SWRL U Swirl Inc (CE)

U-Swirl, Inc. was incorporated in the state of Nevada on November 14, 2005. Its wholly-owned subsidiary is U-Swirl International, Inc. (“U-Swirl”), which was incorporated in the state of Nevada on September 4, 2008 (collectively referred to as the “Company”). A former wholly-owned subsidiary, Moxie Consumer Products, LLC (“Moxie”), a Nevada limited liability company which was organized in the state of Nevada on February 11, 2014 was transferred to new ownership in October 2014.

In September 2008, the Company acquired the worldwide rights to the U-Swirl Frozen Yogurt^TM concept. The U-Swirl concept allows guests a broad choice in frozen yogurt by providing an assortment of non-fat and low-fat flavors, including tart, traditional and no sugar-added options and numerous toppings, including seasonal fresh fruit, sauces, candy and granola. Guests serve themselves and pay by the ounce instead of by the cup size.

In January 2013, the Company entered into agreements to acquire Aspen Leaf Yogurt café assets, consisting of leasehold improvements, property and equipment, for six Aspen Leaf Yogurt cafés and the franchise rights to Yogurtini self-serve frozen yogurt chains from Rocky Mountain Chocolate Factory, Inc. (“RMCF”) in exchange for a 60% controlling ownership interest in the Company, a warrant that allows RMCF to maintain its pro rata ownership interest if existing stock options and/or warrants are exercised, and notes payable totaling $900,000 (the “Rocky Mountain Transaction”).

As a result of the change in control occurring in connection with the aforementioned transactions, the Company has been deemed to have been acquired by RMCF. Following the Rocky Mountain Transaction, the Company retained a significant minority interest of the issued and outstanding common stock. Due to the significant minority interest, the fair value increments and decrements have not been included in the accompanying financial statements. As the accounting acquirer, RMCF will consolidate the Company’s results of operations in its financial statements. RMCF trades on the NASDAQ Global Market under the trading symbol “RMCF”.

In October 2013, the Company acquired the franchise rights to nine self-serve frozen yogurt cafés and license agreements to two self-serve frozen yogurt cafés from Josie’s Frozen Yogurt, LLC (“Josie’s”).

In January 2014, the Company entered into business acquisitions with two operators and franchisors of self-serve frozen yogurt cafés, CherryBerry Enterprises, LLC (“CherryBerry”) and Yogli Mogli, LLC (“Yogli Mogli”), thereby adding 182 cafés. CherryBerry and certain affiliates were acquired for approximately $4.25 million in cash and 4,000,000 shares of the Company’s common stock (the “CherryBerry Acquisition”). Yogli Mogli was acquired for $2.15 million in cash and 277,778 shares of the Company’s common stock (the “Yogli Mogli Acquisition”). Subsequent to the transaction date Yogli Mogli did not complete the anticipated funding of the gift card liability. As a result, the Company has not issued any of the Yogli Mogli shares. As described in Note 17 of our 10K filing for the year ended February 28, 2015, the Company does not anticipate that the shares will be issued. As of May 31, 2015 those shares had not been issued and the Company has recorded an assumed liability associated with the gift card liability.

The Company also entered into an asset acquisition with another operator and franchisor of self-serve frozen yogurt cafés, Fuzzy Peach Franchising, LLC (“Fuzzy Peach”), in February 2014, thereby adding 17 cafés. The Company paid $481,000 at closing, plus an earn-out, based upon royalty income generated by Fuzzy Peach cafés over the next twelve months, that could increase the purchase price by up to another $349,000. RMCF provided the funding for these acquisitions through a related party convertible note, which is secured by all of the Company’s assets. As of May 31, 2015 we had recorded a liability of $146,257 in accounts payable and accrued liabilities associated with the Fuzzy Peach earn out obligation.

U-SWIRL, INC.

NOTES TO THE INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2015 

As of May 31, 2015 the Company had the following locations:

Basis of Presentation - The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information and instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all information and footnotes required by GAAP for complete financial statements. These financial statements reflect all adjustments (consisting only of normal recurring entries, except as noted) which, in the opinion of management, are necessary for fair presentation. Operating results for the three months ended May 31, 2015, are not necessarily indicative of operating results that may be expected during any other interim period or the year ending February 29, 2016.

The consolidated balance sheet as of February 28, 2015, included herein was derived from the audited financial statements as of that date, but does not include all disclosures including notes required by GAAP. As such, the information included in this quarterly report on Form 10-Q should be read in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the fiscal year ended February 28, 2015.

Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.  Actual results could differ from those estimates. Significant estimates in the financial statements are in the fair value of the businesses acquired and the fair value of the Convertible Note.

Fair Value Measurements - Authoritative guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date.  The guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions of what market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the reliability of the inputs as follows:

U-SWIRL, INC.

NOTES TO THE INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2015  

Level 1: Quoted prices are available in active markets for identical assets or liabilities;

Level 2: Quoted prices in active markets for similar assets and liabilities that are observable for the asset or liability; or

Level 3: Unobservable pricing inputs that are generally less observable from objective sources, such as discounted cash flow models or valuations.

The Company has consistently applied the valuation techniques discussed below in all periods presented. The following table presents the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis as of May 31, 2015 and February 28, 2015 by level within the fair value hierarchy:

The Company determined the fair value of the Convertible Note using the income valuation technique. Because of the hybrid nature of the Convertible Note, the Company first valued the debt host contract, or straight “bond”, component using a discounted cash flow analysis, and then valued the compound embedded derivative features using a Flexible Monte Carlo simulation. See Note 8 for discussion of the embedded features. Significant inputs to the valuation model include the coupon rate, effective yield, volatility, expected return and implied equity value. In addition, the following inputs were used in the Flexible Monte Carlo simulation to value the compound embedded derivative scenarios using different conversion dates, conversion rates, likelihood of default, conversion behavior and dilution of stock price on conversion.

The Company’s Convertible Note is included in the Level 3 fair value hierarchy because not all the significant inputs are directly or indirectly observable.

The following table summarizes the valuation techniques, models and significant unobservable inputs used for the Company’s Convertible Note (broken into its components), categorized within Level 3 of the fair value hierarchy:

Significant increases (decreases) in the unobservable inputs used in the fair value measurements would result in a significantly lower (higher) fair value measurement.

U-SWIRL, INC.

NOTES TO THE INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2015  

The following table sets forth a reconciliation of changes in the fair value of the Convertible Note classified as Level 3 in the fair value hierarchy:

New Accounting Pronouncements - In May 2014, FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers,” which supersedes the revenue recognition requirements in “Revenue Recognition (Topic 605),” and requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. ASU 2014-09 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017, and is to be applied retrospectively. Early adoption is permitted for years beginning after December 15, 2016. The Company is currently evaluating the new standard.

In August 2014, the FASB issued ASU 2014-15, “Presentation of Financial Statements—Going Concern.” This guidance requires management to evaluate whether there are conditions or events that raise substantial doubt about an entity's ability to continue as a going concern. If such conditions or events exist, disclosures are required that enable users of the financial statements to understand the nature of the conditions or events, management's evaluation of the circumstances and management's plans to mitigate the conditions or events that raise substantial doubt about the entity's ability to continue as a going concern. We will be required to perform an annual assessment of our ability to continue as a going concern when this standard becomes effective for us in the first quarter of our fiscal year ended February 28, 2017. The adoption of this guidance is not expected to impact our financial position, results of operations or cash flows.

Accounts receivable consisted of the following at May 31, 2015 and February 28, 2015:

At February 28, 2015, accounts receivable, other consists primarily of a receivable owed to us by Moxie as a result of our change in management. The receivable consisted of specific customer accounts receivable collected after the change in management and due to the Company as a part of the release of interest in Moxie assets. At May 31, 2015, accounts receivable, other consists primarily of gift cards receivable.

U-SWIRL, INC.

NOTES TO THE INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2015  

As of May 31, 2015 and February 28, 2015, inventory consisted of the following:

Leasehold improvements, property and equipment consisted of the following as of May 31, 2015 and February 28, 2015:

Depreciation expense for the three months ended May 31, 2015 and 2014 was $113,563 and $134,712, respectively.

Intangible assets at May 31, 2015 and February 28, 2015 consist of the following:

Amortization expense related to intangible assets totaled $89,614 and $91,388 during the three months ended May 31, 2015 and 2014, respectively.

U-SWIRL, INC.

NOTES TO THE INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2015  

At May 31, 2015, annual amortization of intangible assets, based upon our existing intangible assets and current useful lives, is estimated to be the following:

The Company deferred franchisee fees, area development agreement fees and rebate income of $627,289 and $805,860 as of May 31, 2015 and February 28, 2015, respectively.

In July 2013, the Company executed promissory notes with RMCF for the purchase and installation of equipment necessary to convert two company-owned cafés into co-branded RMCF and U-Swirl cafés.  Interest accrues on the notes at the rate of 6% per annum, compounded annually and capitalized during the course of construction.  The notes require monthly payments of principal and interest over a five-year period beginning in October 2013.  Payment of the notes is secured by a security interest in all of the equipment purchased with the proceeds of the notes.

On January 16, 2014, the Company entered into a loan and security agreement (the “Loan Agreement”) with RMCF pursuant to which RMCF agreed to loan the Company up to $7,750,000. As of May 31, 2015, the Company had borrowed $8,038,616 under this Loan Agreement and repaid $2,497,529, for a net principal balance of $5,541,087. Interest accrues on the unpaid principal balance of the loan at the rate of 9% per annum, and is included in the principal balance. Principal and interest are due January 16, 2016. The outstanding principal and interest is convertible at prices of $0.90 and $0.45 per share of preferred stock, respectively, subject to adjustments upon the occurrence of certain events. Payment of the loan is secured by a security interest in all of the Company’s assets.

All payments of principal, interest and fees are payable in cash, shares of Series A Convertible Preferred Stock (the “Preferred Stock”), or a combination thereof, at the option of RMCF. The Preferred Stock to be designated will pay cumulative dividends equal to 9% of the stated value of the Preferred Stock, have a liquidation preference, vote with the Company’s common stock on all matters submitted for a vote of holders of common stock, and be convertible at the option of the holder into shares of the Company’s common stock.

The Company may prepay up to $2,100,000 of the outstanding amounts due to RMCF under the Loan Agreement at its option and without penalty in cash from the proceeds raised from (i) advances on rebates from its yogurt suppliers; and (ii) the exercise of outstanding stock options and warrants. The Company also has the option to redeem all of the amounts owed under the Loan Agreement at any time after January 16, 2015 at the rate of 108% of the total amounts owed, by making payment in cash, shares of Preferred Stock, or a combination thereof, at the option of RMCF.

Mandatory prepayment of the loan is required upon the receipt of proceeds from the disposition of any of the Company’s assets, the issuance of any equity securities by the Company (other than upon exercise of outstanding stock options or warrants), the issuance of any debt securities by the Company, or the receipt of insurance proceeds.

In the event of default, RMCF may charge interest on all amounts due under the Loan Agreement at the default rate of 15% per annum, accelerate payment of all amounts due under the Loan Agreement, and foreclose on its security interest.

U-SWIRL, INC.

NOTES TO THE INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2015  

The loan covenants required the Company to maintain consolidated adjusted EBITDA of $1,804,000 for the twelve months ended May 31, 2015. At May 31, 2015 the Company had reported $1,532,000 of adjusted EBITDA. In the event of default, RMCF may charge interest on all amounts due under the loan agreement with the Company at the default rate of 15% per annum, accelerate payment of all amounts due under the Loan Agreement, and foreclose on its security interest. At May 31, 2015 the conversion of the loan into preferred stock as settlement of the obligation would result in approximately 68% more preferred shares issued when compared to the amount issuable if the Company was compliant with the loan covenants.

As discussed in Note 1, the Convertible Note contains a compound embedded derivative related to the conversion feature, equity indexed interest payments, down-round protection default conversion option, default interest and optional redemption feature. The Company records the Convertible Note at fair value.

The unrealized gain of $85,612 during the three months ended May 31, 2015 represents the change in the fair value adjustment of the convertible note’s derivative feature and is included in the accompanying Consolidated Statements of Operations. The fair value adjustment includes interest payable under the Convertible Note.

The Company is required to pay an undrawn commitment fee equal to 0.10% multiplied by the average daily difference between the loan commitment and the aggregate outstanding loan. The undrawn commitment fee is payable in cash or preferred stock at $0.45 per share.

RMCF may convert outstanding principal, or any portion thereof, into shares of preferred stock by dividing the principal to be converted by $0.90 per share. The conversion price is subject to adjustment for traditional recapitalizations. In the event of default, RMCF has the right to convert the Convertible Note into shares of preferred stock at the lessor of $0.45 or the implied equity value, as defined in the loan agreement, multiplied by 3.

RMCF also entered into a management services agreement with the Company for $542,500 which will be due on January 16, 2016 and the expense associated with this service agreement will be expensed until the fee is due. The management fee is convertible into preferred stock at $0.45 per share. The management services agreement is for services to be provided through January 16, 2016. The amount due is included in Notes Payable Related Party.

As of May 31, 2015 and February 28, 2015, the convertible note due to RMCF consisted of the following:

U-SWIRL, INC.

NOTES TO THE INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2015   

As of May 31, 2015 and February 28, 2015, notes payable due to RMCF consisted of the following:

The following table summarizes annual maturities of our notes payable as of May 31, 2015:

During the three months ended May 31, 2015 and 2014, the Company recognized the following franchise royalties and fees:

U-SWIRL, INC.

NOTES TO THE INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2015   

Occupancy and related expenses consist of the following for the three months ended May 31, 2015 and 2014:

During the three months ended May 31, 2015 and 2014 the Company issued 200,000 and 250,000 shares, respectively, of restricted common stock to its non-employee directors for services pursuant to its Non-Employee Director Compensation Program (the “Program”). Stock granted pursuant to the Program is immediately vested on the grant date. During the three months ended May 31, 2015 the Company issued 50,000 shares of restricted common stock to its CEO for director related services. These shares were issued at the same terms as the award for non-employee directors. Associated with these awards the Company has recorded stock-based compensation expense during the three months ended May 31, 2015 and 2014 of $99,500 and $77,500, respectively, representing the estimated fair value on the date of grant.

The fair value of each stock option grant is estimated on the date of grant using a Black-Scholes option pricing model. Options awarded in November 2011 and expensed until vested, in November 2013, were valued using the following assumptions: volatility rate of 123.53% - 125.65%; risk-free interest rate of 0.40% - 1.09% based on a U.S. Treasury rate of 3 years; and a 3-year expected option life (simplified method). The Company did not recognize any expense during the three months ended May 31, 2015 associated with previously awarded restricted stock, compared to $4,845 of expense recognized in the three months ended May 31, 2014.

On June 27, 2007, the stockholders of our Company adopted the 2007 Stock Option Plan which currently permits the granting of options to purchase up to 1,544,002 shares. The 2007 Stock Option Plan will remain in effect until it is terminated by the board of directors except that no incentive stock option will be granted after June 26, 2017. On April 20, 2011, the stockholders of our Company adopted the 2011 Stock Option Plan which permits the granting of options to purchase up to 750,000 shares.

There was no stock option activity during the three months ended May 31, 2015 or 2014.

In April 2014, the Company called its outstanding Class C Warrants for redemption. Pursuant to a notice of redemption, the holders of the Class C Warrants were given until the close of business on May 22, 2014 to exercise their outstanding warrants at $0.60 per share. Thereafter, any remaining unexercised warrants were cancelled and represent only the right to receive a redemption price of $0.05 per warrant. During the quarter ended May 31, 2014 a total of 1,515,882 Class C Warrants and 44,312 underwriter’s warrants were exercised for gross proceeds of $930,799. The Company deposited $11,343 with the warrant redemption agent to pay the warrant redemption price for the 226,865 Class C Warrants that were not exercised prior to the redemption date.

On April 21, 2014, the Company and RMCF agreed to modify the warrant issued to RMCF in January 2013, which allowed RMCF to maintain its pro-rata ownership interest if existing stock options and/or warrants were exercised. Under that warrant, RMCF had the right to purchase 1.5 times the number of shares of common stock issued upon exercise of the Company’s Class C warrant. Pursuant to the modification, RMCF agreed to exercise that portion of the warrant which corresponded to the exercise of the Class C warrant to the fullest extent possible on a “cashless exercise” basis immediately after the redemption date for the Class C Warrants. A total of 565,261 shares of common stock were issued to RMCF as a result.

U-SWIRL, INC.

NOTES TO THE INTERIM (UNAUDITED) CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2015   

The following is a summary of the Company’s warrant activity:

During the three months ended May 31, 2015 and 2014, the Company expensed $0 and $0 related to stock warrants issued, respectively.

As of May 31, 2015 and February 28, 2015, the Company owed $119,568 and $95,209, respectively, to RMCF for inventories and various operating expenses. See also Note 8, Notes Payable, Related Party.

Management evaluated all activity of the Company through the issue date of the financial statements and concluded that no subsequent events have occurred that would require recognition or disclosure in the financial statements.

On January 17, 2014, the Company entered into an Asset Purchase Agreement with CherryBerry, which was the franchisor of self-serve frozen yogurt retail stores branded as “CherryBerry.” Pursuant to the CherryBerry Purchase Agreement, the Company purchased certain assets of CherryBerry used in its business of franchising frozen yogurt stores, including all of its franchise rights and one company-owned store. The Company also entered into an Asset Purchase Agreement with Yogli Mogli, which was the franchisor of self-serve frozen yogurt retail stores branded as “Yogli Mogli”. Pursuant to the Yogli Mogli Purchase Agreement, the Company purchased certain assets of Yogli Mogli used in its business of franchising frozen yogurt stores, including all of its franchise rights and four company-owned stores. On February 20, 2014 the Company entered into an Asset Purchase Agreement to acquire the business assets of Fuzzy Peach Franchising, LLC. The acquisition of all intellectual property and worldwide franchise and license rights included the rights associated with 17 Fuzzy Peach Frozen Yogurt stores. Associated with these transactions, the Company recorded net restructuring charges of $124,551 during the three months ended May 31, 2014.

Restructuring and acquisition charges incurred were comprised of the following for the three months ended May 31:

No restructuring and asset acquisition charges were incurred during the three months ended May 31, 2015.