Karat Packaging Inc. 10-K

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA KARAT PACKAGING INC. INDEX TO THE CONSOLIDATED FINANCIAL STATEMENTS Audited Consolidated Financial Statements Report of Independent Registered Public Accounting Firm (BDO USA, LLP, Los Angeles, California PCAOB ID No. 243 ) 41 Consolidated Balance Sheets 42 Consolidated Statements of Income 44 Consolidated Statement of Stockholders' Equity 45 Consolidated Statements of Cash Flows 46 Notes to Consolidated Financial Statements 48 40 Report of Independent Registered Public Accounting Firm Stockholders and Board of Directors Karat Packaging Inc. Chino, California Opinion on the Consolidated Financial Statements We have audited the accompanying consolidated balance sheets of Karat Packaging Inc. and subsidiaries (the “Company”) as of December 31, 2022 and 2021, the related consolidated statements of income, stockholders’ equity, and cash flows for the years then ended, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2022 and 2021, and the results of its operations and its cash flows for the years then ended , in conformity with accounting principles generally accepted in the United States of America. Change in Accounting Method Related to Leases As discussed in Notes 2 and 14 to the consolidated financial statements, the Company has changed its method for accounting for leases effective January 1, 2022 due to the adoption of Accounting Standards Codification 842 - Leases. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. /s/ BDO USA, LLP We have served as the Company’s auditor since 2016. Los Angeles, California March 16, 2023 41 KARAT PACKAGING INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share data) December 31, 2022 December 31, 2021 Assets Current assets Cash and cash equivalents (including $ 2,022 and $ 1,163 associated with variable interest entity at December 31, 2022 and 2021, respectively) $ 16,041 $ 6,483 Accounts receivable, net of allowance for bad debt of $ 1,260 and $ 250 at December 31, 2022 and 2021, respectively (including $ 6 and $ 24 associated with variable interest entity at December 31, 2022 and 2021, respectively) 29,912 32,776 Inventories 71,206 58,472 Prepaid expenses and other current assets (including $ 191 and $ 63 associated with variable interest entity at December 31, 2022 and 2021, respectively) 6,641 5,141 Total current assets 123,800 102,872 Property and equipment, net (including $ 45,399 and $ 46,612 associated with variable interest entity at December 31, 2022 and 2021, respectively) 95,568 93,475 Deposits 12,413 6,885 Goodwill 3,510 3,510 Intangible assets, net 353 380 Operating right-of-use assets 15,713 — Other assets (including $ 38 and $ 65 associated with variable interest entity at December 31, 2022 and 2021, respectively) 818 477 Total assets $ 252,175 $ 207,599 Liabilities and Stockholders’ Equity Current liabilities Accounts payable (including $ 2 and $ 136 associated with variable interest entity at December 31, 2022 and 2021, respectively) $ 18,559 $ 18,470 Accrued expenses (including $ 625 and $ 68 associated with variable interest entity at December 31, 2022 and 2021, respectively) 9,005 7,813 Related party payable 4,940 2,003 Income taxes payable (including $ 0 and $ 9 associated with variable interest entity at December 31, 2022 and 2021, respectively) — 85 Customer deposits (including $ 165 and $ 88 associated with variable interest entity at December 31, 2022 and 2021, respectively) 1,281 1,215 Debt, current portion (including $ 957 and $ 1,178 associated with variable interest entity at December 31, 2022 and 2021, respectively) 957 1,178 Operating lease liabilities, current portion 4,511 — Total current liabilities 39,253 30,764 42 December 31, 2022 December 31, 2021 Deferred tax liability 5,156 5,634 Long-term debt, net of current portion and debt discount of $ 216 and $ 200 at December 31, 2022 and December 31, 2021, respectively (including $ 41,558 and $ 35,339 associated with variable interest entity at December 31, 2022 and 2021, respectively, and debt discount of $ 216 and $ 200 associated with variable interest entity at December 31, 2022 and 2021, respectively) 41,558 35,339 Operating lease liabilities, net of current portion 11,623 — Other liabilities (including $ 1,302 and $ 2,637 associated with variable interest entity at December 31, 2022 and 2021, respectively) 2,652 3,837 Total liabilities 100,242 75,574 Commitments and Contingencies (Note 18) Karat Packaging Inc. stockholders’ equity Preferred stock, $ 0.001 par value, 10,000,000 shares authorized, no shares issued and outstanding, as of December 31, 2022 and 2021 — — Common stock, $ 0.001 par value, 100,000,000 shares authorized, 19,908,005 and 19,885,005 shares issued and outstanding, respectively, as of December 31, 2022 and 19,827,417 and 19,804,417 shares issued and outstanding, respectively, as of December 31, 2021 20 20 Additional paid in capital 85,792 83,694 Treasury stock, $ 0.001 par value, 23,000 shares as of both December 31, 2022 and 2021 ( 248 ) ( 248 ) Retained earnings 56,118 39,434 Total Karat Packaging Inc. stockholders’ equity 141,682 122,900 Noncontrolling interest 10,251 9,125 Total stockholders’ equity 151,933 132,025 Total liabilities and stockholders’ equity $ 252,175 $ 207,599 The accompanying notes to the consolidated financial statements are an integral part of these statements.  43 KARAT PACKAGING INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands, except share and per share data) Year Ended December 31, 2022 2021 Net sales $ 422,957 $ 364,244 Cost of goods sold 290,871 256,417 Gross profit 132,086 107,827 Operating expenses: Selling expenses 35,844 32,261 General and administrative expenses (including $ 2,775 and $ 2,550 associated with variable interest entity for the years ended December 31, 2022 and 2021, respectively) 66,227 52,421 Total operating expenses 102,071 84,682 Operating income 30,015 23,145 Other income (expenses) Rental income (including $ 949 and $ 931 associated with variable interest entity for the years ended December 31, 2022 and 2021, respectively) 949 931 Other (expense) income (including $ 0 and $ 9 other income associated with variable interest entity for the years ended December 31, 2022 and 2021, respectively) ( 228 ) 259 Gain (loss) on foreign currency transactions 1,568 ( 412 ) Interest income (including $ 2,171 and $ 1,270 associated with variable interest entity for the years ended December 31, 2022 and 2021, respectively) 2,226 1,512 Interest expense (including $ 1,821 and $ 1,781 associated with variable interest entity for the years ended December 31, 2022 and 2021, respectively) ( 2,017 ) ( 2,907 ) Gain on forgiveness of debt — 5,000 Total other income, net 2,498 4,383 Income before provision for income taxes 32,513 27,528 Provision for income taxes 6,676 5,089 Net income 25,837 22,439 Net income attributable to noncontrolling interest 2,189 1,661 Net income attributable to Karat Packaging Inc. $ 23,648 $ 20,778 Basic and diluted earnings per share: Basic $ 1.19 $ 1.13 Diluted $ 1.19 $ 1.12 Weighted average common shares outstanding, basic 19,824,911 18,409,243 Weighted average common shares outstanding, diluted 19,925,905 18,566,260 The accompanying notes to the consolidated financial statements are an integral part of these statements.  44 KARAT PACKAGING INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In thousands, except share and per share data) Common Stock Treasury Stock Additional Paid-in Capital Retained Earnings Total Stockholders’ Equity Attributable to Karat Packaging Inc. Noncontrolling Interest Total Stockholders’ Equity Shares Amount Shares Amount Balance, January 1, 2021 15,190,000 $ 15 ( 23,000 ) $ ( 248 ) $ 13,981 $ 18,656 $ 32,404 $ 7,464 $ 39,868 Issuance of common stock in connection with our initial public offering, net of issuance costs of $ 5,088 4,542,500 5 — — 67,587 — 67,592 — 67,592 Issuance of common stock upon vesting of restricted stock units 84,917 — — — — — — — — Stock-based compensation — — — — 2,026 — 2,026 — 2,026 Exercise of stock options 10,000 — — — 100 — 100 — 100 Net income — — — — — 20,778 20,778 1,661 22,439 Balance, December 31, 2021 19,827,417 $ 20 ( 23,000 ) $ ( 248 ) $ 83,694 $ 39,434 $ 122,900 $ 9,125 $ 132,025 Cash dividends declared ($ 0.35 per share) — — — — ( 6,964 ) ( 6,964 ) — ( 6,964 ) Issuance of common stock upon vesting of restricted stock units 75,588 — — — — — — — — Stock-based compensation — — — — 2,047 — 2,047 — 2,047 Exercise of stock options 5,000 — — — 51 — 51 — 51 Noncontrolling interest tax withholding — — — — — — ( 1,063 ) ( 1,063 ) Net income — — — — — 23,648 23,648 2,189 25,837 Balance, December 31, 2022 19,908,005 $ 20 ( 23,000 ) $ ( 248 ) $ 85,792 $ 56,118 $ 141,682 $ 10,251 $ 151,933 The accompanying notes to the consolidated financial statements are an integral part of these statements. 45 KARAT PACKAGING, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Year Ended December 31, 2022 2021 Cash flows from operating activities Net income $ 25,837 $ 22,439 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 10,405 10,044 Adjustments to allowance for bad debt 1,010 — Adjustments to inventory reserve 6 68 Write-off of inventory 3,470 1,424 Gain on sale of asset ( 32 ) — Change in fair value of interest rate swap ( 2,159 ) ( 1,512 ) Amortization of loan fees 40 18 Deferred income taxes ( 478 ) ( 483 ) Stock-based compensation 2,047 2,026 Gain on forgiveness of debt — ( 5,000 ) Amortization of operating right-of-use assets 3,822 — Impairment of deposit 465 — (Increase) decrease in operating assets Accounts receivable 1,854 ( 8,938 ) Inventories ( 16,210 ) ( 10,850 ) Prepaid expenses and other current assets ( 1,514 ) 1,389 Deposits ( 145 ) ( 64 ) Other assets 109 ( 316 ) Increase (decrease) in operating liabilities Accounts payable 89 ( 1,599 ) Accrued expenses 1,571 2,854 Related party payable 2,937 ( 3,035 ) Income taxes payable ( 85 ) 44 Customer deposits 66 664 Operating lease liability ( 3,780 ) — Other liabilities 149 300 Other payable — ( 794 ) Net cash provided by operating activities $ 29,474 $ 8,679 Cash flows from investing activities Purchases of property and equipment ( 2,657 ) ( 4,175 ) Proceeds from disposal of property and equipment 77 — Deposits paid for property and equipment ( 12,090 ) ( 8,206 ) Deposits paid for joint venture investment ( 5,876 ) — Deposits refunded from joint venture investment 1,876 — Proceeds from settlement of interest rate swap 825 — Acquisition of Pacific Cup, Inc., net of cash acquired — ( 900 ) Net cash used in investing activities $ ( 17,845 ) $ ( 13,281 ) 46 Year Ended December 31, 2022 2021 Cash flows from financing activities Proceeds from line of credit 21,100 1,470 Payments on line of credit ( 21,100 ) ( 34,639 ) Proceeds from long-term debt 27,477 15,997 Payments on long-term debt ( 21,572 ) ( 39,272 ) Proceeds from issuance of common stock in connection with initial public offering, net of issuance costs — 67,592 Proceeds from exercise of stock options 51 100 Dividends paid to shareholders ( 6,964 ) — Payments on capital lease obligations — ( 611 ) Payments of noncontrolling interest tax withholding ( 1,063 ) — Net cash (used in) provided by financing activities $ ( 2,071 ) $ 10,637 Net increase in cash and cash equivalents 9,558 6,035 Cash and cash equivalents Beginning of year $ 6,483 $ 448 End of year $ 16,041 $ 6,483 Supplemental disclosures of non-cash investing and financing activities: Transfers from deposit to property and equipment $ 9,859 $ 4,981 Acquisition price of Pacific Cup, Inc. included within deposits — 100 Gain on forgiveness of debt — 5,000 Supplemental disclosures of cash flow information: Cash paid for income tax $ 8,303 $ 4,836 Cash paid for interest $ 1,978 $ 2,895 The accompanying notes to the consolidated financial statements are an integral part of these statements.  47 KARAT PACKAGING INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Nature of Operations Lollicup USA Inc. (“Lollicup”) was incorporated on January 21, 2001 under the laws of the State of California as an S-corporation. Effective January 1, 2018, Lollicup elected to convert from an S-Corporation to a C-Corporation. Karat Packaging Inc. (“Karat Packaging”) was incorporated on September 26, 2018 as a Delaware corporation and became the holding company for Lollicup (collectively, the “Company”) through a share exchange with the shareholders of Lollicup. On April 15, 2021, the Company completed an initial public offering of shares of its common stock. The shares are listed on the NASDAQ Global Market under the symbol "KRT". The Company is a manufacturer and distributor of single-use disposable products used in a variety of restaurant and foodservice settings. The Company supplies a wide range of products such as food containers, tableware, cups, lids, cutlery, and straws. The products are available in plastic, paper, biopolymer-based and other compostable forms. In addition to manufacturing and distribution, the Company offers customized solutions to customers, including new product development, design, printing, and logistics services, and distributes certain specialty food and beverages products, such as boba and coffee drinks. The Company supplies products to national and regional distributors, supermarkets, restaurants, and convenience stores as well as to smaller chains and businesses including boutique coffee houses, bubble tea cafes, pizza parlors and frozen yogurt shops. The Company currently operates manufacturing facilities and distribution and fulfillment centers in Chino, California; Rockwall, Texas and Kapolei, Hawaii. In addition, the Company operates six other distribution centers located in Branchburg, New Jersey; Sumner, Washington; Summerville, South Carolina; Kapolei, Hawaii and City of Industry, California. 2. Summary of Significant Accounting Policies Basis of Presentation: The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) and the rules of the Securities and Exchange Commission (“SEC”). Principles of Consolidation: The consolidated financial statements include the accounts of Karat Packaging and its wholly-owned and controlled operating subsidiaries, Lollicup, Lollicup Franchising, LLC (“Lollicup Franchising”) and Global Wells, a variable interest entity wherein the Company is the primary beneficiary. All intercompany accounts and transactions have been eliminated. Noncontrolling Interests: The Company consolidates its variable interest entity, Global Wells, in which the Company is the primary beneficiary. Noncontrolling interests represent third-party equity ownership interests in Global Wells. The Company recognizes noncontrolling interests as equity in the consolidated financial statements separate from the Company’s stockholders’ equity. The amount of net income attributable to noncontrolling interests is disclosed in the consolidated statements of income. Tax payments made by the Company on behalf of the noncontrolling interests are deducted from their equity balances, as shown in the consolidated statements of stockholders’ equity. Estimates and Assumptions: Management uses estimates and assumptions in preparing financial statements in accordance with GAAP. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Actual results could differ materially from the estimates that were assumed in preparing the consolidated financial statements. Estimates that are significant to the consolidated financial statements include stock-based compensation, allowance for doubtful accounts and reserve for slow-moving and obsolete inventory. Reporting Segments: The Company manages and evaluates its operations in one reportable segment. This segment consists of manufacturing and supply of a broad portfolio of single-use products that are used to serve food and beverages and are available in plastic, paper, foam, post-consumer recycled content and renewable materials. It also consists of the distribution of certain specialty food and beverage products, such as boba and coffee drinks, and certain restaurant and warehouse supplies. The Company’s long-lived assets are all located in the United States, and its revenues are all generated in the United States. 48 Earnings per share: Basic earnings per common share is calculated by dividing net income attributable to Karat Packaging, Inc by the weighted average number of common shares outstanding during the related period. Diluted earnings per common share is calculated by adjusting weighted average outstanding shares, assuming conversion of all potentially dilutive shares. Out-of-period adjustment: During the the year ended December 31, 2022, the Company recorded a $ 3,500,000 write off of certain inventory items out of which $ 879,000 was determined to be out-of-period and was recorded to correct immaterial errors in its previously issued quarterly and annual financial statements. The impact of the inventory out-of-period adjustment was a decrease to inventory, operating income and income before provision for income taxes of $ 879,000 , an increase to cost of goods sold of $ 879,000 , and a decrease to net income of $ 664,000 for the year ended December 31, 2022. Reclassification: Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications had no effect on previously reported totals for assets and liabilities, shareholders' equity, cash flows or net income. Cash and cash equivalents: The Company considers all highly liquid investments purchased with an original maturity at the date of purchase of three months or less to be cash equivalents. At December 31, 2022 and 2021, cash and cash equivalents were comprised of cash held in money markets, cash on hand and cash deposited with banks. Accounts Receivable and Allowances: Accounts receivable consists primarily of amounts due from customers. Accounts receivable are carried at their estimated collectible amounts and are periodically evaluated for collectability based on past credit history. The Company recognizes an allowance for bad debt on accounts receivable in an amount equal to the estimated probable losses net of recoveries. The allowance is based on an analysis of historical bad debt write-offs, current past due customers in the aging, risk profiles associated with different customer types, as well as an assessment of specific identifiable customer accounts considered at risk or uncollectible. The Company also maintains a sales allowance primarily related to potential billing adjustments due to situations such as product returns and damages. The amount of the sales allowance is determined based on a historical transaction analysis and any additions to the sales allowance are recorded as a reduction to net revenue. Inventories: Inventories consist of raw materials, work-in-process, and finished goods. Inventory cost is determined using the first-in, first-out (FIFO) method and valued at lower of cost or net realizable value. The Company maintains a reserve for excess and obsolete inventory and carries its inventory at net realizable value, taking into account various factors including historic usage, expected demand, anticipated sales price, and product obsolescence. Property and Equipment: Property and equipment are carried at cost, net of accumulated depreciation and amortization, and net of impairment losses, if any. Depreciation of property and equipment are computed by straight-line method over the estimated useful lives of the related assets. Leasehold improvements are amortized using the straight-line method over the term of the lease, or the estimated life of the improvement, whichever is less. The estimated useful life of property and equipment are as follows: Machinery and equipment 5 years to 15 years Leasehold improvements Lesser of useful life or lease term Vehicles 5 years Furniture and fixtures 7 years Building and building improvements 10 years to 40 years Property held under capital leases 3 years to 5 years Computer hardware and software 3 years Normal repairs and maintenance are expensed as incurred, whereas significant changes that materially increase values or extend useful lives are capitalized and depreciated over the estimated useful lives of the related assets. Deposits: Deposits are payments made for machinery and equipment, and construction and improvement for the Company’s facilities. Included in deposits are also payments made to lessors of leased properties as security for the full and faithful observance of contracts, which will be refunded to the Company upon expiration or termination of the contract. Impairment of Long-lived Assets: The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. If such events or circumstances exist, an impairment test is performed which comprises of two steps. The first step compares the carrying amount of the asset to the sum of expected undiscounted future cash flows. If the sum of expected undiscounted future cash 49 flows exceeds the carrying amount of the asset, no impairment is taken. If the sum of expected undiscounted future cash flows is less than the carrying amount of the asset, a second step is warranted and an impairment loss is measured as the amount by which the carrying amount of the asset exceeds its fair value calculated using the present value of estimated net future cash flows. For the years ended December 31, 2022 and 2021, management concluded that an impairment write-down was not required. Business Combination and Goodwill: The Company applies the acquisition method of accounting for business combinations in accordance with GAAP, which requires the Company to make use of estimates and judgments to allocate the purchase price paid for acquisitions to the fair value of the assets, including identifiable intangible assets, and liabilities acquired. Such estimates may be based on significant unobservable inputs. The Company’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings. Goodwill is the excess of the acquisition price over the fair value of the tangible and identifiable intangible net assets acquired. The Company performs an impairment test of goodwill annually or whenever events and circumstances indicate that the carrying amount of goodwill may exceed its fair value. The Company operates as a single operating segment with one reporting unit and consequently evaluates goodwill for impairment based on an evaluation of the fair value of the Company as a whole. During the years ended December 31, 2022 and 2021, the Company determined no impairments have occurred. The following table summarizes the activity in the Company's goodwill from December 31, 2020 to December 31, 2022: (in thousands) Balance at December 31, 2020 $ 3,113 Goodwill acquired 397 Balance at December 31, 2021 $ 3,510 Goodwill acquired — Balance at December 31, 2022 $ 3,510 Government Grants: Government grants are not recognized unless there is reasonable assurance that the Company and Global Wells will comply with the grants’ conditions and that the grants will be received. As of December 31, 2022 and 2021, the Company received cumulative grants of $ 1,350,000 and $ 1,200,000 , respectively. As of both December 31, 2022 and 2021, Global Wells received cumulative grants of $ 1,302,000 . These grants are reported as deferred income within other liabilities in the accompanying consolidated balance sheets as there are conditions attached to the grants that the Company and Global Wells have not met. These conditions include requiring the facility in Rockwall, Texas to maintain a certain minimum tax value for 5 years calendar years through 2024 (the “Required Period”), continue operations in the facility for the Required Period, have a minimum number of full time equivalent employees with a minimum average annual gross wage employed in the operation of the facility in the Required Period, and promise to not engage in a pattern or practice of unlawful employment of aliens during the Required Period. Derivative Instruments: Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) 815, Derivatives and Hedging , requires companies to recognize all of its derivative instruments as either assets or liabilities in the balance sheet at fair value. The accounting for changes in the fair value (i.e., gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, a company must designate the hedging instrument, based upon the exposure being hedged, as a fair value hedge, cash flow hedge, or a hedge of a net investment in a foreign operation. For derivative instruments not designated as hedging instruments, the gain or loss is recognized in the statement of income during the current period. The Company and Global Wells entered into certain interest rate swaps to manage the interest rate risk, and accounted for such interest rate swaps as a derivative instrument under ASC 815. The interest rate swaps were not designated for hedge accounting and as such, the change in the fair value of interest rate swaps was recognized as interest income (expense) in the accompanying consolidated statements of income. Variable Interest Entities: The Company has a variable interest in Global Wells. In 2017, Lollicup along with three other unrelated parties formed Global Wells. Lollicup has a 13.5 % ownership interest and a 25 % voting interest in Global Wells, located in Rockwall, Texas. The purpose of this entity is to own, construct, and manage a warehouse and a 50 manufacturing facility. Global Wells’ operating agreement may require its members to make additional contributions only upon the unanimous decision of the members or where the cash in Global Wells’ bank account falls below $ 50,000 . In the event that a member is unable to make an additional capital contribution, the other members will be required to make contributions to offset the amount that member cannot contribute, up to $ 25,000 . Global Wells was determined to be a variable interest entity in accordance with ASC Topic 810, Consolidations, however, at the time the investment was made, it was determined that Lollicup was not the primary beneficiary. In 2018, Lollicup entered into an operating lease with Global Wells (“Texas Lease”). In 2020, the Company entered into another operating lease with Global Wells (“New Jersey Lease”). Upon entering into the Texas Lease with Lollicup on March 23, 2018, it was determined that Lollicup holds current and potential rights that give it the power to direct activities of Global Wells that most significantly impact Global Wells’ economic performance, receive significant benefits, or the obligation to absorb potentially significant losses, resulting in Lollicup having a controlling financial interest in Global Wells. As a result, Lollicup was deemed to be the primary beneficiary of Global Wells and has consolidated Global Wells under the risk and reward model of ASC 810, for the period from March 23, 2018. The monthly lease payments for the Texas Lease and New Jersey Lease are eliminated upon consolidation. Assets recognized as a result of consolidating Global Wells do not represent additional assets that could be used to satisfy claims against the Company’s general assets. Conversely, liabilities recognized as a result of consolidating Global Wells do not represent additional claims of the Company’s general assets; they represent claims against the specific assets of Global Wells. See Note 9 — Long Term Debt for a description of the two term loans that Global Wells had with financial institutions as of December 31, 2022. The following financial information includes assets and liabilities of Global Wells and are included in the accompanying consolidated balance sheets, except for those that eliminate upon consolidation: December 31, 2022 December 31, 2021 (in thousands) Cash $ 2,022 $ 1,163 Accounts receivable 53 384 Prepaid expenses and other current assets 191 63 Due from Lollicup USA Inc. 4,700 — Property and equipment, net 45,399 46,612 Other assets 4,262 4,762 Total assets 56,627 52,984 Accounts payable $ 2 $ 497 Accrued expenses 626 68 Income tax payable — 9 Customer deposits 165 88 Due to Lollicup USA Inc. — 2,620 Long-term debt, current portion 957 1,178 Long-term debt, net of current portion 41,558 35,339 Other liabilities 1,302 2,636 Total liabilities $ 44,610 $ 42,435 Revenue Recognition: The Company generates revenues from product sales to customers that include national and regional chains and distributors, fast food restaurants with multiple locations, small businesses, and those that purchase for individual consumption. The Company considers revenue disaggregated by customer type to most accurately reflect the nature and uncertainty of its revenue and cash flows that are affected by economic factors. For the years ended December 31, 2022 and 2021, net sales disaggregated by customer type consist of the amounts shown below. 51 Year Ended December 31, 2022 2021 (in thousands) National and regional chains $ 95,786 $ 86,017 Distributors 242,285 199,902 Online 53,697 50,271 Retail 31,189 28,054 $ 422,957 $ 364,244 • National and regional chains revenue: National and regional chains revenue is derived from chain restaurants and supermarkets with locations across multiple states. Revenue from transactions with national and regional chains is recognized at a point in time upon transfer of control of promised products to customers. Transfer of control typically occurs when the title and risk of loss passes to the customer. Shipping terms generally indicate when the title and risk of loss have passed, which is generally when the products are shipped from the Company’s facility to the customers. • Distributors revenue: Distributors revenues are derived from national and regional distributors across the U.S. that purchase the Company’s products for restaurants, offices, schools, and government entities. Revenue from distributions is recognized at a point in time upon transfer of control of promised products to customers. Transfer of control typically occurs when the title and risk of loss passes to the customer. Shipping terms generally indicate when the title and risk of loss have passed, which is generally when the products are shipped from the Company’s facility to the customers. • Online revenue: Online revenue is derived from small businesses such as small restaurants, bubble tea shops, coffee shops, juice bars and smoothie shops. Revenue from online transactions is recognized at a point in time upon transfer of control of promised products to customers. Transfer of control typically occurs when the title and risk of loss passes to the customer. Shipping terms generally indicate when the title and risk of loss have passed, which is generally when the products are shipped from the Company’s facility to the customers. • Retail revenue: Retail revenue is derived primarily from regional bubble tea shops, boutique coffee shops and frozen yogurt shops. Revenue from retail transactions is recognized at a point in time upon transfer of control of promised products to customers. Transfer of control typically occurs when the title and risk of loss passes to the customer. Shipping terms generally indicate when the title and risk of loss have passed, which is generally when the products are shipped from the Company’s facility to the customers. In addition to product sales, the Company also generates revenue from logistics services which is the transportation and delivery of shipping containers from ports to customers, primarily to retail customers. Logistics services revenue is recognized over time due to the continuous transfer of control to the customer. As control transfers over time, revenue is recognized based on the extent of progress towards completion of the performance obligation. Logistics services revenue was $ 6,150,000 and $ 2,779,000 for the years ended December 31, 2022, and 2021, respectively. The transaction price is the amount of consideration to which the Company expects to be entitled to in exchange for transferring goods to the customer. Revenue is recorded based on the total estimated transaction price, which includes fixed consideration and estimates of variable consideration. Variable consideration includes estimates of rebates and other sales incentives, cash discounts for prompt payment, consideration payable to customers for cooperative advertising and other program incentives, and sales returns. The Company estimates its variable consideration based on contract terms and historical experience of actual results using the expected value method. The performance obligations are generally satisfied shortly after manufacturing and shipment as purchases made by the Company’s customers are manufactured and shipped with minimal lead time. The Company’s contract liabilities consist primarily of rebates, sales incentives, customer deposits and consideration payable to customers for cooperative advertising. As of December 31, 2022 and 2021, the rebates, sales incentives and cooperative advertising were not significant to the financial statements. Customer deposits are included in the current liabilities in the consolidated balance sheets. Shipping and handling fees billed to a customer are recorded within net sales, with corresponding shipping and handling costs recorded in selling expense on the accompanying consolidated statements of income. Shipping and handling fees billed to a customer are not deemed to be separate performance obligations for product sales, as these activities occur before the customer receives the products. Shipping and handling costs included within selling expenses in the consolidated statements of income for the years ended December 31, 2022 and 2021 were $ 32,508,000 and $ 28,525,000 , respectively. 52 Sales taxes collected concurrently with revenue-producing activities and remitted to governmental authorities are excluded from revenue. Sales commissions are expensed as incurred due to the amortization period being less than one year and are recorded in selling expense on the accompanying consolidated statements of income. Advertising Costs: The Company expenses costs of print production, trade show, online marketing, and other advertisements in the period in which the expenditure is incurred. Advertising costs included in operating expenses in the consolidated statements of income were $ 2,418,000 and $ 2,488,000 for the years ended December 31, 2022 and 2021, respectively. Income Taxes: The Company applies the provision of ASC 740, Income Taxes . Under ASC 740, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Deferred tax assets are evaluated for recoverability each reporting period by assessing all positive and negative evidence available in order to assess the need for a valuation allowance. A valuation allowance is used to reduce some or all of the deferred tax assets if, based upon the weight of available evidence, it is more likely than not that such deferred tax assets will not be realized. The Company accounts for uncertainties in income tax in accordance with ASC 740-10, Accounting for Uncertainty in Income Taxes . ASC 740-10 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This accounting standard also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The Company recognizes interest and penalties related to unrecognized tax benefits in the provision for income taxes in the accompanying consolidated statement of income. Accrued interest and penalties are included in the income taxes payable in the consolidated balance sheet. Concentration of Credit Risk: Cash is maintained at financial institutions and, at times, balances exceed federally insured limits. Management believes that the credit risk related to such deposits is minimal. The Company extends credit based on the valuation of the customers’ financial condition and general collateral is not required. Management believes the Company is not exposed to any material credit risk on these accounts. For the years ended December 31, 2022 and 2021, purchases from the following vendor makes up greater than 10 percent of total purchases: Year Ended December 31, 2022 2021 Keary Global Ltd. (“Keary Global”) and its affiliate, Keary International, Ltd. – related parties 11 % 12 % Amounts due to the following vendors at December 31, 2022 and 2021, respectively, that exceed 10 percent of total accounts payable are as follows: December 31, 2022 December 31, 2021 Keary Global and its affiliate, Keary International – related parties 21 % 10 % Fuling Technology Co., Ltd. 18 % 21 % Wen Ho Industrial Co., Ltd * 11 % * Amounts payable represented less than 10% of total accounts payable. No customer accounted for more than 10 percent of sales or accounts receivable for the years ended December 31, 2022 and 2021. Fair Value Measurements: The Company follows ASC 820, Fair Value Measurements , which defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants. ASC 820 establishes a hierarchy of valuation inputs based on the extent to which the inputs are observable in the marketplace. Observable inputs reflect market data obtained from sources independent of the reporting entity and 53 unobservable inputs reflect the entity’s own assumptions about how market participants would value an asset or liability based on the best information available. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value. The three levels of inputs are as follows: Level 1 — Quoted prices in active markets for identical assets or liabilities that the Company has the ability to access as of the measurement date. Level 2 — Inputs that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the same term of the assets or liabilities. Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument. Financial assets are considered Level 3 when their fair values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. The Company has financial instruments classified within the fair value hierarchy, which consist of the following: • At December 31, 2022 and 2021, the Company had a money market account, classified as Level 1 within the fair value hierarchy, and reported as a current asset on the consolidated balance sheets. • At December 31, 2021, the Company had an interest rate swap that met the definition of a derivative, classified as Level 2 within the fair value hierarchy, and reported as other liabilities on the consolidated balance sheet. The fair value of interest rate swap was calculated from pricing models that used volatility to quantify the probability of changes around interest rate trends. This interest rate swap was terminated in June 2022, as further discussed in Note 10 — Interest Rate Swaps . The following table summarizes the Company’s fair value measurements by level at December 31, 2022 for the assets measured at fair value on a recurring basis: Level 1 Level 2 Level 3 (in thousands) Cash equivalents $ 10,609 $ — $ — Fair value, December 31, 2022 $ 10,609 $ — $ — The following table summarize the Company’s fair value measurements by level at December 31, 2021 for the assets and liabilities measured at fair value on a recurring basis: Level 1 Level 2 Level 3 (in thousands) Cash equivalents $ 2,000 $ — $ — Interest rate swap — ( 1,334 ) — Fair value, December 31, 2021 $ 2,000 $ ( 1,334 ) $ — The Company has not elected the fair value option as presented by ASC 825, Fair Value Option for Financial Assets and Financial Liabilities , for the financial assets and liabilities that are not otherwise required to be carried at fair value. Under ASC 820, material financial assets and liabilities not carried at fair value, including accounts receivable, accounts payable, related-party payable, accrued and other liabilities, other payable and borrowings under promissory notes and Line of Credit (as defined below), are reported at their carrying value. 54 The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, related-party payable, accrued and other liabilities and other payable at December 31, 2022 and 2021, approximated fair value because of the short maturity of these instruments. The carrying amount of the Company's Line of Credit approximates fair value because the interest rate is variable in nature. For the $ 21,580,000 term loan that the Company refinanced in June 2022, the carrying amount as of December 31, 2021 approximated fair value because the interest rate was variable in nature. The following is a summary of the carrying amount and estimated fair value of the $ 23,000,000 and $ 28,700,000 term loans that mature in September 2026 and July 2027, respectively: December 31, 2022 Carrying Amount Estimated Fair Value (in thousands) $ 23,000,000 term loan maturing in September 2026 $ 22,168 $ 20,115 $ 28,700,000 term loan maturing in July 2027 20,563 18,918 $ 42,731 $ 39,033 The fair value of these financial instruments was determined using Level 2 inputs. Foreign Currency: The Company includes gains or losses from foreign currency transactions, such as those resulting from the settlement of foreign receivables or payables, in the consolidated statements of income. The Company recorded a foreign currency gain of $ 1,568,000 and a loss of $ 412,000 for the years ended December 31, 2022 and 2021, respectively. Stock-Based Compensation: The Company recognizes stock-based compensation expense related to employee stock options and restricted stock units in accordance with ASC 718, Compensation — Stock Compensation . This standard requires the Company to record compensation expense equal to the fair value of awards granted to employees and non-employees. The fair value of share-based payment awards is estimated on the grant-date using the Black-Scholes option pricing model for stock options, and the closing price of the Company's common stock on the trading day immediately prior to the grant date for restricted stock units. Key input assumptions used in the Black-Scholes option pricing model to estimate the grant date fair value of stock options include the fair value of the Company’s common stock, the expected option term, the expected volatility of the Company’s stock over the option’s expected term, the risk-free interest rate, and the Company’s expected annual dividend yield. The risk-free interest rate assumption for options granted under the 2019 Stock Incentive Plan (the "Plan") is based upon observed interest rates on the United States government securities appropriate for the expected term of the Company’s stock options. The expected term of employee stock options under the Plan represents the weighted-average period that the stock options are expected to remain outstanding. The expected term of options granted is calculated based on the “simplified method,” which estimates the expected term based on the average of the vesting period and contractual term of the stock option. The Company determines the expected volatility assumption using the frequency of daily historical prices of comparable public company’s common stock for a period equal to the expected term of the options. The dividend yield assumption for options granted under the Plan is based on the Company’s history and expectation of dividend payouts. Stock-based compensation expense is based on awards that ultimately vest. Forfeitures are accounted for as they occur. The Company has elected to treat stock-based payment awards with graded vesting schedules and time-based service conditions as separate awards and recognizes stock-based compensation expense over the requisite service period using the graded vesting attribution method. The determination of stock-based compensation is inherently uncertain and subjective and involves the application of valuation models and assumptions requiring the use of judgment. If the Company had made different assumptions, its stock-based compensation expense, and its net income could have been significantly different. 55 Leases: The Company adopted ASU 2016-02, Leases (Topic 842) , as of January 1, 2022 which requires the recognition of the right-of-use ("ROU") assets and related operating and finance lease liabilities on the balance sheet and the disclosure of key information about certain leasing arrangements. The Company adopted this ASU and related amendments under the modified retrospective method with no recast of the comparative period presented in the Company's consolidated financial statements. There was no cumulative adjustment to retained earnings upon adoption. The Company elected certain practical expedients permitted under the transition guidance, including to exclude leases with an initial term of 12 months or less at lease commencement, combine non-lease components together with lease components as a single lease component, and to retain the historical lease classification as well as relief from reviewing expired or existing contracts to determine if they contain leases. The Company determines if an arrangement is a lease at commencement date . Leases are classified as either finance leases or operating leases. The Company has lease agreements for the use of facilities and vehicles, and its lease terms may include options to extend or terminate the lease when it is reasonably certain that it will exercise that option. ROU assets represent the Company's right to use an underlying asset for the lease term, and lease liabilities represent its obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at commencement date based on the present value of lease payments over the lease term using a discount rate based on similarly secured borrowings available to the Company. ROU assets include any prepaid lease amounts and excludes lease incentives. New and Recently Adopted Accounting Standards: The Company is an emerging growth company as that term is used in the Jumpstart Our Business Startups Act of 2012 (the "JOBS Act"), and as such, the Company have elected to take advantage of certain reduced public company reporting requirements. In addition, Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended, or the Securities Act, for complying with new or revised accounting standards, as a result, the Company will adopt new or revised accounting standards on the relevant dates in which adoption of such standards is required for private companies. In February 2016, the FASB issued ASU 2016-02 (Topic 842), " Leases ". This ASU amends a number of aspects of lease accounting, including requiring lessees to recognize operating leases with a term greater than one year on their balance sheet as a ROU asset and corresponding lease liability, measured at the present value of the lease payments. The Company adopted the ASU and the related amendments as of January 1, 2022 under the modified retrospective method with no recast of the comparative period presented in the Company's consolidated financial statements. The Company recorded a ROU asset of $ 8,800,000 and an operating lease liability of $ 9,200,000 upon adoption. See Note 14 — Leases for more information. In June 2016, the FASB issued ASU 2016-13, “ Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments" , which adds to U.S. GAAP an impairment model known as the current expected credit loss (CECL) model that is based on expected losses rather than incurred losses. Under the new guidance, an entity recognizes as an allowance its estimate of expected credit losses, which the FASB believes will result in more timely recognition of such losses. The ASU is also intended to reduce the complexity of U.S. GAAP by decreasing the number of credit impairment models that entities use to account for debt instruments. The ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years for public business entities that are U.S. Securities and Exchange Commission (SEC) filers. For all other public business entities, the ASU is effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. For all other entities, the ASU is effective for fiscal years beginning after December 15, 2021, and interim periods within those fiscal years. Early adoption is permitted beginning after December 15, 2018, including interim periods within those fiscal years. The FASB subsequently issued ASU 2019-10 (Topic 326), “ Financial Instruments-Credit Losses: Effective Dates ” which amends the effective date for SEC filers that are eligible to be ‘smaller reporting companies’, non-SEC filers and all other companies, including not-for-profit companies and employee benefit plans. For calendar-year end companies that are eligible for the deferral, the effective date is January 1, 2023. The Company will adopt the new standard in annual reporting period beginning after January 1, 2023. The Company does not expect the adoption of this ASU to have a material impact on its consolidated financial statements. In March 2020, the FASB issued ASU 2020-3, “ Codification Improvements to Financial Instruments ”, which clarifies the requirement for all entities to provide the fair value option disclosures in paragraphs ASC 825-10-50-24 through 50-32. The guidance also clarifies that the contractual term of a net investment in a lease determined in accordance with ASC 842, “ Leases ”, should be the contractual term used to measure expected credit losses under ASC 326, “ Financial Instruments — Credit Losses ”. This ASU was effective upon adoption of the amendments in ASU 2016-13. The adoption of this ASU did not have a material impact on the consolidated financial statements. 56 3. Acquisitions Pacific Cup, Inc. On March 1, 2021, Lollicup entered into an asset purchase agreement (“the Pacific Cup Agreement”) with Pacific Cup, Inc. (“Pacific Cup”), a manufacturer and distributor of disposable products operating in Kapolei, Hawaii. Pursuant to the Pacific Cup Agreement, Lollicup paid cash consideration of $ 1,000,000 to acquire certain assets of Pacific Cup. Acquisition-related costs were immaterial. The amounts of revenue and earnings of the acquiree since the acquisition date is included in the consolidated statement of income for the reporting period, which is immaterial from March 1, 2021 through December 31, 2021 and for the year ended December 31, 2022. The goodwill recognized in this transaction was derived from expected opportunities to leverage Pacific Cup’s customer base, manufacturing facility, and sales force to expand the Company’s footprint. Goodwill recognized as a result of this acquisition is deductible for income tax purposes, and subject to annual impairment testing, which may give rise to deferred taxes in future periods. The following table summarizes the final valuation of assets acquired as a result of this acquisition: (in thousands) Inventories $ 153 Property and equipment 50 Customer relationships 400 Goodwill 397 Total assets acquired $ 1,000 4. Joint Venture On April 6, 2022, Lollicup entered into a definitive joint venture agreement (the “JV Agreement”) with Happiness Moon Co., Ltd., a Taiwanese company, to jointly establish Bio Earth Technology (“Bio Earth”), a new Taiwanese corporation, for the manufacturing of compostable foodservice products from bagasse. The JV Agreement stipulated an investment by the Company of approximately $ 6,500,000 for a 49 % interest in Bio Earth. Lollicup had invested a total of $ 4,000,000 pursuant to the JV Agreement as of December 31, 2022, which is included in deposits in the accompanying consolidated balance sheet. This total investment comprised of three payments of $ 2,000,000 in April 2022, another $ 2,000,000 in June 2022, and $ 1,876,000 in November 2022, net of a refund of $ 1,876,000 received in December 2022. As of December 31, 2022, the incorporation and registration of Bio Earth had not been completed. See Note 19 — Subsequent Events for subsequent investments made under the JV Agreement. 5. Inventories Inventories consist of the following: December 31, 2022 December 31, 2021 (in thousands) Raw materials $ 18,061 $ 12,543 Semi-finished goods 1,850 1,532 Finished goods 52,044 45,140 Subtotal 71,955 59,215 Less inventory reserve ( 749 ) ( 743 ) Total inventories $ 71,206 $ 58,472 During the year ended December 31, 2022, the Company recorded a $ 3,500,000 write-off of certain inventory items, out of which $ 879,000 was determined to be out-of-period and was recorded to correct immaterial errors in its previously issued quarterly and annual financial statements. 57 6. Property and Equipment December 31, 2022 December 31, 2021 (in thousands) Machinery and equipment $ 70,234 $ 60,935 Leasehold improvements 19,063 18,655 Vehicles 6,725 5,384 Furniture and fixtures 1,016 936 Building 36,599 35,387 Land 11,907 11,907 Computer hardware and software 593 553 146,137 133,757 Less: accumulated depreciation and amortization ( 50,569 ) ( 40,282 ) Total property and equipment, net $ 95,568 $ 93,475 Depreciation and amortization expense on property and equipment was $ 10,378,000 and $ 10,024,000 for the years ended December 31, 2022 and 2021, respectively. Depreciation and amortization expense is reported within general and administrative expense except for depreciation and amortization expense related to manufacturing facilities and equipment, which is included in cost of goods sold on the accompanying consolidated statements of income. 7. Line of Credit Pursuant to the terms of the Business Loan Agreement, dated February 23, 2018, between Lollicup, as borrower, and Hanmi Bank, as lender (as amended, the “Loan Agreement”), the Company has a line of credit with a maximum borrowing capacity of $ 40,000,000 (the “Line of Credit”) secured by the Company’s assets. The Line of Credit also includes a standby letter of credit sublimit, which was amended and increased to $ 2,000,000 on August 18, 2022. The Company is not required to pay a commitment (unused) fee on the undrawn portion of the Line of Credit and interest is payable monthly. On October 6, 2021, the Company amended the Loan Agreement. Prior to October 6, 2021, interest accrued at an annual rate of prime less 0.25 % with a minimum floor of 3.75 %, and the amount that could be borrowed was subject to a borrowing base that was calculated as a percentage of the accounts receivable and inventory balances measured monthly. Additionally, the Company was required to comply with certain financial covenants, including a minimum current ratio, minimum tangible net worth, minimum debt service coverage ratio, and minimum debt to earnings before interest, taxes, depreciation and amortization (“EBITDA”) ratio. The amendment on October 6, 2021, among other things, (1) extended the maturity date to October 6, 2023, (2) revised the interest on any line of credit borrowings to an annual rate of prime less 0.25 %, with a minimum floor of 3.25 %, (3) removed the requirement for the maximum amount of borrowings to be subject to a borrowing base requirement that was calculated as a percentage of accounts receivable and inventory balances, (4) removed the minimum tangible net worth and minimum debt service coverage ratio from the financial covenant requirement, and (5) added a minimum fixed charge coverage ratio in the financial covenant requirement. As of December 31, 2022, the maximum remaining amount that could be borrowed under the Line of Credit was $ 38,930,000 . The Company had $ 0 of borrowings outstanding under the Line of Credit as of both December 31, 2022 and 2021. The amount issued under the standby letter of credit was $ 1,070,000 and $ 0 as of December 31, 2022 and 2021, respectively. As of both December 31, 2022 and 2021, the Company was in compliance with the financial covenants under the Line of Credit. The Company amended the Line of Credit again in March 2023. See Note 19 — Subsequent Events for further discussion. 58 8. Accrued Expenses The following table summarizes information related to accrued expense liabilities: December 31, 2022 December 31, 2021 (in thousands) Accrued miscellaneous expenses $ 2,094 $ 1,054 Accrued interest 108 68 Accrued payroll 1,586 1,456 Accrued vacation and sick pay 543 416 Accrued shipping expenses 1,918 2,868 Accrued professional services fees 600 642 Deferred rent liability — 372 Accrued property tax 1,164 10 Accrued sale taxes and use taxes 992 927 Total accrued expenses $ 9,005 $ 7,813 9. Long-Term Debt Long-term debt consists of the following: December 31, 2022 December 31, 2021 (in thousands) A $ 23,000,000 term loan that matures September 30, 2026, with an initial balance of $ 16,115,000 and an option to request for additional advances up to a maximum of $ 6,885,000 through September 2022, which the Company exercised in February 2022. Interest accrues at a fixed rate of 3.5 % per annum. Principal and interest payments of $ 116,000 are due monthly throughout the term of the loan, with the remaining principal balance due at maturity. The loan is collateralized by substantially all of Global Wells’ assets and is guaranteed by Global Wells and one of the Company’s stockholders. In accordance with the loan agreement, Global Wells is required to comply with certain financial covenants, including a minimum debt service coverage ratio. $ 22,168 $ 15,909 A $ 21,580,000 term loan ("2029 Loan") that was set to mature in May 2029. Interest accrued at prime rate less 0.25 % ( 3.00 % at December 31, 2021) and principal payments ranging from $ 24,000 to $ 40,000 along with interest were due monthly throughout the term of the loan, with the remaining principal balance due at maturity. The loan was collateralized by substantially all of the Company’s and Global Well’s assets and was guaranteed by the Company and its stockholders. The Company incurred debt issuance costs of approximately $ 119,000 , which was reported as a reduction of the carrying value of debt on the accompanying consolidated balance sheet. This loan was refinanced in June 2022 (see below). — 20,808 A $ 28,700,000 term loan ("2027 Loan") that matures July 1, 2027, with an initial balance of $ 20,700,000 and an option to request for additional advances up to a maximum of $ 8,000,000 through June 30, 2023. Interest accrues at a fixed rate of 4.375 % per annum. Principal and interest payments of $$ 104,000 are due monthly throughout the term of the loan, with the remaining principal balance due at maturity. The loan is collateralized by substantially all of Global Wells’ assets and is guaranteed by one of the Company’s stockholders. In accordance with the loan agreement, Global Wells is required to comply with certain financial covenants, including a minimum debt coverage ratio. $ 20,563 $ — Long-term debt 42,731 36,717 Less: unamortized loan fees ( 216 ) ( 200 ) Less: current portion ( 957 ) ( 1,178 ) Long-term debt, net of current portion $ 41,558 $ 35,339 59 KARAT PACKAGING INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS At December 31, 2022, future maturities are: (in thousands) 2023 $ 957 2024 990 2025 1,040 2026 20,653 2027 19,091 $ 42,731 The Company's refinance of the 2029 Loan with the 2027 Loan in June 2022 was accounted for as a debt modification. The Company was in compliance with all of its financial covenants as of both December 31, 2022 and 2021. On April 16, 2020, the Company received a $ 5,000,000 Paycheck Protection Program ("PPP") loan under the Coronavirus Aid, Relief, and Economic Security ("CARES") Act which included, among other terms, an interest rate of 1.00 % per annum. The PPP loan was subject to events of default and other provisions customary for a loan of this type. A PPP loan may be forgiven, partially or in full, if certain conditions are met, principally based on having been disbursed for permissible purposes and maintaining certain average levels of employment and payroll as required by the CARES Act. On June 10, 2021, the full amount of the PPP loan was forgiven. A $ 5,000,000 gain from the forgiveness of the PPP loan was recognized in the consolidated statements of income for the year ended December 31, 2021. 10. Interest Rate Swaps In June 2022, Global Wells terminated its ten-year floating-to-fixed interest rate swap, and recognized cash proceeds of $ 825,000 as gain on the settlement, which was included in interest income in the accompanying consolidated statements of income. This interest rate swap had a notional value of $ 21,580,000 as of the effective date of June 13, 2019 based on the prime rate versus a 5.05 % fixed rate. As of December 31, 2021, the fair value of the interest rate swap was $ 1,334,000 , which is reported as other liabilities in the accompanying consolidated balance sheet. For the years ended December 31, 2022 and 2021, Global Wells recognized $ 2,159,000 (including the gain on settlement) and $ 1,270,000 as interest income related to change in fair value of this interest rate swap, respectively. In June 2019, the Company also entered into a five-year floating-to-fixed interest-rate swap, with an effective date of June 3, 2019, that was based on the prime rate versus 5.19 % fixed rate. The notional was $ 10,000,000 as of June 2019. For the year ended December 31, 2021, the Company recognized approximately $ 47,000 in interest income related to change in fair value of this interest rate swap. In April 2021, the Company terminated this interest rate swap, recognizing $ 196,000 in swap termination fee, which was included in interest expense in the consolidated statements of income for the year ended December 31, 2021 . 11. Stockholder’s Equity The Company’s Certificate of Incorporation authorize both common and preferred stock. The total number of shares of all classes of stock authorized for issuance is 110,000,000 shares, par value of $ 0.001 , with 10,000,000 designed as preferred stock and 100,000,000 designated as common stock. Each holder of common stock and preferred stock shall be entitled to one vote per share held. In April 2021, the Company completed its initial public offering and issued 4,542,500 shares of its common stock. The total amount of proceeds received, net of issuance costs, was approximately $ 67,587,000 . On November 9, 2022, Company declared a dividend of $ 0.35 per share of the Company's common stock. The Company recorded $ 6,964,000 of cash dividends as of December 31, 2022. The Company did no t declare any dividend for the year ended December 31, 2021. 12. Stock-Based Compensation In January 2019, the Company’s board of directors adopted the 2019 Stock Incentive Plan (the “Plan”). A total of 2,000,000 shares of common stock were authorized and reserved for issuance under the Plan in the form of incentive or 60 nonqualified stock options and stock awards. A committee appointed by the board of directors of the Company determines the terms and conditions of each grant under the Plan. Employees, directors, and consultants are eligible to receive stock options and stock awards under the Plan. The aggregate number of shares available under the Plan and the number of shares subject to outstanding options may be increased or decreased by the Plan administrator to reflect any changes in the outstanding common stock by reason of any recapitalization, reorganization, reclassification, stock split, reverse split, combination of shares, exchange of shares, stock dividend or other distribution payable in capital stock or similar transaction. The exercise price of incentive stock options may not be less than the fair market value of the common stock at the date of grant. The exercise price of incentive stock options granted to individuals that own greater than 10% of the voting stock may not be less than 110 % of the fair market value of the common stock at the date of grant. The term of each incentive and nonqualified option is based upon conditions as determined by the option agreement; however, the term can be no more than ten years from the date of the grant. In the case of an incentive stock option granted to an optionee who, at the time the option is granted, owns stock representing more than 10% of the voting power of all classes of stock of the Company or any parent or subsidiary, the term of the option will be a shorter term as provided in the option agreement, but not more than five years from the date of the grant. As of December 31, 2022, a total of 1,322,349 shares of common stock was available for further award grants under the Plan. For the years ended December 31, 2022 and 2021, the Company recognized a total of $ 2,047,000 and $ 2,026,000 in stock-based compensation expense, respectively. The restricted stock units and stock options granted prior to April 15, 2021 were subjected to vesting conditions contingent upon the closing of an initial public offering of the Company. Such awards began vesting on April 15, 2021 when the Company completed its initial public offering. The Company recognizes stock-based compensation over the vesting period, which is generally 3 years for both the restricted stock units and stock options. The Company recognized a net tax benefit of $ 89,000 and $ 237,000 from compensation expense related to stock options and restricted stock units during the years ended December 31, 2022 and 2021, respectively. Stock Options A summary of the Company’s stock option activity under the Plan for the years ended December 31, 2022 and 2021 is as follows: Number of Options Weighted-Average Exercise Price Weighted-Average Remaining Contract Life (In Years) Aggregate Intrinsic Value Outstanding at December 31, 2020 15,000 $ 10.00 8.0 $ — Granted 430,000 18.86 Exercised ( 10,000 ) 10.00 $ 116,000 Outstanding at December 31, 2021 435,000 $ 18.76 9.7 $ 632,000 Granted 50,000 16.53 Exercised ( 5,000 ) 10.00 Forfeited ( 60,000 ) 18.86 Outstanding at December 31, 2022 420,000 $ 18.58 8.8 $ — Expected to vest at December 31, 2022 420,000 $ 18.58 8.8 $ — Exercisable at December 31, 2022 123,333 18.86 8.8 $ — The weighted-average grant-date fair value of stock options granted during the years ended December 31, 2022 and 2021 was $ 5.18 and $ 5.74 respectively. At December 31, 2022, total remaining stock-based compensation cost for unvested stock options under the Plan was approximately $ 792,000 . The cost is expected to be recognized over a weighted-average period of 1.4 years. The aggregate intrinsic value is calculated by subtracting the exercise price of the option from the closing price of the Company’s common stock on December 31, 2022, multiplied by the number of shares per each option. 61 The assumptions that were used to calculate the grant date fair value of the Company’s stock option grants for the year ended December 31, 2022 were as follows: Year Ended December 31, 2022 2021 Risk-free interest rate 1.70 % 1.22 % Expected term (years) 6.25 years 6.25 years Volatility 30 % 30 % Dividend yield 0.40 % 0.40 % Restricted Stock Units The Company issued restricted stock units to its employees. The following table summarizes the unvested restricted stock units for the years ended December 31, 2022 and 2021: Number of Shares Outstanding Weighted Average Grant Date Fair Value Unvested at December 31, 2020 256,000 $ 10.00 Granted 40,000 17.98 Vested ( 84,917 ) 11.55 Forfeited ( 52,083 ) 11.14 Unvested at December 31, 2021 159,000 $ 11.08 Granted 9,900 16.69 Vested ( 75,588 ) 10.72 Forfeited ( 11,166 ) 15.54 Unvested at December 31, 2022 82,146 $ 11.47 The weighted-average grant-date fair value of restricted stock units granted during the years ended December 31, 2022 and 2021 was $ 16.69 and $ 17.98 respectively. The total fair value of restricted stock units, as of their respective vesting date, during the years ended December 31, 2022 and 2021 was $ 1,156,000 and $ 1,884,000 , respectively. In September 2021, the Company’s board of directors accelerated the vesting of the Company’s restricted stock units, with each tranche of award vesting 6 months earlier than the original vesting date. The acceleration of the restricted stock units vesting was treated as an award modification under ASC 718, resulting in an additional stock-based compensation expense of approximately $ 719,000 recognized during the year ended December 31, 2021. At December 31, 2022, total remaining stock-based compensation cost for unvested restricted stock units was approximately $ 327,000 . The cost is expected to be recognized over a weighted-average period of 0.9 years . 13. Earnings Per Share (a) Basic Basic earnings per share is calculated by dividing the net income attributable to equity holders of the Company for the year by the weighted average number of common shares outstanding during the period. Year Ended December 31, 2022 2021 (in thousands, except per share data) Net income attributable to Karat Packaging Inc. $ 23,648 $ 20,778 Weighted average shares 19,825 18,409 Basic earnings per share $ 1.19 $ 1.13 (b) Diluted Diluted earnings per share is calculated based upon the weighted average number of common shares and common equivalent shares outstanding during the period, calculated using the treasury stock method. Under the treasury stock 62 method, exercise proceeds include the amount the employee must pay for exercising stock options and the amount of compensation cost related to stock awards for future services that the Company has not yet recognized. Common equivalent shares are excluded from the computation in periods in which they have an anti-dilutive effect. The following table summarizes the calculation of diluted earnings per share: Year Ended December 31, 2022 2021 (in thousands, except per share data) Net income attributable to Karat Packaging Inc. $ 23,648 $ 20,778 Weighted average shares 19,825 18,409 Dilutive shares Stock options and restricted stock units 101 157 Total dilutive shares 19,926 18,566 Diluted earnings per share $ 1.19 $ 1.12 For the years ended December 31, 2022 and 2021 a total of 449,223 and 234,072 shares of potentially dilutive shares, respectively, have been excluded in the diluted earnings per share calculation due to its anti-dilutive impact on earnings per share. 14. Leases The Company primarily leases manufacturing facilities, distribution centers and office spaces with lease terms expiring through 2031. For the year ended December 31, 2022, the Company recognized the following lease costs in the accompanying consolidated statement of income: (in thousands) Operating lease expense $ 4,522 Short-term lease expense 311 Variable lease expense 817 Total lease expense $ 5,650 For the year ended December 31, 2022, total lease expense included in operating expense and cost of goods sold was $ 3,446,000 and $ 1,076,000 , respectively. Rent expense for the year ended December 31, 2021 was $ 1,783,000 . The following table presents supplemental information related to operating leases for the year ended December 31, 2022: Weighted average remaining lease term 4.27 years Weighted average discount rate 5.32 % Right-of-use assets obtained in exchange for operating lease liabilities 10,727 Cash paid for amounts included in measurement of lease obligations Operating cash flows from operating leases 4,481 As of December 31, 2022, future lease payments under operating leases were as follows: 63 (in thousands) 2023 $ 5,244 2024 4,097 2025 2,926 2026 3,015 2027 1,149 Thereafter 1,212 Total future lease payments 17,643 Less: imputed interest ( 1,509 ) Total lease liability balance $ 16,134 As of December 31, 2021, approximate future minimum lease obligations prior to the adoption of Topic 842 were as follows: (in thousands) 2022 $ 3,055 2023 3,060 2024 1,824 2025 380 2026 374 Thereafter 1,629 $ 10,322 In September 2020, Global Wells entered into an operating lease with an unrelated party as the landlord. The lease generates monthly rental payments from $ 58,000 to $ 61,000 over the lease term of 38 months beginning September 9, 2020. Rental income for the years ended December 31, 2022 and December 31, 2021 were $ 949,000 and $ 931,000 , respectively. The expected rental income is $ 611,000 for the year ended December 31, 2023. 15. Related Party Transactions Keary Global owns 250,004 shares of the Company's common stock as of December 31, 2022, which Keary Global acquired upon exercise of two convertible notes during the third quarter of 2018. Keary Global and its affiliate, Keary International, are owned by one of the Company’s stockholders’ family member. In addition to being a stockholder, Keary Global and Keary International are inventory suppliers and purchasing agents for the Company overseas. The Company has entered into ongoing purchase and supply agreements with Keary Global. At December 31, 2022 and 2021, the Company has accounts payable due to Keary Global and Keary International of $ 4,940,000 and $ 2,003,000 , respectively. Purchases for the years ended December 31, 2022 and 2021 from this related party were $ 42,978,000 and $ 37,021,000 , respectively. 16. Employee Benefits The Company maintains a 401(k) plan for employees who meet specific requirements. The Company matches 100 % of the employees’ contributions up to 3 % of each employee’s salary, 87.5 % of the employees’ contributions up to 4 % of each employee’s salary, and 80 % of the employees’ contributions up to 5 % of each employee’s salary. The Company’s portion of the contributions is expensed as incurred with a total expense of $ 345,000 and $ 322,000 for the years ended December 31, 2022 and 2021, respectively. 17. Income Taxes The provision for income taxes for the years ended December 31, 2022 and 2021, respectively, consisted of: 64 Year Ended December 31, 2022 2021 (in thousands) Current Federal $ 6,291 $ 4,504 State 863 1,068 7,154 5,572 Deferred Federal ( 502 ) ( 576 ) State 24 93 ( 478 ) ( 483 ) Provision for income taxes $ 6,676 $ 5,089 Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amount used for federal and state income tax purposes. The Company’s deferred tax assets (liabilities), calculated using effective tax rates is as follows: December 31, 2022 December 31, 2021 (in thousands) Deferred tax assets: State taxes $ 252 $ 257 Reserves 825 537 Accruals & deferred expenses 66 188 Tenant improvement allowance — 1,216 R&D credit 43 44 Inventory 1,042 1,196 Government grant 343 311 Stock based compensation 573 267 Capitalized research and development costs 1,043 — Operating lease liabilities 8,452 — Total deferred tax assets 12,639 4,016 Deferred tax liabilities: Fixed assets – depreciation ( 10,350 ) ( 9,518 ) Investment in Global Wells Investment Group ( 172 ) ( 132 ) Operating ROU asset ( 7,273 ) — Total deferred tax liabilities ( 17,795 ) ( 9,650 ) Net deferred tax liability $ ( 5,156 ) $ ( 5,634 ) 65 Reconciliation of income taxes are as follows from statutory rate of 21% to the effective tax rate for the years ended December 31, 2022 and 2021, respectively: December 31, 2022 December 31, 2021 (in thousands) Income tax computed at the federal statutory rate $ 6,828 $ 5,780 State taxes, net of federal tax benefits 1,101 1,055 Noncontrolling Interest - Income not subject to tax ( 460 ) ( 349 ) Government forgiveness of debt — ( 1,050 ) Permanent items 31 201 Excess tax benefit from stock based compensation ( 89 ) ( 237 ) Research and development credit ( 455 ) ( 239 ) Other ( 280 ) ( 72 ) Provision for income taxes $ 6,676 $ 5,089 The Company may be audited by the Internal Revenue Service and various state tax authorities. Disputes may arise with these tax authorities involving issues of the timing and amount of deductions and allocations of income and expenses among various tax jurisdictions because of differing interpretations of tax laws and regulations. The Company evaluates its exposures associated with the tax filing positions and, while it believes its positions comply with applicable laws, may record liabilities based upon estimates of the ultimate outcome of these matters and the guidance provided in ASC 740. The Company remains subject to IRS examination for the 2016 through 2021 tax years, and has received notice in February 2019 that it is under examination for years 2016 and 2017. Additionally, the Company files multiple state and local income tax returns and remains subject to examination in various of these jurisdictions for the 2018 through 2021 tax years. As of December 31, 2022, the Company does not have any unrecognized tax benefit. ASC 740, Income Taxes , provides for the recognition of deferred tax assets if realization of these assets is more-likely-than-not. In evaluating the Company’s ability to recover its deferred tax assets, the Company considers all available positive and negative evidence, including its operating results, ongoing tax planning and forecasts of future taxable income on a jurisdiction-by-jurisdiction basis. Based upon the level of historical taxable income, at this time, the Company determined that sufficient positive evidence existed to conclude that it is more likely than not there will be full utilization of the deferred tax assets in each jurisdiction. As such, as of December 31, 2022, based on the available evidence, the Company did not record any valuation allowance. The Taxpayer Certainty and Disaster Relief Act of 2020 (the "TCJA"), enacted on December 27, 2020, added a temporary exception to the 50% limit on the amount that businesses may deduct for food or beverages. Beginning January 1, 2021, through December 31, 2022, the temporary exception allows a 100% deduction for food or beverages from restaurants. The Company evaluated the impacts and incorporated such impacts into its income tax provision. As of January 1, 2022, pursuant to the TCJA, research and experimental expenditures incurred in the current period are required to be capitalized and amortized over five or fifteen years, depending on where the research is conducted. The Company has incorporated such impacts into its provision for income taxes for the year ended December 31, 2022 . In August 2022, the Inflation Reduction Act of 2022 (the "Act") was signed into law. The Act, among other things, imposes a nondeductible 1% excise tax on the fair market value of certain stock that is "repurchased" during the taxable year by publicly traded U.S. corporations or acquired by certain of its subsidiaries. The taxable amount is reduced by the fair market value of certain issuances of stock throughout the year. The Act also imposes a 15% corporate minimum tax on the adjusted financial statement income of large corporations for taxable years beginning after December 31, 2022. We do not expect these tax law changes to have a material impact on our consolidated financial statements; however, we will continue to evaluate their impact. 18. Commitments and Contingencies The Company is a party to, and certain of its property is the subject of, various pending claims and legal proceedings that routinely arise in the ordinary course of its business. Management believes that the outcome of such litigation and claims, should they arise in the future, is not likely to have a material effect on the Company’s financial position or results of income. 66 19. Subsequent Events In January and February 2023, Lollicup made two additional investment payments of $ 1,300,000 and $ 1,600,000 , respectively, and received a refund of $ 950,000 in March 2023, pursuant to the JV Agreement as discussed in Note 4 — Joint Venture . In February 2023, the Company entered into an 88-month lease agreement commencing on April 17, 2023 for a 52,000 square-foot distribution facility in Aurora, Illinois. The term of the lease expires on July 31, 2030 and requires monthly base lease payments ranging from $ 34,000 to $ 43,000 after an initial rent abatement period. In March 2023, the Company amended the Line of Credit, which among other things, (1) extended the maturity date to March 14, 2025, and (2) revised the interest on any line of credit borrowings to an annual rate of one month term Secured Overnight Financing Rate ("SOFR") plus 2.50 %, with a SOFR floor of 1.0 %. 67 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None.