NovaBay Pharmaceuticals Inc

Report****of Independent Registered Public Accounting Firm**

To the Board of Directors and Stockholders of

NovaBay Pharmaceuticals, Inc.

Opinion on the Consolidated Financial Statements

We have audited the accompanying consolidated balance sheets of NovaBay Pharmaceuticals, Inc. and subsidiaries (the “Company”) as of December 31, 2023 and 2022, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2023, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2023 and 2022, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2023, in conformity with accounting principles generally accepted in the United States of America.

Substantial Doubt Regarding Going Concern

The consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has sustained operating losses for the majority of its corporate history and expects that its 2024 expenses will exceed its 2024 revenues, as the Company continues to invest in its commercialization efforts. Additionally, the Company expects to continue incurring operating losses and negative cash flows until revenues reach a level sufficient to support ongoing growth and operations. Accordingly, the Company has determined that its planned operations raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. Our opinion is not modified with respect to this matter.

Basis for Opinion

These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.

Critical Audit Matters

The critical audit matters communicated below are matters arising from the current period audit of the consolidated financial statements that were communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the consolidated financial statements; and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate.

Allowances for Product Returns

As described in Note 2 of the consolidated financial statements, when recognizing revenue from product sales, the Company makes an estimate of the amount of consideration the Company expects to be entitled to receive. Upon recognition of these product sales, the Company records estimates for variable consideration consisting of service fees, discounts, rebates, and product returns, resulting in a reduction in product revenue. The variable consideration provisions are recorded within accrued liabilities in the same period that the related revenue is recognized. Liabilities related to the allowance for product returns involve the use of significant assumptions and judgments in their calculation. These significant assumptions and judgments include historical sales and return rates and inventory levels in the distribution channel, as well as existing return policies with customers.

The Company’s estimated allowance for product returns requires a high degree of judgment and is subject to change based on various quantitative and qualitative factors. Accordingly, extensive audit effort and a high degree of auditor judgment were needed to evaluate management’s estimates and assumptions used in the determination of the allowance for product returns. Therefore, we identified the Company’s allowance for product returns as a critical audit matter.

We obtained an understanding of and evaluated the design of controls relating to the Company’s processes for estimating the allowance for product returns. We evaluated the significant accounting policies relating to product returns, as well as management’s application of the policies, for appropriateness and reasonableness.

We obtained the Company’s allowance for product returns analysis and performed testing procedures on the underlying data that was used in management’s development of the product returns estimate. We compared the significant assumptions used by management to customer contract information, tested the historical returns data used in the analysis, and reviewed subsequent product return activity. In addition, we performed sensitivity analyses of significant assumptions used in the analysis to determine what changes in assumptions are particularly sensitive when calculating the amount of the allowance for product returns. Additionally, we tested the mathematical accuracy of management’s calculation of revenue, net of product sales allowances, and the associated timing of revenue recognition, in the consolidated financial statements.

Impairment Analysis of Goodwill, Indefinite-Lived Intangible Assets and Long-Lived Assets

As described in Notes 2, 7 and 8 of the consolidated financial statements, the Company’s goodwill and indefinite-lived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that it is more likely than not that the assets are impaired. The Company also reviews its long-lived assets for impairment at least annually or whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Management makes critical assumptions and estimates in completing impairment assessments of goodwill, indefinite-lived intangible assets and long-lived assets. The Company’s cash flow projections look several years into the future and include assumptions on variables such as future sales and operating margin growth rates, economic conditions, probability of success, market competition, inflation and discount rates. During the year ended December 31, 2023, the Company recognized an impairment charge related to its DERMAdoctor goodwill, indefinite-lived intangible assets and long-lived assets of $2.6 million.

The Company’s impairment analysis related to its goodwill, indefinite-lived intangible assets and long-lived assets requires a high degree of judgment and is subject to change based on various quantitative and qualitative factors. A high degree of auditor judgment and an increased extent of effort were required when performing audit procedures to evaluate the reasonableness of management’s estimates and assumptions related to the forecasts of future sales and earnings as well as the selection of discount rates, which included the need to involve our valuation specialists. Therefore, we identified the Company’s impairment analysis related to its goodwill, indefinite-lived intangible assets and long-lived assets as a critical audit matter.

We obtained an understanding of and evaluated the design of controls relating to the Company’s impairment review process. We evaluated the significant accounting policies relating to the Company’s impairment analyses, as well as management’s application of the policies, for appropriateness and reasonableness.

We obtained the Company’s impairment analyses and performed testing procedures on the underlying data and assumptions that were used in management’s analyses. To test the estimated fair values of the assets, we performed audit procedures that included, among other things, assessing methodologies used to determine the fair values and testing the significant assumptions discussed above and the accuracy of the underlying data used by the Company. For example, we evaluated management’s forecasted revenue growth rates used in the fair value estimates by comparing those assumptions to the historical results of the Company and current industry, market and economic forecasts. We involved a valuation specialist to assist in evaluating the valuation methodologies and the significant assumptions such as discount rates, as well as testing the mathematical accuracy of the calculation. Additionally, we performed sensitivity analyses of significant assumptions to evaluate the effect on the fair value estimates of the assets. We also considered events that occurred subsequent to year end and the impact they had on the Company’s impairment analyses.

Valuation of the Secured Convertible Notes, Warrants and Derivatives Related to the 2023 Private Placement

As described in Notes 11 and 12 of the consolidated financial statements, in May 2023, the Company closed a private placement (the “2023 Private Placement”) that provided for the issuance and sale of $3.3 million aggregate principal amount of convertible notes and warrants exercisable for up to 5.1 million shares of the Company’s common stock. The Company allocated the proceeds from the 2023 Private Placement between the warrants, an embedded derivative liability, and the convertible notes by applying the residual fair value methodology.

The valuation of the convertible notes, warrants and derivatives related to the 2023 Private Placement and the related allocation of the proceeds requires a high degree of judgment and is subject to change based on various quantitative and qualitative factors. A high degree of auditor judgment and an increased extent of effort were required when performing audit procedures to evaluate the reasonableness of management’s estimates and assumptions related to the valuation of the transaction due to the use of complex valuation models to estimate the value of the convertible notes, warrants and embedded conversion and redeemable features, which included the need to involve our valuation specialists. Therefore, we identified the Company’s valuation of the convertible notes, warrants and derivatives related to the 2023 Private Placement as a critical audit matter.

We obtained an understanding of and evaluated the design of controls relating to the Company’s valuation of the convertible notes, warrants and derivatives related to the 2023 Private Placement. We evaluated the significant accounting policies relating to the Company’s analyses, as well as management’s application of the policies, for appropriateness and reasonableness.

To test the accounting for the convertible notes, warrants and embedded derivative liability in the 2023 Private Placement, we performed audit procedures that included, among other things, obtaining an understanding of the Company’s process to account for the issuance of the convertible notes, warrants and derivatives, reviewing the convertible notes and warrant agreements, and testing the accuracy of the underlying data used in the valuation models by tracing the key inputs to relevant terms contained in the convertible notes and warrant agreements. We also involved a valuation specialist to assist in evaluating the valuation methodologies and significant assumptions used in the valuation model, as well as testing the mathematical accuracy of the calculations.

/s/WithumSmith+Brown, PC

We have served as the Company’s auditor since 2010.

San Francisco, California

March 26, 2024

PCAOB ID Number 100