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VISUALANT INC - 10-K/A - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

January 24, 2014

Overview We were incorporated under the laws of the State of Nevada on October 8, 1998 with authorized common stock of 200,000,000 shares at $0.001 par value. On September 13, 2002 , 50,000,000 shares of preferred stock with a par value of $0.001 were authorized by the stockholders. There are no preferred shares issued and the terms have not been determined. On August 12, 2013 our articles of incorporation were amended to increase the number of our authorized shares of common stock to 500,000,000. Our executive offices are located in Seattle, Washington . The current focus of our business is our ChromaID technology. We have invented a way to shine light at a material (solid surface, liquid, or gas) and measure the amount of light that is reflected back. The pattern of this reflected light is compared to other patterns we have captured and this allows us to identify, detect, or diagnose materials that cannot be identified by the human eye. We refer to this pattern of reflected light as a ChromaIDô. We design ChromaID Scanner devices made with electronic, optical, and software parts to produce and capture the light. Our first product, the ChromaID F12 Lab Kit, scans and identifies solid surfaces. We are marketing this product to customers who are considering licensing the technology. Target markets include, but are not limited to, commercial paint manufacturers, pharmaceutical equipment manufacturers, process control companies, currency paper and ink manufacturers, security card, reader, and scanner manufacturers, food processing, and electronic gaming. We have not yet generated any revenues from the sale of our ChromaID products. Our wholly owned subsidiary, TransTech Systems, Inc. , based in Aurora, Oregon , is a distributor of products, including systems solutions, components and consumables, for employee and government identification, document authentication, access control, and radio frequency identification. TransTech provides these products and services, along with marketing and business development assistance, to a growing channel of value-added resellers and system integrators throughout North America . To date, the majority of the Company's revenues have been generated by our TransTech subsidiary. TransTech provides its channel partners pre-and post-sales support. Technical Services covers training and installation support, in-warranty repair, out of warranty repair, and spares programs. Our Customer Service team provides full sales, configuration, and logistics services. An increasing number of manufacturers are turning to TransTech Systems for channel development and introduction of their products to our market space. On November 11, 2013 , we entered into a Services and License Agreement with Invention Development Management Company, L.L.C. , a Delaware limited liability company. IDMC is affiliated with Intellectual Ventures , which collaborates with inventors, partners with pioneering companies and invests both expertise and capital in the process of invention. On June 10, 2013 , we entered into a Purchase Agreement, Warrants, and Registration Rights Agreement with Special Situations Technology Funds and forty other accredited investors, pursuant to which we issued 52,300,000 shares of common stock at $0.10 per share for a total of $5,230,000 , which amount includes the conversion of $500,000 in outstanding debt of the Company owed to one of its officers. As part of the transaction, which closed on June 14, 2013 , we issued to the investors (i) five year Series A Warrants to purchase a total of 52,300,000 shares of common stock at $0.15 per share; and (ii) five year Series B Warrants to purchase a total of 52,300,000 shares of common stock at $0.20 per share. In addition, GVC Capital LLC , the placement agent in that transaction, was issued five-year warrants to purchase a total of 5,230,000 shares of common stock at $0.10 per share. The transaction was entered into to strengthen our balance sheet, complete the purchase of our TransTech subsidiary, and provide working capital to support the rapid movement of our ChromaID technology into the marketplace. We have a Joint Development Agreement through December 31, 2013 with Sumitomo Precision Products Co., Ltd., which focuses on the commercialization of the ChromaIDô technology as well as a License Agreement providing Sumitomo with an exclusive license of the ChromaIDô technology in identified Asian territories. Sumitomo is publicly traded in Japan and has operations in Japan , United States , China , United Kingdom , Canada and other parts of the world. 21 -------------------------------------------------------------------------------- To date, we have been issued six patents by the United States Office of Patents and Trademarks . See page 5 for more detailed information regarding our patents and our business. RESULTS OF OPERATIONS The following table presents certain consolidated statement of operations information and presentation of that data as a percentage of change from year-to-year. (dollars in thousands) Year Ended September 30, 2013 2012 $ Variance % Variance Revenue $ 8,573 $ 7,924 $ 649 8.2 % Cost of sales 6,717 6,344 373 -5.9 % Gross profit 1,856 1,580 276 17.5 % Research and development expenses 1,169 177 992 -560.5 % Selling, general and administrative expenses 4,581 3,625 956 -26.4 % Operating loss (3,894 ) (2,222 ) (1,672 ) -75.2 % Other income (expense): Interest expense (173 ) (464 ) 291 62.7 % Loss on purchase of outstanding warrants (1,150 ) (500 ) (650 ) -130.0 % Gain on extinguishment of debt - 394 (394 ) -100.0 % Loss on change- derivative liability warrants (1,449 ) - (1,449 ) -100.0 % Other income 31 37 (6 ) -16.2 % Total other expense (2,741 ) (533 ) (2,208 ) -414.3 % Loss before income taxes (6,635 ) (2,755 ) (3,880 ) -140.8 % Income taxes - current benefit (30 ) (29 ) (1 ) -3.4 % Net loss (6,605 ) (2,726 ) (3,879 ) -142.3 % Non-controlling interest 17 6 11 -183.3 % Net loss attributable to Visualant, Inc. common shareholders $ (6,622 ) $ (2,732 ) $ (3,890 ) -142.4 % YEAR ENDED SEPTEMBER 30, 2013 COMPARED TO THE YEAR ENDED SEPTEMBER 30, 2012 SALES Net revenue for the year ended September 30, 2013 increased $649,000 to $8,573,000 as compared to $7,924,000 for the year ended September 30, 2012 . The increase was due to license revenue of $667,000 from Sumitomo and sales of $7,906,000 at TransTech. Net revenue for the year ended September 30, 2012 reflected $333,000 from Sumitomo and sales of $7,591,000 at TransTech. Sumitomo paid the Company an initial payment of $1 million under a License Agreement dated May 31, 2012 providing Sumitomo with an exclusive license of our technology in identified Asian territories. This license revenue was fully recognized by May 31, 2013 . The TransTech increase primarily resulted from the release of new products, including radio frequency and asset tracking and kiosk printer products. COST OF SALES Cost of sales for the year ended September 30, 2013 increased $373,000 to $6,717,000 as compared to $6,344,000 for the year ended September 30, 2012 . The increase was due to increased sales and product mix at TransTech. Gross margin was $667,000 for our license revenue and $1,189,000 from TransTech for a total of $1,856,000 as compared to $1,580,000 for the year ended September 30 , 2012.The gross margin was 21.6% for the year ended September 30, 2013 as compared to 19.9% for the year ended September 30, 2012 . The increase relates to the Sumitomo license revenue, offset by a reduction TransTech gross margin from 16.4% to 15.0% related to the release of new products, including radio frequency and asset tracking and kiosk printer products. New products have lower margins during the product launch and until sales increase. RESEARCH AND DEVELOPMENT EXPENSES Research and development expenses for the year ended September 30, 2013 increased $992,000 to $1,169,000 as compared to $177,000 for the year ended September 30, 2012 . The increase was due to expenditures for personnel and suppliers related to the commercialization of Visualant's ChromaID technology and the expenses incurred for the Joint Development Agreement with Sumitomo. 22 -------------------------------------------------------------------------------- SELLING, GENERAL AND ADMINISTRATIVE EXPENSE Selling, general and administrative expenses for the year ended September 30, 2013 increased $956,000 to $4,581,000 as compared to $3,625,000 for the year ended September 30, 2012 . The increase was due to increased legal expenses ( $325,000 ), salaries ( $362,000 ), stock based compensation expenses ( $250,000 ) and other general expenses ( $19,000 ). The increase in legal expense related to increased patent and trademark expenses and corporate legal expense related to financing transactions, the Gemini and Ascendiant transactions and work related to the James Gingo Employment Agreement. The increase in salaries related to the addition of personnel and salary increases for the CEO and CFO. During the year September 30, 2013 , we recorded non-cash expenses of (i) depreciation and amortization of $398,000 ; (ii) issuance of shares and warrants for services and debt conversions of $528,000 ; and (iii) stock based compensation of $250,000 . As part of the selling, general and administrative expenses for the year ended September 30, 2013 , we incurred investor relation expenses of $38,000 and business development expenses of $333,000 . For the year ended September 30, 2012 , we recorded $195,000 in expenses related to the Sumitomo transactions During the year ended September 30, 2012 , we recorded non-cash expenses of $1,196,000 consisting of (i) depreciation and amortization of $356,000 ; (ii) issuance of shares for services of $327,000 and (iii) stock based compensation of $266,000 . OTHER INCOME/EXPENSE Other expense for the year ended September 30, 2013 was $2,741,000 as compared to other expense of $533,000 for the year ended September 30, 2012 . The expenses for the year ended September 30, 2013 included $1,449,000 related to loss on the change in derivative liability for the warrants issued on June 14, 2013 , $1,150,000 loss on the purchase of warrants and additional investment right, $173,000 for interest expense, offset by $31,000 in other income. The other expense for the year ended September 30, 2012 included interest expense of $464,000 , loss on the purchase of warrants and additional investment right of $500,000 , offset by other income of $37,000 and gain on extinguishment of debt of $394,000 . NET LOSS Net loss for the year ended September 30, 2013 was $6,605,000 as compared to a net loss of $2,726,000 for the year ended September 30, 2012 for the reasons discussed above. The net loss for the year ended September 30, 2013 included non-cash expenses of $2,648,000 , including (i) depreciation and amortization of $398,000 ; (ii) issuance of shares and warrants for services and debt conversions of $527,000 ; (iii) stock based compensation of $250,000 ; (iv) loss on derivative liability- warrants of $1,449,000 ; (v) loss on purchase of warrant and additional investment right of $850,000 ; and (vi) other of $17,000 . The net loss for the year ended September 30, 2012 included non-cash expenses of $802,000 , including (i) depreciation and amortization of $356,000 ; (ii) issuance of shares for services and debt conversions of $365,000 ; (iii) stock based compensation of $266,000 ; and (iv) beneficial conversion feature of $216,000 ; offset by other income of $7,000 and gain on extinguishment of debt of $394,000 . LIQUIDITY AND CAPITAL RESOURCES We had cash of $747,000 and net working capital deficit of approximately $760,000 (excluding the derivative liability- warrants of $4,184,000 ) as of September 30, 2013 . We expect losses to continue as we commercialize our ChromaIDô technology. Our cash used in operations for the year ended September 30, 2013 was $(3,504,000) . The net proceeds from the above-referenced Transaction with Special Situations and the other Investors which closed June 14, 2013 , were used in part to pay the obligations discussed previously to: (i) James Gingo to pay the final note payment to James Gingo related to the TransTech stock acquisition, (ii) Gemini Master Fund, Ltd. for the warrant repurchase, (iii) Ascendiant Capital Markets for the option exercise price, and (iv) Gemini Master Fund, Ltd. for the June 30, 2013 payment under the AIR Termination Agreement. The balance of the proceeds from the Transaction will be used by us for technology development, operating expenses and to pay our debts. We entered into the agreements with Gemini and Ascendiant dated January 23, 2013 but made effective as of the date of their execution by the parties to eliminate the potential dilution. This decision was made as part of the funding transaction with accredited investors that closed on June 14, 2013 . We expect to need to obtain additional financing in the future. There can be no assurance that we will be able to secure funding, or that if such funding is available, the terms or conditions would be acceptable to us. If we are unable to obtain additional financing, we may need to restructure our operations, and divest all or a portion of our business. As part of the transaction with accredited investors which closed June 14, 2013 , the Company issued to the investors Series A Warrants for 52,300,00 common shares at $0.15 per share and Series B Warrants for 52,300,000 common shares at $0.20 per share. If fully exercised, the warrants would provide the following liquidity (before fees) to fund the Company's operations: 23 -------------------------------------------------------------------------------- Series A Warrants - up to $7,845,000 and Series B Warrants - up to $10,460,000 . We expect to consider other funding options if the warrants are not exercised or if we experience any delays in the commercialization of our ChromaIDô technology. We have financed our corporate operations and our technology development through the issuance of convertible debentures, the sale common stock, issuance of common stock in conjunction with an equity line of credit, and loans by our Chief Executive Officer. We finance TransTech operations from operations and a Secured Credit Facility with BFI Finance Corp. On December 9, 2008 TransTech entered into a $1,000,000 secured credit facility with BFI Business Finance to fund its operations. On December 12, 2013 , the secured credit facility was renewed for an additional six months, with a floor for prime interest of 4.5% (currently 4.5%), plus 2.5%. The credit facility includes accounts receivable borrowing based on 80% of eligible trade accounts receivable, not to exceed $1,000,000 . The secured credit facility is collateralized by the assets of TransTech, with a guarantee by Visualant , including all assets of Visualant . Visualant believes any default would be satisfied by the assets of TransTech. Availability under this Secured Credit ranges from $0 to $100,000 ( $60,000 currently) on a daily basis. The remaining balance on the accounts receivable line (currently $534,000 ) must be repaid by the time the secured credit facility expires on June 11, 2014 , or the Company renews by automatic extension for the next successive 6 month term. OPERATING ACTIVITIES Net cash used in operating activities for the year ended September 30, 2013 was $3,504,000 . This amount was primarily related to a net loss of $6,605,000 , an increase in inventory of $256,000 and a reduction in deferred revenue of $667,000 , offset by depreciation and amortization and other non-cash expenses of $2,648,000 , an increase in accounts payable and accrued expenses of $383,000 and loss on purchase of warrants and additional investment right of $850,000 . INVESTING ACTIVITIES Net cash used in investing activities for the year ended September 30, 2013 was $12,000 . This amount was primarily related to capital expenditures of $24,000 , offset by proceeds from the sale of equipment of $12,000 . FINANCING ACTIVITIES Net cash provided by financing activities for the year ended September 30, 2013 was $3,121,000 . This amount was primarily related to net proceeds the issuance of common stock of $4,852,000 , proceeds from the line of credit of $309,000 , offset by repayment of debt of $2,028,000 . During year ended September 30, 2013 , we issued the following: 52,300,000 shares of common stock at $0.10 per share for a total of $5,230,000 , which amount includes the conversion of $500,000 in outstanding debt of the Company owed to one of its officers. 19,771,000 shares related to financing transactions with Gemini and Ascendiant that we previously discussed. 993,000 shares to Ascendiant and received $100,000 under the equity line of credit that we previously discussed. We committed to acquire the Gemini warrant, 4,000,000 Ascendiant shares and the Gemini AIR termination rights as discussed above. This decision was made based on the expected closing of the private placement which closed June 14, 2013 and the need to eliminate the dilution under the Gemini and Ascendiant financing transactions. Our contractual cash obligations as of September 30, 2013 are summarized in the table below: Less Than Greater Than Contractual Cash Obligations Total 1 Year 1-3 Years 3-5 Years 5 Years Operating leases $ 182,655 $ 93,608 $ 89,047 $ 0 $ 0 Notes payable 755,023 753,129 1,894 0 0 Capital expenditures 375,000 75,000 150,000 150,000 0 $ 1,312,678 $ 921,737 $ 240,941 $ 150,000 $ 0 24 -------------------------------------------------------------------------------- CRITICAL ACCOUNTING POLICIES AND ESTIMATES The application of GAAP involves the exercise of varying degrees of judgment. On an ongoing basis, we evaluate our estimates and judgments based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies (see summary of significant accounting policies more fully described in Note 2 to the financial statements set forth in this report), the following policies involve a higher degree of judgment and/or complexity: Inventories Inventories consist primarily of printers and consumable supplies, including ribbons and cards, badge accessories, capture devices, and access control components held for resale and are stated at the lower of cost or market on the first-in, first-out ("FIFO") method. Inventories are considered available for resale when drop shipped and invoiced directly to a customer from a vendor, or when physically received by TransTech at a warehouse location. We record a provision for excess and obsolete inventory whenever an impairment has been identified. There is a $10,000 reserve for impaired inventory as of September 30, 2013 and 2012. Derivative Instruments - Warrants The Company issued 104,600,000 warrants in connection with the June 2013 Private Placement of 52,300,000 shares of common stock. The strike price of these warrants is $0.15 to $0.20 per share. These warrants were not issued with the intent of effectively hedging any future cash flow, fair value of any asset, liability or any net investment in a foreign operation. These warrants were issued with a down-round provision whereby the exercise price would be adjusted downward in the event that additional shares of the Company's common stock or securities exercisable, convertible or exchangeable for the Company's common stock were issued at a price less than the exercise price. Therefore, the fair value of these warrants were recorded as a liability in the consolidated balance sheet and are marked to market each reporting period until they are exercised or expire or otherwise extinguished. The proceeds from the Private Placement were allocated between the Common Shares and the Warrants issued in connection with the Private Placement based upon their estimated fair values as of the closing date at June 14, 2013 , resulting in the aggregate amount of $2,494,710 to the Stockholders' Equity and $2,735,290 to the warrant derivative. During 2013, the Company recognized $1,448,710 of other expense resulting from the increase in the fair value of the warrant liability at September 30, 2013 . Revenue Recognition TransTech revenue is derived from other products and services. Revenue is considered realized when the services have been provided to the customer, the work has been accepted by the customer and collectability is reasonably assured. Furthermore, if an actual measurement of revenue cannot be determined, we defer all revenue recognition until such time that an actual measurement can be determined. If during the course of a contract management determines that losses are expected to be incurred, such costs are charged to operations in the period such losses are determined. Revenues are deferred when cash has been received from the customer but the revenue has not been earned. The Sumitomo Precision Products License fee is being recorded as revenue over the life the Joint Development Agreement. We recorded deferred revenue of $0 and $666,667 as of September 30, 2013 and 2012, respectively. There is no SPM revenue during the year ended September 30, 2013 . Stock Based Compensation We have share-based compensation plans under which employees, consultants, suppliers and directors may be granted restricted stock, as well as options to purchase shares our common stock at the fair market value at the time of grant. Stock-based compensation cost is measured by us at the grant date, based on the fair value of the award, over the requisite service period. For options issued to employees, we recognize stock compensation costs utilizing the fair value methodology over the related period of benefit. Grants of stock options and stock to non-employees and other parties are accounted for in accordance with the ASC 505.


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Source: Edgar Glimpses


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