QS Energy Inc

THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2024 AND 2023

QS Energy, Inc. (“QS Energy”, “Company”) was incorporated on February 18, 1998, as a Nevada Corporation under the name Mandalay Capital Corporation. The Company changed its name to Save the World Air, Inc. on February 11, 1999 and to QS Energy, Inc. on August 11, 2015. The Company’s common stock is quoted under the symbol “QSEP” on the Over-the-Counter Bulletin Board (Pink Sheets). More information including the Company’s fact sheet, logos, media articles, and update information are available at our corporate website, www.qsenergy.com.

QS Energy develops and is seeking to commercialize energy efficiency technologies that assist in meeting increasing global energy demands, improving the economics of oil extraction and transport, and reducing greenhouse gas emissions. The Company's intellectual properties include a portfolio of domestic and international patents and patents pending, a substantial portion of which have been developed in conjunction with and exclusively licensed from Temple University of Philadelphia, PA (“Temple”). QS Energy's primary technology is called Applied Oil Technology (AOT), a commercial-grade crude oil pipeline transportation flow-assurance product. AOT is engineered specifically to reduce pipeline pressure loss, increase pipeline flow rate and capacity, and reduce shippers’ reliance on diluents and drag reducing agents to meet pipeline maximum viscosity requirements. AOT is a 100% solid-state system that has shown to reduce crude oil viscosity by applying a high intensity electrical field to crude oil feedstock while in transit. The AOT product is seeking to transition from the testing, research and development stage to initial production for continued testing in advance of our goal of seeking acceptance and adoption by the midstream pipeline marketplace.

Going Concern

The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the settlement of liabilities and commitments in the normal course of business. As reflected in the accompanying consolidated financial statements, during the nine-months ended September 30, 2024, the Company incurred a net loss of $1,147,000, used cash in operations of $589,000 and had a stockholders’ deficit of $5,552,000 as of that date. In addition, as of September 30, 2024, 43 notes payable with an aggregate balance of $2,287,000 and certain obligations to a former officer are past due. Based on the foregoing, management has concluded that there is substantial doubt about the Company’s ability to continue as a going concern within one year after the date that the consolidated financial statements are being issued. In addition, the Company's independent registered public accounting firm, in its report on the Company's December 31, 2023 financial statements, has raised substantial doubt about the Company's ability to continue as a going concern. The ability of the Company to continue as a going concern is dependent upon the Company’s ability to raise additional funds and implement its business plan. The financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.

At September 30, 2024, the Company had cash on hand in the amount of $237,000. Management estimates that the current funds on hand will be sufficient to continue operations through December 2024. Management is currently seeking additional funds, primarily through the issuance of debt and equity securities for cash to operate our business, including without limitation the expenses it will incur in connection with the license agreements with Temple; costs associated with product development and commercialization of the AOT technologies; costs to manufacture and ship the products; costs to design and implement an effective system of internal controls and disclosure controls and procedures; costs of maintaining our status as a public company, including, without limitation, legal and accounting fees and costs associated therewith, by filing periodic reports with the SEC and fees and costs required to protect our intellectual property. In addition, as discussed below, the Company has substantial contractual commitments, including without limitation salaries to our executive officers pursuant to employment agreements, certain payments to a former officer and consulting fees, during the remainder of 2024 and beyond.

No assurance can be given that any future financing will be available or, if available, that it will be on terms that are satisfactory to the Company. Even if the Company is able to obtain additional financing, it may contain undue restrictions on our operations, in the case of debt financing or cause substantial dilution for our stockholders in case of equity financing.

Basis of Presentation

The accompanying condensed consolidated financial statements are unaudited. These unaudited interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2023, filed with the SEC on April 9, 2024. The condensed consolidated balance sheet as of December 31, 2023, included herein was derived from the audited consolidated financial statements as of that date, but does not include all disclosures, including notes, required by GAAP.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments necessary to fairly present the Company’s financial position and results of operations for the interim periods reflected. Except as noted, all adjustments contained herein are of a normal recurring nature. Results of operations for the fiscal periods presented herein are not necessarily indicative of the full fiscal year-end results.

The accompanying consolidated financial statements of QS Energy Inc. include the accounts of QS Energy Inc. (the Parent) and its wholly owned subsidiaries, QS Energy Pool, Inc. and STWA Asia Pte. Limited. Intercompany transactions and balances have been eliminated in consolidation.

Segment Information

The Company operates and reports in one segment, which consists of the development of energy efficiency technologies. The Company’s operating segment is reported in a manner consistent with the internal reporting provided to the Company’s Chief Operating Decision Maker, which is the Company’s Chief Executive Officer.

Estimates

The preparation of financial statements in conformity with generally accepted accounting principles 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 amounts of revenues and expenses during the reporting period. Significant estimates include those related to accruals for potential liabilities, assumptions used in valuing equity instruments issued for financing and services and valuation allowance for deferred tax assets, among others. Actual results could differ from those estimates.

Basic and Diluted Income (Loss) Per Share

Our computation of earnings per share (“EPS”) includes basic and diluted EPS. Basic EPS is measured as the income (loss) available to common stockholders divided by the weighted average common shares outstanding for the period. Diluted income (loss) per share reflects the potential dilution, using the treasury stock method, that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the income (loss) of the Company as if they had been converted at the beginning of the periods presented, or issuance date, if later.

At September 30, 2024 and 2023, we excluded the following dilutive shares as their effect would have been anti-dilutive.

Stock-Based Compensation

The Company periodically issues stock options and restricted stock awards to employees and non-employees in non-capital raising transactions for services and for financing costs. Stock option grants, which are generally time or performance vested, are measured at the grant date fair value and depending on the conditions associated with the vesting of the award, compensation cost is recognized on a straight-line or graded basis over the vesting period. Recognition of compensation expense for non-employees is in the same period and manner as if the Company had paid cash for the services. The fair value of stock options granted is estimated using the Black-Scholes option-pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life, and future dividends. The assumptions used in the Black-Scholes option pricing model could materially affect compensation expense recorded in future periods.

Research and Development Costs

Research and development costs are expensed as incurred and consist primarily of fees paid to consultants and outside service providers, and other expenses relating to the acquisition, design, development and testing of the Company’s products. Certain research and development activities are incurred under contract. In those instances, research and development costs are charged to operations ratably over the life of the underlying contracts, unless the achievement of milestones, the completion of contracted work, or other information indicates that a different expensing schedule is more appropriate. Payments made pursuant to research and development contracts are initially recorded as advances on research and development contract services in the Company’s consolidated balance sheet and then charged to research and development costs in the Company’s consolidated statement of operations as those contract services are performed.

For the nine-month periods ended September 30, 2024 and 2023 research and development costs were $143,000 and $148,000, respectively. For the three-month periods ended September 30, 2024 and 2023 research and development costs were $48,000 and $47,000, respectively.

Patent Costs

Patent costs consist of patent-related legal and filing fees. Due to the uncertainty associated with the successful development of our AOT and other products, all patent costs are expensed as incurred. During the nine-month periods ended September 30, 2024 and 2023, patent costs were $31,000 and $3,000, respectively, which is included as part of operating expenses in the accompanying consolidated statements of operations.

Warrants

The Company accounts for warrants as either equity-classified or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Accounting Standards Codification (“ASC”) 480, Distinguishing Liabilities from Equity (“ASC 480”), and ASC 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to the Company’s own common stock, among other conditions for equity classification. The Company has determined that the warrants issued in the 2024 convertible note financings (see Note 4) meet the requirements for equity classification. This assessment, which requires the use of professional judgment, is conducted when the warrants are issued and at the end each subsequent quarterly period while the warrants are outstanding. For issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all of the criteria for equity classification, the warrants are required to be liability classified and recorded at their initial fair value on the date of issuance and remeasured at fair value at each balance sheet date thereafter. Changes in the estimated fair value of the warrants that are liability classified are recognized as a non-cash gain or loss in the statement of operations.

Fair Value of Financial Instruments

The authoritative guidance with respect to fair value established a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three levels and requires that assets and liabilities carried at fair value be classified and disclosed in one of three categories, as presented below. Disclosure as to transfers in and out of Levels 1 and 2, and activity in Level 3 fair value measurements, is also required.

Level 1. Observable inputs such as quoted prices in active markets for an identical asset or liability that the Company has the ability to access as of the measurement date. Financial assets and liabilities utilizing Level 1 inputs include active-exchange traded securities and exchange-based derivatives.

Level 2. Inputs, other than quoted prices included within Level 1, which are directly observable for the asset or liability or indirectly observable through corroboration with observable market data. Financial assets and liabilities utilizing Level 2 inputs include fixed income securities, non-exchange-based derivatives, mutual funds, and fair-value hedges.

Level 3. Unobservable inputs in which there is little or no market data for the asset or liability which requires the reporting entity to develop its own assumptions. Financial assets and liabilities utilizing Level 3 inputs include infrequently traded non-exchange-based derivatives and commingled investment funds and are measured using present value pricing models.

The Company determines the level in the fair value hierarchy within which each fair value measurement falls in its entirety, based on the lowest level input that is significant to the fair value measurement in its entirety. In determining the appropriate levels, the Company performs an analysis of the assets and liabilities at each reporting period end.

The carrying value of financial instruments, which consists of accounts payable and accrued expenses is considered to be representative of their respective fair values due to the short-term nature of those instruments.

Recent Accounting Pronouncements

Recent accounting pronouncements and guidance issued by the FASB, including its Emerging Issues Task Force, the American Institute of Certified Public Accountants, and the Securities and Exchange Commission did not or are not believed by management to have a material impact on the Company's present or future consolidated financial statement presentation or disclosures.

As of September 30, 2024 and December 31, 2023, the Company owed $197,000 and $197,000, respectively, pursuant to a separation agreement with a former executive officer effective April 1, 2017 as amended by letter agreements dated effective August 16, 2018 and March 31, 2019, (the “Letter Agreements”) which have been included as part of accounts payable and accrued expenses on the accompanying condensed consolidated balance sheet. The payments are to be made at $10,000 per month. During the nine months ended September 30, 2024 the Company madeno payments.

Convertible notes

As of December 31, 2023, total outstanding notes payable totaled $1,332,000. During the nine-month period ended September 30, 2024, the Company issued convertible promissory notes in the aggregate of $853,000 for cash proceeds of $775,000, net of original issue discount (“OID”) of $78,000. The notes are unsecured, with an 10% OID, mature in twelve months from issuance, and are convertible into 25,763,218 shares of the Company’s common stock at $0.03 to $0.05 per share.

In addition, the Company granted the note holders warrants to purchase 25,763,218 shares of the Company’s common stock with a relative value of $424,000. The warrants are fully vested, and expire one year from the date of issuance. The Company determined the fair value of the warrants by using a Black-Scholes option pricing model, with the following assumptions: expected term of 1.0 year, stock price of $0.03 to $0.08, exercise price of $0.04 to $0.07, volatility of 156% to 174%, risk-free rate of 3.98% to 5.09%, and no forfeiture rate.

Also, during the period ended September 30, 2024, convertible notes of $532,000, net of unamortized discount of $307,000, were converted into 15,578,409 shares of common stock. At September 30, 2024, total outstanding convertible notes payable totaled $1,654,000. As of September 30, 2024, convertible notes payable and accrued interest are convertible into approximately 21,920,856 shares of common stock at conversion rates ranging from $0.02 to $0.48 per share. As of September 30, 2024, a total of 43 convertible notes and accrued interest in the aggregate of $2,287,000 have reached maturity and are past due.

Accrued interest

At December 31, 2023, accrued interest on convertible notes payable totaled $794,000. During the nine-month period ended September 30, 2024, accrued interest of $160,000 was recorded. At September 30, 2024, accrued interest on convertible notes payable totaled $954,000.

Debt discount

At December 31, 2023, the unamortized debt discount was $25,000. During the nine-month period ended September 30, 2024, debt discount of $501,000 was recorded for the relative fair value of warrants of $424,000 and OID of $77,000, debt discount amortization of $49,000 was recorded, and $307,000 of debt discount was removed and included in the carrying amount of related convertible notes payable that were converted into shares of common stock. At September 30, 2024, the unamortized debt discount was $170,000.

In June 2020, the Company was granted a loan (the “PPP loan”) for $151,000 from Cadence Bank, pursuant to the Paycheck Protection Program (the “PPP”) under the CARES Act. The PPP loan is dated June 18, 2020, matures on June 18, 2025, bears interest at a rate of 1% per annum, and is unsecured and guaranteed by the U.S. Small Business Administration (“SBA”). Funds from the PPP loan may only be used for qualifying expenses, including qualifying payroll costs, qualifying group health care benefits, qualifying rent and debt obligations, and qualifying utilities. Management believes the entire loan amount has been used for qualifying expenses and all of the conditions outlined in the PPP loan program were adhered to by the Company. The PPP loan provides for customary events of default including, among other things, payment defaults, breach of representations and warranties, and insolvency events. The Company was in compliance with the terms of the PPP loan as of September 30, 2024. Under the terms of the PPP, certain amounts of the loan may be forgiven if they are used for qualifying expenses. During 2022, the Company received notice that a total of $63,000 of the PPP loan was forgiven. In addition, during 2022, the Company made principal payments on the PPP loan of $12,000, and at December 31, 2023, the balance of the PPP loan was $57,000. During the nine-month period ended September 30, 2024, the Company made principal payments on the PPP loan of $19,000, and at September 30, 2024, the balance of the PPP loan was $38,000.

The Company constructs, develops and tests the AOT technologies with internal resources and through the assistance of various third-party entities. Costs incurred and expensed include fees such as license fees, purchase of test equipment, pipeline pumping equipment, crude oil tank batteries, viscometers, SCADA systems, computer equipment, payroll and other related equipment and various logistical expenses for the purposes of evaluating and testing the Company’s AOT prototypes.

Costs incurred for research and development are expensed as incurred. Purchased materials that do not have an alternative future use are also expensed. Furthermore, costs incurred in the construction of prototypes with no certainty of any alternative future use and established commercial uses are also expensed.

For the nine-month periods ended September 30, 2024 and 2023 research and development costs were $143,000 and $148,000, respectively. For the three-month periods ended September 30, 2024 and 2023 research and development costs were $48,000 and $47,000, respectively.

AOT Prototypes

During the periods ended September 30, 2024 and 2023, the Company incurred total expenses of $2,000 and $6,000, respectively, in the manufacture and testing of the AOT prototype equipment. These expenses have been reflected as part of Research and Development expenses on the accompanying condensed consolidated statements of operations.

Temple University Licensing Agreements

On August 1, 2011, the Company and Temple University (“Temple”) entered into two (2) Exclusive License Agreements (collectively, the “License Agreements”) relating to Temple’s patent applications, patents and technical information pertaining to technology associated with an electric and/or magnetic field assisted fuel injector system (the “First Temple License”), and to technology to reduce crude oil viscosity (the “Second Temple License”). The License Agreements are exclusive, and the territory licensed to the Company is worldwide and replace previously issued License Agreements.

Pursuant to the two licensing agreements, the Company paid Temple a non-refundable license maintenance fee of $300,000 and agreed to pay (i) annual maintenance fees of $187,500; (ii) royalty fee ranging from 4% up to 7% from revenues generated from the licensing agreements; and (iii) 25% of all revenues generated from sub-licensees to secure or maintain the sub-license or option thereon. The term of the licenses commenced in August 2011 and will expire upon expiration of the patents. The agreements can also be terminated by either party upon notification under terms of the licensing agreements or if the Company ceases the development of the patent or fails to commercialize the patent rights.

Total expenses recognized during each nine-month period ended September 30, 2024 and 2023 pursuant to these two License Agreements amounted to $141,000 and has been reflected in Research and Development expenses on the accompanying condensed consolidated statements of operations. In the nine-month periods ended September 30, 2024 and 2023, the Company also recognized penalty interest on past-due balances of $36,000 and $36,000, respectively, which is included as part of interest and financing expense in the accompanying condensed consolidated statements of operations.

As of September 30, 2024 and December 31, 2023, total unpaid fees due to Temple pursuant to these agreements are $2,374,000 and $2,198,000, respectively, which are included as part of Accounts Payable – license agreements in the accompanying condensed consolidated balance sheets. With regards to the unpaid fees to Temple, a total of $135,000 are deferred until such time the Company achieves a revenue milestone of $835,000 or upon termination of the licensing agreements and the remaining $2,239,000 are deemed past due. The Company is currently in discussions with Temple to settle or cure the past due balance.

No revenues were earned from the two License Agreements during the nine-month periods ended September 30, 2024 and 2023.

During the nine months ended September 30, 2024, the Company issued 18,011,738 shares of its common stock as follows:

The Company periodically issues stock options and warrants to employees and non-employees in capital raising transactions, for services, and for financing costs.

Options

Options vest according to the terms of the specific grant and expire from 2 to 10 years from date of grant. The weighted-average, remaining contractual life of employee and non-employee options outstanding at September 30, 2024 was 3.2 years. Stock option activity for the period January 1, 2024 up to September 30, 2024, was as follows:

The weighted average exercise prices, remaining contractual lives for options granted, exercisable, and expected to vest as of September 30, 2024 were as follows:

During the nine-month periods ended September 30, 2024 and 2023, the Company recognized compensation costs based on the fair value of options that vested of $0 and $0 respectively.

As of September 30, 2024, the market price of the Company’s stock was $0.07 per share. At September 30, 2024, the aggregate intrinsic value of the options outstanding at September 30, 2024 was $197,000.

Warrants

The following table summarizes certain information about the Company’s stock purchase warrants activity for the period starting January 1, 2024 up to September 30, 2024.

The weighted average exercise prices, remaining contractual lives for warrants granted, exercisable, and expected to vest as of September 30, 2024 were as follows:

In the nine-month period ending September 30, 2024, the Company issued warrants to purchase 666,663 shares of common stock in exchange for services. The warrants are exercisable at a price range of $0.03 to $0.07, vesting up to one month from the date of grant, and expiring one to two years from the date of grant. Total fair value of these warrants at grant date was $32,000 using the Black-Scholes Option Pricing model with the following assumptions: life ofone totwo years; risk free interest rate of 3.55% to 4.97%; volatility of 169% to 188% and dividend yield of 0%. During the nine-month period ended September 30, 2024, the Company recognized compensation costs based on the fair value of warrants that vested of $32,000.

At September 30, 2024, the Company’s common stock was $0.07 per share. At September 30, 2024, the aggregate intrinsic value of warrants outstanding was $717,000.

In the nine-month period ending September 30, 2023, the Company issued warrants to purchase 666,663 shares of common stock in exchange for services. The warrants are exercisable at a price range of $0.04 to $0.08, vesting up to one month from the date of grant, and expiring one to two years from the date of grant. Total fair value of these warrants at grant date was $34,000 using the Black-Scholes Option Pricing model with the following assumptions: life of 2 to 5 years; risk free interest rate of 4.17% to 5.12%; volatility of 170% to 207% and dividend yield of 0%. During the nine-month period ended September 30, 2023, the Company recognized compensation costs based on the fair value of warrants that vested of $34,000.

During the three months ended September 30, 2024, the Company paid $45,000 of compensation to its Chief Executive Officer, who also serves as the Company’s Chief Financial Officer. No such compensation was paid in 2023.

We are involved in certain legal proceedings that arise from time to time in the ordinary course of our business. Except for income tax contingencies, we record accruals for contingencies to the extent that our management concludes that the occurrence is probable and that the related amounts of loss can be reasonably estimated. Legal expenses associated with the contingency are expensed as incurred. There is no current or pending litigation of any significance with the exception of the matters that have arisen under, and are being handled in, the normal course of business.

In October and November 2024, the Company issued convertible notes payable in the aggregate of $376,000 for cash proceeds of $342,000, net of OID $34,000. The notes are unsecured, with an 10% OID, mature in twelve months from issuance, and are convertible into 12,526,523 shares of the Company’s common stock at $0.03 per share. In addition, the Company granted the note holders warrants to purchase 12,526,523 shares of the Company’s common stock at $0.04 per share. The warrants are fully vested and expire one year from the date of issuance.

In addition, in October 2024, the Company paid $105,000 of compensation to its Chief Executive Officer (CEO) who also serves as the Company’s Chief Financial Officer (CFO). The Company will also pay additional compensation to its CEO and CFO of $50,000 no later than the end of December 2024.