30, 2020 Revenue and cost of revenue Revenue increased $2,298,842 (118%) from $1,947,766 in 2020 to $4,246,608 in 2021. The overall revenue for the third quarter 2021 was higher due to growing “Twist & Go”™ revenue and the gradual return of single serve demand. Cost of revenue for 2021 was $2,597,121 as compared to $1,142,391 in 2020. Our gross profit was $1,631,814 (38.4%) and $790,658 (40.6%) for 2021 and 2020, respectively. Gross margins decreased in the third quarter primarily due to product mix which includes “Twist & Go”™ at lower product margins. We anticipate margins will improve based on improving Twist and Go margins and having a greater mix of higher margin bulk and single serve revenue. As a result, the gross profit percentage for the remainder of 2021 is expected to be approximately 39%. Operating expenses Our operations were primarily directed towards increasing sales and expanding our distribution network. Our general and administrative expenses decreased $450,378 (14%) from $3,284,673 in 2020 to $2,834,295 in 2021, with the improvement primarily driven by the following lower expenses: personnel and marketing and selling expenses resulting from lower headcount and the renegotiation of certain sales commission agreements, stock based compensation, research and development and legal and professional fees. The following is a breakdown of our general and administrative expenses for the nine months ended September 30, 2021 and 2020: nine months ended September 30, nine months ended September 30, 2021 2020 Difference Personnel costs 1,015,070 1,217,690 (202,620 ) Stock based compensation/options 51,857 240,216 (188,359 ) Legal and professional fees 154,188 273,177 (118,989 ) Travel 33,493 69,167 (35,674 ) Rent 59,489 59,657 (168 ) Marketing and selling 117,436 192,006 (74,570 ) Consulting fees 89,956 69,193 20,763 Director fees 200,000 150,000 50,000 Research and development 172,900 326,892 (153,992 ) Shipping and storage 716,552 356,270 360,282 Other expenses 223,354 330,405 (107,051 ) 2,834,295 3,284,673 (450,378 ) 23 Personnel cost represents the cost of employees including salaries, bonuses, employee benefits and employment taxes and continues to be our largest cost. Personnel cost decreased $202,620 (17%) from $1,217,690 to $1,015,070. We had 17 full time employees at the end of the third quarter of 2020, and we currently have 14 full time employees. Stock based compensation is used as an incentive to attract new employees and to compensate existing employees. Stock based compensation includes stock issued and options granted to employees and non-employees. Stock based compensation for the nine months ended September 30, 2021 was $51,857, a decrease of $188,359, or 78%, from the year ago period expense of $240,216. The Company issues additional stock options to its employees from time to time under its Equity Compensation Plan. Legal and professional fees decreased $118,989 (44%) from $273,177 in 2020 to $154,188 in 2021. The decrease was primarily due to renegotiated fees for legal services. We anticipate legal fees related to our business and financing activities to decrease as we have renegotiated arrangements with existing service providers. Travel expenses decreased $35,674 (52%) from $69,167 in 2020 to $33,493 in 2021. The decrease is primarily due to reduction in travel costs associated with terminated employees, tighter controls over sales territories, and reduced travel due to COVID-19. We anticipate that travel expenses for the remainder of this year will gradually pick up and for the second half of 2021 be comparable to 2019 trends. Rent expense remained flat for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2021. Rent expense is for our location in Los Angeles, California. Rent expense for the Los Angeles office is approximately $6,500 per month. We lease office space at 3600 Wilshire Boulevard, Los Angeles, California pursuant to a new lease that commenced on April 1, 2019 and expires March 31, 2023. Marketing and selling expenses decreased $74,570 (39%) from $192,006 in 2020 to $117,436 in 2021. Lower marketing and selling expenses were primarily due to changes that were made to certain sales commission agreements. Consulting fees were $89,956 in 2021, as compared with $69,193 in 2020, an increase of $20,763 (30%). Our consulting fees vary based on needs. We engaged consultants in the areas of finance during the quarter due to reduced headcount. The need for future consulting services will be variable. Director fees increased $50,000 (33%) from $150,000 in 2020 to $200,000 in 2021. Annual director fees are anticipated at $50,000 per non-employee director of which two additional directors will be compensated in 2021. Research and development expenses decreased $153,992 (47%) from $326,892 in 2020 to $172,900 in 2021. These expenses relate to the services performed by our Director of Manufacturing and Product Development, and consultants supporting that employee. The reduction is primarily due to a reduction in labor hours for our development staff. Shipping and storage expense increased $360,282 (101%) from $356,270 in 2020 to $716,552 in 2021. This is primarily due to higher sales volume, higher fuel costs, and from relocating materials from one location to another. We anticipate that shipping and storage expense as a percentage of sales will reduce during the balance of the year, as the Company is able to take advantage of more efficient distribution arrangements as well as an increased volume per load due to higher sales volume in 2021. Other expenses decreased $107,051 (32%) from $330,405 in 2020 to $223,354 in 2021, primarily due to lower insurance expense and the results of the vendor, cash and accrued expenses reconciliation. Other expenses consist of ordinary operating expenses such as investor relations, office, telephone, insurance, and stock related costs. We anticipate these expenses to be comparable to 2020 for the balance of the year. We had operating losses of $1,658,229 and $2,936,392 for the nine-month periods ended September 30, 2021 and 2020, respectively. The improvement of $1,278,163 or 44%, was primarily to higher sales volume and related product margin. 24 The change in the value of the derivative liability is based upon the Black-Scholes model from one period to another. The gain is a result of the change in components of the Black-Scholes model. Components include the Company’s stock price, conversion price, remaining term, volatility, and current discount rate. The derivative liability was settled upon conversion and repayment of the convertible notes. The PPP loan in the amount of $568,131 was forgiven and debt extinguished, resulting in other operating income of $568,131. The debt settlement in the second quarter resulted in debt converted of $399,000 in principal and $280,610 in interest into 1,741,873 shares of common stock, with debt in the amount of $840,000 repaid, resulting in a loss of $193,562. Interest expense for the nine months ended September 30, 2021 was $128,064, as compared with $420,634 for the nine months ended September 30, 2020. Interest decreased $292,570 (70%) due to conversion and repayment of $2,005,366 in convertible notes during the first quarter of 2020, and the debt is fully repaid in second quarter 2021. We had net losses of $1,395,419 and $2,800,843 in the nine-month periods ended September 30, 2021 and 2020, respectively. Liquidity and Capital Resources As of September 30, 2021, we had a working capital surplus of $6,214,494 as compared with a working capital surplus of $1,196,741 at December 31, 2020. The increase in working capital surplus is primarily due to the completion of the private placement of our common stock which resulted in gross proceeds of $6,000,000, offset by the debt extinguishment of all convertible debt of which $840,000 of the principal debt was paid in cash. In 2020, the Company was granted a $568,131 loan under the PPP administered by a Small Business Administration (SBA) approved partner. The loan, which matures in two years, is uncollateralized and is fully guaranteed by the Federal government. The Company was eligible for loan forgiveness of up to 100% of the loan, upon meeting certain requirements, and recorded the forgiveness upon being legally released from the loan obligation by the SBA during the three months ended June 30, 2021. On January 27, 2021, the Company was granted a $568,131 loan under the PPP administered by a SBA approved partner. The loan, which matures in five years, at an interest rate of 1%, and is uncollateralized and is fully guaranteed by the Federal government. The deferral period is 24 weeks plus 10 months from the loan note date. The Company is eligible for loan forgiveness of up to 100% of the loan, upon meeting certain requirements. The Company has recorded a note payable and will record the forgiveness upon being legally released from the loan obligation by the SBA. The Company will be required to repay any remaining balance, plus interest accrued at 1 percent, in monthly payments commencing upon notification that the loan will not be forgiven or only partially forgiven. The Company anticipates the loan to be forgiven in the second half of 2021. On June 1, 2021, the Company completed a private placement of 16,666,666 shares of its common stock at $0.36 per share, resulting in gross proceeds of $6,000,000. In addition, holders of debt converted a total of $399,000 in principal and $234,410 in interest into 1,741,873 shares of common stock and debt in the amount of $840,000 was retired, leaving the Company with no debt except for the PPP loan in the amount of $568,131. During the nine months ended September 30, 2021, we used cash of $1,093,967 in operations, $137,405 for the purchase of equipment, and $4,374 for patents and trademarks. Our liquidity needs will depend on how quickly we are able to profitably ramp up sales, as well as our ability to control and reduce variable operating expenses, and to continue to control and reduce fixed overhead expense. Our operations to date have been financed by the sale of securities, the issuance of convertible debt and the issuance of short-term debt, including related party advances. If we are unable to generate sufficient cash flow from operations with the capital raised we will be required to raise additional funds either in the form of equity or in the form of debt. There are no assurances that we will be able to generate the necessary capital to carry out our current plan of operations. We have entered into a direct lease for premises covering the period April 1, 2019 to March 31, 2023. The aggregate minimum requirements under the non-cancellable direct lease as of September 30, 2021 is $111,180. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to stockholders. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Not required because we are a smaller reporting company. 25