Luvu Brands, Inc. 10-K

ITEM 8. Financial Statements and Supplementary Data. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Consolidated Financial Statements: Report of Independent Registered Public Accounting Firm Auditor Firm ID (PCAOB Number 287 ) F-1 Consolidated Balance Sheets as of June 30, 2022 and 2021 F-2 Consolidated Statements of Operations for the years ended June 30, 2022 and 2021 F-3 Consolidated Statements of Changes in Stockholders’ Equity (Deficit) for the years ended June 30, 2022 and June 30, 2021 F-4 Consolidated Statements of Cash Flows for the years ended June 30, 2022 and 2021 F-5 Notes to Consolidated Financial Statements F-6 20 Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Luvu Brands, Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Luvu Brands, Inc. (the Company) as of June 30, 2022 and 2021, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years in the two-year period ended June 30, 2022, 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 as of June 30, 2022 and 2021, and the results of its operations and its cash flows for each of the years in the two-year period ended June 30, 2022, in conformity with accounting principles generally accepted in the United States of America. 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 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 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 financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. Valuation of inventory and inventory reserves As described in Notes 2 and 4 to the financial statements, the Company has inventories, net totaled to approximately $3.82 million as of June 30, 2022. Inventories are stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out (FIFO) method. The Company establishes reserves for excess and obsolete inventory for each accounting period and records any potential adjustments needed for the reserves. Auditing management’s estimates of the net realizable value of inventories, including inventory reserves was highly judgmental due to the degree of subjectivity involved in assessing the inventory reserves which are based on prevailing circumstances and judgment for consideration of current events, such as economic conditions, that may affect inventory. To test the estimates for the net realizable value of inventories, including inventory reserves, we performed audit procedures that included, among others, evaluating the reasonableness of the inputs used in management’s inventory reserve calculation and analyzing the reserve calculations to determine whether management identified any evidence of slow-moving inventory or any obsolescence due to existing and potential changes in marketability which may impact the reserves. /s/ Liggett & Webb, P.A . We have served as the Company’s auditor since 2012. Boynton Beach, Florida October 12, 2022 F-1 Table of Contents Luvu Brands, Inc. and Subsidiaries Consolidated Balance Sheets As of June 30, 2022 and 2021 2022 2021 Assets: (in thousands, except share data) Current assets: Cash and cash equivalents $ 859 $ 977 Accounts receivable, net of allowance for doubtful accounts and allowance for discounts and returns of $ 7 in 2022 and $ 55 in 2021 1,107 1,134 Inventories, net of allowance for inventory reserve of $ 176 in 2022 and $ 173 in 2021 3,817 3,391 Prepaid expenses 165 145 Total current assets 5,948 5,647 Equipment, property and leasehold improvements, net 2,029 1,934 Finance lease assets 47 27 Operating lease assets 2,255 2,554 Other assets 100 84 Total assets $ 10,379 $ 10,246 Liabilities and stockholders’ equity (deficit): Current liabilities: Accounts payable $ 2,680 $ 2,669 Current debt 1,618 1,599 Other accrued liabilities 545 694 Operating lease liability 331 250 Total current liabilities 5,174 5,212 Noncurrent liabilities: Long-term debt 1,183 1,288 Long-term operating lease liability 2,068 2,423 Total noncurrent liabilities 3,251 3,711 Total liabilities 8,425 8,923 Commitments and contingencies (See Note 15) — — Stockholders’ equity (deficit): Preferred stock, 5,700,000 shares authorized, $ 0.0001 par value none issued and outstanding — — Series A Convertible Preferred stock, 4,300,000 shares authorized $ 0.0001 par value, 4,300,000 shares issued and outstanding with a liquidation preference of $ 1,000 as of June 30, 2022 and 2021 — — Common stock, $ 0.01 par value, 175,000,000 shares authorized, 76,046,249 and 75,037,890 shares issued and outstanding as of June 30, 2022 and 2021, respectively 760 750 Additional paid-in capital 6,183 6,166 Accumulated deficit ( 4,989 ) ( 5,593 ) Total stockholders’ equity (deficit) 1,954 1,323 Total liabilities and stockholders’ equity (deficit) $ 10,379 $ 10,246 The accompanying notes are an integral part of these consolidated financial statements. F-2 Table of Contents Luvu Brands, Inc. and Subsidiaries Consolidated Statements of Operations Years Ended June 30, 2022 and 2021 2022 2021 (in thousands, except share data) Net Sales $ 26,343 $ 23,105 Cost of goods sold 20,342 16,804 Gross profit 6,001 6,301 Operating expenses: Advertising and promotion 574 502 Other selling and marketing 1,189 1,043 General and administrative 2,986 2,694 Depreciation 306 220 Total operating expenses 5,055 4,459 Operating income 946 1,842 Other income (expense): Gain on forgiveness of PPP loan — 1,096 Interest expense and financing costs ( 342 ) ( 375 ) Total other income (expense) ( 342 ) 721 Income from operations before income taxes 604 2,563 Provision for income taxes — — Net income $ 604 $ 2,563 Net income per share: Basic $ 0.01 $ 0.03 Diluted $ 0.01 $ 0.03 Shares used in calculation of net income per share: Basic 75,456,306 74,296,689 Diluted 76,110,815 75,494,948 The accompanying notes are an integral part of these consolidated financial statements. F-3 Table of Contents Luvu Brands, Inc. and Subsidiaries Consolidated Statements of Changes in Stockholders’ Equity (Deficit) For the years ended June 30, 2021 and June 30, 2022 Series A Preferred Additional Total Stock Common Stock Paid-in Accumulated Stockholders’ Shares Amount Shares Amount Capital Deficit Equity (Deficit) (in thousands, except share data) Balance, June 30, 2020 4,300,000 $ — 73,452,596 $ 735 $ 6,147 $ ( 8,156 ) $ ( 1,274 ) Stock-based compensation expense — — — — 15 — 15 Stock option exercises — — 1,585,294 15 4 — 19 Net income — — — — — 2,563 2,563 balance, June 30, 2021 4,300,000 — 75,037,890 750 6,166 ( 5,593 ) 1,323 Stock-based compensation expense — — — — 24 — 24 Stock option exercises — — 1,008,359 10 ( 7 ) — 3 Net income — — — — — 604 604 balance, June 30, 2022 4,300,000 $ — 76,046,249 $ 760 $ 6,183 $ ( 4,989 ) $ 1,954 The accompanying notes are an integral part of these consolidated financial statements. F-4 Table of Contents Luvu Brands, Inc. and Subsidiaries Consolidated Statements of Cash Flows Years Ended June 30, 2022 and 2021 2022 2021 (in thousands) OPERATING ACTIVITIES: Net income $ 604 $ 2,563 Adjustments to reconcile net income to net cash provided by operating activities: Forgiveness of PPP Loan — ( 1,096 ) Depreciation and amortization 306 220 Stock-based compensation expense 24 15 Provision for bad debt 22 1 Provision for inventory reserve 3 32 Amortization of operating lease asset 298 295 Change in operating assets and liabilities: Accounts receivable 5 1 Inventory ( 430 ) ( 1,438 ) Prepaid expenses and other assets ( 34 ) ( 158 ) Accounts payable 12 234 Accrued expenses and interest 17 40 Operating lease liability ( 274 ) ( 209 ) Accrued payroll and related ( 166 ) 40 Net cash provided by operating activities 387 540 INVESTING ACTIVITIES: Investment in equipment, software development and leasehold improvements ( 52 ) ( 210 ) Net cash used in investing activities ( 52 ) ( 210 ) FINANCING ACTIVITIES: Borrowing (repayment) under revolving line of credit ( 13 ) 78 Repayment of unsecured line of credit ( 12 ) ( 11 ) Repayment of credit card advance — ( 56 ) Borrowings under secured note payable — 200 Repayments under secured note payable ( 152 ) ( 239 ) Proceeds from unsecured notes payable 200 200 Repayment of unsecured notes payable ( 200 ) ( 489 ) Payments on equipment notes ( 268 ) ( 189 ) Proceeds from exercise of stock options 3 9 Principal payments on capital leases ( 11 ) ( 8 ) Net cash used in financing activities ( 453 ) ( 505 ) Net decrease in cash and cash equivalents ( 118 ) ( 175 ) Cash and cash equivalents at beginning of year 977 1,152 Cash and cash equivalents at end of year $ 859 $ 977 Supplemental Disclosure of Cash Flow Information: Non cash items: Purchases of equipment with equipment notes $ 346 $ 998 Finance lease asset obligation in exchange for lease payable $ 23 $ 35 Accrued interest converted for exercise of options $ — $ 10 Operating lease asset obtained in exchange for operating lease liability $ — $ 2,684 Cash paid during the year for: Interest $ 338 $ 371 Income taxes $ — $ — The accompanying notes are an integral part of these consolidated financial statements. F-5 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 1. ORGANIZATION AND NATURE OF BUSINESS Luvu Brands, Inc. (the “Company” or Luvu) was incorporated in the State of Florida on February 25, 1999. References to the “Company” in these notes include the Company and its wholly owned subsidiaries, OneUp Innovations, Inc. (“OneUp”), and Foam Labs, Inc. (“Foam Labs”). All operations of the Company are currently conducted by OneUp Innovations, Inc. The Company is an Atlanta, Georgia based designer, manufacturer and marketer of a portfolio of consumer lifestyle brands including: Liberator ® , a brand category of iconic products for enhancing sexual performance; Avana ® inclined bed therapy products, assistive in relieving medical conditions associated with acid reflux, surgery recovery and chronic pain; and Jaxx ® , a diverse range of casual fashion daybeds, sofas and beanbags made from polyurethane foam and repurposed polyurethane foam trim. These products are sold through the Company’s websites, online mass merchants and retail stores worldwide. Many of our products are offered flat-packed and either roll or vacuum compressed to save on shipping and reduce our carbon footprint. Sales are generated through internet and print advertisements. We have a diversified customer base with only one customer accounting for 10 % or more of consolidated net sales in the current and prior fiscal year and no particular concentration of credit risk in one economic sector. Foreign operations and foreign net sales are not material. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation These consolidated financial statements include the accounts and operations of our wholly owned operating subsidiaries, OneUp and Foam Labs. Intercompany accounts and transactions have been eliminated in consolidation. Certain prior period amounts have been reclassified to conform to the current year presentation. The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Use of Estimates The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions in determining the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Significant estimates in these consolidated financial statements include estimates of: income taxes; tax valuation reserves; allowances for doubtful accounts; inventory valuation and reserves, share-based compensation; and useful lives for depreciation and amortization. Actual results could differ materially from these estimates. Revenue Recognition We record revenue based on the five-step model which includes: (1) identifying the contract with the customer; (2) identifying the performance obligations in the contract; (3) determining the transaction price; (4) allocating the transaction price to the performance obligations; and (5) recognizing revenue when the performance obligations are satisfied. Substantially all of our revenue is generated by fulfilling orders for the purchase of manufactured products and product purchased for resale to retailers, wholesalers, or direct to consumers via online channels, with each order considered to be a distinct performance obligation. These orders may be formal purchase orders, verbal phone orders, e-mail orders or orders received online. Shipping and handling activities for which we are responsible under the terms and conditions of the order are not accounted for as performance obligations but as fulfillment costs. These activities are required to fulfill our promise to transfer the goods and are expensed when revenue is recognized. The impact of this policy election is insignificant as it aligns with our current practice. F-6 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 Revenue is measured as the net amount of consideration expected to be received in exchange for fulfilling a performance obligation. We have elected to exclude sales, use and similar taxes from the measurement of the transaction price. The impact of this policy election is insignificant, as it aligns with our current practice. The amount of consideration expected to be received and revenue recognized includes estimates of variable consideration, which includes costs for trade promotion programs, coupons, returns and early payment discounts. Such estimates are calculated using historical averages adjusted for any expected changes due to current business conditions and experience. We review and update these estimates at the end of each reporting period and the impact of any adjustments are recognized in the period the adjustments are identified. In assessing whether collection of consideration from a customer is probable, we consider the customer's ability and intent to pay that amount of consideration when it is due. Payment of invoices is due as specified in the underlying customer agreement, typically 30 days from the invoice date, which occurs on the date of transfer of control of the products to the customer. Revenue is recognized at the point in time that control of the ordered products is transferred to the customer. Generally, this occurs when the product is delivered, or in some cases, picked up from one of our distribution centers by the customer. Deferred revenues Deferred revenues are recorded when the Company has received consideration (i.e. advance payment) before satisfying its performance obligations. Deferred revenues primarily relate to gift cards purchased, but not used, prior to the end of the fiscal period. Our total deferred revenue as of June 30, 2022 and June 30, 2021 was $ 18,118 and $ 16,965 , respectively, and was included in “Other accrued liabilities” on our consolidated balance sheets. Cost of Goods Sold Cost of goods sold includes raw material, labor, manufacturing overhead, and royalty expense. Shipping and Handling Costs We include fees earned on the shipment of our products to customers in sales and include costs incurred on the shipment of product to customers in costs of goods sold. Cash and Cash Equivalents For purposes of reporting cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Allowance for Doubtful Accounts The allowance for doubtful accounts reflects management's best estimate of probable credit losses inherent in the accounts receivable balance. The Company determines the allowance based on historical experience, specifically identified nonpaying accounts and other currently available evidence. The Company reviews its allowance for doubtful accounts monthly with a focus on significant individual past due balances over 90 days. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The Company does not have any off-balance sheet credit exposure related to its customers. The following is a summary of Accounts Receivable as of June 30, 2022 and June 30, 2021. June 30, 2022 June 30, 2021 (in thousands) Accounts receivable $ 1,114 $ 1,189 Allowance for doubtful accounts ( 1 ) ( 1 ) Allowance for discounts and returns ( 6 ) ( 54 ) Total accounts receivable, net $ 1,107 $ 1,134 F-7 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Inventories and Inventory Reserves Inventories are stated at the lower of cost or net realizable value. Cost is determined using the first-in, first-out (FIFO) method. Net realizable value is defined as sales price less cost to dispose and a normal profit margin. Inventory costs include materials, labor, depreciation and overhead. The company establishes reserves for excess and obsolete inventory, based on prevailing circumstances and judgment for consideration of current events, such as economic conditions, that may affect inventory. The reserve required to record inventory at lower of cost or net realizable value may be adjusted in response to changing conditions. Concentration of Credit Risk The Company maintains its cash accounts with banks located in Georgia. The total cash balances are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $ 250,000 per bank. The Company had cash balances on deposit at June 30, 2022 and 2021 that exceeded the balance insured by the FDIC by $ 717,316 and $ 807,766 , respectively. Accounts receivable are typically unsecured and are derived from revenue earned from customers primarily located in North America and Europe. During 2022, we purchased 34 % of total inventory purchases from one vendor. During 2021, we purchased 34 % of total inventory purchases from one vendor. As of June 30, 2022, two of the Company’s customers represent 21 % and 13 % of the total accounts receivables, respectively. As of June 30, 2021, two of the Company’s customers represent 40 % and 14 % of the total accounts receivable, respectively. Sales to (and through) Amazon accounted for 31 % and 29 % of our net sales during each of the years ended June 30, 2022 and June 30, 2021 respectively. Fair Value of Financial Instruments At June 30, 2022 and 2021, our financial instruments included cash and cash equivalents, accounts receivable, accounts payable, short-term debt, and other long-term debt. The fair values of these financial instruments approximated their carrying values based on either their short maturity or current terms for similar instruments. The Company measures the fair value of its assets and liabilities under the guidance of ASC 820, Fair Value Measurements and Disclosures , which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. ASC 820 does not require any new fair value measurements, but its provisions apply to all other accounting pronouncements that require or permit fair value measurement. ASC 820 clarifies that fair value is an exit price, representing the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants based on the highest and best use of the asset or liability. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. ASC 820 requires the Company to use valuation techniques to measure fair value that maximize the use of observable inputs and minimize the use of unobservable inputs. These inputs are prioritized as follows: • Level 1: Observable inputs such as quoted prices for identical assets or liabilities in active markets; F-8 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) • Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly such as quoted prices for similar assets or liabilities or market-corroborated inputs; and • Level 3: Unobservable inputs for which there is little or no market data, which require the reporting entity to develop its own assumptions about how market participants would price the assets or liabilities. The valuation techniques that may be used to measure fair value are as follows: A. Market approach - Uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. B. Income approach - Uses valuation techniques to convert future amounts to a single present amount based on current market expectations about those future amounts, including present value techniques, option-pricing models and excess earnings method. C. Cost approach - Based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Advertising Costs Advertising costs are expensed in the period when the advertisements are first aired or distributed to the public. Prepaid advertising (included in prepaid expenses) was $ 1,050 at June 30, 2022 and $ 5,000 at June 30, 2021. Advertising expense for the years ended June 30, 2022 and 2021 was $ 574,146 and $ 501,711 , respectively. Research and Development Research and development expenses for new products are expensed as they are incurred. Expenses for new product development (included in general and administrative expense) totaled $ 117,079 for the year ended June 30, 2022 and $ 109,024 for the year ended June 30, 2021. Property and Equipment Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method over estimated service lives for financial reporting purposes of 2 - 10 years. Expenditures for major renewals and betterments which extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred. When properties are disposed of, the related costs and accumulated depreciation are removed from the respective accounts, and any gain or loss is recognized currently. Operating Leases On November 2, 2020, the Company entered into an agreement with its landlord on a new lease for the current facilities for six years and two months, beginning January 1, 2021. The new lease includes two months of rent abatement totaling $ 103,230 . Under the new lease, the monthly rent on the facility is $ 51,615 with annual escalations of 3% with the final two months of rent at $ 61,605 . In addition, the Company will pay the landlord a 2% property management fee. The rent expense for the year ended June 30, 2022 and June 30,2021 was $ 652,752 and $ 501,480 respectively. F-9 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Under ASC 842, which was adopted July 1, 2019, the Company determines whether the arrangement is or contains a lease based on the unique facts and circumstances present. Most leases with a term greater than one year are recognized on the balance sheet as right-of-use assets, lease liabilities and, if applicable, long-term lease liabilities. The Company elected not to recognize leases with a term less than one year on its balance sheet. Operating lease right-of-use (ROU) assets and their corresponding lease liabilities are recorded based on the present value of lease payments over the expected remaining lease term. The interest rate implicit in lease contracts is typically not readily determinable. As a result, the Company utilizes its incremental borrowing rates, which are the rates incurred to borrow on a collateralized basis over a similar term, an amount equal to the lease payments in a similar economic environment. In accordance with the guidance in ASU 2016-02, components of a lease should be split into three categories: lease components (e.g. land, building, etc.), non-lease components (e.g. common area maintenance, consumables, etc.), and non-components (e.g. property taxes, insurance, etc.) Then the fixed and in-substance fixed contract consideration (including any related to non-components) must be allocated based on fair values to the lease components and non-lease components. Although separation of lease and non-lease components is required, the Company elected the practical expedient to not separate lease and non-lease components. The lease component results in an operating right-of-use asset being recorded on the balance sheet and amortized on a straight-line basis as lease expense. Under prior guidance ASC 840, rent expense and lease incentives from operating leases were recognized on a straight-line basis over the lease term. The difference between rent expense recognized and rental payments was recorded as deferred rent in the accompanying consolidated balance sheets. The Company also leases certain equipment under operating leases, as more fully described in NOTE 15 - Commitments and Contingencies . Segment Information We have identified three reportable sales channels: Direct, Wholesale and Other . Direct includes product sales through our five e-commerce sites. Wholesale includes Liberator, Jaxx, and Avana branded products sold to distributors and retailers, purchased products sold to retailers, and private label items sold to other resellers. The Wholesale category also includes contract manufacturing services, which consists of specialty items that are manufactured in small quantities for certain customers, and which, to date, has not been a material part of our business. Other consists principally of shipping and handling fees and costs derived from our Direct business and fulfillment service fees. The following is a summary of sales results for the Direct, Wholesale , and Other channels. Year Ended June 30, 2022 Year Ended June 30, 2021 % Change (in thousands) Net Sales by Channel: Direct $ 7,136 $ 6,919 3 % Wholesale $ 18,546 $ 15,618 19 % Other $ 661 $ 568 16 % Total Net Sales $ 26,343 $ 23,105 14 % F-10 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Year Ended Margin Year Ended Margin % June 30, 2022 % June 30, 2021 % Change (in thousands) (in thousands) Gross Profit by Channel: Direct $ 3,289 46 % $ 3,329 48 % ( 1 )% Wholesale $ 4,017 22 % $ 4,216 27 % ( 4 )% Other $ ( 1,305 ) ( 197 )% $ ( 1,244 ) ( 219 )% 5 % Total Gross Profit $ 6,001 23 % $ 6,301 27 % ( 4 )% Recent accounting pronouncements From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) or other standard setting bodies that are adopted by the Company as of the specified effective date. Adopted during the year ended June 30, 2021 Fair Value Measurement In August 2018, the FASB issued Accounting Standards Update (“ASU”) No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement . The new standard eliminates, adds and modifies certain disclosure requirements for fair value measurement as part of the FASB’s disclosure framework project. Under the new standard, the amount and reason for a transfer between Level 1 and Level 2 of the fair value hierarchy are no longer required to be disclosed, but public companies are required to disclose a range and weighted average of significant unobservable inputs for Level 3 fair value measurements. The Company adopted the new standard on July 1, 2020; however, it did not have a significant impact on the Company’s financial statements. Collaborative Arrangements In November 2018, the FASB issued ASU No. 2018-18, Collaborative Arrangements (Topic 808): Clarifying the Interaction between Topic 808 and Topic 606 . The new standard clarifies that certain transactions between participants in a collaborative arrangement should be accounted for under Topic 606 when the counterparty is a customer. The new standard also precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue from contracts with customers if the counterparty is not a customer for that transaction. The guidance amends Topic 808 to refer to the unit-of-account guidance in Topic 606 and requires it to be used only when assessing whether a transaction is in the scope of Topic 606. The Company adopted the new standard on July 1, 2020; however, it did not have a significant impact on the Company’s financial statements. Adopted effective July 1, 2021 Financial Instruments—Credit Losses In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments . The new standard requires that financial assets measured at amortized cost be presented at the net amount expected to be collected and separately measure an allowance for credit losses that is deducted from the amortized cost basis of those financial assets. The Company early adopted the new standard on July 1, 2021; however, it did not have a significant impact on the Company’s financial statements. F-11 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Recent accounting pronouncements (continued) Income Taxes In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes . The new standard includes several provisions that simplify the accounting for income taxes by removing certain exceptions to the general principles in Topic 740 and increasing consistency and clarity for the users of financial statements. The Company adopted the new standard on July 1, 2021; however, it did not have a significant impact on the Company’s financial statements. Investments – Equity Securities, Investments – Equity Method and Joint Ventures, and Derivatives and Hedging In January 2020, the FASB issued ASU No. 2020-01, Investments – Equity Securities (Topic 321), Investments – Equity Method and Joint Ventures (Topic 323), and Derivatives and Hedging (Topic 815)—Clarifying the Interactions between Topic 321, Topic 323, and Topic 815 . The new standard addresses interactions between the guidance to account for certain equity securities under ASC Topic 321, the guidance to account for investments under the equity method of accounting in ASC Topic 323 and the guidance in ASC Topic 815, which could change how an entity accounts for an equity security under the measurement alternative or a forward contract or purchased option to purchase securities that, upon settlement of the forward contract or exercise of the purchased option, would be accounted for under the equity method of accounting or the fair value option in accordance with ASC Topic 825, Financial Instruments . These amendments improve current U.S. GAAP by reducing diversity in practice and increasing comparability of the accounting for any such interactions. The Company adopted the new standard on July 1, 2021; however, it did not have a significant impact on the Company’s financial statements. Net Income Per Share In accordance with FASB Accounting Standards Codification No. 260, “Earnings Per Share”, basic net income per share is computed by dividing the net income available to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income available to common stockholders by the weighted average number of common and common equivalent shares outstanding during the period. The total potential dilutive securities as of June 30, 2022 and 2021 are as follows: 2022 2021 Convertible Preferred Stock 4,300,000 4,300,000 Stock options – 2015 Plan 1,975,000 2,500,000 Total 6,275,000 6,800,000 F-12 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Income Taxes We utilize the asset and liability method of accounting for income taxes. We recognize deferred tax liabilities or assets for the expected future tax consequences of temporary differences between the book and tax basis of assets and liabilities. We regularly assess the likelihood that our deferred tax assets will be recovered from future taxable income. We consider projected future taxable income and ongoing tax planning strategies in assessing the amount of the valuation allowance necessary to offset our deferred tax assets that will not be recoverable. We have recorded and continue to carry a full valuation allowance against our gross deferred tax assets that will not reverse against deferred tax liabilities within the scheduled reversal period. If we determine in the future that it is more likely than not that we will realize all or a portion of our deferred tax assets, we will adjust our valuation allowance in the period we make the determination. We expect to provide a full valuation allowance on our future tax benefits until we can sustain a level of profitability that demonstrates our ability to realize these assets. At June 30, 2022, we carried a valuation allowance of $ 1.4 million against our net deferred tax assets. Stock Based Compensation We account for stock-based compensation to employees in accordance with FASB ASC 718, Compensation – Stock Compensation. We measure the cost of each stock option and restricted stock award at its fair value on the grant date. Each award vests over the subsequent period during which the recipient is required to provide service in exchange for the award (the vesting period). The cost of each award is recognized as expense in the financial statements over the respective vesting period. NOTE 3. IMPAIRMENT OF LONG-LIVED ASSETS We follow FASB ASC 360, Property, Plant, and Equipment, regarding impairment of our other long-lived assets (property, plant and equipment). Our policy is to assess our long-lived assets for impairment annually in the fourth quarter of each year or more frequently if events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. An impairment loss is recognized only if the carrying value of a long-lived asset is not recoverable and is measured as the excess of its carrying value over its fair value. The carrying amount of a long-lived asset is considered not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use of a long-lived asset. Assets to be disposed of and related liabilities would be separately presented in the consolidated balance sheet. Assets to be disposed of would be reported at the lower of the carrying value or fair value less costs to sell and would not be depreciated. There was no impairment as of June 30, 2022 or 2021. NOTE 4. INVENTORIES All inventories are stated at the lower of cost (which approximates first-in, first-out) or net realizable value. The Company’s inventories consist of the following components at June 30, 2022 and 2021: 2022 2021 (in thousands) Raw materials $ 1,893 $ 1,637 Work in process 440 396 Finished goods 1,660 1,531 Total inventories 3,993 3,564 Allowance for inventory reserves ( 176 ) ( 173 ) Total inventories, net of allowance $ 3,817 $ 3,391 F-13 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 5. EQUIPMENT, PROPERTY AND LEASEHOLD IMPROVEMENTS, NET Equipment, property and leasehold improvements at June 30, 2022 and 2021 consisted of the following: 2022 2021 Estimated Useful Life (in thousands) Factory equipment $ 3,840 $ 3,567 2 - 10 years Computer equipment and software 1,167 1,146 5 - 7 years Office equipment and furniture 205 205 5 - 7 years Leasehold improvements 480 480 10 years Projects in process 318 222 Subtotal 6,010 5,620 Accumulated depreciation ( 3,981 ) ( 3,686 ) Equipment and leasehold improvements, net $ 2,029 $ 1,934 Depreciation expense was $ 305,643 and $ 220,635 for the years ended June 30, 2022 and 2021, respectively. NOTE 6. OTHER ACCRUED LIABILITIES Other accrued liabilities at June 30, 2022 and 2021 consisted of the following: 2022 2021 (in thousands) Accrued compensation $ 344 $ 509 Accrued expenses and interest 201 185 Other accrued liabilities $ 545 $ 694 NOTE 7. CURRENT AND LONG-TERM DEBT SUMMARY Current and long-term debt at June 30, 2022 and 2021 consisted of the following: 2022 2021 Current debt: (in thousands) Unsecured lines of credit (Note 12) $ 25 $ 37 Line of credit (Note 11) 1,070 1,083 Short-term unsecured notes payable (Note 8) 200 100 Current portion of equipment notes payable (Note 15) 308 219 Current portion secured notes payable (Note 13) - 152 Current portion of finance leases payable (Note 15) 15 8 Credit card advance (net of discount) (Note 10) - - Total current debt 1,618 1,599 Long-term debt: Unsecured notes payable (Note 8) 200 300 Equipment notes payable (Note 15) 842 853 Finance leases payable (Note 15) 25 19 Notes payable- related party (Note 9) 116 116 Total long-term debt $ 1,183 $ 1,288 F-14 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 8. UNSECURED NOTES PAYABLE Unsecured notes payable at June 30, 2022 and 2021 consisted of the following: 2022 2021 Current debt: (in thousands) 20 % Unsecured note, interest only, due October 31, 2021 (1) - 100 13.5 % Unsecured note, interest only, due May 1, 2023 (2) 200 - Total current debt 200 100 Long-term debt: 20 % Unsecured note, interest only, due July 31, 2021 (3) - 100 13.5 % Unsecured note, interest only, due May 1, 2023 (2) - 200 13.5 % Unsecured note, interest only, due July 31, 2023 (3) 100 - 13.5 % Unsecured note, interest only, due October 31, 2023 (1) 100 - Total long-term debt 200 300 Total unsecured notes payable $ 400 $ 400 (1) Unsecured note payable for $ 100,000 to an individual with interest payable monthly at 20 %, principal originally due in full on October 31, 2014, extended to October 31, 2019, then extended to October 31, 2021. This note was repaid in full on October 31, 2021 and replaced with a new note from an entity controlled by the same lender with interest payable monthly at 13.5%, principal due in full on October 31, 2023 . Personally guaranteed by principal stockholder. (2) Unsecured note payable for $ 200,000 to an individual with interest payable monthly at 20 %, principal originally due in full on May 1, 2013, extended to May 1, 2019, then extended to May 1, 2021. This note was repaid in full on April 30, 2021 and replaced with a new note from an entity controlled by the same lender with interest payable monthly at 13.5%, principal due in full on May 1, 2023 . Personally guaranteed by principal stockholder. (3) Unsecured note payable for $ 100,000 to an individual with interest payable monthly at 20 %, principal originally due in full on July 31, 2013, extended to July 31, 2019, then extended to July 31, 2021. This note was repaid in full on July 30, 2021 and replaced with a new note from an entity controlled by the same lender with interest payable monthly at 13.5%, principal due in full on July 31, 2023 . Personally guaranteed by principal stockholder. NOTE 9. NOTES PAYABLE - RELATED PARTY Related party notes payable at June 30, 2022 and 2021 consisted of the following: 2022 2021 (in thousands) Unsecured note payable to an officer, with interest at 3.25 %, due July 1, 2023 $ 40 $ 40 Unsecured note payable to an officer, with interest at 3.25 %, due July 1, 2023 76 76 Total unsecured notes payable 116 116 Less: current portion — — Long-term unsecured notes payable $ 116 $ 116 F-15 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 10. CREDIT CARD ADVANCES On August 28, 2019, the Company borrowed $ 250,000 from Power Up against its future credit card receivables. Terms for this loan calls for a repayment of $ 290,000 , which includes a one-time finance charge of $ 40,000 , approximately ten months after the funding date. A 1 % loan origination fee was deducted, and the Company received net proceeds of $ 247,500 . This loan was repaid in full on September 16, 2020. This loan was guaranteed by the Company and was personally guaranteed by the Company’s CEO and controlling shareholder, Louis S. Friedman (see Note 16). NOTE 11. LINE OF CREDIT The Company’s wholly owned subsidiary, OneUp and OneUp’s wholly owned subsidiary, Foam Labs has entered into a credit facility with a finance company, Advance Financial Corporation dated May 24, 2011, as amended, to provide it with an asset based line of credit of up to $ 1,200,000 against 85% of eligible accounts receivable (as defined in the agreement) for the purpose of improving working capital and includes an Inventory Advance (as defined in the agreement) of up to the lesser of $ 500,000 or 125 % of the eligible accounts receivable loan. The term of the agreement was one year, renewable for additional one-year terms unless either party provides written notice of non-renewal at least 90 days prior to the end of the current financing period. The credit facility is secured by our accounts receivable and other rights to payment, general intangibles, inventory and equipment, and are subject to eligibility requirements for current accounts receivable. Advances under the agreement are currently charged interest at a rate of prime rate plus 2 % over the lenders Index Rate. In addition, there is a Monthly Service Fee (as defined in the agreement) of currently 0.05 % per month. The Company’s President and Chief Executive Officer (CEO), Louis Friedman, has personally guaranteed the repayment of the facility. In addition, the Company has provided its corporate guarantee of the credit facility (see Note 16). On June 30, 2022, the balance owed under this line of credit was $ 1,070,069 . As of June 30, 2022, we were current and in compliance with all terms and conditions of this line of credit. Management believes cash flows generated from operations, along with current cash and investments as well as borrowing capacity under the line of credit should be sufficient to finance capital requirements required by operations. If new business opportunities do arise, additional outside funding may be required. NOTE 12. UNSECURED LINES OF CREDIT The Company has drawn a cash advance on one unsecured lines of credit that is in the name of the Company and Louis S. Friedman (see Note 16). The terms of this unsecured line of credit calls for monthly payments of principal and interest, with interest at 8 %. The aggregate amount owed on the unsecured line of credit was $ 24,879 at June 30, 2022 and $ 36,680 at June 30, 2021. NOTE 13. SECURED NOTE PAYABLE On February 17, 2021, the Company entered into an agreement with Amazon, whereby Amazon agreed to loan OneUp Innovations a total of $ 200,000 . Repayment of this note is by 12 monthly payments of $ 17,675 , which includes interest at 10.99 %. This loan was repaid in full on February 17, 2022. The Company has granted Amazon a security interest in the assets of the Company. F-16 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 14. PPP LOAN On April 26, 2020, the Company entered into a promissory note (the “PPP Note”) evidencing an unsecured loan in the amount of $ 1,096,200 made to the Company under the Payroll Protection Plan ("PPP"). The PPP is a liquidity facility program established by the U.S. government as part of the CARES Act in response to the negative economic impact of the COVID-19 outbreak. The PPP Loan to the Company is being administered by Ameris Bank. The PPP Loan has a two-year term and bears interest at a rate of 1.0 % per annum. Monthly principal and interest payments are deferred for six months. Beginning November 26, 2020, seven months from the date of the PPP Note, the Company is required to make monthly payments of principal and interest in the amount of $ 61,691 . The PPP Loan is a forgivable loan to the extent proceeds are used to cover qualified documented payroll, mortgage interest, rent, and utility costs over a 24-week measurement period (as amended) following loan funding. For the loan to be forgiven, the Company is required to formally apply for forgiveness, and potentially, required to pass an audit that it met the eligibility qualifications of the loan. Within 150 days from the application, the Company will be notified whether or not the loan is forgiven. On December 18, 2020, the Company was informed by Ameris Bank that the PPP Note had been forgiven by the U.S. Small Business Administration. In accounting for the terms of the PPP Loan, the Company is guided by ASC 470 Debt , and ASC 450-30 Gain contingency . Accordingly, the Company derecognized the PPP Note liability of $ 1,096,200 and recorded it as Other Income, as the forgiveness was certain. NOTE 15. COMMITMENTS AND CONTINGENCIES Operating Leases The Company leases its facilities under non-cancelable operating leases expiring at the end of 2026. Right-of-use assets represent the right to use an underlying asset for the lease term and lease liabilities represent the obligation to make lease payments arising from the lease. Right-of-use assets and liabilities for the lease renewal were recognized at the inception date which is November 2, 2020 based on the present value of lease payments over the lease term, using the Company’s incremental borrowing rate based on the information available. At June 30, 2022, the weighted average remaining lease term for the lease renewal is 6 years and the weighted average discount rate is 14.49 %. Supplemental balance sheet information related to leases at June 30, 2022 is as follows: Supplemental balance sheet information related to leases at June 30, 2022 is as follows: Operating leases Balance Sheet Classification (in thousands) Right-of-use assets Operating lease right-of-use assets, net $ 2,255 Current lease liabilities Operating lease obligations $ 331 Non-current lease liabilities Long-term operating lease obligations 2,068 Total lease liabilities $ 2,399 F-17 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 15. COMMITMENTS AND CONTINGENCIES (continued) Maturities of operating lease liabilities at June 30, 2022 are as follows: Payments (in thousands) 2023 642 2024 680 2025 721 2026 762 2027 and thereafter 528 Total undiscounted lease payments 3,333 Less: Present value discount ( 934 ) Total operating lease liability balance $ 2,399 Equipment Notes Payable The Company has acquired equipment under the provisions of long-term equipment notes. For financial reporting purposes, minimum note payments relating to the equipment have been capitalized. The equipment acquired with these equipment notes has a total cost of approximately $ 1,761,393 . These assets are included in the fixed assets listed in Note 5 - Equipment and Leasehold Improvements and include production equipment. The equipment notes have stated or imputed interest rates ranging from 10.5 % to 11.3 %. The following is an analysis of the minimum future equipment note payable payments subsequent to June 30, 2022: Year ending June 30, (in thousands) 2023 388 2024 367 2025 322 2026 203 2027 37 Future Minimum Note Payable Payments $ 1,317 Less Amount Representing Interest ( 167 ) Present Value of Minimum Note Payable Payments 1,150 Less Current Portion ( 308 ) Long-Term Obligations under Equipment Notes Payable $ 842 Finance Leases Payable The Company has lease obligations for equipment under the provisions of long-term finance leases. For financial reporting purposes, minimum lease payments relating to the equipment have been capitalized. The equipment acquired with these leases has a total cost of approximately $ 58,152 . These assets are included in the finance lease and include production equipment. On June 22, 2020 the Company entered into finance lease agreement with Wells Fargo in the amount of $ 34,761 with monthly payment of $ 850 with 48-month term at an imputed interest rate of 8.09 %. On February 1, 2022 the Company entered into finance lease agreement with Raymond in the amount of $ 22,862 with monthly payment of $ 514 with 48-month term at an imputed interest rate of 3.75 %. F-18 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 15. COMMITMENTS AND CONTINGENCIES (continued) The following is an analysis of the minimum finance lease payable payments subsequent to June 30, 2022: Year ending June 30, (in thousands) 2023 17 2024 17 2025 6 2026 3 Future Minimum Finance Lease Payable Payments $ 43 Less Amount Representing Interest ( 3 ) Present Value of Minimum Finance Lease Payable Payments 40 Less Current Portion ( 15 ) Long-Term Obligations under Finance Lease Payable $ 25 Employment Agreements The Company has entered into an employment agreement with Louis Friedman, President and Chief Executive Officer. The agreement provides for an annual base salary of $ 150,000 and eligibility to receive a bonus. In certain termination situations, the Company is liable to pay severance compensation to Mr. Friedman for up to nine months at his current salary. Legal Proceedings As of the date of this Annual Report, there are no material pending legal or governmental proceedings relating to the Company or properties to which the Company is a party, and to the Company’s knowledge there are no material proceedings to which any of its directors, executive officers or affiliates are a party adverse to the Company or which have a material interest adverse to the Company. NOTE 16. RELATED PARTY TRANSACTIONS The Company has a subordinated note payable to an officer of the Company who is also the wife of the Company’s CEO (Louis Friedman) and majority shareholder in the amount of $ 76,000 (see Note 9). Interest on the note during the year ended June 30, 2022 was accrued by the Company at the prevailing prime rate (which is currently 4.75 %) and totaled $ 2,611 . The accrued interest on the note as of June 30, 2022 was $ 32,760 . This note is subordinate to all other credit facilities currently in place. On October 30, 2010, Mr. Friedman, loaned the Company $ 40,000 (see Note 9). Interest on the note during the year ended June 30, 2022 was accrued by the Company at the prevailing prime rate (which is currently 4.75 %) and totaled $ 1,374 . The accrued interest on the note as of June 30, 2022 was $ 6,889 . This note is subordinate to all other credit facilities currently in place. The Company’s CEO, Louis Friedman, has personally guaranteed the repayment of the loan obligation to Advance Financial Corporation (see Note 11 – Line of Credit). In addition, Luvu Brands has provided its corporate guarantees of the credit facility. On June 30, 2022, the balance owed under this line of credit was $ 1,070,069 . F-19 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 16. RELATED PARTY TRANSACTIONS (continued) On July 20, 2011, the Company issued an unsecured promissory note to an individual for $ 100,000 . Terms of the promissory note call for monthly interest payments of $ 1,667 (equal to interest at 20 % per annum), with the principal amount due in full on July 31, 2012 ; extended by the holder to July 31, 2021 under the same terms (see Note 8). This note was repaid in full on July 30, 2021 and replaced with a new note from an entity controlled by the same lender with interest payable monthly at 13.5%, principal due in full on July 31, 2023. Repayment of this promissory note is personally guaranteed by the Company’s CEO and controlling shareholder, Louis S. Friedman. On October 31, 2013, the Company issued an unsecured promissory note to an individual for $ 100,000 . Terms of the promissory note call for monthly interest payments of $ 1,667 (equal to interest at 20 % per annum) beginning on November 30, 2013, with the principal amount due in full on or before October 31, 2014 extended by the holder to October 31, 2021 (see Note 8). This note was repaid in full on October 31,2021 and replaced with a new note from an entity controlled by the same lender with interest payable monthly at 13.5%, principal due in full on October 31, 2023. Repayment of the promissory note is personally guaranteed by the Company’s CEO and majority shareholder, Louis S. Friedman. On May 1, 2012, an individual loaned the Company $ 200,000 with an interest rate of 20 %. Interest on the loan is being paid monthly, with the principal due in full on May 1, 2013 ; then extended to May 1, 2021 (see Note 8). This note was repaid in full on April 30, 2021 and replaced with a new note from an entity controlled by the same lender with interest payable monthly at 13.5%, principal due in full on May 1, 2023. Mr. Friedman has personally guaranteed the repayment of the loan obligation. The loans from Power Up Lending Group, Ltd. (see Note 10) were guaranteed by the Company (including OneUp and Foam Labs) and were personally guaranteed by the Company’s CEO and majority shareholder, Louis S. Friedman. Power Up Lending Group, Ltd. is controlled by Curt Kramer, who also controls HCI. As last reported to us, HCI owns 7.1% of our common stock. The Company has drawn a cash advance on one unsecured lines of credit that is in the name of the Company and Louis S. Friedman. The terms of this unsecured line of credit calls for monthly payments of principal and interest, with interest at 8 %. The aggregate amount owed on the unsecured line of credit was $ 24,879 at June 30, 2022 and $ 36,680 at June 30, 2021 (see Note 12). The loan is personally guaranteed by the Company’s CEO and majority shareholder, Louis S. Friedman. NOTE 17. STOCKHOLDERS’ EQUITY Options At June 30, 2022, the Company had the 2015 Equity Incentive Plan (the “2015 Plan”), which is shareholder-approved and under which 2,225,000 shares are reserved for issuance under the 2015 Plan until that Plan terminates on August 31, 2025. Under the 2015 Plan, eligible employees and certain independent consultants may be granted options to purchase shares of the Company’s common stock. The shares issuable under the 2015 Plan will either be shares of the Company’s authorized but previously unissued common stock or shares reacquired by the Company, including shares purchased on the open market. As of June 30, 2022, the number of shares available for issuance under the 2015 Plan was 250,000 . F-20 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 17. STOCKHOLDERS’ EQUITY (continued) A summary of option activity under the Company’s stock plan for the years ended June 30, 2022 and 2021 is presented below: Option Activity Shares Weighted Average Exercise Price Weighted Average Remaining Contractual Term Aggregate Intrinsic Value Outstanding at June 30, 2020 4,250,000 $ 0.02 1.7 years $ 624,700 Granted 350,000 $ 0.15 4.8 years Exercised ( 1,600,000 ) $ 0.01 Forfeited or Expired ( 500,000 ) $ 0.05 Outstanding at June 30, 2021 2,500,000 $ 0.04 1.9 years $ 974,300 Granted 900,000 $ 0.18 4.8 years Exercised ( 1,175,000 ) $ 0.03 Forfeited or Expired ( 250,000 ) $ 0.07 Outstanding at June 30, 2022 1,975,000 $ 0.10 3.0 years $ 107,500 Exercisable at June 30, 2022 750,000 $ 0.03 1.0 years $ 80,078 The aggregate intrinsic value in the table above is before applicable income taxes and represents the excess amount over the exercise price optionees would have received if all options had been exercised on the last business day of the period indicated, based on the Company’s closing stock price of $ 0.14 , $ 0.43 , and $ 0.17 at June 30, 2022, 2021 and 2020, respectively. There were 900,000 stock options granted during the year ended June 30, 2022 and 350,000 stock options granted during the year ended June 30, 2021. During the year ended June 30, 2022 and June 30, 2021 the Company’s proceeds from stock options exercise under 2015 Plan were $ 3,000 and $ 8,750 respectively. The range of fair value assumptions related to options granted during the years ended June 30, 2022 and 2021 were as follows: 2022 2021 Exercise Price: $ 0.16 - $ 0.30 $ 0.13 - $ 0.17 Volatility: 500 % - 519 % 469 % - 489 % Risk Free Rate: 0.65 % - 2.90 % 0.25 % - 0.49 % Vesting Period: 4 years 4 years Forfeiture Rate: 0 % 0 % Expected Life: 4.1 years 4.1 years Dividend Rate: 0 % 0 % F-21 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 17. STOCKHOLDERS’ EQUITY (continued) The following table summarizes the weighted average characteristics of outstanding stock options as of June 30, 2022: Outstanding Options Exercisable Options Exercise Prices Number of Shares Remaining Life (Years) Weighted Average Price Number of Shares Weighted Average Price .01 to .03 925,000 1.2 $ 0.03 725,000 $ 0.03 .05 50,000 1.0 $ 0.05 — — .15 to .20 950,000 4.7 $ 0.17 25,000 $ 0.17 .30 50,000 4.1 $ 0.30 — — Total stock options 1,975,000 3.0 $ 0.10 750,000 $ 0.03 We account for stock-based compensation to employees in accordance with FASB ASC 718, Compensation – Stock Compensation. We measure the cost of each stock option and at its fair value on the grant date. Each award vests over the subsequent period during which the recipient is required to provide service in exchange for the award (the vesting period). The cost of each award is recognized as expense in the financial statements over the respective vesting period. All stock option grants made under the Plan were at exercise prices no less than the Company’s closing stock price on the date of grant. Options under the Plan were determined by the board of directors in accordance with the provisions of the plan. The terms of each option grant include vesting, exercise, and other conditions are set forth in a Stock Option Agreement evidencing each grant. No option can have a life in excess of ten (10) years. The Company records compensation expense for employee stock options based on the estimated fair value of the options on the date of grant using the Black-Scholes option-pricing model. The model requires various assumptions, including a risk-free interest rate, the expected term of the options, the expected stock price volatility over the expected term of the options, and the expected dividend yield. Compensation expense for employee stock options is recognized ratably over the vesting term. The Company has no awards with market or performance conditions. Stock-based compensation expense recognized in the consolidated statements of operations for each of the fiscal years ended June 30, 2022 and 2021 is based on awards ultimately expected to vest. As of June 30, 2022, total unrecognized stock-based compensation expense related to all unvested stock options was $ 163,906 which is expected to be expensed over a weighted average period of 3.6 years. In determining the grant date fair value of option awards under the equity incentive plans, the Company applied the Black-Scholes option pricing model. Based upon limited option exercise history, the Company has generally used the “simplified” method outlined in SEC Staff Accounting Bulletin No. 110 to estimate the expected life of stock option grants. Management believes that the historical volatility of the Company’s stock price on OTCQB best represents the expected volatility over the estimated life of the option. The risk-free interest rate is based upon published U.S. Treasury yield curve rates at the date of grant corresponding to the expected life of the stock option. An assumed dividend yield of zero reflects the fact that the Company has never paid cash dividends and has no intentions to pay dividends in the foreseeable future. F-22 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 17. STOCKHOLDERS’ EQUITY (continued) The following table summarizes stock-based compensation expense by line item in the consolidated statements of operations, all relating to employee stock plans: For the Years Ended June 30, 2022 2021 (in thousands) Cost of Goods Sold $ 3 $ - Other Selling and Marketing 11 4 General and Administrative 10 11 Total $ 24 $ 15 Share Purchase Warrants As of June 30, 2022 and 2021, there were no share purchase warrants outstanding. Common Stock The Company’s authorized common stock was 175,000,000 shares at June 30, 2022 and 2021. Common shareholders are entitled to dividends if and when declared by the Company’s Board of Directors, subject to preferred stockholder dividend rights. At June 30, 2022, the Company had reserved the following shares of common stock for issuance: June 30, 2022 Shares of common stock reserved for issuance under the 2015 Stock Option Plan 2,225,000 Shares of common stock issuable upon conversion of the Preferred Stock 4,300,000 Total shares of common stock equivalents 6,525,000 During fiscal year 2022 and fiscal year 2021 the Company issued 1,008,359 and 1,585,294 common shares respectively for stock option exercises under 2015 Equity Incentive Plan. Preferred Stock On February 18, 2011, the Company filed an amendment to its Articles of Incorporation, effective February 9, 2011, authorizing the issuance of preferred stock and the Company now has 10,000,000 authorized shares of preferred stock, par value $ 0.0001 per share, of which 4,300,000 shares have been designated and issued as Series A Convertible Preferred Stock. Each share of Series A Convertible Preferred Stock is convertible into one share of common stock and has a liquidation preference of $ 0.2325 ($ 1,000,000 in the aggregate). Liquidation payments to the preferred holders have priority and are made in preference to any payments to the holders of common stock. In addition, each share of Series A Convertible Preferred Stock is entitled to the number of votes equal to the result of: (i) the number of shares of common stock of the Company issued and outstanding at the time of such vote multiplied by 1.01; divided by (ii) the total number of Series A Convertible Preferred Shares issued and outstanding at the time of such vote. At each meeting of shareholders of the Company with respect to any and all matters presented to the shareholders of the Company for their action or consideration, including the election of directors, holders of Series A Convertible Preferred Shares shall vote together with the holders of common shares as a single class. F-23 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 18. INCOME TAXES Deferred tax assets and liabilities are computed by applying the effective U.S. federal income tax rate to the gross amounts of temporary differences and other tax attributes. Deferred tax assets and liabilities relating to state income taxes are not material. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. As of June 30, 2022 and 2021, the Company believed it was more likely than not that future tax benefits from net operating loss carryforwards and other deferred tax assets would not be realizable through generation of future taxable income; therefore, they were fully reserved. The components of deferred tax assets and liabilities at June 30, 2022 and 2021 are approximately as follows: 2022 2021 (in thousands) Deferred tax assets: Inventory reserves $ 46 $ 45 Allowance for doubtful accounts 2 14 Stock-based compensation 106 100 Net operating loss carry-forwards 1,233 1,384 Total gross deferred tax assets 1,387 1,543 Valuation allowance ( 1,387 ) ( 1,543 ) Net deferred tax assets $ — $ — The income tax provision differs from the amount of income tax determined by applying the U.S. federal and state income tax rates of 25% to pretax (income) loss from operations for the years ended June 30, 2022 and 2021 due to the following: 2022 2021 Net (income) loss $ ( 156 ) $ ( 660 ) Permanent differences and change in tax rate estimate — 282 Valuation (allowance) 156 378 Net tax benefit $ — $ — At June 30, 2022, the Company had net operating loss (NOL) carryforwards of approximately $ 4.7 million that may be offset against future taxable income. During 2022 and 2021, the total change in the valuation allowance was approximately $ 156,000 and $ 378,000 , respectively. The Company’s ability to use its NOL carryforwards may be substantially limited due to ownership change limitations that may have occurred or that could occur in the future, as required by Section 382 of the Internal Revenue Code of 1986, as amended (the Code), as well as similar state provisions. These ownership changes may limit the amount of NOL that can be utilized annually to offset future taxable income and tax, respectively. In general, an “ownership change” as defined by Section 382 of the Code results from a transaction or series of transactions over a three-year period resulting in an ownership change of more than 50.0 % of the outstanding stock of a company by certain stockholders or public groups. F-24 Table of Contents Luvu Brands, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the years ended June 30, 2022 and 2021 NOTE 18. INCOME TAXES (continued) The Company has not completed a study to assess whether an ownership change has occurred or whether there have been multiple ownership changes since the Company became a “loss corporation” under the definition of Section 382. If the Company has experienced an ownership change, utilization of the NOL carryforwards would be subject to an annual limitation under Section 382 of the Code, which is determined by first multiplying the value of the Company’s stock at the time of the ownership change by the applicable long-term, tax-exempt rate, and then could be subject to additional adjustments, as required. Any limitation may result in expiration of a portion of the NOL carryforwards before utilization. Further, until a study is completed and any limitation known, no positions related to limitations are being considered as an uncertain tax position or disclosed as an unrecognized tax benefit. Any carryforwards that expire prior to utilization as a result of such limitations will be removed from deferred tax assets with a corresponding reduction of the valuation allowance. Due to the existence of the valuation allowance, it is not expected that any possible limitation will have an impact on the results of operations or financial position of the Company. The NOL carryforwards of approximately $4.7 million can be carried forward indefinitely, but are limited to 80 % of taxable income in any one year. The tax years that remain subject to examination by major taxing jurisdictions are those for the years ended June 30, 2013 through 2022. The Company has not filed its Federal or State tax returns for 2017 through 2021 but expects to file these returns before the end of calendar year 2022. NOTE 19. – SUBSEQUENT EVENTS There are no events required to be disclosed under this Item. F-25 Table of Contents ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. There are no events required to be disclosed under this Item.