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Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2024

or

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number: 001-41567

ProSomnus, Inc.

(Exact name of registrant as specified in its charter)

DE

88-2978216

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification Number)

5675 Gibraltar Drive

Pleasanton, CA 94588

(Address of Principal Executive Offices)

(844) 537-5337

(Registrant’s telephone number)

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class

    

Trading symbol

    

Name of Exchange on which registered

Common Stock, par value $0.0001 per share

(1)

(1)

Warrants, each whole warrant exercisable for one share of Common Stock for $11.50 per share

(1)

(1)

(1)On April 24, 2024, the Nasdaq Stock Market LLC filed a Form 25 to delist the Company’s common stock and warrants and remove such securities from registration under Section 12(b) of the Securities Exchange Act of 1934, as amended. Since April 18, 2024, the Company’s Common Stock and Warrants have been traded on the over-the-counter market under the symbols “OSAP” and “OSAPW”, respectively.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes      No  

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).   Yes      No  

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer

Accelerated filer

¨

Non-accelerated filer

  

Smaller reporting company

Emerging growth company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes      No  

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes No

As of May 10, 2024, there were 17,394,064 shares of the registrant’s common stock outstanding.

Table of Contents

TABLE OF CONTENTS

PROSOMNUS, INC.

    

    

Page

Part I

Financial Information

Item 1.

Financial Statements (Unaudited)

1

Condensed Consolidated Balance Sheets as of March 31, 2024 and December 31, 2023

1

Condensed Consolidated Statements of Operations for the three months ended March 31, 2024 and 2023

2

Condensed Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders’ Deficit for the three months ended March 31, 2024 and 2023

3

Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2024 and 2023

4

Notes to Condensed Consolidated Financial Statements

5

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

29

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

38

Item 4.

Controls and Procedures

39

Part II

Other Information

40

Item 1.

Legal Proceedings

40

Item 1A.

Risk Factors

40

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

40

Item 3.

Defaults Upon Senior Securities

40

Item 4.

Mine Safety Disclosures

41

Item 5.

Other Information

41

Item 6.

Exhibits

41

Exhibit Index

42

Signatures

43

Table of Contents

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PROSOMNUS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

(In thousands, except share amounts and par value)

    

March 31, 2024

    

December 31, 2023

ASSETS

 

  

 

  

Current assets:

 

  

 

  

Cash

 

$

3,477

 

$

6,363

Restricted cash

700

700

Accounts receivable, net

 

4,339

 

3,839

Inventory

 

2,023

 

2,039

Prepaid expenses and other current assets

 

1,111

 

1,369

Total current assets

 

11,650

 

14,310

Property and equipment, net

 

3,166

 

3,358

Finance lease right-of-use assets

3,603

3,265

Operating lease right-of-use assets

4,981

5,069

Other assets

 

479

 

285

Total assets

 

$

23,879

 

$

26,287

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ DEFICIT

 

  

 

  

Current liabilities:

 

  

 

  

Accounts payable

$

4,532

$

4,047

Accrued expenses and other current liabilities

5,646

6,756

Equipment financing obligation

59

57

Finance lease liabilities

1,117

1,052

Operating lease liabilities

318

304

Senior Convertible Notes at fair value, current portion

12,734

2,125

Subordinated Convertible Notes at fair value

14,551

Total current liabilities

38,957

14,341

Equipment financing obligation, net of current portion

113

129

Finance lease liabilities, net of current portion

2,256

2,009

Operating lease liabilities, net of current portion

5,134

5,221

Senior Convertible Notes at fair value, net of current portion

12,152

Subordinated Convertible Notes at fair value

18,320

Earnout and warrant liability

168

716

Total liabilities

46,628

52,888

Commitments and contingencies

Redeemable convertible preferred stock:

Redeemable Convertible Series A Preferred Stock, $0.0001 par value, stated value $1,000; 25,000 shares designated at March 31, 2024 and December 31, 2023; 9,436 shares issued and outstanding at March 31, 2024 and December 31, 2023; liquidation preference of $14,154 at March 31, 2024 and December 31, 2023

11,555

11,555

Stockholders’ deficit:

Preferred stock, $0.0001 par value, 1,500,000 shares authorized at March 31, 2024 and December 31, 2023; no shares issued or outstanding

Common Stock, $0.0001 par value, 150,000,000 shares authorized at March 31, 2024 and December 31, 2023; 17,394,064 and 17,388,599 shares issued and outstanding at March 31, 2024 and December 31, 2023, respectively

2

2

Additional paid-in capital

197,142

196,731

Accumulated deficit

(231,448)

(234,889)

Total stockholders’ deficit

(34,304)

(38,156)

Total liabilities, redeemable convertible preferred stock and stockholders’ deficit

$

23,879

$

26,287

See accompanying notes to unaudited condensed consolidated financial statements.

1

Table of Contents

PROSOMNUS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

(In thousands, except per share data)

Three Months Ended March 31,

    

2024

    

2023

Revenue

$

7,458

$

5,808

Operating expenses:

Cost of revenue

3,833

2,756

Sales and marketing

1,976

2,824

General and administrative

2,485

3,353

Research and development

955

1,019

Total operating expenses

9,249

9,952

Net loss from operations

(1,791)

(4,144)

Other income (expense)

Interest expense, net

(1,146)

(1,172)

Change in fair value of earnout liability

490

1,500

Change in fair value of debt

5,885

(1,827)

Change in fair value of warrant liability

58

(843)

Other expense, net

(55)

(406)

Total other income (expense), net

5,232

(2,748)

Net income (loss)

$

3,441

$

(6,892)

Net income (loss) per share attributable to common stockholders

Basic

$

0.20

$

(0.43)

Diluted

$

(0.02)

$

(0.43)

Weighted average shares of Common Stock used in per share calculation:

Basic

17,392,983

16,041,464

Diluted

64,618,931

16,041,464

See accompanying notes to unaudited condensed consolidated financial statements.

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PROSOMNUS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK

AND STOCKHOLDERS’ DEFICIT (UNAUDITED)

For the three months ended March 31, 2024

(In thousands, except share data)

Redeemable Convertible

Preferred Stock

Additional

Total

Series A

Common Stock

Paid-In

 

 Accumulated

Stockholders'

    

Shares

    

Amount

    

Shares

    

Amount

    

    

Capital

    

Deficit

    

Deficit

Balance as of December 31, 2023

9,436

$

11,555

17,388,599

$

2

$

196,731

$

(234,889)

$

(38,156)

Issuance of shares, net

5,465

Issuance costs - ProSomnus Inc.

(3)

(3)

Stock-based compensation expense

414

414

Net income

3,441

3,441

Balance as of March 31, 2024

9,436

$

11,555

17,394,064

$

2

$

197,142

$

(231,448)

$

(34,304)

For the three months ended March 31, 2023

(In thousands, except share data)

Redeemable Convertible

Preferred Stock

Additional

Total

Series A

Common Stock

Paid-In

 

 Accumulated

Stockholders'

Shares

    

Amount

    

Shares

    

Amount

    

    

Capital

    

Deficit

    

Deficit

Balance as of December 31, 2022

$

16,041,464

$

2

$

190,299

$

(210,795)

$

(20,494)

Stock-based compensation expense

226

226

Net loss

(6,892)

(6,892)

Balance as of March 31, 2023

$

16,041,464

$

2

$

190,525

$

(217,687)

$

(27,160)

See accompanying notes to unaudited condensed consolidated financial statements.

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PROSOMNUS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(In thousands)

Three Months Ended March 31,

    

2024

    

2023

CASH FLOWS FROM OPERATING ACTIVITIES:

Net income (loss)

$

3,441

$

(6,892)

Adjustments to reconcile net income (loss) to net cash used in operating activities:

Depreciation and amortization

 

226

 

167

Amortization of assets obtained under finance leases

265

180

Amortization of operating right-of-use assets

88

136

Noncash interest

 

572

 

1,101

Allowance for credit losses

 

32

 

139

Stock-based compensation

 

414

 

226

Change in fair value of earnout liability

(490)

(1,500)

Change in fair value of debt

(5,885)

1,827

Change in fair value of warrant liability

 

(58)

 

843

Loss on disposal of property and equipment

 

117

Right-of-use asset impairment

274

Other non-cash operating expense

 

23

 

100

Changes in operating assets and liabilities:

 

Accounts receivable

 

(532)

 

41

Inventory

 

16

 

(118)

Prepaid expenses and other current assets

 

258

 

276

Other assets

 

(194)

 

Accounts payable

 

485

 

(792)

Accrued expenses and other current liabilities

 

(1,110)

 

708

Operating lease liabilities

(73)

75

Net cash used in operating activities

 

(2,522)

 

(3,092)

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

Purchases of property and equipment

 

(34)

 

(975)

Net cash used in investing activities

 

(34)

 

(975)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

Principal payments on finance lease obligations

 

(316)

 

(274)

Principal payments on equipment financing obligation

(14)

(15)

Net cash used in financing activities

 

(330)

 

(289)

Net change in cash and restricted cash

 

(2,886)

 

(4,356)

Cash and restricted cash at beginning of period

 

7,063

 

15,916

Cash and restricted cash at end of period

$

4,177

$

11,560

Supplemental disclosure of cash flow information:

 

 

Cash paid for interest

$

457

$

Supplemental disclosure of noncash investing and financing activities:

 

 

ROU assets obtained in exchange for finance lease obligations

$

628

$

See accompanying notes to unaudited condensed consolidated financial statements.

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PROSOMNUS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 1 — DESCRIPTION OF THE BUSINESS

Company Organization

ProSomnus, Inc., and its wholly owned subsidiaries, ProSomnus Holdings, Inc. and ProSomnus Sleep Technologies, Inc. (collectively, the “Company”) is an innovative medical technology company that develops, manufactures, and markets its proprietary line of precision intraoral medical devices for treating and managing patients with obstructive sleep apnea (“OSA”).

The Company is located in Pleasanton, California and was incorporated as a Delaware company on May 3, 2022.  Its accounting predecessor company, ProSomnus Sleep Technologies, Inc. was incorporated as a Delaware company on March 2, 2016.

On December 6, 2022, Lakeshore Acquisition I Corp. (“Lakeshore”) consummated a series of transactions that resulted in the combination (the “Business Combination”) of Lakeshore with ProSomnus Holdings, Inc. and its wholly-owned subsidiary, ProSomnus Sleep Technologies, Inc., pursuant to an Agreement and Plan of Merger, dated May 9, 2022. Pursuant to the Merger Agreement, Lakeshore merged with and into ProSomnus Holdings, and changed its name to ProSomnus, Inc.

The transaction was accounted for as a reverse recapitalization with ProSomnus Sleep Technologies, Inc. being the accounting acquirer and Lakeshore as the acquired Company for accounting purposes. Accordingly, all historical financial information presented in the consolidated financial statements represents the accounts of  ProSomnus Sleep Technologies, Inc.

NOTE 2 — BASIS OF ACCOUNTING AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements were prepared in accordance with generally accepted accounting principles in the United States of America (“U.S GAAP”). Certain information and footnote disclosures required for annual financial statements have been condensed or excluded in accordance with SEC rules and regulations and GAAP applicable to interim unaudited financial statements. Accordingly, the condensed consolidated financial statements do not include all of the information and footnotes required by GAAP for audited annual financial statements. In the opinion of management, the condensed consolidated financial statements reflect all adjustments of a normal and recurring nature that are considered necessary for a fair presentation of the results for the interim periods presented. These unaudited condensed consolidated financial statements and the accompanying notes should be read in conjunction with the audited consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2023 filed with the SEC on March 27, 2024.

The results of operations for the three months ended March 31, 2024 are not necessarily indicative of the results to be expected for the year ending December 31, 2024 or any future periods. The condensed consolidated balance sheet as of December 31, 2023 has been derived from audited financial statements at that date but does not include all of the information required by GAAP for complete financial statements.  

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Intercompany balances and transactions have been eliminated in consolidation.

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Liquidity and Management’s Plans

The Company has incurred recurring losses from operations and recurring negative cash flows from operating activities. The Company expects operating losses and negative cash flows from operations to continue for the foreseeable future. 

As discussed further in Note 14- Subsequent Events, on May 7, 2024 (the “Petition Date”), the Company voluntarily entered into a Restructuring Support Agreement (including all exhibits thereto, collectively, the “RSA”) with (i) certain of its existing affiliates and subsidiaries (as set forth in the RSA, and together with the Company, the “Company Parties”); and (ii) certain sponsoring Senior Noteholders and Subordinated Noteholders (the “Sponsoring Noteholders”). The Company commenced a voluntary petition (the “Chapter 11 Cases”) under Chapter 11 of the U.S. Bankruptcy Code (the “Bankruptcy Code”) in the U.S. Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”).

Pursuant to Section 362 of the Bankruptcy Code, the filing of the Chapter 11 Cases automatically stayed most actions against the Company, including actions to collect indebtedness incurred prior to the Petition Date or to exercise control over the Company property. Subject to certain exceptions under the Bankruptcy Code, the filing of the Company Chapter 11 Cases also automatically stayed the filing of most legal proceedings and other actions against or on behalf of the Company or their property to recover on, collect or secure a claim arising prior to the Petition Date or to exercise control over property of the Company bankruptcy estates, unless and until the Court modifies or lifts the automatic stay as to any such claim.

In accordance with ASC Subtopic 205-40, Presentation of Financial Statements-Going Concern (“ASC 205-40”), the Company has the responsibility to evaluate whether conditions and/or events raise substantial doubt about our ability to meet our obligations as they become due within one year after the date that the financial statements are issued. Management considered the Company’s current financial condition and liquidity sources, including cash and managed accessibility, forecasted future cash flows and the Company’s obligations due one year from the issuance date of the financial statements. As a result of the Chapter 11 Cases, the realization of assets and the satisfaction of liabilities are subject to significant uncertainty. While operating as a debtor-in-possession entity pursuant to the Bankruptcy Code, the Company may sell, or otherwise dispose of or liquidate, assets or settle liabilities, subject to the approval of the Bankruptcy Court or as otherwise permitted in the ordinary course of business, for amounts other than those reflected in the accompanying unaudited Interim Consolidated Financial Statements. Further, the Chapter 11 plan is likely to materially change the amounts and classifications of assets and liabilities reported in our unaudited Interim Condensed Consolidated Balance Sheet as of March 31, 2024 and going forward. In performing this evaluation, management concluded that under the standards of ASC 205-40, substantial doubt exists about the Company’s ability to continue as a going concern due to the risks and uncertainties surrounding the Chapter 11 Cases, the defaults under the Company’s debt agreements and the Company’s financial condition. The Company’s future plans, including those in connection with the Chapter 11 Cases, are not yet finalized, fully executed or approved by the Bankruptcy Court, and therefore cannot be deemed probable of mitigating this substantial doubt within 12 months of the date of issuance of these financial statements. The Company’s condensed consolidated financial statements included herein do not include any adjustments related to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern and instead have been prepared assuming that the Company will continue as a going concern and contemplating the realization of assets and the satisfaction of the Company’s liabilities and commitments incurred in the normal course of business.

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. GAAP assuming that the Company will continue as a going concern. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result should the Company be unable to continue as a going concern.

Management’s Plans Related to Going Concern

The Company’s ability to continue as a going concern depends principally on its ability to successfully exit the Chapter 11 Cases, including the completion of the financings proposed within the RSA. Upon the successful exit from the Chapter 11 Cases, the Company’s ability to continue as a going concern will depend upon its ability to execute on its plans to achieve revenue growth forecast, control operating costs, and obtain additional financing. The Company’s successful exit from the Chapter 11 Cases, the outcome of such exit, and the Company’s post exit operating plans are subject to many factors currently unknown and there can be no assurance that the current operating plan or cash flow break-even plan will be achieved in the time frame anticipated by the Company.

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The Company has entered into a RSA with certain of its Sponsoring Noteholders.  The material terms include an aggregate of $20.0 million of potential capital to the Company, including through a debtor-in-possession credit facility and potential new-money equity. The Sponsoring Noteholders have committed to provide an $13.0 million credit facility, of which $6.5 million has been provided, and to consummate a new-money equity capital raise in an amount of at least $9.0 million to be funded upon exit from the Chapter 11 Cases.

Although the Company intends to pursue the RSA in accordance with the stated terms; there can be no assurance that the Company will be successful in completing the Restructuring, whether on the same or different terms than those provided in the RSA.

In addition to the Chapter 11 Cases, based on the Company’s current level of expenditures and future cash flow projections, the Company believes it’s current unrestricted cash balance will not be sufficient for the Company to continue operations as a going concern for at least one year from the issuance date of these condensed consolidated financial statements. Additionally, the indentures governing the Company’s Senior Convertible Notes and Subordinated Convertible Notes (as defined below and, collectively the “Convertible Notes”) contain monthly and quarterly financial covenants. Failure to comply with the covenants or obtain a waiver and extension from the holders of each series of our Convertible Notes could result in an event of default under each of the indentures governing our Convertible Notes and result in an acceleration of the Convertible Notes. The Company believes these factors raise substantial doubt about its ability to continue as a going concern.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and disclosure of contingent assets and liabilities. Though macroeconomic factors such as inflation, exchange rate fluctuations and concerns about an economic downturn present additional uncertainty, the Company continues to use the best information available to form its critical accounting estimates. Actual results could differ from these estimates, and such differences could materially affect the results of operations reported in future periods. The Company’s significant estimates in these consolidated financial statements relate to the fair values, and the underlying assumptions used to formulate such fair values, of its Series A Preferred Stock, Convertible Notes, earn-out liability, and warrants. Estimates also include the provision for credit losses, warranty and earned discount accruals, measurements of tax assets and liabilities and stock-based compensation.

Concentrations, Credit Risk and Market Risk

Financial instruments that potentially subject the Company to a concentration of credit risk principally consist of accounts receivable and cash.

The Company sells its products to customers primarily in North America and Europe. To reduce credit risk, management performs periodic credit evaluations of its customers’ financial condition. No customers exceeded more than 10% of the Company’s revenue or accounts receivables as of and for the three months ended March 31, 2024 and December 31, 2023.

The Company maintains its cash in bank accounts which, at times, may exceed federally insured limits as guaranteed by the Federal Deposit Insurance Corporation (“FDIC”). As of March 31, 2024 and December 31, 2023, the Company had $3.9 million and $6.8 million in excess of the FDIC insured limit, respectively. The Company’s investment policy, which is predicated on capital preservation and liquidity, limits investments to instruments denominated and payable in US dollars. The Company believes its credit risk is mitigated due to the high quality of the banks in which it places its deposits. Historically, the Company has not experienced significant credit losses from financial instruments.

Fair Value of Financial Instruments

The accounting standard for fair value measurements provides a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. Fair value is defined as the price that would be received for an asset or the exit price that would be paid to transfer a liability in the principal or most advantageous market in an orderly transaction between market participants on the measurement date.

This accounting standard establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs, where available. The following summarizes the three levels of inputs that may be used to measure fair value:

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Level 1 Inputs — The valuation is based on quoted prices in active markets for identical instrument.

Level 2 Inputs — The valuation is based on observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model — based valuation techniques for which all significant assumptions are observable in the market.

Level 3 Inputs — The valuation is based on unobservable inputs that are supported by minimal or no market activity and that are significant to the fair value of the instrument. Level 3 valuations are typically performed using pricing models, discounted cash flow methodologies, or similar techniques that incorporate management’s own estimates of assumptions that market participants would use in pricing the instrument, or valuations that require significant management judgment or estimation.

Changes in fair value measurements categorized within Level 3 of the fair value hierarchy are analyzed each period based on changes in estimates or assumptions and recorded as appropriate.

The Company’s financial instruments consist primarily of cash, accounts receivable (net of allowance for doubtful accounts), accounts payable and accrued expenses, long-term debt instruments, earnout and warrant liabilities.

The carrying amounts of financial instruments such as cash, restricted cash, accounts receivable, prepaid expenses and other current assets, accounts payable, and accrued expenses approximate the related fair values due to the short-term maturities of these instruments. The carrying value of the Company’s equipment financing obligation is considered to approximate its fair value because the interest rate is comparable to current rates for financing available to the Company. Under the fair value option as prescribed by FASB Accounting Standards Codification (“ASC”) 825, Financial Instruments, The Company has elected to record the Company’s convertible debt instruments at fair value. The Company’s earnout and warrant liabilities are presented at fair value on the condensed consolidated balance sheets.

The following tables provide a summary of the financial instruments that are measured at fair value on a recurring basis (in thousands):

    

March 31, 2024

    

Fair Value

    

Level 1

    

Level 2

    

Level 3

Senior Convertible Notes

$

12,734

$

$

$

12,734

Subordinated Convertible Notes

14,551

14,551

Earnout liability

130

130

Warrant liability

38

38

    

December 31, 2023

    

Fair Value

    

Level 1

    

Level 2

    

Level 3

Senior Convertible Notes

$

14,277

$

$

$

14,277

Subordinated Convertible Notes

18,320

18,320

Earnout liability

620

620

Warrant liability

96

96

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

Cash and Cash Equivalents

The Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash and cash equivalents. At March 31, 2024 and December 31, 2023, the Company had no cash equivalents.

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Restricted Cash

The Company’s restricted cash as of March 31, 2024 and December 31, 2023 of $0.7 million consisted of a letter of credit on hand with the Company's financial institution as collateral for an office lease.

Impairment of Long-Lived Assets

The Company’s long-lived assets primarily include property and equipment and finance and operating right-of-use assets. The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured at the amount by which the carrying amount of the asset exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of carrying amount or the fair value less costs to sell. During 2023, the Company moved to its new headquarters and principal manufacturing facility. Upon moving, the Company expensed a total of $0.3 million relating to the carrying value of the remaining leasehold improvements and amounts due under the remaining lease term of the previous facility. The right-of-use asset and leasehold improvements charge was recorded in other expense, net in the consolidated statements of operations for the year ended December 31, 2023. 

Senior and Subordinated Convertible Notes

The Company accounts for its Notes, as derivatives in accordance with, ASC 815, Derivatives and Hedging, depending on the nature of the derivative instrument. ASC 815 requires each contract that is not a derivative in its entirety be assessed to determine whether it contains embedded derivatives that are required to be bifurcated and accounted for as a derivative financial instrument. The embedded derivative is bifurcated from the host contract and accounted for as a freestanding derivative if the combined instrument is not accounted for in its entirety at fair value with changes in fair value recorded in earnings, the terms of the embedded derivative are not clearly and closely related to the economic characteristics of the host contract, and a separate instrument with the same terms as the embedded derivative would qualify as a derivative instrument. Embedded derivatives are measured at fair value and remeasured at each subsequent reporting period, and recorded within Convertible Notes, net on the accompanying condensed consolidated balance sheets and changes in fair value recorded in other expense within the condensed consolidated statements of operations. Debt discounts under these arrangements are amortized to interest expense using the interest method over the earlier of the term of the related debt or their earliest date of redemption.

The Company has analyzed the redemption, conversion, settlement, and other derivative instrument features of its Convertible Notes.

The Company identified that the (i) redemption features, (ii) Lender’s Optional Conversion feature, (iii) Lender’s Optional Conversion upon Merger Event feature and (iv) additional interest rate upon certain events feature meet the definition of a derivative. The Company analyzed the scope exception for all the above features under ASC 815-10-15-74(a).
Based on the further analysis, the Company identified that the (i) Lender’s Optional Conversion feature, (ii) Lender’s Optional Conversion upon Merger Event feature and (iii) additional interest rate upon certain events feature, do not meet the settlement criteria to be considered indexed to equity. The Company concluded that each of these features should be classified as a derivative liability measured at fair value with the changes in fair value in the condensed consolidated statement of operations.
The Company also identified that the redemption features are settled in cash and do not meet the indexed to equity and the equity classification scope exception, thus, they must be bifurcated from the Convertible Notes and accounted for separately at fair value on a recurring basis reflecting the changes in fair value in the condensed consolidated statement of operations.

The Company determined the Convertible Notes contained multiple embedded derivatives that are required to be bifurcated, two of which are conversion features.

As per ASC 815, the fair value election is allowable provided the debt was not issued at a substantial premium. The Company concluded that the Convertible Notes were not issued at a premium and hence the Company elected the fair value option under ASC 815-15-25. The Company elected to record changes in fair value through the condensed consolidated statement of operations as a fair

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value adjustment of the convertible debt at each reporting period (with the portion of the change that results from a change in the instrument-specific credit risk recorded separately in other comprehensive income, if applicable). The Company has elected to separately present interest expense related to the Convertible Notes within the condensed consolidated statement of operations. Thus, the multiple embedded derivatives do not need to be separately bifurcated and fair valued. The Convertible Notes are reflected at their respective fair values on the condensed consolidated balance sheets.

Warrants

The Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in ASC 480, Distinguishing Liabilities from Equity (“ASC 480”) and ASC 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to the Company’s own Common Stock, par value $0.0001 (“Common Stock”), among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent reporting period end date while the warrants are outstanding.

For issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and then remeasured at fair value at each balance sheet date thereafter. Changes in the estimated fair value of the liability classified warrants are recognized as other income or expense on the condensed consolidated statements of operations.

Revenue Recognition

The Company creates customized precision milled intraoral medical devices and recognizes revenue upon meeting the following criteria:

Identifying the contract with a customer: Customers submit an order in the form of a prescription and oral scan to the Company.
Identifying the performance obligations within the contract: The sole performance obligation is the delivery of a completed customized intraoral device.
Determining the transaction price: Prices are determined by standardized pricing sheets and adjusted for discounts, allowances and remakes.
Allocating the transaction price to the performance obligations: The full transaction price is allocated to the completed intraoral device as it is the only element in the transaction.
Recognizing revenue as the performance obligation is satisfied at a point in time: revenue is recognized upon transfer of control which occurs upon shipment of the product.

The Company does not require collateral or any other form of security from customers. Inbound shipping and handling costs related to sales are billed to customers. The Company charges for inbound shipping/handling and the costs are classified as Cost of Revenue. Outbound shipping costs are not billed to customers and are included in sales and marketing expenses. Taxes collected from customers and remitted to governmental authorities are excluded from revenue.

Standalone selling price for the various intraoral device models are determined using the Company’s standard pricing sheet. The Company invoices customers upon shipment of the product and invoices are due within 30 days. Amounts that have been invoiced are

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recorded in accounts receivable and revenue as all revenue recognition criteria have been met. The Company does not have a financing component related to its revenue arrangements.

The Company utilizes the practical expedient which permits expensing of costs to obtain a contract when the expected amortization period is one year or less. Accordingly, the Company expenses employee sales commissions when incurred as the period over which the sales commission asset that would have been recognized is less than one year.

Leases

The Company assesses at contract inception whether a contract is, or contains, a lease. Generally, the Company determines that a lease exists when (1) the contract involves the use of a distinct identified asset, (2) the Company obtains the right to substantially all economic benefits from use of the asset, and (3) the Company has the right to direct the use of the asset. A lease is classified as a finance lease when one or more of the following criteria are met: (1) the lease transfers ownership of the asset by the end of the lease term, (2) the lease contains an option to purchase the asset that is reasonably certain to be exercised, (3) the lease term is for a major part of the remaining useful life of the asset, (4) the present value of the lease payments equals or exceeds substantially all of the fair value of the asset or (5) the asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. A lease is classified as an operating lease if it does not meet any of these criteria.

At the lease commencement date, the Company recognizes a right-of-use (“ROU”) asset and a lease liability for all leases, except short term leases with an original term of twelve months or less. The ROU asset represents the right to use the leased asset for the lease term. The lease liability represents the present value of the lease payments under the lease. The ROU asset is initially measured at cost, which primarily comprises the initial amount of the lease liability, less any lease incentives received. All ROU assets are periodically reviewed for impairment in accordance with standards that apply to long-lived assets. The lease liability is initially measured at the present value of the lease payments, discounted using an estimate of the Company’s incremental borrowing rate for a collateralized loan with the same term as the underlying leases for operating leases and the implied rate in the lease agreement for finance leases.

Lease payments included in the measurement of lease liabilities consist of (1) fixed lease payments for the noncancelable lease term, (2) fixed lease payments for optional renewal periods where it is reasonably certain the renewal option will be exercised, and (3) variable lease payments that depend on an underlying index or rate, based on the index or rate in effect at lease commencement. The Company’s real estate operating lease agreement requires variable lease payments that do not depend on an underlying index or rate established at lease commencement. Such payments and changes in payments are recognized in operating expenses when incurred.

Lease expense for operating leases consists of the fixed lease payments recognized on a straight-line basis over the lease term plus variable lease payments as incurred. Lease expense for finance leases consists of the amortization of assets obtained under finance leases on a straight-line basis over the lease term and interest expense on the lease liability based on the discount rate at lease commencement.

Net income (Loss) per Share Attributable to Common Stockholders

Basic net income (loss) per share attributable to Common Stockholders is calculated by dividing the net income (loss) attributable to Common Stockholders by the weighted average number of shares of Common Stock outstanding during the period, without consideration of potentially dilutive securities.

Diluted net income (loss) per share is computed by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock and potentially dilutive securities outstanding for the period. For the purposes of the diluted net income (loss) per share calculation, common stock options, RSU awards, Convertible Series A Preferred Stock, warrants to purchase common stock, earnout shares, and convertible notes are considered to be potentially dilutive securities. For the periods presented that the Company has reported a net loss, diluted net loss per common share is the same as basic net loss per common share for those periods.

Recent Accounting Pronouncements

During November 2023, the FASB issued ASU 2023-07, Segment Reporting-Improvements to Reportable Segment Disclosures. The new FASB guidance requires incremental disclosures related to a public entity’s reportable segments but does not change the

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definition of a segment, the method for determining segments, or the criteria for aggregating operating segments into reportable segments. The FASB issued the new guidance primarily to provide financial statements users with more disaggregated expense information about a public entity’s reportable segments. The ASU is effective for public entities for fiscal years beginning after December 15, 2023, and interim periods in fiscal years beginning after December 15, 2024. The guidance is effective for the Company’s 2024 Form 10-K. The Company is currently evaluating the impact of adoption on the Company’s consolidated financial statements and its related disclosures.

In December 2023, the FASB released ASU 2023-09, titled "Enhancements to Income Tax Disclosures," with the aim of improving the clarity and usefulness of income tax disclosures. The update focuses primarily on enhancing disclosures related to rate reconciliation and income taxes paid. ASU 2023-09 becomes effective for annual reporting periods starting after December 15, 2024, with early adoption permitted. While the changes prescribed by ASU 2023-09 are implemented prospectively, retrospective application is also allowed. The Company has chosen not to early adopt this standard and is currently evaluating the impact of adoption on the Company’s consolidated financial statements and its related disclosures.

The Company continues to monitor new accounting pronouncements issued by the FASB and does not believe any other accounting pronouncements issued through the date of this report will have a material impact on the Company's consolidated financial statements. 

NOTE 3 — INVENTORY

Inventory consists of the following (in thousands):

March 31,

December 31,

    

2024

    

2023

Raw materials

$

1,861

$

1,967

Work-in-process

 

162

 

72

$

2,023

$

2,039

 

NOTE 4 — PROPERTY AND EQUIPMENT

Property and equipment consist of the following (in thousands):

March 31,

December 31,

    

2024

    

2023

Manufacturing equipment

$

4,042

$

4,042

Computers and software

 

1,213

 

1,200

Construction in progress

20

Leasehold improvements

 

846

 

846

 

6,121

 

6,088

Less: accumulated depreciation

 

(2,955)

 

(2,730)

Property and equipment, net

$

3,166

$

3,358

Depreciation and amortization expense for property and equipment was $0.2 million for both the three months ended March 31, 2024 and 2023, respectively.

The Company disposed property and equipment assets of $0.7 million which had an accumulated depreciation of $0.6 million during the three months ended March 31, 2023. The resulting $0.1 million loss on disposal is reflected in the condensed consolidated statement of operations as other expense.

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NOTE 5 — ACCRUED EXPENSES

Accrued expenses consist of the following (in thousands):

March 31,

December 31,

    

2024

    

2023

Compensation related accruals

$

2,397

$

3,387

Marketing programs

1,293

934

Interest

695

382

Warranty

465

465

Professional fees

635

632

Inventory purchases and freight

613

Other

161

343

$

5,646

$

6,756

NOTE 6 — LEASES

The Company has entered into four equipment leases during the three months ended March 31, 2024, which have been classified as finance leases. The lease terms for these leases range from three to five years, with a total monthly lease payment of approximately $28.0 thousand. As of March 31, 2024, the Company has recorded the right-of-use (ROU) assets and lease liability for these leases, with an aggregate amount of $0.6 million.

On May 17, 2022, the Company signed a ten-year lease for the Company’s corporate headquarters. The lease commenced on December 15, 2022 and resulted in the recognition of $5.4 million of operating ROU asset and lease liability. The monthly payment is approximately $0.1 million and is subject to stated annual escalations. The Company received five months free rent.

For the corporate headquarters lease, the Company provided a $0.3 million security deposit, which is recorded in other assets on the accompanying condensed consolidated balance sheets. The Company's largest investor initially guaranteed $1.7 million for the lease agreement, followed by a rolling one-year guarantee. The Company replaced the guarantee with a letter of credit of $0.7 million secured by a certificate of a deposit for the same amount that is recorded as restricted cash on the accompanying condensed consolidated balance sheet. On February 28, 2023, the Company vacated its previous corporate office premises with a remaining lease term of approximately ten months. Since there was no new cash inflow generated or expected from the sale or sublease of property and leasehold improvements at the location, the Company recorded an impairment loss on the ROU operating lease assets and leasehold improvements of $0.3 million and $0.1 million, respectively. The Company also accrued liabilities of $0.1 million in anticipation of expected common area maintenance payments on the remainder of the lease. The impairment loss and the accrued expenses are reflected as other expense in the consolidated statements of operations as of December 31, 2023. No such impairment loss and the accrued expenses are recorded in the condensed consolidated statements of operations for the three months ended March 31, 2024.

The Company’s finance leases consist of various machinery, equipment, computer-related equipment, or software and have remaining terms from less than one year to five years.

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The components of the Company’s lease cost, weighted average lease terms and discount rates are presented in the tables below (in thousands, except lease term and discount rate):

    

Three months ended March 31,

2024

    

2023

Operating lease expense:

 

  

 

  

Operating lease cost

$

223

$

265

Finance lease expense:

 

 

Amortization of assets obtained under finance leases

265

180

Interest on lease liabilities

90

78

Variable lease expense

3

Total expense

$

581

$

523

March 31,

December 31,

Operating leases:

2024

 

2023

Weighted average remaining lease term (in years)

8.75

9.0

Weighted average discount rate

10.00

%

10.00

%

Finance leases:

Weighted average remaining lease term (in years)

3.12

3.0

Weighted average discount rate

10.48

%

10.21

%

    

Three Months Ended March 31,

2024

 

2023

Supplemental cash flow information related to operating leases was as follows (in thousands):

 

  

  

Operating cash flows from operating leases

$

209

$

47

Operating cash flows from finance leases (interest)

79

81

Right-of-use assets consisted of the following (in thousands):

March 31,

December 31,

2024

 

2023

Manufacturing equipment

    

$

5,866

$

5,237

Computers and software

686

700

Leasehold improvements

 

218

 

218

Total

 

6,770

 

6,155

Less accumulated amortization

 

(3,167)

 

(2,890)

ROU assets for finance leases

 

3,603

 

3,265

ROU assets for operating leases

 

4,981

 

5,069

Total ROU assets

$

8,584

$

8,334

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At March 31, 2024, the following table presents maturities of the Company’s finance and operating lease liabilities (in thousands):

Three Months Ended March 31, 2024

    

Finance

Operating

2024 (remaining 9 months)

$

1,071

$

628

2025

1,286

861

2026

983

887

2027

 

430

914

2028

168

 

941

Thereafter

14

4,056

Total minimum lease payments

3,952

 

8,287

Less amount representing interest

(579)

 

(2,835)

Present value of minimum lease payments

3,373

 

5,452

Less current portion

(1,117)

 

(318)

Lease obligations, less current portion

$

2,256

$

5,134

NOTE 7 — DEBT

Equipment Financing Obligation

At March 31, 2024, the Company’s future principal maturities under the equipment financing obligations are summarized as follows (in thousands):

Three Months Ended March 31, 2024

    

Amount

2024 (remaining 9 months)

$

43

2025

64

2026

65

Total principal maturities

172

Less: current portion

(59)

Equipment financing obligation, net of current portion

$

113

Convertible Debt Agreements

Senior Convertible Notes

On December 6, 2022, the Company entered into the Indenture for Senior Secured Convertible Notes due December 6, 2025, dated December 6, 2022 by and among the Company, ProSomnus Holdings and ProSomnus Sleep Technologies, as guarantors, and Wilmington Trust, National Association, as trustee and collateral agent (as amended, the “Senior Indenture”), and issued Senior Secured Convertible Notes, due December 6, 2025 (the “Existing Senior Convertible Notes”), with an aggregate principal amount of $17.0 million, pursuant to the senior securities purchase agreement, dated August 26, 2022. In connection with the closing of the offering of the Existing Senior Convertible Notes, the Company issued 36,469 shares of Common Stock and 169,597 warrants (the “Existing Senior Convertible Notes Warrants”) to purchase Common Stock. The Existing Senior Convertible Notes Warrants entitle the note holders to purchase shares of Common Stock, subject to adjustment, at a purchase price per share of $11.50. The debt bears interest at 9% per annum. Interest is payable in cash quarterly.

On June 29, 2023, the Company entered into the First Supplemental Indenture, dated as of June 29, 2023, by and among the Company, ProSomnus Holdings and ProSomnus Sleep Technologies, as guarantors, and Wilmington Trust, National Association (the “First Senior Supplemental Indenture”). The First Senior Supplemental Indenture, among other things, (i) effects certain changes to the minimum EBITDA and minimum revenue financial covenants (ii) requires mandatory redemption of the Existing Senior Convertible Notes in consecutive quarterly installments equal to $0.8 million in the aggregate on January 1, April 1, July 1 and October 1 of each year, commencing October 1, 2024, until the earlier of the maturity date of the Existing Senior Convertible Notes or the date the Existing Senior Convertible Notes are no longer outstanding, and (iii) corrects an error in the definition of Conversion Rate.

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On September 20, 2023, the Company entered into the Second Supplemental Indenture (the “Second Senior Supplemental Indenture”) to the Senior Indenture, by and among the Company, ProSomnus Holdings and ProSomnus Sleep Technologies, as guarantors, and Wilmington Trust, National Association, as trustee and collateral agent. The Second Senior Supplemental Indenture amends the Senior Indenture to, among other things, permit the sale of the securities underlying the convertible debt (the “Securities”) and the Exchanges.

Subordinated Convertible Notes

On December 6, 2022, the Company entered into that certain Indenture for Subordinated Secured Convertible Notes due April 6, 2026, dated December 6, 2022 by and among the Company, ProSomnus Holdings and ProSomnus Sleep Technologies, as guarantors, and Wilmington Trust, National Association, as trustee and collateral agent (as amended, the “Subordinated Indenture”), and issued the Subordinated Secured Convertible Notes due April 6, 2026 (“Existing Subordinated Convertible Notes” and, together with the Existing Senior Convertible Notes, the “Existing Convertible Notes”), with an aggregate principal amount of approximately $17.5 million, pursuant to the previously disclosed Subordinated Securities Purchase Agreement, dated August 26, 2022. In connection with the closing of the offering, the Company issued 290,244 shares of Common Stock and 1,745,310 warrants (“Subordinated Convertible Notes Warrants”  and, together with the Senior Convertible Notes Warrants, the “Convertible Notes Warrants”) to purchase Common Stock to certain Convertible Debt holders. The debt has an interest rate of Prime Rate plus an additional 9% per annum with a term of 3 years. Interest is due quarterly in cash or in kind at the option of the Company.  

On June 6, 2023, in accordance with the Subordinated Indenture, the conversion rate of the Subordinated Convertible Notes increased from approximately 86.95665 shares of common stock per $1,000 of the sum of the principal amount of the Subordinated Convertible Notes to approximately 192.3808 shares of common stock per $1,000 of the sum of the principal amount of the Subordinated Convertible Notes.

On June 29, 2023, the Company entered into the First Supplemental Indenture, dated as of June 29, 2023, by and among the Company, ProSomnus Holdings and ProSomnus Sleep Technologies, as guarantors, and Wilmington Trust, National Association (the "First Subordinated Supplemental Indenture”), which, among other things, (i) effects certain changes to the minimum EBITDA and minimum revenue financial covenants and (ii) corrects an error in the definition of Conversion Rate.

On September 8, 2023, the Company issued 230,494 shares of Common Stock in connection with a notice of conversion from a holder of the Company’s Subordinated Convertible Notes, pursuant to which such holder irrevocably exercised its right to convert $1.0 million principal amount. The Company recorded the fair value of the principal amount and accrued interest converted of $0.9 million as Common Stock and additional paid-in capital.

On September 20, 2023, the Company entered into the Second Supplemental Indenture (the “Second Subordinated Supplemental Indenture”) to the Subordinated Indenture, pursuant to which the Company issued the Existing Subordinated Convertible Notes. The Second Subordinated Supplemental Indenture amends the Subordinated Indenture to, among other things, permit the sale of the Securities and the Exchanges.

On December 6, 2023, in accordance with the Subordinated Indenture, the conversion rate of the Subordinated Convertible Notes increased from approximately 192.3808 shares of common stock per $1,000 of the sum of the principal amount of the Subordinated Convertible Notes to approximately 222.22222 shares of common stock per $1,000 of the sum of the principal amount of the Subordinated Convertible Notes.

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Table of Contents

The Convertible Notes include the following embedded features:

Embedded Feature

Nature

Description

Optional redemption – Election of Company

Redemption feature (embedded call option)

At any time after the later of (i) the eighteen-month anniversary of the initial issue date and (ii) the date that the Senior Debt is no longer outstanding, if the daily volume weighted-average price of the Company’s Common Stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days exceeds $18.00, the Company may redeem a portion of or all of the principal amount (including accrued and unpaid interest), plus any liquidated damages and any other amounts due in respect of the Notes redeemable in cash.

Mandatory redemption – Events of Default

Redemption feature (embedded contingent call option)

The Company is required to prepay all of the outstanding principal balance and accrued and unpaid interest upon bankruptcy-related events of default.

Lenders’ Optional redemption – Events of Default

Redemption feature (embedded contingent call option)

Holders of at least 25% aggregate principal amount of the Notes can require the Company to pay all of the outstanding principal balance and accrued and unpaid interest upon any event of default that is not bankruptcy related.

Lender’s Optional Conversion

Conversion feature

At each Lenders’ option, subject to specific conditions, it may convert all or any portion of its Notes at an initial conversion rate, which is reduced (and only reduced) at various dates and subject to certain adjustments to the conversion rate in the case of specified events. If a note is converted, the Company will adjust the conversion rate to account for any accrued and unpaid interest on such note plus any Make-Whole Amount related to such note.

Lenders’ Optional Conversion Upon Merger Event

Other feature

Upon a merger event, Note holders of each $1,000 principal amount of Notes are entitled to convert such notes plus accrued interest, plus the Make-Whole Amount related to the in kind and amount of reference property that a holder of a number of shares of Common Stock equal to the conversion rate in effect immediately prior to such event would have owned or been entitled to receive upon such event.

Additional interest rate upon certain non-credit related events

Other feature

Upon an event of default, additional interest will be incurred. Additional interest will also be incurred if the Notes are not freely tradeable.

Ability to pay interest in kind (PIK Interest)*

Other feature

The Company has the election to pay interest in cash or in-kind.

*The PIK interest feature is only present in the Subordinated Convertible Note, and not available in the Senior Convertible Notes.

The Company assessed the embedded features within these Convertible Note and determined the following:

The Optional Redemption feature (1), the Mandatory redemption feature (2)  and the Lender’s Optional redemption feature (3) met the definition of a derivative and were not clearly and closely related to the host contract and required separate accounting. Further, the redemption features are settled in cash and would therefore not meet the indexed to equity and equity classification scope exception. Thus, these redemption features were concluded to be embedded derivatives that should be bifurcated from the loan and accounted for separately at fair value on a recurring basis.
The Lender’s Optional Conversion feature (4) and the Lender’s Optional Conversion Upon Merger (5) event features also met the definition of a derivative and were not clearly and closely related to the host contract and required separate accounting. The economic characteristics of the Lender’s Optional Conversion feature (4) and the Make Whole premium on Lenders’ Optional Conversion Upon Merger Event (5) were based on fair value of the underlying shares. The settlement amount of the interest make-whole is not indexed to the issuer’s equity but is based on stated interest cash flows. The Lenders Optional Conversion Upon Merger event feature is contingent on merger event. This exercise contingency is allowable as it is not based on market or an observable index. The Company noted that features (4) and (5) did not meet the indexed to equity and equity classification scope exception. Therefore, these conversion features were concluded to be embedded derivatives that should be bifurcated from the loan and accounted for separately at fair value on a recurring basis through the consolidated statements of operations.

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Table of Contents

The additional interest rate upon certain non-credit related events (6) are triggered based on timely filing of financial information and the tradability of the Notes, these are not related to the economic characteristics of debt. Therefore, this feature is not clearly and closely related to the debt host. The additional interest payment is settled in cash and hence did not meet the derivative scope exception. However, since the probability of the Convertibles Notes being freely tradeable or Company’s failure to timely file is estimated to be less than 5%, the Company concluded that the fair value of this feature is not material. Thus, even though this additional interest feature was concluded to be an embedded derivative, it was not fair valued separately.
The ability to pay PIK interest feature is clearly and closely related to the debt, and was not be evaluated separately as a derivative feature.

The Company determined the Notes contained multiple embedded derivatives that are required to be bifurcated, two of which are conversion features. As per ASC 815, if there is a conversion feature that is required to be bifurcated, the cash conversion feature and beneficial conversion feature guidance is not applicable to such conversion feature and the fair value election is allowable provided the debt was not issued at a substantial premium. As the proceeds received at issuance from these Convertible Notes do not exceed the principal amount that will be paid at maturing, there is no substantial premium.

Further, ASC 815-15-25 provides that if an entity has a hybrid financial instrument that would require bifurcation of embedded derivatives under ASC 815, the entity may irrevocably elect to initially and subsequently measure a hybrid financial instrument in its entirety at fair value with changes in fair value recognized in earnings. The Company elected to measure the Senior and Subordinated Convertible Notes in their entirety at fair value with changes in fair value recognized as non-operating gain or loss in the consolidated statements of operations at each balance sheet date in accordance with ASC 815-15-25.

Financing Transaction

On September 20, 2023, the Company entered into a Securities Purchase Agreement (the “Securities Purchase Agreement”, and the transactions contemplated by the Securities Purchase Agreement, the “Financing Transaction”) with certain third-party and related party investors (the “Investors”), pursuant to which the Company issued (i)  an aggregate of 10,426 shares of the Company’s Series A Preferred Stock, par value $0.0001 per share (the “Series A Preferred Stock”), for an aggregate purchase price of $10.4 million at a per share purchase price of $1,000, and (ii) (A) with respect to Investors that held the Existing Convertible Notes, new convertible notes on substantially similar terms to such Noteholder Investor’s Existing Convertible Notes other than that such new notes will be convertible into shares of Common Stock, at a conversion price of $1.00 per share subject to the terms and conditions of the applicable new indenture pursuant to which the applicable series of New Notes have been issued by the Company (the “New Notes”), in exchange for such Noteholder Investor’s portion of the principal amount outstanding of the Existing Convertible Notes (the “Exchanges”) pursuant to exchange agreements entered into between the Company and each of the Noteholder Investors (together, the “Exchange Agreements”) and/or (B) warrants to purchase shares of Common Stock at an exercise price of $1.00 per share (such warrants, the “Transaction Warrants”).  

Fair Value Election

The Company has elected to measure the Convertible Notes, including the New Notes, in their entirety at fair value with changes in fair value recognized as non-operating gain or loss in the condensed consolidated statements of operations (with the portion of the change that results from a change in the instrument-specific credit risk recorded separately in other comprehensive income, if applicable).

The estimated fair values of the convertible debt were determined using a Monte Carlo Simulation method. The Company simulated the stock price using a Geometric Brownian Motion until maturity.  For each simulation path the Company calculated the convertible bond value at maturity and then discount that back to the valuation date. Finally, the value of the convertible bond is determined by averaging the discounted cash flows of all the simulated paths.

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The following assumptions were used as of March 31, 2024 and December 31, 2023:

Monte Carlo Simulation Assumptions

Asset

Risky

Expected

Risk-Free

As of March 31, 2024

Price

Yield

    

Volatility

    

Interest Rate

    

Senior Convertible Notes

$

0.57

29.20

%

65

%

4.73

%

Subordinated Convertible Notes

0.57

38.50

%

70

%

4.59

%

Monte Carlo Simulation Assumptions

Asset

Risky

Expected

Risk-Free

As of December 31, 2023

Price

Yield

    

Volatility

    

Interest Rate

    

Senior Convertible Notes

$

0.98

25.00

%

65

%

4.27

%

Subordinated Convertible Notes

0.98

34.30

%

55

%

4.17

%

The following is a summary of changes in fair value of the Convertible Notes for three months ended March 31, 2024 and 2023 (in thousands):

Senior
Convertible Notes

Subordinated
Convertible Notes

Beginning fair value, December 31, 2023

$

14,277

$

18,320

Paid-in-kind interest

572

Change in fair value of debt

(1,543)

(4,341)

Ending fair value, March 31, 2024

$

12,734

$

14,551

Senior
Convertible Notes

Subordinated
Convertible Notes

Beginning fair value, December 31, 2022

$

13,651

$

10,356

Paid-in-kind interest

724

Change in fair value of debt

827

1,000

Ending fair value, March 31, 2023

$

14,478

$