NEPHROS INC

NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (unaudited)

Note 1 –Organization and Nature of Operations

Nephros, Inc. (“Nephros” or the “Company”) was incorporated under the laws of the State of Delaware on April 3, 1997. The Company was founded by health professionals, scientists and engineers affiliated with Columbia University to develop advanced end stage renal disease (“ESRD”) therapy technology and products.

Beginning in 2009, Nephros introduced high performance liquid purification filters to meet the demand for water purification in certain medical markets. The Company’s filters, generally classified as ultrafilters, are primarily used in hospitals for the prevention of infection from waterborne pathogens, such as legionella and pseudomonas, and in dialysis centers for the removal of biological contaminants from water and bicarbonate concentrate. The Company also develops and sells water filtration products for commercial applications, focusing on the hospitality and food service markets. The water filtration business is a reportable segment, referred to as the Water Filtration segment.

In July 2018, the Company formed a subsidiary, Specialty Renal Products, Inc. (“SRP”), to drive the development of its second-generation hemodiafiltration system and other products focused on improving therapies for patients with renal disease. After SRP’s formation, the Company assigned to SRP all of the Company’s rights to three patents relating to the Company’s hemodiafiltration technology, which were carried at zero book value. On March 9, 2023, the SRP Stockholders approved a plan of dissolution to wind down SRP’s operations, liquidate SRP’s remaining assets and dissolve SRP, and SRP filed a certificate of dissolution with the State of Delaware on April 13, 2023. As a result of the SRP Stockholders’ approval of the plan of dissolution and provisions therein and after satisfying all of SRP’s liabilities, there are no assets available for distribution to the holders of any of SRP’s capital stock, including its Series A Preferred Stock. As such, the value recorded to non-controlling interest was written to zero and the impact reclassified to the Company’s additional paid-in capital as the Company retained control of SRP.

The Company’s primary U.S. facility is located at 380 Lackawanna Place, South Orange, New Jersey 07079. This location along with our Whippany, NJ facility, houses the Company’s corporate headquarters, research, manufacturing, and distribution facilities.

Note 2 –Basis of Presentation and Liquidity

Interim Financial Information

The accompanying unaudited consolidated interim financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 8 and Article 10 of Regulation S-X. The consolidated balance sheet as of December 31, 2023 was derived from the Company’s audited financial statements. Accordingly, they do not include all of the information and footnotes required by GAAP for annual financial statements. Results as of and for the three months ended March 31, 2024 are not necessarily indicative of the results that may be expected for the year ending December 31, 2024.

The consolidated interim financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2023.

Segment Reporting

The Company operates in only one business segment from which the Company’s chief operating decision maker evaluates the financial performance of the Company.

Consolidation

The accompanying consolidated financial statements include the accounts of Nephros, Inc. and its subsidiary, SRP, which was dissolved pursuant to a plan of dissolution adopted by its stockholders on March 9, 2023 and the subsequent filing of a certificate of dissolution with the State of Delaware on April 13, 2023. All intercompany accounts and transactions were eliminated in the preparation of the accompanying consolidated financial statements.

Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, at the date of the financial statements, and the reported amount of revenues and expenses, during the reporting period. Actual results could differ materially from those estimates. Included in these estimates are assumptions about the collection of accounts receivable, value of inventories, useful life of fixed assets and intangible assets, the assessment of expected cash flows used in evaluating goodwill and other long-lived assets, the assessment of the ability to continue as a going concern and assumptions used in determining stock compensation such as expected volatility and risk-free interest rate.

Liquidity

In connection with SRP’s plan of dissolution and pursuant to an agreement between the Company and SRP entered into on May 24, 2023, SRP assigned substantially all of its remaining assets to the Company in satisfaction of the entire loan balance. See “Note 11 – Stockholders’ Equity – Noncontrolling Interest” Accordingly, as of March 31, 2024, there was no outstanding balance of this loan.

The Company has sustained operating losses every quarter through March 31, 2024, generating an accumulated deficit of $144.6 million as of March 31, 2024. However, in 2023, the Company’s operating cash flow was positive due to increased sales, improved gross margins, careful expense management, a reduction in inventory, and the dispositions of the Pathogen Detection Systems and SRP businesses. These actions resulted in the Company generating cash from operations of approximately $0.8 million for the twelve months ended December 31, 2023. Conversely, net cash from operations was negative for the three months ended March 31, 2024 due to an operating loss, payment of prior year annual bonuses, and an increase in inventory. The Company continues to focus on growth in sales and managing tight expenses in order to turn cash flow positive from operations. The investment in inventory in the first quarter of 2024 is preparing for higher volumes in the future. The Company believes that the tight focus on operations and its current cash balances are sufficient to fund its current operating plan through at least the next 12 months from the date of issuance of the accompanying consolidated financial statements. However, in the event that the Company’s operating results do not meet its expectations, the Company may need to further reduce discretionary expenditures such as headcount, R&D projects, and other variable costs.

Recent Accounting Pronouncements, Not Yet Effective

In March, the FASB issued ASU 2024-01, “ASC 718-Scope Application of Profits Interest and Similar Awards,” which provides guidance to assist entities in determining whether profits interest and similar awards should be accounted for in accordance with Topic 718, Compensation—Stock Compensation. The guidance is effective for the Company’s fiscal year 2025, including interim periods. Early adoption is permitted. The Company is assessing the impact of adopting this guidance on its consolidated financial statements.

In December 2023, the FASB issued ASU 2023-09, “Improvements to Income Tax Disclosures,” which enhances the transparency and decision usefulness of income tax disclosures. The guidance is effective for the Company’s annual reporting period ending December 31, 2025. Early adoption is permitted. The Company is assessing the impact of adopting this guidance on its consolidated financial statements.

Concentration of Credit Risk

The Company deposits its cash in financial institutions. At times, such deposits may be in excess of insured limits. To date, the Company has not experienced any impairment losses on its cash. The Company also limits its credit risk with respect to accounts receivable by performing credit evaluations when deemed necessary.

Major Customers

For the three months ended March 31, 2024, and 2023, the following customers accounted for the following percentages of the Company’s revenues, respectively:

As of March 31, 2024 and December 31, 2023, the following customers accounted for the following percentages of the Company’s accounts receivable, respectively:

Accounts Receivable

The Company recognizes an allowance that reflects a current estimate of credit losses expected to be incurred over the life of a financial asset, including trade receivables. The Company continuously monitors collections and payments from its customers and maintains a provision for estimated credit losses. The Company determines its allowance for doubtful accounts by considering a number of factors, including the length of time balances are past due, the Company’s previous loss history, the customer’s current ability to pay its obligations to the Company and the expected condition of the general economy and the industry as a whole. The Company writes off accounts receivable when they are determined to be uncollectible. The allowance for doubtful accounts was approximately $11,000 as of March 31, 2024, and December 31, 2023, respectively.

Depreciation Expense

Depreciation related to equipment utilized in the manufacturing process is recognized in cost of goods sold on the consolidated statements of operations and comprehensive loss. For each of the three months ended March 31, 2024, and 2023, depreciation expense was approximately $1,000.

Note 3 –Revenue Recognition

The Company recognizes revenue related to product sales when product is shipped via external logistics providers and the other criteria of ASC 606 are met. Product revenue is recorded net of returns and allowances. There was no allowance for sales returns for the three months ended March 31, 2024, or 2023. In addition to product revenue, the Company recognizes revenue related to sales of services to customers, royalties, and other agreements in accordance with the five-step model in ASC 606. Other revenues recognized for the three months ended March 31, 2024, and 2023 were approximately $16,000 and $35,000, respectively.

Note 4 –Fair Value Measurements

The Company measures certain financial instruments and other items at fair value.

To determine the fair value, the Company uses the fair value 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 market participants would use to value an asset or liability and are developed based on market data obtained from independent sources. Unobservable inputs are inputs based on assumptions about the factors market participants would use to value an asset or liability.

To measure fair value, the Company uses the following fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable:

Level 1 – Quoted prices in active markets for identical assets or liabilities.

*Level 2 –*Inputs other than Level 1 that are observable for the asset or liability, either directly or indirectly, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data by correlation or other means.

Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Value is determined using pricing models, discounted cash flow methodologies, or similar techniques and also includes instruments for which the determination of fair value requires significant judgment or estimation.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

The Company evaluates its financial assets and liabilities subject to fair value measurements on a recurring basis to determine the appropriate level of classification for each reporting period.

At March 31, 2024 and December 31, 2023, the Company’s cash equivalents consisted of money market funds. The Company values its cash equivalents using observable inputs that reflect quoted prices for securities with identical characteristics and classify the valuation techniques that use these inputs as Level 1.

At March 31, 2024 and December 31, 2023, the fair value measurements of the Company’s assets and liabilities measured on a recurring basis were as follows:

Assets and Liabilities Not Measured at Fair Value on a Recurring Basis

The carrying amounts of accounts receivable, accounts payable and accrued expenses approximate fair value due to the short-term maturity of these instruments.

The carrying amounts of the secured long-term note payable, lease liabilities and equipment financing approximate fair value as of March 31, 2024 and December 31, 2023 because those financial instruments bear interest at rates that approximate current market rates for similar agreements with similar maturities and credit.

Note 5 –Inventory

Inventory is stated at the lower of cost or net realizable value using the first-in, first-out method and consists of raw materials and finished goods. The Company’s inventory components as of March 31, 2024 and December 31, 2023, were as follows:

Note 6 –Intangible Assets and Goodwill

Intangible Assets

Intangible assets as of March 31, 2024, and December 31, 2023 are set forth in the table below. Gross carrying values and accumulated amortization of the Company’s intangible assets by type are as follows:

The Company recognized amortization expense of approximately $8,000 and $11,000 for the three months ended March 31, 2024 and March 31, 2023, respectively. All were recognized in selling, general and administrative expenses on the accompanying condensed consolidated statement of operations and comprehensive loss.

As of March 31, 2024, future amortization expense for each of the next five years is (in thousands):

Goodwill

Goodwill had a carrying value on the Company’s consolidated balance sheets of $0.8 million at March 31, 2024 and December 31, 2023, respectively.

Note 7 –License and Supply Agreement, net

On April 23, 2012, the Company entered into a License and Supply Agreement (as thereafter amended, the “License and Supply Agreement”) with Medica S.p.A. (“Medica”), an Italy-based medical product manufacturing company, for the marketing and sale of certain filtration products based upon Medica’s proprietary Medisulfone ultrafiltration technology in conjunction with the Company’s filtration products, and for an exclusive supply arrangement for the filtration products. Under the License and Supply Agreement, Medica granted to the Company an exclusive license, with right of sublicense, to market, promote, distribute, offer for sale and sell the filtration products worldwide, with certain limitations on territory, during the term of the License and Supply Agreement. In addition, the Company granted to Medica an exclusive license under the Company’s intellectual property to make the filtration products during the term of the License and Supply Agreement. The filtration products covered under the License and Supply Agreement includes both certain products based on Medica’s proprietary Versatile microfiber technology and certain filtration products based on Medica’s proprietary Medisulfone ultrafiltration technology. In December 2023, the Company signed a new agreement with Medica which extends the term until December 31, 2028, unless earlier terminated by either party in accordance with the terms of the License and Supply Agreement.

In exchange for the license, the gross value of the intangible asset capitalized was $2.3 million. License and supply agreement, net, on the consolidated balance sheet is $0.3 million as of March 31, 2024 and December 31, 2023, respectively. Accumulated amortization is $2.0 million as of March 31, 2024 and December 31, 2023, respectively. The intangible asset is being amortized as an expense over the life of the License and Supply Agreement. Amortization expense of approximately $14,000 and $33,000 was recognized in the three months ended March 31, 2024 and 2023, respectively on the consolidated statement of operations and comprehensive loss.

As of December 11, 2023, the Company contractually has agreed to pay interest per month at the EURIBOR 360-day rate plus 500 basis points calculated on the principal amount of any outstanding invoices that are overdue by more than 15 days beyond the original payment terms. There was no interest recognized for the three months ended March 31, 2024 or March 31, 2023.

In addition, for the period beginning April 23, 2014 through December 31, 2023, the Company paid Medica a royalty rate of 3% of net sales of the filtration products sold, subject to reduction as a result of a supply interruption pursuant to the terms of the License and Supply Agreement. Approximately $96,000 for the three months ended March 31, 2023 was recognized as royalty expense and is included in cost of goods sold on the consolidated statement of operations and comprehensive loss. Approximately $96,000 of this royalty expense was included in accounts payable as of March 31, 2023.

Note 8 –Secured Note Payable

On March 27, 2018, the Company entered into a Secured Promissory Note Agreement (the “Secured Note”) with Tech Capital for a principal amount of $1.2 million. As of March 31, 2023, the principal balance of the Secured Note was paid off.

The Secured Note had a maturity date of April 1, 2023. The unpaid principal balance accrued interest at a rate of 8% per annum. Principal and interest payments were due on the first day of each month commencing on May 1, 2018. The Secured Note was subject to terms and conditions of and was secured by security interests granted by the Company in favor of Tech Capital under the Loan and Security Agreement entered into on August 17, 2017 and subsequently amended on December 20, 2019 (the “Loan Agreement”). An event of default under such Loan Agreement was an event of default under the Secured Note and vice versa.

During the three months ended March 31, 2023, the Company made payments under the Secured Note of approximately $71,000. Included in the total payments made, approximately $1,000 was recognized as interest expense on the consolidated statement of operations and comprehensive loss for the three months ended March 31, 2023.

Note 9 –Leases

The Company has operating leases for corporate offices, warehouse space, an automobile, and office equipment. The leases have remaining lease terms of 1 year to 5 years.

Lease cost, as presented below, includes costs associated with leases for which right-of-use (“ROU”) assets have been recognized as well as short-term leases.

The components of total lease costs were as follows:

Supplemental cash flow information related to leases was as follows:

Supplemental balance sheet information related to leases was as follows:

As of March 31, 2024, maturities of lease liabilities were as follows:

Note 10 –Stock Plans and Share-Based Payments

The fair value of stock options and restricted stock is recognized as stock-based compensation expense in the Company’s consolidated statement of operations and comprehensive loss. The Company calculates stock-based compensation expenses in accordance with ASC 718. The fair value of stock-based awards is amortized over the vesting period of the award.

Stock Options

During the three months ended March 31, 2024, the Company did not grant stock options to purchase shares of common stock to employees.

Stock-based compensation expense related to stock options was ($17,000) and $179,000 for the three months ended March 31, 2024 and 2023, respectively. For the three months ended March 31, 2024, approximately ($18,000) and $1,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying consolidated statement of operations and comprehensive loss. The net credit to stock-based compensation expense for the three months ended March 31, 2024 was due to the reversal of expense related to an immaterial error associated with the forfeiture of unvested options for employee terminations that occurred in prior fiscal periods partially offset by stock based compensation expense of approximately $58,000 related to unvested employee stock options. For the three months ended March 31, 2023, approximately $159,000 and $20,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying consolidated statement of operations and comprehensive loss.

There wasno tax benefit related to expense recognized in the three months ended March 31, 2024 and 2023, as the Company is in a net operating loss position. As of March 31, 2024, there was $579,000 of total unrecognized compensation expense related to unvested stock-based awards granted under the equity compensation plans, which will be amortized over the weighted average remaining requisite service period of 2.8 years.

Restricted Stock

Total stock-based compensation expense for restricted stock on the Company’s consolidated statement of operations was approximately $8,000 and $13,000 for the three months ended March 31, 2024 and 2023, respectively. For the three months ended March 31, 2024 and 2023, approximately $8,000 and $13,000, respectively, are included in selling, general and administrative expenses on the accompanying consolidated statement of operations and comprehensive loss.

No shares of restricted stock were issued during the three months ended March 31, 2024.During the three months ended March 31, 2023,23,781 shares of restricted stock were issued to employees,133,722 shares of restricted stock were issued to board members all related to services rendered during the year ended December 31, 2022. In addition,30,000 shares of restricted stock were issued to contractors during the period ended March 31, 2023. All restricted shares issued during the three months ended March 31, 2023, have a vesting period of six months.

As of March 31, 2024, there was approximately $7,000 of unrecognized compensation expense related to unvested stock-based awards granted under the equity compensation plans, which will be amortized over the weighted average remaining requisite service period of approximately 0.1 years.

The aggregate shares of common stock legally issued and outstanding as of March 31, 2024 is greater than the aggregate shares of common stock outstanding for accounting purposes by the amount of unvested restricted shares.

SRP Equity Incentive Plan

SRP’s 2019 Equity Incentive Plan was approved on May 7, 2019 under which 150,000 shares of SRP’s common stock are reserved for the issuance of options and other awards. This plan is no longer operational, due to the wind down of SRP’s operations and its April 2023 dissolution.

Due to the Company’s acquisition of the non-controlling interest in SRP during the three months ended March 31, 2023, all remaining equity-based awards have been forfeited and no further expense will be incurred related to these awards. There were no SRP stock options or other equity awards granted during the three months ended March 31, 2023. For the three months ended March 31, 2023, a credit of approximately ($27,000) was recognized for expense related to the SRP equity-based awards. Stock-based compensation expense related to the SRP equity-based awards is included in selling, general and administrative expenses on the accompanying consolidated statement of operations and comprehensive loss.

Note 11 –Stockholders’ Equity

Noncontrolling Interest

In separate transactions in September 2018 and February 2022, SRP issued and sold an aggregate of 700,003 shares of its Series A Preferred Stock for aggregate gross proceeds of approximately $3.5 million. Of such shares, the Company purchased 62,500 shares in the February 2022 transaction, maintaining a 62.5% ownership stake in SRP. Approximately $188,000 of the proceeds from the February 2022 sales were recorded as an increase to the equity of the non-controlling interests. In addition to the Company’s purchase of Series A Preferred Stock from SRP,, the Company also loaned to SRP the principal amount of $1.3 million, $1.0 million of which was advanced during the year ended December 31, 2020.

In March 2023, the board of directors of SRP adopted, and the stockholders of SRP approved, a plan to wind down SRP’s operations and dissolve, and in April 2023, SRP filed a certificate of dissolution with the State of Delaware. In accordance with its plan of dissolution, after SRP satisfied its other outstanding liabilities, SRP assigned to the Company all of its remaining assets, including its intellectual property rights, in satisfaction of outstanding indebtedness owed to the Company in the approximate amount of $1.5 million. No other assets are available for distribution to any of SRP’s stockholders, including the Company, in respect of their shares of SRP capital stock, including the Series A Preferred. As a result of the dissolution described above, it was determined approximately $24,000 of inventory likely had no value and was written off in the period ended March 31, 2023.

Note 12 –Net Loss per Common Share

Basic loss per common share is calculated by dividing net loss available to common shareholders by the number of weighted average common shares issued and outstanding. Diluted loss per common share is calculated by dividing net loss available to common shareholders by the weighted average number of common shares issued and outstanding for the period, plus amounts representing the dilutive effect from the exercise of stock options and warrants and unvested restricted stock, as applicable. The Company calculates dilutive potential common shares using the treasury stock method, which assumes the Company will use the proceeds from the exercise of stock options and warrants to repurchase shares of common stock to hold in its treasury stock reserves.

The following potentially dilutive securities have been excluded from the computations of diluted weighted average shares outstanding as they would be antidilutive:

Note 13 –Commitments and Contingencies

Purchase Commitments

In exchange for the rights granted under the License and Supply Agreement with Medica (see Note 7 – License and Supply Agreement, net), the Company agreed to make certain minimum annual aggregate purchases from Medica over the term of the License and Supply Agreement. For the year ended December 31, 2024, the Company has agreed to make minimum annual aggregate purchases from Medica of €4.2 million (approximately $4.6 million). As of March 31, 2024, the Company’s aggregate purchase commitments totaled €2.8 million (approximately $3 million).

Contractual Obligations

See Note 9 – Leases for a discussion of the Company’s contractual obligations.