Red Cat Holdings, Inc. 10-Q

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes and other financial data included elsewhere in this Quarterly Report on Form 10-Q. The Management's Discussion and Analysis contains forward-looking statements that involve risks and uncertainties, such as statements relating to our liquidity, and our plans for our business focusing on (i) selling drones and related components, and (ii) cloud-based analytics, storage, and services for drones. Any statements that are not historical fact are forward-looking statements. When used, the words “believe,” “plan,” “intend,” “anticipate,” “target,” “estimate,” “expect,” and the like, and/or future-tense or conditional constructions (“will,” “may,” “could,” “should,” etc.), or similar expressions, identify certain of these forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results or events to differ materially from those expressed or implied by the forward-looking statements in this Quarterly Report on Form 10-Q. The Company’s actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of many factors. Investors should also review the risk factors in the Company’s Annual Report on Form 10-K filed with the SEC on August 13, 2020. All forward-looking statements speak only as of the date on which they are made. The Company does not undertake any obligation to update such forward-looking statements to reflect events that occur or circumstances that exist after the date of this Quarterly Report on Form 10-Q except as required by federal securities law. Recent Developments Acquisition of Red Cat Propware, Inc . Effective May 15, 2019, we closed a Share Exchange Agreement (the “Exchange Agreement”) with Red Cat Propware, Inc., a Nevada corporation (“Red Cat Propware”) and its then current shareholders (the “Acquisition”) pursuant to which we acquired all of the issued and outstanding capital stock of Red Cat Propware in exchange for our issuance of: (i) an aggregate of 236,000,000 shares of our common stock, and (ii) 2,169,068.0554 shares of Series A Preferred Stock (“Series A Stock”) to the Red Cat Propware shareholders which constituted approximately 83.33% of our issued an outstanding share capital on a fully-diluted basis at such time. With the exception of shares held by our current Chief Executive Officer, Jeffrey Thompson, the convertibility of shares of Series A Stock is limited such that a holder of Series A Stock may not convert Series A Stock to our common stock to the extent that the number of shares of common stock to be issued pursuant to such conversion, when aggregated with all other shares of common stock owned by the holder at such time, would result in the holder beneficially owning more than 4.99% of all of our outstanding common stock (the “Beneficial Ownership Limit”). Reverse Stock Split Effective August 1, 2019, we conducted a 1 for 1,200 reverse split of our common stock which resulted in the automatic conversion of all Series A Stock to common stock, with exception of certain Series A Stock subject to the Beneficial Ownership Limit. Following the reverse split, our remaining shares of Series A Stock are convertible to common stock at a ratio of approximately 8.33 shares of common stock for each share of Series A Stock. Merger Agreement with Rotor Riot, LLC On December 31, 2019, the Company entered into an Agreement of Merger (the “Merger Agreement”) with Rotor Riot Acquisition Corp., a wholly owned Ohio subsidiary of the Company (the “Ohio Acquisition Sub”), Rotor Riot, LLC, an Ohio limited liability company (“Rotor Riot”), and the three members of Rotor Riot (the “Members”). Pursuant to the terms of the Merger Agreement, upon consummation of the merger contemplated by the Merger Agreement (the “Merger”), the Ohio Acquisition Sub merged with and into Rotor Riot, with Rotor Riot continuing as the surviving entity and a wholly owned subsidiary of the Company. At the effective time of the Merger, the issued and outstanding membership interests of Rotor Riot held by the Members, which represented 100% of Rotor Riot’s issued and outstanding membership interests, were converted into shares of common stock of the Company. On January 22, 2020, the parties to the Merger Agreement entered into an amendment to the Merger Agreement, joined in by Rotor Riot Acquisition Corp., a newly formed, wholly owned Delaware subsidiary of the Company (the “Delaware Acquisition Sub”), pursuant to which, among other things, the Delaware Acquisition Sub replaced the Ohio Acquisition Sub as the acquisition subsidiary to merge with and into Rotor Riot in connection with the Merger. 17 The Merger was consummated as of January 23, 2020 (the “Effective Date”). At the closing of the Merger, the Company entered into a make whole agreement with Rotor Riot, Brains Riding in Tanks, LLC, an Ohio limited liability company and the majority owner of Rotor Riot (“BRIT”), and Chad Kapper, the Chief Executive Officer and Manager of Rotor Riot, and the Chief Executive Officer and beneficial owner of 100% of the membership interests of BRIT (“Kapper”), pursuant to which the Company agreed to pay certain financial obligations of Rotor Riot as of the Effective Date. This included the issuance to BRIT of a promissory note (the “BRIT Promissory Note”), as of the Effective Date, in the principal amount of $175,000 (the “Principal Amount”), at an interest rate of 4.75% per annum (“Interest”), with $3,500 of the Principal Amount to be paid monthly, and the remaining Principal Amount and any accrued and unpaid Interest to be paid on the earlier of (A) twelve months from the date of issuance, and (B) the closing of an equity offering by the Company of no less than $3,000,000. On January 23, 2020, the Effective Date, pursuant to the terms of the Merger Agreement, as amended, the Delaware Acquisition Sub merged with and into Rotor Riot. Rotor Riot was the surviving corporation in the Merger and, as a result of the Merger, became a wholly owned subsidiary of the Company. Rotor Riot sells products and services in the drone marketplace, primarily focused on FPV (First Person View), including unmanned aircraft systems, components, and accessories. In accordance with the terms of the Merger Agreement, at the closing of the Merger, each Member of Rotor Riot received its pro rata portion of the total number of shares of the Company’s common stock issued based on: (A)(i) the purchase price of $3,700,000, minus, (ii) $915,563 (which included certain debt and other obligations of Rotor Riot and its Chief Executive Officer that the Company agreed to assume (the “Assumed Obligations”) divided by (B) the volume weighted average price (“VWAP”) of the Company’s common stock for the twenty trading days prior to the closing date of the Merger. Based on a share issuance value of $2,784,437 and a VWAP of $1.25445, the Company issued an aggregate of 2,219,650 shares of common stock to the members of Rotor Riot. Immediately following the Merger, the Company had 19,148,698 shares of common stock issued and outstanding. In connection with the Merger, BRIT, received 1,997,684 shares, which represented approximately 10.4% of the Company following the consummation of the Merger. The Merger was intended to be treated as a tax-free reorganization under Section 368(a) of the Internal Revenue Code of 1986, as amended. Fat Shark Acquisition On September 30, 2020, the Company entered into a share purchase agreement (“Share Purchase Agreement”) with Greg French (“French”), the founder and sole shareholder of Fat Shark Holdings, Ltd., (“Fat Shark”), to acquire all of the issued and outstanding shares of Fat Shark and its subsidiaries for an aggregate purchase price of $7,000,000. Pursuant to the Share Purchase Agreement, at the closing on November 6, 2020, $5,750,000 of the purchase price was paid by the Company by the issuance of (i) 5,227,223 shares of common stock (784,091 of which will be held in escrow for up to 18 months to satisfy indemnification obligations of Fat Shark and French and certain working capital adjustments) and (i) a senior secured promissory note in the original principal amount of $1,000,000, subject to a floating charge under Cayman Island law on all of the assets of Fat Shark and its subsidiaries, and $250,000 in cash. The indemnification obligations are subject to certain limitations and survive for two years following closing and require $25,000 in claims before any claim can be asserted. The Share Purchase Agreement also provides that for two years following closing, neither French nor his affiliates may engage in a business competing with the Company’s drone or FPV goggle business or solicit any of the Company’s customers or suppliers. The Company agreed to register the shares issuable in the transaction under the Securities Act of 1933, as amended (the “Act”), under certain circumstances and the shares are subject to various restrictions on disposition for a period of two years following closing. At any time following a private or public offering of debt or equity securities of at least $6 million prior to the three year anniversary of closing (“Qualified Financing”) (during which offerings French also has the right to sell up to $1,000,000 of the shares received), French has the right to a single demand registration under the Act of all or a portion of the shares, unless the aggregate public offering price (before deducting discounts and commissions) is less than $25,000,000. 18 Up to the greater of 20% or $1,000,000 of the shares received by French may be sold prior to the 12 month anniversary of the closing in privately negotiated transactions (provided the purchaser agrees to be subject to the same restrictions on such shares), thereafter for twelve months, up to 10% of the average daily volume of the common stock during the prior 10 trading days may be sold. The Share Purchase Agreement also requires French to sell a pro-rata amount of his common stock and provides for mandatory participation in certain sales by the Company. In addition, on November 2, 2020, Fat Shark issued a senior note in the amount of $1,500,000 to French based upon an estimated positive working capital adjustment to the note of $500,000 and cancelled approximately $950,000 in indebtedness owed by Fat Shark to French. The note matures on November 1, 2023, subject to partial acceleration and repayment in certain circumstances including from the sale of certain securities by the Company for cash. The note is subject to a floating charge under Cayman law on all of the assets of Holdings and its subsidiaries. Plan of Operations The Company’s primary business is to provide products, services and solutions to the drone industry. It operates in three sectors of the drone industry. Rotor Riot designs and sells drones and related components. Rotor Riot is focused on the consumer market and sells its products through its e-commerce platform operated at www.rotorriot.com. The Company is also developing software solutions to provide secure cloud-based analytics, storage and services for the drone industry. Its initial product candidate is Dronebox, a blockchain technology that records, stores and analyzes flight data and information from a drone, much like the “black box” utilized by the airline industry. The Company plans to offer Dronebox as a Software-as-a-Service platform. The Company closed the acquisition of Fat Shark Holdings (“Fat Shark”) on November 6, 2020. Fat Shark is a leading provider of headsets and goggles for professional FPV (First Person View) racers and drone pilots and has an estimated 85% share of its market. The Company expects that Fat Shark will generate a majority of its revenue over the next 12 months. This acquisition continues the Company’s efforts to become a fully-integrated drone business with a strong supply chain, as well as a provider of software solutions for the drone industry. Results of Operations Three Months Ended October 31, 2020 and October, 2019 Revenue During the three months ended October 31, 2020 (or the “2020 period”), we generated revenues totaling $427,807 compared to zero revenues during the three months ended July 31, 2019 (or the “2019 period”). On January 23, 2020, we completed a merger with Rotor Riot which sells drone technology on its e*commerce site located at www.rotorriot.com. The sales reported in the 2020 period represent those generated on the e*commerce site during the three months ended October 31, 2020. Prior to the merger with Rotor Riot, we did not have any revenue generating activities. Operating Expenses During the three months ended October 31, 2020, we incurred operations expense of $122,697 compared to zero during the 2019 period. Expenses incurred during the 2020 period related to the core operations of Rotor Riot which began in January 2020 following our merger with Rotor Riot. During the three months ended October 31, 2020, we incurred research and development expenses totaling $96,559 compared to $76,724 for the three months ended October 31, 2019 resulting in a increase of $19,835, or 26%. The increase relates to payroll associated with employees hired from Rotor Riot who are working on the research and development of new drone technologies. During the three months ended October 31, 2020, we incurred sales and marketing expenses of $24,679 compared to zero during the three months ended October 31, 2019. Costs incurred in the 2020 period related to the Rotor Riot business and included sales commissions for referrals. During the three months ended October 31, 2020, we incurred general and administrative expenses totaling $345,007 compared to $139,397 for the three months ended October 31, 2019 resulting in an increase of $205,610, or 148%. Stock based compensation costs included in general and administrative expenses totaled $94,629 in the 2020 period compared to zero in the 2019 period. In addition, professional services costs were significantly higher in the 2020 period because the Company is now a commercial enterprise with more complex operations compared to the 2019 period when the Company was in a developmental stage. 19 Other Expense Other expense totaled $232,390 during the three months ended October 31, 2020 compared to zero during the three months ended October 31, 2019. The expense incurred during the 2020 period related to the Derivative Liability recorded in connection with the Company’s issuance of Convertible debentures and warrants in October 2020. There were no such transactions during the 2019 period. Net Loss Net Loss during the three months ended October 31, 2020 totaled $722,281 compared to a Net Loss of $216,121 during the three months ended October 31, 2019, representing an increase of $506,160, or 234%. Operating expenses totaled $588,942 during the 2020 period compared to $216,121 during the 2019 period, representing an increase of $372,821, or 172%. This increase is attributable to the merger with Rotor Riot in January 2020 and costs associated with operating that business. Other expense totaled $232,390 during the three months ended October 31, 2020 compared to zero during the three months ended October 31, 2019. The expense incurred during the 2020 period related to the Derivative Liability recorded in connection with the Company’s issuance of Convertible debentures and warrants in October 2020. These increases were partially offset by a positive gross margin of $99,051 from operations of the Rotor Riot e*commerce site during the 2020 period. Six Months Ended October 31, 2020 and October, 2019 Revenue During the six months ended October 31, 2020 (or the “2020 period”), we generated revenues totaling $976,089 compared to zero revenues during the six months ended July 31, 2019 (or the “2019 period”). On January 23, 2020, we completed a merger with Rotor Riot which sells drone technology on its e*commerce site located at www.rotorriot.com. The sales reported in the 2020 period represent those generated on the e*commerce site during the six months ended October 31, 2020. Prior to the merger with Rotor Riot, we did not have any revenue generating activities. Operating Expenses During the six months ended October 31, 2020, we incurred operations expense of $211,730 compared to zero during the 2019 period. Expenses incurred during the 2020 period related to the core operations of Rotor Riot which began in January 2020 following our merger with Rotor Riot. During the six months ended October 31, 2020, we incurred research and development expenses totaling $193,814 compared to $262,419 for the six months ended October 31, 2019 resulting in a decrease of $68,605, or 26%. During the first half of the 2019 period, personnel resources were substantially dedicated to the research and development of drone technologies and software. These efforts have decreased, both in absolute dollars and relative to the Company’s overall allocation of its personnel resources, during the 2020 period as the Company’s focus has transitioned to operating a commercial enterprise. During the six months ended October 31, 2020, we incurred sales and marketing expenses of $48,815 compared to zero during the three months ended October 31, 2019. Costs incurred in the 2020 period primarily related to the Rotor Riot business and included sales commissions for referrals. During the six months ended October 31, 2020, we incurred general and administrative expenses totaling $619,977 compared to $275,204 for the six months ended October 31, 2019 resulting in an increase of $344,773, or 125%. Stock based compensation costs included in general and administrative expenses totaled $189,258 in the 2020 period compared to zero in the 2019 period. In addition, professional services costs were significantly higher in the 2020 period because the Company is now a commercial enterprise with more complex operations compared to the 2019 period when the Company was in a developmental stage. Other Expense Other expense totaled $232,390 during the six months ended October 31, 2020 compared to zero during the six months ended October 31, 2019. The expense incurred during the 2020 period related to the Derivative Liability recorded in connection with the Company’s issuance of Convertible debentures and warrants in October 2020. There were no such transactions during the 2019 period. 20 Net Loss Net Loss during the six months ended October 31, 2020 totaled $1,105,525 compared to a Net Loss of $537,623 during the six months ended October 31, 2019, representing an increase of $567,902, or 106%. Operating expenses totaled $1,074,336 during the 2020 period compared to $537,623 during the 2019 period, representing an increase of $536,713, or 100%. This increase is attributable to the merger with Rotor Riot in January 2020 and costs associated with operating that business. Other expense totaled $232,390 during the six months ended October 31, 2020 compared to zero during the six months ended October 31, 2019. The expense incurred during the 2020 period related to the Derivative Liability recorded in connection with the Company’s issuance of Convertible debentures and warrants in October 2020. These increases were partially offset by a positive gross margin of $201,201 from operations of the Rotor Riot e*commerce site during the 2020 period. Cash Flows Operating Activities Net cash used in operating activities was $568,452 during the three months ended October 31, 2020 compared to net cash used in operating activities of $415,848 during the three months ended October 31, 2019 representing an increase of $152,604, or 37%. Net cash used in operations, net of non-cash expenses associated with the Derivative Liability and stock based compensation, totaled $640,612 in the 2020 period compared to $525,556 in the 2019 period, resulting in an increase of 115,056, or 22%. The increase primarily related to higher net costs associated with becoming a commercial enterprise through the merger with Rotor Riot in January 2020. Net cash provided through changes in operating assets and liabilities totaled $72,160 during the three months ended October 31, 2020 compared to $109,708 during the three months ended October 31, 2019, representing a decrease of $37,548, or 34%. Changes in operating assets and liabilities can fluctuate significantly from period to period depending upon the timing and level of multiple factors, including inventory purchases and vendor payments. Investing Activities No cash was provided by investing activities during the three months ended October 31, 2020 compared to $24,704 during the three months ended October 31, 2019. The Company acquired $24,704 of cash in connection with an acquisition completed in the 2019 period. Financing Activities Net cash provided by financing activities totaled $811,849 during the six months ended October 31, 2020 compared to $152,239 during the six months ended October 31, 2019, representing an increase of $659,610, or 433%. Financing activities can vary, in nature and amount, from period to period. During the 2020 period, net cash of $580,000 and $235,756 was provided through the issuance of convertible debentures and notes payable, respectively. During the 2019 period, net cash of $152,239 was provided through the exercise of a warrant. Liquidity and Capital Resources As of October 31, 2020, we had current assets totaling $650,551, including cash of $480,065 and inventory of $170,486. Current liabilities as of October 31, 2020 totaled $1,989,456 including derivative liability of $812,390, notes payable totaling $354,527, accounts payable totaling $355,092 and amounts due to a related party of $329,777. Our net working capital as of October 31, 2020 was negative $1,388,905. We have only recently begun generating revenues and have reported net losses since our inception. To date, we have funded our operations through private offerings of common stock primarily from individual private investors. We do not have sufficient cash resources to meet our working capital needs for the next 12 months and will require additional capital in order to execute our business plan. 21 2019 Convertible Note Offering In November 2019, we issued a convertible note in the principal amount of $300,000 to one accredited investor and in December 2019 we issued a convertible note in the principal amount of $125,000 to a director and a convertible note in the principal amount of $25,000 to our chief executive officer. (collectively, the “Notes”). The Notes have a two-year term and bear interest at a rate of 12%. Interest on the Notes may be paid in cash or in shares of common stock of the Company at the Conversion Price (as defined below). The Notes are convertible into shares of common stock at the holder’s sole discretion as follows: (A) prior to consummating an equity financing which generates gross proceeds of not less than $3,000,000 (a “Qualified Offering”), then at the 30 day volume weighted average of the closing price of a share of our common stock as listed or quoted on the market in which the shares are then traded or listed, or (B) after we have consummated a Qualified Offering, at 40% of the price per share of common stock sold in the Qualified Offering (the “Conversion Price”) . We may, upon 10 business days prior notice, pre-pay the Notes, including all accrued interest, in whole or in part, provided that any such prepayment prior to the one-year anniversary of the Note issuance will be at a price equal to 112% of the then outstanding original principal amount. Upon an event of default, as described in the Notes, the outstanding principal and interest will become immediately due and payable. Additionally, under the Note, unless waived by the holder, the holder is not be entitled to convert the Note if such conversion would result in beneficial ownership by the holder and its affiliates of more than 9.99% of the outstanding shares of common stock of the Company on such date. 2020 Convertible Note Offering On October 5, 2020, the Company closed a private offering of convertible promissory notes in the aggregate principal amount of $600,000 and issued five-year warrants to purchase an aggregate of 399,996 shares of common stock. The notes accrue interest at the rate of 12% per annum and are payable two years from the date of issuance. The notes are convertible into common stock at a conversion price of $1.00 per share or, upon the consummation of an offering of common stock resulting in the listing for trading on the NYSE American, the Nasdaq Capital Market, the Nasdaq Global Market, the Nasdaq Global Select Market or the New York Stock Exchange at a price equal to 75% of the price of the securities sold in such offering (a “Qualified Offering”). The notes also contain protection from dilution in the event of a lower priced issuance. Upon an event of default, as described in the note, the conversion price will equal the lower of (i) the thirty day volume weighted average of the closing price of the Company’s common stock if the conversion occurs prior to a Qualified Offering, or (ii) 65% multiplied by the lowest closing price of the common stock during the twenty consecutive trading day period immediately prior to the conversion. The Company may prepay all or any portion of the note, without penalty or premium, upon at least ten business days’ prior notice to the noteholder. Upon issuance by the Company of a security, or amendment to a security, that the noteholder reasonably believes is more favorable, such term, at noteholder’s option, will become a part of the note, except for certain exempt issuances. No conversions under the note will be effected that will result in the noteholder, together with any affiliate, beneficially owning in excess of 9.99% of the Company’s outstanding common stock immediately after giving effect to such conversion. The Warrants are exercisable at a price equal to the lower of (i) $1.50 per share or (ii) if a Qualified Offering occurs, at a 25% discount to the price per share of the common stock offered in such Qualified Offering. The number of shares of common stock for which the Warrant is exercisable is subject to adjustment in the event of a stock split or dividend, and similar event or certain corporate events such reorganizations and mergers. In the event of a reorganization or reclassification of capital stock, the consolidation or merger, or the sale or other disposition of all or substantially all the property, assets, business, and goodwill of the Company, the warrant holder will be entitled to purchase the kind and amount of shares of capital stock which the Warrant entitled the warrant holder to purchase immediately prior to such event. The Warrants also include piggyback registration rights. Until we are able to sustain operations through the sale of products and services, we will continue to fund operations through equity and/or debt transactions. We can provide no assurance that the financing described above will be sufficient to fund our operations until we are able to sustain operations through the sale of products and services. In addition, there can be no assurance that such additional financing, if required, will be available to us on acceptable terms, or at all. 22 Going Concern We have only recently begun generating revenues and have reported net losses since our inception. The success of our business plan during the next 12 months and beyond will be contingent upon generating sufficient revenue to cover our operating costs and/or upon obtaining additional financing. The report from our independent registered public accounting firm for the fiscal year ended April 30, 2020 includes an explanatory paragraph stating the Company has recurring net losses from operations, negative operating cash flows, does not yet generate revenue from operations and will need additional working capital for ongoing operations. These factors, among others, raise substantial doubt about the Company's ability to continue as a going concern. If we are unable to obtain sufficient funding, our business, prospects, financial condition and results of operations will be materially and adversely affected and we may be unable to continue as a going concern. We are presently seeking to address these going concerns through efforts to raise capital through the public markets, release our first commercial product and pursue acquisitions of complementary, revenue generating companies which are accretive to our operating results. We can provide no assurance that any of these efforts will be successful or, that even if successful, that they will alleviate doubts about our ability to continue as a going concern. Critical Accounting Policies and Estimates Our financial statements and accompanying notes have been prepared in accordance with GAAP applied on a consistent basis. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We regularly evaluate the accounting policies and estimates that we use to prepare our financial statements. A complete summary of these policies is included in the notes to our financial statements. In general, management’s estimates are based on historical experience, on information from third party professionals, and on various other assumptions that are believed to be reasonable under the facts and circumstances. Actual results could differ from those estimates made by management. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements. Recently Issued Accounting Pronouncements The Company has implemented all new accounting pronouncements that are in effect. These pronouncements did not have any material impact on the financial statements unless otherwise disclosed, and the Company does not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on its financial position or results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are a smaller reporting company and are not required to provide this information.