Prophase Labs Annual Report 2013

FY2013 Annual Report · Prophase Labs
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ANNUAL REPORT
2013

LETTER TO THE

SHAREHOLDERS

Dear Fellow Shareholders:

I am proud to report to you that the effective implementation of our business plan has enabled the
Company to achieve its first profitable fiscal year since 2005.

After net sales bottomed in fiscal 2010 at $14.5 million, we developed and implemented a long term
strategy to grow our sales revenues. The results speak for themselves as our net sales in fiscal 2013
grew to $25 million which equates to a 72.6% increase versus fiscal 2010. As a result of our improved
marketing plans and the introduction of new, thoroughly researched and well received products, our
sales growth has been outpacing the general cough/cold category and also has increased on a
percentage basis more than many of our competitors. Our growth over these three years is
particularly striking given the negative macroeconomic factors which included a relatively weak
incidence of upper respiratory illness and pressure by retailers to decrease available shelf space for
the cough/cold category.

Over these past three years, we improved our core Cold-EEZE(cid:2) Cold Remedy lozenge flavors and
packaging; improved our relationships with our partners, i.e. the retailers who carry our products on
their shelves; revamped our entire marketing and in-store merchandising campaigns; restructured
and downsized our corporate headquarters staff; and lastly, upgraded the quality and effectiveness
of virtually every vendor and consultant with whom we conduct business.

For the fall of 2013, we secured national distribution of our latest new product introduction,
Immune Support QuickMelts(cid:2). The continued broad
Cold-EEZE(cid:2) Cold Remedy Plus Natural
acceptance of our new products by our key retailers demonstrates that we have restored and
continue to enhance the value of the Cold-EEZE(cid:2) brand.

LOOKING AHEAD

As in 2013, our goals for 2014 are to continue to follow this successful strategy. We plan to introduce
another new premium Cold-EEZE(cid:2) Cold Remedy product (which we expect to be available
nationally in the fall of 2014) that will shorten the duration of the common cold as well as provide
additional attractive health benefits.

Looking beyond 2014, our strategy will be to introduce products both inside and outside of the
cough/cold category to leverage our strong distribution platform and expertise.

Continuing to grow our revenues and leverage our efficient infrastructure will increase the value of
our Company to the benefit of all shareholders. As always, thank you for your continued loyalty and
support.

Sincerely,

Ted Karkus
Chairman and Chief Executive Officer

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)
(cid:4)

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the ﬁscal year ended December 31, 2013
OR

□

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from

to

Commission ﬁle number 01-21617

ProPhase Labs, Inc.

(Exact name of registrant as speciﬁed in its charter)

Nevada
(State or other jurisdiction
of incorporation or organization)

621 N. Shady Retreat Road, Doylestown, Pennsylvania
(Address of principal executive offices)

23-2577138
(I.R.S. Employer
Identiﬁcation No.)

18901
(Zip Code)

Registrant’s telephone number, including area code (215) 345-0919

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Name of each exchange on which registered

Common Stock, $0.0005 par value per share
Common Share Purchase Rights

NASDAQ Global Market
NASDAQ Global Market

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as deﬁned in Rule 405 of the Securities Act. Yes (cid:6) No (cid:4)
Indicate by check mark if the registrant is not required to ﬁle reports pursuant to Section 13 or Section 15(d) of the Act. Yes (cid:6) No (cid:4)
Indicate by check mark whether the registrant (1) has ﬁled all reports required to be ﬁled by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to ﬁle such reports), and
(2) has been subject to such ﬁling requirements for the past 90 days. Yes (cid:4) No (cid:6)

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site,

if any, every
Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or such
shorter period that the registrant was required to submit and post such ﬁles). Yes (cid:4) No (cid:6)

Indicate by check mark if disclosure of delinquent ﬁlers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not
contained herein, and will not be contained, to the best of registrant’s knowledge, in deﬁnitive proxy or information statements incorporated
by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (cid:4)

Indicate by check mark whether the registrant is a large accelerated ﬁler, an accelerated ﬁler, a non-accelerated ﬁler or a smaller
reporting company. See deﬁnition of ‘‘large accelerated ﬁler’’, ‘‘accelerated ﬁler’’ and ‘‘smaller reporting company’’ in Rule 12b-2 of the
Exchange Act. (Check one):

Large accelerated ﬁler □
Indicate by check mark whether the registrant is a shell company (as deﬁned in Rule 12b-2 of the Act). Yes (cid:6) No (cid:4)
The aggregate market value of the registrant’s voting and non-voting common stock held by non-affiliates was $15,803,329 as of

Non-accelerated ﬁler □ Smaller reporting company (cid:4)

Accelerated ﬁler □

June 30, 2013, based on the closing price of the common stock on The NASDAQ Global Market.

Number of shares of each of the registrant’s classes of securities outstanding on March 25, 2014
Common stock, $0.0005 par value per share: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common share purchase rights: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16,660,324
—

Information set forth in Part III of this report is incorporated by reference to the registrant’s proxy statement for the 2014 annual

meeting of stockholders.

DOCUMENTS INCORPORATED BY REFERENCE

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TABLE OF CONTENTS

Part I

Item 1.

Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1A.

1B.

2.

3.

4.

5.

6.

7.

Part II

Risk Factors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Legal Proceedings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Mine Safety Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Management’s Discussion and Analysis of Financial Condition and Results of
Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7A.

Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . .

Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . .

Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Directors, Executive Officers and Corporate Governance. . . . . . . . . . . . . . . . . . .

Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Security Ownership of Certain Beneﬁcial Owners and Management and Related
Stockholder Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Certain Relationships and Related Transactions and Director Independence . . . . . .

Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8.

9.

9A

9B.

10.

11.

12.

13.

14.

Part III

Part IV

15.

Exhibits and Financial Statement Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . .

Signatures

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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2

8

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24

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33

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60

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60

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63

i

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PART I

Forward-Looking Statements

This Annual Report on Form 10-K (‘‘Report’’) contains ‘‘forward-looking statements’’ within the
meaning of Section 27A of the Securities Act of 1933, as amended (the ‘‘Securities Act’’) and Section 21E of
the Securities Exchange Act of 1934, as amended (the ‘‘Exchange Act’’). These forward looking statements
relate to future events or our future ﬁnancial performance and involve known and unknown risks, uncertainties
and other factors that may cause our or our industry’s actual results,
levels of activity, performance or
achievements to be materially different from any future results, levels of activity, performance or achievements
expressed or implied by the forward-looking statements. Many of these factors are beyond our ability to
predict. Given the risks and uncertainties surrounding forward-looking statements, you should not place undue
reliance on these statements. Forward-looking statements typically are identiﬁed by use of terms such as
‘‘anticipate’’, ‘‘believe’’, ‘‘plan’’, ‘‘expect’’, ‘‘intend’’, ‘‘may’’, ‘‘will’’, ‘‘should’’, ‘‘estimate’’, ‘‘predict’’,
‘‘potential’’,
‘‘continue’’ and similar words although some forward-looking statements are expressed
differently. This Report may contain forward-looking statements attributed to third parties relating to their
estimates regarding the growth of our markets. You are cautioned that such forward looking statements are not
guarantees of future performance and that all forward-looking statements address matters that involve risk and
uncertainties, and there are many important risks, uncertainties and other factors that could cause our actual
results, levels of activity, performance, achievements and prospects, as well as those of the markets we serve,
to differ materially from the forward-looking statements contained in this Report.

Such risks and uncertainties include, but are not limited to:

•

•

•

•

•

•

•

•

•

•

•

•

•

The ability of our management to successfully implement our business plan and strategy;

Our ability to fund our operations including the cost and availability of capital and credit;

Our ability to compete effectively, including our ability to maintain and increase our markets and/or
market share in the markets in which we do business;
Our dependence on sales from our principal product, Cold-EEZE(cid:7) Cold Remedy, and our ability to
successfully develop and commercialize our new products;

Changes in our retail and distribution customers strategic business plans including, but not limited
to, (i) expansions, mergers, and/or consolidations, (ii) retail shelf space allocations for products
within each outlet and in particular the cough/cold category in which we compete, (iii) changes in
their private label assortment and (iv) product selections, distribution allocation, merchandising
programs and retail pricing of our products as well as competitive products;

The uncertain length and severity of the general ﬁnancial and economic downturn, the timing and
strength of an economic recovery, if any, and their impacts on our business including demand for
our products;

Our ability to protect our proprietary rights;

Our continued ability to comply with regulations relating to our current products and any new
products we develop, including our ability to effectively respond to changes in laws and regulations
or the interpretation thereof including changing market rules and evolving federal, state and regional
laws and regulations;

Potential disruptions in our ability to manufacture our products or our access to raw materials;

Seasonal ﬂuctuations in demand for our products;

Our ability to attract, retain and motivate our key employees;

The ability of Phusion Laboratories, LLC, a 50% owned joint venture, to successfully implement its
business plan and strategy to develop and commercialize one or more non-prescription remedies
using certain patented and proprietary technology; and

Other risks identiﬁed in this Report.

1

You should also consider carefully the statements under other sections of this Report, including the Risk
Factors included in Item 1A, which address additional risks that could cause our actual results to differ from
those set forth in any forward-looking statements. Our forward-looking statements speak only as the date of
this Report. We undertake no obligation to publicly update or review any forward-looking statements, whether
as a result of new information, future developments or otherwise.

Where You Can Find Other Information

ProPhase Labs, Inc. (‘‘we’’, ‘‘us’’ or the ‘‘Company’’) ﬁles periodic and current reports, proxy statements
and other information with the Securities and Exchange Commission (the ‘‘SEC’’). We make available on our
website (www.ProPhaseLabs.com) free of charge our Annual Reports on Form 10-K, Quarterly Reports on
Form 10-Q, Current Reports on Form 8-K and any amendments to or exhibits included in those reports as
soon as reasonably practical after we electronically ﬁle such materials with or furnish them to the SEC.
Information appearing on our website is not part of this Annual Report on Form 10-K. You can also read and
copy any materials we ﬁle with the SEC at
the SEC’s Public Reference Room at 100 F Street, NE,
Washington D.C. 20549-1004. You may request copies of these documents, upon payment of a duplication
fee, by writing the SEC at its principal office at 100 F Street, NE Room 1580, Washington, D.C. 20549-1004.
In addition, the SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information
statements regarding issuers that ﬁle electronically with the SEC, including the Company.

Item 1. Business

General Development of Business

We are a manufacturer, marketer and distributor of a diversiﬁed range of homeopathic and health
products that are offered to the general public. We are also engaged in the research and development of
potential over-the-counter (‘‘OTC’’) drug, natural base health products along with supplements, personal care
and cosmeceutical products.

Our primary business is the manufacture, distribution, marketing and sale of OTC cold remedy products
to consumers through national chain, regional, specialty and local retail stores. Our ﬂagship brand is
Cold-EEZE(cid:7) Cold Remedy and our principal product is Cold-EEZE(cid:7) zinc gluconate lozenges, proven in
clinical studies to reduce the duration and severity of symptoms of the common cold by 42%. In addition to
Cold-EEZE(cid:7) Cold Remedy lozenges, we market and distribute non-lozenge forms of our proprietary zinc
gluconate formulation, (i) Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) and (ii) Cold-EEZE(cid:7) Cold Remedy Oral
Spray. In Fiscal 2013, we expanded our Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) product line and began
shipments to retailers in July 2013 two new products, Cold-EEZE(cid:7) Plus Immune Support QuickMelts(cid:7) and
Cold-EEZE(cid:7) Plus Immune Support + Energy QuickMelts(cid:7). Each of these new Cold-EEZE(cid:7) QuickMelts(cid:7)
products are based on our proprietary zinc gluconate formulation in combination with certain immune system
support and natural energy active ingredients.

Cold-EEZE(cid:7) Cold Remedy is an established product in the health care and cold remedy market. For
Fiscal 2013, 2012 and 2011, our revenues have come principally from our OTC cold remedy products.
For Fiscal 2013 and 2012, our net sales for each period were related to markets in the United States.

We use a December 31 year-end for ﬁnancial reporting purposes. References herein to the ﬁscal year
ended December 31, 2013 shall be the term ‘‘Fiscal 2013’’ and references to other ‘‘Fiscal’’ years shall mean
the year, which ended on December 31 of the year indicated.

We are a corporation organized in Nevada in July 1989. Our principal executive offices are located at
621 N. Shady Retreat Road, Doylestown, Pennsylvania 18901 and our telephone number is 215-345-0919.
The terms, ‘‘we’’, ‘‘us’’ and the ‘‘Company’’ refer to the Company together with its consolidated subsidiaries
unless the context otherwise requires.

Description of Business Operations

Cold-EEZE(cid:7) Cold Remedy is one of our most popular OTC cold remedy products and its beneﬁts are
derived from its proprietary zinc gluconate formulation. Cold-EEZE(cid:7) Cold Remedy lozenges effectiveness has
been substantiated in two double-blind clinical studies proving that Cold-EEZE(cid:7) Cold Remedy lozenges

2

reduce the duration of the common cold by 42%. We acquired worldwide manufacturing and distribution
rights to our lozenge formulation in 1992 and commenced national marketing in 1996. In addition to our
the Cold-EEZE(cid:7) Cold Remedy proprietary zinc gluconate formulation is available in
lozenge product,
two additional cold remedy delivery forms, (i) a fast dissolving QuickMelt and (ii) an Oral Spray. The
demand for our OTC cold remedy products is seasonal, where the third and fourth quarters of each year
generally have the largest sales volume.

Our business operations are concentrated on the development, manufacturing, marketing and distribution
of our proprietary Cold-EEZE(cid:7) Cold Remedy lozenge products and on the development of various product
extensions. Our product line of OTC cold remedy products are reviewed regularly to identify new consumer
opportunities and/or trends in ﬂavor, convenience, packaging and delivery systems or forms to help improve
market share for our products. Additionally, we are active in exploring new product technologies, applications,
product line extensions and other new product opportunities consistent with our company and brand image,
and our standard of proven consumer beneﬁt and efficacy.

Manufacturing Facility

Our wholly owned subsidiary, Pharmaloz Manufacturing, Inc. (‘‘PMI’’), produces our Cold-EEZE(cid:7) Cold
Remedy lozenges and other lozenge products in addition to performing operational tasks such as warehousing
and shipping. Our PMI facility is located in Lebanon, Pennsylvania. Additionally, our PMI facility is a
in contract
United States Food and Drug Administration (‘‘FDA’’)
manufacturing and distribution activities. PMI also produces and sells therapeutic lozenges to unaffiliated third
party retail, wholesale and distribution outlets.

registered facility that engages

Joint Venture — Phusion Laboratories, LLC

On March 22, 2010, we, Phosphagenics Limited (‘‘PSI Parent’’), an Australian corporation,
Phosphagenics Inc. (‘‘PSI’’), a Delaware corporation and subsidiary of PSI Parent, and Phusion Laboratories,
LLC (the ‘‘Joint Venture’’), a Delaware limited liability company, entered into a Limited Liability Company
Agreement (the ‘‘LLC Agreement’’) of the Joint Venture and additional related agreements for the purpose of
developing and commercializing, for worldwide distribution and sale, a wide range of non-prescription
remedies using PSI Parent’s proprietary patented TPMTM technology (‘‘TPM’’). TPM facilitates the delivery
and depth of penetration of active molecules in pharmaceutical, nutraceutical, and other products. Pursuant to
the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture.

Due to multiple factors affecting our capital position, including (i) the $2.1 million payment we made in
December 2012 under the Settlement Agreement and Mutual General Release (the ‘‘Settlement Agreement’’)
between the Company and John C. Godfrey, the Estate of Nancy Jane Godfrey and Godfrey Science and
Design (together the ‘‘Godfreys’’) (see Note 5 to Notes to Consolidated Financial Statements) and (ii) some of
the product market research performed, we expect to modify the Joint Venture’s product development plans to
product
stagger
the
pre-commercialization investments required. We expect
to continue pre-commercialization research and
product development initiatives during the latter half of Fiscal 2014 or Fiscal 2015. Furthermore, we do not
expect that the Joint Venture will derive any meaningful revenues, if any, until its commercialization efforts
are completed which is not expected to occur until at the earliest the latter half of Fiscal 2014 or Fiscal 2015.

development

initiatives

periods

certain

and/or

future

defer

into

due

to

In connection with the LLC Agreement, PSI Parent granted to us, pursuant to the terms of a License
Agreement, dated March 22, 2010 (the ‘‘Original License Agreement’’), (i) an exclusive, royalty-free,
world-wide (subject to certain limitations), paid-up license to exploit OTC drugs and certain other products
that embody certain of PSI Parent’s TPM-related patents and related know-how (collectively,
the ‘‘PSI
Technology’’) and (ii) a non-exclusive, royalty-free, world-wide (subject to certain limitations), paid-up license
to exploit certain compounds that embody the PSI Technology for use in a product combining one or more of
such compounds with an OTC drug or in a product that is part of a regimen that includes the application of
an OTC drug. Pursuant
the Original License Agreement, we issued to PSI Parent
1,440,000 shares of our common stock, $0.005 par value (‘‘Common Stock’’) having an aggregate value of
$2.6 million (such share, the ‘‘PSI Shares’’) and made a one-time payment of $1.0 million.

to the terms of

The Joint Venture is managed by a four-person Board of Managers, with two managers appointed by
each member. The LLC Agreement contains other standard terms in such arrangements, including provisions

3

relating to the governance of the Joint Venture, indemniﬁcation obligations of the Joint Venture, allocation of
proﬁts and losses, the distribution of funds to the members and restrictions on transfer of a member’s interest.

In accordance with a Contribution Agreement, dated March 22, 2010 (the ‘‘Contribution Agreement’’), by
and among us, PSI Parent, PSI, and the Joint Venture, we transferred, conveyed and assigned to the Joint
Venture all of our rights, title and interest in, to and under the Original License Agreement, and the Joint
Venture assumed, and undertook to pay, discharge and perform when due, all of our liabilities and obligations
under and arising pursuant to the Original License Agreement (such actions, collectively, the ‘‘Assignment and
Assumption’’).

Pursuant to the Contribution Agreement and in order to reﬂect the Assignment and Assumption, we, PSI
Parent and the Joint Venture entered into an Amended and Restated License Agreement, dated March 22, 2010
(the ‘‘Amended License Agreement’’), which amends and restates the Original License Agreement to reﬂect
that the Joint Venture is the licensee thereunder and which otherwise contains substantially the same terms as
the Original License Agreement. The Joint Venture has the right to grant one or more sub-licenses of the
rights granted under the Amended License Agreement to one or more third parties for reasonable consideration
in any part of the applicable territory. The Amended License Agreement provides that PSI Parent shall not,
directly or through third parties, exploit the covered intellectual property during the term thereof, subject to
certain limitations. The Amended License Agreement will remain in effect until the expiration of the last to
expire of the patents included within the PSI Technology or any extensions thereof. Either party may
terminate the Amended License Agreement upon written notice to the other party in the event of certain
events involving bankruptcy or insolvency. The Amended License Agreement also contains, among other
things, provisions concerning the treatment of conﬁdential information, the ownership of intellectual property
and indemniﬁcation obligations.

Pursuant to the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture.
PSI Parent conducts and oversees much of the product development, formulation, testing and other research
and development needed by the Joint Venture, and we will oversee much of the production, distribution, sales
and marketing. The LLC Agreement provides that each member may be required, from time to time and
subject to certain limitations, to make capital contributions to the Joint Venture to fund its operations, in
accordance with agreed upon budgets for products to be developed. Speciﬁcally, we contributed in Fiscal 2010
$500,000 in cash as initial capital and we are committed to fund up to $2.0 million, subject to agreed upon
budgets (which have not been established to date), toward the initial development and marketing costs of new
products for the Joint Venture. The Joint Venture has not engaged in any ﬁnancial transactions, other than
organizational expenses and general market and initial product evaluation and analysis. At December 31,
2013, cash and equivalents includes $378,000 which is expected to be used by the Joint Venture to fund future
product development initiatives currently under consideration by PSI Parent, PSI and us.

Our determination is that the Joint Venture qualiﬁes as a VIE and that we are the primary beneﬁciary. We
have consolidated the Joint Venture ﬁnancial statements beginning with the quarter ended March 31, 2010. In
Fiscal 2010, we recorded our $3.6 million payment representing the estimated fair value to acquire the product
license as an intangible asset. We currently estimate the expected remaining useful life of the product license
to be approximately 13 years which we will begin amortizing the cost of intangible asset once product
development and commercialization begins. Thus far, the Joint Venture has not generated any revenues and its
expenses, including organizational, marketing analysis and preliminary formulations have been absorbed by
the respective Joint Venture members. Furthermore, the liabilities and other obligations incurred, if any, by the
Joint Venture is without recourse to us and do not create a claim on our general assets.

The product development effort of the Joint Venture is a multi-stage process that includes (i) market
analysis and research, (ii) product formulation research and development, (iii) product evaluation, (iv) product
commercialization, (v) production and distribution, and (vi) retail and consumer advertising and marketing. We
conducted preliminary market
to develop differentiated,
science-based, efficacious products that deliver results to consumers and we have worked with PSI and PSI
Parent to provide initial formulations for certain identiﬁed OTC active ingredients. In December 2011, we
initiated a study of these preliminary formulations to evaluate product attributes, performance and potential

to identify market opportunities

analysis

4

commercial viability. These initial studies were completed in Fiscal 2013. Our initial studies provided certain
positive indications and additional studies will be required. Such additional studies have not yet been
scheduled.

Products

OTC Cold-Remedy Products

In May 1992, we entered into an exclusive agreement for worldwide representation, manufacturing and
marketing of a zinc gluconate formulation. This zinc gluconate formulation is the foundation of our brand;
Cold-EEZE(cid:7) Cold Remedy products which are distributed principally in the United States. Cold-EEZE(cid:7) Cold
Remedy is an OTC consumer product used to reduce the duration of the common cold. We have substantiated
the effectiveness of Cold-EEZE(cid:7) Cold Remedy lozenges through a variety of studies. A randomized
double-blind placebo-controlled study, conducted at Dartmouth College of Health Science, Hanover,
New Hampshire, concluded that the lozenge formulation treatment, initiated within 48 hours of symptom
onset, resulted in a signiﬁcant reduction in the total duration of the common cold.

On May 22, 1992, ‘‘Zinc and the Common Cold, a Controlled Clinical Study,’’ was published in England
in the Journal of International Medical Research, Volume 20, Number 3, Pages 234-246. According to this
publication, (a) ﬂavorings used in other zinc lozenge products (citrate, tartrate, separate, orotate, picolinate,
mannitol or sorbitol) render the zinc inactive and unavailable to the patient’s nasal passages, mouth and throat
where cold symptoms have to be treated, (b) this patented formulation delivers approximately 93% of the
active zinc to the mucosal surfaces and (c) the patient has the same sequence of symptoms as in the absence
of treatment but goes through the phases at an accelerated rate and with reduced symptom severity.

On July 15, 1996, results of a randomized double-blind placebo-controlled study on the common cold,
which commenced at the Cleveland Clinic Foundation on October 3, 1994, were published. The study ‘‘Zinc
Gluconate Lozenges for Treating the Common Cold’’ was completed and published in The Annals of Internal
Medicine — Volume 125 Number 2. Using a 13.3mg lozenge (almost half the strength of the lozenge used in
the Dartmouth study), the result still showed a 42% reduction in the duration of common cold symptoms.

In addition to Cold-EEZE(cid:7) Cold Remedy lozenges, we market and distribute non-lozenge forms of our
proprietary zinc gluconate formulation, (i) Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) and (ii) Cold-EEZE(cid:7)
Cold Remedy Oral Spray. Cold-EEZE(cid:7) Cold Remedy Oral Spray is a liquid form of our zinc gluconate
formulation that is sprayed in the mouth. Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) are fast dissolving tablets
that are taken orally.

The Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) product

(i) Cold-EEZE(cid:7)
Daytime/Nighttime QuickMelts(cid:7) (launched in Fiscal 2012) and (ii) Cold-EEZE(cid:7) Plus Immune Support
QuickMelts(cid:7) and Cold-EEZE(cid:7) Plus Immune Support + Energy QuickMelts(cid:7) (each launched in Fiscal 2013).
We also manufacture, market and distribute organic cough drops and a Vitamin C supplement (‘‘Organix’’)
and perform contract manufacturing services of cough drop and other OTC cold remedy products for
third parties.

comprised of

line

is

Our business is subject to federal and state health and safety laws and regulations. Our OTC cold
remedies are subject
including the FDA.
to regulations by various federal, state and local agencies,
Additionally, Cold-EEZE(cid:7), a homeopathic cold remedy, is subject to the Homeopathic Pharmacopoeia of the
United States. See ‘‘Regulatory Matters’’ below for more information.

Patents, Trademarks, Royalty and Commission Agreements

We do not currently own patents for our OTC cold-remedy products. We maintain various trademarks for
each of our products including Cold-EEZE(cid:7), Kids-EEZE(cid:7), QuickMelts(cid:7), Organix Rx Complete(cid:7) and Organix
Rx Defense(cid:7).

We currently own various domestic and international patents covering certain product development
initiatives principally developed under our Pharma subsidiary operations. To date, we have not realized any
levels of revenues from such patents and we have suspended in Fiscal 2009 any further
meaningful
commercialization efforts for various products under such patents.

5

Our Joint Venture has (i) an exclusive, royalty-free, world-wide (subject to certain limitations), paid-up
license to exploit OTC drugs (and certain other products) that embody certain PSI Technology and (ii) a
to certain limitations) paid-up license to exploit certain
non-exclusive, royalty-free, world-wide (subject
compounds that embody the PSI Technology for use in a product combining one or more of such compounds
with an OTC drug or in a product that is part of a regimen that includes the application of an OTC drug.

Product Distribution and Customers

Our products are distributed through national chain, regional, specialty and local retail stores throughout
the United States. Revenues for Fiscal 2013, 2012 and 2011 were $25.0 million, $22.4 million and
$17.5 million, respectively. Walgreen Company (‘‘Walgreens’’), Wal-Mart Stores Inc (‘‘Wal-Mart’’) and CVS
Caremark Corporation (‘‘CVS’’) accounted for approximately 20.4%, 14.3% and 11.6%, respectively, of our
Fiscal 2013 revenues. Walgreens, Wal-Mart and CVS accounted for approximately 19.3%, 13.8% and 13.4%,
respectively, of our Fiscal 2012 revenues. Walgreens, Wal-Mart, CVS and Rite-Aid Corp (‘‘Rite Aid’’)
accounted for approximately 17%, 14%, 13% and 12%, respectively, of our Fiscal 2011 revenues. The loss of
sales to any one or more of these large retail customers could have a material adverse effect on our business
operations and ﬁnancial condition.

In addition, we have entered into multiple broker, distributor and representative agreements with

third parties which provide for commission compensation based on sales performance.

Research and Development

We have historically invested signiﬁcantly in research and development activities. Our research and

development costs for Fiscal 2013, 2012 and 2011 were $824,000, $1.3 million and $1.1 million respectively.

During Fiscal 2013, 2012 and 2011, our research and development initiatives have been principally
focused on product
line development and/or line extensions for OTC cold remedy products under the
Cold-EEZE(cid:7) brand. In addition, our Joint Venture is at its early stage of development where product and
market research has been initiated and new product initiatives are being evaluated and prioritized for future
development and commercialization utilizing the licensed PSI Technology. Through the Joint Venture, PSI
Parent will conduct and oversee much of the product development, formulation, testing and other research and
development needed by the Joint Venture, and we will oversee much of the production, distribution, sales and
marketing.

ingredients, applications and other products,

Currently, we fund our research and development costs with cash generated from operations. In addition
to funding from operations, we may seek to raise capital through the issuance of securities or to other
ﬁnancing sources to support our research and development activities including new product technologies,
applications, licensing, commercialization and other development opportunities, as well as acquisitions of new
that may be
formulations,
developed through the Joint Venture. Any such funding through the issuance of our equity securities would
result in the dilution of current stockholder ownership. Should research or commercialization activity progress
on certain formulations, resulting expenditures may require substantial ﬁnancial support and may necessitate
the consideration of alternative approaches such as licensing, joint venture or partnership arrangements that
meet our long term goals and objectives. Ultimately, should internal working capital be insufficient and
external funding methods or other business arrangements become unattainable, it could result in the deferral or
loss of future growth and development opportunities.

including those products,

if any,

Regulatory Matters

We are subject to federal and state laws and regulations adopted for the health and safety of users of
pharmaceutical and health care products. Our OTC cold remedy products are subject to regulation by various
federal, state, and local agencies, including the FDA. In addition, our Cold-EEZE(cid:7) Cold Remedy products are
subject to the standards established by the Homeopathic Pharmacopoeia of the United States. These regulatory
authorities have broad powers, and we may be subject to regulatory and legislative changes that can affect the
economics of the industry by requiring changes in operating practices or by inﬂuencing the demand for and
the costs of manufacturing or distributing its products. Our Cold-EEZE(cid:7) Cold Remedy products are
considered a homeopathic drug and are exempt from pre-approval requirements and other, but not all, FDA
requirements.

6

listing of the product

in FDA’s product database, and packaging,

Many homeopathic drug products, including Cold-EEZE(cid:7) Cold Remedy products, are manufactured and
distributed under FDA enforcement policies that provide criteria needed to market a homeopathic OTC drug
product without FDA approval. We believe we meet those requirements, which include registration of our
manufacturing facility,
labeling, and
manufacturing homeopathic drugs in compliance with current good manufacturing practice (‘‘cGMP’’)
regulations. Due to the unique nature of homeopathic drug products, some cGMP requirements are not
applicable, including certain expiration dating, and testing and release for distribution. In addition, the FDA is
currently not enforcing the requirement for a laboratory determination of identity and strength of each active
ingredient prior to release for distribution, although this exemption is pending FDA review and we cannot
assure that the exemption will be permanently implemented. We also cannot assure that the FDA will agree
with our determination of compliance. If the FDA disagrees, the FDA could, upon inspection, issue a notice of
violations, referred to as a form FDA-483, or issue a Warning Letter, or both. If we fail to take timely
corrective actions to the satisfaction of FDA,
the agency can initiate legal actions, such as seizure and
injunction, which could include a recall order or the entry of a consent decree, or both. In addition, we could
be subject to monetary penalties and even criminal prosecution for egregious conduct. We believe that we are
in compliance with all such laws, regulations, and standards currently in effect including the Food, Drug, and
Cosmetics Act as amended from time to time, and the standards established under the Homeopathic
Pharmacopoeia of the United States.

Pre-clinical development, clinical

labeling, marketing, distribution and
trials, product manufacturing,
licensing and/or acquisition of potential new products are also generally subject to federal and state regulation
in the United States and other countries. Obtaining FDA and any other required regulatory approval for certain
OTC products, or seeking the issuance of a ﬁnal monograph from the FDA for certain OTC products, can
require substantial resources and take several years. The length of this process depends on the type,
complexity and novelty of the product and the nature of the disease or other indications to be treated. If we
cannot obtain regulatory approval of, or ﬁnal OTC monograph for, a new product(s) in a timely manner or if
patents are not granted or are subsequently challenged, it could have a material adverse effect on our business
and ﬁnancial condition.

Competition

We compete with other suppliers of OTC cold remedy products. These suppliers range widely in size.
Some of our competitors have signiﬁcantly greater ﬁnancial, technical or marketing resources than we do.
Management believes that our Cold-EEZE(cid:7) Cold Remedy lozenge products, which have been clinically
proven in two double-blind studies to reduce the severity of common cold symptoms, offer a signiﬁcant
advantage over many of our competitors in the OTC cold remedy market. We believe that our ability to
compete depends on a number of factors, including product quality and price, availability, speed to market,
consumer marketing, reliability, credit terms, brand name recognition, delivery time and post-sale service and
support.

Employees

At December 31, 2013, we employed 50 full-time employees, the majority of which were employed at
our manufacturing facility in a production function. The remaining employees were involved in an executive,
sales, marketing or administrative capacity. None of our employees are covered by a collective bargaining
agreement or are members of a union.

Suppliers; Raw Materials

We derive our sales principally from our Cold-EEZE(cid:7) Cold Remedy zinc gluconate products which are
available in various forms — lozenges, oral spray and QuickMelts(cid:7) — and various ﬂavors for purchase by
consumers at retail stores. We also produce private label lozenge products for sale to certain retail customers.
Our zinc lozenge products are manufactured by us at our Lebanon, Pennsylvania facility. The constituent raw
materials and packaging used in the manufacture and presentation of these items are procured from various
sources with additional suppliers having been identiﬁed in the event that alternatives are required. While the
absence of a current raw materials or packaging source may cause short term interruption, we expect that
identiﬁed alternative sources would ﬁll our needs in a short time and any transition period would be mitigated

7

by adequate levels of ﬁnished product available for sale. Certain products within our line of products such as
Cold-EEZE(cid:7) Cold Remedy Oral Spray and Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) are manufactured for us
by third party contract manufacturers and while currently purchased from single sources, we do not believe
that there would be a material revenue risk to us if product availability was jeopardized.

Item 1A. Risk Factors

Any of the following risks could materially affect our business, ﬁnancial condition, or results of
operations. These risks could also cause our actual results to differ materially from those indicated in the
forward-looking statements contained herein and elsewhere. The risks described below are not the only risks
facing us. Additional risks not currently known to us or those we currently deem to be immaterial may also
materially and adversely affect our business, ﬁnancial condition or results of operations.

Our business is subject to signiﬁcant competitive pressures

The OTC healthcare product, pharmaceutical and consumer product industries are highly competitive.
Many of our competitors have substantially greater capital resources, technical staffs, facilities, marketing
resources, product development, distribution and experience than we do. Our competitors may have certain
advantages, including the ability to allocate greater resources for new product development, marketing and
other purposes.

We believe that our ability to compete depends on a number of factors, including product quality and
price, availability, speed to market, consumer marketing, reliability, credit terms, brand name recognition,
delivery time and post-sale service and support, and new and existing product
innovation and
commercialization. There can be no assurance that we will be able to compete successfully in the future. If we
are unable to compete effectively, our earnings may be signiﬁcantly negatively impacted.

Our long range business plan may not be successful

We have aligned our operations to focus principally in the research, development, manufacture, marketing
and sale of OTC cold remedy and consumer products, natural based health products and other supplement and
cosmeceutical products.
into other
arrangements with respect to new formulations, ingredients, applications and other products developed by
third parties who may be seeking our commercialization, marketing and distribution expertise.

In addition, we may seek to acquire from third parties or enter

There can be no assurance that we will be able to effectuate our business plan successfully or that our
revenue growth will continue. In addition, we may not be successful in acquiring or otherwise entering into
any new lines of business and, if we are successful in doing so, there can be no assurance that such new
business will achieve proﬁtability.

We will need to obtain additional capital to support long term product development and commercialization
programs

Our ability to achieve and sustain operating proﬁtability depends in large part on our ability to
commence, execute and complete new and existing product innovation and commercialization, including the
Joint Venture product development
required, clinical programs to obtain regulatory
approvals in the United States and elsewhere. We can give no assurance that we will be able to achieve such
product innovation and commercialization, to obtain any required approvals or to achieve signiﬁcant levels of
sales.

initiatives, and,

if

international regulatory or other technical approvals, (ii) whether we elect

The amount of capital that may be needed to complete product development initiatives will depend on
many factors which may include but are not limited to (i) the cost involved in applying for and obtaining
FDA,
to establish partnering
arrangements for development, sales, manufacturing and marketing of such products, (iii) the level of future
sales of OTC cold remedy products, and expense levels for marketing efforts, (iv) whether we can establish
and maintain strategic arrangements for development, sales, manufacturing and marketing of our products, and
(v) whether any or all of the options for our Common Stock issued to employees of the Company are
exercised and the timing and amount of these exercises.

8

Should research or commercialization activity progress on certain formulations, resulting expenditures
may require substantial ﬁnancial support. The current sales level of our OTC cold remedy products may not
generate all the funds we anticipate will be needed to support future product acquisition or development.
Accordingly, in addition to funding from operations, we may in the short and long term seek to raise capital
through the issuance of securities or to secure other ﬁnancing sources to support our research, new product
technologies, applications, licensing, commercialization and other development opportunities. If we obtain
such funding through the issuance of equity securities, it would result in the dilution of current stockholders’
ownership in the Company. Any debt ﬁnancing, if available, may include ﬁnancial and other covenants that
could restrict use of proceeds of such ﬁnancing or impose other business and ﬁnancial restrictions on us. In
addition, we may consider alternative approaches such as licensing, joint venture, or partnership arrangements
to provide long term capital. There can be no assurances that we will have access to the capital required to
fun these aspects of our business on favorable terms or at all.

We may not be able to access our Equity Line of Credit under commercially reasonable terms

On November 21, 2012, we entered into the equity line of credit agreement (such arrangement, the
‘‘Equity Line’’) with Dutchess Opportunity Fund II, LP (‘‘Dutchess’’) whereby, Dutchess committed to
purchase, subject to certain restrictions and conditions, up to 2,500,000 shares of our Common Stock, over a
period of 36 months expiring in December 2015.

In Fiscal 2013, we sold an aggregate of 289,474 shares of Common Stock to Dutchess in which we
derived approximately net proceeds of $444,000. In Fiscal 2012, we sold an aggregate of 883,722 shares of
Common Stock to Dutchess in which we derived approximately $1.1 million in net proceeds. During the
period January 1, 2014 through to February 25, 2014, we sold an aggregate of 559,318 shares of Common
Stock to Dutchess under and pursuant
to the Equity Line and derived net proceeds of approximately
$947,000. At March 15, 2014, we have 767,486 shares of our Common Stock available for sale, at our
discretion, under the terms of the Equity Line and covered pursuant to a registration statement.

To the extent that we do not generate sufficient cash from operations, we may need to access our Equity
Line to ﬁnance our growth. Recent volatility in the credit markets and the potential impact on the liquidity of
major ﬁnancial institutions may have an adverse effect on our ability to fund our business strategy through our
Equity Line on terms that we believe to be reasonable, or at all. Our Equity Line is limited and may not be
sufficient to meet our capital requirements.

Our Equity Line with Dutchess may not be available to us if we elect to make a draw down

Pursuant

to the Equity Line, Dutchess committed to purchase, subject

to certain conditions, up to
2,500,000 shares of our Common Stock over a thirty-six month period. Dutchess will not be obligated to
purchase shares under the Equity Line unless certain conditions are met, which include, among others:
effectiveness of the registration statement; the continued listing of our stock on the NASDAQ Global Market;
our compliance with our obligations under the purchase agreement and registration rights agreement entered
into with Dutchess; the absence of injunctions or other governmental actions prohibiting the issuance of our
Common Stock to Dutchess; the absence of violations of shareholder approval requirements with respect to
such issuance of our common stock to Dutchess and the accuracy of representations and warranties made to
Dutchess. If we are unable to access funds through the Equity Line, we may be unable to access capital on
favorable terms or at all.

Any draw downs under our Equity Line with Dutchess may result in dilution to our shareholders

If we sell shares to Dutchess under the equity line, it will have a dilutive effect on the holdings of our
current shareholders, and may result in downward pressure on the price of our Common Stock. If we draw
down amounts under the equity line, we will issue shares to Dutchess at a discount of 5% from the average
price of our Common Stock. If we draw down amounts under the equity line when our share price is
decreasing, we will need to issue more shares to raise the same amount than if our stock price was higher.
Issuances in the face of a declining share price will have an even greater dilutive effect than if our share price
were stable or increasing, and may further decrease our share price.

9

We may not be able to commercialize new products through our Joint Venture

The Joint Venture is at its early stage of development where product and market research has been
future development and
initiated and new product
initiatives are being evaluated and prioritized for
commercialization. Prior to any new product being available for sale, substantial resources will have to be
committed to commercialize a product which may include research, development, preclinical testing, clinical
trials, manufacturing scale-up and regulatory approval. The Joint Venture may disrupt our ongoing operations,
divert management from day-to-day responsibilities and increase our expenses.

We face signiﬁcant technological risks inherent in developing these products. The Joint Venture may be
subject to delays and/or ultimately unable to successfully implement its business plan and strategy to develop
and commercialize one or more non-prescription remedies using certain patented and proprietary TPMTM that
exploit certain compounds that embody the TPMTM for use in a product combining one or more of such
compounds with an OTC drug. The commercialization and ultimate product market acceptance is subject to,
among other inﬂuences, consumer purchasing trends, demand for our OTC drug, health and wellness trends,
regulatory factors, retail acceptance and overall economic and market conditions. As a consequence, we may
suspend or abandon some or all of our proposed new products before they become commercially viable which
could have an adverse affect on our business. Even if we develop and obtain approval of a new product, if we
cannot successfully commercialize it
in a timely manner, our business and ﬁnancial condition may be
materially adversely affected.

Instability and volatility in the ﬁnancial markets could have a negative impact on our business, ﬁnancial
condition, results of operations and cash ﬂows

In recent years, there has been substantial volatility in ﬁnancial markets due at least in part to the global
economic environment. In addition, there has been substantial uncertainty in the capital markets and access to
ﬁnancing is uncertain. Moreover, customer spending habits may be adversely affected by the current economic
environment and prevailing high unemployment rates in the United States. These conditions could have an
adverse effect on our industry and business, including our access to funding sources, demand for our products
and our customers’ ability to continue to purchase our products, which could have a material adverse effect on
our ﬁnancial condition, results of operations and cash ﬂows.

To the extent that we do not generate sufficient cash from operations, we may need to issue equity or to
incur indebtedness to ﬁnance our growth. Recent turmoil and volatility in the credit markets and the potential
impact on the liquidity of major ﬁnancial institutions may have an adverse effect on our ability to fund our
business strategy through borrowings, under either existing or newly created instruments in the public or
private markets on terms that we believe to be reasonable, or at all.

Commodity price increases will increase our operating costs and may negatively affect ﬁnancial results

Commodity prices impact our business directly through the cost of raw materials used to make our
products (such as corn syrup, sucrose and other commodities and ingredients) and the amount we pay to
purchase packaging for our products (such as paper, board and plastic). Commodities such as these are
including ﬂuctuations in
susceptible to price volatility caused by conditions outside of our control,
commodities markets, currency ﬂuctuations, availability of supply, weather, consumer demand and changes in
governmental agricultural programs. Increases in the price of our commodities and other raw materials would
negatively impact our gross margins and/or our sales volume if we were unable to offset such increases
through increases in our selling price, changes in product mix or cost reduction/productivity enhancement
efforts.

The sales of our primary product ﬂuctuates by season and from Cold Season to Cold Season

Our sales are derived principally from our OTC cold remedy products. A signiﬁcant portion of our
business is highly seasonal, which causes major variations in operating results from quarter to quarter. The
third and fourth quarters generally represent the largest sales volume for our OTC cold remedy products. In
addition, our sales are inﬂuenced by and subject to ﬂuctuations in the timing of purchase and the ultimate
level of demand for our products which are a function of the timing, length and severity of each cold season.
Generally, a Cold Season is deﬁned as the period of September to March when the incidence of the common
cold rises as a consequence of the change in weather and other factors.

10

There can be no assurance that we will be able to manage our working capital needs and inventory to
meet the ﬂuctuating demand for these products. Failure to accurately predict and respond to consumer demand
may result in the production of excess inventory which may be expensive to store or which we may be
required to dispose if such excess inventory remains unsold. Conversely, if products achieve greater success
than anticipated for any given quarter, this may result in insufficient inventory to meet customer demand. If
we do not manage our working capital needs and inventory, our business and ﬁnancial condition may be
materially adversely affected.

Our performance may ﬂuctuate when our retail customers are affected simultaneously by the same economic,
regulatory or health and wellness factors

Our revenues are signiﬁcantly concentrated in our OTC cold remedy products. Our retail customers are
subject to ﬂuctuations of business based upon consumer purchasing trends, demand for cold remedy products
and overall economic and market conditions. Consequently, many retailers will likely be inﬂuenced at the
same time by similar economic conditions, regulatory factors or health and wellness trends, which can affect
the level of demand for our products. It is reasonable to expect that, if one retailer reduces or delays its
purchasing in response to a general economic, regulatory or health and wellness factor, other retailers may
also decide to reduce or delay their purchasing at approximately the same time. Accordingly, our sales are
subject to ﬂuctuations as a result of such factors.

We have a concentration of sales to and accounts receivable from several large retail customers

retail stores, our ﬁve largest customers account

Although we have a broad range of retail customers that includes many national chain, regional, specialty
for a signiﬁcant percentage of our sales,
and local
approximately 57% of total revenues for each of Fiscal 2013 and 2012, respectively. In addition, retail
customers comprising the ﬁve largest accounts receivable balances represented 68% and 65% of total accounts
receivable balances at December 31, 2013 and 2012, respectively. We extend credit to retail customers based
upon an evaluation of their ﬁnancial condition and credit history, and collateral is not generally required. If
one or more of these large retail customers cannot pay, the write-off of their accounts receivable could have a
material adverse effect on our operations and ﬁnancial condition. The loss of sales to any one or more of these
large retail customers would also have a material adverse effect on our ﬁnancial condition, results of
operations and cash ﬂows.

Retail customer’s strategic business plans may negatively inﬂuence the distribution of our products to
consumer.

Changes in our retail and distribution customers strategic business plans including, but not limited to,
(i) expansions, mergers, and/or consolidations, (ii) retail shelf space allocations for products within each outlet
and in particular the cough/cold category in which we compete, (iii) changes in their private label assortment
and (iv) product selections, distribution allocation, merchandising programs and retail pricing of our products
as well as competitive products could affect the consumer sales of our products and could result in a material
adverse effect to our business and ﬁnancial condition.

Our future success depends on the continued sales of our principal product

For Fiscal 2013 and 2012, our cold remedy products, principally Cold-EEZE(cid:7) Cold Remedy, represented
approximately 94% and 95%, respectively, of our total sales. Accordingly, we depend on the continued
acceptance of Cold-EEZE(cid:7) Cold Remedy products by our customers. Our investments in and strategies used
for our brand marketing are critical to achieve brand awareness with current consumers, educate potential new
consumers and convert potential consumers into customers. However,
there can be no assurance that
Cold-EEZE(cid:7) Cold Remedy products will continue to receive, maintain or increase market acceptance. The
inability to successfully commercialize Cold-EEZE(cid:7) Cold Remedy products in the future and/or expand its
product line, for any reason, would have a material adverse effect on our ﬁnancial condition, prospects and
ability to continue operations.

11

Our products and potential new products are or may be subject to extensive governmental regulation

Our business is regulated by various agencies of the states and localities where our products are sold.
Governmental regulations in foreign countries where we plan to commence or expand sales may prevent or
delay entry into a market or prevent or delay the introduction, or require the reformulation of certain of our
products. In addition, no prediction can be made as to whether new domestic or foreign legislation regulating
our activities will be enacted. Any new legislation could have a material adverse effect on our business,
ﬁnancial condition and operations. Non-compliance with any applicable requirements may subject us or the
manufacturers of our products to agency action, including warning letters, ﬁnes, product recalls, seizures and
injunctions.

The manufacturing, processing, formulation, packaging, labeling and advertising of our cold remedy
products are subject to regulation by several federal agencies, including (i) the FDA, (ii) the Federal Trade
Commission (‘‘FTC’’), (iii) the Consumer Product Safety Commission, (iv) the United States Department of
Agriculture, (v) the United States Postal Service, (vi) the United States Environmental Protection Agency and
(vii) the United States Occupational Safety and Health Administration.

including vitamins, minerals and herbs,

In addition to OTC and prescription drug products, the FDA regulates the safety, manufacturing, labeling
and distribution of dietary supplements,
food
supplements, over-the-counter and prescription drugs and cosmetics. The FTC also has overlapping
jurisdiction with the FDA to regulate the promotion and advertising of vitamins, over-the-counter drugs,
cosmetics and foods. In addition, our cold remedy products are homeopathic remedies which are subject to
standards established by the Homeopathic Pharmacopoeia of the United States (‘‘HPUS’’). HPUS sets the
standards for source, composition and preparation of homeopathic remedies which are officially recognized
under the Federal Food, Drug and Cosmetics Act, as amended.

food additives,

Preclinical development, clinical trials, product manufacturing, labeling, distribution and marketing of
potential new products are also subject to federal and state regulation in the United States and other countries.
Clinical trials and product marketing and manufacturing are subject to the rigorous review and approval
processes of the FDA and foreign regulatory authorities. To obtain approval of a new drug product, a
company must demonstrate through adequate and well-controlled clinical trials that the drug product is safe
and effective for its intended use. Obtaining FDA and other required regulatory approvals is lengthy and
expensive. Typically, obtaining regulatory approval for pharmaceutical products requires substantial resources
and takes several years. The length of this process depends on the type, complexity and novelty of the product
and the nature of the disease or other indication to be treated. Preclinical studies must comply with FDA
regulations. Clinical trials must also comply with FDA regulations to ensure safety of the human subjects in
the trial and may require large numbers of test subjects, complex protocols and possibly lengthy follow-up
periods. Consequently, satisfaction of government regulations may take several years: may cause delays in
introducing potential new products for considerable periods of time and may require imposing costly
procedures upon our activities. If regulatory approval of new products is not obtained in a timely manner or
not at all, we could be materially adversely affected. Even if regulatory approval of new products is obtained,
such approval may impose limitations on the indicated uses for which the products may be marketed which
could also materially adversely affect our business, ﬁnancial condition and future operations.

We have a history of losses and limited working capital

We have experienced net losses for each of the seven of the past eight ﬁscal years. In Fiscal 2013 we
realized net income of $405,000. There can be no assurance that our strategic focus will result in any revenue
growth or that we will be successful in initiating or acquiring any new lines of business, or that any such new
lines of business will achieve proﬁtability. As of December 31, 2013, we had working capital of
approximately $6.7 million which we believe is an acceptable and adequate level of working capital to
support our business. Our ability to fund working capital needs will depend on our ability to generate cash in
the future.

12

Our ability to use our net operating loss carryforwards to offset future taxable income may be subject to
certain limitations

In general, under Section 382 of the Internal Revenue Code of 1986, as amended, or the Code, a
corporation that undergoes an ‘‘ownership change’’ is subject to limitations on its ability to use its pre-change
net operating loss carryforwards, or NOLs, to offset future taxable income. Future changes in our stock
ownership, some of which are outside of our control, could result in an ownership change under Section 382
of the Code. Furthermore, our ability to use NOLs of companies that we may acquire in the future may be
subject to limitations. For these reasons, we may not be able to use a material portion of the NOLs reﬂected
on our balance sheet, even if we attain proﬁtability.

Our success is dependent on key personnel

Our success depends, in part, upon the continued service of key personnel, such as Mr. Ted Karkus,
Chairman and Chief Executive Officer, Mr. Robert V. Cuddihy, Jr., Chief Operating Officer and Chief
Financial Officer, and certain managers and strategists within the Company. If we are unable to attract and
retain such personnel, the loss of the services of any one of them could have a material adverse effect on us.

In order to be successful, we must retain and motivate executives and other key employees, including
those in managerial, technical, marketing and health product positions. In particular, our product generation
efforts depend on hiring and retaining qualiﬁed health and science professionals. Competition for skilled
employees who can perform the services that we require is intense and hiring, training, motivating, retaining
and managing employees with the skills required is time-consuming and expensive. If we are not be able to
hire sufficient professional staff to support our operations, or to train, motivate, retain and manage the
employees we do hire, it could have a material adverse effect on our business operations or ﬁnancial results.

We are dependent on our manufacturing facility and suppliers for certain of our cold remedy products

Our manufacturing, warehousing and distribution center is located in Lebanon, Pennsylvania. In the event
temporarily, our
of a disruption of this facility, we would need to outsource to third parties, at
manufacturing, warehousing and distribution requirements. While such secondary sources have been identiﬁed
for our products,
if we are unable to ﬁnd other sources or there were a delay in the ramp-up for the
production and distribution operations for some of our products, it could have a material adverse effect on our
operations.

least

Certain raw material active ingredients used in connection with the Cold-EEZE(cid:7) products are purchased
from a single unaffiliated supplier. Should the relationship terminate or the vendor become unable to supply
material, we believe that current contingency plans would prevent such termination from materially affecting
our operations, although there may be delays in production of our products until an acceptable replacement
supplier is located.

Our inability to ﬁnd alternative sources for some of our manufacturing and raw materials may have a
material adverse effect on our operations and ﬁnancial condition.
the terms on which
manufacturers and suppliers will make products and raw materials available to us could have a material effect
on our success.

In addition,

The manufacturing of OTC products and dietary supplements is subject

to applicable current good
manufacturing practice (‘‘cGMP’’) regulations and FDA inspections. We believe we are in substantial
compliance with material provisions of the applicable cGMP regulations. Contract manufacturers are also
subject to these same requirements and we require such compliance in our contractual relationships with such
manufacturers. However, we cannot assure that the FDA will agree with our determination of compliance. If
the FDA disagrees, it could, upon inspection of our facility, issue a notice of violations, referred to as a
form FDA-483, or issue a Warning Letter, or both. If the FDA concludes that there is an imminent public
health threat or if we fail to take timely corrective actions to the satisfaction of the FDA, the agency can
initiate legal actions, such as seizure and injunction, which could include a recall order or the entry of a
consent decree, or both. In addition, we could be subject to monetary penalties and even criminal prosecution
for egregious conduct. The FDA could initiate similar legal actions against the contract manufacturer if it
the availability of our products. While
concludes its facility is not

in compliance, which would affect

13

secondary sources have been identiﬁed for our products, our inability to ﬁnd other sources or a delay in the
ramp-up for the production and distribution operations for some of its products may have a material adverse
effect on our operations.

We are uncertain as to whether we can protect our proprietary rights

The strength of our patent position and proprietary formulations and compounds may be important to our
long-term success. We currently own numerous U.S. and foreign patents in connection with potential products;
however there can be no assurance that
these patents and proprietary formulations and compounds will
effectively protect our products from duplication by others. In addition, we may not be able to afford the
expense of any litigation which may be necessary to enforce our rights under any of the patents. Furthermore,
independently develop our
there can be no assurance that
technologies, know-how, ideas, concepts and documentation, which could have a material adverse effect on
our ﬁnancial condition.

third parties will not obtain access to or

Although we believe that current and future products do not and will not infringe upon the patents or
violate the proprietary rights of others, if any of our current or future products do infringe upon the patents or
proprietary rights of others, we may have to modify the products or obtain an additional license for the
manufacture and/or sale of such products. We could also be prohibited from selling the infringing products. If
we were found to infringe on the proprietary rights of others, it is uncertain whether we would be able to take
corrective actions in a timely manner, upon acceptable terms and conditions, or at all, and the failure to do so
could have a material adverse effect upon our business, ﬁnancial condition and operations.

Our existing products and potential new products expose us to potential product liability claims

Our business results in exposure to an inherent risk of potential product liability claims, including claims
for serious bodily injury or death caused by the sales of our existing products and the products which are
being developed. These claims could lead to substantial damage awards. While we currently maintain product
liability insurance, a successful claim brought against us in excess of, or outside of, existing insurance
coverage could have a material adverse effect on our results of operations and ﬁnancial condition. Claims
against us, regardless of their merit or eventual outcome, may also have a material adverse effect on the
consumer demand for our products.

We are involved in litigation matters and are a defendant in a stockholder derivative lawsuit ﬁled by our
former CEO

We are, from time-to-time, subject to various legal proceedings and claims, either asserted or unasserted.
Any such claims, whether with or without merit, can be time-consuming and expensive to defend and can
divert management’s attention and resources. While management believes that we have adequate insurance
coverage and, if applicable, accrued loss contingencies for all known matters, there is no assurance that the
outcome of all current or future litigation will not have a material adverse effect on us.

A purported derivative lawsuit was ﬁled against us, our officers and directors, as described under ‘‘Part I,
Item 3, Legal Proceedings’’. We believe the lawsuit is without merit and we intend to engage in a vigorous
defense of such litigation. If we are not successful in our defense of this litigation, we could be forced to
make signiﬁcant payments to or other settlements with our stockholders and their lawyers, and such payments
or settlement arrangements could have a material adverse effect on our business, operating results or ﬁnancial
condition. Regardless of the outcome, the litigation could result in substantial costs and signiﬁcant adverse
impact on our reputation and divert management’s attention and resources, which could have a material
adverse effect on our business, operating results or ﬁnancial condition. We also have certain obligations to
indemnify our officers and directors and to advance expenses to such officers and directors. Although we have
purchased liability insurance for our directors and officers, if our insurance carriers should deny coverage, or
if the indemniﬁcation costs exceed the insurance coverage, we may be forced to bear some or all of these
indemniﬁcation costs directly, which could be substantial and may have an adverse effect on our business,
ﬁnancial condition, results of operations and cash ﬂows. If the cost of our liability insurance increases
signiﬁcantly, or if this insurance becomes unavailable, we may not be able to maintain or increase our levels
of insurance coverage for our directors and officers, which could make it difficult to attract or retain qualiﬁed
directors and officers.

14

A competing brand to Cold-EEZE(cid:7) owns an Option to Acquire 1,453,427 of our shares of Common Stock
from our former CEO, Guy Quigley, and acquired by proxy the voting rights of such shares

In May 2012, we received an expression of interest and a non-binding proposal to be acquired by
Matrixx, a competitor of Cold-EEZE(cid:7). In September 2012, Matrixx purchased for $200,000 a three year
option to acquire 1,453,427 shares of our Common Stock for $1.40 per share from Guy J. Quigley, our former
Chairman and Chief Executive Officer. Matrixx also acquired from Mr. Quigley a voting proxy to vote the
shares subject to the option.

In October 2012, we received a revised non-binding proposal, on essentially the same terms as Matrixx’s
earlier offer, except that in the latest proposal Matrixx raised the proposed price by $0.20 per share. At a
meeting held on October 24, 2012, our board of directors unanimously rejected the October 2012 Matrixx
proposal after careful consideration and consultation with its advisors. On February 5, 2013, Matrixx informed
us that it has withdrawn its unsolicited offer to acquire us.

Matrixx continues to hold its voting proxy and an option to purchase shares from Guy Quigley. The
Matrixx option to purchase shares expires in September 2015. Circumstances may occur in which the interests
of Matrixx could be in conﬂict with the interests of other shareholders. Accordingly, Matrixx’s ability to
inﬂuence us through voting their shares may affect our other shareholders or the market price of our Common
Stock may be adversely affected.

Certain Offıcers, Directors and former executives and their families own a substantial amount of our Common
Stock

As of March 25, 2014, our executive officers and directors beneﬁcially owned approximately 18.6% of
our Common Stock and Mr. Guy J. Quigley, Mr. Quigley’s spouse and Matrixx beneﬁcially owned,
approximately 17.4% of our Common Stock. These individuals have signiﬁcant inﬂuence over the outcome of
all matters submitted to stockholders for approval, including the election of directors. Consequently, they
exercise substantial inﬂuence over all major decisions including major corporate actions such as mergers and
other business combinations transactions which could result in or prevent a change of control of the Company.
Circumstances may occur in which the interests of these shareholders could be in conﬂict with the interests of
other shareholders. Accordingly, a stockholder’s ability to inﬂuence us through voting their shares may be
limited or the market price of our Common Stock may be adversely affected.

We incur signiﬁcant costs as a result of operating as a public company, and our management devotes
substantial time to new compliance initiatives

We have incurred and will continue to incur signiﬁcant legal, accounting and other expenses as a public
company, including costs resulting from public company reporting obligations under the Exchange Act and
regulations regarding corporate governance practices. The listing requirements of The NASDAQ Global
Market require that we satisfy certain corporate governance requirements relating to director independence,
distributing annual and interim reports, stockholder meetings, approvals and voting, soliciting proxies, conﬂicts
of interest and a code of conduct. Our management and other personnel will need to devote a substantial
amount of time to all of these requirements. Moreover, the reporting requirements, rules and regulations will
increase our legal and ﬁnancial compliance costs and will make some activities more time-consuming and
costly. These reporting requirements, rules and regulations, coupled with the increase in potential litigation
exposure associated with being a public company, could make it more difficult for us to attract and retain
qualiﬁed persons to serve on our board of directors or board committees or to serve as executive officers.

In addition, the Sarbanes-Oxley Act of 2002 (‘‘Sarbanes-Oxley’’) and the related rules of the Securities
and Exchange Commission require that we maintain effective internal control over ﬁnancial reporting and
disclosure controls and procedures. During the course of our review and testing, we may identify deﬁciencies
and be unable to remediate them before we must provide the required reports. We or our independent
registered public accounting ﬁrm may not be able to conclude on an ongoing basis that we have effective
internal control over ﬁnancial reporting, which could harm our operating results, cause investors to lose
conﬁdence in our reported ﬁnancial information and cause the trading price of our stock to fall.

Our compliance with Section 404 of Sarbanes-Oxley may require that we incur substantial expense and
expend signiﬁcant management time on compliance related issues. Moreover, if we are not able to comply
with the requirements of Section 404 in a timely manner, or if we or our independent registered public

15

accounting ﬁrm identify deﬁciencies in our internal control over ﬁnancial reporting that are deemed to be
material weaknesses, the market price of our stock would likely decline and we could be subject to sanctions
or investigations by Nasdaq, the SEC or other regulatory authorities, which would require additional ﬁnancial
and management resources.

Our stock price is volatile

The market price of our Common Stock has experienced signiﬁcant volatility. From January 1, 2013 to
March 25, 2014, the trading prices of our stock have ranged from $1.40 to $2.98 per share. There are several
factors which could affect
including announcements of technological
innovations for new commercial products by us or our competitors, developments concerning propriety rights,
new or revised governmental regulation or general conditions in the market for our products. Sales of a
substantial number of shares by existing stockholders could also have an adverse effect on the market price of
our Common Stock.

the price of our Common Stock,

Future sales of shares of our Common Stock in the public market could adversely affect the trading price of
shares of the Common Stock and our ability to raise funds in new stock offerings

Future sales of substantial amounts of shares of our Common Stock in the public market, or the
perception that such sales are likely to occur, could affect prevailing trading prices of our Common Stock. As
of March 25, 2014, we had 16,660,324 shares of Common Stock outstanding.

As of March 25, 2014, there are outstanding options, which are fully vested, to purchase an aggregate of
753,250 shares of our Common Stock at an average exercise price of $1.92 per share. If these options are
exercised, and the holders of these options were to attempt to sell a substantial amount of their holdings at
once, the market price of our Common Stock would likely decline. Moreover, the perceived risk of this
potential dilution could cause stockholders to attempt to sell their shares and investors to ‘‘short’’ our stock, a
practice in which an investor sells shares that he or she does not own at prevailing market prices, hoping to
purchase shares later at a lower price to cover the sale. As each of these events would cause the number of
shares of Common Stock being offered for sale to increase, our Common Stock’s market price would likely
further decline. All of these events could combine to make it very difficult for us to sell equity or
equity-related securities in the future at a time and price that we deem appropriate.

Our Common Stock may be delisted from The NASDAQ Global Market, which would adversely affect the
price and liquidity of our Common Stock

Our Common Stock is currently listed on The NASDAQ Global Market. If our Common Stock is
delisted,
it could reduce the price of our Common Stock and the levels of liquidity available to our
stockholders. In addition, the delisting of our Common Stock could materially adversely affect our access to
the capital markets, and any limitation on liquidity or reduction in the price of our Common Stock could
materially adversely affect our ability to raise capital on terms acceptable to us or at all. Delisting from The
NASDAQ Global Market could also result in other negative implications, including the potential loss of
conﬁdence by suppliers, customers and employees, the loss of institutional investor interest and fewer business
development opportunities.

If securities or industry analysts do not publish research or reports about our business or if they issue an
adverse or misleading opinion regarding our stock, our stock price and trading volume could decline

The trading market for our Common Stock will be inﬂuenced by the research and reports that industry or
securities analysts publish about us or our business. If any of the analysts who cover us issue an adverse or
misleading opinion regarding us, our business model, products or stock performance, our stock price would
likely decline. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly,
we could lose visibility in the ﬁnancial markets, which in turn could cause our stock price or trading volume
to decline. Moreover, the unpredictability of our ﬁnancial results likely reduces the certainty, and therefore
reliability, of the forecasts by securities or industry analysts of our future ﬁnancial results, adding to the
potential volatility of our stock price.

We do not intend to pay cash dividends in the foreseeable future

We have not paid cash dividends on our Common Stock since our inception. Our intention is to retain
earnings, if any, for use in the business and we do not anticipate paying any cash dividends to stockholders in
the foreseeable future.

16

Our Articles of Incorporation and By-laws contain certain provisions that may be barriers to a takeover

Our Articles of Incorporation and By-laws contain certain provisions which may deter, discourage, or
make it difficult for another person or entity to gain control of the Company through a tender offer, merger,
proxy contest or similar transaction or series of transactions. These provisions may deter a future tender offer
or other takeover attempt which could include a premium over the market price of our Common Stock at the
time. Such provisions could depress the trading price of our Common Stock.

We have agreed to indemnify our Offıcers and Directors from liability

In accordance with sections 78.7502 and 78.751 of the Nevada General Corporation Law our Articles of
Incorporation provide that we will indemnify any person who is or was made a party to, or is or was
threatened to be made a party to, any pending, completed, or threatened action, suit or proceeding because he
or she is or was a director, officer, employee or agent of the Company or is or was serving at the Company’s
request as a director, officer, employee or agent of any corporation, partnership, joint venture, trust or other
enterprise. These provisions permit us to advance expenses to an indemniﬁed party in connection with
defending any such proceeding, upon receipt of an undertaking by the indemniﬁed party to repay those
amounts if it is later determined that the party is not entitled to indemniﬁcation. In August 2009, we entered
into indemnity agreements with each member of our board of directors and Mr. Cuddihy. These agreements
provide, among other things, that we will indemnify each officer and director in the event they become a party
or otherwise a participant in any action or proceeding on account of their service as a director or officer of the
Company (or service for another corporation or entity in any capacity at the request of the Company) to the
fullest extent permitted by applicable law. These indemnity provisions may reduce the likelihood of derivative
litigation against directors and officers and discourage or deter stockholders from suing directors or officers for
breaches of their duties to the Company, even though such an action, if successful, might otherwise beneﬁt the
Company or its stockholders. In addition, to the extent that we expend funds to indemnify directors and
officers, funds will be unavailable for operational purposes.

Item 1B. Unresolved Staff Comments

Not applicable.

Item 2. Properties

Our corporate headquarters is located in Doylestown, Pennsylvania. We purchased this property in 1998.
Our headquarters is approximately 13,000 square feet and is comprised of office space and a storage area. Our
principal manufacturing facility is located in Lebanon, Pennsylvania. The facility was purchased in
October 2004. The facility has a total area of approximately 57,500 square feet, comprised of manufacturing,
warehousing and office space. We believe that our existing facilities are adequate at this time and do not
anticipate the need for additional facilities in the foreseeable future.

Item 3. Legal Proceedings

PROPHASE LABS, INC. (formerly THE QUIGLEY CORPORATION) VS. GUY QUIGLEY, GARY QUIGLEY,
SCANDA SYSTEMS LIMITED, SCANDA SYSTEMS LTD, CHILESHA HOLDINGS LTD, KEVIN BROGAN,
INNERLIGHT HOLDINGS,
INC., GEORGE LONGO, GRAHAM BRANDON AND PACIFIC RIM
PHARMACEUTICALS LTD

On August 23, 2010, we initiated an action in the Court of Common Pleas of Bucks County,
Pennsylvania Civil Action No. 2010-08227. This action is against certain former officers and directors of the
Company, including a shareholder that beneﬁcially owns approximately 17.4% of our Common Stock, and
against certain third parties. The Company has asserted claims arising from, among other things, a variety of
transactions and payments previously made or entered into by the Company. All of the transactions and events
that are the subject of this litigation occurred prior to June 2009 and the installation of the current board of
directors. We are seeking recovery of monetary damages and other relief. Pre-trial discovery is on-going at
this time and a date certain for trial has been ordered for June 9, 2014. At this time, no prediction as to the
outcome of this action can be made.

17

GUY QUIGLEY VS. TED KARKUS, ROBERT V. CUDDIHY, JR., MARK BURNETT, MARK LEVENTHAL,
MARK FRANK, LOUIS GLECKEL, MD, JAMES McCUBBIN AND PROPHASE LABS, INC. AS A NOMINAL
DEFENDANT

We were named as a nominal defendant in a purported derivative complaint ﬁled on February 2, 2012 by
stockholder and former director and Chief Executive Officer Guy Quigley in the Court of Common Pleas of
Philadelphia County, Pennsylvania (No. 111200409). The complaint also names as a defendant each of our
directors and executive officers. Among other things, the suit alleges various breaches of ﬁduciary and other
duties, and seeks recovery of unspeciﬁed damages and other relief. Prior to ﬁling this complaint, the plaintiff
applied to the same court for permission to take pre-complaint discovery on the basis that
the plaintiff
required such discovery in order to assert claims. The court denied the plaintiff’s request. We believe the
lawsuit is without merit and intend to vigorously defend against it. On April 5, 2013, the court entered an
order allowing limited pre-trial discovery limited to demand futility and plaintiff adequacy issues, which was
completed by July 12, 2013. We ﬁled a motion to dismiss on July 26, 2013 on demand futility and plaintiff
adequacy issues. On August 26, 2013 the court heard oral arguments regarding the Company’s motion for
summary judgment and dismissal with prejudice. The court stayed any additional discovery until the court
rules on our motion to dismiss with and our motion is currently pending with the court. At this time, no
prediction as to the outcome of this action can be made.

As noted above, we previously commenced litigation against the plaintiff, Guy Quigley, and other parties
in August 2010 in the Bucks County Court of Common Pleas, Pennsylvania (No. 2010-08227). The
August 2010 action remains pending.

PROPHASE LABS,
(formerly THE QUIGLEY CORPORATION) VS. GUY QUIGLEY, KARIBA
HOLDINGS, LIMITED, WENDY QUIGLEY, GARY QUIGLEY, FRANCES QUIGLEY (A/K/A FRANCES
BOSTON) AND JOSEPHINE QUIGLEY (A/K/A JOSEPHINE GLEESON)

INC.

On July 19, 2012, we initiated an action in the Court of Common Pleas of Bucks County, Pennsylvania
(‘‘Kariba Complaint’’) (No. 2011-09815). The Kariba Complaint names as defendants (i) a former officer and
director of the Company, who is a shareholder that beneﬁcially owns approximately 17.4% of our Common
Stock, (ii) certain family members of such former officer and director, some of whom are former employees of
the Company, and (iii) certain third parties. The Company has asserted claims arising from, among other
things, a variety of transactions and payments previously made or entered into by the Company. The Kariba
Complaint asserts additional claims not previously asserted in the action ProPhase Labs, Inc. (formerly The
Quigley Corporation) vs. Guy Quigley, Gary Quigley, Scanda Systems Limited, Scanda Systems LTD,
Chilesha Holdings LTD, Kevin Brogan, Innerlight Holdings, Inc., George Longo, Graham Brandon, Paciﬁc
Rim Pharmaceuticals LTD and John Doe Defendants (No. 2010-08227). All of the transactions and events that
are the subject of the Kariba Complaint occurred prior to June 2009 and the installation of the current board
of directors. We are seeking recovery of monetary damages and other relief. Pre-trial discovery is on-going
and at this time, no prediction as to the outcome of this action can be made.

GARY QUIGLEY VS. EAST BAY MANAGEMENT, INC., TED KARKUS AND JOHN DOE 1

East Bay Management, Inc., Ted Karkus and John Doe 1 were named as defendants in a purported
complaint ﬁled on June 10, 2013 by Gary Quigley, the brother of our stockholder and former director and
Chief Executive Officer Guy Quigley, in the Court of Common Pleas of Philadelphia County, Pennsylvania
(No. 2013-04393). The suit alleges ﬁve causes of action against the defendants, including the Company’s
Chief Executive Officer, for (i) fraud, (ii) conversion, (iii) unjust enrichment, (iv) conspiracy and (v) piercing
the corporate veil. On July 10, 2013, Mr. Karkus removed the case to the United States District Court for
Eastern Pennsylvania. On August 16, 2013, Mr. Karkus ﬁled a Motion to Dismiss for Failure to State a Claim.
Mr. Gary Quigley responded to the motion to dismiss. On January 7, 2014, the court heard oral arguments
regarding the motion to dismiss. The court stayed any additional discovery until the court rules on the motion
to dismiss and the motion is currently pending with the court. At this time, no prediction as to the outcome of
this action can be made.

On January 15, 2014, our Board of Directors, without the presence of Ted Karkus, voted to indemnify
Mr. Karkus and pay the expenses incurred by him in connection with this legal matter. This action has been
and will continue to be vigorously defended by Mr. Karkus, who denies any wrongdoing.

18

THE ESTATE OF JOSEPHINE QUIGLEY AND KARIBA HOLDINGS LIMITED VS. EAST BAY
MANAGEMENT, INC., TED KARKUS, SCOTT STRADY AND JOHN DOE

above)

East Bay Management, Inc., Ted Karkus, Scott Strady and John Doe were named as defendants in a
purported complaint ﬁled on August 9, 2013 by the Estate of Josephine Quigley,
the mother of our
stockholder and former director and Chief Executive Officer Guy Quigley, and Kariba Holdings Limited (see
in the Court of Common Pleas of Philadelphia County, Pennsylvania
Kariba Compliant
(No. 2013-006131). Guy Quigley, our stockholder, former director and Chief Executive Officer of the
Company, ﬁled this suite as Executor of the Estate of Josephine Quigley and as a representative of Kariba
Holdings. The suit alleges ﬁve causes of action against
including the Company’s Chief
Executive Officer, for (i) fraud, (ii) conversion, (iii) unjust enrichment, (iv) conspiracy and (v) piercing the
corporate veil. On September 23, 2013, Mr. Karkus removed the case to the United States District Court for
Eastern Pennsylvania. On September 23, 2013, Mr. Karkus ﬁled a Motion to Dismiss for Failure to State a
Claim. The Estate of Josephine Quigley and Kariba Holdings Limited responded to the motion to dismiss. On
January 7, 2014, the court heard oral arguments regarding the motion to dismiss. The court stayed any
additional discovery until the court rules on the motion to dismiss and the motion is currently pending with
the court. At this time, no prediction as to the outcome of this action can be made.

the defendants,

On January 15, 2014, our Board of Directors, without the presence of Ted Karkus, voted to indemnify
Mr. Karkus and pay the expenses incurred by him in connection with this legal matter. This action has been
and will continue to be vigorously defended by Mr. Karkus, who denies any wrongdoing.

Other Litigation

In the normal course of our business, we are named as defendant in legal proceedings. It is our policy to

vigorously defend litigation and/or enter into settlements of claims where management deems appropriate.

Item 4. Mine Safety Disclosures

Not applicable.

19

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of
Equity Securities

Market Information

Our Common Stock is currently traded on The NASDAQ Global Market under the trading symbol
‘‘PRPH.’’ The price set forth in the following table represents the high and low bid prices for our Common
Stock for each quarter of the Fiscal 2013 and 2012, as reported on The NASDAQ Global Market.

Common Stock

Quarter Ended
March 31, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
June 30,
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
September 30, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
December 31,

High
$2.25
$1.72
$2.25
$2.31

Low
$1.40
$1.42
$1.42
$1.52

High
$1.22
$1.14
$1.44
$1.68

Low
$0.90
$0.65
$1.00
$1.24

2013

2012

Holders

As of March 17, 2014, there were approximately 249 holders of record of our Common Stock, including
brokerage ﬁrms, clearing houses, and/or depository ﬁrms holding the Company’s securities for their respective
clients. The exact number of beneﬁcial owners of our securities is not known but exceeds 400.

Dividends

We have not declared, nor paid any cash dividends on our Common Stock since our Company’s
inception. At this time, we intend to retain our earnings to ﬁnance future growth and maintain liquidity. Future
cash dividends, if any, will be at the discretion of our Board of Directors and will depend upon, among other
things, our future operations and earnings, capital requirements, general ﬁnancial condition, contractual and
ﬁnancing restrictions and such other factors as our Board of Directors may deem relevant.

Warrants and Options

In addition to our outstanding Common Stock, there were reserved for issuance 753,250 shares of our
the

Common Stock underlying outstanding unexercised and vested options as of December 31, 2013 at
price-per-share stated and expiration date indicated, as follows:

Description
Option Plan . . . . . . . . . . . . . . . . . . . . . . . .
Option Plan . . . . . . . . . . . . . . . . . . . . . . . .
Option Plan . . . . . . . . . . . . . . . . . . . . . . . .
Option Plan . . . . . . . . . . . . . . . . . . . . . . . .
Option Plan . . . . . . . . . . . . . . . . . . . . . . . .
Option Plan . . . . . . . . . . . . . . . . . . . . . . . .
Option Plan . . . . . . . . . . . . . . . . . . . . . . . .
Option Plan . . . . . . . . . . . . . . . . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . . . . . . .

Number of
Options
40,500
26,500
590,000
25,000
10,000
50,000
7,500
3,750
753,250

Exercise
Price
$ 9.50
$13.80
$ 1.00
$ 1.08
$ 0.87
$ 1.17
$ 1.36
$ 1.48

Expiration
Date

October 26, 2014
December 11, 2015
December 14, 2017
May 28, 2018
November 5, 2018
December 18, 2018
December 20, 2019
April 9, 2020

20

Securities Authorized Under Equity Compensation

The following table sets forth certain information regarding stock option and warrant grants made to

employees, directors and consultants:

SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS

Number of
Securities to be
Issued Upon
Exercise of
Outstanding
Options
(A)

Weighted
Average
Exercise Price of
Outstanding
Options
(B)

Number of
Securities
Remaining
Available for
Future Issuance
Under Equity
Compensation Plans
(Excluding Securities
Reﬂected in Column A)
(C)

Plan Category
Equity Plans Approved by

Security Holders(1),(2),(3) . . .

1,637,500

$1.60

438,294

(1) An incentive stock option plan was instituted in Fiscal 1997 (the ‘‘1997 Plan’’) and approved by the
stockholders in Fiscal 1998. Options pursuant to the 1997 Plan have been granted to directors, executive
officers and employees. At December 31, 2013, we are precluded from issuing any additional options or
grants in the future under the 1997 Plan pursuant to the terms of the plan document. An aggregate of
67,000 stock options previously granted pursuant to the terms of the 1997 Plan remain available for
exercise at any time prior to such options’ respective expiration dates.

(2) On May 5, 2010, our shareholders approved the 2010 Equity Compensation Plan, which was
subsequently amended, restated and approved by shareholders on April 24, 2011 and further amended and
approved by our shareholders on May 6, 2013 (the ‘‘2010 Plan’’). The 2010 Plan provides that the total
number of shares of Common Stock that may be issued is equal to 1.6 million shares plus up to 900,000
shares that were authorized for issuance but unissued under the 1997 Plan, an aggregate of 2.5 million
shares. All of our employees, including employees who are officers or members of the Board are eligible
to participate in the 2010 Plan. Consultants and advisors who perform services for us are also eligible to
participate in the 2010 Plan. At December 31, 2013, we have outstanding 1,570,500 stock options,
subject to vesting, under the 2010 Plan. For the year ended December 31, 2013, we charged to operations
$160,000 for compensation expense for the fair value of the vested portion of the stock options (see
Note 6 to Notes to Consolidated Financial Statements). At December 31, 2013, there are 262,159 shares
of Common Stock that may be issued in the future pursuant to the 2010 Plan.

(3) On May 5, 2010, our shareholders approved the 2010 Directors’ Equity Compensation Plan which was
subsequently amended and approved by our shareholders on May 6, 2013. The 2010 Directors’ Equity
Compensation Plan provides that the total number of shares of Common Stock that may be issued under
the 2010 Directors’ Equity Compensation Plan is equal to 425,000. For the year ended December 31,
2013, 16,470 shares of our Common Stock were granted. At December 31, 2013, there are 176,135
shares of Common Stock that may be issued pursuant to the 2010 Directors Equity Compensation Plan.

Equity Line of Credit

On November 21, 2012, we entered into the equity line of credit agreement (such arrangement, the
‘‘Equity Line’’) with Dutchess whereby Dutchess committed to purchase, subject to certain restrictions and
conditions, up to 2,500,000 shares of our Common Stock, over a period of 36 months from the ﬁrst trading
day following the effectiveness of the registration statement registering the resale of shares purchased by
Dutchess pursuant to the Equity Line. On November 26, 2012, we ﬁled a registration statement with the SEC
to register for sale for up to 2,500,000 shares of our Common Stock and the registration statement was
deemed effective by the SEC on December 12, 2012.

We may draw on the facility from time to time, as and when we determine appropriate in accordance
with the terms and conditions of the Equity Line. The maximum amount that we are entitled to put to
Dutchess in any one draw down notice is the greater of (i) 500% of the average daily volume of our Common
Stock traded on the NASDAQ Global Market for the one (1) trading day prior to the date of delivery of the
applicable draw down notice, multiplied by the closing price for such trading day, or (ii) $250,000.

21

The purchase price under the Equity Line is set at ninety-ﬁve percent (95%) of the lowest daily volume
weighted average price (VWAP) of our Common Stock during the ﬁve (5) consecutive trading day period
beginning on the date of delivery of the applicable draw down notice. We have the right to withdraw all or
any portion of any put, except that portion of the put that has already been sold to a third party, including any
portion of a put that is below the minimum acceptable price set forth on the put notice, before the closing. In
the event Dutchess receives more than a ﬁve percent (5%) return on the net sales for a speciﬁc put, Dutchess
must remit such excess proceeds to us; however, in the event Dutchess receives less than a ﬁve percent (5%)
return on the net sales for a speciﬁc put Dutchess has the right to use any such excess proceeds to off-set
against the aggregated deﬁcit proceeds.

There are put restrictions applied on days between the draw down notice date and the closing date with
respect to that particular put. During such time, we are not allowed to deliver another draw down notice. In
addition, Dutchess is not obligated to purchase shares if its total number of shares beneﬁcially held at that
time would exceed 9.99% of the number of shares of our Common Stock as determined in accordance with
Rule 13d-1(j) of the Securities Exchange Act. In addition, we are not permitted to draw on the facility unless
there is an effective registration statement to cover the resale of the shares.

In Fiscal 2013, we sold an aggregate of 289,474 shares of Common Stock to Dutchess in which we
derived approximately $444,000 in net proceeds. In Fiscal 2012, we sold an aggregate of 883,722 shares of
Common Stock to Dutchess under and pursuant to the Equity Line in which we derived approximately net
proceeds of $1.1 million. The sales of the shares under the Equity Line were deemed to be exempt from
registration under the Securities Act in reliance upon Section 4(2) (or Regulation D promulgated thereunder).

During the period January 1, 2014 through to February 25, 2014, we sold an aggregate of 559,318 shares
of Common Stock to Dutchess under and pursuant
to the Equity Line and derived net proceeds of
approximately $947,000. At March 25, 2014, we have 767,486 shares of our Common Stock available for
sale, at our discretion, under the terms of the Equity Line and covered pursuant to a registration statement.

Other Stock Issuances

Pursuant to the terms of Mr. Cuddihy’s prior employment agreement dated August 19, 2009, Mr. Cuddihy
received an annual grant of shares of Common Stock equal to $50,000, payable quarterly, promptly following
the close of each quarter. The value of the shares is calculated based on the average closing price of our
shares for the last ﬁve (5) trading days of the quarter in which the shares are earned. For the year ended
December 31, 2012, Mr. Cuddihy was issued an aggregate of 10,757 shares earned in Fiscal 2011 pursuant to
the terms of his employment agreement.

22

Item 6. Selected Financial Data

The following table sets forth the selected ﬁnancial data appearing in or derived from our consolidated
ﬁnancial statements for and at the end of the years ended December 31, 2013, 2012, 2011 2010 and 2009. The
selected ﬁnancial data should be read in conjunction with the consolidated ﬁnancial statements appearing
elsewhere herein, and with Item 7 — Management’s Discussion and Analysis of Financial Condition and
Results of Operations (in thousands, except per share amounts):

Statement of Income Data:
Net sales

. . . . . . . . . . . . . . . . . . . . . . .

Gross proﬁt

. . . . . . . . . . . . . . . . . . . . .

Income (loss) from operations . . . . . . . . .

Net income (loss)

. . . . . . . . . . . . . . . . .

Basic income (loss) per share . . . . . . . . .

Diluted income (loss) per share . . . . . . . .

Weighted average shares outstanding:

2013

$25,032

$16,671

$

$

$

$

405

405

0.03

0.03

Year Ended December 31,
2011

2010

2012

$22,406

$14,252

$ (1,091)

$ (1,091)

$ (0.07)

$ (0.07)

$17,453

$11,282

$ (2,710)

$ (2,710)

$ (0.18)

$ (0.18)

$14,502

$ 8,830

$ (3,501)

$ (3,501)

$ (0.25)

$ (0.25)

2009

$19,816

$11,569

$ (3,842)

$ (3,842)

$ (0.30)

$ (0.30)

Basic . . . . . . . . . . . . . . . . . . . . . . . .
Diluted . . . . . . . . . . . . . . . . . . . . . . .

15,839
16,276

14,843
14,843

14,817
14,817

14,285
14,285

12,963
12,963

2013

2012

As of December 31,
2011

2010

2009

Balance Sheet Data:
Working capital . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . .
Other long term obligations . . . . . . . . . . .
Stockholders’ equity . . . . . . . . . . . . . . . .

$ 6,655
$17,420
$
200
$12,596

$ 5,809
$16,661
$
300
$11,451

$ 5,342
$19,079
$ —
$11,226

$ 7,521
$21,695
$ —
$13,460

$11,475
$21,330
$ —
$14,059

23

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Our Business. We are a manufacturer, marketer and distributor of a diversiﬁed range of homeopathic
and health products that are offered to the general public. We are also engaged in the research and
development of potential natural based health products along with supplement and cosmeceutical products.

Our primary business is the manufacture, distribution, marketing and sale of over-the-counter (‘‘OTC’’)
cold remedy products to consumers through national chain, regional, specialty and local retail stores.
One ﬂagship brand is Cold-EEZE(cid:7) Cold Remedy and our principal product is Cold-EEZE(cid:7) Cold Remedy zinc
gluconate lozenges, proven in clinical studies to reduce the duration of
the common cold by 42%.
Cold-EEZE(cid:7) Cold Remedy is an established product in the health care and cold remedy market. For Fiscal
2013, 2012 and 2011, our revenues from continuing operations have come principally from our OTC cold
remedy products.

Recent Events

Revenue Growth

We have implemented a business and marketing strategy designed to deliver results to our stockholders
over the long term. This multi-phase strategy was implemented during the 2010-2011 Cold Season. Generally,
a cold season is deﬁned as the period of September to March (‘‘Cold Season’’) when the incidence of the
common cold rises as a consequence of the change in weather and other factors.

Our strategic initiatives include preserving the Cold-EEZE(cid:7) Cold Remedy brand, repositioning the
Cold-EEZE(cid:7) Cold Remedy brand for growth and then leveraging the Cold-EEZE(cid:7) Cold Remedy brand. We
believe that by investing in our Cold-EEZE(cid:7) Cold Remedy brand, we are building our distribution platform
and pipeline. We have made important investments in new product development, consumer and healthcare
professional education and consumer and retail-based marketing. Each of these strategic components, when
aggregated, have led to securing increased shelf space with our retailers and have provided us with the
opportunity to introduce new and improved products, including the national launch of two additional cold
the 2013-2014 Cold Season: Cold-EEZE(cid:7) Cold Remedy Plus Immune Support
remedy products for
QuickMelts(cid:7) and Cold-EEZE(cid:7) Cold Remedy Plus Immune Support + Energy QuickMelts(cid:7).

Through our strategic initiatives, we have grown our net sales and generated net income for Fiscal 2013.
Our net sales increased 11.7% in Fiscal 2013 as compared to net sales in Fiscal 2012. In addition, we
generated net
loss of
$1.1 million, or ($0.07) per share, for Fiscal 2012. Our net sales growth is incremental to the net sales growth
of 28.4% achieved in Fiscal 2012 as compared to Fiscal 2011. We have increased our net sales an aggregate
of 43.4% in Fiscal 2013 as compared to Fiscal 2011 and we have returned to proﬁtability.

income of $405,000, or $0.03 per share,

in Fiscal 2013 as compared to a net

Phusion Laboratories, LLC, Joint Venture

On March 22, 2010, we, Phosphagenics Limited (‘‘PSI Parent’’), an Australian corporation,
Phosphagenics Inc. (‘‘PSI’’), a Delaware corporation and subsidiary of PSI Parent, and Phusion Laboratories,
LLC (the ‘‘Joint Venture’’), a Delaware limited liability company, entered into a Limited Liability Company
Agreement (the ‘‘LLC Agreement’’) of the Joint Venture and additional related agreements for the purpose of
developing and commercializing, for worldwide distribution and sale, a wide range of non-prescription
remedies using PSI Parent’s proprietary patented TPMTM technology (‘‘TPM’’). TPM facilitates the delivery
and depth of penetration of active molecules in pharmaceutical, nutraceutical, and other products. Pursuant to
the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture.

Due to multiple factors affecting our capital position, including (i) the $2.1 million payment we made in
December 2012 under the Settlement Agreement and Mutual General Release (the ‘‘Settlement Agreement’’)
between the Company and John C. Godfrey, the Estate of Nancy Jane Godfrey and Godfrey Science and
Design (together the ‘‘Godfreys’’) (see Note 5 to Notes to Consolidated Financial Statements) and (ii) some of
the product market research performed, we expect to modify the Joint Venture’s product development plans to
stagger
the
product
to continue pre-commercialization research and
pre-commercialization investments required. We expect
product development initiatives during the latter half of Fiscal 2014. Furthermore, we do not expect that the

development

initiatives

periods

certain

and/or

future

defer

into

due

to

24

Joint Venture will derive any meaningful revenues, if any, until its commercialization efforts are completed
which is not expected to occur until at the earliest the latter half of Fiscal 2014 or Fiscal 2015.

Income Taxes

As of December 31, 2013, we have net operating loss carry-forwards of approximately $34.7 million for
federal purposes that will expire beginning in Fiscal 2020 through 2032. Additionally, there are net operating
loss carry-forwards of $20.1 million for state purposes that will expire beginning in Fiscal 2018 through 2032.
Until sufficient taxable income to offset the temporary timing differences attributable to operations, and the tax
deductions attributable to option, warrant and stock activities are assured, a valuation allowance equaling the
total deferred tax asset is being provided. As a consequence of the accumulated losses of the Company, we
believe that this allowance is required due to the uncertainty of realizing these tax beneﬁts in the future.

Seasonality of the Business

Our sales are derived principally from our OTC cold remedy products. A signiﬁcant portion of our
business is highly seasonal, which causes major variations in operating results from quarter to quarter. The
third and fourth quarters generally represent the largest sales volume for our OTC cold remedy products with
a corresponding increase in marketing and advertising expenditures designed to promote our products during
the Cold Season. In addition, our sales are inﬂuenced by and subject to ﬂuctuations in the timing of purchase
and the ultimate level of demand for our products which are a function of the timing, length and severity of
each cold season. We track health and wellness trends and develop retail promotional strategies to align our
production scheduling, inventory management and marketing programs to optimize consumer purchases.

Results of Operations

Fiscal 2013 compared with Fiscal 2012

Net sales for Fiscal 2013 increased $2.6 million, or 11.7%, to $25.0 million as compared to $22.4 million
for Fiscal 2012. The increase in net sales is principally due to (i) an increase in our retail customers’
purchases in the ﬁrst and fourth quarter of Fiscal 2013, as compared to the same periods in Fiscal 2012, in an
effort by retailers to maintain adequate shelf and warehouse stock during peak seasonal demand to meet an
increase in consumer demand at retail of our OTC cold remedy products, (ii) sales of our Cold-EEZE(cid:7) Cold
Remedy Daytime/Nighttime QuickMelts(cid:7),
launched in July 2012 and Cold-EEZE(cid:7) Cold Remedy Oral
Spray initially launched in August 2011, and (iii) sales of our Cold-EEZE(cid:7) Cold Remedy Plus Immune
Support + Energy QuickMelts(cid:7) and Cold-EEZE(cid:7) Cold Remedy Plus Immune Support QuickMelts(cid:7) launched
in July 2013. In addition, net sales of our contract manufacturing operations increased $568,000 in Fiscal
2013 to $1.8 million as compared to $1.3 million in Fiscal 2012 due to ﬂuctuations in contract manufacturing
orders from non-related third party entities to produce lozenge-based products.

Industry data is suggesting that the incidence of upper respiratory disorders for Fiscal 2013 were on
average comparable to the incidence levels in Fiscal 2012. However, within each ﬁscal period, the incidence
of upper respiratory disorders trended signiﬁcantly higher the ﬁrst quarter of Fiscal 2013, an increase of
approximately 13%, as compared to ﬁrst quarter of Fiscal 2012, where as the fourth quarter of Fiscal 2013
trended down approximately 11% as compared to the fourth quarter of Fiscal 2012. Although the average
incidence of upper respiratory disorders, on average remained stable from year to year, we believe that we
have increased our net sales through, among other initiatives, increased investments in our sales, marketing,
advertising, consumer communication and promotion of our ﬂagship brand, Cold-EEZE(cid:7) Cold Remedy. In
addition, we support our Cold-EEZE(cid:7) Cold Remedy products through traditional techniques such as in-store
promotion, media advertising and other programs. We compete for market share with new products entering
the category and face retailer initiatives that attempt to reduce the number of products they carry on shelf
within the cold and ﬂu category.

Cost of sales increased $207,000 for Fiscal 2013 to $8.4 million as compared to $8.2 million for Fiscal
2012. The increase in cost of sales is principally due to our increased sales from period to period. We realized
gross margins of 66.6% for Fiscal 2013, as compared to 63.6% in Fiscal 2012, an increase of 3.0%. The
increase of 3.0% in gross margin is principally due to ﬂuctuations in our product mix shipped from period to
period and the improved absorption of ﬁxed production costs. Gross margins are principally inﬂuenced by

25

ﬂuctuations in quarter-to-quarter production volume, ﬁxed production costs and related overhead absorption,
raw ingredient costs, inventory mark to market write-downs, if any, retail cooperative incentive promotion and
the timing of shipments to customers which are factors of the seasonality of our sales activities and products.

Sales and marketing expense for Fiscal 2013 increased $592,000 to $9.5 million as compared to
$8.9 million for Fiscal 2012. The increase in sales and marketing expense for Fiscal 2013 as compared to
Fiscal 2012 was principally due to an increase in advertising expenditures as we expanded the scope and
timing of our media and product promotion advertising campaigns from period to period. We continue to
make signiﬁcant, strategic marketing investments in an effort to build and grow the sales of our OTC cold
remedy products.

General and administrative (‘‘G&A’’) expenses decreased $234,000 for Fiscal 2013 to $5.9 million as
compared to $6.1 million in Fiscal 2012. The decrease in G&A expense for Fiscal 2013 as compared to Fiscal
2012 was primarily due to a decrease in personnel expenses and professional fees.

Research and development costs for Fiscal 2013 and 2012 were $824,000 and $1.3 million, respectively.
The decrease of $477,000 in research and development costs for Fiscal 2013 as compared to Fiscal 2012 was
principally due a decrease in the scope, timing, cost and amount of research and development activity from
period to period. In February 2013, we introduced to the retail trade two new products, Cold-EEZE(cid:7) Cold
Remedy Plus Immune Support + Energy QuickMelts(cid:7) and Cold-EEZE(cid:7) Cold Remedy Plus Immune Support
QuickMelts(cid:7) which began shipping to our retailer customers in July 2013. Additionally, we continue to
engage in other research and development activities that we determine are appropriate and we may increase
our research and development activities in future periods.

In Fiscal 2012 as a result of the Settlement Agreement, we realized $1.0 million beneﬁt as a consequence
of a reduction of the previously recorded accrued royalties and commission obligation of $3.5 million. Under
the Settlement Agreement, the Godfreys assigned, transferred and conveyed to us all of their right, title, and
the trademark Cold-EEZE(cid:7), among other
interest
intellectual property associated with such trademark.

in U.S. Trademark Registration No. 1,838,542 for

Interest and other income for Fiscal 2013 was $2,000 as compared to $7,000 for Fiscal 2012. The
decrease of $5,000 for Fiscal 2013 as compared to Fiscal 2012 was principally the result of decreased bank
balances during Fiscal 2013 and lower interest rates. Interest expense for Fiscal 2013 was $13,000 as
compared to zero for Fiscal 2012 as a consequence of interest paid pursuant to the terms of the Settlement
Agreement consummated in December 2012.

As noted above, we have net operating loss carry-forwards for both federal and certain states. As a
consequence of these loss carry-forwards, we did not incur income tax expense for Fiscal 2013 or Fiscal 2012.

As a consequence of the effects of the above, the net income for Fiscal 2013, was $405,000, or $0.03 per

share, as compared to a net loss of $1.1 million, or ($0.07) per share, for Fiscal 2012.

Fiscal 2012 compared with Fiscal 2011

Net sales for Fiscal 2012 increased $4.9 million, or 28.4%, to $22.4 million as compared to $17.5 million
for Fiscal 2011. The increase in net sales is principally due to (i) an increase in our retail customers’
purchases in the ﬁrst and fourth quarter of Fiscal 2012, as compared to the same periods in Fiscal 2011, in an
effort by those retailers to maintain adequate shelf and warehouse stock during peak seasonal demand to meet
an increase in consumer demand at retail of our OTC cold remedy products, (ii) sales of our Cold-EEZE(cid:7)
Cold Remedy Daytime/Nighttime QuickMelts(cid:7), a new product launched in July 2012 and Cold-EEZE(cid:7) Cold
Remedy Oral Spray initially launched in August 2011 and expanded its distribution in Fiscal 2012. In
addition, our net sales of our contract manufacturing operations increased $455,000 in Fiscal 2012 to
$1.3 million as compared to $856,000 in Fiscal 2011 due to ﬂuctuations in contract manufacturing orders from
non-related third party entities to produce lozenge-based products.

Industry data is suggesting that the incidence of upper respiratory disorders for Fiscal 2012 were on
average 3% below the incidence levels in Fiscal 2011. Although the average incidence of upper respiratory
declined during Fiscal 2012, we believe that we have increased our net sales through, among other initiatives,
increased investments in our sales, marketing, advertising, consumer communication and promotion of our

26

ﬂagship brand, Cold-EEZE(cid:7) Cold Remedy In addition, we support our Cold-EEZE(cid:7) Cold Remedy products
through traditional techniques such as in-store promotion, media advertising and other programs. We compete
for market share with new products entering the category and face retailer initiatives that attempt to reduce the
number of products they carry on shelf within the cold and ﬂu category.

Cost of sales increased $2.0 million for Fiscal 2012 to $8.2 million as compared to $6.2 million for
Fiscal 2011. The increase in cost of sales is principally due to our increased sales from period to period. We
realized gross margins of 63.6% for Fiscal 2012, as compared to 64.6% in Fiscal 2011, a decrease of 1.0%.
Our gross margin reﬂects the net effect of (i) an increase in the absorption rate of ﬁxed production overhead
costs as a percentage of revenues as a consequence of increased shipments to retailers, offset by (ii) an
increase in raw ingredient and packaging costs and (iii) an increase in retail merchandising and promotions.
Gross margins are principally inﬂuenced by ﬂuctuations in quarter-to-quarter and year-to-year production
volume, ﬁxed production costs and related overhead absorption, raw ingredient costs,
inventory mark to
market write-downs, if any, and the timing of shipments to customers which are factors of the seasonality of
our sales activities and products.

Sales and marketing expense for Fiscal 2012 increased $1.0 million to $8.9 million as compared to
$7.9 million for Fiscal 2011. The increase in sales and marketing expense for Fiscal 2012 as compared to
Fiscal 2011 was principally due to an increase in advertising expenditures as we expanded the scope and
timing of our media and product promotion advertising campaigns from period to period as we continue to
make signiﬁcant, strategic marketing investments in an effort to build and grow the sales of our OTC cold
remedy products.

General and administrative (‘‘G&A’’) expenses increased $1.1 million for Fiscal 2012 to $6.1 million as
compared to $5.0 million in Fiscal 2011. The increase in G&A expense for Fiscal 2012 as compared to Fiscal
2011 was primarily due to an increase in personnel expenses and professional fees.

Research and development costs for Fiscal 2012 and 2011 were $1.3 million and $1.1 million,
respectively. The increase of $200,000 in research and development costs for Fiscal 2012 as compared to
Fiscal 2011 was principally due to an increase in personnel expenses and an increase in the scope, timing and
amount of research and development activity from period to period. In February 2012, we introduced to the
retail trade an offering of a new product, Cold-EEZE(cid:7) Cold Remedy Daytime/Nighttime QuickMelts(cid:7). The
Cold-EEZE(cid:7) Cold Remedy Daytime/Nighttime QuickMelts(cid:7) began shipping to retailers in July 2012.
Additionally, we continue to engage in other research and development activities that we determine are
appropriate and we may increase our research and development activities in future periods as a consequence
of the Joint Venture.

Under the Settlement Agreement, the Godfreys assigned, transferred and conveyed to us all of their right,
title, and interest in U.S. Trademark Registration No. 1,838,542 for the trademark Cold-EEZE(cid:7), among other
intellectual property associated with such trademark. As a result of the Settlement Agreement, we realized
$1.0 million beneﬁt as a consequence of a reduction of the previously recorded accrued royalties and
commission obligation of $3.5 million.

Interest and other income for Fiscal 2012 was $7,000 as compared to $28,000 for Fiscal 2011. The
decrease of $21,000 for Fiscal 2012 as compared to Fiscal 2011 was principally the result of decreased bank
balances and lower interest rates.

As noted above, we have net operating loss carry-forwards for both federal and certain states. As a
consequence of these loss carry-forwards and our loss realized during Fiscal 2012, we did not incur income
tax expense for Fiscal 2012 or Fiscal 2011.

As a consequence of the effects of the above, the net loss for Fiscal 2012, was $1.1 million, or ($0.07)

per share, as compared to a net loss of $2.7 million, or ($0.18) per share, for Fiscal 2011.

27

Liquidity and Capital Resources

Our aggregate cash and cash equivalents as of December 31, 2013 were $1.6 million as compared to
$572,000 at December 31, 2012. Our working capital was $6.7 million and $5.8 million as of December 31,
2013 and December 31, 2012, respectively. Changes in working capital for Fiscal 2013 were principally due
to the net effect of (i) cash provided by operations of $1.1 million comprised principally of net income of
$405,000 and a decrease in prepaid expenses of $886,000, (ii) net proceeds of $471,000 derived from the sale
of our Common Stock and the exercise of stock options offset by, (iii) capital expenditures of $442,000 and
(iv) the installment payment of $100,000 pursuant to the terms of the Settlement Agreement.

On November 21, 2012, we entered into the equity line of credit agreement (such arrangement, the
‘‘Equity Line’’) with Dutchess whereby Dutchess committed to purchase, subject to certain restrictions and
conditions, up to 2,500,000 shares of our Common Stock, over a period of 36 months from the ﬁrst trading
day following the effectiveness of the registration statement registering the resale of shares purchased by
Dutchess pursuant to the Equity Line. On November 26, 2012, we ﬁled a registration statement with the SEC
to register for sale for up to 2,500,000 shares of our Common Stock and the registration statement was
deemed effective by the SEC on December 12, 2012.

We may draw on the facility from time to time, as and when we determine appropriate in accordance
with the terms and conditions of the Equity Line. The maximum amount that we are entitled to put to
Dutchess in any one draw down notice is the greater of (i) 500% of the average daily volume of our Common
Stock traded on the NASDAQ Global Market for the one (1) trading day prior to the date of delivery of the
applicable draw down notice, multiplied by the closing price for such trading day, or (ii) $250,000.

The purchase price under the Equity Line is set at ninety-ﬁve percent (95%) of the lowest daily volume
weighted average price (VWAP) of our Common Stock during the ﬁve (5) consecutive trading day period
beginning on the date of delivery of the applicable draw down notice. We have the right to withdraw all or
any portion of any put, except that portion of the put that has already been sold to a third party, including any
portion of a put that is below the minimum acceptable price set forth on the put notice, before the closing. In
the event Dutchess receives more than a ﬁve percent (5%) return on the net sales for a speciﬁc put, Dutchess
must remit such excess proceeds to us; however, in the event Dutchess receives less than a ﬁve percent (5%)
return on the net sales for a speciﬁc put Dutchess has the right to use any such excess proceeds to off-set
against the aggregated deﬁcit proceeds.

There are put restrictions applied on days between the draw down notice date and the closing date with
respect to that particular put. During such time, we are not allowed to deliver another draw down notice. In
addition, Dutchess is not obligated to purchase shares if its total number of shares beneﬁcially held at that
time would exceed 9.99% of the number of shares of our Common Stock as determined in accordance with
Rule 13d-1(j) of the Securities Exchange Act. In addition, we are not permitted to draw on the facility unless
there is an effective registration statement to cover the resale of the shares.

In Fiscal 2013, we sold an aggregate of 289,474 shares of Common Stock to Dutchess in which we
derived approximately $444,000 in net proceeds. In Fiscal 2012, we sold an aggregate of 883,722 shares of
Common Stock to Dutchess under and pursuant to the Equity Line In which we derived approximately net
proceeds of $1.1 million. The sales of the shares under the Equity Line were deemed to be exempt from
registration under the Securities Act in reliance upon Section 4(2) (or Regulation D promulgated thereunder).

During the period January 1, 2014 through to February 25, 2014, we sold an aggregate of 559,318 shares
of Common Stock to Dutchess under and pursuant
to the Equity Line and derived net proceeds of
approximately $947,000. At March 25, 2014, we have 767,486 shares of our Common Stock available for
sale, at our discretion, under the terms of the Equity Line and covered pursuant to a registration statement.

its broader range of products,

Management believes that its strategy to maintain Cold-EEZE(cid:7) Cold Remedy as a recognized brand
name,
together with revenue for our
its adequate manufacturing capacity,
operations, our current working capital and our available Equity Credit Line, if exercised, should provide a
source of capital
the current research and
development expenditures related to new products. In addition to the funding from operations, we may in the
short and long term raise capital through the issuance of securities through our Equity Credit Line or secure

to fund normal business operations. Our operations support

28

other ﬁnancing sources to support such product development research, new product acquisitions or a venture
investment or acquisition. Such funding through the issuance of equity securities would result in the dilution
of current stockholders’ ownership in the Company. Should our product development initiatives progress on
certain formulations, additional development expenditures may require substantial ﬁnancial support and may
necessitate the consideration of alternative approaches such as licensing,
joint venture, or partnership
arrangements that we determine will meet our long term goals and objectives. Ultimately, should internal
funding methods or other business arrangements become
working capital be insufficient and external
unattainable, it would likely result in the deferral or abandonment of future development relative to current
and prospective product development initiatives and formulations.

Pursuant to the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture.
PSI Parent will conduct and oversee much of the product development, formulation, testing and other research
and development needed by the Joint Venture, and we will oversee much of the production, distribution, sales
and marketing. The LLC Agreement provides that each member may be required, from time to time and
subject to certain limitations, to make capital contributions to the Joint Venture to fund its operations, in
accordance with agreed upon budgets for products to be developed. Speciﬁcally, we contributed in Fiscal 2010
$500,000 in cash as initial capital and we are committed to fund up to $2.0 million, subject to agreed upon
budgets (which have not been established to date), toward the initial development and marketing costs of new
products for the Joint Venture. The newly formed Joint Venture has not engaged in any ﬁnancial transactions,
other than organizational expenses and general market and initial product evaluation and analysis. At
December 31, 2013, cash and equivalents includes $378,000 which is expected to be used by the Joint
Venture to fund future product development
initiatives currently under consideration by PSI Parent, PSI
and us.

Management is not aware of any trends, events or uncertainties that have or are reasonably likely to have
a material negative impact upon our (i) short-term or long-term liquidity, or (ii) net sales or income from
continuing operations. Any challenge to our patent rights could have a material adverse effect on our future;
however, we are not aware of any condition that would make such an event probable. Our business is subject
to seasonal variations thereby impacting liquidity and working capital during the course of our ﬁscal year.

Management believes that cash generated from operations, along with its current cash balances, will be
sufficient to ﬁnance working capital and capital expenditure requirements for at least the next twelve months.
However, in the longer term, as previously discussed, we may require additional capital to support, among
other items, (i) new product introductions, (ii) expansion of our product marketing and promotion activities,
(iii) additional research development activities, (iv) further investment
in our Joint Venture, (iv) venture
investments or acquisitions and/or (v) support current operations. Since late Fiscal 2008, there has been
substantial volatility and a decline in the capital and ﬁnancial markets due at least in part to the constricted
global economic environment resulting in substantial uncertainty and access to ﬁnancing is uncertain.
Moreover, consumer and as a consequence, customer spending habits may be adversely affected by the current
economic crisis. These conditions could have an adverse effect on our industry and business, including our
ﬁnancial condition, results of operations and cash ﬂows.

To the extent that we do not generate sufficient cash from operations, we may need to incur indebtedness
to ﬁnance plans for growth. Recent turmoil and stagnation in the credit markets and the potential impact on
the liquidity of major ﬁnancial institutions may have an adverse effect on our ability to fund our business
strategy through borrowings, under either existing or newly created instruments in the public or private
markets on terms that we believe to be reasonable, if at all.

29

Our future contractual obligations and commitments at December 31, 2013 consist of the following

(in thousands):

Year
2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total

Employment
Contracts
$1,025
555

—
—
$1,580

Settlement
Agreement
$100
100
100

—
$300

Total
$1,125
655
100
—
—
$1,880

Off-Balance Sheet Arrangements

It is not our usual business practice to enter into off-balance sheet arrangements such as guarantees on
loans and ﬁnancial commitments and retained interests in assets transferred to an unconsolidated entity for
securitization purposes. We have no off-balance sheet arrangements that have, or are reasonably likely to have,
a material current or future effect on our ﬁnancial condition, changes in ﬁnancial condition, revenues or
expenses, results of operations, liquidity, capital expenditures or capital resources.

Impact of Inﬂation

We are subject to normal inﬂationary trends and anticipate that any increased costs would be passed on

to our customers. Inﬂation has not had a material effect on our business.

Critical Accounting Estimates

The preparation of ﬁnancial statements in conformity with accounting principles generally accepted in the
United States (‘‘GAAP’’) requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent liabilities at the dates of the ﬁnancial statements
and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ
from those estimates. Our signiﬁcant accounting policies are described in Note 2 of the Notes to Consolidated
Financial Statements included under Item 8 of this Part II. However, certain accounting policies are deemed
‘‘critical’’, as they require management’s highest degree of judgment, estimates and assumptions. These
accounting estimates and disclosures have been discussed with the Audit Committee of our Board of
Directors. A discussion of our critical accounting policies, the judgments and uncertainties affecting their
application and the likelihood that materially different amounts would be reported under different conditions or
using different assumptions are as follows:

Revenue Recognition — Sales Allowances

When providing for the appropriate sales returns, allowances, cash discounts and cooperative incentive
promotion costs (‘‘Sales Allowances’’), we apply a uniform and consistent method for making certain
assumptions for estimating these provisions. These estimates and assumptions are based on historical
experience, current trends and other factors that management believes to be relevant at the time the ﬁnancial
statements are prepared. Management reviews the accounting policies, assumptions, estimates and judgments
on a quarterly basis. Actual results could differ from those estimates.

Our primary product, Cold-EEZE(cid:7) Cold Remedy lozenges, utilizes a proprietary zinc gluconate
formulation which has been clinically proven to reduce the severity and duration of common cold symptoms.
Factors considered in estimating the appropriate sales returns and allowances for this product include it being
(i) a unique product with limited competitors, (ii) competitively priced, (iii) promoted, (iv) unaffected for
remaining shelf-life as there is no product expiration date and (v) monitored for inventory levels at major
customers and third-party consumption data. In addition to Cold-EEZE(cid:7) Cold Remedy lozenges, we market
and distribute a variety of Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) and a Cold-EEZE(cid:7) Cold Remedy Oral
Spray. We also manufacture, market and distribute an organic cough drop and a Vitamin C supplement
(‘‘Organix(cid:7)’’). Each of the Cold-EEZE(cid:7) Cold Remedy Oral Spray and QuickMelts(cid:7) products, and Organix(cid:7)
products carry shelf-life expiration dates for which we aggregate such new product market experience data

30

and update our sales returns and allowances estimates accordingly. Sales allowances estimates are tracked at
the speciﬁc customer and product line levels and are tested on an annual historical basis, and reviewed
quarterly. Additionally, we monitor current developments by customer, market conditions and any other
occurrences that could affect the expected provisions relative to net sales for the period presented.

Our return policy accommodates returns for (i) discontinued products, (ii) store closings and (iii) products
that have reached or exceeded their designated expiration date. We do not impose a period of time within
which product may be returned. All requests for product returns must be submitted to us for pre-approval. The
main components of our returns policy are: (i) we will accept returns that are due to damaged product that is
un-saleable and such return request activity fall within an acceptable range, (ii) we will accept returns for
products that have reached or exceeded designated expiration dates and (iii) we will accept returns in the
event that we discontinue a product provided that the customer will have the right to return only such items
it purchased directly from us. We will not accept return requests pertaining to customer inventory
that
‘‘Overstocking’’ or ‘‘Resets’’. We will only accept return requests for product
in its intended package
conﬁguration. We reserve the right
to customers who have made
unauthorized deductions contrary to our return policy or pursue other methods of reimbursement. We
compensate the customer for authorized returns by means of a credit applied to amounts owed or to be owed
and in the case of discontinued product only, also by way of an exchange. We do not have any signiﬁcant
product exchange history.

to terminate shipment of product

We classify product returns into principally three categories, (i) non-routine returns, (ii) obsolete product
and (iii) product mix realignment by certain of our customers. ‘‘Non-routine’’ returns are deﬁned as product
returned to us as a consequence of unanticipated circumstances principally due to (i) retail store closings or
(ii) unexpected poor retail sell through to consumers causing us to discontinue the product. ‘‘Obsolete’’ returns
are deﬁned as product returned to us as a consequence of product shelf-life ‘‘use by’’ expiration date.
‘‘Product mix realignment’’ returns are deﬁned as product returned to us due to initiatives by the trade to
discontinue purchasing certain of our products. Product mix realignment returns are generally nominal and are
frequently related to discontinued or soon to be discontinued products.

Our return policy accommodates returns for (i) discontinued products, (ii) store closings and (iii) products
that have reached or exceeded designated expiration date. The following is a summary of the change in the
return provision for the years ended December 31, 2013 and 2012 (in thousands):

Return provision at December 31, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net change in the return provision Fiscal 2012 . . . . . . . . . . . . . . . . . . . . . . . . . .
Return provision at December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net change in the return provision Fiscal 2013 . . . . . . . . . . . . . . . . . . . . . . . . . .
Return provision at December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Amount
$1,667
(375)
1,292
227
$1,519

For Fiscal 2013, 2012 and 2011, net sales of products with limited shelf-life and expiration dates were

$4.3 million, $3.2 million and $2.0 million, respectively.

For Fiscal 2013, the return provision increased by $227,000. The increase in the return provision was
principally due to (i) a charge of $1.4 million, including $534,000 for products with shelf-life expiration dates
(obsolete returns), offset by (ii) net returns of $1.2 million associated principally with Fiscal 2013 and Fiscal
2012 received and processed during Fiscal 2013.

For Fiscal 2012, the return provision decreased by $375,000. The decrease in the return provision was
principally due to (i) a charge of $1.1 million, including $631,000 for products with shelf-life expiration dates
(obsolete returns), offset by (ii) net returns of $1.4 million associated principally with Fiscal 2012 and Fiscal
2011 received and processed during Fiscal 2012.

A one percent deviation for these sales allowance provisions for the Fiscal 2013, 2012 and 2011 would
affect net sales by approximately $303,000, $274,000 and $219,000, respectively. A one percent deviation for
cooperative incentive promotions reserve provisions for Fiscal 2013, 2012 and 2011 could affect net sales by
approximately $285,000, $260,000 and $210,000, respectively.

31

Effect of Recent Accounting Pronouncements

In June 2011, the Financial Accounting Standards Board (‘‘FASB’’) issued Accounting Standards Update
No. 2011-05,
‘‘Comprehensive Income (ASU Topic 220): Presentation of Comprehensive Income,’’
(‘‘ASU 2011-05’’) which amends current comprehensive income guidance. This accounting update eliminates
the option to present the components of other comprehensive income as part of the statement of shareholders’
Instead, comprehensive income must be presented in either a single continuous statement of
equity.
comprehensive income which contains two sections, net
income and other comprehensive income, or in
two separate but consecutive statements. ASU 2011-05 was effective for ﬁscal periods beginning after
December 15, 2011 with early adoption permitted. In December 2011,
the FASB issued ASU 2011-12
‘‘Deferral of the Effective Date for Amendments to the Presentation of Reclassiﬁcations of Items out of
Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.’’ This accounting
update stated that the speciﬁc requirement to present items that are reclassiﬁed from other comprehensive
income to net income alongside their respective components of net income and other comprehensive income
will be deferred. In February 2013, the FASB issued ASU 2013-02 ‘‘Reporting of Amounts Reclassiﬁed Out
of Accumulated Other Comprehensive Income’’. This accounting update requires companies to present the
effects on the line items of net income of signiﬁcant reclassiﬁcations out of accumulated other comprehensive
income if the amount being reclassiﬁed is required under U.S. generally accepted accounting principles to be
reclassiﬁed in its entirety to net income in the same reporting period. ASU 2013-02 is effective prospectively
for ﬁscal years beginning after December 15, 2012. The adoption of ASU 2013-02 did not have a material
impact on our consolidated ﬁnancial position, results of operations or cash ﬂows.

In July 2013,

‘‘Presentation of an
the FASB issued Accounting Standards Update No. 2013-11,
Unrecognized Tax Beneﬁt When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit
Carryforward Exists’’ (‘‘ASU 2013-11’’). ASU 2013-11 amends Accounting Standards Codiﬁcation 740,
‘‘Income Taxes,’’ to require that in certain cases, an unrecognized tax beneﬁt, or portion of an unrecognized
tax beneﬁt, should be presented in the ﬁnancial statements as a reduction to a deferred tax asset for a net
operating loss carryforward, a similar tax loss, or a tax credit carryforward when such items exist in the same
taxing jurisdiction. The amendments in this update are effective for ﬁscal years, and interim periods within
those years, beginning after December 15, 2013. Early adoption is permitted. The amendments should be
applied prospectively to all unrecognized tax beneﬁts that exist at
the effective date, and retrospective
application is permitted. We are currently evaluating the impact, if any this update will have on our ﬁnancial
statements.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Like virtually all commercial enterprises, we can be exposed to the risk (‘‘market risk’’) that the cash
ﬂows to be received or paid relating to certain ﬁnancial instruments could change as a result of changes in
interest rate, exchange rates, commodity prices, equity prices and other market changes.

Our operations are not subject to risks of material foreign currency ﬂuctuations, nor do we use derivative
ﬁnancial instruments in our investment practices. We place our marketable investments in instruments that
meet high credit quality standards. We do not expect material losses with respect to our investment portfolio
results of
or excessive exposure to market
one percentage point change in short-term interest rates would not have a material impact on our future
earnings, fair value, or cash ﬂows related to investments in cash equivalents or interest-earning marketable
securities.

risks associated with interest

rates. The impact on our

Current economic conditions may cause a decline in business and consumer spending which could
adversely affect our business and ﬁnancial performance including the collection of accounts receivables,
realization of inventory and recoverability of assets. In addition, our business and ﬁnancial performance may
be adversely affected by current and future economic conditions, including a reduction in the availability of
credit, ﬁnancial market volatility and recession.

32

Item 8. Financial Statements and Supplementary Data

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
ProPhase Labs, Inc.

We have audited the accompanying consolidated balance sheets of ProPhase Labs, Inc. and Subsidiaries
(the ‘‘Company’’) as of December 31, 2013 and 2012, and the related consolidated statements of operations,
stockholders’ equity, and cash ﬂows for each of the years in the three-year period ended December 31, 2013.
The ﬁnancial statements are the responsibility of the Company’s management. Our responsibility is to express
an opinion on these ﬁnancial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the ﬁnancial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform, an audit of its internal control over ﬁnancial reporting. Our
audits included consideration of internal control over ﬁnancial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
ﬁnancial statements. An audit also includes assessing the accounting principles used and signiﬁcant estimates
made by management, as well as evaluating the overall ﬁnancial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, the ﬁnancial statements referred to above present fairly, in all material respects, the
consolidated ﬁnancial position of ProPhase Labs, Inc. and Subsidiaries as of December 31, 2013 and 2012,
and the consolidated results of their operations and their cash ﬂows for each of the years in the three-year
period ended December 31, 2013,
in conformity with accounting principles generally accepted in the
United States of America.

/S/ EisnerAmper LLP

Iselin, New Jersey
March 27, 2014

33

PROPHASE LABS, INC AND SUBSIDARIES

CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)

ASSETS

Cash and cash equivalents (Note 2)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses and other current assets (Note 2) . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Property, plant and equipment, net of accumulated depreciation of $4,064 and

$3,860, respectively (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . .

Intangible asset, licensed technology (Note 8)

LIABILITIES AND STOCKHOLDERS’ EQUITY

LIABILITIES
Accounts payable
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued advertising and other allowances (Note 2) . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other current liabilities (Note 4)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other long term obligation (Note 5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total long term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total current liabilities

December 31,

2013

2012

$ 1,638
5,319
2,521
1,801
11,279

2,564
3,577
$ 17,420

$ 1,011
2,847
766
4,624
200
200

$

572
5,409
2,051
2,687
10,719

2,365
3,577
$ 16,661

$ 1,296
2,760
854
4,910
300
300

COMMITMENTS AND CONTINGENCIES (Note 5) . . . . . . . . . . . . . . . . . .

—

—

STOCKHOLDERS’ EQUITY
Common stock, $.0005 par value; authorized 50,000,000; issued: 21,437,059

and 21,056,115 shares, respectively (Note 6)

. . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Additional paid-in-capital
Accumulated deﬁcit
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Treasury stock, at cost, 5,336,053 and 5,336,053 shares, respectively (Note 6) . .

11
43,607
(5,385)
(25,637)
12,596
$ 17,420

11
42,867
(5,790)
(25,637)
11,451
$ 16,661

See accompanying notes to consolidated ﬁnancial statements

34

PROPHASE LABS, INC & SUBSIDARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)

Net sales (Notes 2 and 11)
Cost of sales (Note 2)
Gross proﬁt

. . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Operating expenses:

Sales and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . .
Research and development (Note 2)
. . . . . . . . . . . . . . . . . . . . . . . .
Settlement beneﬁt (Note 5)
Total operating expense . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations . . . . . . . . . . . . . . . . . . . . . . . .
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations before taxes . . . . . . . . . . . . . . .
Income tax (beneﬁt) (Note 9)
. . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income (loss)

Basic income (loss) per share:

Year Ended December 31,
2012
$22,406
8,154
14,252

2011
$17,453
6,171
11,282

2013
$25,032
8,361
16,671

9,538
5,893
824
—
16,255
416
2
(13)
405
—
405

$

8,946
6,127
1,301
(1,024)
15,350
(1,098)
7
—
(1,091)
—
$ (1,091)

7,904
5,028
1,088
—
14,020
(2,738)
28
—
(2,710)
—
$ (2,710)

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

0.03

$ (0.07)

$ (0.18)

Diluted income (loss) per share:

Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

0.03

$ (0.07)

$ (0.18)

Weighted average common shares outstanding:

Basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15,839
16,276

14,843
14,843

14,817
14,817

See accompanying notes to consolidated ﬁnancial statements

35

Total
13,460
(2,710)

131

294

500

(449)
11,226
(1,091)

153

93
1,070
11,451
405

27

160

109
444
$12,596

PROPHASE LABS, INC & SUBSIDARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share data)

Common Stock
Shares
14,707,619

Par
Value
10

Additional
Paid-In
Capital
40,627

Retained
Earnings
(Deﬁcit)
(1,989)
(2,710)

Treasury
Stock
(25,188)

Balance at December 31, 2010 . . . .
Net loss . . . . . . . . . . . . . . . . . .
Share-based compensation

expense . . . . . . . . . . . . . . . .

Common stock granted pursuant

to an employment agreement . .

341,254

Common stock granted pursuant

to a compensation plan . . . . . .

466,710

131

294

500

(690,000)
14,825,583

10

41,552

(449)
(25,637)

(4,699)
(1,091)

Treasury stock purchase

(Note 8) . . . . . . . . . . . . . . . .
Balance at December 31, 2011 . . . .
Net loss . . . . . . . . . . . . . . . . . .
Share-based compensation

expense . . . . . . . . . . . . . . . .

Common stock granted pursuant

to an employment agreement . .
Common stock issued (Note 6) . .
Balance at December 31, 2012 . . . .
Net income . . . . . . . . . . . . . . .
Proceeds from exercise of stock

options . . . . . . . . . . . . . . . . .

25,000

Share-based compensation

expense . . . . . . . . . . . . . . . .

Common stock granted pursuant

10,757
883,722
15,720,062

1
11

153

93
1,069
42,867

27

160

(5,790)
405

(25,637)

to a compensation plan . . . . . .
Common stock issued (Note 6) . .
Balance at December 31, 2013 . . . .

66,470
289,474
16,101,006

—
$11

109
444
$43,607

$(5,385)

$(25,637)

See accompanying notes to consolidated ﬁnancial statements

36

PROPHASE LABS, INC & SUBSIDARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

Cash ﬂows from operating activities:
Net income (loss)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Adjustments to reconcile net loss to net cash provided by (used

in) operating activities:
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . .
Gain on the sale of ﬁxed assets
. . . . . . . . . . . . . . . . . . . . .
Reduction of payment obligation, settlement beneﬁt . . . . . . . .
Share-based compensation expense . . . . . . . . . . . . . . . . . . .

Changes in operating assets and liabilities:

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses and other assets . . . . . . . . . . . . . . . . . . . .
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued advertising and other allowances
. . . . . . . . . . . . . .
Accrued royalties and commissions . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . .
Other operating assets and liabilities, net
Net cash provided by (used in) operating activities . . . . . . .

Cash ﬂows from investing activities:

Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Proceeds from the sale of ﬁxed assets . . . . . . . . . . . . . . . . .
. . . . . . . . . . . .

Net cash ﬂows used in investing activities

Cash ﬂows from ﬁnancing activities:

Proceeds from the exercise of stock options . . . . . . . . . . . . .
Proceeds from issuance of common stock . . . . . . . . . . . . . .
Payment of long term obligation . . . . . . . . . . . . . . . . . . . . .
Purchase of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . .
Net cash provided by (used in) ﬁnancing activities . . . . . . .
Net increase (decrease) in cash and cash equivalents . . . . . . . . .
. . . . . . . . . . . .
Cash and cash equivalents at beginning of year
. . . . . . . . . . . . . . . .
Cash and cash equivalents at end of year

Supplemental disclosures of cash ﬂow information:

Year Ended December 31,
2012

2011

2013

$ 405

$(1,091)

$(2,710)

243
—
—
269

90
(470)
886
(285)
87
—
(88)
1,137

(442)
—
(442)

27
444
(100)
—
371
1,066
572
$1,638

252
—
(1,024)
246

(2,190)
637
(940)
411
(199)
(2,100)
269
(5,729)

(310)
—
(310)

—
1,070
—
—
1,070
(4,969)
5,541
572

$

355
(28)
—
631

1,602
(1,006)
(864)
396
(565)
—
81
(2,108)

(300)
166
(134)

—
—
—
(449)
(449)
(2,691)
8,232
$ 5,541

Income taxes paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interest paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ —

$

13

$ —

$ —

$ —

$ —

Common stock issued, in lieu of cash, as payment of accrued

compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ —

$ —

$

294

See accompanying notes to consolidated ﬁnancial statements

37

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — ORGANIZATION AND BUSINESS

ProPhase Labs, Inc (‘‘we’’, ‘‘us’’ or the ‘‘Company’’), organized under the laws of the State of Nevada,
is a manufacturer, marketer and distributor of a diversiﬁed range of homeopathic and health products that are
offered to the general public. We are also engaged in the research and development of potential
over-the-counter (‘‘OTC’’) drug, natural based health products along with supplement, personal care and
cosmeceutical products.

Our primary business is the manufacture, distribution, marketing and sale of OTC cold remedy products
to consumers through national chain, regional, specialty and local retail stores. Our ﬂagship brand is
Cold-EEZE(cid:7) Cold Remedy and our principal product is Cold-EEZE(cid:7) Cold Remedy zinc gluconate lozenges,
proven in clinical studies to reduce the duration of the common cold by 42%. In addition to Cold-EEZE(cid:7)
Cold Remedy lozenges, we market and distribute non-lozenge forms of our proprietary zinc gluconate
formulation, (i) Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) and (ii) Cold-EEZE(cid:7) Cold Remedy Oral Spray.
Cold-EEZE(cid:7) Cold Remedy Oral Spray is a liquid form of our zinc gluconate formulation that is sprayed in
the mouth. Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) are fast dissolving tablets that are taken orally.

The Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) product

(i) Cold-EEZE(cid:7)
Daytime/Nighttime QuickMelts(cid:7) (launched in Fiscal 2012) and (ii) Cold-EEZE(cid:7) Plus Immune Support
QuickMelts(cid:7) and Cold-EEZE(cid:7) Plus Immune Support + Energy QuickMelts(cid:7) (each launched in Fiscal 2013).
We also manufacture, market and distribute organic cough drops and a Vitamin C supplement (‘‘Organix’’)
and perform contract manufacturing services of cough drop and other OTC cold remedy products for
third parties.

comprised of

line

is

Cold-EEZE(cid:7) Cold Remedy is an established product

in the health care and cold remedy market.
For Fiscal 2013, 2012 and 2011, our revenues have come principally from our OTC cold remedy products.
For Fiscal 2013 and 2012, our net sales for each period were related to markets in the United States.

On March 22, 2010, we, Phosphagenics Limited (‘‘PSI Parent’’), an Australian corporation,
Phosphagenics Inc. (‘‘PSI’’), a Delaware corporation and subsidiary of PSI Parent, and Phusion Laboratories,
LLC (the ‘‘Joint Venture’’), a Delaware limited liability company, entered into a Limited Liability Company
Agreement (the ‘‘LLC Agreement’’) of the Joint Venture and additional related agreements for the purpose of
developing and commercializing, for worldwide distribution and sale, a wide range of non-prescription
remedies using PSI Parent’s proprietary patented TPMTM technology (‘‘TPM’’). TPM facilitates the delivery
and depth of penetration of active molecules in pharmaceutical, nutraceutical, and other products. Pursuant to
the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture (see Note 8).

Our business is subject to seasonal variations thereby impacting liquidity and working capital during the

course of our ﬁscal year.

We use a December 31 year-end for ﬁnancial reporting purposes. References herein to the ﬁscal year
ended December 31, 2013 shall be the term ‘‘Fiscal 2013’’ and references to other ‘‘Fiscal’’ years shall mean
the year, which ended on December 31 of the year indicated. The term the ‘‘we’’, ‘‘us: or the ‘‘Company’’ as
used herein also refer, where appropriate, to the Company, together with its subsidiaries unless the context
otherwise requires.

NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The consolidated ﬁnancial statements (‘‘Financial Statements’’) include the accounts of the Company and
its wholly owned subsidiaries and its Joint Venture, a variable interest entity (see Note 8). All intercompany
transactions and balances have been eliminated.

38

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES − (continued)

Seasonality of the Business

Our net sales are derived principally from our OTC cold remedy products. Currently, our sales are
inﬂuenced by and subject to ﬂuctuations in the timing of purchase and the ultimate level of demand for our
products which are a function of the timing, length and severity of each cold season. Generally, a cold season
is deﬁned as the period of September to March when the incidence of the common cold rises as a
consequence of the change in weather and other factors. We generally experience in the third and fourth
quarter higher
levels of net sales along with a corresponding increase in marketing and advertising
expenditures designed to promote its products during the cold season. Revenues and related marketing costs
are generally at their lowest levels in the second quarter when consumer demand generally declines. We track
health and wellness trends and develop retail promotional strategies to align our production scheduling,
inventory management and marketing programs to optimize consumer purchases.

Use of Estimates

The preparation of ﬁnancial statements and the accompanying notes thereto, in conformity with generally
accepted accounting principles in the United States (‘‘GAAP’’), requires management to make estimates and
assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the ﬁnancial statements and reported amounts of revenues and expenses during the
respective reporting periods. Examples include the provision for bad debt, sales returns and allowances,
inventory obsolescence, useful lives of property and equipment and intangible assets, impairment of property
and equipment and intangible assets, income tax valuations and assumptions related to accrued advertising.
When providing for the appropriate sales returns, allowances, cash discounts and cooperative incentive
promotion costs (‘‘Sales Allowances’’), we apply a uniform and consistent method for making certain
assumptions for estimating these provisions. These estimates and assumptions are based on historical
experience, current trends and other factors that management believes to be relevant at the time the ﬁnancial
statements are prepared. Management reviews the accounting policies, assumptions, estimates and judgments
on a quarterly basis. Actual results could differ from those estimates.

Our primary product, Cold-EEZE(cid:7) Cold Remedy lozenges, utilizes a proprietary zinc gluconate
formulation which has been clinically proven to reduce the severity and duration of common cold symptoms.
Factors considered in estimating the appropriate sales returns and allowances for this product include it being
(i) a unique product with limited competitors, (ii) competitively priced, (iii) promoted, (iv) unaffected for
remaining shelf-life as there is no product expiration date and (v) monitored for inventory levels at major
customers and third-party consumption data. In addition to Cold-EEZE(cid:7) Cold Remedy lozenges, we market
and distribute a variety of Cold-EEZE(cid:7) Cold Remedy QuickMelts(cid:7) and a Cold-EEZE(cid:7) Cold Remedy Oral
Spray. We also manufacture, market and distribute an organic cough drop and a Vitamin C supplement
(‘‘Organix(cid:7)’’). Each of the Cold-EEZE(cid:7) Cold Remedy Oral Spray and QuickMelts(cid:7) products, and Organix(cid:7)
products carry shelf-life expiration dates for which we aggregate such new product market experience data
and update our sales returns and allowances estimates accordingly. Sales allowances estimates are tracked at
the speciﬁc customer and product line levels and are tested on an annual historical basis, and reviewed
quarterly. Additionally, we monitor current developments by customer, market conditions and any other
occurrences that could affect the expected provisions relative to net sales for the period presented.

Cash Equivalents

We consider all highly liquid investments with an initial maturity of three months or less at the time of
purchase to be cash equivalents. Cash equivalents include cash on hand and monies invested in money market
funds. The carrying amount approximates the fair market value due to the short-term maturity of these
investments.

39

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES − (continued)

Inventory

Inventory is valued at the lower of cost, determined on a ﬁrst-in, ﬁrst-out basis (FIFO), or market.
Inventory items are analyzed to determine cost and the market value and appropriate valuation adjustments are
established. At December 31, 2013 and 2012 the ﬁnancial statements include adjustments to reduce inventory
for excess or obsolete inventory of $635,000 and $890,000, respectively. At December 31, 2013 and 2012,
inventory included raw material, work in progress and packaging amounts of $1.6 million and $1.0 million,
respectively, and ﬁnished goods of $958,000 and $1.0 million, respectively.

Property, Plant and Equipment

Property, plant and equipment are recorded at cost. We use the straight-line method in computing
depreciation for ﬁnancial reporting purposes. The depreciation expense is computed in accordance with the
estimated asset lives (see Note 3).

Concentration of Risks

Future revenues, costs, margins and proﬁts will continue to be inﬂuenced by our ability to maintain our
manufacturing availability and capacity together with our marketing and distribution capabilities and the
requirements associated with the development of OTC and other personal care products in order to continue to
compete on a national and/or international level.

Our business is subject to federal and state laws and regulations adopted for the health and safety of
users of our products. Our OTC cold remedy products are subject to regulations by various federal, state and
local agencies, including the Food and Drug Administration (‘‘FDA’’) and, as applicable, the Homeopathic
Pharmacopoeia of the United States.

Financial

instruments that potentially subject us to signiﬁcant concentrations of credit risk consist

principally of cash investments and trade accounts receivable.

We maintain cash and cash equivalents with certain major ﬁnancial institutions. As of December 31,
2013, our cash was $1.6 million and our bank balance was $1.8 million. Of the total bank balance, $554,000
was covered by federal depository insurance and $1.2 million was uninsured.

Trade accounts receivable potentially subjects us to credit risk. We extend credit to our customers based
upon an evaluation of the customer’s ﬁnancial condition and credit history and generally we do not require
collateral. Our broad range of customers includes many national chain, regional, specialty and local retail
stores (see Note 11). During Fiscal 2013, 2012 and 2011, effectively all of our net revenues were related to
domestic markets.

Our revenues are principally generated from the sale of OTC cold remedy products which approximated
94%, 95% and 95% of total revenues for Fiscal 2013, 2012 and 2011, respectively. A signiﬁcant portion of
our business is highly seasonal, which causes major variations in operating results from quarter to quarter. The
third and fourth quarters generally represent the largest sales volume for the OTC cold remedy products.

Raw materials used in the production of the products are available from numerous sources. Certain raw
material active ingredients used in connection with Cold-EEZE(cid:7) Cold Remedy products are purchased from a
single unaffiliated supplier. Should the relationship terminate or the vendor become unable supply material, we
believe that
the current contingency plans would prevent a termination from materially affecting our
operations. However, if the relationship was terminated, there may be delays in production of our products
until an acceptable replacement supplier is located.

Long-lived Assets

We review the carrying value of our long-lived assets with deﬁnite lives whenever events or changes in
circumstances indicate that the carrying amount of the assets may not be recoverable. When indicators of
impairment exist, we determine whether the estimated undiscounted sum of the future cash ﬂows of such

40

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES − (continued)

assets is less than their carrying amounts. If less, an impairment loss is recognized in the amount, if any, by
which the carrying amount of such assets exceeds their respective fair values. The determination of fair value
if available, or independent appraisals; sales price
is based on quoted market prices in active markets,
negotiations; or projected future cash ﬂows discounted at a rate determined by management
to be
commensurate with our business risk. The estimation of fair value utilizing discounted forecasted cash ﬂows
includes signiﬁcant judgments regarding assumptions of revenue, operating and marketing costs; selling and
industry
administrative expenses;
competition; and general economic and business conditions, among other factors.

rates; property and equipment additions and retirements;

interest

Fair value is based on the prices that would be received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants at the measurement date. In order to increase consistency
and comparability in fair value measurements, a three-tier fair value hierarchy prioritizes the inputs used to
measure fair value. These tiers include: Level 1, deﬁned as observable inputs such as quoted prices in active
markets; Level 2, deﬁned as inputs other than quoted prices in active markets that are either directly or
indirectly observable; and Level 3, deﬁned as unobservable inputs for which little or no market data exists,
therefore requiring an entity to develop its own assumptions.

Revenue Recognition

Sales are recognized at the time ownership is transferred to the customer. Revenue is reduced for trade
promotions, estimated sales returns, cash discounts and other allowances in the same period as the related
sales are recorded. We make estimates of potential future product returns and other allowances related to
current period revenue. We analyze historical returns, current trends, and changes in customer and consumer
demand when evaluating the adequacy of the sales returns and other allowances.

Our return policy accommodates returns for (i) discontinued products, (ii) store closings and (iii) products
that have reached or exceeded their designated expiration date. We do not impose a period of time within
which product may be returned. All requests for product returns must be submitted to us for pre-approval. The
main components of our returns policy are: (i) we will accept returns that are due to damaged product that is
un-saleable and such return request activity fall within an acceptable range, (ii) we will accept returns for
products that have reached or exceeded designated expiration dates and (iii) we will accept returns in the
event that we discontinue a product provided that the customer will have the right to return only such items
it purchased directly from us. We will not accept return requests pertaining to customer inventory
that
‘‘Overstocking’’ or ‘‘Resets’’. We will only accept return requests for product
in its intended package
conﬁguration. We reserve the right
to customers who have made
unauthorized deductions contrary to our return policy or pursue other methods of reimbursement. We
compensate the customer for authorized returns by means of a credit applied to amounts owed or to be owed
and in the case of discontinued product only, also by way of an exchange. We do not have any signiﬁcant
product exchange history.

to terminate shipment of product

As of December 31, 2013 and December 31, 2012, we included a provision for sales allowances of
$128,000 and $109,000, respectively, which are reported as a reduction to account receivables. Additionally,
accrued advertising and other allowances as of December 31, 2013 include $1.5 million for estimated future
sales returns and $1.3 million for cooperative incentive promotion costs. As of December 31, 2012, accrued
advertising and other allowances include $1.3 million for estimated future sales returns and $1.5 million for
cooperative incentive promotion costs.

Shipping and Handling

Product sales carry shipping and handling charges to the purchaser, included as part of the invoiced price,

which is classiﬁed as revenue. In all cases, costs related to this revenue are recorded in cost of sales.

41

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES − (continued)

Stock Compensation

We recognize all share-based payments to employees and directors, including grants of stock options, as
compensation expense in the ﬁnancial statements based on their fair values. Fair values of stock options are
determined through the use of the Black-Scholes option pricing model. The compensation cost is recognized
as an expense over the requisite service period of the award, which usually coincides with the vesting period.

Stock and stock options for purchase of our common stock, $0.0005 par value, (‘‘Common Stock’’) have
been granted to both employees and non-employees pursuant to the terms of certain agreements and stock
option plans (see Note 6). Stock options are exercisable during a period determined by us, but in no event
later than ten years from the date granted. In Fiscal 2013, 2012 and 2011, we charged to operations $269,000,
$246,000 and $631,000, respectively, for share-based compensation expense for the aggregate fair value of
stock grants issued and vested stock options earned.

Variable Interest Entity

The Joint Venture, of which we own a 50% membership interest, qualiﬁes as a variable interest entity
(‘‘VIE’’) and we have consolidated the Joint Venture beginning with the quarter ended March 31, 2010
(see Note 8).

Advertising and Incentive Promotions

Advertising and incentive promotion costs are expensed within the period in which they are utilized.
Advertising and incentive promotion expense is comprised of media advertising, presented as part of sales and
marketing expense; cooperative incentive promotions and coupon program expenses, which are accounted for
as part of net sales; and free product, which is accounted for as part of cost of sales. Advertising and incentive
promotion costs incurred for Fiscal 2013, 2012 and 2011 were $10.8 million, $10.2 million, and $8.8 million,
respectively. Included in prepaid expenses and other current assets was $1.3 million and $2.2 million at
December 31, 2013 and 2012, respectively, relating to prepaid deposits for advertising and promotion
programs scheduled principally for the ﬁrst quarter of Fiscal 2014 and 2013, respectively.

Research and Development

Research and development costs are charged to operations in the period incurred. Expenditures for Fiscal
2013, 2012 and 2011 were $824,000, $1.3 million and $1.1 million, respectively. For Fiscal 2013, Fiscal 2012
and Fiscal 2011, research and development costs are related principally to new product development initiatives
and costs associated with OTC cold remedy products.

Income Taxes

We utilize the asset and liability approach which requires the recognition of deferred tax assets and
liabilities for the future tax consequences of events that have been recognized in our ﬁnancial statements or
tax returns. In estimating future tax consequences, we generally consider all expected future events other than
enactments of changes in the tax law or rates. Until sufficient taxable income to offset the temporary timing
differences attributable to operations and the tax deductions attributable to option, warrant and stock activities
are assured, a valuation allowance equaling the total net current and non-current deferred tax asset is being
provided (see Note 9).

We utilize a two-step approach to recognizing and measuring uncertain tax positions. The ﬁrst step is to
evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is
more likely than not that the position will be sustained on audit, including resolution of related appeals or
litigation processes, if any. The second step is to measure the tax beneﬁt as the largest amount which is more
than ﬁfty percent
likely of being realized upon ultimate settlement. Any interest or penalties related to
uncertain tax positions will be recorded as interest or administrative expense, respectively.

The major jurisdiction for which we ﬁle income tax returns is the United States. The Internal Revenue
Service (‘‘IRS’’) has examined our then tax year ended September 30, 2005 and has made no changes to the

42

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES − (continued)

ﬁled tax returns. The tax years 2006 and forward remain open to examination by the IRS. The tax years 2004
and forward remain open to examination by the various state taxing authorities to which we are subject.

Fair Value of Financial Instruments

Cash and cash equivalents, accounts receivable, accounts payable and long term obligations are reﬂected
in the Financial Statements at carrying value which approximates fair value because of the short-term maturity
of these instruments. Determination of the fair value of related party payables, if any, is not practicable due to
their related party nature.

Recently Issued Accounting Standards

In June 2011, the Financial Accounting Standards Board (‘‘FASB’’) issued Accounting Standards Update
No. 2011-05,
‘‘Comprehensive Income (ASU Topic 220): Presentation of Comprehensive Income,’’
(‘‘ASU 2011-05’’) which amends current comprehensive income guidance. This accounting update eliminates
the option to present the components of other comprehensive income as part of the statement of shareholders’
Instead, comprehensive income must be presented in either a single continuous statement of
equity.
comprehensive income which contains two sections, net
income and other comprehensive income, or in
two separate but consecutive statements. ASU 2011-05 was effective for ﬁscal periods beginning after
December 15, 2011 with early adoption permitted. In December 2011,
the FASB issued ASU 2011-12
‘‘Deferral of the Effective Date for Amendments to the Presentation of Reclassiﬁcations of Items out of
Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.’’ This accounting
update stated that the speciﬁc requirement to present items that are reclassiﬁed from other comprehensive
income to net income alongside their respective components of net income and other comprehensive income
will be deferred. In February 2013, the FASB issued ASU 2013-02 ‘‘Reporting of Amounts Reclassiﬁed Out
of Accumulated Other Comprehensive Income’’. This accounting update requires companies to present the
effects on the line items of net income of signiﬁcant reclassiﬁcations out of accumulated other comprehensive
income if the amount being reclassiﬁed is required under U.S. generally accepted accounting principles to be
reclassiﬁed in its entirety to net income in the same reporting period. ASU 2013-02 is effective prospectively
for ﬁscal years beginning after December 15, 2012. The adoption of ASU 2013-02 did not have a material
impact on our consolidated ﬁnancial position, results of operations or cash ﬂows.

In July 2013,

‘‘Presentation of an
the FASB issued Accounting Standards Update No. 2013-11,
Unrecognized Tax Beneﬁt When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit
Carryforward Exists’’ (‘‘ASU 2013-11’’). ASU 2013-11 amends Accounting Standards Codiﬁcation 740,
‘‘Income Taxes,’’ to require that in certain cases, an unrecognized tax beneﬁt, or portion of an unrecognized
tax beneﬁt, should be presented in the ﬁnancial statements as a reduction to a deferred tax asset for a net
operating loss carryforward, a similar tax loss, or a tax credit carryforward when such items exist in the same
taxing jurisdiction. The amendments in this update are effective for ﬁscal years, and interim periods within
those years, beginning after December 15, 2013. Early adoption is permitted. The amendments should be
applied prospectively to all unrecognized tax beneﬁts that exist at
the effective date, and retrospective
application is permitted. We are currently evaluating the impact, if any this update will have on our ﬁnancial
statements.

43

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3 — PROPERTY, PLANT AND EQUIPMENT

The components of property and equipment are as follows (in thousands):

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Buildings and improvements
. . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . .
Machinery and equipment
Computer software . . . . . . . . . . . . . . . . . . . . . . .
Furniture and ﬁxtures . . . . . . . . . . . . . . . . . . . . .

Less: Accumulated depreciation . . . . . . . . . . . . . .

December 31,

2013
$ 504
2,852
2,812
271
189
6,628
4,064
$2,564

2012
$ 504
2,597
2,771
164
189
6,225
3,860
$2,365

Estimated Useful
Life

10 − 39 years
3 − 7 years
3 years
5 years

Depreciation expense for Fiscal 2013, 2012 and 2011 was $243,000, $252,000, and $355,000,

respectively.

NOTE 4 — OTHER CURRENT LIABILITIES

At December 31, 2013 and 2012, other current liabilities include $350,000 and $548,000, respectively,

related to accrued compensation.

NOTE 5 — COMMITMENTS AND CONTINGENCIES

Employment Agreements

On November 8, 2011, we entered into new employment agreements, effective as of January 1, 2012,
with each of Mr. Ted Karkus and Mr. Robert Cuddihy (the ‘‘Employment Agreements’’). The Employment
Agreements supersede the employment agreements of Mr. Karkus and Mr. Cuddihy, dated August 19, 2009,
that had been scheduled to terminate on July 15, 2012. The scheduled termination dates of the Employment
Agreements is July 15, 2015, which is three years following the scheduled expiration date set forth in the
executives’ former employment agreements.

Under his new employment agreement with the Company, Mr. Karkus agreed to an annual base salary of
$675,000 as Chief Executive Officer. Under the terms of his former employment agreement with the
Company, as amended, Mr. Karkus was entitled to annual base compensation of $750,000, consisting of a
$600,000 base salary and $150,000 in stock based compensation. Mr. Karkus is eligible to receive an annual
increase in base salary and may be awarded a bonus in the sole discretion of the Compensation Committee
and also will receive regular beneﬁts routinely provided to other senior executives of the Company.

Under his new employment agreement with the Company, Mr. Cuddihy agreed to an annual base salary
of $350,000 as Chief Financial Officer and Chief Operating Officer. Under
the terms of his former
employment agreement with the Company as the Company’s Chief Operating Officer, Mr. Cuddihy was
entitled to annual base compensation of $325,000, consisting of a $275,000 base salary and $50,000 in stock
based compensation. Mr. Cuddihy is eligible to receive an annual increase in base salary and may be awarded
a bonus in the sole discretion of the Compensation Committee and also will receive regular beneﬁts routinely
provided to other senior executives of the Company.

Each executive is subject to non-competition restrictions for up to a period of either six (6) months or
eighteen (18) months following termination of employment depending on the nature of the termination. Each
executive is also eligible for a gross up payment in the event that any amounts payable under the agreements
(or any other plan, program, policy or arrangement with the Company) become subject to the excise tax
imposed by Section 4999 of the Internal Revenue Code.

44

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 — COMMITMENTS AND CONTINGENCIES − (continued)

The Employment Agreements also provide for payments upon certain terminations and change in control
beneﬁts to ensure that they work to secure the best outcome for stockholders in the event of a possible change
in control, even if it means that they lose their jobs as a result. Under the Employment Agreements, in the
event of the termination by the Company of the employment of Mr. Karkus or Mr. Cuddihy without cause or
due to a voluntary resignation by either executive with Good Reason (as deﬁned in the agreements), each
executive will be paid a lump sum severance payment in cash equal to the greater of (A) the amount equal to
eighteen (18) months base salary or (B) the amount equal to the his base salary for the remainder of the term
as if the agreement had not been terminated.

Additionally, each executive is entitled to receive a lump sum severance payment in cash equal to the
greater of A or B, if he, within twenty four (24) months of a Change in Control (as deﬁned in the agreements)
of the Company, is terminated without cause or due to a voluntary resignation by him with Good Reason
(as deﬁned in the agreements). Each executive may also participate at Company expense in all medical and
dental plans for the remainder of the term of his employment agreement in the event the Company terminates
the employment agreement for any reason, except for the Company’s termination for Cause (as deﬁned in the
agreements) or a voluntary resignation by him without Good Reason (as deﬁned in the agreements).

Settlement Agreement

In November 2004 we commenced an action against John C. Godfrey, Nancy Jane Godfrey, and Godfrey
Science and Design, Inc. (together the ‘‘Godfreys’’) for injunctive relief regarding the ownership of the
Cold-EEZE(cid:7) trademark., The Godfreys subsequently asserted against us counterclaims and sought monetary
damages and injunctive and declaratory relief relative to the Cold-EEZE(cid:7) trademark and other intellectual
property.

On December 20, 2012, we and the Godfreys, including the Estate of Nancy Jane Godfrey, entered into a
Settlement Agreement and Mutual General Release (the ‘‘Settlement Agreement’’), pursuant to which we
resolved all disputes, including claims asserted by us and counterclaims asserted against us in the action.
Pursuant to the terms of the Settlement Agreement, we paid the Godfreys $2.1 million in December 2012 and
we agreed to make four additional annual payments of $100,000 due in December of each of the next four
years. Each annual payment in the amount of $100,000 will accrue interest at the per annum rate of 3.25%.
The ﬁrst annual installment of $100,000 plus accrued interest of $13,000 was paid in December 2013. Under
the Settlement Agreement, the Godfreys assigned, transferred and conveyed to us all of their right, title, and
the trademark Cold-EEZE(cid:7), among other
interest
intellectual property associated with such trademark. As a result of the Settlement Agreement, we realized
$1.0 million beneﬁt due to the reduction of the previously recorded accrued royalties and commission
obligation of $3.5 million. At December 31, 2013, other current liabilities and other long term obligation
include $100,000 and $200,000, respectively, for the three remaining annual installment payments.

in U.S. Trademark Registration No. 1,838,542 for

PROPHASE LABS, INC. (formerly THE QUIGLEY CORPORATION) VS. GUY QUIGLEY, GARY QUIGLEY,
SCANDA SYSTEMS LIMITED, SCANDA SYSTEMS LTD, CHILESHA HOLDINGS LTD, KEVIN BROGAN,
INNERLIGHT HOLDINGS,
INC., GEORGE LONGO, GRAHAM BRANDON AND PACIFIC RIM
PHARMACEUTICALS LTD

On August 23, 2010, we initiated an action in the Court of Common Pleas of Bucks County,
Pennsylvania Civil Action No. 2010-08227. This action is against certain former officers and directors of the
Company, including a shareholder that beneﬁcially owns approximately 17.4% of our Common Stock, and
against certain third parties. The Company has asserted claims arising from, among other things, a variety of
transactions and payments previously made or entered into by the Company. The transactions and events that
are the subject of this litigation occurred prior to June 2009 and the installation of the current board of
directors. We are seeking recovery of monetary damages and other relief. Pre-trial discovery is on-going at
this time and a date certain for trial has been ordered for June 9, 2014. At this time, no prediction as to the
outcome of this action can be made.

45

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 — COMMITMENTS AND CONTINGENCIES − (continued)

GUY QUIGLEY VS. TED KARKUS, ROBERT V. CUDDIHY, JR., MARK BURNETT, MARK LEVENTHAL,
MARK FRANK, LOUIS GLECKEL, MD, JAMES McCUBBIN AND PROPHASE LABS, INC. AS A NOMINAL
DEFENDANT

We were named as a nominal defendant in a purported derivative complaint ﬁled on February 2, 2012 by
stockholder and former director and Chief Executive Officer Guy Quigley in the Court of Common Pleas of
Philadelphia County, Pennsylvania (No. 111200409). The complaint also names as a defendant each of our
directors and executive officers. Among other things, the suit alleges various breaches of ﬁduciary and other
duties, and seeks recovery of unspeciﬁed damages and other relief. Prior to ﬁling this complaint, the plaintiff
applied to the same court for permission to take pre-complaint discovery on the basis that
the plaintiff
required such discovery in order to assert claims. The court denied the plaintiff’s request. We believe the
lawsuit is without merit and intend to vigorously defend against it. On April 5, 2013, the court entered an
order allowing limited pre-trial discovery limited to demand futility and plaintiff adequacy issues, which was
completed by July 12, 2013. We ﬁled a motion to dismiss on July 26, 2013 on demand futility and plaintiff
adequacy issues. On August 26, 2013 the court heard oral arguments regarding the Company’s motion for
summary judgment and dismissal with prejudice. The court stayed any additional discovery until the court
rules on our motion to dismiss with and our motion is currently pending with the court. At
this time,
no prediction as to the outcome of this action can be made.

As noted above, we previously commenced litigation against the plaintiff, Guy Quigley, and other parties
in August 2010 in the Bucks County Court of Common Pleas, Pennsylvania (No. 2010-08227). The
August 2010 action remains pending.

PROPHASE LABS,
(formerly THE QUIGLEY CORPORATION) VS. GUY QUIGLEY, KARIBA
HOLDINGS, LIMITED, WENDY QUIGLEY, GARY QUIGLEY, FRANCES QUIGLEY (A/K/A FRANCES
BOSTON) AND JOSEPHINE QUIGLEY (A/K/A JOSEPHINE GLEESON)

INC.

On July 19, 2012, we initiated an action in the Court of Common Pleas of Bucks County, Pennsylvania
(‘‘Kariba Complaint’’) (No. 2011-09815). The Kariba Complaint names as defendants (i) a former officer and
director of the Company, who is a shareholder that beneﬁcially owns approximately 17.4% of our Common
Stock, (ii) certain family members of such former officer and director, some of whom are former employees of
the Company, and (iii) certain third parties. The Company has asserted claims arising from, among other
things, a variety of transactions and payments previously made or entered into by the Company. The Kariba
Complaint asserts additional claims not previously asserted in the action ProPhase Labs, Inc. (formerly The
Quigley Corporation) vs. Guy Quigley, Gary Quigley, Scanda Systems Limited, Scanda Systems LTD,
Chilesha Holdings LTD, Kevin Brogan, Innerlight Holdings, Inc., George Longo, Graham Brandon, Paciﬁc
Rim Pharmaceuticals LTD and John Doe Defendants (No. 2010-08227). All of the transactions and events that
are the subject of the Kariba Complaint occurred prior to June 2009 and the installation of the current board
of directors. We are seeking recovery of monetary damages and other relief. Pre-trial discovery is on-going
and at this time, no prediction as to the outcome of this action can be made.

GARY QUIGLEY VS. EAST BAY MANAGEMENT, INC., TED KARKUS AND JOHN DOE 1

East Bay Management, Inc., Ted Karkus and John Doe 1 were named as defendants in a purported
complaint ﬁled on June 10, 2013 by Gary Quigley, the brother of our stockholder and former director and
Chief Executive Officer Guy Quigley, in the Court of Common Pleas of Philadelphia County, Pennsylvania
(No. 2013-04393). The suit alleges ﬁve causes of action against the defendants, including the Company’s
Chief Executive Officer, for (i) fraud, (ii) conversion, (iii) unjust enrichment, (iv) conspiracy and (v) piercing
the corporate veil. On July 10, 2013, Mr. Karkus removed the case to the United States District Court for
Eastern Pennsylvania. On August 16, 2013, Mr. Karkus ﬁled a Motion to Dismiss for Failure to State a Claim.
Mr. Gary Quigley responded to the motion to dismiss. On January 7, 2014, the court heard oral arguments
regarding the motion to dismiss. The court stayed any additional discovery until the court rules on the motion
to dismiss and the motion is currently pending with the court. At this time, no prediction as to the outcome of
this action can be made.

46

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 — COMMITMENTS AND CONTINGENCIES − (continued)

On January 15, 2014, our Board of Directors, without the presence of Ted Karkus, voted to indemnify
Mr. Karkus and pay the expenses incurred by him in connection with this legal matter. This action has been
and will continue to be vigorously defended by Mr. Karkus, who denies any wrongdoing.

THE ESTATE OF JOSEPHINE QUIGLEY AND KARIBA HOLDINGS LIMITED VS. EAST BAY MANAGEMENT,
INC., TED KARKUS, SCOTT STRADY AND JOHN DOE

above)

East Bay Management, Inc., Ted Karkus, Scott Strady and John Doe were named as defendants in a
purported complaint ﬁled on August 9, 2013 by the Estate of Josephine Quigley,
the mother of our
stockholder and former director and Chief Executive Officer Guy Quigley, and Kariba Holdings Limited (see
Kariba Compliant
in the Court of Common Pleas of Philadelphia County, Pennsylvania
(No. 2013-006131). Guy Quigley, our stockholder, former director and Chief Executive Officer of the
Company, ﬁled this suite as Executor of the Estate of Josephine Quigley and as a representative of Kariba
Holdings. The suit alleges ﬁve causes of action against
including the Company’s Chief
Executive Officer, for (i) fraud, (ii) conversion, (iii) unjust enrichment, (iv) conspiracy and (v) piercing the
corporate veil. On September 23, 2013, Mr. Karkus removed the case to the United States District Court for
Eastern Pennsylvania. On September 23, 2013, Mr. Karkus ﬁled a Motion to Dismiss for Failure to State a
Claim. The Estate of Josephine Quigley and Kariba Holdings Limited responded to the motion to dismiss.
On January 7, 2014, the court heard oral arguments regarding the motion for dismissal. The court stayed any
additional discovery until the court rules on the motion for dismissal and the motion is currently pending with
the court. At this time, no prediction as to the outcome of this action can be made.

the defendants,

On January 15, 2014, our Board of Directors, without the presence of Ted Karkus, voted to indemnify
Mr. Karkus and pay the expenses incurred by him in connection with this legal matter. This action has been
and will continue to be vigorously defended by Mr. Karkus, who denies any wrongdoing.

Other Litigation

In the normal course of our business, we are named as defendant in legal proceedings. It is our policy to

vigorously defend litigation and/or enter into settlements of claims where management deems appropriate.

Future Obligations

We have approximate future obligations over the next ﬁve years as follows (in thousands):

Year
2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total

Employment
Contracts
$1,025
555
—
—
—
$1,580

Settlement
Agreement
$100
100
100
—
—
$300

Total
$1,125
655
100
—
—
$1,880

NOTE 6 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION

Stockholder Rights Plan

On September 8, 1998, our Board of Directors declared a dividend distribution of Common Stock
Purchase Rights (each individually, a ‘‘Right’’ and collectively, the ‘‘Rights’’) payable to the stockholders of
record on September 25, 1998, thereby creating a Stockholder Rights Plan (the ‘‘Rights Agreement’’). The
Plan was amended effective May 23, 2008 and further amended effective August 18, 2009. The Rights
Agreement, as amended, provides that each Right entitles the stockholder of record to purchase from the
Company that number of common shares having a combined market value equal to two times the Rights
exercise price of $45. The Rights are not exercisable until the distribution date, which will be the earlier of a

47

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

public announcement that a person or group of affiliated or associated persons has acquired 15% or more of
the outstanding common shares, or the announcement of an intention by a similarly constituted party to make
a tender or exchange offer resulting in the ownership of 15% or more of the outstanding common shares.
The dividend has the effect of giving the stockholder a 50% discount on the share’s current market value for
exercising such right. In the event of a cashless exercise of the Right, and the acquirer has acquired less than
50% beneﬁcial ownership of the Company, a stockholder may exchange one Right for one common share of
the Company. The Rights Agreement, as amended, includes a provision pursuant to which our Board of
Directors may exempt from the provisions of the Rights Agreement an offer for all outstanding shares of our
Common Stock that the directors determine to be fair and not inadequate and to otherwise be in the best
interests of the Company and its stockholders, after receiving advice from one or more investment banking
ﬁrms. The expiration date of the Rights Agreement, as amended, is September 25, 2018.

Equity Line of Credit

On November 21, 2012, we entered into the equity line of credit agreement (such arrangement, the
‘‘Equity Line’’) with Dutchess Opportunity Fund II, LP (‘‘Dutchess’’) whereby Dutchess committed to
purchase, subject to certain restrictions and conditions, up to 2,500,000 shares of our Common Stock, over a
period of 36 months from the ﬁrst
trading day following the effectiveness of the registration statement
registering the resale of shares purchased by Dutchess pursuant to the Equity Line. On November 26, 2012,
we ﬁled a registration statement with Securities and Exchange Commission (‘‘SEC’’) to register for sale for
up to 2,500,000 shares of our Common Stock and the registration statement was deemed effective by the SEC
on December 12, 2012.

We may draw on the facility from time to time, as and when we determine appropriate in accordance
with the terms and conditions of the Equity Line. The maximum amount that we are entitled to put to
Dutchess in any one draw down notice is the greater of (i) 500% of the average daily volume of our Common
Stock traded on the NASDAQ Global Market for the one (1) trading day prior to the date of delivery of the
applicable draw down notice, multiplied by the closing price for such trading day, or (ii) $250,000.

The purchase price under the Equity Line is set at ninety-ﬁve percent (95%) of the lowest daily volume
weighted average price (VWAP) of our Common Stock during the ﬁve (5) consecutive trading day period
beginning on the date of delivery of the applicable draw down notice. We have the right to withdraw all or
any portion of any put, except that portion of the put that has already been sold to a third party, including any
portion of a put that is below the minimum acceptable price set forth on the put notice, before the closing. In
the event Dutchess receives more than a ﬁve percent (5%) return on the net sales for a speciﬁc put, Dutchess
must remit such excess proceeds to us; however, in the event Dutchess receives less than a ﬁve percent (5%)
return on the net sales for a speciﬁc put Dutchess has the right to use any such excess proceeds to off-set
against the aggregated deﬁcit proceeds.

There are put restrictions applied on days between the draw down notice date and the closing date with
respect to that particular put. During such time, we are not allowed to deliver another draw down notice. In
addition, Dutchess is not obligated to purchase shares if its total number of shares beneﬁcially held at that
time would exceed 9.99% of the number of shares of our Common Stock as determined in accordance with
Rule 13d-1(j) of the Securities Exchange Act of 1934, as amended. In addition, we are not permitted to draw
on the facility unless there is an effective registration statement to cover the resale of the shares.

In December 2012, we sold an aggregate of 883,722 shares of Common Stock to Dutchess under and
pursuant to the Equity Line. We derived approximately $1.1 million in net proceeds through the usage of the
Equity Line of which we received $839,000 of such proceeds prior to December 31, 2012 and we have
included in receivables the balance of $230,000 which we received on January 4, 2013. In March 2013 and
December 2013, we sold an aggregate of 125,000 and 164,474 shares of our Common Stock, respectively,
under and pursuant to the Equity Line and derived net proceeds of $195,000 and $250,000, respectively.
We have included in receivables $250,000 derived from the December 2013 sale of shares; we received the

48

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

proceeds on January 8, 2014. The sales of the shares under the Equity Line were deemed to be exempt from
registration under the Securities Act of 1933, as amended in reliance upon Section 4(2) (or Regulation D
promulgated thereunder).

During the period January 1, 2014 through to February 25, 2014, we sold an aggregate of 559,318 shares
to the Equity Line and derived net proceeds of

of Common Stock to Dutchess under and pursuant
approximately $947,000.

At March 25, 2014, we have 767,486 shares of our Common Stock available for sale, at our discretion,

under the terms of the Equity Line and covered pursuant to a registration statement.

The 1997 Option Plan

On December 2, 1997, our Board of Directors approved a Stock Option Plan (the ‘‘1997 Plan’’), which
was amended in 2005, and provided for the granting of up to 4.5 million shares of Common Stock. Under the
1997 Plan, we were permitted to grant options to employees, officers or directors of the Company at variable
percentages of the market value of stock at the date of grant. No incentive stock option could be exercisable
more than ten years after the date of grant or ﬁve years after the date of grant where the individual owns
more than ten percent of the total combined voting power of all classes of stock. Stockholders approved the
1997 Plan in Fiscal 1998. No options were granted under this Plan during Fiscal 2013, 2012 or 2011.

At December 31, 2013, we are precluded from issuing any additional options or grants in the future
under the 1997 Plan pursuant to the terms of the plan document. Options previously granted continue to be
available for exercise at any time prior to such options’ respective expiration dates, but in no event later than
ten years from the date granted. At December 31, 2013, there are 67,000 options outstanding with various
expiration dates ranging from October 2014 through December 2015, depending upon the date of grant.

The 2010 Equity Compensation Plan

On May 5, 2010, our shareholders approved the 2010 Equity Compensation Plan which was subsequently
amended, restated and approved by our shareholders on April 24, 2011 and further amended and approved by
shareholders on May 6, 2013 (the ‘‘2010 Plan’’). The 2010 Plan provides that the total number of shares of
Common Stock that may be issued under the 2010 Plan is equal to 1.6 million shares plus up to 900,000
shares that are authorized for issuance but unissued under the 1997 Plan for an aggregate of 2.5 million
shares. The 1997 Plan expired on December 2, 2007 and no additional awards may be made. As of
December 31, 2013, 1,481,750 of the options issued under the 1997 Plan prior to December 2007 expired
unexercised or were terminated. As a consequence, these shares are deemed and remain unissued which up to
a maximum of 900,000 shares became available for issuance under the 2010 Plan and the remaining 581,750
options are deemed cancelled.

49

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

Stock Options

All of the Company’s employees, including employees who are officers or members of the Board are
eligible to participate in the 2010 Plan. Consultants and advisors who perform services for the Company are
also eligible to participate in the 2010 Plan. For Fiscal 2013, 2012 and 2011, we granted, 420,500, 15,000 and
220,000 options, respectively, to employees to acquire our Common Stock pursuant to the terms of 2010 Plan.
Presented below is a summary of the terms of the grant of options:

Number of options granted . . . . . . . . . . . . .
Vesting period . . . . . . . . . . . . . . . . . . . . . .
Maximum term of option from date of grant. .
Exercise price per share . . . . . . . . . . . . . . .
Weighted average fair value per share of

2013
420,500
2 − 3 years
6 − 7 years
$1.48 − $1.65

Year Ended December 31,
2012
15,000
3 years
7 years
$1.36

2011
220,000
4 years
7 years
$0.87 − $1.17

options granted during the year

. . . . . . . .

$0.56

$0.85

$0.58

We used the Black-Scholes option pricing model during Fiscal 2013, 2012 and 2011 to determine the fair
value of the stock options at the date of grant. Based upon our limited historical experience, we estimated
approximately, 33,000 of the options granted in Fiscal 2011 may ultimately be forfeited and no options
granted in Fiscal 2013 and 2012 are estimated to be forfeited. Additionally, we determined the expected term
of the stock option grants to be a range between 3.75 to 6.5 years, calculated using the ‘‘simpliﬁed’’ method
in accordance with the SEC Staff Accounting Bulletin 110. We use the ‘‘simpliﬁed’’ method since we changed
the vesting terms, tax treatment and the recipients of our stock options beginning in Fiscal 2010 such that we
believe our historical data does not provide a reasonable basis upon which to estimate expected term.

Presented below is a summary of assumptions used in determining the fair value of the stock options at

the date of grant:

Expected option life . . . . . . . . . . . . . .
Weighted average risk free rate . . . . . .
Dividend yield . . . . . . . . . . . . . . . . .
Expected volatility . . . . . . . . . . . . . . .

2013
3.75 − 4.5 years
0.36%
0%
47.33% − 82.09%

Year Ended December 31,
2012
4.5 years
0.75%
0%
83.06%

2011
4.75 years
1.28%
0%
75.84% − 78.62%

The fair value of the stock options at

in Fiscal 2013, 2012 and 2011 was
approximately $237,000, $13,000 and $127,000, respectively. Each of the stock options granted were subject
to vesting such that the fair value of the stock options granted is charged to operations over the vesting
period. For Fiscal 2013, 2012 and 2011, we charged to operations $160,000, $153,000 and $131,000,
respectively, for share-based compensation expense for the aggregate fair value of the vested stock options
earned.

the time of the grant

At December 31, 2013, of the options granted in Fiscal 2013, 2012 and 2011 686,250 were vested and
884,250 are subject to vesting. At December 31, 2013, there are 262,159 options available for grant to
purchase shares of Common Stock that may be issued pursuant to the terms of the 2010 Plan.

50

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

A summary of the status of our stock options granted to both employees and non-employees as of
December 31, 2013, 2012 and 2011 and changes during the years then ended is presented below
(in thousands, except per share data):

2013

Weighted
Average
Exercise
Price

$1.72
1.64
1.08
4.53
$1.60

$1.32

Shares

1,307
420
(25)
(64)
1,638

884
754
262

Year Ended December 31,
2012

Weighted
Average
Exercise
Price

$1.88
1.36
—
8.11
$1.72

$1.01

Shares

1,333
15
—
(41)
1,307

719
588
—

2011

Weighted
Average
Exercise
Price

$2.99
1.10
—
8.67
$1.88

$1.02

Shares

1,300
220
—
(187)
1,333

957
376
14

Options outstanding − beginning of

. . . . . . . . . . . . . . . . . . . .
year
Granted . . . . . . . . . . . . . . . . . .
Exercised . . . . . . . . . . . . . . . . .
Cancelled . . . . . . . . . . . . . . . . .
Options outstanding − end of year . .
Options granted and subject to

future vesting . . . . . . . . . . . . . .
Exercisable, at end of year . . . . . . .
. . . . . . . . . . . .
Available for grant

The unrecognized share-based compensation expense related to the options granted but not vested,
(options to acquire 884,250 shares) was approximately $522,000 at December 31, 2013. These options subject
to vesting (i) vest over the next 1 to 3 years, (ii) have a 6 to 7 year term from the date of grant, (iii) are
exercisable at a weighted average price of $1.31 and (iv) the unrecognized share-based compensation expense
is expected to be recognized over a weighted average period of 2.3 years.

The following table summarizes information about stock options outstanding and stock options

exercisable at December 31, 2013 (in thousands, except remaining life and per share data):

Range of Exercise Prices
$0.87 − $1.17 . . . . . . . . . . . . . . . . . . . . . . .
$1.18 − $1.65 . . . . . . . . . . . . . . . . . . . . . . .
$1.66 − $9.50 . . . . . . . . . . . . . . . . . . . . . . .
$9.51 − $13.80 . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total

Options Outstanding and Exercisable
Weighted
Average
Remaining
Contractual Life
4.6
6.1
0.8
2.0

Weighted
Average Exercise
Price Per Share
$ 1.01
$ 1.40
$ 9.50
$13.80
$ 1.93

Number
Outstanding
675
11
40
27
753

The total intrinsic value of options exercised during Fiscal 2013 was $12,000. There were no options
exercised during Fiscal 2012 or 2011. The aggregate intrinsic value of (i) options outstanding, (ii) options
outstanding and expected to vest in the future and (iii) options outstanding and exercisable at December 31,
2013 was $678,000, $465,000 and $273,000, respectively.

Stock Grants

In April 2011,

the Compensation Committee of the Board of Directors approved an amendment

to
Mr. Karkus’ then employment agreement, dated August 19, 2009 (the ‘‘Amendment’’) to lower his annual
salary by $150,000 (or $12,500 per month) in exchange for a grant of restricted stock equal in value to the
salary reduction. Pursuant to the Amendment, Mr. Karkus’ annual base salary was decreased from $750,000
per year to $600,000 per year, effective May 1, 2011 thru July 15, 2012, which was the end of the term of his
then employment agreement, as amended. As a consequence of the Amendment, a restricted stock grant under

51

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

the 2010 Plan equal to $12,500 of shares per month thru the end of the term (14.5 months). The restricted
stock grant was made in an upfront grant of 161,830 shares, subject to certain future vesting conditions, at a
value of $181,000 as of the grant date. The grant was made in April 2011 and the amount of the shares issued
was calculated based on the average closing price of our Common Stock for the last ﬁve (5) trading days
prior to and including the issuance date of April 21, 2011. For Fiscal 2012 and 2011, we charged to operations
$81,000 and $100,000, respectively, as share-based compensation expense for the restricted stock grant.

In addition, in April 2011, the Compensation Committee of the Board of Directors granted Mr. Karkus
133,928 shares of Common Stock under the 2010 Plan as payment for his Fiscal 2010 bonus. Furthermore, in
December 2011, the Compensation Committee of the Board of Directors granted Mr. Karkus 134,409 shares
of Common Stock under the 2010 Plan valued at $150,000 as payment for his Fiscal 2011 bonus.

In April 2011, Mr. Karkus also agreed to convert into shares of our Common Stock $144,000 of deferred
and unpaid cash compensation owed to him thru April 2011, resulting in an issuance of 128,571 shares under
the 2010 Plan. The amount of these shares issued to Mr. Karkus was calculated based on the average closing
price of the Company’s shares for the last ﬁve (5) trading days prior to and including the issuance dates of
April 21, 2011.

In December 2011,

the Board of Directors granted Mr. Cuddihy
33,603 shares of Common Stock, under the 2010 Plan valued at $37,500 as payment for 50% of his Fiscal 2011
bonus.

the Compensation Committee of

In December 2013,

the Compensation Committee of the Board of Directors granted Mr. Karkus
50,000 shares of Common Stock, under the 2010 Plan valued at $82,000 as payment for a portion of his
Fiscal 2013 bonus.

The 2010 Directors Equity Compensation Plan

On May 5, 2010, our shareholders approved the 2010 Directors’ Equity Compensation Plan which was
subsequently amended and approved by shareholders on May 6, 2013. A primary purpose of the 2010
Directors’ Equity Compensation Plan is to provide us with the ability to pay all or a portion of the fees of
Directors in restricted stock instead of cash. The 2010 Directors’ Equity Compensation Plan provides that the
total number of shares of Common Stock that may be issued under the 2010 Directors’ Equity Compensation
Plan is equal to 425,000 shares. In Fiscal 2013, 2012 and 2011, we granted 16,470, zero and 164,770 shares,
for director
respectively, of our Common Stock valued at $27,000, zero and $162,000,
compensation. At December 31, 2013, there are 176,135 shares of Common Stock that may be issued pursuant
to the terms of the 2010 Directors’ Equity Compensation Plan.

respectively,

Stock Option Exercises and Other Grants

For Fiscal 2013, we derived net proceeds of $27,000, as a consequence of the exercise of options to
acquire 25,000 of our Common Stock pursuant to the terms of our 2010 Option Plan. There were no stock
options exercised in Fiscal 2012 or 2011.

In Fiscal 2011, pursuant to the terms of Mr. Cuddihy’s prior employment agreement dated August 19,
2009, Mr. Cuddihy received an annual grant of shares of Common Stock that is equal to $50,000, payable
quarterly, promptly following the close of each quarter calculated based on the average closing price of our
Common Stock for the last ﬁve (5) trading days of the quarter. For Fiscal, 2011, Mr. Cuddihy earned,
51,642 shares, valued at $50,000, as share-based compensation.

Purchase of Treasury Stock

In September 2011, we entered into a redemption agreement with PSI Parent. Under the terms of the
redemption agreement, we redeemed 690,000 shares of our Common Stock held by PSI Parent for the aggregate
redemption price of $448,500 in cash (see Note 8). The redemption price was equal to $0.65 per share.

52

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7 — DEFINED CONTRIBUTION PLANS

We maintain the ProPhase Labs, Inc 401(k) Savings and Retirement Plan, a deﬁned contribution plan for
our employees. Our contributions to the plan are based on the amount of the employee plan contributions and
compensation. Our contributions to the plan in Fiscal 2013, 2012 and 2011 were $100,000, $104,000 and
$88,000, respectively.

NOTE 8 — INVESTMENT IN PHUSION LABORATORIES, LLC.

On March 22, 2010, we, PSI Parent, PSI and the Joint Venture entered into the LLC Agreement of the
Joint Venture and additional related agreements for the purpose of developing and commercializing, for
worldwide distribution and sale, a wide range of non-prescription remedies using PSI Parent’s proprietary
patented TPM.

In connection with the LLC Agreement, PSI Parent granted to us, pursuant to the terms of a License
Agreement, dated March 22, 2010 (the ‘‘Original License Agreement’’), (i) an exclusive, royalty-free,
world-wide (subject to certain limitations), paid-up license to exploit OTC drugs and certain other products
the ‘‘PSI
that embody certain of PSI Parent’s TPM-related patents and related know-how (collectively,
Technology’’) and (ii) a non-exclusive, royalty-free, world-wide (subject to certain limitations), paid-up license
to exploit certain compounds that embody the PSI Technology for use in a product combining one or more of
such compounds with an OTC drug or in a product that is part of a regimen that includes the application of
an OTC drug. Pursuant to the terms of the Original License Agreement, we issued to PSI Parent 1,440,000
shares of our common stock, $0.005 par value (‘‘Common Stock’’) having an aggregate value of $2.6 million
(such share, the ‘‘PSI Shares’’) and made a one-time payment of $1.0 million.

The Joint Venture is managed by a four-person Board of Managers, with two managers appointed by
each member. The LLC Agreement contains other standard terms in such arrangements, including provisions
relating to the governance of the Joint Venture, indemniﬁcation obligations of the Joint Venture, allocation of
proﬁts and losses, the distribution of funds to the members and restrictions on transfer of a member’s interest.

On the date the PSI Shares were issued, PSI Parent agreed, pursuant to a Share Transfer Restriction
Agreement, dated March 22, 2010 (the ‘‘Share Transfer Restriction Agreement’’), between us and PSI Parent,
that, with certain exceptions, it would not sell or otherwise dispose of any of the PSI Shares prior to June 1,
2012 (see discussion below). The PSI Shares were issued pursuant to an exemption from registration under
the Securities Act, by virtue of Section 4(2) of the Securities Act and by virtue of Rule 506 of Regulation D
under the Securities Act. Such sale and issuance did not involve any public offering and was made without
general solicitation or advertising. Additionally, PSI Parent represented to us, among other things, that PSI
Parent is not a US Person (as deﬁned in Regulation S under the Securities Act), that PSI Parent is an
accredited investor with access to all relevant information necessary to evaluate its investment and that the
PSI Shares were being acquired for investment purposes only.

In September 2011, PSI Parent entered into certain Private Resale Agreements (‘‘PSAs’’) with seven third
party purchasers, under which Phosphagenics sold, with our consent, an aggregate of 750,000 shares of our
Common Stock. Under the PSAs, the purchasers may not, without the prior written consent of the Company,
prior to the one year anniversary of the PSAs, directly or indirectly, sell, give, pledge, hypothecate, assign or
otherwise transfer
in part. Contemporaneously with PSI Parent
consummating the PSAs, we consummated an agreement with PSI Parent to redeem the then remaining
690,000 PSI Shares held by PSI Parent.

the purchased shares,

in whole or

In accordance with a Contribution Agreement, dated March 22, 2010 (the ‘‘Contribution Agreement’’), by
and among us, PSI Parent, PSI, and the Joint Venture, we transferred, conveyed and assigned to the
Joint Venture all of our rights, title and interest in, to and under the Original License Agreement, and the Joint
Venture assumed, and undertook to pay, discharge and perform when due, all of our liabilities and obligations
under and arising pursuant to the Original License Agreement (such actions, collectively, the ‘‘Assignment and
Assumption’’).

53

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8 — INVESTMENT IN PHUSION LABORATORIES, LLC. − (continued)

Pursuant to the Contribution Agreement and in order to reﬂect the Assignment and Assumption, we, PSI
Parent and the Joint Venture entered into an Amended and Restated License Agreement, dated March 22, 2010
(the ‘‘Amended License Agreement’’), which amends and restates the Original License Agreement to reﬂect
that the Joint Venture is the licensee thereunder and which otherwise contains substantially the same terms as
the Original License Agreement. The Joint Venture has the right to grant one or more sub-licenses of the
rights granted under the Amended License Agreement to one or more third parties for reasonable consideration
in any part of the applicable territory. The Amended License Agreement provides that PSI Parent shall not,
directly or through third parties, exploit the covered intellectual property during the term thereof, subject to
certain limitations. The Amended License Agreement will remain in effect until the expiration of the last to
expire of the patents included within the PSI Technology or any extensions thereof. Either party may
terminate the Amended License Agreement upon written notice to the other party in the event of certain
events involving bankruptcy or insolvency. The Amended License Agreement also contains, among other
things, provisions concerning the treatment of conﬁdential information, the ownership of intellectual property
and indemniﬁcation obligations.

Pursuant to the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture.
PSI Parent conducts and oversees much of the product development, formulation, testing and other research
and development needed by the Joint Venture, and we will oversee much of the production, distribution, sales
and marketing. The LLC Agreement provides that each member may be required, from time to time and
subject to certain limitations, to make capital contributions to the Joint Venture to fund its operations, in
accordance with agreed upon budgets for products to be developed. Speciﬁcally, we contributed in Fiscal 2010
$500,000 in cash as initial capital and we are committed to fund up to $2.0 million, subject to agreed upon
budgets (which have not been established to date), toward the initial development and marketing costs of new
products for the Joint Venture. The Joint Venture has not engaged in any ﬁnancial transactions, other than
organizational expenses and general market and initial product evaluation and analysis. At December 31,
2013, cash and equivalents includes $378,000 which is expected to be used by the Joint Venture to fund future
product development initiatives currently under consideration by PSI Parent, PSI and us.

Our determination is that the Joint Venture qualiﬁes as a VIE and that we are the primary beneﬁciary.
We have consolidated the Joint Venture ﬁnancial statements beginning with the quarter ended March 31, 2010.
In Fiscal 2010, we recorded our $3.6 million payment representing the estimated fair value to acquire the
product license as an intangible asset. We currently estimate the expected remaining useful life of the product
license to be approximately 13 years which we will begin amortizing the cost of intangible asset once product
development and commercialization begins. Thus far, the Joint Venture has not generated any revenues and its
expenses, including organizational, marketing analysis and preliminary formulations have been absorbed by
the respective Joint Venture members. Furthermore, the liabilities and other obligations incurred, if any, by the
Joint Venture is without recourse to us and do not create a claim on our general assets.

During Fiscal 2012 and due to multiple factors affecting our capital position, including the payment we
made in December 2012 under the Settlement Agreement and some of the product market research performed,
we expect to modify the Joint Venture’s product development plans to stagger and/or defer into future periods
certain product development initiatives due to the pre-commercialization investments required. We expect to
continue pre-commercialization research and product development
initiatives during the latter half of
Fiscal 2014 or Fiscal 2015. Furthermore, we do not expect that the Joint Venture will derive any meaningful
revenues, if any, until its commercialization efforts are completed which is not expected to occur until at the
earliest the latter half of Fiscal 2014 or Fiscal 2015.

Due to multiple factors affecting our capital position, including (i) the $2.1 million payment we made in
December 2012 under the Settlement Agreement and (ii) some of the product market research performed, we
expect to modify the Joint Venture’s product development plans to stagger and/or defer into future periods
initiatives due to the pre-commercialization investments required. As of
certain product development

54

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8 — INVESTMENT IN PHUSION LABORATORIES, LLC. − (continued)

December 31, 2013, we have not established a formal commercialization program timeline pending the results
from additional clinical studies. We do not project that any such OTC products will be available for shipment
within the next
to continue pre-commercialization research and product
development initiatives during the latter half of Fiscal 2014. Furthermore, we do not expect that the Joint
Venture will derive any meaningful revenues, if any, until its commercialization efforts are completed which is
not expected to occur until at the earliest the latter half of Fiscal 2014 or Fiscal 2015.

twelve months. We expect

NOTE 9 — INCOME TAXES

The components of the provision (beneﬁt) for income taxes, in the consolidated statement of operations

are as follows (in thousands):

Year Ended December 31,
2012

2011

2013

Current

Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Deferred

Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total
Income taxes from continuing operations before valuation

allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Change in valuation allowance . . . . . . . . . . . . . . . . . . . .
Income tax (beneﬁt) . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total

$ —
—
—

1,216
(999)
217
$ 217

$ 217
(217)
—
$ —

$ —
—
—

(618)
1,377
759
$ 759

$ 759
(759)
—
$ —

$ —
—
—

(877)
(21)
(898)
$(898)

$(898)
898
—
$ —

A reconciliation of the statutory federal income tax expense (beneﬁt) to the effective tax is as follows (in

thousands):

Year Ended December 31,
2012
$ (661)
1,377
43

2011
$(925)
(21)
48

2013
$ 138
17
62

217
(217)
—
$ —

759
(759)
—
$ —

(898)
898
—
$ —

Statutory rate − federal . . . . . . . . . . . . . . . . . . . . . . . . . .
State taxes, net of federal beneﬁt . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . .
Permanent differences and other

Income tax from continuing operation before valuation

allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Change in valuation allowance . . . . . . . . . . . . . . . . . . . .
Income tax (beneﬁt) . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total

55

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9 — INCOME TAXES − (continued)

The components of permanent and other differences are as follows (in thousands):

Year Ended December 31,
2012

2011

2013

Permanent items:

Meals and Entertainment
Return to provision adjustment

. . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . .
Charitable contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Share-based compensation expense for stock options granted(1)
. . .

$ 7
—
1
54
$62

$ 6
(46)
4
79
$ 43

$ 2
—
—
46
$48

(1) This item relates to share-based compensation expense for ﬁnancial reporting purposes not deducted for

tax purposes until such options are exercised.

The tax effects of the primary ‘‘temporary differences’’ between values recorded for assets and liabilities
for ﬁnancial reporting purposes and values utilized for measurement in accordance with tax laws giving rise to
our deferred tax assets are as follows (in thousands):

Net operating loss and capital loss carryforward . . . . . . . . .
Consulting-royalty costs . . . . . . . . . . . . . . . . . . . . . . . . .
Trademark . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment in Phusion . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total

2013
$ 13,569
80
819
(387)
(34)
1,009
(15,056)

Year Ended December 31,
2012
$ 14,158
121
—
—
60
983
(15,322)
—

2011
$ 13,170
1,431
—
—
235
757
(15,593)
—

— $

$

$

A valuation allowance for all of our net deferred tax assets has been provided as we are unable to
determine, at this time, that the generation of future taxable income against which the net operating loss
(‘‘NOL’’) carryforwards could be used can be predicted to be more likely than not. The net change in the
valuation allowance for Fiscal 2013, 2012 and 2011 was $266,000, $271,000 and ($898,000), respectively.
Certain exercises of options and warrants, and restricted stock issued for services that became unrestricted
resulted in reductions to taxes currently payable and a corresponding increase to additional-paid-in-capital for
prior years. In addition, certain tax beneﬁts for option and warrant exercises totaling $6.5 million are deferred
and will be credited to additional-paid-in-capital when the NOL’s attributable to these exercises are utilized.
As a result,
income tax expense. The net operating loss
carry-forwards currently approximate $34.7 million for federal purposes will expire beginning in Fiscal 2020
through 2032. Additionally, there are net operating loss carry-forwards of $20.4 million for state purposes that
will expire beginning in Fiscal 2018 through 2032.

these NOL’s will not be available to offset

NOTE 10 — EARNINGS PER SHARE

Basic earnings per share (‘‘EPS’’) excludes dilution and is computed by dividing income available to
common stockholders by the weighted-average number of common shares outstanding for the period. Diluted
EPS reﬂects the potential dilution 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 shared in the
earnings of the entity. Diluted EPS also utilizes the treasury stock method which prescribes a theoretical buy
back of shares from the theoretical proceeds of all options and warrants outstanding during the period. Since

56

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10 — EARNINGS PER SHARE − (continued)

there is a large number of options and warrants outstanding, ﬂuctuations in the actual market price can have a
variety of results for each period presented.

A reconciliation of

the applicable numerators and denominators of

the income statement periods

presented is as follows (in thousands, except per share amounts):

Income
$405

2013
Shares
15,839

EPS
$0.03

Year Ended December 31,
2012
Shares
$(1,091) 14,843

Loss

EPS

2011
Loss
Shares
$(0.07) $(2,710) 14,817

—
$405

437
16,276

—
$0.03

—

—
$(1,091) 14,843

—

—
$(0.07) $(2,710) 14,817

—

EPS
$(0.18)

—
$(0.18)

Basic EPS . . . . . .

Dilutives:
Options/Warrants . .
Diluted EPS . . . . .

For Fiscal 2012 and 2011, diluted earnings per share is the same as basic earnings per share due to the
inclusion of common stock, in the form of stock options and warrants (‘‘Common Stock Equivalents’’), would
have an anti-dilutive effect on the loss per share. For Fiscal 2012 and 2011, there were Common Stock
Equivalents in the amount of 177,035 and 48,375, respectively, which were in the money, that were excluded
in the earnings per share computation due to their dilutive effect.

NOTE 11 — SIGNIFICANT CUSTOMERS

Our products are distributed through national chain, regional, specialty and local retail stores throughout
the United States. Revenues for Fiscal 2013, 2012 and 2011 were $25.0 million, $22.4 million and
$17.5 million, respectively. Walgreen Company (‘‘Walgreens’’), Wal-Mart Stores Inc (‘‘Wal-Mart’’) and CVS
Caremark Corporation (‘‘CVS’’) accounted for approximately 20.4%, 14.3% and 11.6%, respectively, of our
Fiscal 2013 revenues. Walgreens, Wal-Mart and CVS accounted for approximately 19.3%, 13.8% and 13.4%,
respectively, of our Fiscal 2012 revenues. Walgreens, Wal-Mart, CVS and Rite-Aid Corp (‘‘Rite Aid’’)
accounted for approximately 17%, 14%, 13% and 12%, respectively, of our Fiscal 2011 revenues. The loss of
sales to any one or more of these large retail customers could have a material adverse effect on our business
operations and ﬁnancial condition.

We are subject to account receivable credit concentrations from time-to-time as a consequence of the
timing, payment pattern and ultimate purchase volumes or shipping schedules with our customers. These
concentrations may impact our overall exposure to credit risk, either positively or negatively, in that our
customers may be similarly affected by changes in economic, regulatory or other conditions that may impact
the timing and collectability of amounts due to us. Customers comprising the ﬁve largest accounts receivable
balances represented 68% and 65% of total
trade receivable balances at December 31, 2013 and 2012,
respectively. Management believes that the provision for possible losses on uncollectible accounts receivable
is adequate for our credit loss exposure. The allowance for doubtful accounts was zero for both December 31,
2013 and 2012.

57

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12 — QUARTERLY INFORMATION (UNAUDITED)

The following table presents unaudited quarterly ﬁnancial information for Fiscal 2013 and Fiscal 2012 (in

thousands, except per share amounts):

March 31,

June 30,

September 30,

December 31,

Quarter Ended

Fiscal 2013

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . .
Gross proﬁt
. . . . . . . . . . . . . . . . . . . .
Net income (loss)

$7,542
$5,339
$ 290

$ 1,939
$
928
$(1,719)

Basic and diluted income (loss) per share:

Basic income (loss) per share . . . . . . . . . .
Diluted income (loss) per share . . . . . . . . .

$ 0.02
$ 0.02

$ (0.11)
$ (0.11)

Fiscal 2012

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . .
Gross proﬁt
. . . . . . . . . . . . . . . . . . . .
Net income (loss)

$6,018
$4,340
$ (688)

$ 1,894
$
825
$(1,930)

$5,949
$3,817
$1,237

$ 0.08
$ 0.08

$5,415
$3,399
$1,074

$9,602
$6,587
$ 597

$ 0.04
$ 0.04

$9,079
$5,688
$ 453

Basic and diluted income (loss) per share:

Net income (loss)

. . . . . . . . . . . . . . . . . .

$ (0.05)

$ (0.13)

$ 0.07

$ 0.04

58

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None

Item 9A. Controls and Procedures

Disclosure Controls and Procedures

We maintain disclosure controls and procedures designed to provide reasonable assurance that material
information required to be disclosed by us in the reports ﬁled or submitted under the Securities Exchange Act
of 1934 is recorded, processed, summarized and reported within the time periods speciﬁed in the SEC rules
and forms, and that the information is accumulated and communicated to our management, including our
Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding
required disclosure. We performed an evaluation, under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of the disclosure controls and procedures as of the end of the period covered by this
report. Based on our review, our management, including our Chief Executive Officer and Chief Financial
Officer, concluded that the Company’s disclosure controls and procedures were effective at the reasonable
assurance level as of the end of the period covered by this Report.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining an adequate system of internal control
over ﬁnancial reporting. Our system of internal control over ﬁnancial reporting is designed to provide
reasonable assurance regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements
for external purposes in accordance with accounting principles generally accepted in the United States of
America.

Our internal control over ﬁnancial reporting includes those policies and procedures that:

•

•

•

pertain to the maintenance of records that, in reasonable detail, accurately and fairly reﬂect our
transactions and dispositions of our assets;

provide reasonable assurance that our transactions are recorded as necessary to permit preparation of
our ﬁnancial statements in accordance with accounting principles generally accepted in the
United States of America, and that our receipts and expenditures are being made only in accordance
with authorizations of our management and our directors; and

provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition,
use, or disposition of our assets that could have a material effect on the ﬁnancial statements.

Because of its inherent limitations, a system of internal control over ﬁnancial reporting can provide only
reasonable assurance and may not prevent or detect misstatements. Further, because of changes in conditions,
effectiveness of
time. Our system contains
self-monitoring mechanisms, and actions are taken to correct deﬁciencies as they are identiﬁed.

internal controls over ﬁnancial

reporting may vary over

Our management conducted an evaluation of our effectiveness of the system of internal control over
ﬁnancial reporting based on the framework in Internal Control — Integrated Framework issued in 1992 by the
review, our
Committee of Sponsoring Organizations of
management, including our Chief Executive Officer and Chief Financial Officer, concluded that the Company’s
internal controls over ﬁnancial reporting were effective as of December 31, 2013.

the Treadway Commission. Based upon our

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal control over ﬁnancial reporting during Fiscal 2013 that have

materially affected, or are reasonably likely to materially affect, our internal control over ﬁnancial reporting.

Item 9B. Other Information

None

59

PART III

Item 10. Directors, Executive Officers and Corporate Governance

The information required under this item is incorporated by reference to the Company’s Proxy Statement
for the 2014 Annual Meeting of Stockholders (the ‘‘2014 Proxy Statement’’) which is to be ﬁled with the SEC
not later than 120 days after the close of our ﬁscal year ended December 31, 2013 and is hereby incorporated
by reference.

Item 11. Executive Compensation

The information required under this item is incorporated by reference to the 2014 Proxy Statement.

Item 12. Security Ownership of Certain Beneﬁcial Owners and Management and Related Stockholder
Matters

The information required under this item is incorporated by reference to the 2014 Proxy Statement.

Item 13. Certain Relationships and Related Transactions and Director Independence

The information required under this item is incorporated by reference to the 2014 Proxy Statement.

Item 14. Principal Accountant Fees and Services

The information required under this item is incorporated by reference to the 2014 Proxy Statement.

60

PART IV

Item 15. Exhibits and Financial Statement Schedules

(a) Exhibits:

3.1

3.2

3.3

4.1

10.1*

10.2

10.3

10.4

10.5

10.6

10.7

10.8

10.9

10.10

10.11

10.12*

10.13*

10.14*

Articles of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1
of Form 10-KSB/A ﬁled on April 4, 1997).

Certiﬁcate of Amendment to the Articles of Incorporation of the Company, effective May 5, 2010
(incorporated by reference to Exhibit 3.1 of Form 8-K ﬁled on May 10, 2010).

By-laws of the Company as amended and restated effective August 18, 2009, (incorporated by
reference to Exhibit 3.1 of Form 8-K ﬁled on August 18, 2009).

Specimen Common Stock Certiﬁcate (incorporated by reference to Exhibit 4.1 of Form 10-KSB/A
ﬁled on April 4, 1997).

1997 Stock Option Plan (incorporated by reference to Exhibit 10.1 of the Company’s Registration
Statement on Form S-8 (File No. 333-61313) ﬁled on August 13, 1998).

Exclusive Representation and Distribution Agreement dated May 4, 1992 between the Company
and Godfrey Science and Design, Inc. et al (incorporated by reference to Exhibit 10.2 of
Form 10-KSB/A ﬁled on April 4, 1997).
Rights Agreement dated September 15, 1998 between the Company and American Stock Transfer
and Trust Company (incorporated by reference to Exhibit 1 to the Company’s Registration Statement
on Form 8-A ﬁled on September 18, 1998).
First Amendment to the Rights Agreement, dated as of May 20, 2008 between the Company and
American Stock Transfer and Trust Company (incorporated by reference to Exhibit 99.1 of
Form 8-K ﬁled on May 23, 2008).
Sale agreement of Darius to Innerlight Holdings, Inc. dated February 29, 2008 incorporated by
reference to Exhibit 99.1 of Form 8-K ﬁled on March 3, 2008).
Second Amendment to the Rights Agreement, dated as of August 18, 2009 between the Company
and American Stock Transfer and Trust Company (incorporated by reference to Exhibit 10.1 of
Form 8-K ﬁled on August 18, 2009).
Form of Indemniﬁcation Agreement between the Company and each of its Officers and Directors
dated August 19, 2009 (incorporated by reference to Exhibit 10.1 of Form 8-K ﬁled on August 19,
2009).
Limited Liability Company Agreement, dated March 22, 2010, between the Company,
Phosphagenics Limited, Phosphagenics Inc., and Phusion Laboratories, LLC. (incorporated by
reference to Exhibit 10.11 of Form 10-K ﬁled on March 24, 2010).
Contribution Agreement, dated March 22, 2010, between the Company, Phosphagenics Limited,
Phosphagenics Inc., and Phusion Laboratories, LLC. (incorporated by reference to Exhibit 10.12 of
Form 10-K ﬁled on March 24, 2010).

License Agreement, dated March 22, 2010, between the Company and Phosphagenics Limited.
(incorporated by reference to Exhibit 10.13 of Form 10-K ﬁled on March 24, 2010).

Amended and Restated License Agreement, dated March 22, 2010, between the Company,
Phosphagenics Limited, Phosphagenics Inc., and Phusion Laboratories, LLC. (incorporated by
reference to Exhibit 10.14 of Form 10-K ﬁled on March 24, 2010).

2010 Equity Compensation Plan (incorporated by reference to Exhibit B of the Company’s Annual
Proxy Statement on Schedule 14A ﬁled on April 2, 2010).

2010 Directors’ Equity Compensation Plan (incorporated by reference to Exhibit C of
Company’s Annual Proxy Statement on Schedule 14A ﬁled on April 2, 2010).
Amendment to 2010 Directors’ Equity Compensation Plan (incorporated by reference to Exhibit 10.3
of Form 8-K ﬁled on May 10, 2010).

the

61

10.15*

10.16*

10.17*

10.18*

10.19

10.20

10.21*

10.22*

10.23

10.24

10.25*

10.26*

14.1

21.1**
23.1**

31.1**
31.2**
32.1**

32.2**

Form of Option Agreement pursuant to 2010 Equity Compensation Plan (incorporated by reference
to Exhibit 10.4 of Form 8-K ﬁled on May 10, 2010).

Form of Option Agreement pursuant to 2010 Directors’ Equity Compensation Plan (incorporated by
reference to Exhibit 10.5 of Form 8-K ﬁled on May 10, 2010).

Form of Restricted Stock Award Agreement pursuant to 2010 Directors’ Equity Compensation Plan
(incorporated by reference to Exhibit 10.6 of Form 8-K ﬁled on May 10, 2010).

2010 Amended and Restated Equity Compensation Plan (incorporated by reference to Exhibit A of
the Company’s Annual Proxy Statement on Schedule 14A ﬁled on March 14, 2011).

Redemption Agreement with Phosphagenics Ltd. (incorporated by reference to Exhibit 10.1 of
Form 8-K ﬁled on September 23, 2011).

Employment Agreement dated January 1, 2012 between Ted Karkus and the Company (incorporated
by reference to Exhibit 99.2 of Form 10-Q ﬁled on November 10, 2011).

Employment Agreement dated January 1, 2012 between Robert V. Cuddihy, Jr., and the Company
(incorporated by reference to Exhibit 99.1 of Form 10-Q ﬁled on November 10, 2011).

Investment Agreement by and between ProPhase Labs, Inc. and Dutchess Opportunity Fund II, LP,
dated as of November 26, 2012 (incorporated by reference to Exhibit 10.3 of Form 8-K ﬁled on
November 27, 2012).

Inc.

Registration Rights Agreement by and between ProPhase Labs, Inc. and Dutchess Opportunity
Fund II, LP, dated as of November 26, 2012 (incorporated by reference to Exhibit 10.3 of Form 8-K
ﬁled on November 27, 2012).
f/k/a The Quigley
Settlement Agreement and Mutual Release between ProPhase Labs,
Corporation and John C. Godfrey, the Estate of Nancy Jane Godfrey, and Godfrey Science and
Design, Inc. dated December 20, 2012 (incorporated by reference to Exhibit 10.25 of Form 10-K
ﬁled on March 28, 2013).
Amendment to Amended and Restated 2010 Equity Compensation Plan (incorporated by reference to
Appendix A of the Company’s Annual Proxy Statement on Schedule 14A ﬁled on April 3, 2013).
Amendment to 2010 Directors’ Equity Compensation Plan (incorporated by reference to Appendix B
of the Company’s Annual Proxy Statement on Schedule 14A ﬁled on April 3, 2013).
Code of Ethics (incorporated by reference to Exhibit II of the Proxy Statement on Schedule 14A
ﬁled on March 31, 2003).
Subsidiaries of ProPhase Labs, Inc.
Consent of EisnerAmper LLP, Independent Registered Public Accounting Firm, dated March 27,
2014.
Certiﬁcation of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certiﬁcation of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certiﬁcation of the Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

Certiﬁcation of the Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

Indicates a management contract or compensatory plan or arrangement

*
** Filed herewith

62

SIGNATURES

Pursuant

the
registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,

Date: March 27, 2014

PROPHASE LABS, INC.
Registrant

By: /s/ Ted Karkus
Ted Karkus,
Chairman of the Board,
Chief Executive Officer and Director

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the

following persons on behalf of the registrant and in the capacities and on the dates indicated:

Principal Executive Officer

Principal Financial and Accounting Officer

By: /s/ Ted Karkus
Ted Karkus
Chairman of the Board and
Chief Executive Officer

Date: March 27, 2014

/s/ Mark Burnett
Mark Burnett

/s/ Mark Frank
Mark Frank

/s/ Mark Leventhal
Mark Leventhal

Date: March 27, 2014

By: /s/ Robert V. Cuddihy, Jr.
Robert V. Cuddihy, Jr.
Chief Operating Officer and
Chief Financial Officer

Directors

/s/ Louis Gleckel
Louis Gleckel

/s/ James McCubbin
James McCubbin

63

[This page intentionally left blank.] 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
EXHIBIT 21.1

SUBSIDIARIES OF PROPHASE LABS, INC.

Subsidiaries
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pharmaloz Manufacturing Inc.
Phusion Laboratories, LLC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Phusion Labs Manufacturing, Inc.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Quigley Pharma Inc.

State or other
Jurisdiction of
Incorporation
Delaware
Delaware
Delaware
Delaware

Ownership
Percentage
100%
50%
100%
100%

The above subsidiaries are included in the consolidated ﬁnancial statements for

the year ended

December 31, 2013.

EXHIBIT 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of ProPhase Labs, Inc.:

We consent to the incorporation by reference in the Registration Statements of ProPhase Labs, Inc. and
Subsidiaries on Forms S-8 (No. 333-73456, No. 333-61313, No. 333-10059, No. 333-14687, No. 333-26589,
333-132770 and 333-169697), Form SB-2 (No. 333-31241) and Forms S-3 (No. 333-86976, 333-104148,
333-119748 and 333-185167) of our report dated March 27, 2014, on our audits of the consolidated ﬁnancial
statements of ProPhase Labs, Inc. and Subsidiaries as of December 31, 2013 and 2012 and for each of the
years in the three-year period ended December 31, 2013, to be ﬁled on or about March 27, 2014.

/s/ EISNERAMPER LLP

Iselin, New Jersey
March 27, 2014

OFFICER’S CERTIFICATION PURSUANT TO
RULE 13a-14(a)/15d-14(a) OF THE SECURITIES EXCHANGE ACT OF 1934

I, Ted Karkus, certify that:

EXHIBIT 31.1

1.

I have reviewed this Annual Report on Form 10-K of ProPhase Labs, Inc.;

2. Based on my knowledge, this Annual Report does not contain any untrue statement of a material
fact or omit
in light of the
to state a material fact necessary to make the statements made,
circumstances under which such statements were made, not misleading with respect to the period
covered by this Annual Report;

3. Based on my knowledge, the ﬁnancial statements, and other ﬁnancial information included in this
Annual Report, fairly present in all material respects the ﬁnancial condition, results of operations
and cash ﬂows of the registrant as of, and for, the periods presented in this Annual Report;

4.

The registrant’s other certifying officer and I are responsible for establishing and maintaining
disclosure controls and procedures (as deﬁned in Exchange Act Rules 13a-15(e) and 15d-15(e)) and
internal control over ﬁnancial reporting (as deﬁned in Exchange Act Rule 131-15(f) and 15d015(f)
for the registrant and have:

(a) designed such disclosure controls and procedures, or caused such disclosure controls and
procedures to be designed under our supervision, to ensure that material information relating to
the registrant, including its consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this Annual Report is being prepared;

(b) designed such internal control over ﬁnancial reporting, or caused such internal control over
ﬁnancial reporting to be designed under our supervision,
to provide reasonable assurance
regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for
external purposes in accordance with generally accepted accounting principles;

(c)

evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented
in this Annual Report our conclusions about the effectiveness of the disclosure controls and
procedures, as of the end of the period covered by this report based on such evaluation; and

(d) disclosed in this report any change in the registrant’s internal control over ﬁnancial reporting
that occurred during the registrant’s most recent ﬁscal quarter (the registrant’s fourth ﬁscal
quarter in the case of an annual report) that has materially affected, or is reasonably likely to
materially affect, the registrant’s internal control over ﬁnancial reporting; and

5.

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of
internal control over ﬁnancial reporting, to the registrant’s auditors and the audit committee of the
registrant’s board of directors (or persons performing the equivalent functions):

(a)

all signiﬁcant deﬁciencies and material weaknesses in the design or operation of internal control
over ﬁnancial reporting which are reasonably likely to adversely affect the registrant’s ability to
record, process, summarize and report ﬁnancial information; and

(b) any fraud, whether or not material, that involves management or other employees who have a

signiﬁcant role in the registrant’s internal control over ﬁnancial reporting.

Date: March 27, 2014

By: /s/ Ted Karkus
Ted Karkus
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)

OFFICER’S CERTIFICATION PURSUANT TO
RULE 13a-14(a)/15d-14(a) OF THE SECURITIES EXCHANGE ACT OF 1934

I, Robert V. Cuddihy, Jr., certify that:

EXHIBIT 31.2

1.

I have reviewed this Annual Report on Form 10-K of ProPhase Labs, Inc.;

2. Based on my knowledge, this Annual Report does not contain any untrue statement of a material
fact or omit
in light of the
to state a material fact necessary to make the statements made,
circumstances under which such statements were made, not misleading with respect to the period
covered by this Annual Report;

3. Based on my knowledge, the ﬁnancial statements, and other ﬁnancial information included in this
Annual Report, fairly present in all material respects the ﬁnancial condition, results of operations
and cash ﬂows of the registrant as of, and for, the periods presented in this Annual Report;

4.

The registrant’s other certifying officer and I are responsible for establishing and maintaining
disclosure controls and procedures (as deﬁned in Exchange Act Rules 13a-15(e) and 15d-15(e)) and
internal control over ﬁnancial reporting (as deﬁned in Exchange Act Rule 131-15(f) and 15d015(f)
for the registrant and have:

(a) designed such disclosure controls and procedures, or caused such disclosure controls and
procedures to be designed under our supervision, to ensure that material information relating to
the registrant, including its consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this Annual Report is being prepared;

(b) designed such internal control over ﬁnancial reporting, or caused such internal control over
ﬁnancial reporting to be designed under our supervision,
to provide reasonable assurance
regarding the reliability of ﬁnancial reporting and the preparation of ﬁnancial statements for
external purposes in accordance with generally accepted accounting principles;

(c)

evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented
in this Annual Report our conclusions about the effectiveness of the disclosure controls and
procedures, as of the end of the period covered by this report based on such evaluation; and

(d) disclosed in this report any change in the registrant’s internal control over ﬁnancial reporting
that occurred during the registrant’s most recent ﬁscal quarter (the registrant’s fourth ﬁscal
quarter in the case of an annual report) that has materially affected, or is reasonably likely to
materially affect, the registrant’s internal control over ﬁnancial reporting; and

5.

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of
internal control over ﬁnancial reporting, to the registrant’s auditors and the audit committee of the
registrant’s board of directors (or persons performing the equivalent functions):

(a)

all signiﬁcant deﬁciencies and material weaknesses in the design or operation of internal control
over ﬁnancial reporting which are reasonably likely to adversely affect the registrant’s ability to
record, process, summarize and report ﬁnancial information; and

(b) any fraud, whether or not material, that involves management or other employees who have a

signiﬁcant role in the registrant’s internal control over ﬁnancial reporting.

Date: March 27, 2014

By: /s/ Robert V. Cuddihy, Jr.
Robert V. Cuddihy, Jr.
Chief Operating Officer
and Chief Financial Officer
(Principal Accounting and Financial Officer)

EXHIBIT 32.1

PROPHASE LABS, INC.
CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER
PURSUANT TO RULE 13a-14(b) OF THE SECURITIES EXCHANGE ACT OF 1934
AND 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Ted Karkus, Chief Executive Officer of ProPhase Labs, Inc., a Nevada corporation (the ‘‘Registrant’’),
in connection with the Registrant’s Annual Report on Form 10-K for the period ended December 31, 2013, as
ﬁled with the Securities and Exchange Commission on the date hereof (the ‘‘Report’’), do hereby represent,
warrant and certify, in compliance with Rule 13a-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that, to the best of
my knowledge:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities

Exchange Act of 1934, as amended; and

(2) The information contained in the Report fairly presents,

in all material respects,

the ﬁnancial

condition and results of operations of the Registrant.

/s/ Ted Karkus
Ted Karkus
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)

March 27, 2014

EXHIBIT 32.2

PROPHASE LABS, INC.
CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER
PURSUANT TO RULE 13a-14(b) OF THE SECURITIES EXCHANGE ACT OF 1934
AND 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

I, Robert V. Cuddihy, Jr., Chief Financial Officer of ProPhase Labs, Inc., a Nevada corporation (the
‘‘Registrant’’),
in connection with the Registrant’s Annual Report on Form 10-K for the period ended
December 31, 2013, as ﬁled with the Securities and Exchange Commission on the date hereof (the ‘‘Report’’),
do hereby represent, warrant and certify, in compliance with Rule 13a-14(b) of the Securities Exchange Act of
1934 and 18 U.S.C Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that,
to the best of my knowledge:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities

Exchange Act of 1934, as amended; and

(2) The information contained in the Report fairly presents,

in all material respects,

the ﬁnancial

condition and results of operations of the Registrant.

/s/ Robert V. Cuddihy, Jr.
Robert V. Cuddihy, Jr.
Chief Operating Officer and
Chief Financial Officer
(Principal Accounting and Financial Officer)

March 27, 2014

PROPHASE LABS, INC.

CORPORATE OFFICERS AND DIRECTORS

CORPORATE INFORMATION
Form 10-K Exhibits

Ted Karkus

Chairman & Chief Executive Officer

Robert V. Cuddihy, Jr.

Executive Vice President, Chief Operating
Officer & Chief Financial Officer

A copy of exhibits to the Company’s Annual Report
on Form 10-K will be furnished upon payment of a
specified fee to any stockholder upon written
request
the following
address:

to Investor Relations at

Investor Relations
ProPhase Labs, Inc.

Mr. Ted Karkus
621 N. Shady Retreat Road
Doylestown, PA 18901

Stock Exchange Listing

NASDAQ Global Market
Stock Symbol: PRPH

Transfer Agent

American Stock Transfer & Trust Company, LLC
59 Maiden Lane
New York, NY 10038

Independent Registered Public Accounting Firm

EisnerAmper, LLP
Iselin, NJ 08830

Attorneys

Reed Smith LLP
New York, NY 10022

Mark Burnett

Director

Mark Frank

Director

Louis Gleckel, MD

Director

Mark Leventhal

Director

James McCubbin

Director

SUBSIDIARIES

SUBSIDIARIES

STATE OR OTHER
JURISDICTION OF
INCORPORATION

Pharmaloz Manufacturing Inc.
Phusion Laboratories, LLC
Phusion Labs Manufacturing, Inc.
Quigley Pharma Inc.

Delaware
Delaware
Delaware
Delaware

The above subsidiaries are included in the consolidated
financial statements for the year ended December 31, 2013.

PROPHASE LABS, INC.
621 N. SHADY RETREAT ROAD • DOYLESTOWN, PA 18901
PHONE 215.345.0919 • WWW.PROPHASELABS.COM

(cid:3) PROPHASE LABS, INC. ALL RIGHTS RESERVED. PRINTED IN USA.