Item 2. Management’s Discussion and Analysis
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read together with our unaudited condensed consolidated interim financial statements and the related notes and other financial information included in this Report. Some of the information contained in this discussion and analysis or set forth elsewhere in this Report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties as described under the heading “Cautionary Note on Forward-Looking Statements” below. You should review the disclosure under the heading “Risk Factors” in this Report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statement.
CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q, including the sections entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains express or implied forward-looking statements that are based on our management’s belief and assumptions and on information currently available to our management. Although we believe that the expectations reflected in forward-looking statements are reasonable, such statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by forward-looking statements. All statements other than statements of historical fact contained in this Report are forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “could,” “will,” “would,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “intend,” “predict,” “seek,” “contemplate,” “project,” “continue,” “potential,” “ongoing” or the negative of these terms or other comparable terminology.
These forward-looking statements include, but are not limited to, statements about:
● the implementation of our business model and strategic plans for our business, technologies and products;
● the rate and degree of market acceptance of any of our products or organic semiconductor technology in
● general, including changes due to the impact of (i) new semiconductor technologies, (ii) the performance of organic semiconductor technology, whether perceived or actual, relative to competing semiconductor materials, and (iii) the performance of our products, whether perceived or actual, compared to competing silicon-based and other products;
● the timing and success of our, and our customers’, product releases;
● our ability to develop new products and technologies;
● our estimates of our expenses, ongoing losses, future revenue and capital requirements, including our
our needs for additional financing;
● our ability to obtain additional funds for our operations and our intended use of any such funds;
● our ability to become listed and remain eligible on an over-the-counter quotation system;
● our receipt and timing of any royalties, milestone payments or payments for products, under any current or future collaboration, license or other agreements or arrangements;
● our ability to obtain and maintain intellectual property protection for our technologies and products and our ability to operate our business without infringing the intellectual property rights of others;
● the strength and marketability of our intellectual property portfolio;
● our dependence on current and future collaborators for developing, manufacturing or otherwise bringing our products to market;
● the ability of our third-party supply and manufacturing partners to meet our current and future business needs;
● our exposure to risks related to international operations;
● our dependence on third-party fabrication facilities;
● the impact of the COVID-19 pandemic and any future communicable disease outbreak on our business and operations;
● our relationships with our executive officers, directors and significant stockholders;
● our expectations regarding our classification as a “smaller reporting company,” as defined under the
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Securities Exchange Act of 1934, as amended (the “Exchange Act”), and an “emerging growth company” under the JOBS Act (as defined below) in future periods;
● our future financial performance;
● the competitive landscape of our industry;
● the impact of government regulation and developments relating to us, our competitors or our industry;
● the timing of the consummation of the purchase by the Octopus Investors (as defined below) of our common stock; and other risks and uncertainties, including those listed under the caption “Risk Factors.”
These statements relate to future events or our future operational or financial performance, and involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements. Factors that may cause actual results to differ materially from current expectations include, among other things, those listed under “Risk Factors” and elsewhere in this Form 10-Q.
Any forward-looking statement in this Form 10-Q reflects our current view with respect to future events and is subject to these and other risks, uncertainties and assumptions relating to our business, results of operations, industry and future growth. Given these uncertainties, you should not place undue reliance on these forward looking statements. No forward-looking statement is a guarantee of future performance. You should read this Form 10-Q and the documents that we reference in this Form 10-Q and have filed with the SEC as exhibits hereto completely and with the understanding that our actual future results may be materially different from any future results expressed or implied by these forward-looking statements. Except as required by law, we assume no obligation to update or revise these forward looking statements for any reason, even if new information becomes available in the future.
Overview
On February 23, 2021, we entered into a Share Exchange Agreement (the “Exchange Agreement”) with SmartKem Limited (“SmartKem”), a private company incorporated under the Laws of England and Wales, and the former shareholders of SmartKem. Pursuant to the Exchange Agreement, all of the equity interests in SmartKem, except certain “deferred shares” which had no economic or voting rights (“Deferred Shares”) and which were purchased by us for an aggregate purchase price of $1.40, were exchanged for shares of our common stock, par value $0.0001 per share (“common stock”), and SmartKem became our wholly owned subsidiary (the “Exchange”). The Exchange was consummated on February 23, 2021.
As a result of the Exchange, we legally acquired the business of SmartKem and are continuing the existing business operations of SmartKem as a public reporting company under the name SmartKem, Inc. The Exchange was treated as a recapitalization and reverse acquisition for us for financial reporting purposes, and SmartKem is considered the acquirer for accounting purposes.
As a result of the Exchange and the change in our business and operations, a discussion of our past financial results is not pertinent, and under applicable accounting principles, the historical financial results of SmartKem, the accounting acquirer, prior to the Exchange are considered our historical financial results.
We are seeking to reshape the world of electronics with a revolutionary semiconductor platform that enables a new generation of displays, sensors and logic. SmartKem’s patented TRUFLEX® inks are solution deposited at a low temperature, on low-cost substrates to make organic thin-film transistor (OTFT) circuits. Our semiconductor platform can be used in a number of applications including mini-LED displays, AMOLED displays, fingerprint sensors and logic circuits. We develop our materials at our research and development facility in Manchester, UK, and at our semiconductor manufacturing process at the Centre of Process Innovation (CPI) in Sedgefield, UK. We have an extensive IP portfolio including approximately 120 issued patents.
Since our inception in 2009, we have devoted substantial resources to the research and development of materials and production processes for the manufacture of organic thin film transistors and the enhancement of our intellectual property. Our loss before income taxes was $2.7 million and $0.6 million for the three months ended September 30, 2021 and 2020, respectively. Our loss before income taxes was $14.4 million and $21.7 million for the nine months
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ended September 30, 2021 and 2020, respectively. As of September 30, 2021, our accumulated deficit was $72.4 million. Substantially all of our operating losses have resulted from expenses incurred in connection research and development activities and from general and administrative costs associated with our operations.
We expect to continue to incur significant expenses and operating losses for the foreseeable future. We expect our expenses will increase in connection with our ongoing activities as we:
● continue to develop our core material, EDA tools and foundry services;
● add sales and field applications personnel and incur related expenses to support operational growth;
● increase activity directly related to promoting our products to increase revenues; and
● add financial accounting and management systems to position us for growth and incur additional legal and accounting expense as we operate as a public company.
Recent Developments
Exchange
On February 23, 2021, we entered into a Share Exchange Agreement (the “Exchange Agreement”) with SmartKem Limited (“SmartKem”), a private company incorporated under the Laws of England and Wales, and the former shareholders of SmartKem. Pursuant to the Exchange Agreement, all of the equity interests in SmartKem, except certain “deferred shares” which had no economic or voting rights (“Deferred Shares”) and which were purchased by us for an aggregate purchase price of $1.40, were exchanged for shares of our common stock, par value $0.0001 per share (“common stock”), and SmartKem became our wholly owned subsidiary (the “Exchange”). The Exchange was consummated on February 23, 2021.
On February 23, 2021, our board of directors and all of our pre-Exchange stockholders approved an amended and restated certificate of incorporation, which was effective upon its filing with the Secretary of State of the State of Delaware on February 23, 2021 and through which we changed our name to “SmartKem, Inc.” On February 23, 2021, our board of directors and all of our pre-Exchange stockholders also adopted restated bylaws.
At the closing of the Exchange (the “Closing”), each SmartKem ordinary share issued and outstanding immediately prior to the Closing (other than the Deferred Shares) was exchanged for 0.0111907 of a share of our common stock and each SmartKem A ordinary share issued and outstanding immediate prior to the Closing was exchanged for 0.0676668 of a share of our common stock, with the maximum number of shares of our common stock issuable to the former holders of SmartKem’s ordinary shares and A ordinary shares equal to 12,725,000. This includes enterprise management incentive options to purchase 124,497,910 SmartKem ordinary shares (the “SmartKem EMI Options”) issued and outstanding immediately prior to the Closing that were accelerated and exercised by the holders thereof for a like number of ordinary shares and exchanged for shares of our common stock pursuant to the Exchange. Immediately prior to the Closing, an aggregate of 2,500,000 shares of our common stock owned by our stockholders prior to the Exchange were forfeited and cancelled (the “Stock Forfeiture”).
In addition, pursuant to the Exchange Agreement and upon Closing, the unexercised non tax- advantaged options (the “SmartKem Unapproved Options”) to purchase SmartKem ordinary shares issued and outstanding were waived and released by the holders in consideration for new options to purchase such number of shares of our common stock equal to the number of shares of SmartKem ordinary shares subject to the relevant SmartKem Unapproved Option immediately prior to the Exchange, multiplied by the applicable Exchange conversion ratio (which was equal to 0.0111907), with any fraction rounded to the nearest whole number. The exercise price per share of each such new option is equal to the then-current exercise price of the relevant SmartKem Unapproved Option divided by the applicable Exchange conversion ratio (which was equal to 0.0111907) (rounded to the nearest one-tenth of one cent), except for new options issued to a U.S. person which have an exercise price of $2.00 per share. The new options were issued pursuant to our 2021 Plan. The new options replacing the SmartKem Unapproved Options cover an aggregate of 402,586
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shares of our common stock, with options covering 336,557 shares of our common stock having an exercise price of $0.001 per share and the options covering the remaining 66,029 shares of our common stock having an exercise price of $2.00 per share.
SmartKem is considered the accounting acquirer in the Exchange and will account for the transaction as a capital transaction because SmartKem’s former shareholders received substantially all of the voting rights in the combined entity and SmartKem’s senior management represents all of the senior management of the combined entity.
Private Placement
Following the Closing, on February 23, 2021, we sold 10,162,000 shares of our common stock and pre- funded warrants to purchase up to 2,168,000 shares of our common stock for aggregate gross proceeds of approximately $24.6 million pursuant to a private placement offering of our common stock (or pre-funded warrants in lieu thereof) at a purchase price of $2.00 per share or $1.99 per pre-funded warrant, as applicable. Pursuant to the offering, we offered to certain purchasers whose purchase of shares of our common stock in the offering would otherwise have resulted in the purchaser, together with its affiliates and certain related parties, beneficially owning more than 4.99% (or, at the election of the purchaser, 9.99%) of our outstanding common stock immediately following the closing of the offering, the opportunity to purchase, if any such purchaser so chose, pre-funded warrants in lieu of shares of our common stock that would otherwise have resulted in such purchaser’s beneficial ownership exceeding 4.99% (or, at the election of the purchaser, 9.99%) of our outstanding common stock, at a purchase price of $1.99 per pre-funded warrant. Each pre-funded warrant is exercisable for one share of our common stock at an exercise price of $0.01 per share. The private placement offering is referred to herein as the “Offering.”
Key Factors Affecting Our Performance
There are a number of industry factors that affect our business which include, among others:
Overall Demand for Products and Applications using Organic thin film transistors
Our potential for growth depends significantly on the adoption of organic thin film transistor (OTFT) materials in the display and sensor markets and our ability to capture a significant share of any market that does develop. We expect that demand for our technology will also fluctuate based on various market cycles, continuously evolving industry supply chains, trade and tariff terms, as well as evolving competitive dynamics in each of the respective markets. These uncertainties make demand difficult to forecast for us and our customers.
Intense and Constantly Evolving Competitive Environment
Competition in the industries we serve is intense. Many companies have made significant investments in product development and production equipment. To remain competitive, market participants must continuously increase product performance, reduce costs and develop improved ways to serve their customers. To address these competitive pressures, we have invested in research and development activities to support new product development, improve ease of use, lower product costs and deliver higher levels of performance to differentiate our products in the market.
Governmental Trade and Regulatory Conditions
Our potential for growth depends on a balanced and stable trade, political, economic and regulatory environment among the countries where we do business. Changes in trade policy such as the imposition of tariffs or export bans to specific customers or countries could reduce or limit demand for our products in certain markets.
Technological Innovation and Advancement
Innovations and advancements in organic materials continue to expand the potential commercial application for our products. However, new technologies or standards could emerge, or improvements could be made in existing technologies that could reduce or limit the demand for our products in certain markets.
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Intellectual Property Issues
We rely on patented and non-patented proprietary information relating to product development, manufacturing capabilities and other core competencies of our business. Protection of intellectual property is critical. Therefore, steps such as additional patent applications, confidentiality and non-disclosure agreements, as well as other security measures are important. While we believe we have a strong patent portfolio and there is no actual or, to our knowledge, threatened litigation against us for patent-related matters, litigation or threatened litigation is a common method to effectively enforce or protect intellectual property rights. Such action may be initiated by or against us and would require significant management time and expenses.
Components of Results of Operations
Revenue
Our revenue currently consists of revenue from the sale of demonstration products.
Cost of Revenues. Cost of revenues consists of (1) direct product costs incurred for the raw materials and manufacturing services for our products, (2) fixed product costs primarily relating to production, manufacturing and personnel and (3) depreciation consisting primarily of expenses related to our fixed assets. We expect our cost of goods sold attributable to direct product costs to increase proportionately with increases in revenue, and our cost of goods sold attributable to fixed product costs to remain substantially flat or moderately increase in connection with increases in revenue.
Other Operating Income. Our other income includes government grants received for qualifying research and development projects, and research and development tax credits related to the United Kingdom’s Research and Development Expenditure Credit scheme, which is a government tax incentive designed to reward innovative companies for investing in research and development. The income associated with these items are recognized in the period which the research and development expenses occurred. Additionally, during the three months ended September 30, 2021, the Company received government grants under the United Kingdom’s Coronavirus Job Retention Scheme.
Operating Expenses
Research and Development. Research and development expenses consist primarily of compensation and related costs for personnel, including share-based compensation and employee benefits as well as costs associated with design, fabrication and testing of OTFT devices. In addition, research and development expenses include depreciation expenses related to our fixed assets. We expense research and development expenses as incurred. As we continue to invest in developing our technology for new products, we expect research and development expenses to remain flat or moderately increase in absolute dollars but to decline as a percentage of revenue.
Selling, General and Administrative. Selling, general and administrative expenses consist primarily of allocated compensation and related costs for personnel, including share-based compensation, employee benefits and travel. In addition, general and administrative expenses include third-party consulting, legal, audit, accounting services, allocations of overhead costs, such as rent, facilities and information technology. We expect general and administrative expenses to increase in absolute dollars in future periods due to additional legal, accounting, insurance, investor relations and other costs associated with being a public company, as well as other costs associated with growing our business.
Non Operating Income (Expense)
Interest Expense. We issued convertible loans to a number of investors in 2018 and 2019. These loans were all converted to equity in 2020. The loans contained a beneficial conversion feature that resulted in a loan discount upon issue which was recognized as interest expense over the lifetime of the loan. Upon conversion of the loans the remaining unamortised loan discount was recognized as interest expense in 2020.
Interest Income. Interest income is interest on our cash deposits.
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Other Income; Other income is the gain or loss on remeasurement of lease liabilities
Changes in Fair Value of Derivative Assets. The convertible loans contained variable conversion price scenarios that were evaluated and determined to be derivatives that were bifurcated from the loan notes and accounted for separately. The resulting derivative is accounted for at estimated market value with changes in the market value recorded in income.
Loss on Conversion of Convertible Notes. In January 2020 when the convertible loan notes were converted to A ordinary shares, a loss on conversion was recognized. The loss represents the difference between the fair value of the A ordinary shares issued and the carrying value of the convertible loan notes plus accrued interest and the fair market value of the embedded derivative on the date of conversion.
Income Tax Expense. Income tax expense consists primarily of income taxes in jurisdictions in which we conduct business. We did not incur any income tax in 2021 or 2020.
Foreign Currency Translation. Foreign currency translation reflect adjustments made due to currency fluctuations.
Results of Operations
The following tables set forth our results of operations for the periods presented. The information in the tables below should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in Part I, Item 1 of this Form 10-Q. The period-to-period comparisons of financial results in the tables below are not necessarily indicative of future results.
Three month-periods ended September 30, 2021 and 2020
Our results of operations for the three month-periods ended September 30, 2021 and 2020 are as follows:
Three Months Ended September 30,
Increase (Decrease)
US$000
2021
2020
Amount
Percentage
Revenue
$
—
$
50
$
(50)
(100)
%
Cost of revenue
—
26
(26)
(100)
%
Gross Profit
—
24
(24)
(100)
%
Other Operating Income
447
747
(300)
(40)
%
Operating Expenses
Research and development
1,356
1,102
254
23
%
Selling, general and administrative
1,368
292
1,076
368
%
Transaction expenses
—
—
—
—
%
Total operating expenses
2,724
1,394
1,330
95
%
Loss from operations
(2,277)
(623)
(1,654)
265
%
Non Operating (Expense)/Income
(Loss)/gain on foreign currency transactions
(386)
1
(387)
(38,700)
%
Interest expense
—
—
—
—
%
Interest income
1
—
1
—
%
Total non operating (expense)/income
(385)
1
(386)
(38,600)
%
Loss before income taxes
(2,662)
(622)
(2,040)
328
%
Income tax expense
—
—
—
—
Foreign Currency Translation
82
156
(74)
(47)
%
Total comprehensive loss
$
(2,580)
$
(466)
$
(2,114)
454
%
We did not record any revenue in the three months ended September 30, 2021, compared to $50 thousand of revenue for the three months ended September 30, 2020. Accordingly, revenue, cost of revenues and gross profit were all $0 for the three months ended September 30, 2021, a 100% decrease in each of these balances compared to the three months ended September 30, 2020.
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Other operating income decreased by $300 thousand, or 40%, to $447 thousand for the three months ended September 30, 2021, compared to $747 thousand for the 2020 period. Other operating income in 2021 comprised research and development tax credits while in 2020 it comprised $245 thousand of research and development tax credits and $502 thousand of research and development grant monies.
Operating expenses increased $1.3 million, or 95%, to $2.7 million for the three months ended September 30, 2021, compared to $1.4 million for the comparable period of 2020. The increase was primarily due to the matters described below.
Research and development expense, which represents 50% and 79% of our total operating expenses for the three months ended September 30, 2021 and 2020, respectively, increased by $0.3 million, or 23%, to $1.4 million for the three months ended September 30, 2021, compared to $1.1 million for the three months ended September 30, 2020. The increase was primarily due to expenses incurred in further developing core materials and in fabricating demonstrator devices to promote our technology to prospective customers and partners.
Selling, general and administrative expense, which represents 50% and 21% of our total operating expenses for the three months ended September 30, 2021 and 2020, respectively increased by $1.1 million or 368% to $1.4 million for the three months ended September 30, 2021, compared to $0.3 million for the three months ended September 30, 2020. This increase was mainly due to an increase in staff costs resulting from adding to our sales teams in the US and Asia and the strengthening of our finance team to prepare our company’s US public company financial reporting, as well as from the additional legal, accounting and insurance expenses of operating as a public company.
The loss on foreign currency transactions was $386 thousand for the three months ended September 30, 2021, compared to a gain of $1 thousand for the three months ended September 30, 2020, an increase of $387 thousand. The loss was due to fluctuations in U.S. dollar/U.K. pound value arising from transactions denominated in foreign currencies and the translation of certain foreign currency subsidiary balances.
Interest income was less than $1 thousand for the three months ended September 30, 2021, compared to $0 for the three months ended September 30, 2020. The increase was due to higher average cash deposits during the third quarter of 2021 compared to the third quarter of 2020, offset by reductions in the credit interest rates on our cash deposits.
The loss before income taxes was $2.7 million for the three months ended September 30, 2021, an increase of $2.0 million, compared to a loss before income taxes of $0.6 million for the three months ended September 30, 2020. The increase in loss was attributable to the higher research and development expense and the higher selling, general and administrative expense described in the preceding paragraphs.
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Nine month-periods ended September 30, 2021 and 2020
Our results of operations for the nine month-periods ended September 30, 2021 and 2020 are as follows:
Nine Months Ended September 30,
Increase (Decrease)
US$000
2021
2020
Amount
Percentage
Revenue
$
—
$
71
$
(71)
(100)
%
Cost of revenue
—
38
(38)
(100)
%
Gross Profit
—
33
(33)
(100)
%
Other Operating Income
1,135
1,125
10
1
%
Operating Expenses
Research and development
6,725
3,213
3,512
109
%
Selling, general and administrative
6,695
1,061
5,634
531
%
Transaction expenses
1,329
—
1,329
—
%
Total operating expenses
14,749
4,274
10,475
245
%
Loss from operations
(13,614)
(3,116)
(10,498)
337
%
Non Operating (Expense)/Income
Loss on foreign currency transactions
(799)
—
(799)
—
%
Interest expense
(19)
(6,835)
6,816
(100)
%
Interest income
3
3
—
—
%
Change in fair value of derivative asset
—
(6,282)
6,282
(100)
%
Loss on conversion of convertible notes payable
—
(5,470)
5,470
(100)
%
Total non operating expense
(815)
(18,584)
17,769
(96)
%
Loss before income taxes
(14,429)
(21,700)
7,271
(34)
%
Income tax expense
—
—
—
—
Foreign Currency Translation
115
(405)
520
(128)
%
Total comprehensive loss
$
(14,314)
$
(22,105)
$
7,791
(35)
%
We did not record any revenue in the nine months ended September 30, 2021, compared to $71 thousand of revenue for the nine months ended September 30, 2020. Accordingly, revenue, cost of revenues and gross profit were all $0 for the nine months ended September 30, 2021, a 100% decrease in each of these balances compared to the nine months ended September 30, 2020.
Other operating income was $1.1 million for both the nine months ended September 30, 2021 and the nine months ended September 30, 2020. Other operating income in 2021 largely comprised $944 thousand of research and development tax credits and $181 thousand in research and development grant monies. Other operating income in 2020 comprised $623 thousand of research and development tax credits and $502 thousand of research and development grant monies.
Operating expenses increased $10.5 million, or 245%, to $14.7 million for the nine months ended September 30, 2021, compared to $4.3 million for the comparable period of 2020. The increase was primarily due to the matters described below.
Research and development expense, which represents 46% and 75% of our total operating expenses for the nine months ended September 30, 2021 and 2020, respectively, increased by $3.5 million, or 109%, to $6.7 million for the nine months ended September 30, 2021, compared to $3.2 million for the nine months ended September 30, 2020. The increase was primarily due to stock-based compensation expense in 2021 as detailed in Note 11 Share-Based Compensation to our unaudited consolidated financial statements (Part I, Item 1 of this Form 10-Q) and expenses incurred in further developing core materials and in fabricating demonstrator devices to promote our technology to prospective customers and partners.
Selling, general and administrative expense, which represents 45% and 25% of our total operating expenses for the nine months ended September 30, 2021 and 2020, respectively, increased by $5.6 million, or 531%, to $6.7 million for
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the nine months ended September 30, 2021, compared to $1.1 million for the nine months ended September 30, 2020. This increase was mainly due stock-based compensation expense in 2021 as detailed in Note 11 Share-Based Compensation to our unaudited consolidated financial statements (Part I, Item 1 of this Form 10-Q), from adding to our sales teams in the US and Asia and the strengthening of our finance team to prepare our company’s US public company financial reporting, as well as from the additional legal, accounting and insurance expenses of operating as a public company.
Transaction costs of $1.3 million associated with the Exchange were incurred in the nine months ended September 30, 2021.
The loss on foreign currency transactions was $799 thousand for the nine months ended September 30, 2021, compared to $0 for the nine months ended September 30, 2020, an increase of $799 thousand. The increase was due to fluctuations in U.S. dollar/U.K. pound value arising from transactions denominated in foreign currencies and the translation of certain foreign currency subsidiary balances.
Interest expense was $19 thousand for the nine months ended September 30, 2021, compared to $6.8 million for the nine months ended September 30, 2020, a decrease of $6.8 million. The decrease resulted from the conversion in early 2020 of all outstanding loan notes to equity which resulted in the interest expense recognition of unamortized loan discounts.
Interest income was $3 thousand for the nine months ended September 30, 2021, unchanged from the nine months ended September 30, 2020. Reductions in the credit interest rates on our cash deposits offset the higher average cash deposits held in 2021.
The change in fair value of derivative assets was zero for the nine months ended September 30, 2021, compared to $6.3 million for the nine months ended September 30, 2020, a decrease of $6.3 million or 100%. The decrease resulted from the 2020 change in market value reflected the change in probability of conversion immediately before the conversion date.
The loss on conversion of convertible notes payable was $0 for the nine months ended September 30, 2021, compared to $5.5 million for the nine months ended September 30, 2020. The 2020 loss resulted from the difference between the fair value of the A ordinary shares issued and the carrying value of the convertible loan notes plus accrued interest and the fair market value of the embedded derivative on the date of conversion in 2020.
The loss before income taxes was $14.4 million for the nine months ended September 30, 2021, a decrease of $7.3 million, compared to a loss before income taxes of $21.7 million for the nine months ended September 30, 2020. The decrease in loss was attributable to a reduction in non-operating losses resulting from the accounting recognition of loans converted to equity during 2020, partially offset by higher stock compensation expense, transaction costs from the Exchange in 2021 and operating expenses associated with being a public company.
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Liquidity and Capital Resources
Since inception, we have not generated significant revenue from product sales, and we have incurred significant operating losses and had an accumulated deficit of $72.5 million as of September 30, 2021. We have not commercialized any products and may not generate significant revenue from product sales during 2021, if at all. To date, we have funded our operations primarily with proceeds from the private sale of equity and debt securities and borrowing against our research and development credits. As of September 30, 2021, our cash and cash equivalents were $14.7 million. The following table shows a summary of our cash flows for the periods presented:
Nine Months Ended September 30,
US$000
2021
2020
Net cash used in operating activities
(8,100)
(2,593)
Net cash used by investing activities
(282)
(90)
Net cash provided by financing activities
22,204
4,592
Net change in cash
13,822
1,909
Effect of exchange rate changes on cash
133
(116)
Cash, beginning of period
764
412
Cash, end of period
$
14,719
$
2,205
Operating Activities
Net cash used in operating activities was $8.1 million for the nine months ended September 30, 2021, compared to $2.6 million for the nine months ended September 30, 2020, an increase of $5.5 million. The increase resulted primarily from our increased research and development activity, the operating expenses associated with being a public company, the expenses incurred in connection with the Exchange and movements in our working capital balances.
Investing Activities
We used $282 thousand of cash in investing activities during the nine months ended September 30, 2021, compared to net cash used of $90 thousand for the nine months ended September 30, 2020, an increase of $192 thousand. The increase resulted primarily from a higher level of investment in laboratory and capital equipment in 2021.
Financing Activities
Net cash provided by financing activities was $22.2 million for the nine months ended September 30, 2021 compared with $4.6 million generated from financing activities in 2020. Net cash provided by financing activities during the nine months ended September 30, 2021 resulted primarily from the net proceeds of the Offering.
We expect that our cash and cash equivalents will be sufficient to support our operations through the first quarter of 2023. We will need to obtain additional funds to satisfy our operational needs and to fund our sales and marketing efforts, research and development expenditures, and business development activities. Our future capital requirements will depend on many factors including our ability to generate revenue from product sales, the timing and extent of spending to support our sales and marketing, product development and research and development efforts and our needs for working capital to support our business operations. We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies, including intellectual property rights.
Until such time, if ever, as we can generate substantial product revenue, we expect to finance our working capital requirements through a combination of equity offerings, debt financings, collaborations, strategic alliances and marketing, distribution or licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect your rights as a common stockholder. Debt financing and preferred equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take
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specific actions, such as incurring additional debt, making acquisitions or capital expenditures or declaring dividends. If we raise additional funds through collaborations, strategic alliances or marketing, distribution or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or products, or grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings or other arrangements when needed, we may be required to delay, limit, reduce or terminate commercialization, our research and product development, or grant rights to develop and market our products that we would otherwise prefer to develop and market ourselves.
In January 2021 SmartKem entered into a Facility Agreement (the “Facility Agreement”) with FRCF 2 Limited (“Lender”) pursuant to which the Lender provided SmartKem with a secured term loan facility in the amount of $738 thousand (the “Facility”) as an advance against certain research and development tax credit payments expected to be received by SmartKem. Interest on amounts outstanding on the Facility bore interest at a monthly rate of 1.25%, compounded monthly, and were payable on demand. Payment of all amounts outstanding on the Facility were due on July 26, 2021. SmartKem had the right to prepay all or part of the outstanding amounts under the Facility, subject to a pre-payment penalty equal to two months’ accrued interest if such amounts were repaid prior to March 26, 2021. SmartKem was required to repay the Facility with the proceeds of the expected tax credit payments. SmartKem paid the Lender an arrangement fee of $37 thousand in connection with the establishment of the Facility. SmartKem agreed to certain affirmative and negative covenants in the Facility Agreement requiring SmartKem to provide certain information to the Lender and preventing SmartKem from, among other things: (i) incurring additional indebtedness for borrowed money, (ii) making certain payments to insiders, (iii) selling, transferring or otherwise disposing of assets other than in the ordinary course of business or in other limited circumstances, (iv) creating any additional security interest on any of its assets, (v) engaging in any sale lease-back transaction, (vi) selling, transferring or otherwise disposing of its receivables on recourse terms, (vii) entering into any arrangement under which money or the benefit of a bank or other account may be applied, set-off or made subject to a combination of accounts, or (viii) entering into any other preferential arrangement. Upon the occurrence of any event of default (defined to include, among other things, payment defaults, a breach of any representation, warranty or covenant, certain bankruptcy-related events or a Change of Control of SmartKem), the Lender may declare all amounts outstanding under the Facility due and owing (at which point interest would begin to accrue at a default rate of 4% per month) and exercise its rights with respect to its security interest in SmartKem’s assets. Pursuant to the terms of a Debenture entered into in connection with the Facility Agreement, SmartKem granted a security interest in all of its assets to the Lender.
The consummation of the Exchange constituted a Change of Control of SmartKem under the Facility. Under the terms of the Facility Agreement, a Change of Control would constitute an event of default commencing on the tenth business day after the Change of Control. We repaid the amounts that were outstanding under the Facility Agreement with a portion of the proceeds of the Offering before the end of such ten business day period.
Off-Balance Sheet Transactions
We did not have during the periods presented, and we do not currently have, any off-balance sheet financing arrangements or any relationships with unconsolidated entities or financial partnerships, such as structured finance or special purpose entities, that were established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Critical Accounting Policies and Estimates
Our consolidated financial statements and the related notes thereto included in this Report are prepared in accordance with U.S. GAAP. The preparation of consolidated financial statements also requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses, and related disclosures. These estimates are developed based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ significantly from the estimates made by management. To the extent that there are differences between our estimates and actual results, our future financial statement presentation, financial condition, results of operation, and cash flows will be affected. A summary of our critical accounting policies is presented in Note 2 Summary of Significant Accounting Policies to our unaudited
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consolidated financial statements (Part I, Item 1 of this Form 10-Q). There were no material changes to our critical accounting policies during the three and nine months ended September 30, 2021.
Going Concern Evaluation
Our condensed consolidated financial statements included elsewhere herein have been presented on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. We have financed our activities principally from the issuance of ordinary shares, and debt securities. We have experienced recurring losses since inception and expect to incur additional losses in the future in connection with research and development activities.
In the nine months ended September 30, 2021, we raised net proceeds of $22.2 million through the Offering and at September 30, 2021 we had $14.7 million of cash after funding net cash used in operations for the nine month period ended September 30, 2021 of $8.1 million, $1.7 million of which was used in the three months ended September 30, 2021.
We expect that our available cash balances will provide sufficient liquidity to fund our current obligations and projected working capital and capital expenditure requirements for at least the next 12 months. Our management consider it is appropriate to continue to adopt the going concern basis in preparing the consolidated financial statements.
Internal Control Over Financial Reporting
During the year ended December 31, 2020 and for the period ended September 30, 2021, our management and independent registered public accounting firm identified material weaknesses related (i) the fact that certain members of our finance team and personnel are able to operate across a number of different functions and have user access that gives rise to segregation of duties risks in connection with our information technology infrastructure and (ii) the fact that policies and procedures with respect to the review, supervision and monitoring of our accounting and reporting functions were either not designed and in place, or not operating effectively.
We are currently in the process of remediating these material weaknesses and are taking steps that we believe will address their underlying causes. We have recruited additional finance personnel including those with expertise in generally accepted accounting principles and controls over financial reporting, have implemented measures to restrict system access and have, with the support of external experts, commenced design, documentation and operation of policies and procedures covering our accounting and reporting functions.
Under the direction of the Audit Committee, management will continue to review and make necessary changes to the overall design of our internal control environment, as well as to policies and procedures to improve the overall effectiveness of internal controls during the period ending December 31, 2021.
JOBS Act Accounting Election
We are an emerging growth company, as defined in the Jumpstart Our Business Startups Act, or the JOBS Act. The JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. This provision allows an emerging growth company to either early adopt or delay the adoption of some accounting standards until those standards would otherwise apply to private companies. We have elected to use the extended transition period under the JOBS Act until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Not applicable.
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Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.