Prophase Labs Annual Report 2014

FY2014 Annual Report · Prophase Labs
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ANNUAL REPORT
2014

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

FORM 10-K

(Mark One)
(cid:3)

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

For the ﬁscal year ended December 31, 2014
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:5) No (cid:3)
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:5) No (cid:3)
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:3) No (cid:5)

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:3) No (cid:5)

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:3)

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:5) No (cid:3)
The aggregate market value of the registrant’s voting and non-voting common stock held by non-affiliates was $20,476,528 as of

Smaller reporting company (cid:3)

Non-accelerated ﬁler □

Accelerated ﬁler □

June 30, 2014, 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, 2015
Common stock, $0.0005 par value per share: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common share purchase rights:

15,892,296
—

Information set forth in Part III of this report is incorporated by reference to the registrant’s proxy statement for the 2015 annual

meeting of stockholders.

DOCUMENTS INCORPORATED BY REFERENCE

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
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 53 . . . . .

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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Forward-Looking Statements

PART I

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’’,
‘‘continue’’ and similar words although some forward-looking statements are expressed
‘‘potential’’,
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:6) Cold Remedy, and our ability to
successfully develop and commercialize our new products within the cough-cold category or other
categories such as dietary supplements;

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 general ﬁnancial and economic uncertainty, ﬂuctuations in consumer conﬁdence and the strength
if any, and their impacts on our business including demand for our
of an economic recovery,
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;

1

•

•

Our ability to defend and prevail in a putative class action complaint which purports to be brought
as a class action on behalf of purchasers of certain products sold by the Company, that alleges the
Company engaged in false and misleading marketing, advertising and sales of such products; and

Other risks identiﬁed in this Report.

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:6) Cold Remedy and our principal product is Cold-EEZE(cid:6) Cold Remedy 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:6) Cold Remedy lozenges, we market and distribute non-lozenge forms of our
proprietary zinc gluconate formulation, (i) Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) and (ii) Cold-EEZE(cid:6)
Cold Remedy Oral Spray. In Fiscal 2013, we expanded our Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) product
line and began shipments to retailers in July 2013 Cold-EEZE(cid:6) Plus Immune Support + Energy QuickMelts(cid:6).
In Fiscal 2014 we began shipments in June 2014 of Cold-EEZE(cid:6) Plus Natural Multi-Symptom QuickMelts(cid:6).
these new Cold-EEZE(cid:6) QuickMelts(cid:6) products are based on our proprietary zinc gluconate
Each of
formulation in combination with certain natural (i) immune system support, (ii) energy, (iii) sleep and
relaxation, and/or (iv) cold and ﬂu symptom relieving active ingredients.

Cold-EEZE(cid:6) Cold Remedy is an established product in the health care and cold remedy market. For
Fiscal 2014, 2013 and 2012, our revenues have come principally from our OTC cold remedy products. For
Fiscal 2014 and 2013, 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, 2014 shall be the term ‘‘Fiscal 2014’’ 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.

2

Description of Business Operations

Cold-EEZE(cid:6) 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:6) Cold Remedy lozenges effectiveness has
been substantiated in two double-blind clinical studies proving that Cold-EEZE(cid:6) Cold Remedy lozenges
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
lozenge product, the Cold-EEZE(cid:6) Cold Remedy proprietary zinc gluconate formulation is available in 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:6) 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:6) Cold
Remedy lozenges and other lozenge products in addition to performing operational tasks such as warehousing,
customer order processing and shipping. Our PMI facility is located in Lebanon, Pennsylvania. Additionally,
our PMI facility is a United States Food and Drug Administration (‘‘FDA’’) registered facility that engages in
contract manufacturing and distribution activities. PMI also produces and sells therapeutic lozenges to
unaffiliated third party retail, wholesale and distribution outlets.

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:6) Cold Remedy products which are distributed principally in the United States. Cold-EEZE(cid:6) 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:6) 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.

3

In addition to Cold-EEZE(cid:6) Cold Remedy lozenges, we market and distribute non-lozenge forms of our
proprietary zinc gluconate formulation, (i) Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) and (ii) Cold-EEZE(cid:6)
Cold Remedy Oral Spray. Cold-EEZE(cid:6) Cold Remedy Oral Spray is a liquid form of our zinc gluconate
formulation that is sprayed in the mouth. Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) are fast dissolving tablets
that are taken orally.

The Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) product

(i) Cold-EEZE(cid:6)
Daytime/Nighttime QuickMelts(cid:6) (launched in Fiscal 2012) (ii) Cold-EEZE(cid:6) Plus Immune Support + Energy
QuickMelts(cid:6) (launched in Fiscal 2013) and (iii) Cold-EEZE(cid:6) Plus Multi-Symptom QuickMelts(cid:6) (launched in
Fiscal 2014). We also manufacture, market and distribute organic cough drops and a Vitamin C supplement
(‘‘Organix’’) and perform contract manufacturing services of cough drop, dietary supplements, 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:6), 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:6), Kids-EEZE(cid:6), QuickMelts(cid:6), Organix Rx Complete(cid:6) and Organix
Rx Defense(cid:6).

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
meaningful
levels of revenues from such patents and we have suspended in Fiscal 2009 any further
commercialization efforts for various products under such patents.

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, a Delaware
limited liability company, entered into a Limited Liability Company Agreement (the ‘‘LLC Agreement’’) of
the Phusion joint venture and additional
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 Phusion joint venture.

related agreements

for

Our Phusion joint venture has (i) an exclusive, royalty-free, world-wide (subject to certain limitations),
that embody certain PSI Parent’s
paid-up license to exploit OTC drugs (and certain other products)
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 (see Note 9 to
Notes to Consolidated Financial Statements).

Product Distribution and Customers

Our products are distributed through national chain, regional, specialty and local retail stores throughout
the United States. Revenues for Fiscal 2014, 2013 and 2012 were $22.1 million, $25.0 million and
$22.4 million, respectively. Walgreen Company (‘‘Walgreens’’), Wal-Mart Stores Inc (‘‘Wal-Mart’’) and CVS
Health Corporation (‘‘CVS’’) accounted for approximately 18.9%, 16.9% and 11.3%, respectively, of our
Fiscal 2014 revenues. Walgreens, Wal-Mart and 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. 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.

4

Research and Development

We have historically invested signiﬁcantly in research and development activities. Our research and
development costs for Fiscal 2014, 2013 and 2012 were $1.3 million, $824,000 and $1.3 million respectively.
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:6) brand.

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
formulations, ingredients, applications and other products. 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.

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:6) 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:6) Cold Remedy products are
considered a homeopathic drug and are exempt from pre-approval requirements and other, but not all, FDA
requirements.

listing of the product

in FDA’s product database, and packaging,

Many homeopathic drug products, including Cold-EEZE(cid:6) 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

5

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:6) 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, 2014, we employed 54 full-time employees and 1 part-time employee, 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:6) Cold Remedy zinc gluconate products which are
available in various forms — lozenges, oral spray and QuickMelts(cid:6) — and various ﬂavors for purchase by
consumers at retail stores. We also produce private label lozenge products for sale to certain retail customers.
We manufacture our zinc lozenge products 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
by adequate levels of ﬁnished product available for sale. Certain products within our line of products such as
Cold-EEZE(cid:6) Cold Remedy Oral Spray and Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) are manufactured for us
by third party contract manufacturers and while currently purchased from single sources, we have identiﬁed
additional suppliers in the event that alternatives are required. We anticipate that if alternative supplies become
necessary, they would ﬁll our needs in a short time and any transition period would be mitigated by adequate
levels of ﬁnished product available for sale.

6

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.

Cough-cold category and product innovation

Our ﬂagship Cold-EEZE(cid:6) Cold Remedy brand is an established brand within the cough-cold category.
However, some retailers are reallocating shelf space away from the cough-cold category to other product
categories. With cough-cold shelf space at a premium, opportunities in the future to introduce new
Cold-EEZE(cid:6) branded products in the cough-cold category may be limited. Therefore, to continue to grow our
Company, we
and
pre-commercialization initiatives in the dietary supplement category. While management anticipates the growth
potential in this product category may be better, the risks associated with introducing new products that do not
leverage the Cold-EEZE(cid:6) brand name may be signiﬁcant. Therefore, no assurance can be made that our new
product efforts will be successful.

series of new product development

in the process of

implementing a

are

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 and, if 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
to obtain any required
approvals or to achieve signiﬁcant levels of sales.

innovation and commercialization,

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 or dietary supplement products, and expense levels for marketing efforts, (iv) whether we can

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

7

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, $0.0005 par value, (‘‘Common
Stock’’) issued to employees of the Company are exercised and the timing and amount of these exercises.

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 May 29, 2014 we executed a new equity line of credit agreement (such arrangement, the ‘‘2014
Equity Line’’) with Dutchess Opportunity Fund II LP (‘‘Dutchess’’) whereby, Dutchess committed to
purchase, subject to certain restrictions and conditions, up to 3,000,000 shares of the Company’s Common
Stock, over a period of 36 months expiring May 2017.

In Fiscal 2014, we sold an aggregate of 2,561,520 shares of Common Stock to Dutchess under the 2012
Equity Line in which we derived net proceeds of $3.7 million. At March 15, 2015, we have 438,480 shares of
our Common Stock available for sale, at our discretion, under the terms of the 2014 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 2014
Equity Line to ﬁnance our growth. Our 2014 Equity Line is limited and may not be sufficient to meet our
capital requirements. If we need to seek other sources of capital, uncertainty 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 2014 Equity Line on terms that we believe to be reasonable, or at all.

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

Pursuant to the 2014 Equity Line, Dutchess is committed to purchase, subject to certain conditions, the
remaining 438,480 shares of our Common Stock from time to time through May 2017. Dutchess will not be
obligated to purchase shares under the 2014 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 2014 Equity Line, we may be
unable to access capital on favorable terms or at all.

Any draw downs under our 2014 Equity Line with Dutchess may result in dilution to our shareholders

If we sell shares to Dutchess under the 2014 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 2014 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 2014 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.

8

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/under employment
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. 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
susceptible to price volatility caused by conditions outside of our control,
including ﬂuctuations in
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.

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.

9

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

Although we have a broad range of retail customers that includes many national chain, regional, specialty
and local retail stores, our ﬁve largest customers accounted for a signiﬁcant percentage of our sales,
approximately 58% of total revenues for Fiscal 2014. For Fiscal 2013, ﬁve of our largest customers accounted
for a signiﬁcant percentage of our sales, approximately 57% of total revenues. In addition, retail customers
comprising the ﬁve largest accounts receivable balances represented 67% and 68% of total accounts receivable
balances at December 31, 2014 and 2013, 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 2014 and 2013, our cold remedy products, principally Cold-EEZE(cid:6) Cold Remedy, represented
approximately 95% and 94%, respectively, of our total sales. Accordingly, we depend on the continued
acceptance of Cold-EEZE(cid:6) 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
there can be no assurance that
consumers and convert potential consumers into customers. However,
Cold-EEZE(cid:6) Cold Remedy products will continue to receive, maintain or increase market acceptance. The
inability to successfully commercialize Cold-EEZE(cid:6) 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.

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.

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

including vitamins, minerals and herbs,

food additives,

10

standards for source, composition and preparation of homeopathic remedies which are officially recognized
under the Federal Food, Drug and Cosmetics Act, as amended.

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 four of the past ﬁve ﬁscal years. 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, 2014, we had working capital of approximately $8.2 million which we believe is an acceptable
and adequate level of working capital to support our business for at least the next twelve months ending
March 31, 2016. Our ability to fund working capital needs will depend on our ability to generate cash in the
future.

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 (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.

11

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
of a disruption of this facility, we would need to outsource to third parties, at
temporarily, our
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:6) 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
the contract manufacturer if it
egregious conduct. The FDA could initiate similar legal actions against
the availability of our products. While
concludes its facility is not
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.

in compliance, which would affect

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.

12

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

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. Furthermore, there is no assurance that the outcome of all
current or future litigation will not have a material adverse effect on us.

Two purported class action lawsuits have been ﬁled against us and our CEO, as described under
‘‘Part I, Item 3, Legal Proceedings’’. As described under ‘‘Part I, Item 3, Legal Proceedings’’, on October 17,
2014, we initiated a demand for arbitration with the American Arbitration Association. This demand for
arbitration pertains to our Phusion Labs, LLC (‘‘Phusion’’)
is against
Phosphagenics, Inc. and Phosphagenics LTD (collectively known as the ‘‘Phosphagenics Entities’’). We have
raised certain claims based upon the alleged Phosphagenics Entities’ breach of licenses agreement for the
exploitation of certain intellectual property and, separately, breach of the Phusion joint venture operating
agreement. The Phosphagenics Entities have made counter claims of breaches against
the Company and
Phusion.

joint venture and the matter

We also have certain obligations to indemnify our officers and directors and to advance expenses to such
officers and directors. See ‘‘We have agreed to indemnify our Offıcers and Directors from liability.’’ 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.

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.

13

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
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, 2014 to
March 25, 2015, the closing price of our stock has ranged from $1.25 to $2.25 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, 2015, we had 15,892,296 shares of Common Stock outstanding.

As of March 25, 2015, there are outstanding options, which are fully vested, to purchase an aggregate of
1,476,750 shares of our Common Stock at an average exercise price of $1.37 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.

14

Our offıcers and directors own a substantial amount of our Common Stock

As of March 25, 2015, our executive officers and directors beneﬁcially owned approximately 25.6% 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 our officers and directors could be in conﬂict with the interests of other shareholders.
Accordingly, a shareholder’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 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.

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.

15

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, and

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

See ‘‘Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent
Events — Settlement Agreement.’’

ELI WEISBLUM AND JAMES LOREN GIBBS V. PROPHASE LABS, INC. AND THEODORE KARKUS and
JAMES LOREN GIBBS V. PROPHASE LABS, INC.

On May 19, 2014, a putative class action complaint was ﬁled by a consumer (the ‘‘Complainant’’)
against the Company and our Chief Executive Officer, in the United States District Court, Southern District of
New York. On February 25, 2015, a putative class action complaint was ﬁled by another consumer (the
‘‘Second Complainant’’) against
in the United States District Court, Northern District of
California.

the Company,

These lawsuits, which purports to be brought as a class action on behalf of purchasers of certain products
sold by the Company, alleges that the Company engaged in false and misleading marketing, advertising and
sales with respect to such products. The Complainant and the Second Complainant seek, among other things,
certiﬁcation of the case as a class action, a judgment against the defendants for damages in an amount to be
determined by the court and/or jury, and an award of fees and expenses to plaintiffs and their attorneys.

Both of these cases were settled and are pending dismissal with prejudice pursuant to a conﬁdential
settlement agreement reached among and between the parties as of March 23, 2015. The settlement agreement
was reached after the parties had engaged in signiﬁcant pre-trial discovery. The Company determined to enter
into this settlement agreement
team to focus their
attention and resources towards the continued growth and operations of the Company. The terms of the
settlement were not material to the Company.

in order to allow the Company and its management

PROPHASE LABS, INC. PROPHASE LABS, INC. FOR THE BENEFIT OF PHUSION LABORATORIES, LLC
vs. Phosphagenics, Inc., Phosphagenics, LTD and Phusion Laboratories, LLC as a nominal defendant

is against

On October 17, 2014, we initiated a demand for arbitration with the American Arbitration Association,
case number 01-14-0001-7373. This demand for arbitration pertains to our Phusion joint venture and the
matter
the Phosphagenics Entities. We have raised certain claims based upon the alleged
Phosphagenics Entities’ breach of a certain amended and restated licenses agreement for the exploitation of
certain intellectual property and, separately, breach of the Phusion joint venture operating agreement as
between the Company and the Phosphagenics Entities. The Phosphagenics Entities have made counter claims
of breaches against the Company and Phusion. This matter is at its preliminary stage and at this time, no
prediction as to the outcome of this action can be made.

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.

16

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 closing bid prices for our
Common Stock for each quarter of the Fiscal 2014 and 2013, as reported on The NASDAQ Global Market.

Common Stock

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

High
$2.25
$2.05
$1.68
$1.50

Low
$1.66
$1.50
$1.38
$1.25

High
$2.25
$1.72
$2.25
$2.31

Low
$1.40
$1.42
$1.42
$1.52

2014

2013

Holders

As of March 23, 2015, there were approximately 225 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 1,476,750 shares of our
the

Common Stock underlying outstanding unexercised and vested options as of December 31, 2014 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 . . . . . . . . . . . . . . . . . . . . . . . .
Option Plan . . . . . . . . . . . . . . . . . . . . . . . .
Total . . . . . . . . . . . . . . . . . . . . . . . . . . .

Number of
Options

26,500
935,000
56,250
15,000
75,000
202,750
11,250
7,500
147,500
1,476,750

Exercise
Price
$13.80
$ 1.00
$ 1.08
$ 0.87
$ 1.17
$ 1.65
$ 1.36
$ 1.48
$ 1.39

Expiration
Date

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

17

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) . . . . . . . . . . . . . . . . .

1,739,500

$1.40

167,467

(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, 2014, 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
26,500 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 date.

(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, 2014, we have outstanding 1,713,000 stock
options, subject to vesting, under the 2010 Plan. For Fiscal 2014, we charged to operations $472,000 for
compensation expense for the fair value of the vested portion of the stock options (see Note 5 to Notes to
Consolidated Financial Statements). At December 31, 2014, there are 19,659 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,
2014, 28,327 shares of our Common Stock were granted. At December 31, 2014,
there are
to the 2010 Directors Equity
147,808 shares of Common Stock that may be issued pursuant
Compensation Plan.

2012 Equity Line of Credit

On November 21, 2012, we entered into the equity line of credit agreement (such arrangement, the
‘‘2012 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 2012 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 amended this registration statement effective May 29, 2014 to withdraw and
remove from registration all unissued and unsold shares. We also agreed with Dutchess to terminate the 2012
Equity Line as of May 28, 2014.

18

During the period January 1, 2014 through May 23, 2014, we sold an aggregate of 698,207 shares of
Common Stock to Dutchess under and pursuant to the 2012 Equity Line and we derived net proceeds of
$1.2 million. The sales of the shares under the 2012 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).

2014 Equity Line of Credit

The Company and Dutchess executed a new equity line of credit agreement (such arrangement, the
‘‘2014 Equity Line’’) dated May 28, 2014 whereby Dutchess committed to purchase, subject
to certain
restrictions and conditions, up to 3,000,000 shares of the Company’s Common Stock, over a period of
36 months from the effectiveness of the registration statement registering the resale of shares purchased by
Dutchess pursuant to the Investment Agreement. On May 29, 2014, we ﬁled a registration statement with the
SEC to register for sale up to 3,000,000 shares of our Common Stock and the registration statement was
declared effective by the SEC on June 4, 2014.

We may in our discretion draw on the facility from time to time, as and when we determine appropriate
in accordance with the terms and conditions of the 2014 Equity Line. The maximum number of shares that
the Company is entitled to put to Dutchess in any one draw down notice shall not exceed shares with a
purchase price of $500,000, calculated in accordance with the 2014 Equity Line. We may deliver a notice for
a subsequent put from time to time, following the one day pricing period for the prior put.

Under the 2014 Equity Line the purchase price shall be set at ninety-ﬁve percent (95%) of the volume
weighted average price (VWAP) of the Company’s Common Stock during the one trading day immediately
following our put notice. The Company has 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 the Company; however, in the Dutchess receives less than a ﬁve percent (5%) return on the net sales for a
speciﬁc put, Dutchess will have the right to deduct from the proceeds of the put amount on the applicable
closing date so Dutchess’s return will equal ﬁve percent (5%).

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, the Company shall not be entitled to deliver another draw
down notice. In addition, Dutchess will not be obligated to purchase shares if Dutchess’s total number of
shares beneﬁcially held at that time would exceed 4.99% 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.

During the period June 13, 2014 through December 31, 2014, we sold an aggregate of 2,561,520 shares
of our Common Stock to Dutchess under and pursuant to the 2014 Equity Line and we derived net proceeds
of $3.7 million. The sales of the shares under the 2014 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). At December 31, 2014, we have 438,480 shares of our Common Stock available for
sale, at our discretion, under the terms of the 2014 Equity Line and covered pursuant to a registration
statement.

Other Stock Issuances

In December 2014, we issued 300,000 shares of our Common Stock valued at $1.31 per share for an
aggregate of $393,000, as payment for a portion of the litigation costs incurred prior to December 31, 2014
related to the Settlement Agreement (deﬁned below). The 300,000 shares of our Common Stock 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. The Settlement Agreement fully
resolved certain legal cases including ProPhase Labs, Inc. v. Quigley, et al., Court of Common Pleas of Bucks
County, Pennsylvania, Civ. A. No. 2010-08227; ProPhase Labs, Inc. v. Quigley, et al., Court of Common
Pleas of Bucks County, Pennsylvania, Civ. A. No. 2011-09815; the appeal ﬁled by the plaintiff in the matter

19

Quigley v. ProPhase Labs. Inc.’s Offıcers and Directors, el al, Court of Common Pleas of Philadelphia
County, December Term, 2011, No. 111200409; together with certain ancillary litigation (see Note 8 to Notes
to Consolidated Financial Statements).

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, 2014, 2013, 2012 2011 and 2010. 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:

2014

$22,070
$14,179
$ (7,834)
$ (7,834)
$ (0.47)
$ (0.47)

Year Ended December 31,
2012

2011

2013

$25,032
$16,671
405
$
405
$
0.03
$
0.03
$

$22,406
$14,252
$ (1,091)
$ (1,091)
$ (0.07)
$ (0.07)

$17,453
$11,282
$ (2,710)
$ (2,710)
$ (0.18)
$ (0.18)

2010

$14,502
$ 8,830
$ (3,501)
$ (3,501)
$ (0.25)
$ (0.25)

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

16,773
16,773

15,839
16,276

14,843
14,843

14,817
14,817

14,285
14,285

2014

2013

As of December 31,
2012

2011

2010

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

$ 8,217
$16,057
100
$
$10,716

$ 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

20

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:6) Cold Remedy and our principal product is Cold-EEZE(cid:6) Cold Remedy zinc
gluconate lozenges, proven in clinical studies to reduce the duration of
the common cold by 42%.
Cold-EEZE(cid:6) Cold Remedy is an established product in the health care and cold remedy market. In addition to
Cold-EEZE(cid:6) Cold Remedy lozenges, we market and distribute non-lozenge forms of our proprietary zinc
gluconate formulation, (i) Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) and (ii) Cold-EEZE(cid:6) Cold Remedy Oral
Spray. In Fiscal 2014, we expanded our Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) product line and began
shipments to retailers in July 2014, Cold-EEZE(cid:6) Cold Remedy Plus Multi-Symptom QuickMelts(cid:6) for cold
and ﬂu. Each of our Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) products are based on our proprietary zinc
gluconate formulation in combination with certain natural (i) immune system support, (ii) energy, (iii) sleep
and relaxation, and/or (iv) cold and ﬂu symptom relieving active ingredients. For Fiscal 2014, 2013 and 2012,
our revenues from continuing operations have come principally from our OTC cold remedy products.

Recent Events

Settlement Agreement

Effective September 4, 2014, we consummated a deﬁnitive, global Settlement Agreement (‘‘Settlement
Agreement’’) resolving all of our litigation with certain of the Company’s former managers and with certain
shareholders. The cases that have been settled include ProPhase Labs, Inc. v. Quigley, et al., Court of
Common Pleas of Bucks County, Pennsylvania, Civ. A. No. 2010-08227; ProPhase Labs, Inc. v. Quigley,
et al., Court of Common Pleas of Bucks County, Pennsylvania, Civ. A. No. 2011-09815; the appeal ﬁled by
the plaintiff in the matter Quigley v. ProPhase Labs. Inc.’s Offıcers and Directors, el al, Court of Common
Pleas of Philadelphia County, December Term, 2011, No. 111200409; together with certain ancillary litigation.

The Settlement Agreement amicably resolved these matters and provided, in part, that the parties adverse
to the Company in the two Bucks County cases (i) returned to the Company 3,896,764 shares of the
Company’s Common Stock for which they are listed as the record owners to the Company; and (ii) paid
$440,000 to the Company. In addition, the Company paid $500,000 to the beneﬁt of one of the defendants and
$37,000 to a third party, to defray certain costs and expenses associated with the Settlement Agreement.
Exclusive of legal related costs, the payments received and the payments made pursuant to the Settlement
Agreement resulted in a net charge to administration expense of $97,000 for Fiscal 2014. Pursuant to the
Settlement Agreement, the parties also have agreed to (i) a mutual release of all claims, (ii) a standstill
agreement whereby, for a period of ten years, the adverse parties will not acquire Company shares, and
(iii) the dismissal of all pending litigation involving the Company, its directors and affiliates on the one hand,
and the other parties. Management believes the Settlement Agreement will allow the Company and its
management team to focus more time, attention and resources towards the continued growth and operations of
the Company.

The 3,896,764 shares of Common Stock received pursuant to the terms of the Settlement Agreement were
recorded as treasury stock and as an additional contribution to our additional paid-in capital, valued at
$5.1 million, or $1.31 per share, representing the fair value of the shares at September 4, 2014.

Product Development

Our ﬂagship Cold-EEZE(cid:6) Cold Remedy brand has generally performed well within the cough-cold
category over the past several years. However, some retailers are reallocating shelf space away from the
cough-cold category to other product categories. With cough-cold shelf space at a premium, opportunities in
the future to introduce new Cold-EEZE(cid:6) branded products in the cough-cold category may be limited.
Therefore, to continue to grow our Company, we are in the process of implementing a series of new product
development and pre-commercialization initiatives in the dietary supplement category. While management
anticipates the growth potential in this category may be better, the risks associated with introducing new

21

products that do not leverage the Cold-EEZE(cid:6) brand name may be higher. Therefore, no assurance can be
made that our new product efforts will be successful. We currently expect that at least one product in this new
category will begin shipping in late Fiscal 2015 or early Fiscal 2016.

Phusion Laboratories, LLC (‘‘Phusion’’)

As

are

discussed

above, we

implementing

initiatives have advanced,

and
pre-commercialization initiatives principally in the dietary supplement category. While several of our product
including those speciﬁc to the dietary supplement category, our
development
Phusion product development
this time,
management believes that any products embodying the licensed technology to be developed by Phusion will
not be available until ﬁscal 2016 or 2017 at the earliest, may be more limited than previously forecasted and
may encompass fewer products or have limited retail distribution.

initiatives have not progressed to management’s satisfaction. At

new product

development

series

of

a

Pursuant to our established accounting policies, we conducted the Fiscal 2013 annual analysis of our
intangible asset as of December 31, 2013 by comparing the estimated fair value of the licensed technology
based on the income approach (which utilizes forecasted discounted cash ﬂows to estimate the fair value of
the licensed technology) against the then carrying value. As we concluded that, as of December 31, 2013, the
fair value according to the income approach exceeded book value, we concluded there was no impairment of
the subject intangible asset.

During the third quarter of Fiscal 2014, our evaluation of the Company’s progress in its new product
development pipeline and delays in Phusion product development caused management to reassess projections
(including income projections) relied upon in December 2013. Accordingly, management performed an
impairment analysis for the period ended September 30, 2014 for the licensed technology. As a consequence
of our impairment assessment, we determined that a full impairment occurred of the intangible asset, licensed
technology. As a consequence, we charged to operations a $3.6 million impairment charge during the third
quarter of Fiscal 2014.

On October 17, 2014, we initiated a demand for arbitration with the American Arbitration Association.
This demand for arbitration pertains to the Phusion joint venture and the matter is against the Phosphagenics
Entities. The Phosphagenics Entities have made counter claims of breaches against the Company and Phusion.
This matter is at its preliminary stage and at this time, no prediction as to the outcome of this action can
be made.

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.

Income Taxes

As of December 31, 2014, we have net operating loss carry-forwards of approximately $38.6 million for
federal purposes that will expire beginning in Fiscal 2020 through 2033. Additionally, there are net operating
loss carry-forwards of $20.1 million for state purposes that will expire beginning in Fiscal 2018 through 2033.
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.

22

Results of Operations

Fiscal 2014 compared with Fiscal 2013

Net sales for Fiscal 2014 decreased $2.9 million, or 11.8%,

to $22.1 million as compared to
$25.0 million for Fiscal 2013. The decrease in net sales from Fiscal 2013 to Fiscal 2014 is principally due to
the net effects of (i) a reduction in promotional display programs shipped due principally to certain retail
customers reducing their allocation of display space for the cough-cold category, (ii) an increase in our
cooperative incentive promotion and coupon costs, which are recorded as a reduction to our revenues, offset
by (iii) an increase in shipments of our QuickMelts(cid:6) products. In addition, net sales of our contract
manufacturing operations decreased $433,000 in Fiscal 2014 to $1.4 million as compared to $1.8 million in
Fiscal 2013 due to ﬂuctuations in contract manufacturing orders from non-related third party entities to
produce lozenge-based products.

Cost of sales for Fiscal 2014 were $7.9 million as compared to $8.4 million for Fiscal 2013. For Fiscal
2014 and Fiscal 2013, we realized a gross margin of 64.2% and 66.6%, respectively. The decrease of 2.4% in
gross margin from the prior period is principally due to (i) an increase in our cooperative incentive promotion
and coupon costs and (ii) a reduction in the absorption of ﬁxed production costs as a consequence of a decline
in net sales, (iii) ﬂuctuations in our product mix shipped from period to period and (iv) the initial expenses
incurred as a consequence of a packaging transition to a slightly narrower package of our Cold-EEZE(cid:6) Cold
Remedy lozenges at certain retail accounts to obtain additional/new distribution of our Cold-EEZE(cid:6) Cold
Remedy QuickMelts(cid:6) products for Fiscal 2014. Gross margins are principally inﬂuenced by 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 2014 decreased $573,000 to $9.0 million as compared to
$9.5 million for Fiscal 2013. The decrease in sales and marketing expense for Fiscal 2014 as compared to
Fiscal 2013 was principally due to a decrease in advertising expenditures as we managed 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 increased $2.2 million for Fiscal 2014 to $8.1 million as
compared to $5.9 million in Fiscal 2013. The increase in G&A expense for Fiscal 2014 as compared to Fiscal
2013 was primarily due to an increase in professional and legal fees related to certain, now resolved, litigation
matters, and in personnel expenses.

Research and development costs for Fiscal 2014 and 2013 were $1.3 million and $824,000, respectively.
The increase of $498,000 in research and development costs for Fiscal 2014 as compared to Fiscal 2013 was
principally due an increase in the scope, timing, cost and amount of research and development activity from
period to period. 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 our impairment assessment, we determined that a full impairment occurred of the
Phusion intangible asset, license technology. As a consequence, for Fiscal 2014 we charged to operation a
$3.6 million impairment charge.

Interest and other income for Fiscal 2014 and 2013 was $4,000 and $2,000 respectively. Interest expense
for Fiscal 2014 was $10,000 as compared to $13,000 for Fiscal 2013 as a consequence of interest paid
pursuant to the terms of the Godfrey 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 2014 or Fiscal 2013.

As a consequence of the effects of the above, the net loss for Fiscal 2014, was $7.8 million, or ($0.47)

per share, as compared to a net income of $405,000, or $0.03 per share, for Fiscal 2013.

23

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:6)
Cold Remedy Daytime/Nighttime QuickMelts(cid:6), launched in July 2012 and Cold-EEZE(cid:6) Cold Remedy Oral
Spray initially launched in August 2011, and (iii) sales of our Cold-EEZE(cid:6) Cold Remedy Plus Immune
Support + Energy QuickMelts(cid:6) and Cold-EEZE(cid:6) Cold Remedy Plus Immune Support QuickMelts(cid:6) 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.

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
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:6) Cold
Remedy Plus Immune Support + Energy QuickMelts(cid:6) and Cold-EEZE(cid:6) Cold Remedy Plus Immune Support
QuickMelts(cid:6) 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 Godfrey 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 Godfrey Settlement Agreement, the Godfreys assigned, transferred and conveyed to us
in U.S. Trademark Registration No. 1,838,542 for the trademark
all of their right,
Cold-EEZE(cid:6), among other intellectual property associated with such trademark.

title, and interest

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.

24

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.

Liquidity and Capital Resources

Our aggregate cash and cash equivalents as of December 31, 2014 were $2.9 million as compared to
$1.6 million at December 31, 2013. Our working capital was $8.2 million and $6.7 million as of
December 31, 2014 and December 31, 2013, respectively. Changes in working capital for Fiscal 2014 were
principally due to the net effect of (i) cash used in operations of $3.2 million comprised principally of (a) net
loss of $7.8 million, inclusive of the non-cash charges of (x) $3.6 million impairment (y) $1.0 million share
based compensation and stock grants and (b) an increase in accrued advertising of $838,000, (c) increase to
inventory of $771,000 (d) increase to accounts receivable of $517,000, (ii) capital expenditures of $312,000
and (iii) the installment payment of $100,000 pursuant to the terms of the Godfrey Settlement Agreement,
offset by (iv) net proceeds of $4.9 million from the sales of our Common Stock.

2012 Equity Line of Credit

On November 21, 2012, we entered into the 2012 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 following the effectiveness of the registration statement registering the
resale of shares purchased by Dutchess. We also terminated the 2012 Equity Line as of May 28, 2014.

In December 2012, we sold an aggregate of 883,722 shares of Common Stock to Dutchess under and
pursuant to the 2012 Equity Line. We derived approximately $1.1 million in net proceeds through the usage of
the 2012 Equity Line of which we received $839,000 of such proceeds prior to December 31, 2012 and
$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 2012 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 proceeds on January 8, 2014. During the
period January 1, 2014 through May 23, 2014, we sold an aggregate of 698,207 shares of Common Stock to
Dutchess under and pursuant to the 2012 Equity Line and we derived net proceeds of $1.2 million. The sales
of the shares under the 2012 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).

2014 Equity Line of Credit

The Company and Dutchess executed the 2014 Equity Line dated May 28, 2014 whereby Dutchess
committed to purchase, subject to certain restrictions and conditions, up to 3,000,000 shares of the Company’s
Common Stock, over a period of 36. On May 29, 2014, we ﬁled a registration statement with the SEC to
register for sale up to 3,000,000 shares of our Common Stock and the registration statement was declared
effective by the SEC on June 4, 2014. See Market for Registrant’s Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities — 2014 Equity Line of Credit for more information about
the terms and conditions of the 2014 Equity Line.

During the period June 13, 2014 through December 31, 2014, we sold an aggregate of 2,561,520 shares
of our Common Stock to Dutchess under and pursuant to the 2014 Equity Line and we derived net proceeds
of $3.7 million. The sales of the shares under the 2014 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). At December 31, 2014, we have 438,480 shares of our Common Stock available for
sale, at our discretion, under the terms of the 2014 Equity Line and covered pursuant to a registration
statement.

As a consequence of the seasonally of our business, we realize variations in operating results and demand
for working capital
to quarter. As of December 31, 2014, we had working capital of
approximately $8.2 million and 438,480 shares of Common Stock available for sale under the 2014 Equity
line. We believe our current working capital and available 2014 Equity Line is an acceptable and adequate
level of working capital to support our business for at least the next twelve months ending March 31, 2016.

from quarter

25

Our future contractual obligations and commitments at December 31, 2014 consist of the following (in

thousands):

Year
2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total

Employment
Contracts
$1,025
1,025
1,025
—
—
$3,075

Godfrey
Settlement
Agreement
$100
100
—

—
$200

Total
$1,125
1,125
1,025
—
—
$3,275

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:6) 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:6) Cold Remedy lozenges, we market
and distribute a variety of Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) and a Cold-EEZE(cid:6) Cold Remedy Oral
Spray. We also manufacture, market and distribute an organic cough drop and a Vitamin C supplement
(‘‘Organix(cid:6)’’). Each of the Cold-EEZE(cid:6) Cold Remedy Oral Spray and QuickMelts(cid:6) products, and Organix(cid:6)
products carry shelf-life expiration dates for which we aggregate such new product market experience data

26

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, 2014 and 2013 (in thousands):

Return provision at December 31, 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net change in the return provision Fiscal 2013 . . . . . . . . . . . . . . . . . . . . . . . . . .
Return provision at December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net change in the return provision Fiscal 2014 . . . . . . . . . . . . . . . . . . . . . . . . . .
Return provision at December 31, 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Amount
$1,292
227
1,519
(1)
$1,518

For Fiscal 2014, 2013 and 2012, net sales of products with limited shelf-life and expiration dates were

$5.1 million, $4.3 million and $3.2 million, respectively.

For Fiscal 2014, the return provision decreased by $1,000. The decrease in the return provision was
principally due to (i) a charge of $1.2 million, including $571,000 for products with shelf-life expiration dates
(obsolete returns), offset by (ii) net returns of $1.2 million associated principally with Fiscal 2014 and Fiscal
2013 received and processed during Fiscal 2014.

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.

A one percent deviation for these sales allowance provisions for the Fiscal 2014, 2013 and 2012 would
affect net sales by approximately $278,000, $303,000 and $274,000, respectively. A one percent deviation for
cooperative incentive promotions reserve provisions for Fiscal 2014, 2013 and 2012 could affect net sales by
approximately $263,000, $285,000 and $260,000, respectively.

27

Effect of Recent Accounting Pronouncements

a Similar Tax Loss, or

In July 2013, the Financial Accounting Standards Board (‘‘FASB’’) issued Accounting Standards Update
‘‘Presentation of an Unrecognized Tax Beneﬁt When a Net Operating Loss
(‘‘ASU’’) No. 2013-11,
Carryforward,
(‘‘ASU 2013-11’’).
a Tax Credit Carryforward Exists’’
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. The amendments should be applied prospectively to all unrecognized tax beneﬁts that exist at the
effective date, and retrospective application is permitted. The adoption of ASU 2013-11 did not have a
material impact on our consolidated ﬁnancial position, results from operations or cash ﬂows.

In May 2014, the FASB issued new accounting guidance ASU No. 2014-09, ‘‘Revenue from Contracts
with Customers’’, on revenue recognition. The new standard provides for a single ﬁve-step model to be
applied to all revenue contracts with customers as well as requires additional ﬁnancial statement disclosures
that will enable users to understand the nature, amount, timing and uncertainty of revenue and cash ﬂows
relating to customer contracts. Companies have an option to use either a retrospective approach or cumulative
effect adjustment approach to implement the standard. There is no option for early adoption. This ASU is
effective for ﬁscal years and interim periods within those years beginning after December 15, 2016. We are
currently evaluating the impact of the new guidance on our consolidated ﬁnancial statements.

In June 2014, the FASB issued new accounting guidance ASU 2014-12, ‘‘Accounting for Share-Based
Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the
Requisite Service Period’’. The amendments in this update require that a performance target that affects
vesting and that could be achieved after the requisite service period be treated as a performance condition.
Companies should apply existing guidance in ASC 718, ‘‘Compensation — Stock Compensation’’, as it relates
to awards with performance conditions that affect vesting to account for such awards. The amendments in this
update will be effective as of January 1, 2016. Earlier adoption is permitted. We may apply the amendments
in this update either: (1) prospectively to all awards granted or modiﬁed after the effective date; or
(2) retrospectively to all awards with performance targets that are outstanding as of the beginning of the
earliest annual period presented in the ﬁnancial statements and to all new or modiﬁed awards thereafter. If a
retrospective transition is adopted, the cumulative effect of applying this update as of the beginning of the
earliest annual period presented in the ﬁnancial statements should be recognized as an adjustment to the
opening retained earnings balance at that date. In addition, if a retrospective transition is adopted, we may use
hindsight in measuring and recognizing the compensation cost. We are currently assessing the impact of this
update, and believe that its adoption on January 1, 2016 will not have a material impact on our consolidated
ﬁnancial statements.

In August 2014, the FASB issued ASU 2014-15, ‘‘Disclosure of Uncertainties about an Entity’s Ability to
Continue as a Going Concern’’. The amendments in this update state that in connection with preparing
ﬁnancial statements for each annual and interim reporting period, an entity’s management should evaluate
whether there are conditions or events that raise substantial doubt about the entity’s ability to continue as a
going concern within one year after the date that the ﬁnancial statements are issued (or within one year after
the date that the ﬁnancial statements are available to be issued, when applicable). The amendments in this
update are effective for the annual reporting period beginning after December 15, 2016, and for annual periods
and interim periods thereafter. Early application is permitted. The adoption of ASU 2014-15 is not expected to
have a material impact on our consolidated ﬁnancial statements.

28

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
or excessive exposure to market
results of
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.

29

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, 2014 and 2013, 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, 2014.
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, 2014 and 2013,
and the consolidated results of their operations and their cash ﬂows for each of the years in the three-year
period ended December 31, 2014,
in conformity with accounting principles generally accepted in the
United States of America.

/s/ EisnerAmper LLP

Iselin, New Jersey
March 27, 2015

30

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 $4,341 and

$4,064, respectively (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . .

Intangible asset, licensed technology (Note 9)

LIABILITIES AND STOCKHOLDERS’ EQUITY

LIABILITIES
Accounts payable
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued advertising and other allowances (Note 2) . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other current liabilities (Note 4)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other long term obligation (Note 8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total long term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Total current liabilities

COMMITMENTS AND CONTINGENCIES (Note 8) . . . . . . . . . . . . . . . . . .

STOCKHOLDERS’ EQUITY
Common stock, $.0005 par value; authorized 50,000,000; issued: 25,125,113

and 21,437,059 shares, respectively (Note 5)

. . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Additional paid-in-capital
Accumulated deﬁcit
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Treasury stock, at cost, 9,232,817 and 5,336,053 shares, respectively (Note 5) . .

December 31,

2014

2013

$ 2,926
5,836
3,292
1,404
13,458

2,599
—
$ 16,057

$

667
3,685
889
5,241
100
100

—

$ 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

—

13
54,664
(13,219)
(30,742)
10,716
$ 16,057

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

See accompanying notes to consolidated ﬁnancial statements

31

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)
Impairment Charge (Note 9)
. . . . . . . . . . . . . . . . . . . . . . .
Total operating expense . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations . . . . . . . . . . . . . . . . . . . . . . . .
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations before taxes . . . . . . . . . . . . . . .
Income tax (beneﬁt) (Note 7)
. . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income (loss)

Basic income (loss) per share:

Year Ended December 31,
2013
$25,032
8,361
16,671

2012
$22,406
8,154
14,252

2014
$22,070
7,891
14,179

8,965
8,143
1,322
—
3,577
22,007
(7,828)
4
(10)
(7,834)
—
$ (7,834)

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)

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

$ (0.47)

$

0.03

$ (0.07)

Diluted income (loss) per share:

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

$ (0.47)

$

0.03

$ (0.07)

Weighted average common shares outstanding:

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

16,773
16,773

15,839
16,276

14,843
14,843

See accompanying notes to consolidated ﬁnancial statements

32

PROPHASE LABS, INC & SUBSIDARIES

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

Balance at December 31, 2011 . . . . . .
Net loss
. . . . . . . . . . . . . . . . . . .
Share-based compensation expense. .
Common stock granted pursuant to

an employment agreement

. . . . .
Common stock issued (Note 5) . . . .
Balance at December 31, 2012 . . . . .
Net income . . . . . . . . . . . . . . . . .
Proceeds from exercise of stock

options

. . . . . . . . . . . . . . . . . .
Share-based compensation expense. .
Common stock granted pursuant to a
compensation plan . . . . . . . . . . .
Common stock issued (Note 5) . . . .
Balance at December 31, 2013 . . . . .
Net loss
. . . . . . . . . . . . . . . . . . .
Share-based compensation expense. .
Common stock issued for services

performed (Note 5) . . . . . . . . . .
Common stock granted pursuant to a
compensation plan . . . . . . . . . . .
Common stock issued (Note 5) . . . .
Treasury stock acquired puruant to a
settlement agreement (Note 5) . . .
Balance at December 31, 2014 . . . . .

Common Stock
Shares
Outstanding,
Net of Shares
of Treasury
Stock
14,825,583

10,757
883,722
15,720,062

25,000

66,470
289,474
16,101,006

300,000

128,327
3,259,727

(3,896,764)
15,892,296

1
11

11

2

$13

Par
Value
$10

Additional
Paid-In
Capital
$41,552

Retained
Earnings
(Deﬁcit)
$ (4,699)
(1,091)

Treasury
Stock

Total

$(25,637) $11,226
(1,091)
153

153

93
1,069
42,867

27
160

109
444
43,607

472

393

179
4,908

(5,790)
405

(25,637)

(5,385)
(7,834)

(25,637)

93
1,070
11,451
405

27
160

109
444
12,596
(7,834)
472

393

179
4,910

5,105
$54,664

$(13,219)

(5,105)

—
$(30,742) $10,716

See accompanying notes to consolidated ﬁnancial statements

33

PROPHASE LABS, INC & SUBSIDARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

Cash ﬂows from operating activities:
Net (loss) income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$(7,834)

$ 405

$(1,091)

Year Ended December 31,
2013

2012

2014

Adjustments to reconcile net (loss) income to net cash provided by

(used in) operating activities:
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gain on the sale of ﬁxed assets
. . . . . . . . . . . . . . . . . . . . . . .
Reduction of payment obligation, settlement beneﬁt . . . . . . . . . .
Impairment charge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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

277
(6)
—
3,577
1,044

(517)
(771)
397
(344)
838
—
123
(3,216)

(312)
6
(306)

Cash ﬂows from ﬁnancing activities:

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

Net cash provided by ﬁnancing activities

—
4,910
(100)
4,810
1,288
1,638
$ 2,926

Supplemental disclosures of cash ﬂow information:

Treasury stock acquired pursuant to a settlement agreement

. . . .

$ 5,105

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

Common stock issued, in lieu of cash, as payment for service . . .

$

$

10

393

243
—
—
—
269

90
(470)
886
(285)
87
—
(88)
1,137

(442)
—
(442)

27
444
(100)
371
1,066
572
$1,638

$ —

$

13

$ —

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

$

$ —

$ —

$ —

See accompanying notes to consolidated ﬁnancial statements

34

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:6) Cold Remedy and our principal product is Cold-EEZE(cid:6) Cold Remedy zinc gluconate lozenges,
proven in clinical studies to reduce the duration of the common cold. In addition to Cold-EEZE(cid:6) Cold
Remedy lozenges, we market and distribute non-lozenge forms of our proprietary zinc gluconate formulation,
(i) Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) and (ii) Cold-EEZE(cid:6) Cold Remedy Oral Spray. Cold-EEZE(cid:6)
Cold Remedy Oral Spray is a liquid form of our zinc gluconate formulation that is sprayed in the mouth.
Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) are fast dissolving tablets that are taken orally.

The Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) product line is comprised of (i) Cold-EEZE(cid:6) Daytime/
Nighttime QuickMelts(cid:6) (launched in Fiscal 2012),
(ii) Cold-EEZE(cid:6) Plus Immune Support + Energy
QuickMelts(cid:6) (launched in Fiscal 2013) and (iii) Cold-EEZE(cid:6) Plus Multi-Symptom QuickMelts(cid:6) (launched in
Fiscal 2014). 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.

Cold-EEZE(cid:6) Cold Remedy is an established product in the health care and cold remedy market. For
Fiscal 2014, 2013 and 2012, our revenues have come principally from our OTC cold remedy products. For
Fiscal 2014 and 2013, our net sales for each period were related to markets in the United States.

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, 2014 shall be the term ‘‘Fiscal 2014’’ 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 Phusion Laboratories LLC (‘‘Phusion’’), a variable interest entity
(see Note 9). All intercompany transactions and balances have been eliminated.

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

35

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

health and wellness trends and develop retail promotional strategies to align our production scheduling,
inventory management and marketing programs to optimize consumer purchases.

As a consequence of the seasonally of our business, we realize variations in operating results and demand
for working capital
to quarter. As of December 31, 2014, we had working capital of
approximately $8.2 million and 438,480 shares of Common Stock available for sale under the 2014 Equity
line. We believe our current working capital and available 2014 Equity Line is an acceptable and adequate
level of working capital to support our business for at least the next twelve months ending March 31, 2016.

from quarter

Use of Estimates

The preparation of ﬁnancial statements and the accompanying notes thereto, in conformity with generally
accepted accounting principles in the United States of America (‘‘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:6) 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:6) Cold Remedy lozenges, we market
and distribute a variety of Cold-EEZE(cid:6) Cold Remedy QuickMelts(cid:6) and a Cold-EEZE(cid:6) Cold Remedy Oral
Spray. We also manufacture, market and distribute an organic cough drop and a Vitamin C supplement
(‘‘Organix(cid:6)’’). Each of the Cold-EEZE(cid:6) Cold Remedy Oral Spray and QuickMelts(cid:6) products, and Organix(cid:6)
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.

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

36

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

established. At December 31, 2014 and 2013, the ﬁnancial statements include adjustments to reduce inventory
for excess or obsolete inventory of $797,000 and $635,000, respectively. The components of inventory are as
follows (in thousands):

Raw materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Work in process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finished goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

December 31,

2014
$ 798
418
2,076
$3,292

2013
$ 434
164
1,923
$2,521

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,
2014, our cash was $2.9 million and our bank balance was $3.1 million. Of the total bank balance, $626,000
was covered by federal depository insurance and $2.4 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 2014, 2013 and 2012, 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%, 94% and 95% of total revenues for Fiscal 2014, 2013 and 2012, 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:6) 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.

37

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

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
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
administrative expenses;
industry
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, 2014 and 2013, we included a provision for sales allowances of $129,000 and
$128,000, respectively, which are reported as a reduction to account receivables. Additionally, accrued
advertising and other allowances as of December 31, 2014 include $1.5 million for estimated future sales
returns and $2.1 million for cooperative incentive promotion costs. As of December 31, 2013, accrued
advertising and other allowances include $1.5 million for estimated future sales returns and $1.3 million for
cooperative incentive promotion costs.

38

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

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.

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 5). Stock options are exercisable during a period determined by us, but in no event
later than ten years from the date granted. In Fiscal 2014, 2013 and 2012, we charged to operations
$1.0 million, $269,000 and $246,000, respectively, for share-based compensation expense for the aggregate
fair value of stock and 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 Phusion joint venture beginning with the quarter ended March 31,
2010 (see Note 9).

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 2014, 2013 and 2012 were $10.9 million, $10.8 million and $10.2 million,
respectively. At December 31, 2014 and 2013, prepaid expenses and other current assets included $885,000
and $1.3 million, respectively, relating to prepaid deposits for advertising and promotion programs scheduled
principally for the ﬁrst quarter of Fiscal 2015 and 2014, respectively.

Research and Development

Research and development costs are charged to operations in the period incurred. Expenditures for Fiscal
2014, 2013 and 2012 were $1.3 million, $824,000 and $1.3 million, respectively. For Fiscal 2014, Fiscal 2013
and Fiscal 2012, 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 7).

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

39

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

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
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 and accounts payable 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 July 2013, the Financial Accounting Standards Board (‘‘FASB’’) issued Accounting Standards Update
(‘‘ASU’’) No. 2013-11, ‘‘Presentation of an 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. The amendments should be applied prospectively
to all unrecognized tax beneﬁts that exist at the effective date, and retrospective application is permitted. The
adoption of ASU 2013-11 did not have a material impact on our consolidated ﬁnancial position, results from
operations or cash ﬂows.

In May 2014, the FASB issued new accounting guidance ASU No. 2014-09, ‘‘Revenue from Contracts
with Customers’’, on revenue recognition. The new standard provides for a single ﬁve-step model to be
applied to all revenue contracts with customers as well as requires additional ﬁnancial statement disclosures
that will enable users to understand the nature, amount, timing and uncertainty of revenue and cash ﬂows
relating to customer contracts. Companies have an option to use either a retrospective approach or cumulative
effect adjustment approach to implement the standard. There is no option for early adoption. This ASU is
effective for ﬁscal years and interim periods within those years beginning after December 15, 2016. We are
currently evaluating the impact of the new guidance on our consolidated ﬁnancial statements.

In June 2014, the FASB issued new accounting guidance ASU 2014-12, ‘‘Accounting for Share-Based
Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the
Requisite Service Period’’. The amendments in this update require that a performance target that affects
vesting and that could be achieved after the requisite service period be treated as a performance condition.
Companies should apply existing guidance in ASC 718, ‘‘Compensation — Stock Compensation’’, as it relates
to awards with performance conditions that affect vesting to account for such awards. The amendments in this
update will be effective as of January 1, 2016. Earlier adoption is permitted. We may apply the amendments
in this update either: (1) prospectively to all awards granted or modiﬁed after the effective date; or
(2) retrospectively to all awards with performance targets that are outstanding as of the beginning of the
earliest annual period presented in the ﬁnancial statements and to all new or modiﬁed awards thereafter. If a
retrospective transition is adopted, the cumulative effect of applying this update as of the beginning of the
earliest annual period presented in the ﬁnancial statements should be recognized as an adjustment to the
opening retained earnings balance at that date. In addition, if a retrospective transition is adopted, we may use

40

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

hindsight in measuring and recognizing the compensation cost. We are currently assessing the impact of this
update, and believe that its adoption on January 1, 2016 will not have a material impact on our consolidated
ﬁnancial statements.

In August 2014, the FASB issued ASU 2014-15, ‘‘Disclosure of Uncertainties about an Entity’s Ability to
Continue as a Going Concern’’. The amendments in this update state that in connection with preparing
ﬁnancial statements for each annual and interim reporting period, an entity’s management should evaluate
whether there are conditions or events that raise substantial doubt about the entity’s ability to continue as a
going concern within one year after the date that the ﬁnancial statements are issued (or within one year after
the date that the ﬁnancial statements are available to be issued, when applicable). The amendments in this
update are effective for the annual reporting period beginning after December 15, 2016, and for annual periods
and interim periods thereafter. Early application is permitted. The adoption of ASU 2014-15 is not expected to
have a material impact on our 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,

2014
$ 504
3,016
2,933
291
196
6,940
4,341
$2,599

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

Estimated Useful
Life

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

Depreciation expense for Fiscal 2014, 2013 and 2012 was $277,000, $243,000 and $252,000,

respectively.

NOTE 4 — OTHER CURRENT LIABILITIES

At December 31, 2014 and 2013, other current liabilities include $372,000 and $350,000, respectively,

related to accrued compensation.

NOTE 5 — 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 ‘‘1998 Rights Agreement’’).
The Plan was amended effective May 23, 2008 and further amended effective August 18, 2009. The 1998
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
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

41

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

50% beneﬁcial ownership of the Company, a stockholder may exchange one Right for one common share of
the Company. The 1998 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.

On June 10, 2014, the Board of Directors of the Company approved, and on June 18, 2014, the Company
entered into, an Amended and Restated Rights Agreement with American Stock Transfer & Trust Company,
LLC, as Rights Agent
(the ‘‘2014 Rights Agreement’’), which amends and restates the 1998 Rights
Agreement, as amended. The Rights Agreement modiﬁes the existing terms of the 1998 Rights Agreement, as
amended, in the following ways: (i) the expiration date of rights issued pursuant to the Rights Agreement (the
‘‘Rights’’) is extended to June 18, 2024, (ii) the limited exemption for Guy Quigley from the deﬁnition of
‘‘Acquiring Person’’ is decreased to his ownership as reported in the Company’s proxy statement for the 2014
annual meeting of shareholders, or any lesser amount he subsequently owns, (iii) an exemption was added for
Ted Karkus, our Chairman and Chief Executive Officer, to acquire up to 20% of the Company’s Common
Stock, (iv) the redemption price for the Rights was decreased from $0.01 per Right to $0.0001 per Right, and
(v) certain other changes were made for the sake of clarity and consistency.

Treasury Stock Acquired Pursuant to a Settlement Agreement

Effective September 4, 2014, we consummated a deﬁnitive, global Settlement Agreement (‘‘Settlement
Agreement’’) resolving all of our litigation with certain of the Company’s former managers and with certain
shareholders. The cases that have been settled include ProPhase Labs, Inc. v. Quigley, et al., Court of
Common Pleas of Bucks County, Pennsylvania, Civ. A. No. 2010-08227; ProPhase Labs, Inc. v. Quigley,
et al., Court of Common Pleas of Bucks County, Pennsylvania, Civ. A. No. 2011-09815; the appeal ﬁled by
the plaintiff in the matter Quigley v. ProPhase Labs. Inc.’s Offıcers and Directors, el al, Court of Common
Pleas of Philadelphia County, December Term, 2011, No. 111200409; together with certain ancillary litigation.

The Settlement Agreement amicably resolved these matters and provided, in part, that the parties adverse
to the Company in the two Bucks County cases (i) returned to the Company 3,896,764 shares of the
Company’s Common Stock for which they are listed as the record owners to the Company; and (ii) paid
$440,000 to the Company. In addition, the Company paid $500,000 to the beneﬁt of one of the defendants and
$37,000 to a third party, to defray certain costs and expenses associated with the Settlement Agreement.
Exclusive of legal related costs, the payments received and the payments made pursuant to the Settlement
Agreement resulted in a net charge to administrative expense of $97,000 for Fiscal 2014. Pursuant to the
Settlement Agreement, the parties also have agreed to (i) a mutual release of all claims, (ii) a standstill
agreement whereby, for a period of ten years, the adverse parties will not acquire Company shares, and
(iii) the dismissal of all pending litigation involving the Company, its directors and affiliates on the one hand,
and the other parties.

The 3,896,764 shares of Common Stock received pursuant to the terms of the Settlement Agreement were
recorded as treasury stock and as an additional contribution to our additional paid-in capital, valued at
$5.1 million, or $1.31 per share, representing the fair value of the shares at September 4, 2014.

2012 Equity Line of Credit

On November 21, 2012, we entered into the equity line of credit agreement (such arrangement, the
‘‘2012 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 2012 Equity Line. On November 26,
2012, we ﬁled a registration statement with Securities and Exchange Commission (‘‘SEC’’) to register for sale

42

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

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 amended this registration statement effective May 29, 2014 to withdraw and
remove from registration all unissued and unsold shares. We also agreed with Dutchess to terminate the 2012
Equity Line as of May 28, 2014.

In December 2012, we sold an aggregate of 883,722 shares of Common Stock to Dutchess under and
pursuant to the 2012 Equity Line. We derived approximately $1.1 million in net proceeds through the usage of
the 2012 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 2012 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
proceeds on January 8, 2014. During the period January 1, 2014 through May 23, 2014, we sold an aggregate
of 698,207 shares of Common Stock to Dutchess under and pursuant to the 2012 Equity Line and we derived
net proceeds of $1.2 million. The sales of the shares under the 2012 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).

2014 Equity Line of Credit

The Company and Dutchess executed a new equity line of credit agreement (such arrangement, the
‘‘2014 Equity Line’’) dated May 28, 2014 whereby Dutchess committed to purchase, subject
to certain
restrictions and conditions, up to 3,000,000 shares of the Company’s Common Stock, over a period of
36 months from the effectiveness of the registration statement registering the resale of shares purchased by
Dutchess pursuant to the Investment Agreement. On May 29, 2014, we ﬁled a registration statement with the
SEC to register for sale up to 3,000,000 shares of our Common Stock and the registration statement was
declared effective by the SEC on June 4, 2014.

We may in our discretion draw on the facility from time to time, as and when we determine appropriate
in accordance with the terms and conditions of the 2014 Equity Line. The maximum number of shares that
the Company is entitled to put to Dutchess in any one draw down notice shall not exceed shares with a
purchase price of $500,000, calculated in accordance with the 2014 Equity Line. We may deliver a notice for
a subsequent put from time to time, following the one day pricing period for the prior put.

The purchase price shall be set at ninety-ﬁve percent (95%) of the volume weighted average price
(VWAP) of the Company’s Common Stock during the one trading day immediately following our put notice.
The Company has 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 the Company; however,
in the Dutchess receives less than a ﬁve percent (5%) return on the net sales for a speciﬁc put, Dutchess will
have the right to deduct from the proceeds of the put amount on the applicable closing date so Dutchess’s
return will equal ﬁve percent (5%).

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, the Company shall not be entitled to deliver another draw
down notice. In addition, Dutchess will not be obligated to purchase shares if Dutchess’s total number of
shares beneﬁcially held at that time would exceed 4.99% 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.

43

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

During the period June 13, 2014 through December 31, 2014, we sold an aggregate of 2,561,520 shares
of our Common Stock to Dutchess under and pursuant to the 2014 Equity Line and we derived net proceeds
of $3.7 million. The sales of the shares under the 2014 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). At December 31, 2014, we have 438,480 shares of our Common Stock available for
sale, at our discretion, under the terms of the 2014 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
the total combined voting power of all classes of stock.
individual owns more than ten percent of
Stockholders approved the 1997 Plan in Fiscal 1998. No options were granted under this Plan during Fiscal
2014, 2013 or 2012.

At December 31, 2014, 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, 2014, there are 26,500 options outstanding under the 1997
Option Plan with an expiration date of December 2015.

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. At December 31, 2014, there are 1,713,000 options outstanding under the 2010 Equity
Compensation Plan (see ‘‘Stock Options’’ below).

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 2014, 2013 and 2012, we granted, 147,500, 420,500
and 15,000 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 options granted
. . . . . . . . . . . . . . . . . . . . . . . . . .

during the year

Year Ended December 31,
2013
420,500
2 − 3 years
6 − 7 years
$1.48 − $1.65

2014
147,500
none
7 years
$1.39

2012
15,000
3 years
7 years
$1.36

$0.59

$0.56

$0.85

44

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

We used the Black-Scholes option pricing model during Fiscal 2014, 2013 and 2012 to determine the fair
value of the stock options at the date of grant. Based upon our limited historical experience, we determined
the expected term of the stock option grants to be a range between 2.5 to 6.5 years, calculated using the
‘‘simpliﬁed’’ method in accordance with the SEC Staff Accounting Bulletin 110. We use the ‘‘simpliﬁed’’
method since 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 . . . . . . . . . . . . . . . . . . . .

2014
3.5 years

Year Ended December 31,
2013
3.75 − 4.5 years

0.10%
0%
52.43%

0.36%
0%
47.33% − 82.09%

2012
4.5 years

0.75%
0%
83.06%

The fair value of the stock options at the time of the grant in Fiscal 2014, 2013 and 2012 was $87,000,
$237,000 and $13,000, respectively. For Fiscal 2014 stock options granted were not subject to a vesting
period. Additionally, the remaining vesting period for options originally issued in Fiscal 2010 of 200,000 was
accelerated to be fully vested at December 31, 2014. The aggregate fair value of $217,000 for each of the
stock options granted in Fiscal 2014 and the accelerated vesting period of previously issued options were
charged to operations in Fiscal 2014. Each of the stock options granted for Fiscal 2013 and Fiscal 2012 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 and 2012, we charged to operations $160,000 and $153,000, respectively, for
share-based compensation expense for the aggregate fair value of the vested stock options earned.

At December 31, 2014, of the options granted under the 2010 Equity Compensation Plan 1,450,250 were
vested and 262,750 are subject to vesting. At December 31, 2014, there are 19,659 options available for grant
to purchase shares of Common Stock that may be issued pursuant to the terms of the 2010 Plan.

A summary of the status of our stock options granted pursuant the 1997 Plan and the 2010 Plan as of
December 31, 2014, 2013 and 2012 and changes during the years then ended is presented below (in
thousands, except per share data):

2014

Year Ended December 31,
2013

2012

Options outstanding − beginning of year . . . . . . . . .
Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Options outstanding − end of year . . . . . . . . . . . . .

Weighted
Average
Exercise
Price
$1.60
1.39
—
9.50
$1.40

Weighted
Average
Exercise
Price
$1.72
1.64
1.08
4.53
$1.60

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

Shares
1,638
148
—
(46)
1,740

Options granted and subject to future vesting . . . . .

263

$ —

884

$1.32

Exercisable, at end of year . . . . . . . . . . . . . . . . . .

1,477

Available for grant

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

20

1,085

262

Weighted
Average
Exercise
Price
$1.88
1.36
—
8.11
$1.72

$1.01

Shares
1,333
15
—
(41)
1,307

719

588

—

45

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 — STOCKHOLDERS’ EQUITY AND STOCK COMPENSATION − (continued)

The unrecognized share-based compensation expense related to the options granted but not vested,
(options to acquire 262,750 shares) was $137,000 at December 31, 2014. 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 $1.54 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 . . . . . . . . . . . . . . . . . . . . . . . . .
$1.36 − $1.65 . . . . . . . . . . . . . . . . . . . . . . . . .
$13.80 . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total

Options Outstanding and Exercisable

Number
Outstanding
1,081
369
27
1,477

Weighted
Average
Remaining
Contractual Life
3.1
5.4
1.0

Weighted
Average Exercise
Price Per Share
$ 1.01
$ 1.53
$13.80
$ 1.37

The total intrinsic value of options exercised during Fiscal 2013 was $12,000. There were no options
exercised during Fiscal 2014 or 2012. 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,
2014 was $472,000, $16,000 and $456,000, respectively.

Stock Option Exercises

There were no stock options exercised in Fiscal 2014 or 2012. 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.

Stock Grants and Other Issuances

In December 2014, we issued 300,000 shares of our Common Stock valued at $1.31 per share for an
aggregate of $393,000, as payment for a portion of the litigation costs incurred prior to December 31, 2014
related to the Settlement Agreement. The 300,000 shares of our Common Stock 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.

In each of December 2014 and 2013, the Compensation Committee of the Board of Directors granted
Mr. Karkus 100,000 shares and 50,000 shares of Common Stock, respectively, under the 2010 Plan valued at
$139,000 and $82,000, respectively, as payment for a portion of his Fiscal 2014 and 2013 bonus, respectively.

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 the ‘‘2010 Directors’ Plan). A primary
purpose of the 2010 Directors’ 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’ Plan provides that the total number of shares
of Common Stock that may be issued under the 2010 Directors’ Plan is equal to 425,000 shares. In Fiscal
2014, 2013 and 2012, we granted 28,327, 16,470 and zero shares, respectively, of our Common Stock valued
at $41,000, $27,000 and zero, respectively, for director compensation. At December 31, 2014,
there are
147,808 shares of Common Stock that may be issued pursuant to the terms of the 2010 Directors’ Equity
Compensation Plan.

46

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 6 — 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 2014, 2013 and 2012 were $101,000, $100,000 and
$104,000, respectively.

NOTE 7 — INCOME TAXES

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

are as follows (in thousands):

Current

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

Deferred
Federal
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

Total
Income taxes from continuing operations before

valuation allowance . . . . . . . . . . . . . . . . . . . . . . .
Change in valuation allowance . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Income tax (beneﬁt)

Total

Year Ended December 31,
2013

2012

2014

$ —
—
—

(2,471)
(74)
(2,545)
$(2,545)

$(2,545)
2,545
—
$ —

$ —
—
—

1,216
(999)
217
$ 217

$ 217
(217)
—
$ —

$ —
—
—

(618)
1,377
759
$ 759

$ 759
(759)
—
$ —

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

(in thousands):

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

Income tax from continuing operation before

Year Ended December 31,
2013
$ 138
17
62

2014
$(2,662)
(51)
168

2012
$ (661)
1,377
43

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

(2,545)
2,545
—
$ —

217
(217)
—
$ —

759
(759)
—
$ —

47

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7 — INCOME TAXES − (continued)

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

Permanent items:

Meals and Entertainment
Return to provision adjustment

. . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . .
Charitable contributions . . . . . . . . . . . . . . . . . . . . . .
Share-based compensation expense for stock options

granted(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Year Ended December 31,
2013

2012

$ 7
—
1

54
$62

$ 6
(46)
4

79
$ 43

2014

$

7
—
1

160
$168

(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

2014
$ 14,983
39
752
(483)
(45)
2,508
(17,754)
—
$

Year Ended December 31,
2013
$ 13,569
80
819
(387)
(34)
1,009
(15,056)
—
$

2012
$ 14,158
121
—
—
60
983
(15,322)
—
$

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 2014, 2013 and 2012 was $2.7 million, $266,000 and $271,000, 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 $6.7 million are deferred
and will be credited to additional-paid-in-capital when the NOL’s attributable to these exercises are utilized.
income tax expense. The net operating loss
As a result,
carry-forwards currently approximate $38.6 million for federal purposes will expire beginning in Fiscal 2020
through 2033. Additionally, there are net operating loss carry-forwards of $20.1 million for state purposes that
will expire beginning in Fiscal 2018 through 2033.

these NOL’s will not be available to offset

48

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8 — COMMITMENTS AND CONTINGENCIES

Godfrey 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:6) trademark. The Godfreys subsequently asserted against us counterclaims and sought monetary
damages and injunctive and declaratory relief relative to the Cold-EEZE(cid:6) trademark and other intellectual
property.

to the terms of

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 ‘‘Godfrey Settlement Agreement’’), pursuant to which
we resolved all disputes, including claims asserted by us and counterclaims asserted against us in the action.
the Godfrey Settlement Agreement, we paid the Godfreys $2.1 million in
Pursuant
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 annual installment of $100,000 plus accrued interest of $10,000 and $100,000 and
accrued interest of $13,000 were paid in December 2014 and 2013, respectively. Under the Godfrey
Settlement Agreement, the Godfreys assigned, transferred and conveyed to us all of their right, title, and
the trademark Cold-EEZE(cid:6), among other
interest
intellectual property associated with such trademark. As a result of the Godfrey 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, 2014, each of other current liabilities and other long term
obligation include $100,000 and $100,000, respectively, for the two remaining annual installment payments
due in Fiscal 2015 and 2016, respectively.

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

ELI WEISBLUM AND JAMES LOREN GIBBS V. PROPHASE LABS, INC. AND THEODORE KARKUS and
JAMES LOREN GIBBS V. PROPHASE LABS, INC.

On May 19, 2014, a putative class action complaint was ﬁled by a consumer (the ‘‘Complainant’’)
against the Company and our Chief Executive Officer, in the United States District Court, Southern District of
New York. On February 25, 2015, a putative class action complaint was ﬁled by another consumer (the
‘‘Second Complainant’’) against
in the United States District Court, Northern District of
California.

the Company,

These lawsuits, which purport to be brought as a class action on behalf of purchasers of certain products
sold by the Company, allege that the Company engaged in false and misleading marketing, advertising and
sales with respect to such products. The Complainant and Second Complainant seek, among other things,
certiﬁcation of the case as a class action, a judgment against the defendants for damages in an amount to be
determined by the court and/or jury, and an award of fees and expenses to plaintiffs and their attorneys.

Both of these cases were settled and are pending dismissal with prejudice pursuant to a conﬁdential
settlement agreement reached among and between the parties as of March 23, 2015. The settlement agreement
was reached after the parties had engaged in signiﬁcant pre-trial discovery. The Company determined to enter
into this settlement agreement
team to focus their
attention and resources towards the continued growth and operations of the Company. The terms of the
settlement were not material to the Company.

in order to allow the Company and its management

PROPHASE LABS, INC. PROPHASE LABS, INC. FOR THE BENEFIT OF PHUSION LABORATORIES, LLC
vs. Phosphagenics, Inc., Phosphagenics, LTD and Phusion Laboratories, LLC as a nominal defendant

On October 17, 2014, we initiated a demand for arbitration with the American Arbitration Association,
case number 01-14-0001-7373. This demand for arbitration pertains to our Phusion joint venture and the
matter is against Phosphagenics, Inc. and Phosphagenics LTD (collectively known as the ‘‘Phosphagenics
Entities’’). We have raised certain claims based upon the alleged Phosphagenics Entities’ breach of a certain

49

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8 — COMMITMENTS AND CONTINGENCIES − (continued)

amended and restated licenses agreement for the exploitation of certain intellectual property and, separately,
breach of the Phusion joint venture operating agreement as between the Company and the Phosphagenics
Entities. The Phosphagenics Entities have made counter claims of breaches against the Company and Phusion.
This matter is at its preliminary stage and at this time, no prediction as to the outcome of this action can
be made.

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.

Employment Agreements

On November 8, 2011, we entered into employment agreements, effective as of January 1, 2012, with
each of executives, Mr. Ted Karkus, Chief Executive Officer, and Mr. Robert V. Cuddihy, Jr., Chief Operating
Officer and Chief Financial Officer, (the ‘‘2012 Employment Agreements’’). The scheduled termination date of
the 2012 Employment Agreements is July 15, 2015.

Under Mr. Karkus’s employment agreement with the Company, Mr. Karkus agreed to an annual base
salary of $675,000. 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 Mr. Cuddihy’s employment agreement with the Company, Mr. Cuddihy agreed to an annual base
salary of $350,000. 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.

On January 14, 2015, we entered into new employment agreements, effective as of January 1, 2015, with
Mr. Karkus and Mr. Cuddihy (the ‘‘2015 Employment Agreements’’). The 2015 Employment Agreements
supersede the 2012 Employment Agreements that had been scheduled to terminate on July 15, 2015. The 2015
Employment Agreements were approved by our Compensation Committee.

Under his new employment agreement, Mr. Karkus agreed to an annual base salary of $675,000 as Chief
Executive Officer. 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. In the event of the termination by the Company of the
employment of Mr. Karkus without cause or due to a voluntary resignation by Mr. Karkus with Good Reason
(as deﬁned in his employment agreement), Mr. Karkus will be paid 2.5 times his base salary (‘‘Mr. Karkus
Severance’’), with one-half of such amount as a lump sum severance payment in cash and the remaining
one-half paid in 12 equal consecutive, monthly installments commencing on the ﬁrst business day of the
month following the effective date of the termination; and all of the stock options and/or restricted stock held
by Mr. Karkus shall automatically vest concurrently upon such termination of employment, regardless of any
prior existing vesting schedules. If Mr. Karkus is terminated without cause or leaves with Good Reason in
contemplation of (or within 24 months following) a change in control of the Company, then, in lieu of the
Mr. Karkus Severance payment described above, Mr. Karkus shall
instead receive a one-time severance
payment in cash equal to the greater of (i) $2.5 million, and (ii) 299 percent of his average annual total
Form W-2 compensation for the three calendar years immediately preceding the date of termination.

Under his new employment agreement, Mr. Cuddihy agreed to an annual base salary of $350,000 as
Chief Financial Officer and Chief Operating Officer. 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. In the event of the
termination by the Company of the employment of Mr. Cuddihy without cause or due to a voluntary

50

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 8 — COMMITMENTS AND CONTINGENCIES − (continued)

resignation by Mr. Cuddihy with Good Reason (as deﬁned in his Employment Agreement), Mr. Cuddihy will
be paid 1.5 times his base salary (‘‘Mr. Cuddihy Severance’’), with one-half of such amount as a lump sum
severance payment in cash and the remaining one-half paid in 12 equal consecutive, monthly installments
commencing on the ﬁrst business day of the month following the effective date of the termination; and all of
the stock options and/or restricted stock held by Mr. Cuddihy shall automatically vest concurrently upon such
termination of employment, regardless of any prior existing vesting schedules. If Mr. Cuddihy is terminated
without cause or leaves with Good Reason in contemplation of (or within 24 months following) a change in
control of the Company, then, in lieu of the Mr. Cuddihy Severance payment described above, Mr. Cuddihy
shall instead receive a one-time severance payment in cash equal to the greater of (i) $1.0 million and
(ii) 299 percent of his average annual total Form W-2 compensation for the three calendar years immediately
preceding the date of termination.

Future Obligations

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

Year
2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total

NOTE 9 — INVESTMENT IN A JOINT VENTURE

Employment
Contracts
$1,025
1,025
1,025
—
—
$3,075

Godfrey
Settlement
Agreement
$100
100
—
—
—
$200

Total
$1,125
1,125
1,025
—
—
$3,275

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, a Delaware
limited liability company, entered into a Limited Liability Company Agreement (the ‘‘LLC Agreement’’) of
the Phusion joint venture and additional
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 Phusion joint venture.

related agreements

for

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
that embody certain of PSI Parent’s TPM-related patents and related know-how (collectively,
‘‘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.

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

51

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9 — INVESTMENT IN A JOINT VENTURE − (continued)

Pursuant to the Original License Agreement, we issued 1,440,000 shares of our Common Stock having an
aggregate value of approximately $2.6 million to PSI Parent (such shares, the ‘‘PSI Shares’’), and made a
one-time payment to PSI Parent of $1.0 million.

In accordance with a Contribution Agreement, dated March 22, 2010 (the ‘‘Contribution Agreement’’), by
and among us, PSI Parent, PSI, and the Phusion joint venture, we transferred, conveyed and assigned to
Phusion all of our rights, title and interest in, to and under the Original License Agreement, and Phusion
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 Phusion is the licensee thereunder and which otherwise contains substantially the same terms as
the Original License Agreement. Phsuion 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
intellectual property and
concerning the
indemniﬁcation obligations.

the ownership of

treatment of

information,

conﬁdential

Pursuant to the LLC Agreement, we and PSI each own a 50% membership interest in the Phusion joint
venture. PSI Parent will conduct and oversee much of the product development, formulation, testing and other
research and development needed by Phsuion, 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 Phusion 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 Phusion. Phusion has not engaged in any ﬁnancial transactions, other than organizational expenses and
general market and initial product evaluation and analysis. At December 31, 2014, cash and cash equivalents
includes $371,000 which is available to be used by Phusion 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 the $3.6 million payment noted above representing the estimated fair value to
acquire the product license as an intangible asset. The estimated the expected remaining useful life of the
product
license is approximately 12.50 years which we would have begun amortizing the cost of the
intangible asset once product development and commercialization begins (see impairment charge discussed
below). 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.

As previously announced, we

and
pre-commercialization initiatives principally in the dietary supplement category. While several of our product

series of new product development

implementing a

are

52

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 9 — INVESTMENT IN A JOINT VENTURE − (continued)

initiatives have advanced,

including those speciﬁc to the dietary supplement category, our
development
Phusion product development
this time,
management believes that any products embodying the licensed technology to be developed by Phusion will
not be available until ﬁscal 2016 or 2017 at the earliest, and may be more limited than previously forecasted
and may encompass fewer products or have limited retail distribution.

initiatives have not progressed to management’s satisfaction. At

Pursuant to our established accounting policies, we conducted the Fiscal 2013 annual analysis of our
intangible asset as of December 31, 2013 by comparing the estimated fair value of the licensed technology
based on the income approach (which utilizes forecasted discounted cash ﬂows to estimate the fair value of
the licensed technology) against the then carrying value. As we concluded that, as of December 31, 2013, the
fair value according to the income approach exceeded book value, we concluded there was no impairment of
the subject intangible asset.

During the third quarter of Fiscal 2014, our evaluation of the Company’s progress in its new product
development pipeline and delays in Phusion product development caused management to reassess projections
(including income projections) relied upon in December 2013. Accordingly, management performed an
impairment analysis for the period ended September 30, 2014 for the licensed technology. As a consequence
of our impairment assessment, we determined that a full impairment occurred of the intangible asset, licensed
technology. As a consequence, we charged to operations a $3.6 million impairment charge during the third
quarter of Fiscal 2014.

On October 17, 2014, we initiated a demand for arbitration with the American Arbitration Association.
This demand for arbitration pertains to the Phusion joint venture and the matter is against the Phosphagenics
Entities. The Phosphagenics Entities have made counter claims of breaches against the Company and Phusion
(see Note 8).

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
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):

2014
Shares
Basic EPS . . . . . . . . $(7,834) 16,773

Loss

EPS
$(0.47)

Year Ended December 31,
2013
Shares
15,839

EPS
$0.03

Income
$405

2012
Shares
$(1,091) 14,843

Loss

EPS
$(0.07)

Dilutives:
—
Options/Warrants . . .
Diluted EPS . . . . . . $(7,834) 16,773

—

—
$(0.47)

—
$405

437
16,276

—
$0.03

—

—
$(1,091) 14,843

—
$(0.07)

For Fiscal 2014 and 2012, 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 2014 and 2012, there were Common Stock
Equivalents in the amount of 598,609 and 177,035, respectively, which were in-the-money, that were excluded

53

PROPHASE LABS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10 — EARNINGS PER SHARE − (continued)

in the earnings per share computation due to their dilutive effect. In addition, for Fiscal 2014, 2013 and 2012,
there were Common Stock Equivalents in the amount of 26,500, 472,500 and 114,000, respectively, which
were out-of-the-money (the exercise price of the stock option was greater than the average market price for
the period), 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 2014, 2013 and 2012 were $22.1 million, $25.0 million and
$22.4 million, respectively. Walgreen Company (‘‘Walgreens’’), Wal-Mart Stores Inc (‘‘Wal-Mart’’) and CVS
Health Corporation (‘‘CVS’’) accounted for approximately 18.9%, 16.9% and 11.3%, respectively, of our
Fiscal 2014 revenues. Walgreens, Wal-Mart Stores and 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. 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 67% and 68% of total
trade receivable balances at December 31, 2014 and 2013,
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,
2014 and 2013.

NOTE 12 — QUARTERLY INFORMATION (UNAUDITED)

The following table presents unaudited quarterly ﬁnancial information for Fiscal 2014 and Fiscal 2013 (in

thousands, except per share amounts):

March 31,

June 30,

September 30,

December 31,

Quarter Ended

Fiscal 2014

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

$6,171
$3,980
$ (804)

$ 1,797
792
$
$(3,138)

$ 5,130
$ 3,510
$(3,216)

$8,972
$5,896
$ (676)

Basic and diluted loss per share:

Net loss . . . . . . . . . . . . . . . . . . . . . . . . .

$ (0.05)

$ (0.19)

$ (0.18)

$ (0.05)

Fiscal 2013

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

$7,542
$5,339
$ 290

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

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

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)

$ 0.08
$ 0.08

$9,602
$6,587
$ 597

$ 0.04
$ 0.04

54

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
reporting based on the framework in Internal Control-Integrated Framework issued by the
ﬁnancial
Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework). Based upon our
review, our 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, 2014.

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal control over ﬁnancial reporting during Fiscal 2014 that have

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

Item 9B. Other Information

None

55

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 2015 Annual Meeting of Stockholders (the ‘‘2015 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, 2014 and is hereby incorporated
by reference.

Item 11. Executive Compensation

The information required under this item is incorporated by reference to the 2015 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 2015 Proxy Statement.

Item 13. Certain Relationships and Related Transactions and Director Independence

The information required under this item is incorporated by reference to the 2015 Proxy Statement.

Item 14. Principal Accountant Fees and Services

The information required under this item is incorporated by reference to the 2015 Proxy Statement.

56

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*

Inc. et al

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,
(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).
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).
Amended and Restated Rights Agreement, dated as of June 18, 2015 between the Company and
American Stock Transfer and Trust Company (incorporated by reference to Exhibit 4.1 of Form 8-K
ﬁled on June 19, 2014).
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

57

10.15*

10.16*

10.17*

10.18*

10.19

10.20*

10.21*

10.22*

10.23

10.24

10.25*

10.26*

10.27*

10.28*

10.29*

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).
Employment Agreement dated January 1, 2015 between Ted Karkus and the Company (incorporated
by reference to Exhibit 99.2 of Form 8-K ﬁled on January 14, 2015).
Employment Agreement dated January 1, 2015 between Robert V. Cuddihy, Jr. and the Company
(incorporated by reference to Exhibit 99.1 of Form 8-K ﬁled on January 14, 2015).
Investment Agreement by and between ProPhase Labs, Inc. and Dutchess Opportunity Fund II, LP,
dated as of May 28, 2014 (incorporated by reference to Exhibit 10.1 of Form 8-K ﬁled on May 28,
2014).
Registration Rights Agreement by and between ProPhase Labs, Inc. and Dutchess Opportunity
Fund II, LP, dated as of May 28, 2014 (incorporated by reference to Exhibit 10.2 of Form 8-K ﬁled
on May 28, 2014).
Settlement Agreement and Mutual Release between ProPhase Labs,
f/k/a The Quigley
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).
Global Settlement Agreement between ProPhase Labs, Inc. and certain of the Company’s former
litigation
managers and with certain shareholders dated September 4, 2014 resolving all
matters between the parties (incorporated by reference to Exhibit 99.3 of Form 8-K dated
September 4, 2014).
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,
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.

Independent Registered Public Accounting Firm, dated

Inc.

58

Indicates a management contract or compensatory plan or arrangement

*
** Filed herewith

40**
41**
42**
43**
44**
45**

101
101
101
101
101
101

INS — XBRL Instance Document
SCH — XBRL Taxonomy Extension Schema Document
CAL — XBRL Taxonomy Extension Calculation Linkbase Document
DEF — XBRL Taxonomy Extension Deﬁnition Linkbase Document
LAB — XBRL Taxonomy Extension Label Linkbase Document
PRE — XBRL Taxonomy Extension Presentation Linkbase Document

59

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, 2015

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, 2015

/s/ Mark Burnett
Mark Burnett

/s/ Mark Frank
Mark Frank

/s/ Mark Leventhal
Mark Leventhal

Date: March 27, 2015

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

60

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, 2014.

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, 333-185167, 333-196352) of our report dated March 27, 2015, on our audits of the consolidated
ﬁnancial statements of ProPhase Labs, Inc. and Subsidiaries as of December 31, 2014 and 2013 and for each
of the years in the three-year period ended December 31, 2014, which report is included in this Annual Report
on Form 10-K to be ﬁled on or about March 27, 2015.

/s/ EISNERAMPER LLP

Iselin, New Jersey
March 27, 2015

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, 2015

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, 2015

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, 2014, 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, 2015

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, 2014, 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, 2015

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PROPHASE LABS, INC.

CORPORATE OFFICERS AND DIRECTORS

CORPORATE INFORMATION

Ted Karkus

Form 10-K Exhibits

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
the following
request
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, 2014.

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

(cid:2) PROPHASE LABS, INC. ALL RIGHTS RESERVED. PRINTED IN USA.