Item 1A. RISK FACTORS
Our operations and financial
results are subject to various risks and uncertainties including those described below. You should consider carefully the risks and uncertainties
described below, in addition to other information contained in this Annual Report on Form 10-K, including our consolidated financial
statements and related notes. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties
that we are unaware of, or that we currently believe are not material, may also become important factors that adversely affect our business.
If any of the following risks or others not specified below materialize, our business, financial condition and results of operations
could be materially and adversely affected. In that case, the trading price of our common stock could decline.
Risks Relating to Our Business
Our proprietary brand offerings expose us to various risks.
We expect to continue to
grow our portfolio of proprietary brand offerings. We have invested in development and procurement resources and marketing efforts relating
to these proprietary brand offerings. Although we believe that our proprietary brand products offer value to our customers at each price
point and provide us with higher gross margins than comparable third-party branded products we sell, the expansion of our proprietary
brand offerings also subjects us to certain specific risks in addition to those discussed elsewhere in this section, such as:
• Potential mandatory or voluntary product recalls;
An increase in sales of our
proprietary brands may also adversely affect our sales of our vendors’ products, which may, in turn, adversely affect our relationship
with our vendors. Our failure to adequately address some or all of these risks could have a material adverse effect on our business,
results of operations and financial condition.
Our competitors and potential competitors
may develop products and technologies that are more effective or commercially attractive than our products.
Our products compete against
national and regional products and private label products produced by various suppliers, many of which are established companies that
provide products that perform functions similar to our products. Our competitors may develop or market products that are more effective
or commercially attractive than our current or future products. Some of our competitors have substantially greater financial, operational,
marketing and technical resources than we do. Moreover, some of these competitors may offer a broader array of products and sell their
products at prices lower than ours, and may have greater name recognition. In addition, if demand for our specialty indoor gardening
supplies and products continues to grow, we may face competition from new entrants into our field. Due to this competition, there is
no assurance that we will not encounter difficulties in generating or increasing revenues and capturing market share. In addition, increased
competition may lead to reduced prices and/or margins for products we sell. We may not have the financial resources, relationships with
key suppliers, technical expertise or marketing, distribution or support capabilities to compete successfully in the future.
We may not successfully develop new products
or improve existing products or maintain our effectiveness in reaching consumers through rapidly evolving communication vehicles.
Our future success depends,
in part, upon our ability to improve our existing products and to develop, manufacture and market new products to meet evolving consumer
needs. We cannot be certain that we will be successful in developing, manufacturing and marketing new products or product innovations
which satisfy consumer needs or achieve market acceptance, or that we will develop, manufacture and market new products or product innovations
in a timely manner. If we fail to successfully develop, manufacture and market new products or product innovations, or if we fail to
reach existing and potential consumers, our ability to maintain or grow our market share may be adversely affected, which in turn could
materially adversely affect our business, financial condition and results of operations. In addition, the development and introduction
of new and products and product innovations require substantial research, development and marketing expenditures, which we may be unable
to recoup if such new products or innovations do not achieve market acceptance.
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Many of the products we distribute
and market, such as our fertilizers and nutrients, contain ingredients that are subject to regulatory approval or registration with certain
U.S. state regulators. The need to obtain such approval or registration could delay the launch of new products or product innovations
that contain ingredients or otherwise prevent us from developing and manufacturing certain products and product innovations.
Negative economic conditions, specifically
in the U.S. and Canada, could adversely affect our business.
Uncertain
global economic conditions could adversely affect our business. Negative global economic trends, particularly in the U.S. and Canada,
such as decreased consumer and business spending, high unemployment levels, reduced rates of home ownership and housing starts, high foreclosure
rates and declining consumer and business confidence, pose challenges to our business and could result in declining revenues, profitability
and cash flow. Although we continue to devote significant resources to support our brands, unfavorable economic conditions may negatively
affect consumer demand for our products. Our most price-sensitive customers may trade down to lower priced products during challenging
economic times or if current economic conditions worsen, while other customers may reduce discretionary spending during periods of economic
uncertainty, which could reduce sales volumes of our products in favor of our competitors’ products or result in a shift in our
product mix from higher margin to lower margin products.
The effects of the COVID-19 pandemic are
unpredictable and may materially affect our customers and how we operate our business, and the duration and extent to which the pandemic
continues (including any re-emergence of COVID-19) to threaten our future results of operations and overall financial performance remains
uncertain.
In December 2019, COVID-19
was identified. On March 11, 2020, the World Health Organization characterized COVID-19 as a global pandemic. The COVID-19 pandemic has
resulted in a widespread health crisis that has adversely affected businesses, economies and financial markets worldwide and has caused
significant volatility in U.S. and international debt and equity markets. While the rollout of vaccines has begun, the timing of vaccinations,
herd immunity, and the lifting of shelter in place and similar restrictions and movement restrictions is unknown.
Examples of how COVID-19 may
impact our business, results of operations and stock price include, but are not limited to:
The duration and extent of
the impact on our business from the COVID-19 pandemic depends on future developments that cannot be accurately predicted at this time
(e.g., the severity and transmission rate of the virus, the extent and effectiveness of containment measures, and the impact of these
and other factors on our employees, customers, vendors and partners, including their respective productivity). Furthermore, our limited
operating history combined with the uncertainty created by the COVID-19 pandemic significantly increases the difficulty of forecasting
operating results and of strategic planning. For example, we have recently incurred high operating costs and experienced unreliable results
in connection with maritime transportation. If we are unable to effectively predict and manage the impact of the COVID-19 pandemic on
our business, our results of operations and financial condition may be negatively impacted.
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Our business has experienced an accelerated
rate of growth which may be due in part to lifestyle changes in the wake of the COVID-19 pandemic; if so, our recent accelerated rate
of growth may not be sustainable.
Although we cannot precisely
quantify in absolute or relative terms, our accelerated rate of growth in net sales for the year ended December 31, 2020 correlates with
shelter-in-place orders issued in many locations in March 2020 in response to the COVID-19 pandemic. Our net sales for the year ended
December 31, 2020 were approximately 46% higher as compared to the year ended December 31, 2019. A portion of our net sales during this
period could be due to pull-through demand for our products due to higher consumption of CEA products from individuals spending more
time at home due to shelter-in-place measures. Although uncertainty created by the COVID-19 pandemic remains, and various state budgets
remain under economic pressure, creating a greater chance of further cannabis legalization, we cannot assure you that such growth will
continue.
Our international operations make us susceptible
to the costs and risks associated with operating internationally.
We operate some of our distribution
centers in Canada and Spain and source products globally. We also operate a registered office in China. Accordingly, we are subject to
risks associated with operating in foreign countries, including:
• fluctuations in currency exchange rates;
• additional costs of compliance with local regulations;
• additional costs associated with fuel prices and freight expenses;
• in certain countries, historically higher rates of inflation than in the U.S.;
• changes in U.S. and foreign laws regarding trade and investment;
• difficulty in obtaining distribution and support for our products.
In
addition, our operations outside the U.S. are subject to the risk of new and different legal and regulatory requirements in local
jurisdictions, potential difficulties in staffing and managing local operations and potentially adverse tax consequences. The costs associated
with operating our continuing international business could adversely affect our results of operations, financial condition and cash flows
in the future.
We have incurred and will continue to incur
increased costs as a result of being a public company.
We became a public company
on December 9, 2020. As a public company, we have incurred and will continue to incur significant legal, accounting, insurance and other
expenses that we did not incur as a private company. For example, we have and will incur increased legal and accounting costs as a result
of being subject to the information and reporting requirements of the Exchange Act, and other federal securities laws. The costs of preparing
and filing periodic and other reports, proxy statements and other information with the SEC and furnishing audited reports to stockholders,
will cause significant increase in our expenses than if we remained privately-held. The cost of being a public company have and will divert
resources that might otherwise have been used to develop our business, which could have a material adverse effect on our company.
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As a privately held company,
we were not required to comply with certain corporate governance and financial reporting practices and policies required of a public reporting
company. As a public company, we are required to file with the SEC annual and quarterly information and other reports pursuant to the
Exchange Act. We are also required to ensure that we have the ability to prepare financial statements that are fully compliant with all
SEC reporting requirements on a timely basis. In addition, the Sarbanes-Oxley Act, the Dodd-Frank Wall Street Reform and Consumer Protection
Act, the listing requirements of the Nasdaq Global Select Market and other applicable securities rules and regulations impose various
requirements on public companies. Our management and other personnel have and will devote a substantial amount of time to compliance with
these requirements. Moreover, these rules and regulations will continue to increase our legal and financial compliance costs and will
make some activities more time-consuming and costly. We cannot predict or estimate the amount of additional costs we will continue to
incur as a public company or the specific timing of such costs.
As a public company, we have
and will, among other things:
• enhance our investor relations function;
These changes require a significant
commitment of additional resources and many of our competitors already comply with these obligations. We may not be successful in complying
with these obligations and the significant commitment of resources required for complying with them could have a material adverse effect
on our business, financial condition and results of operations. These laws and regulations could also make it more difficult or costly
for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced
policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. These laws and regulations could
also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our committees of our board
of directors or as our executive officers.
In addition, if we fail to
implement the requirements with respect to our internal accounting and audit functions, our ability to report our results of operations
on a timely and accurate basis could be impaired and we could suffer adverse regulatory consequences or violate applicable listing standards.
There could also be a negative reaction in the financial markets due to a loss of investor confidence in us and the reliability of our
financial statements, which could have a material adverse effect on our business, financial condition and results of operations.
The changes necessitated
by becoming a public company require a significant commitment of resources and management supervision that has increased and may continue
to increase our costs and might place a strain on our systems and resources. As a result, our management’s attention might be diverted
from other business concerns. If we fail to maintain an effective internal control environment or to comply with the numerous legal and
regulatory requirements imposed on public companies, we could make material errors in, and be required to restate, our financial statements.
Any such restatement could result in a loss of public confidence in the reliability of our financial statements and sanctions imposed
on us by the SEC. We cannot predict or estimate the amount of additional costs we may incur or the timing of such costs. If we are unable
to satisfy our obligations as a public company, we could be subject to delisting of our common stock, as applicable, fines, sanctions
and other regulatory action and potentially civil litigation.
As a result of being a public company,
we are obligated to develop and maintain proper and effective internal controls over financial reporting, and any failure to maintain
the adequacy of these internal controls may adversely affect investor confidence in our company and, as a result, the value of our common
stock.
We may be required, pursuant
to Section 404 to furnish a report by management on, among other things, the effectiveness of our internal control over financial reporting
for the fiscal year ending December 31, 2021. This assessment will need to include disclosure of any material weaknesses identified by
our management in our internal control over financial reporting. Following the date we are no longer an “emerging growth company,”
our independent registered public accounting firm will be required to attest to the effectiveness of our internal control over financial
reporting in our first annual report required to be filed with the SEC. We have recently commenced the costly and challenging process
of compiling the system and processing documentation necessary to perform the evaluation needed to comply with Section 404, but we may
not be able to complete our evaluation, testing and any required remediation in a timely fashion once initiated. Our compliance with
Section 404 will require that we incur substantial expenses and expend significant management efforts. We may need to hire additional
accounting and financial staff, or leverage outside resources, with appropriate public company experience and technical accounting knowledge
and compile the system and process documentation necessary to perform the evaluation needed to comply with Section 404.
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During the evaluation and
testing process of our internal controls, if we identify one or more material weaknesses in our internal control over financial reporting,
we will be unable to certify that our internal control over financial reporting is effective. We cannot assure you that there will not
be material weaknesses or significant deficiencies in our internal control over financial reporting in the future. Any failure to maintain
internal control over financial reporting could severely inhibit our ability to accurately report our financial condition or results
of operations. If we are unable to conclude that our internal control over financial reporting is effective, or if our independent registered
public accounting firm determines we have a material weakness or significant deficiency in our internal control over financial reporting,
we could lose investor confidence in the accuracy and completeness of our financial reports, the market price of our common stock could
decline, and we could be subject to sanctions or investigations by the SEC or other regulatory authorities. Failure to remedy any material
weakness in our internal control over financial reporting, or to implement or maintain other effective control systems required of public
companies, could also restrict our future access to the capital markets.
We identified material weaknesses in our
internal control over financial reporting, and if we are unable to achieve and maintain effective internal control over financial reporting,
the accuracy and timing of our financial reporting may be adversely affected.
Prior to our initial public
offering (“IPO”) in December 2020, we were a private company with limited accounting and finance personnel, adequate review
processes and other resources with which to address our internal controls and procedures. In connection with the audit of our financial
statements for fiscal 2019, we and our independent registered public accounting firm identified control deficiencies in the design and
operation of our internal control over financial reporting that constituted material weaknesses previously disclosed in our registration
statement on Form S-1 which was declared effective on December 9, 2020.
A “material weakness”
is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility
that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. Our management
determined that the previously disclosed material weaknesses have not been remediated as of December 31, 2020: that (i) we did not maintain
a sufficient complement of personnel with an appropriate degree of technical knowledge commensurate with our accounting and reporting
requirements and (ii) our controls related to the preparation, review, and analysis of accounting information and financial statements
were not adequately designed or appropriately implemented to identify material misstatements in our financial reporting on a timely basis
for our U.S. entities and Eddi’s. These material weaknesses could result in a misstatement of account balances or disclosures that
would result in a material misstatement to the annual or interim financial statements that would not be prevented or detected.
We have taken several
actions towards remediating these material weaknesses. In particular, we (i) hired and continue to hire, additional qualified accounting
and financial reporting personnel with technical and/or public company experience, (ii) implemented new control procedures over certain
areas previously deemed ineffective related to the preparation, review, and analysis of accounting information and financial statements
and (iii) engaged and continue to engage an external advisor to assist management in completing a Sarbanes-Oxley Act compliant risk assessment,
creating detailed control documentation for in-scope business and information technology processes, identifying further control gaps
and providing assistance on remediation procedures, and designing and implementing a Sarbanes-Oxley Act sub-certification process. Although
we have taken steps to address the material weaknesses, we are still in the process of completing the remediation and we cannot assure
you that the steps we are taking will be sufficient to remediate our material weaknesses or prevent future material weaknesses or significant
deficiencies from occurring.
We can give no assurance
that additional material weaknesses in our internal control over financial reporting will not be identified in the future. Our failure
to implement and maintain effective internal control over financial reporting could result in errors in our financial statements that
could result in a restatement of our financial statements and cause us to fail to meet our reporting obligations.
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Acquisitions, other strategic alliances
and investments could result in operating difficulties, dilution, and other harmful consequences that may adversely impact our business
and results of operations.
Acquisitions are an important
element of our overall corporate strategy, and these transactions could entail material investments by us and be material to our financial
condition and results of operations. We expect to evaluate and enter into discussions regarding a wide array of potential strategic transactions.
The process of integrating an acquired company, business, or product has created, and will continue to create, unforeseen operating difficulties
and expenditures. The areas where we face risks may include, but are not limited to:
• failure to successfully further develop the acquired business or products;
• transition of operations, users and customers onto our existing platforms;
Our due diligence may fail
to identify all liabilities associated with acquisitions and we may not assess the relative benefits and detriments of making an acquisition
and may pay acquisition consideration exceeding the value of the acquired business. Our failure to address these risks or other problems
encountered in connection with our past or future acquisitions and investments or strategic alliances could cause us to fail to realize
the anticipated benefits of such acquisitions, investments or alliances, incur unanticipated liabilities, and harm our business generally.
Our acquisitions could also
result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities or amortization expenses, or impairment
of goodwill and purchased long-lived assets, and restructuring charges, any of which could harm our financial condition or results of
operations and cash flows.
Although acquisitions are
an important element of our overall corporate strategy, there can be no assurance that we will be able to identify appropriate acquisition
targets, successfully acquire identified targets or successfully integrate the business of acquired companies to realize the full, anticipated
benefits of such acquisitions.
Damage to our reputation could have an
adverse effect on our business.
Maintaining our strong reputation
is a key component in our success. Product recalls, our inability to ship, sell or transport our products, governmental investigations
and other matters may harm our reputation and acceptance of our products, which may materially and adversely affect our business operations,
decrease sales and increase costs.
In addition, perceptions
that the products we distribute and market are not safe could adversely affect us and contribute to the risk we will be subjected to
legal action. We distribute and market a variety of products, such as nutrients, and growing media. On occasion, allegations or news
reports may be made that some of these products have failed to perform up to expectations or have caused damage or injury to individuals
or property. Public perception that the products we distribute or market are not safe could impair our reputation, involve us in litigation,
damage our brand names and have a material adverse effect on our business.
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Our marketing activities may not be successful.
We invest substantial resources
in advertising, consumer promotions and other marketing activities to maintain, extend and expand our brand image. There can be no assurance
that our marketing strategies will be effective or that the amount we invest in advertising activities will result in a corresponding
increase in sales of our products. If our marketing initiatives are not successful, we will have incurred significant expenses without
the benefit of higher revenues.
Our operations may be impaired if our information
technology systems, or those of our third-party vendors, fail to perform adequately or if we or our third-party vendors are the subject
of a data breach or cyber-attack.
We rely on information technology
systems in order to conduct business, including communicating with employees and our distribution centers, ordering and managing materials
from suppliers, selling and shipping products to retail customers and analyzing and reporting results of operations, as well as for storing
sensitive, personal and other confidential information. While we have taken steps to ensure the security of our information technology
systems, our security measures or those of our third-party vendors may not be effective and our or our third-party vendors’ systems
may nevertheless be vulnerable to computer viruses, security breaches and other disruptions from unauthorized users. If our or our third-party
vendors’ information technology systems are damaged or cease to be available or function properly for an extended period of time,
whether as a result of a significant cyber incident or otherwise, our ability to communicate internally as well as with our retail customers
could be significantly impaired, which may adversely impact our business.
Additionally, the techniques
used to obtain unauthorized, improper or illegal access to information technology systems are constantly evolving, may be difficult to
detect quickly and often are not recognized until after they have been launched against a target. We may be unable to anticipate these
techniques, react in a timely manner or implement adequate preventative or remedial measures. Any operational failure or breach of security
from these increasingly sophisticated cyber threats could lead to the loss or disclosure of both our and our retail customers’
financial, product, and other confidential information, as well as personally identifiable information about our employees or customers,
result in negative publicity and expensive and time-consuming regulatory or other legal proceedings, damage our relationships with our
customers and have a material adverse effect on our business and reputation. In addition, we may incur significant costs and operational
consequences in connection with investigating, mitigating, remediating, eliminating and putting in place additional tools and devices
designed to prevent future actual or perceived security incidents, as well as in connection with complying with any notification or other
obligations resulting from any security incidents. Because we do not control our third-party vendors, or the processing of data by our
third-party vendors, our ability to monitor our third-party vendors’ data security is limited and we cannot ensure the integrity
or security of the measures they take to protect and prevent the loss of our or our consumers’ data. As a result, we are subject
to the risk that cyber-attacks on, or other security incidents affecting, our third-party vendors may adversely affect our business even
if an attack or breach does not directly impact our systems.
We occupy many of our facilities under
long-term non-cancellable leases, and we may be unable to renew our leases at the end of their terms.
Many of our facilities and
distribution centers are located on leased premises subject to non-cancellable leases. Typically, our leases have initial terms ranging
from three to ten years, with options to renew for specified periods of time. We believe that our future leases will likely also be long-term
and non-cancellable and have similar renewal options. If we close or stop fully utilizing a facility, we will most likely remain obligated
to perform under the applicable lease, which would include, among other things, making the base rent payments, and paying insurance,
taxes and other expenses on the leased property for the remainder of the lease term. Our future minimum aggregate rental commitments
for leases for our facilities and distribution centers, as of December 31, 2020, is approximately $22.1 million for leases classified
as operating and $408,000 for leases classified as financing. Our inability to terminate a lease when we stop fully utilizing a facility
or exit a market can have a significant adverse impact on our financial condition, operating results and cash flows.
In addition, at the end of
the lease term and any renewal period for a facility, we may be unable to renew the lease without substantial additional cost, if at
all. If we are unable to renew our facility leases, we may close or relocate a facility, which could subject us to construction and other
costs and risks, which in turn could have a material adverse effect on our business and operating results. Further, we may not be able
to secure a replacement facility in a location that is as commercially viable, including access to rail service. Having to close a facility,
even briefly to relocate, could reduce the sales that such facility would have contributed to our revenues.
The estimates and judgments we make, or
the assumptions on which we rely, in preparing our consolidated financial statements could prove inaccurate.
Our consolidated financial
statements have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make
estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses, the amounts of charges accrued
by us and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other
assumptions that we believe to be reasonable under the circumstances. We cannot assure, however, that our estimates, or the assumptions
underlying them, will not change over time or otherwise prove inaccurate. Any potential litigation related to the estimates and judgments
we make, or the assumptions on which we rely, in preparing our consolidated financial statements could have a material adverse effect
on our financial results, harm our business, and cause our share price to decline.
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In order to increase our sales and marketing
infrastructure, we will need to grow the size of our organization, and we may experience difficulties in managing this growth.
As we continue to work to
expand our business, we will need to expand the size of our employee base for managerial, operational, sales, marketing, financial and
other resources. Future growth would impose significant added responsibilities on members of management, including the need to identify,
recruit, maintain, motivate and integrate additional employees. In addition, our management may have to divert a disproportionate amount
of its attention away from our day-to-day activities and devote a substantial amount of time to managing these growth activities. Our
future financial performance and our ability to continue to grow our operation and compete in the hydroponics industry effectively will
depend, in part, on our ability to effectively manage any future growth.
Potential tariffs or a global trade war
could increase the cost of our products, which could adversely impact the competitiveness of our products and our financial results.
Since 2018, the U.S. has imposed
tariffs on certain imports from China, including on lighting and environmental control equipment manufactured in China. If the U.S. administration
imposes additional tariffs, or if additional tariffs or trade restrictions are implemented by the U.S. or other countries the cost of
our products manufactured in China and imported into the U.S. or other countries could increase, which in turn could adversely affect
the demand for these products and have a material adverse effect on our business and results of operations. As of the date of this Annual
Report on Form 10-K, tariffs have not adversely affected the purchase price of our products manufactured in China and imported into the
U.S.
Unanticipated changes in our tax provisions,
the adoption of new tax legislation or exposure to additional tax liabilities could affect our profitability and cash flows.
We
are subject to income and other taxes in the U.S. federal jurisdiction and various local, state and foreign jurisdictions. Our
effective tax rate in the future could be adversely affected by changes to our operating structure, changes in the mix of earnings in
countries with differing statutory tax rates, changes in the valuation of deferred tax assets (such as net operating losses and tax credits)
and liabilities, changes in tax laws and the discovery of new information in the course of our tax return preparation process. In particular,
the carrying value of deferred tax assets, which are predominantly related to our operations in the U.S., is dependent on our ability
to generate future taxable income of the appropriate character in the relevant jurisdiction.
From time to time, tax proposals
are introduced or considered by the U.S. Congress or the legislative bodies in local, state and foreign jurisdictions that could also
affect our tax rate, the carrying value of our deferred tax assets, or our tax liabilities. Our tax liabilities are also affected by
the amounts we charge for inventory, services, licenses and funding. We are subject to ongoing tax audits in various jurisdictions. In
connection with these audits (or future audits), tax authorities may disagree with our determinations and assess additional taxes. We
regularly assess the likely outcomes of our audits in order to determine the appropriateness of our tax provision. As a result, the ultimate
resolution of our tax audits, changes in tax laws or tax rates, and the ability to utilize our deferred tax assets could materially affect
our tax provision, net income and cash flows in future periods.
We may be limited in our ability to utilize,
or may not be able to utilize, net operating loss carryforwards to reduce our future tax liability.
As of December 31, 2020,
we had U.S. federal net operating loss (“NOL”) carryforwards of approximately $62.5 million, the utilization of which may
be limited annually due to certain change in ownership provisions of Section 382 of the Internal Revenue Code of 1986, as amended (the
“Code”). Our NOL carryforwards will begin to expire in 2037. Please refer to Note 12, Income Taxes, in our consolidated
financial statements included elsewhere in this Annual Report on Form 10-K for a further discussion of the carryforward of our NOLs.
As of December 31, 2020, we maintained a valuation allowance of approximately $34.4 million on the majority of our net deferred tax assets.
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An “ownership change”
(generally defined as greater than 50-percentage-point cumulative changes in the equity ownership of certain stockholders over a rolling
three-year period) under Section 382 of the Code may limit our ability to utilize fully our pre-change NOL carryforwards to reduce our
taxable income in periods following the ownership change. In general, an ownership change would limit our ability to utilize NOL carryforwards
to an amount equal to the aggregate value of our equity at the time of the ownership change multiplied by a specified tax-exempt interest
rate, subject to increase by certain built-in gains. Similar provisions of state tax law may also apply to our state NOL carryforwards.
As a result of the IPO, the aggregate ownership change exceeded the 50% threshold. The annual limitation resulting from this ownership
change is not expected to result in the expiration of the NOL carryforwards before utilization. In addition, future changes in our stock
ownership, some of which may be beyond our control, could result in additional ownership changes under Section 382 of the Code.
If we need additional capital to fund our
operations, we may not be able to obtain sufficient capital and may be forced to limit the scope of our operations.
In connection with our growth
strategies, we may experience increased capital needs and accordingly, we may not have sufficient capital to fund our future operations
without additional capital investments. There can be no assurance that additional capital will be available to us. If we cannot obtain
sufficient capital to fund our operations, we may be forced to limit the scope of our expansion.
If product liability lawsuits are brought
against us, we may incur substantial liabilities.
We face a potential risk
of product liability as a result of any of the products that we offer for sale. For example, we may be sued if any product we sell allegedly
causes injury or is found to be otherwise unsuitable during product testing, manufacturing, marketing or sale. Any such product liability
claims may include allegations of defects in manufacturing, defects in design, a failure to warn of dangers inherent in the product,
negligence, strict liability and a breach of warranties. Claims could also be asserted under state consumer protection acts. If we cannot
successfully defend ourselves against product liability claims, we may incur substantial liabilities. Even successful defense would require
significant financial and management resources. Regardless of the merits or eventual outcome, liability claims may result in: (i) decreased
demand for products that we may offer for sale; (ii) injury to our reputation; (iii) costs to defend the related litigation; (iv) a diversion
of management’s time and our resources; (v) substantial monetary awards to trial participants or patients; (vi) product recalls,
withdrawals or labeling, marketing or promotional restrictions; (vii) a decline in our stock price. Our inability to obtain and retain
sufficient product liability insurance at an acceptable cost to protect against potential product liability claims could prevent or inhibit
the commercialization of products we develop. We do not maintain any product liability insurance. Even if we obtain product liability
insurance in the future, we may have to pay amounts awarded by a court or negotiated in a settlement that exceed our coverage limitations
or that are not covered by our insurance, and we may not have, or be able to obtain, sufficient capital to pay such amounts.
Risks Relating to Our Indebtedness
The JPMorgan Credit Facility has restrictions
on our ability to sell our products directly to the cannabis industry.
We and our subsidiaries
entered into a credit agreement with JPMorgan Chase Bank, N.A. (“JPMorgan”) on March 29, 2021 (the “JPMorgan Credit
Facility”). The JPMorgan Credit Facility refinanced the Encina Credit Facility and is an asset based loan that contains
customary covenants, restrictions and defaults. The JPMorgan Credit Facility prohibits the Subsidiary Obligors from selling our
products to the cannabis industry. As a result, the Subsidiary Obligors do not sell our products directly to the cannabis industry.
We are in compliance with the terms set forth by the JPMorgan Credit Facility and maintain policies and procedures that are
designed to promote and achieve continued compliance with these requirements.
These compliance requirements
may require that we be more selective than our competitors when selecting to whom we sell our products, and in certain situations, may
afford our competitors a competitive advantage compared to us if we are not able to sell our products to a certain customer, and may
negatively impact our marketing efforts, sales and reputation in the market. Moreover, any breach of these compliance requirements, could
result in the occurrence of an event of default under the JPMorgan Credit Facility, which would entitle JPMorgan to accelerate the
payment of all obligations then outstanding, without any action by them or notice of any kind. The foregoing events would have a material
adverse effect on our business, results of operations and financial condition.
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Substantially all of the Subsidiary Obligors’
assets are pledged to secure obligations under the Subsidiary Obligors outstanding indebtedness.
The
Subsidiary Obligors have granted a continuing security interest in substantially all of their assets to JPMorgan, as security for the
Subsidiary Obligors’ obligations under JPMorgan Credit Facility. If the Subsidiary Obligors default on any of their obligations
under these agreements and JPMorgan will be entitled to exercise remedies available it them resulting from such default, including increasing
the applicable interest rate on all amounts outstanding, declaring all amounts due thereunder immediately due and payable, assuming possession
of the secured assets, and exercising rights and remedies of a secured party under the Uniform Commercial Code, as applicable then in
the U.S., or the Personal Property Security Act, as applicable then in Canada. Our ability to conduct our business may be materially
harmed as a result of the exercise of any remedies, in the event that such remedies are exercisable, by JPMorgan.
The Subsidiary Obligors existing debt agreements
contain, and our or our subsidiaries’ future debt agreements may contain, restrictions that may limit our flexibility in operating
our business.
The Subsidiary Obligors’
existing debt agreements contain, and any documents governing our or our subsidiaries’ future indebtedness may contain, numerous
financial and operating covenants that limit the discretion of management with respect to certain business matters. Such restrictive
covenants include restrictions on, among others, our or our subsidiaries’ ability to: (1) incur additional indebtedness; (2) create
or suffer to exist any liens upon any of our or our subsidiaries’ property; (3) pay dividends and other distributions or enter
into agreements restricting our subsidiaries’ ability to pay dividends; (4) make any restricted investment; (5) make certain loans;
make certain dispositions of assets; (6) merge, amalgamate, combine or consolidate; (7) engage in certain transactions with stockholders
or affiliates; (8) amend or otherwise alter the terms of our or our subsidiaries’ indebtedness; or (9) alter the business that
we conduct. The Subsidiary Obligors’ existing debt agreements also require, and any documents governing our or our subsidiaries’
future indebtedness may require, us to meet certain financial ratios and tests. Noncompliance with the applicable financial ratios and
tests are specified defaults under the JPMorgan Credit Facility.
The Subsidiary Obligors’
ability to comply with these and other provisions of their existing debt agreements is dependent on our future performance, which will
be subject to many factors, some of which are beyond our control. The breach of any of these covenants or noncompliance with any of these
financial ratios and tests could result in an event of default under the existing debt agreements, which, if not cured or waived, could
result in acceleration of the related debt and the acceleration of debt under other instruments evidencing indebtedness that may also
contain cross-acceleration or cross-default provisions. Variable rate indebtedness subjects the Subsidiary Obligors to the risk of higher
interest rates, which could cause our future debt service obligations to increase significantly.
Uncertainty relating to the London interbank
offered rate (“LIBOR”) and the potential discontinuation of LIBOR in the future may adversely affect our interest expense.
LIBOR is widely used as a reference for setting
the interest rate on loans globally. The JPMorgan Credit Facility provides that loans denominated in US dollars bear interest at the Eurodollar
Rate plus 1.95% and those denominated in Canadian dollars bear interest at the CDOR rate plus 1.95%. Both rates are ultimately based on
LIBOR and there is a floor of 0.0% for each rate. LIBOR is the subject of recent national, international and other regulatory guidance
and proposals for reform or discontinuation. In particular, on July 27, 2017, the Chief Executive of the U.K. Financial Conduct Authority,
which regulates LIBOR, announced that it will no longer persuade or compel banks to submit rates for the calculation of LIBOR after 2021.
Subsequently, the ICE Benchmark Administration announced its plan to extend the date most U.S. dollar LIBOR values would cease
being computed to June 30, 2023.
The JPMorgan Credit Facility contains benchmark
replacement terms pursuant to which the LIBOR-based rates will convert to Secured Overnight Funding Rate (SOFR) based rates or other alternative
rates upon the occurrence of certain events. The floor of 0.0% would continue to apply to any alternative rate. SOFR (and other
potential alternative rates) are overnight rates, while LIBOR has seven varying rates on terms of one day to one year. The JPMorgan
Credit Facility utilizes one-month LIBOR. The agreement attempts to provide mechanisms whereby the tenor (one month) of the LIBOR
based rates would remain the same even though SOFR is an overnight rate. In addition, LIBOR incorporates built in credit risk component
because it is based on the aggregate cost of borrowing by a bank and SOFR does not have this component since it is based on overnight
transactions in the Treasury repurchase market. Accordingly, there are inherent difficulties in matching these two rates and it is possible
that the use of SOFR may result in a higher rate. In the event that one of the alternative rates are not available, the JPMorgan Credit
Facility provides that the US loans would convert to the CB Floating Rate plus 1.95% and the Canadian loans would convert to the Canadian
Prime Rate.
There is no guarantee that
an alternate interest rate will be established for the JPMorgan Credit Facility, and even if an alternative interest rate is established,
such alternate interest rate may be higher than a corresponding interest rate benchmarked to LIBOR, especially given uncertainty as to
the effectiveness of alternative rate-setting methodologies prior to their utilization in practice. Uncertainty as to the nature of any
potential modification to or discontinuation of LIBOR, the decline in usefulness of LIBOR as an interest rate reference prior to its discontinuation,
the establishment of alternative interest rates or the implementation of any other potential changes may materially and adversely affect
our interest expense.
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Risks Relating to Third Parties
Our reliance on a limited base of suppliers
for certain products, such as light ballasts, may result in disruptions to our business and adversely affect our financial results.
Although we continue to implement
risk-mitigation strategies for single-source suppliers, we rely on a limited number of suppliers for certain of our light ballasts, used
in manufacturing our lighting systems. A portion of our key suppliers experienced significant volume demands in 2020, which impacted
supplier performance. If we are unable to maintain supplier arrangements and relationships, if we are unable to contract with suppliers
at the quantity and quality levels needed for our business, or if any of our key suppliers becomes insolvent or experience other financial
distress, we could experience disruptions in production, which could have a material adverse effect on our financial condition, results
of operations and cash flows.
A significant interruption in the operation
of our or our suppliers’ facilities could impact our capacity to produce products and service our customers, which could adversely
affect revenues and earnings.
Operations at our and our
suppliers’ facilities are subject to disruption for a variety of reasons, including fire, flooding or other natural disasters,
disease outbreaks or pandemics, acts of war, terrorism, government shut-downs and work stoppages. Some of our key suppliers experienced
significant demand and increased volume for the year 2020. A significant interruption in the operation of our or our suppliers’
facilities, especially for those products manufactured at a limited number of facilities, such as fertilizer and liquid products, could
significantly impact our capacity to sell products and service our customers in a timely manner, which could have a material adverse
effect on our customer relationships, revenues, earnings and financial position.
If our suppliers are unable to source raw
materials in sufficient quantities, on a timely basis, and at acceptable costs, our ability to sell our products may be harmed.
The manufacture of some of
our products is complex and requires precise high quality manufacturing that is difficult to achieve. We have in the past, and may in
the future, experience difficulties in manufacturing our products on a timely basis and in sufficient quantities. These difficulties
have primarily related to difficulties associated with ramping up production of newly introduced products and may result in increased
delivery lead-times and increased costs of manufacturing these products. Our failure to achieve and maintain the required high manufacturing
standards could result in further delays or failures in product testing or delivery, cost overruns, product recalls or withdrawals, increased
warranty costs or other problems that could harm our business and prospects.
In determining the required
quantities of our products and the manufacturing schedule, we must make significant judgments and estimates based on historical experience,
inventory levels, current market trends and other related factors. Because of the inherent nature of estimates, there could be significant
differences between our estimates and the actual amounts of products we require, which could harm our business and results of operations.
Disruptions in availability or increases
in the prices of raw materials sourced by suppliers could adversely affect our results of operations.
We source many of our product
components from outside of the U.S. The general availability and price of those components can be affected by numerous forces beyond our
control, including political instability, trade restrictions and other government regulations, duties and tariffs, price controls, changes
in currency exchange rates and weather.
A significant disruption
in the availability of any of our key product components could negatively impact our business. In addition, increases in the prices of
key commodities and other raw materials could adversely affect our ability to manage our cost structure. Market conditions may limit
our ability to raise selling prices to offset increases in our raw material costs. Our proprietary technologies can limit our ability
to locate or utilize alternative inputs for certain products. For certain inputs, new sources of supply may have to be qualified under
regulatory standards, which can require additional investment and delay bringing a product to market.
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If our suppliers that currently, or in
the future, sell directly to the retail market in which we conduct our current or future business, enhance these efforts and cease or
decrease their sales through us, our ability to sell certain products could be harmed.
Our
distribution and sales and marketing capabilities provide significant value to our suppliers. Distributed brand suppliers sell through
us in order to access thousands of retail and commercial customers across the U.S. and Canada with short order lead times, no minimum
order quantity on individual items, free or minimal freight expense and trade credit terms. Based on our knowledge and communication with
our suppliers, we believe some of our suppliers sell directly to the retail market. If these suppliers were to cease working with us,
or proceed to enhance their direct-to-customer efforts, our product offerings, reputation, operation and business could be materially
adversely effected.
Risks Relating to the Cannabis Industry
We sell our products through
third-party retailers and resellers which do not exclusively sell to the cannabis industry. It is evident to us that the movement towards
the legalization of cannabis in the U.S. and its legalization in Canada has ultimately had a significant, positive impact on our industry.
Accordingly, the risks referred to below, to the extent they relate to our customers could impact us indirectly. In addition, if our
business is deemed to transact with companies involved in the cannabis business, these risks could apply directly to us. “Cannabis
Industry Participants” means the potential customers and end-users of our products who are engaged in the cannabis industry.
We are subject to a number of risks, directly
and indirectly through Cannabis Industry Participants, because cannabis is illegal under federal law.
Cannabis is illegal under
federal law. Federal law and enforcement may adversely affect the implementation of medical cannabis and/or adult-use cannabis laws,
and may negatively impact our revenues and profits.
Under the CSA, the U.S. Government
lists cannabis as a Schedule I controlled substance (i.e., deemed to have no medical value), and accordingly the manufacturing (cultivation),
sale, or possession of cannabis is federally illegal. It is also federally illegal to advertise the sale of cannabis or to sell paraphernalia
designed or intended primarily for use with cannabis, unless the paraphernalia is authorized by federal, state, or local law. The United
States Supreme Court has ruled in United States v. Oakland Cannabis Buyers’ Coop. and Gonzales v. Raich, 532 U.S. 483 (2001), that
the federal government has the right to regulate and criminalize cannabis, even for medical purposes. The illegality of cannabis under
federal law preempts state laws that legalize its use. Therefore, strict enforcement of federal law regarding cannabis would likely adversely
affect our revenues and results of operations.
Other laws that directly
impact the cannabis growers that are end users of certain of our products include:
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The former administration,
or any new administration or attorney general, could change federal enforcement policy or execution and decide to enforce the federal
cannabis laws more strongly. On January 4, 2018, former U.S. Attorney General Jeff Sessions issued a memorandum rescinding previous guidance
(directing U.S. Department of Justice and the U.S. Attorneys’ offices to focus their cannabis enforcement efforts under federal
law only in identified priority areas, such as sale to minors, criminal enterprises, and interstate sales). Under the Sessions memorandum,
local U.S. Attorneys’ offices retain discretion regarding the prosecution of cannabis activity authorized under state laws and regulations.
While former U.S. Attorney General William Barr expressed support for the National Organization to Reform Marijuana Laws (“NORML”)
during his Senate testimony on April 10, 2019, further change in the federal approach towards enforcement could negatively affect the
industry, potentially ending it entirely. Any such change in the federal government’s enforcement of current federal laws could
cause significant financial damage to us. The legal uncertainty and possible future changes in law could negatively affect our growth,
revenues, results of operations and success generally.
Federal authorities may decide
to change their current posture and begin to enforce current federal cannabis law and, if they decide to ignore the principles in the
Cole Memorandum issued in 2013 (the “Cole Memorandum”) and begin to aggressively enforce such laws, it is possible that they
could allege that we violated federal laws by selling products used in the cannabis industry. As a result, active enforcement of the
current federal regulatory position on cannabis may thus directly or indirectly adversely affect our revenues and profits.
Violations of any U.S. federal
laws and regulations could result in significant fines, penalties, administrative sanctions, convictions or settlements arising from
civil proceedings conducted by either the U.S. federal government or private citizens, or criminal charges, including, but not limited
to, disgorgement of profits, cessation of business activities or divestiture. This could have a material adverse effect on our business,
including our reputation and ability to conduct business, the listing of our securities on any stock exchanges, the settlement of trades
of our securities, our ability to obtain banking services, our financial position, operating results, profitability or liquidity or the
market price of our publicly traded shares. In addition, it is difficult for us to estimate the time or resources that would be needed
for the investigation of any such matters or their final resolution because, in part, the time and resources that may be needed are dependent
on the nature and extent of any information requested by the applicable authorities involved, and such time or resources could be substantial.
Cannabis Industry Participants are subject
to federal and state controlled substance laws and regulations. As a result, we are indirectly subject to a number of risks
related to controlled substances.
We sell our products through
third-party retailers and resellers which do not exclusively sell to the cannabis industry. Some of our products are sold to Cannabis
Industry Participants and used in connection with cannabis businesses that are subject to federal and state controlled substance laws
and regulations. Companies that transact directly or indirectly with cannabis businesses are subject to a number of risks related to
controlled substances, which risks could reduce demand for our products by Cannabis Industry Participants. Such risks include, but are
not limited to, the following:
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Furthermore, the JPMorgan
Credit Facility restricts our ability to sell our products directly to the cannabis industry. As a result, the Subsidiary Obligors do
not sell our products directly to the cannabis industry.
Our growth is highly dependent on the U.S.
cannabis market. New California regulations caused licensing shortages and future regulations may create other limitations
that decrease the demand for our products. State level regulations adopted in the future may adversely impact our business.
The base of cannabis growers
in the U.S. has grown over the past 20 years since the legalization of cannabis for medical uses in states such as California, Colorado,
Michigan, Nevada, Oregon and Washington, with a large number of those growers depending on products similar to those we distribute. The
U.S. cannabis market is still in its infancy and early adopter states such as California, Colorado and Washington represent a large portion
of historical industry revenues. If the U.S. cannabis cultivation market does not grow as expected, our business, financial condition
and results of operations could be adversely impacted.
Cannabis remains illegal
under U.S. federal law, with cannabis listed as a Schedule I substance under the CSA. Notwithstanding laws in various states permitting
certain cannabis activities, all cannabis activities, including possession, distribution, processing and manufacturing of cannabis and
investment in, and financial services or transactions involving proceeds of, or promoting such activities remain illegal under various
U.S. federal criminal and civil laws and regulations, including the CSA, as well as laws and regulations of several states that have
not legalized some or any cannabis activities to date. Compliance with applicable state laws regarding cannabis activities does not protect
us from federal prosecution or other enforcement action, such as seizure or forfeiture remedies, nor does it provide any defense to such
prosecution or action. Cannabis activities conducted in or related to conduct in multiple states may potentially face a higher level
of scrutiny from federal authorities. Penalties for violating federal drug, conspiracy, aiding, abetting, bank fraud and/or money laundering
laws may include prison, fines, and seizure/forfeiture of property used in connection with cannabis activities, including proceeds derived
from such activities.
We sell our products through
third-party retailers and resellers which do not exclusively sell to the cannabis industry, however, it is evident to us that the movement