Purple Innovation, Inc. 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements This Annual Report on Form 10-K, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933, as amended (the “Securities Act”) and the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements other than statements of historical facts are statements that could be deemed forward-looking statements. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “momentum,” “seeks,” “estimates,” “continues,” “endeavors,” “strives,” “may,” variations of such words, and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses (including the discussion under the heading “Outlook for Growth”), and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including those under “Part I, Item 1A. Risk Factors,” and elsewhere herein. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason. The following discussion is intended to provide a more comprehensive review of the operating results and financial condition of Purple than can be obtained from reading the Consolidated Financial Statements alone. The discussion should be read in conjunction with the Consolidated Financial Statements and the notes thereto included in “Part II Item 8. Financial Statements.” Overview of Our Business Our mission is to help people feel and live better through innovative comfort solutions. We are a digitally-native vertical brand founded on comfort product innovation with premium offerings. We design and manufacture a variety of innovative, branded and premium comfort products, including mattresses, pillows, cushions, bases, sheets, and other products. Our products are the result of over 30 years of innovation and investment in proprietary and patented comfort technologies and the development of our own manufacturing processes. Our proprietary gel technology, Hyper-Elastic Polymer, underpins many of our comfort products and provides a range of benefits that differentiate our offerings from other competitors’ products. We market and sell our products through direct-to-consumer e-commerce and Purple retail showrooms and retail brick-and-mortar wholesale partners. Organization The Company consists of Purple Inc. and its consolidated subsidiary, Purple LLC. Purple Inc. was incorporated in Delaware on May 19, 2015 as a special purpose acquisition company under the name of GPAC. On February 2, 2018, the Company consummated a transaction structured similar to a reverse recapitalization (the “Business Combination”) pursuant to which Purple Inc. acquired an equity interest in Purple LLC and became its sole managing member. As the sole managing member of Purple LLC, Purple Inc., through its officers and directors, is responsible for all operational and administrative decision making and control of the day-to-day business affairs of Purple LLC without the approval of any other member. At December 31, 2021, Purple Inc. had a 99% economic interest in Purple LLC while other Class B unit holders had the remaining 1%. COVID-19 Pandemic Developments The COVID-19 pandemic has impacted many aspects of our operations, directly and indirectly, including disruption of our employees, consumer behavior, distribution and logistics, our suppliers, and the market overall. The scope and nature of these impacts continue to evolve. Because of the COVID-19 pandemic, we have taken precautionary measures recommended by the appropriate national and state health agencies to manage our resources and mitigate the adverse impact of the pandemic, which is intended to help minimize the risk to our Company, employees, customers, and the communities in which we operate. Although we have taken measures to protect our business, we cannot predict the specific duration for which precautionary measures relating to COVID-19 will stay in effect. We may elect or be required to take additional measures as the information available to us continues to develop, including with respect to our employees, manufacturing facilities and distribution centers, and relationships with our suppliers and customers. Based on our current projections, subject to certain assumptions regarding the duration and severity of the COVID-19 pandemic, and government, consumer, and our responses thereto, we believe our cash on hand and ongoing cash generated from our e-commerce, wholesale and retail showroom sales channels will be sufficient to cover our working capital requirements and anticipated capital expenditures for the next 12 months. While most state and local governments have eased restrictions on commercial retail activity, it is possible that a recent resurgence in cases of COVID-19 or one of its future variants could prompt a return to tighter restrictions in certain areas of the country. Furthermore, while the sleep product industry has fared much better during the pandemic than certain other sectors of the economy, continued economic weakness may eventually have an adverse impact upon the industry and our business. Therefore, significant uncertainty remains regarding the ongoing impact of the COVID-19 outbreak upon our financial condition and future results of operations, as well as upon the significant estimates and assumptions we utilize in reporting certain assets and liabilities. Recent Developments in Our Business Production and Demand Developments During the second quarter of 2021, following an accident that resulted in the death of an employee and subsequent safety improvements involving the Mattress Max machines, we encountered isolated production challenges caused by unanticipated mechanical and maintenance issues when bringing the machines back online. As a result, we experienced significantly reduced production levels causing shipment backlogs that unfavorably affected both second and third quarter net revenues. We exited the month of July with production from our existing machines back at planned levels and emerged from our backlog position at the end of August. With our production back at planned levels, we were able to increase our finished goods inventory to adequate stock levels that enabled us to resume timely shipments to our customers during the latter part of the third quarter. 49 Even though we were able to return to planned production capacity in the third quarter, our results of operations did not return to expected levels, which we believe was primarily due to slower than expected acceleration back to prior trending demand levels. We also believe that the production challenges experienced in the second and third quarters adversely affected the confidence of consumers and our wholesale partners in our ability to timely deliver our products, which resulted in reduced orders and increased cancellations from e-commerce, wholesale and Purple retail showroom customers. Further, in an effort to manage costs as we worked to resolve the production issues described above, we initiated a reduction in marketing spend late in the second quarter that carried through most of the third quarter, which further negatively affected demand for our products, particularly in our e-commerce sales channel. In addition to adversely impacting immediate demand, these issues also interrupted our momentum in growth for future periods. Although we did generate net revenue growth of 7.2% in the fourth quarter compared to the prior year fourth quarter, we experienced an operating loss in the quarter due to lower gross margins, higher marketing costs and an increase in general and administrative expenses. While our production and marketing efforts returned to planned levels in the fourth quarter, post-pandemic demand is shifting away from e-commerce and back towards retail brick-and-mortar. We believe this shift will continue through 2022. In addition to a slower recovery to expected demand levels following our return to full production capacity and shift in demand from e-commerce to physical stores, our business has also been adversely impacted by increases in raw material, labor and freight costs. While we are still able to obtain necessary materials when needed, the costs of such materials have increased significantly, consistent with general macroeconomic trends. In addition, as experienced in other industries, in order to remain competitive in hiring the labor necessary to maintain our production, we have had to increase wages and other compensation. These increases in materials and labor costs have resulted in higher cost of goods sold and lower margins. We believe that raw material, labor and freight costs will continue to remain at elevated levels or increase further in the foreseeable future. In order to offset the impact of these costs on our gross margins, we have taken a number of pricing actions in the fourth quarter and early 2022. In February 2022, we completed a restructuring of our workforce that was necessitated by a realignment of our cost structure. As a result of the realignment and restructuring, we reduced employee headcount by approximately 15%. In addition, we have initiated a number of other projects to improve efficiencies and reduce costs. Following several years of hyper growth and increased investments to support current and future expansion, we are now focusing on right-sizing our operations, improving our execution and refining our strategies to drive profitable growth in the current market environment. We are also closely monitoring the impacts of COVID-19 and general economic conditions on global supply chain, manufacturing, and logistics operations. As inflationary pressures increase, we anticipate that our production and operating costs will similarly increase. In addition, COVID-19 and other events, including port closures or labor shortages, have resulted in the continuation or worsening of manufacturing and shipping costs, delays and constraints. While most of our domestic suppliers have been able to continue operations and provide necessary materials when needed, we have experienced some constraints from certain suppliers, with respect to both the availability and cost of materials. We have also experienced some delays in shipments from our suppliers. Any significant delay or interruption in our supply chain could impair our ability to meet the demands of our customers and could negatively impact our business. Mattress Firm Relationship On November 8, 2021, Purple LLC and Mattress Firm agreed to terminate the September 2018 retailer agreement and replace it with a new agreement that has terms consistent with the Company’s standard retailer agreement. This new agreement provides opportunity for continued partnership and growth with Mattress Firm while also eliminating the prior exclusivity arrangements. With the constraints on entering markets in which Mattress Firm conducts business no longer in place, this creates opportunities to partner with new specialty retailers that were previously not available to us. Revolving Line of Credit In September 2020, Purple LLC entered into a financing arrangement with KeyBank National Association and a group of financial institutions that provided for a $45.0 million term loan and a $55.0 million revolving line of credit. In November 2021, the Company executed a $55.0 million draw on its revolving line of credit, which represented the full amount available under the line. The outstanding balance on the revolving line of credit was classified as long-term debt in the Company’s consolidated balance sheet as of December 31, 2021. 50 First Amendment to 2020 Credit Agreement Our operating and financial results for the year ended December 31, 2021 did not satisfy our financial and performance covenants required pursuant to the 2020 Credit Agreement. In order to avoid a breach of such covenants and related default, on February 28, 2022, prior to the covenant compliance certification date under the 2020 Credit Agreement, we entered into the first amendment of the 2020 Credit Agreement. The amendment contains a covenant waiver period such that the net leverage ratio and fixed charge coverage ratio will not be tested for the fiscal quarter ended December 31, 2021 through the fiscal quarter ended June 30, 2022. Other changes in the amendment include modification of leverage ratio and fixed charge coverage definitions and thresholds, the addition of minimum liquidity requirements with mandatory prepayments of the revolving loan if cash exceeds $25.0 million, new weekly and monthly reporting requirements, limits on the amount of capital expenditures, the addition of a lease incurrence test for opening additional showrooms, and additional negative covenants during a covenant amendment period that will extend into 2023 until certain conditions are met. In addition, the interest rate on outstanding borrowings under the 2020 Credit Agreement changed from LIBOR with a floor of 0.5% plus an applicable margin (historically at 3.0%) to an initial rate of SOFR with a floor of 0.5% plus 4.75%, for a total rate of 5.25% as long as the applicable liquidity threshold is met. If it is not met, then the interest rate goes to SOFR with a floor of 0.5% plus 9.00%. Once the consolidated leverage ratio is below 3.00 to 1.00, the interest rate will be based on SOFR with a floor of 0.5% plus a 3.00% to 3.75% depending on the consolidated leverage ratio. Pursuant to the amendment, the Company paid fees and expenses of $0.9 million and prepaid all principal payments due in 2022 of $2.5 million. Outlook for Growth To support our plans for future growth, we are initially focusing on the following immediate opportunities: ● Right-size labor force and effectively manage labor ● Manage capacity utilization to promote efficient use of production facilities as we grow into production footprint ● Develop and execute on strategies to meaningfully expand our wholesale presence ● Build premium brand position to deliver 20% market share of the premium mattress category, from current approximately 11% market share ● Manage input costs, operating efficiencies, and pricing to offset gross margin erosion, with a goal to return gross margins to approximately the levels achieved in 2020 by the end of 2022 ● Strengthen research and development disciplines and go-to-market processes in order to expand our current categories and position our business to eventually expand to adjacent categories There is no guarantee that we will be able to effectively execute on these opportunities, which are subject to risks, uncertainties, and assumptions that are difficult to predict, including the risks described under “Part I, Item 1A. Risk Factors” and elsewhere herein. Therefore, actual results may differ materially and adversely from those described above. In addition, we may, in the future, adapt these focuses in response to changes in the market or our business. Critical Accounting Estimates In connection with the preparation of our consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”), we are required to make estimates and assumptions about future events and apply judgments that affect the reported amounts of assets, liabilities, sales, expenses and the related disclosures. Predicting future events is inherently an imprecise activity and as such requires the use of judgment. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time our consolidated financial statements are prepared. On a regular basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Management believes the accounting estimates discussed below are the most critical because they require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Revenue Recognition The Company’s revenue recognition accounting methodology contains uncertainties because it requires management to make assumptions and to apply judgment to estimate the amount and timing of future sales returns and uncollectible accounts. The Company’s estimates of the amount and timing of sales returns and uncollectible accounts are based primarily on historical transaction experience. The Company’s sales return liability decreased from $8.4 million at December 31, 2020 million to $7.1 million as of December 31, 2021. The Company’s allowance for doubtful accounts as of December 31, 2021 and 2020 was not material. The Company does not believe there is a reasonable likelihood that there will be any material changes in the accounting methodology, future estimates or assumptions used to measure the estimated liability for sales returns and exchanges or credit losses. However, if actual results are not consistent with the Company’s estimates or assumptions, it may be exposed to losses or gains that could be material. 51 Warranty Liabilities The Company provides a limited warranty on most of the products it sells. The estimated warranty costs, which are expensed at the time of sale and included in cost of revenues, are based on the results of product testing, industry and historical trends and warranty claim rates incurred and are adjusted for any current or expected trends as appropriate. The Company regularly assesses and adjusts the estimate of accrued warranty claims by updating claims rates for actual trends and projected claim costs. The Company classifies as non-current those estimated warranty costs expected to be paid out in greater than one year. As of December 31, 2021, the current and non-current portions of the Company’s warranty liabilities were $3.9 million and $11.1 million, respectively, compared to $2.8 million and $5.6 million, respectively, at December 31, 2020. We have not made any material changes in the warranty liability assessment methodology used and we do not believe there is a reasonable likelihood that a material change in the estimates or assumptions we use to calculate our warranty liability will occur. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material. Warrant Liability The Company accounts for the sponsor warrants issued in connection with its initial public offering and simultaneous private placement as liabilities. The liability for these warrants was initially measured at fair value on the date of the Business Combination and is subsequently re-measured to fair value at each reporting date or exercise date with changes in the fair value included in earnings. The Company uses the Black-Scholes model to determine the fair value of the liability associated with the sponsor warrants. The model uses key assumptions and inputs such as exercise price, fair market value of common stock, risk free interest rate, warrant life and expected volatility. This liability generally increases or decreases based upon changes in the fair value of sponsor warrants outstanding at the end of a respective period and decreases as sponsor warrants are exercised during the respective periods. During 2021, this liability decreased from $92.7 million at December 31, 2020 to $4.3 million at December 31, 2021 due to $64.3 million related to the fair value of warrants exercised and $24.1 million associated with changes in the valuation inputs. We have not made any material changes in the valuation methodology used. Although we do not believe there is a reasonable likelihood there will be a material change in the estimates or assumptions used to calculate this liability, a 10% increase in our stock price at December 31, 2021 would have increased the warrant liability by $0.9 million. Income Taxes Accounting for income taxes requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. In assessing the realizability of deferred tax assets, management considers whether it is more-likely-than-not that the deferred tax assets will be realized. During fiscal 2020, the Company achieved three-year cumulative income for the first time and determined that it would likely generate sufficient taxable income to utilize some of its deferred tax assets. Based on this and other positive evidence, the Company concluded it was more likely than not that some of its deferred tax assets would be realized and that a full valuation allowance for its deferred tax assets was no longer appropriate. The Company recognized deferred tax benefits of $3.6 million and $45.8 million in its consolidated statements of operations for the years ended December 31, 2021 and 2020, respectively. Deferred tax assets and liabilities are calculated by applying existing tax laws and the rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the year of the enacted rate change. Our effective tax rate is primarily impacted by the allocation of income taxes to the noncontrolling interest and changes in our valuation allowance . In certain cases, we also base this estimate on business plan forecasts and other expectations about future outcomes. Changes in positive and negative evidence, including differences between our future operating results and estimates, could result in the establishment of an additional valuation allowance against our deferred tax assets. Accounting for deferred taxes is based upon estimates of future results. Judgment is required in determining the future tax consequences of events that have been recognized in our consolidated financial statements and/or tax returns. Differences between the anticipated and actual outcomes of these future results could have a material impact on our consolidated financial statements. Also, changes in existing federal and state tax laws and corporate income tax rates could affect future tax results and the realization of deferred tax assets over time. 52 The Company accounts for uncertainty in income taxes using a recognition and measurement threshold for tax positions taken or expected to be taken in a tax return, which are subject to examination by federal and state taxing authorities. The tax benefit from an uncertain tax position is recognized when it is more likely than not that the position will be sustained upon examination by taxing authorities based on technical merits of the position. The amount of the tax benefit recognized is the largest amount of the benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. The effective tax rate and the tax basis of assets and liabilities reflect management’s estimates of the ultimate outcome of various tax uncertainties. Judgment is required in evaluating uncertain tax positions. We evaluate our uncertain tax positions quarterly based on various factors, including changes in facts or circumstances, tax laws or the status of audits by tax authorities. Changes in the recognition or measurement of uncertain tax positions could have a material impact on our consolidated financial statements in the period in which we make the change. As of December 31, 2021 and 2020, no uncertain tax positions were recognized as liabilities in the consolidated financial statements. Tax Receivable Agreement In connection with the Business Combination, the Company entered into an agreement with InnoHold LLC (InnoHold) , which provides for the payment by the Company to InnoHold of 80% of the net cash savings, if any, in U.S. federal, state and local income tax that the Company actually realizes (or is deemed to realize in certain circumstances) in periods after the closing of the Business Combination as a result of (i) any tax basis increases in the assets of Purple LLC resulting from the distribution to InnoHold of the cash consideration, (ii) the tax basis increases in the assets of Purple LLC resulting from the redemption by Purple LLC or the exchange by the Company, as applicable, of Class B Paired Securities or cash, as applicable, and (iii) imputed interest deemed to be paid by the Company as a result of, and additional tax basis arising from, payments it makes under the agreement. As noncontrolling interest holders exercise their right to exchange or cause Purple LLC to redeem all or a portion of its Class B Units, a liability under the Tax Receivable Agreement may be recorded based on 80% of the estimated future cash tax savings that the Company may realize as a result of increases in the basis of the assets of Purple LLC attributed to the Company as a result of such exchange or redemption. The amount of the increase in asset basis, the related estimated cash tax savings and the attendant tax receivable agreement liability to be recorded will depend on the price of the Company’s Class A Stock at the time of the relevant redemption or exchange. As a result of the initial merger transaction and subsequent exchanges of Class B Units for Class A Stock, the potential future tax receivable agreement liability was $168.1 million as of December 31, 2021 compared to $172.0 million as of December 31, 2020. In addition, we estimated the amount of payments expected to be paid within the next 12 months to be $5.8 million and classified this amount as a current liability in our 2021 Consolidated Balance Sheet, which was paid in January 2022. To the extent our estimate differs from actual results, we may be required to reclassify portions of our liabilities under this agreement between current and non-current. We are currently unable to determine the total future amount of these payments due to the unpredictable nature of several factors, including the timing of future exchanges, the market price of shares of Class A Stock at the time of the exchanges, the extent to which such exchanges are taxable and the amount and timing of future taxable income sufficient to utilize tax attributes that give rise to the payments under the tax receivable agreement. 53 Results of Operations A discussion regarding our financial condition and results of operations for the year ended December 31, 2021 compared to the year ended December 31, 2020 is presented below. A separate discussion regarding our financial condition and results of operations for the year ended December 31, 2020 compared to the year ended December 31, 2019 can be found under Item 7 of Part II of our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2020, filed with the SEC on May 10, 2021. Operating Results for the Year Ended December 31, 2021 compared to the year ended December 31, 2020 The following table sets forth for the periods indicated, our results of operations and the percentage of total net revenues represented in our consolidated statements of operations: Year Ended December 31, 2021 % Net Revenues 2020 % Net Revenues Revenues, net $ 726,227 100.0 % $ 648,471 100.0 % Cost of revenues 431,253 59.4 343,374 53.0 Gross profit 294,974 40.6 305,097 47.0 Operating expenses: Marketing and sales 239,290 33.0 187,991 29.0 General and administrative 72,095 9.9 39,925 6.2 Research and development 6,939 1.0 5,955 0.9 Total operating expenses 318,324 43.8 233,871 36.1 Operating income (loss) (23,350 ) (3.2 ) 71,226 11.0 Other income (expense): Interest expense (1,872 ) (0.3 ) (4,654 ) (0.7 ) Other income (expense), net (194 ) — (91 ) — Loss on extinguishment of debt — — (5,782 ) (0.9 ) Change in fair value – warrant liabilities 24,054 3.3 (300,073 ) (46.3 ) Tax receivable agreement income (expense) 4,016 0.6 (34,155 ) (5.3 ) Total other income (expense), net 26,004 3.6 (344,755 ) (53.2 ) Net income (loss) before income taxes 2,654 0.4 (273,529 ) (42.2 ) Income tax benefit (expense) 1,217 0.2 43,749 6.7 Net income (loss) 3,871 0.5 (229,780 ) (35.4 ) Net income (loss) attributable to noncontrolling interest (160 ) — 7,087 1.1 Net income (loss) attributable to Purple Innovation, Inc. $ 4,031 0.6 $ (236,867 ) (36.5 ) Revenues, Net Net revenues increased $77.8 million, or 12.0%, to $726.2 million for the year ended December 31, 2021 compared to $648.5 million for the year ended December 31, 2020. This increase primarily consisted of wholesale net revenues growing $88.8 million, or 54.5% and Purple retail showroom net revenues increasing $21.9 million, or 207.9%. These increases were offset in part by e-commerce net revenues decreasing $33.0 million, or 6.9%. Our wholesale business was favorably impacted by wholesale partner expansion coupled with wholesale partner doors being open all of 2021 while the prior year was negatively impacted by the pandemic and the temporary shutdown of wholesale partner operations during 2020. Net revenue growth associated with the Purple retail showrooms was primarily due to the opening of new showrooms. Net revenue growth overall was negatively affected by the production issues we experienced in the second and third quarters of 2021, as our ability to manufacture and deliver our products was adversely impacted, which resulted in reduced orders and increased cancellations. Also, in response to these production delays, we initiated a reduction in marketing spend late in the second quarter that carried through most of the third quarter, which further impacted demand for our products, particularly with respect to our e-commerce channel. The growth in net revenues from a product perspective, reflected a $42.4 million increase in mattress sales, a $24.1 million increase in other sleep product sales and an $11.3 million increase in other product sales, was primarily driven by an increase in wholesale and Purple retail showroom revenues. We believe that sales of our products are typically subject to seasonality corresponding to different periods of the consumer spending cycle, holidays and other seasonal factors. Our sales may also vary with the performance of the broader economy consistent with the market. 54 Cost of Revenues The cost of revenues increased $87.9 million, or 25.6%, to $431.3 million for the year ended December 31, 2021 compared to $343.4 million for the year ended December 31, 2020. This increase, which was comprised of a $50.9 million increase in direct material costs, a $31.8 million increase in labor and overhead costs, and a $5.2 million increase in other costs, was primarily due to increased sales volume and higher raw material, labor and freight costs. Our gross profit percentage, which decreased to 40.6% of net revenues in 2021 from 47.0% in 2020, was adversely impacted by the elevated level of our material, labor and freight costs, the unfavorable impact of inefficiencies realized as we worked to resolve the production issues described above (see Production and Demand Developments above) and a higher proportion of wholesale channel revenue, which carries a lower gross margin than revenue from the e-commerce channel. While we have returned to planned production capacity, we anticipate that raw material, labor and freight costs will continue to remain at elevated levels. Marketing and Sales Marketing and sales expense increased $51.3 million, or 27.3%, to $239.3 million for the year ended December 31, 2021 compared to $188.0 million for the year ended December 31, 2020. This increase reflected a $19.4 million increase in advertising costs due in part to higher advertising rates in 2021, a $22.3 million increase in marketing costs related primarily to planned expansion of our workforce, an $8.4 million increase in showroom-related expenses associated with our continued showroom expansion, and a $1.2 million increase in wholesale-related marketing and selling costs. Marketing and sales expense as a percentage of net revenues was 33.0% in 2021 compared to 29.0% in 2020. This increase was primarily due to demand levels and net revenue growth being lower than expected relative to the increase in marketing and sales costs we incurred in 2021. General and Administrative General and administrative expense increased $32.2 million, or 80.6%, to $72.1 million for the year ended December 31, 2021 compared to $39.9 million for the year ended December 31, 2020. This increase was primarily due to a $18.8 million increase in legal and professional fees, a $6.6 million increase related to payroll costs attributed to planned increases in our workforce, and a $6.8 million increase in all other expenses consistent with the growth of the Company. The increase in legal and professional fees was primarily due to underwriting commissions we paid related to shares sold by Coliseum Capital Partners coupled with higher consulting, professional and recruiting expenses. Research and Development Research and development costs increased $1.0 million, or 16.5%, to $6.9 million for the year ended December 31, 2021 from $6.0 million for the year ended December 31, 2020. This increase was primarily due to an increase in payroll costs related to planned increases in our research and development workforce. 55 Operating Income (Loss) Operating income (loss) decreased $94.6 million to an operating loss of $23.4 million for the year ended December 31, 2021 compared to operating income of $71.2 million for the year ended December 31, 2020. This decrease was primarily due to net revenues being unfavorably impacted by production issues in the second and third quarters of 2021, lower than expected demand, reduced gross margins due in part to elevated raw material, labor and freight costs, increased marketing and sales expenses, and higher general and administrative costs. Interest Expense Interest expense totaled $1.9 million for the year ended December 31, 2021 as compared to $4.7 million for the year ended December 31, 2020. The $2.8 million decrease was due in part to $1.0 million of interest capitalized during 2021. The remaining decrease was due to a $35.0 million loan, which carried an interest rate of 12.00%, being refinanced in the third quarter of 2020 with a $45.0 million term loan at an initial interest rate of 3.50%. In November 2021, the Company executed a $55.0 million draw on its revolving line of credit at an initial borrowing rate of 3.50%, which resulted in $0.3 million of interest expense in 2021. Interest expense in 2021 also included a full year of amortization of deferred loan costs associated with the term loan and fees related to the revolving line of credit. Loss on Extinguishment of Debt On September 3, 2020, the Company paid $45.0 million to retire, in full, all indebtedness related to Purple LLC’s 2018 credit agreement. The payment included $25.0 million for the original loan under the agreement, $10.0 million for a subsequent incremental loan, $6.6 million for paid-in-kind interest, $2.5 million for a prepayment fee and $0.9 million for accrued interest. As a result of paying off this loan, the Company recognized a $5.8 million loss on extinguishment of debt in its 2020 consolidated statement of operations. Change in Fair Value – Warrant Liabilities There were 15.5 million public warrants issued in connection with GPAC’s formation and initial public offering and 12.8 million sponsor warrants issued pursuant to a simultaneous private placement with the initial public offering. The Company has accounted for these warrants as liabilities and recorded them at fair value on the date of the transaction and subsequently re-measured them to fair value at each reporting date with changes in fair value included in earnings. The 1.9 million sponsor warrants outstanding at December 31, 2021 had a fair value of $4.3 million. The fair value of the sponsor warrants outstanding at December 31, 2020 was $92.7 million. All of the public warrants were exercised in 2020. During the year ended December 31, 2021, we recognized a gain of $24.1 million in our consolidated statement of operations related to a decrease in the fair value of the sponsor warrants exercised in 2021 or that were outstanding at December 31, 2021. During the year ended December 31, 2020, we recognized a loss of $240.7 million in our consolidated statement of operations related to increases in the fair value of the public and sponsor warrants exercised during 2020 or that were outstanding at December 31, 2020. On February 26, 2019, two of the three lenders involved with the original loan under the 2018 credit arrangement also funded a $10.0 million incremental loan and received 2.6 million warrants to purchase 2.6 million shares of the Company’s Class A Stock at a price of $5.74 per share, subject to certain adjustments. The Company accounted for these warrants as liabilities and recorded them at fair value on the date of the transaction and subsequently re-measured them to fair value at each reporting date with changes in the fair value included in earnings. On November 9, 2020, the Company issued 2.6 million shares of Class A Stock pursuant to the exercise of these warrants held by the lenders who funded the incremental loan. The Company determined the fair value of these warrants to be $81.0 million at the time of the exercise. During the year ended December 31, 2020, the Company recorded a loss related to increases in the fair value of the warrants of $59.4 million. 56 Tax Receivable Agreement Income (Expense) In connection with the Business Combination, we entered into an agreement which generally provides for the payment by us to InnoHold of 80% of certain tax benefits, if any, that we realize as a result of increases in our allocable share of the tax basis of the tangible and intangible assets of Purple LLC. The tax receivable agreement liability totaled $168.1 million and $172.0 million at December 31, 2021 and 2020, respectively. During 2021, we realized $4.0 million of tax receivable agreement income due to the impact of a change in tax rates and recording the 2020 provision to return adjustments. The $3.9 million reduction in the 2021 tax receivable agreement liability reflected $4.0 million that was recorded as tax receivable agreement income coupled with a payment of $0.6 million made during the year. These decreases in the liability were offset in part by $0.8 million that related to current year exchanges and was recorded as a decrease to additional paid-in capital in the 2021 consolidated statement of stockholders’ equity. Income Tax Benefit (Expense) Our income tax benefit was $1.2 million for the year ended December 31, 2021 compared to an income tax benefit of $43.7 million for the year ended December 31, 2020. This decrease was primarily due to $35.5 million of the valuation allowance associated with the Company’s federal and state deferred tax assets being released and recorded as an income tax benefit during 2020. Noncontrolling Interest The Company calculates net income or loss attributable to noncontrolling interests on a quarterly basis using their weighted average ownership percentage. Net loss attributed to noncontrolling interests was $0.2 million in 2021 compared to net income of $7.1 million in 2020. The decrease in the level of net income (loss) attributed to noncontrolling interests primarily resulted from the noncontrolling interest ownership percentage being significantly lower in 2021. Liquidity and Capital Resources Our principal sources of funds are cash flows from operations, supplemented with borrowings made pursuant to our credit facilities and cash and cash equivalents on hand. Principal uses of funds consist of payments of principal and interest on our debt facilities, capital expenditures and working capital needs as well as other contractual obligations described below. Our working capital needs depend largely upon the timing of cash receipts from product sales, payments to vendors and others, changes in inventories, and operating lease payment obligations. Our cash and working capital positions were $91.6 million and $87.5 million, respectively, as of December 31, 2021 compared to $123.0 million and $96.9 million, respectively, as of December 31, 2020. Cash used for capital expenditures increased from $39.1 million in 2020 to $57.1 million in 2021. This increase primarily resulted from ongoing investments in our business that included building out our new manufacturing facility in Georgia that became fully operational in 2021, enhancing our manufacturing and safety capabilities at our manufacturing facility in Utah, scaling our infrastructure to support the growth of our workforce, and continued opening of new Purple retail showrooms throughout 2021. As described above, we experienced production and demand issues in the second and third quarters of 2021 that adversely affected net revenues and we have also experienced increases in raw material, labor and freight costs. While we have returned to planned production levels, we currently anticipate that the impact of lower-than-expected demand and higher material, labor and freight costs will continue to adversely affect our business and results of operations into the first quarter of 2022. These issues have also adversely affected our ability to comply with covenants under the 2020 credit agreement. In order to offset the impact of these costs on our gross margins, we have taken a number of pricing actions in the fourth quarter and early 2022. In February 2022, we reduced employee headcount by approximately 15%. In addition, we have initiated a number of other projects to improve efficiencies and reduce costs. In the event our cash flow from operations or other sources of financing are less than anticipated, we believe we will be able to fund operating expenses based on our ability to scale back operations, reduce marketing spend and postpone or discontinue our growth strategies. In such event, this could result in slower growth or no growth, and we may run the risk of losing key suppliers, we may not be able to timely satisfy customer orders, and we may not be able to retain all of our employees. In addition, we may be forced to restructure our obligations to current creditors, pursue work-out options or seek additional funding sources including new debt or equity capital. Our ability to obtain additional debt or alternative capital on acceptable terms or at all is subject to a variety of uncertainties, including instability in the credit and financial markets resulting from macroeconomic factors and approval from the lenders under the 2020 Credit Agreement. Adequate financing may not be available or, if offered, may only be available on unfavorable terms. The restrictive covenants in the 2020 Credit Agreement, as amended, may make it difficult to obtain additional capital on terms that are favorable to us and to execute on our growth strategies, including the acquisition of other businesses or technologies. There is no assurance we would be able to obtain the capital we could potentially require. As a result, there can be no assurance that we will be able to fund our future operations or growth strategies. In addition, future equity or debt financings may require us to also issue warrants or other equity securities that are likely to be dilutive to our existing stockholders. Newly issued securities may include preferences or superior voting rights or, as described above, may be combined with the issuance of warrants or other derivative securities, which each may have additional dilutive effects. Furthermore, we may incur substantial costs in pursuing future capital and financing, including investment banking fees, legal fees, accounting fees, printing and distribution expenses and other costs. We may also be required to recognize non-cash expenses in connection with certain securities we may issue, such as convertible notes and warrants, which will adversely impact our financial condition. If we cannot raise additional funds on favorable terms or at all, we may not be able to carry out all or parts of our long-term growth strategy, maintain our growth and competitiveness or continue in business. 57 In response to the COVID-19 pandemic, we took a number of precautionary measures to manage our resources and mitigate its adverse effect. Given the initial difficultly in predicting how long the pandemic would persist and its full impact, we managed our business and opportunities to preserve liquidity. In the second half of 2020, we ended most of the cash preservation programs and returned to full production to meet increased demand. During 2021, we have increased our inventory levels and invested in our manufacturing capacity and showroom expansion. Subject to certain assumptions regarding the duration and severity of the COVID-19 pandemic, and our responses thereto, based on our current projections we believe our cash on hand, cash generated from our e-commerce and wholesale channels, and continued ramp up of Purple retail store operations will be sufficient to cover our working capital requirements and anticipated capital expenditures for the next 12 months. During 2021, 6.6 million sponsor warrants were exercised on a cash and cashless basis resulting in the issuance of 2.3 million shares of Class A Stock. The proceeds received for the cash exercise was $0.1 million. At December 31, 2021, there were 1.9 million sponsor warrants outstanding. During 2020, 15.5 million public warrants and 4.3 million sponsor warrants were exercised resulting in the issuance of 7.6 million shares of Class A Stock and cash proceeds to the Company of $46.4 million. Debt On September 3, 2020, the Company paid $45.0 million to retire, in full, all indebtedness related to Purple LLC’s 2018 credit agreement. The payment included $25.0 million for the original loan under the agreement, $10.0 million for a subsequent incremental loan, $6.6 million for paid-in-kind interest, $2.5 million for a prepayment fee and $0.9 million for accrued interest. Also on September 3, 2020, Purple LLC entered into the 2020 Credit Agreement that provided for a $45.0 million term loan and a $55.0 million revolving line of credit. The agreement has a five-year term and borrowing rates for both the term loan and revolving line of credit and were initially based on Purple LLC’s leverage ratio and ranged from LIBOR plus a 3.00% to 3.75% margin with a LIBOR minimum of 0.50%. Pursuant to the first amendment of the 2020 Credit Agreement, the interest rates have changed from LIBOR to SOFR with new interest rate amounts and thresholds as noted below. Proceeds from the term loan were used to retire all indebtedness associated with the 2018 credit agreement. In November 2021, the Company executed a $55.0 million draw on its revolving line of credit, which represented the full amount available under the line. The outstanding balance on the revolving line of credit was classified as long-term debt in the Company’s consolidated balance sheet as of December 31, 2021. 58 Our operating and financial results for the year ended December 31, 2021 did not satisfy our financial and performance covenants required pursuant to the 2020 Credit Agreement. In order to avoid a breach of such covenants and related default, on February 28, 2022, prior to the covenant compliance certification date under the 2020 Credit Agreement, we entered into the first amendment of the 2020 Credit Agreement. The amendment contains a covenant waiver period such that the net leverage ratio and fixed charge coverage ratio will not be tested for the fiscal quarter ended December 31, 2021 through the fiscal quarter ended June 30, 2022. Other changes in the amendment include modification of leverage ratio and fixed charge coverage definitions and thresholds, the addition of minimum liquidity requirements with mandatory prepayments of the revolving loan if cash exceeds $25.0 million, new weekly and monthly reporting requirements, limits on the amount of capital expenditures, the addition of a lease incurrence test for opening additional showrooms, and additional negative covenants during a covenant amendment period that will extend into 2023 until certain conditions are met. In addition, the interest rate on outstanding borrowings under the 2020 Credit Agreement changed from LIBOR with a floor of 0.5% plus an applicable margin (historically at 3.0%) to an initial rate of SOFR with a floor of 0.5% plus 4.75%, for a total rate of 5.25% as long as the applicable liquidity threshold is met. If it is not met, then the interest rate goes to SOFR with a floor of 0.5% plus 9.00%. Once the consolidated leverage ratio is below 3.00 to 1.00, the interest rate will be based on SOFR with a floor of 0.5% plus a 3.00% to 3.75% depending on the consolidated leverage ratio. Pursuant to the amendment, the Company paid fees and expenses of $0.9 million and prepaid all principal payments due in 2022 of $2.5 million. Tax Receivable Agreement We are required to make certain payments to InnoHold under the tax receivable agreement, which may have a material adverse effect on our liquidity and capital resources. We are currently unable to determine the total future amount of these payments due to the unpredictable nature of several factors, including the timing of future exchanges, the market price of shares of Class A Stock at the time of the exchanges, the extent to which such exchanges are taxable and the amount and timing of future taxable income sufficient to utilize tax attributes that give rise to the payments under the agreement. As of December 31, 2021, the tax receivable agreement liability reflected in the Company’s consolidated balance sheet is $168.1 million of which $5.8 million is presented as other current liabilities. Other Contractual Obligations In addition, we have other material contractual obligations, which primarily consist of operating lease obligations. See Note 6 of the consolidated financial statements for additional information. Cash Flows for the year ended December 31, 2021 compared to the year ended December 31, 2020 The following summarizes our cash flows for the years ended December 31, 2021 and 2020 as reported in our consolidated statements of cash flows (in thousands): Years Ended December 31, 2021 2020 Net cash provided by (used in) operating activities $ (30,903 ) $ 81,257 Net cash used in investing activities (57,059 ) (39,139 ) Net cash provided by financing activities 56,623 47,359 Net increase (decrease) in cash (31,339 ) 89,477 Cash, beginning of the period 122,955 33,478 Cash, end of the period $ 91,616 $ 122,955 59 Cash used in operating activities was $30.9 million during the year ended December 31, 2021 compared to $81.3 million of cash provided by operating activities during the year ended December 31, 2020. The decrease in cash flows from operations primarily resulted from an $83.6 million decrease in cash provided by operating income items which was mainly driven by net revenues being unfavorably impacted by production and demand issues experienced in the second and third quarters of 2021, increased material, labor and shipping costs, higher marketing and sales expenses, increased legal and professional fees and planned increases in our workforce. The decrease in cash provided by operations was further impacted by a $28.5 million decrease in operating cash flows related to net changes in operating assets and liabilities for the year ended December 31, 2021 compared to the prior year. This decrease consisted of decreased cash from changes in period-over-period fluctuations in inventories, accounts payable and accrued liabilities, offset in part by an increase in cash related to changes in the year-over-year fluctuations in accounts receivable and prepaid inventory and other assets. Cash used in investing activities was $57.1 million for the year ended December 31, 2021 compared to $39.1 million for the year ended December 31, 2020. This increase primarily resulted from continuing to invest in our business by building out our new manufacturing facility in Georgia that became fully operational in 2021, enhancing our manufacturing and safety capabilities at our manufacturing facility in Utah, scaling our infrastructure to support the growth of our workforce, and continued opening of new Purple retail showrooms during 2021. Cash provided by financing activities during the year ended December 31, 2021 was $56.6 million, an increase of $9.3 million from cash provided by financing activities of $47.4 million during the year ended December 31, 2020. Financing activities in 2021 included $55.0 million in proceeds from the Company’s revolving line of credit, $4.1 million in proceeds from an InnoHold indemnification payment and $1.5 million of proceeds from warrant and stock option exercises. The cash received from these financing activities was offset in part by $2.3 million in principal payments on the term loan, member tax distributions of $1.2 million and a $0.6 million payment for the tax receivable agreement. Recent Accounting Pronouncements For a description of recently adopted and issued accounting standards, including the respective dates of adoption and expected effects on our results of operations and financial condition, refer to Note 2 to our financial statements included in this Annual Report on Form 10-K. 60