NEPHROS INC

NOTES TO CONDENSED 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.

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 and Significant Accounting Policies

Interim Financial Information

The accompanying unaudited condensed 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 condensed 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 nine months ended September 30, 2024 are not necessarily indicative of the results that may be expected for the year ending December 31, 2024.

The condensed 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 condensed 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 condensed consolidated financial statements.

Use of Estimates

The preparation of consolidated financial statements in conformity with 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 September 30, 2024, there was no outstanding balance of this loan.

Although we generated positive cash flow from operations of $1.1 million for the nine months ended September 30, 2023, we had negative cash flows from operations of $1.8 million for the nine months ended September 30, 2024. Our operations have consumed substantial amounts of cash since inception, generating an accumulated deficit of $144.7 million as of September 30, 2024.

While we achieved net income for the three months ended September 30, 2024, at present we cannot be certain that we will be able to generate a sufficient amount of product revenue to achieve profitability on an ongoing basis.

The Company continues to focus on growth in sales and managing tight expenses with the goal of returning to cash flow positive from operations. The investment in inventory in 2024 is preparing for higher sales volumes of key products 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 condensed consolidated financial statements. However, if 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 2024, 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 annual reporting period ending December 31, 2025, including interim periods. Early adoption is permitted. The Company is assessing the impact of adopting this guidance on its condensed 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 condensed consolidated financial statements.

In November 2023, the FASB issued ASU 2023-07, “Improvements to Reportable Segment Disclosures,” which improves reportable segment disclosure requirements, primarily through enhanced disclosures about significant segment expenses. The guidance is effective for the Company beginning in the annual reporting period ending December 31, 2024 and interim periods beginning in fiscal year 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 September 30, 2024, and 2023, the following customers accounted for the following percentages of the Company’s revenues, respectively:

For the nine months ended September 30, 2024, and 2023, the following customers accounted for the following percentages of the Company’s revenues, respectively:

As of September 30, 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 credit losses was approximately $11,000 and $14,000 as of September 30, 2024, and September 30, 2023, respectively.

Goodwill

Goodwill represents the excess of the purchase price over the fair value of the net tangible and intangible assets acquired in a business combination. In accordance with ASC Topic 350,Intangibles-Goodwill and Other, the Company does not amortize goodwill, but tests it for impairment annually on October 1 st of each fiscal year or more frequently if events or changes in circumstances indicate that the asset may be impaired. The Company operates as one reporting segment. When testing goodwill for impairment, the Company may first perform an optional qualitative assessment. The qualitative factors evaluated by the Company include macro-economic conditions of the business environment, overall financial performance, and other entity specific factors as deemed appropriate. If under such qualitative analysis the Company determines that it is not more likely than not that the reporting segment’s fair value is less than its carrying amount, then no further analysis is necessary. If the Company determines that it is more likely than not that the fair value of its reporting unit is less than its carrying amount, then the quantitative impairment test will be performed. Under the quantitative impairment test, if the carrying amount of the Company’s reporting segment exceeds its fair value, the Company will recognize an impairment loss in an amount equal to that excess but limited to the total amount of goodwill. No goodwill impairment was recorded for the three and nine months ended September 30, 2024 and 2023.

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 and nine months ended September 30, 2024, or 2023. In addition to product revenue, the Company recognizes revenue related to services to customers, royalties and other agreements in accordance with the five-step model in ASC 606. Other revenues recognized for the three and nine months ended September 30, 2024 were approximately $46,000 and $106,000, respectively. Other revenues recognized for the three and nine months ended September 30, 2023 were approximately $29,000 and $72,000, 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 September 30, 2024 the Company’s cash equivalents consisted of money market funds. At December 31, 2023, the Company’s cash equivalents consisted of money market funds and certificates of deposit. 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 September 30, 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 their short-term nature.

The carrying amounts of the lease liabilities and equipment financing approximate fair value as of September 30, 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 quality.

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 September 30, 2024 and December 31, 2023, were as follows:

Note 6 –Intangible Assets and Goodwill

Intangible Assets

Intangible assets as of September 30, 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 each of the three months ended September 30, 2024 and September 30, 2023. All were recognized in selling, general and administrative expenses on the accompanying condensed consolidated statement of operations.

The Company recognized amortization expense of approximately $24,000 and $31,000 for each of the nine months ended September 30, 2024 and September 30, 2023. All were recognized in selling, general and administrative expenses on the accompanying condensed statement of operations.

As of September 30, 2024, future amortization expense for each of the next five years is (in thousands):

Goodwill

Goodwill has a carrying value on the Company’s condensed consolidated balance sheets of approximately $0.8 million at September 30, 2024 and December 31, 2023.

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 condensed consolidated balance sheet is $0.2 million and $0.3 million as of September 30, 2024 and December 31, 2023, respectively. Accumulated amortization is $2 million as of September 30, 2024 and December 31, 2023. 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 each of the three months ended September 30, 2024 and 2023 on the condensed consolidated statement of operations.

As of December 11, 2023, the Company has agreed with Medica 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 nine months ended September 30, 2024 or September 30, 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 $102,000 for the three months ended September 30, 2023 was recognized as royalty expense and is included in cost of goods sold on the condensed consolidated statement of operations. Approximately $292,000 for the nine months ended September 30, 2023 was recognized as royalty expense and is included in cost of goods sold on the condensed consolidated statement of operations. Approximately $102,000 of this royalty expense was included in accounts payable as of September 30, 2023. Starting in 2024, the Company is no longer required to pay Medica royalties.

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 September 30, 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 September 30, 2023, no payments were made under the Secured Note, as the Note was repaid in full at March 31, 2023.

During the nine months ended September 30, 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 condensed consolidated statements of operations for the nine months ended September 30, 2023.

Note 9 –Leases

The Company has operating leases for corporate offices 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 September 30, 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 condensed consolidated statement of operations. The Company calculates stock-based compensation expense in accordance with ASC 718. The fair value of stock-based awards is amortized over the vesting period of the award.

Stock Options

The Company granted stock options to purchase 85,198 shares of common stock to employees during the nine months ended September 30, 2024. These stock options are being expensed over the respective vesting period, which is based on a service condition. The fair value of the stock options granted during the nine months ended September 30, 2024, was approximately $0.1 million.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. The below assumptions for the risk-free interest rates, expected dividend yield, expected lives and expected stock price volatility were utilized for the stock options granted during the nine months ended September 30, 2024.

Stock-based compensation expense related to stock options was approximately $64,000 and $137,000 for the three months ended September 30, 2024 and 2023, respectively. For the three months ended September 30, 2024, approximately $62,000 and $2,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations. For the three months ended September 30, 2023, approximately $134,000 and $3,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations.

Stock-based compensation expense related to stock options was $76,000 and $486,000 for the nine months ended September 30, 2024 and 2023, respectively. For the nine months ended September 30, 2024, approximately $71,000 and $5,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations. Stock-based compensation expense for the nine months ended September 30, 2024 consisted of $185,000 expense for shares vested, partially offset by a credit of $109,000 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. For the nine months ended September 30, 2023, approximately $450,000 and $36,000 are included in selling, general and administrative expenses and research and development expenses, respectively, on the accompanying condensed consolidated statement of operations.

There wasno tax benefit related to expense recognized in the three or nine months ended September 30, 2024 and 2023, as the Company is in a net operating loss position. As of September 30, 2024, there was approximately $555,000 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 2.5 years.

Restricted Stock

There wasno stock-based compensation expense for restricted stock on the Company’s condensed consolidated statement of operations for the three months ended September 30, 2024. Total stock-based compensation expense for restricted stock was approximately $12,000 for the three months ended September 30, 2023 which is included in selling, general and administrative expenses on the accompanying condensed consolidated statement of operations.

Total stock-based compensation expense for restricted stock was approximately $15,000 and $49,000 for the nine months ended September 30, 2024 and 2023, respectively. During the nine months ended September 30, 2023,23,781 shares of restricted stock were issued to employees and 133,722 shares of restricted stock were issued to board members 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 nine months ended September 30, 2023. All restricted shares issued during the nine months ended September 30, 2023, have a vesting period of six months.

As of September 30, 2024, there wasno unrecognized compensation expense related to unvested stock-based awards granted under the equity compensation plans.

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 nine months ended September 30, 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 nine months ended September 30, 2023. For the nine months ended September 30, 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 condensed consolidated statement of operations.

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 Income (Loss) per Common Share

Basic income (loss) per common share is calculated by dividing net income (loss) available to common shareholders by the number of weighted average common shares issued and outstanding. Diluted income (loss) per common share is calculated by dividing net income (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.

A reconciliation of the Company’s basic and diluted income (loss) per common share is as follows:

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

Contractual Obligations

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