Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is provided in addition to the accompanying consolidated financial statements and notes to assist readers in understanding our results of operations, financial condition, and cash flows. The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated 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” above. You should review the disclosure under the heading “Item1A. 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.
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Overview
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 $17.1 million and $23.1 million for the year ended December 31, 2021 and 2020, respectively. As of December 31, 2021, our accumulated deficit was $75.1 million. Substantially all our operating losses have resulted from expenses incurred in connection with research and development activities and from general and administrative costs associated with our operations.
Recent Developments
Share Exchange (“the 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.
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, the historical financial results of SmartKem, the accounting acquirer, prior to the Exchange are considered our historical financial results.
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
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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 Equity Incentive Plan (the “2021 Plan”). The new options replacing the SmartKem Unapproved Options cover an aggregate of 402,586 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.
Private Placement (“Offering”)
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 $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.
Octopus Share Purchase
On January 27, 2022, we sold an aggregate of 1,000,000 shares of our common stock at a purchase price of $2.00 per share to Octopus Titan VCT plc and Octopus Investments Nominees Limited in accordance with the Letter Agreement, dated as of February 23, 2021, between the Company and Octopus Titan VCT plc and certain related parties.
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.
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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.
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 year ended December 31, 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. We do not believe that it is possible at this time to accurately project total program-specific expenses through commercialization. There are numerous factors associated with the successful commercialization of our technology many of which cannot be determined with accuracy at this time based on our stage of development. Additionally, future commercial and other factors beyond our control will impact our development programs and plans.
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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.
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Non-Operating Income (Expense)
Financial Income/(Expense), Net aggregates the following amounts:
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 unamortized loan discount was recognized as interest expense in 2020.
Interest Income. Interest income is interest on our cash deposits.
Other Income; Other income is the gain or loss on remeasurement of lease liabilities
Change 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 Payable. 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 expense 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 consolidated financial statements and related notes included in Part II, Item 8 of this Form 10-K. The period-to-period comparisons of financial results in the tables below are not necessarily indicative of future results.
Comparison of Loss from Operations for the years ended December 31, 2021 and 2020
Our results of operations for the years ended December 31, 2021 and 2020 are as follows:
Year Ended December 31,
Increase (Decrease)
US$000
2021
2020
Amount
Percentage
Revenue
$
18
$
94
$
(76)
(81)
%
Cost of revenue
8
55
(47)
(85)
%
Gross Profit
10
39
(29)
(74)
%
Other operating income
1,285
1,437
(152)
(11)
%
Operating Expenses
Research and development
8,199
4,319
3,880
90
%
Selling, general and administrative
8,069
1,707
6,362
373
%
Transaction expenses
1,329
—
1,329
—
%
Total operating expenses
17,597
6,026
11,571
192
%
Loss from operations
$
(16,302)
$
(4,550)
$
(11,752)
258
%
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Revenue and Cost of Revenue
Our revenue currently consists of revenue from the sale of demonstration products. The year on year change in revenue and gross profit reflects the one off nature of these sales, consistent with our current stage of commercialization.
Other Operating Income
Year Ended December 31,
Increase (Decrease)
% of total
% of total
2021
2020
Amount
Percentage
2021
2020
Research & development tax credit
$
1,095
$
922
$
173
19
%
85%
64%
Research & development grants
181
498
(317)
(64)
%
14%
35%
Other grants
9
17
(8)
(47)
%
1%
1%
Total other operating income
$
1,285
$
1,437
$
(152)
(11)
%
100%
100%
Our Other Operating 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 (RDEC) scheme, which is a government tax incentive designed to reward innovative companies for investing in research and development. The increase in RDEC Tax Credit reflects higher eligible expenditure in 2021 compared to 2020. In 2021, R&D grant funding was secured for the “SmartLight” project that successfully demonstrated OTFT mini-LED backlights for displays with improved light uniformity and lower defects.
Operating Expenses
Year Ended December 31,
Increase (Decrease)
% of total
% of total
2021
2020
Amount
Percentage
2021
2020
Research and development
$
8,199
$
4,319
$
3,880
90
%
47%
72%
Selling, general and administrative
8,069
1,707
6,362
373
%
46%
28%
Transaction expenses
1,329
—
1,329
—
%
7%
0%
Total operating expenses
$
17,597
$
6,026
$
11,571
192
%
100%
100%
Operating expenses increased by $11.6 million, or 192%, to $17.6 million for the year ended December 31, 2021, compared to $6.0 million for the comparable period of 2020.
The increase in Research and development expense was primarily due to stock-based compensation expense of $3.0 million in 2021 and from expenditure to further develop core materials and fabricate demonstrator devices to promote our technology to prospective customers and partners.
The increase in Selling, general and administrative expense was mainly due to $3.2 million stock-based compensation expense in 2021, from adding to our sales teams in the US and Asia and the strengthening of our finance team to prepare the 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 year ended December 31, 2021.
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
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● 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.
Non-Operating (Expenses)/Income and Net Loss
Year Ended December 31,
Increase (Decrease)
2021
2020
Amount
Percentage
Loss from operations
$
(16,302)
$
(4,550)
$
(11,752)
258
%
Non-operating (Expense)/Income
Loss on foreign currency transactions
(808)
—
(808)
—
%
Other income
—
1
(1)
(100)
%
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
(824)
(18,583)
17,759
(96)
%
Loss before income taxes
(17,126)
(23,133)
6,007
(26)
%
Income tax expense
—
—
—
—
Net Loss
$
(17,126)
$
(23,133)
$
6,007
(26)
%
The increase loss on foreign currency transactions in was due to fluctuations in U.S. dollar/U.K. pound value arising from transactions denominated in foreign currencies and the translation of foreign currency denominated balances on intra-group loans that were first advanced in 2021.
In the year ended December 31, 2020, the Company’s convertible loan notes were converted to equity following a qualifying event. $6.8 million of Interest Expense resulted from recognition of unamortized loan discounts, $6.3 million of expense arose from change in the fair value of derivative assets that reflected the change in probability of conversion immediately before the conversion date and a $5.5 million loss on conversion of convertible notes payable arose from the difference between the fair value of the A ordinary shares issued and the carrying value of the convertible loan notes. These expenses plus accrued interest and the fair market value of the embedded derivative on the date were all recorded as non-operating expenses. For information regarding convertible notes and derivative assets, please refer to Notes 7 and 8 to our consolidated financial statements.
The loss before income taxes was $17.1 million for the year ended December 31, 2021, a decrease of $6.0 million, compared to a loss before income taxes of $23.1 million for the year ended December 31, 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.
Liquidity and Capital Resources
To date, we have funded our liquidity and capital requirements primarily with proceeds from the private sale of our equity and debt securities and borrowing against our research and development credits. As of December 31, 2021, our cash and cash equivalents were $12.2 million compared with $764 thousand as of December 31, 2020. On January 27, 2022, we sold an aggregate of 1,000,000 shares of our common stock to existing investors at a price of $2.00 per share for total gross proceeds of $2.0 million. For subsequent events, refer to Note 16 to our Notes to Consolidated Financial Statements included in this Annual Report on Form 10-K.
We believe that our cash and cash equivalents will be sufficient to support our expected liquidity and working capital requirements for at least the next twelve months. However, in the event that we enter into contracts involving significant sales of our products, development agreements, license agreements, collaborations, acquisitions or other material transactions, we may require additional working capital to support our increased obligations. To date, we have
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not recorded significant revenues related to product sales and therefore do not have any present need to fund inventory or accounts receivable.
In the long-term, 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 liquidity and working 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, our entry into one or more material agreements containing significant performance obligations and our needs for working capital to support our business operations. Until such time, if ever, as we can generate sufficient cash through 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. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all.
The following table shows a summary of our cash flows for the years ended December 31, 2021 and 2020, respectively:
Year Ended December 31,
Increase (Decrease)
US$000
2021
2020
Amount
Percentage
Net cash used in operating activities
$
(10,536)
$
(4,082)
$
(6,454)
158
%
Net cash used by investing activities
(341)
(118)
(223)
189
%
Net cash provided by financing activities
22,204
4,592
17,612
384
%
Net change in cash
11,327
392
10,935
2,790
%
Effect of exchange rate changes on cash
135
(40)
175
(438)
%
Cash, beginning of year
764
412
352
85
%
Cash, end of year
$
12,226
$
764
$
11,462
1,500
%
Operating Activities
Net cash used in operating activities was $10.5 million for the year ended December 31, 2021, compared to $4.1 million for the year ended December 31, 2020, an increase of $6.4 million. The increase resulted primarily from a decrease in our net loss of $6.0 million, offset by a decrease of non-cash expense of $12.0 million and an unfavorable movement in operating assets and liabilities of $0.4 million.
Investing Activities
Net cash used in investing activities was $341 thousand for the year ended December 31, 2021, compared to $118 thousand for the year ended December 31, 2020, an increase of $223 thousand. The increase resulted from a higher level of investment in laboratory and capital equipment purchases in 2021 to support our increased research and development activity. In the future, we expect to continue to incur capital expenditures to support our research and development activities and wider business operations.
Financing Activities
Net cash flows provided by financing activities was $22.2 million for the year ended December 31, 2021, compared to $4.6 million for the year ended December 31, 2020, an increase of $17.6 million. The increase was due to the net proceeds of the Offering of $22.2 million, compared to $4.6 million from our 2020 private placement.
In January 2021, the Company entered into a term loan facility for $0.7 million acting as an advance of and secured against certain R&D tax credit amounts due. The facility together with accrued interest of $19 thousand was repaid in full in March 2021.
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Contractual Payment Obligations
Our principal commitments primarily consist of obligations under leases for office space and purchase commitments in the normal course of business for research & development facilities and services, communications infrastructure and administrative services. These will be funded from the company’s cash balances and working capital.
Payments Due by Period
US$(000)
2022
2023
2024
Total
Operating lease obligations
$
93
$
22
$
7
$
122
Purchase obligations
837
516
69
1,422
$
930
$
538
$
76
$
1,544
Recently Issued Accounting Pronouncements
For recently issued accounting announcements, see “Recently Issued Accounting Pronouncements” in Note 2, Significant Accounting Policies and Recent Accounting Pronouncements, in the Notes to our Consolidated Financial Statements included in this Annual Report on Form 10-K.
Critical Accounting Policies and Estimates
Our consolidated financial statements and the related notes thereto included in this Report are prepared in accordance with US 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.
We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates. Critical accounting policies and estimates are those that we consider the most important to the portrayal of our financial condition and results of operations because they require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of the matters that are inherently uncertain.
Accounting for Stock-Based Compensation:
We account for stock-based compensation in accordance with ASC 718, Compensation-Stock Compensation . ASC 718 requires companies to estimate the fair value of equity-based payment awards on the date of grant using a Black-Scholes option-pricing model. We recognize compensation expenses for the value of our equity awards granted based on the straight-line method over the requisite service period of each of the awards.
We estimate the fair value of each stock option award using the Black-Scholes option-pricing model, which uses as inputs the fair value of our common stock and assumptions we make for the volatility of our common stock, the expected term of our stock-based awards, the risk-free interest rate for a period that approximates the expected term of our stock-based awards, and our expected dividend yield. Prior to February 2022, the Company’s common stock was not traded on an over the counter or national securities exchange and consequently the Company developed estimates for the inputs to the option-pricing model.
We estimated the fair value of the shares of common stock by referencing arms-length transactions inclusive of the common shares underlying which occurred on or near the valuation date(s) or when these were not available, we determined the fair value of common share using methodologies, approaches and assumptions consistent with the
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AICPA Practice Guide, Valuation of Privately Held Company Equity Securities Issued as Compensation. We estimate our expected volatility based on the historical volatility of a set of our publicly traded peer companies. The risk-free interest rate assumption is based on observed interest rates for the appropriate term of the Company’s options on a grant date. The expected option term assumption for options granted in 2021 under the 2021 Plan is the contractual term, as the service period is implied under the practical expedient since the Company does not have sufficient exercise history to estimate expected term of its historical option awards.
The assumptions used in determining the fair value of stock-based awards represent our best estimates, but the estimates involve inherent uncertainties and the application of our judgment. As a result, if factors change and we use significantly different assumptions or estimates, our stock-based compensation expense could be materially different in the future.
Valuation allowance of deferred tax assets:
Income taxes are recorded in accordance with ASC 740, Income Taxes (“ASC 740”), which provides for deferred taxes using an asset and liability approach. The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are provided, if based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
We considered the positive and negative evidence bearing upon its ability to realize the deferred tax assets. In addition to the Company’s history of cumulative losses, the Company cannot be certain that future taxable income will be sufficient to realize its deferred tax assets. Accordingly, a full valuation allowance has been provided against its net deferred tax assets at both December 31, 2021 and 2020. Should the Company change its determination, based on the evidence available as to the amount of its deferred tax assets that can be realized, the valuation allowance will be adjusted with a corresponding impact to the provision for income taxes in the period in which such determination is made and which may be material.
Convertible Notes
SmartKem accounts for its convertible notes in accordance with ASC 470-20, Debt with Conversion and Other Options (“ASC 470-20”), which requires the liability and equity components of convertible debt instruments to be separately accounted for in a manner that reflects the issuer’s nonconvertible debt borrowing rate.
Debt discount created by the bifurcation of embedded feature in the convertible notes are reflected as a reduction to the related debt liability. The discount is amortized to interest expense over the term of the debt using the effective-interest method.
Derivative Asset for Embedded Conversion Features
SmartKem does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks.
SmartKem evaluates convertible notes to determine if those contracts or embedded components of those contracts qualify as derivatives to be accounted for separately. In circumstances where the embedded conversion option in a convertible instrument is required to be bifurcated and there are also other embedded derivative instruments in the convertible instrument that are required to be bifurcated, the bifurcated derivative instruments are accounted for as a single, compound derivative instrument. The result of this accounting treatment is that the fair value of the embedded derivative is recorded as either an asset or a liability and marked-to-market each balance sheet date, with the change in fair value recorded in the statements of operations as other income or expense. Upon conversion or exercise of a derivative instrument, the instrument is marked to fair value at the conversion date and then that fair value is reclassified to equity.
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The fair value of the embedded conversion features are estimated using a Monte Carlo simulation model, in which possible outcomes and their values are simulated repeatedly and randomly. Under the Monte Carlo method SmartKem estimated the fair value of the convertible notes conversion feature at the time of issuance and subsequent remeasurement dates, utilizing the with-and without method, where the value of the derivative feature is the difference in values between a note simulated with the embedded conversion feature and the value of the same note simulated without the embedded conversion feature. Estimating fair values of embedded conversion features requires the development of significant and subjective estimates that may, and are likely to, change over the duration of the instrument with related changes in internal and external market factors.
For more information regarding our accounting policies, see Note 2, Summary of Significant Accounting Policies and Recent Accounting Pronouncements, in our Notes to Consolidated Financial Statements in this Annual Report on Form 10-K.
Going Concern Evaluation
Our 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 year ended December 31, 2021, we raised net proceeds of $22.2 million through the Offering and at December 31, 2021 we had $12.2 million of cash and cash equivalents after funding net cash used in operations for the year ended December 31, 2021 of $10.5 million.
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 from the issuance date of these consolidated financial statements through the first quarter of 2023. Our management consider it is appropriate to continue to adopt the going concern basis in preparing the consolidated financial statements.
Our future viability is dependent on our ability to raise additional capital to satisfy our operational needs and to fund our sales and marketing efforts, research and development expenditures, and business development activities. Until such time, if ever, as we can generate sufficient cash through 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. We may be unable to raise additional funds or enter into such other agreements or arrangements when needed on favorable terms, or at all.
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 consolidated financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
We are a smaller reporting company as defined in Rule 12b-2 of the Exchange Act; therefore, pursuant to Item 301(c) of Regulation S-K, we are not required to provide the information required by this Item.
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