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NET ELEMENT, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

August 14, 2014

The following discussion should be read and evaluated in conjunction with the unaudited condensed consolidated financial statements and notes thereto contained in this Report and with the discussion under "Forward-Looking Statements" on page 2 at the beginning of this Report and the Risk Factors set forth in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 and in Part II, Item 1A of this Report.



Overview; Recent Developments

Results of Operations for the Three Months Ended June 30, 2014 Compared to the Three Months Ended June 30, 2013

We reported net income of $1,347,769 or $.04 per share, for the three months ended June 30, 2014 as compared with a net loss of ($20,231,697) or $(0.72) per share, for the three months ended June 30, 2013. Income from continuing operations (including income attributable to the non-controlling interest) for the three months ended June 30, 2014 was $1,347,769 or $.04 per share as compared to a loss from continuing operations of ($19,978,177) or ($.71) per share for the three months ended June 30, 2013. Our net income for the three months ended June 30, 2014 was primarily the result of gains from restructuring of the MBF debt of $1,596,000, the net effect from Cayman Invest note conversion of $562,908, recovery of $352,993 in mobile operator penalties and a reduction in bad debt allowance of $1,640,111 for aggregator advances in our mobile payment processing business. Net revenues consist primarily of payment processing fees. Net revenues were $4,912,035 for the three months ended June 30, 2014 as compared to $5,607,609 for the three months ended June 30, 2013. The decrease in net revenues is primarily due to the mobile payment processing operation change of its billing system and business development personnel which impacted revenues unfavorably by $666,953. The following table sets forth our sources of revenues for the three month periods ending June 30, 2014 and 2013. For three months ended Increase / Source of Revenues 2014 2013 (Decrease) Credit Card Processing Fees $ 4,573,740$ 4,602,361$ (28,621 ) Mobile Payment Processing 338,295 1,005,248 (666,953 ) Total $ 4,912,035$ 5,607,609$ (695,574 )

Cost of revenues represents direct costs of generating revenues, including commissions, purchases of short numbers, interchange expense and processing fees. Cost of revenues for the three months ended June 30, 2014 was $3,345,087 as compared to $4,133,953 for the three months ended June 30, 2013. The year over year decrease in cost of revenues of $788,866 is primarily a result of decrease of mobile payment processing cost of revenues due to a $370,346 recovery of penalties in the current quarter. 25 Operating expenses totaled $1,629,928 for the three months ended June 30, 2014, as compared to operating expenses of $21,096,401 for the three months ended June 30, 2013. Total operating expenses for the three months ended June 30, 2014 consisted of general and administrative expenses of $2,545,552, recovery of provision for loan losses of $1,540,415 and depreciation and amortization expense of $624,790. For the three months ended June 30, 2013, general and administrative expenses were $3,486,950, or 17% of total operating expenses. Loan losses for the three months ended June 30, 2013 were $5,792,487 and depreciation and amortization was $616,964. The components of our general and administrative expenses are discussed below. General and administrative expenses were $2,545,552 for the three months ended June 30, 2014 as compared to $3,486,950 for the three months ended June 30, 2013. General and administrative expenses for the three months ended June 30, 2014 and 2013 consisted of operating expenses not otherwise delineated in our Condensed Statements of Operations and Comprehensive Loss, including non-cash compensation expense, salaries and benefits, professional fees, rent, filing fees and other expenses required to run our business, as follows: Three Months Three Months Ended June 30, Ended June 30, Variance Category 2014 2013 Increase/(Decrease) Non-cash compensation expense $ 700,468$ 150,000 $ 550,468 Salaries, benefits, taxes and contractor payments 814,100 1,112,425 (298,325 ) Professional fees 743,778 1,257,538 (513,760 ) Rent 118,356 180,233 (61,877 ) Other expenses 168,850 786,754 (617,904 ) Totals $ 2,545,552$ 3,486,950 $ (941,398 ) Salaries, benefits, taxes and contractor payments were $814,100 for the three months ended June 30, 2014 as compared to $1,112,425 for three months ended June 30, 2013, representing a decrease of $298,325 as follows: Salaries Salaries and and benefits Benefits for the for the three Three months Months Variance ended June Ended June (Increase) / Group 30, 2014 30, 2013 Decrease Net Element (Corporate) $ 342,734$ 223,022$ 119,712 Yapik 0 - 0 Music 0 2,084 (2,084 ) NetLab 53,887 213,825 (159,938 ) TOT GROUP 310,742 454,410 (143,668 ) OOO Net Element Russia 106,737 219,084 (112,347 ) Total $ 814,100$ 1,112,425$ (298,325 ) The primary reasons for the decrease in salaries was the decrease in salaries in NetLabs in the amount of $159,938 due to cost cutting measures and the elimination of salaries in Music in the amount of $182,089 due to the divesture of Music in third quarter of 2013, offset by the inclusion of $242,200 of salaries from TOT Payments (f/k/a Unified Payments, LLC) and Aptito, which were acquired subsequent to June 30, 2013. Professional fees were $743,778 for the for three months ended June 30, 2014 as compared to $1,257,538 for the three months ended June 30, 2013, representing a decrease of $513,760 as follows: Three months Three months Variance ended June 30, ended June 30, Increase / 2014 2013 (Decrease) General Legal $ 42,819$ 391,826$ (349,007 ) SEC Compliance Legal Fees 75,000 105,689 (30,689 ) Accounting and Auditing 114,680 383,876 (269,196 ) Tax Compliance and Planning 16,800

7,100 9,700 Consulting 494,479 369,047 125,432 Total $ 743,778$ 1,257,538$ (513,760 ) The most significant decreases in professional fees were attributable to general legal fees ($349,007), accounting / auditing fees ($269,196), SEC Compliance and Legal ($30,689) while there was an increase in consulting ($125,432). General legal expenses decreased $349,007 for three months ended March 31, 2014 versus the three months ended March 31, 2013 primarily due to a settlement of fees for amounts less than accrued in prior periods. During the three months ended June 30, 2013 we also used additional outside legal counsel to assist in the reorganization of the Company after its merger transaction with Net Element. Accounting and auditing fees were $269,196 lower because the Company had additional work related to the mergers and acquisitions and deconsolidation during the three months ended June 30, 2013. 26 Other general and administrative expenses were $168,851 for the three months ended June 30, 2014 as compared to $786,754 in other expenses for the three months ended June 30, 2013, representing a decrease of $617,903. The primary reason for the decrease was due to a $463,857 decrease in foreign currency transaction losses. We recorded a net bad debt recovery for provision for bad debts of $1,540,415 for the three months ended June 30, 2014, which consisted of a favorable adjustment to the bad debt allowance of $1,640,111, associated with Russian operations and net ACH rejects of ($99,696) in the normal course of operations. We had $406,585 for bad debts and unrecoverable advances for the three months ended June 30, 2013 due to a provision for advances to aggregators. Depreciation and amortization expense consists of depreciation expense on fixed assets in service and the amortization of merchant portfolios, client acquisition costs, IP software, intellectual property and employee non-compete agreements. Depreciation and amortization expense was $624,790 for the three months ended June 30, 2014, as compared with $616,964 for the three months

ended June 30, 2013. Total interest expense, net for the three months ended June 30, 2014 amounted to $1,770,255 versus $920,353 of interest expense, net for the three months ended June 30, 2013. The increase was primarily due to the interest recognized on amortizing the discounts on the Cayman Invest financing, which amounted to $1,043,844, offset by a $194,055 decrease interest as a result of restructuring the MBF Note and repayment of the RBL loans in April. For the three months ended June 30, 2014, we recorded a gain on the change in fair value on the beneficial conversion derivative in the amount of $5,568,158 as a result of the conversion of the Cayman Invest loan to common stock. This was offset by a loss on debt payoff of the Cayman Invest loan in the amount of ($3,962,406) primarily due to the write-off of the remaining debt discount on the loan. There was no similar activity in 2013. Additionally, we had a $1,596,000 gain for the three months ended June 30, 2014 on the restructuring of the MBF loan, primarily due to the cancellation of $1,800,000 of debt, reducing the principal balance to $3,000,000, in exchanged for stock worth $204,000 at the date of the exchanged. The gain on debt restructure was $0 for the three months ended June 30, 2013. We recognized a loss of $28,320 for the three months ended June 30, 2014 due to the disposal of obsolete assets. There were no disposals during the three months ended June 30, 2013.



We had other expense, in the amount of $6,394 and $5,809 due to foreign taxes, for the three months ended June 30, 2014 and 2013 respectively.

The net loss attributable to noncontrolling interests amounted to $12,965 for the three months ended June 30, 2014 as compared to $570,730 noncontrolling loss for the three months ended June 30, 2013. The $12,965 was attributed to TOT Group's Aptito subsidiary. The noncontrolling interest reflects the results of operations of subsidiaries that are allocable to equity owners other than the Company.



Results of Operations for the Six Months Ended June 30, 2014 Compared to the Six Months Ended June 30, 2013

We reported a net loss of $2,245,559 or $.07 per share, for the six months ended June 30, 2014 as compared with a net loss of $23,465,528 or $0.83 per share, for the six months ended June 30, 2013. Loss from continuing operations (including loss attributable to the non-controlling interest) for the six months ended June 30, 2014 was $2,245,559 or $.07 per share as compared to a loss from continuing operations of $22,841,066 or $.81 per share for six months ended June 30, 2013. Net revenues consist primarily of payment processing fees. Net revenues were $9,755,514 for the six months ended June 30, 2014 as compared to $6,475,759 for the six months ended June 30, 2013. The increase in net revenues is primarily due to six months of activity in 2014 as compared to 2.5 months of activity in 2013 for TOT Payments processing fees. In addition, we earned $1,561,151 of revenue from its former First Data Portfolio during the six months ended June 30, 2013. The income from this portfolio was lost in the third Quarter of 2013 due to contractual issues. This loss of revenue was partially offset by growth of our current portfolios. The following table sets forth our sources of revenues for the six month periods ended June 30, 2014 and 2013. 27 For the six months ended Increase / Source of Revenues June 30, 2014 June 30, 2013 (Decrease) Credit Card Processing Fees $ 8,668,620$ 6,461,284$ 2,207,336 Mobile Payment Processing 1,086,894 14,475 1,072,419 Total $ 9,755,514$ 6,475,759$ 3,279,755

Cost of revenues represents direct costs of generating revenues, including commissions, purchases of short numbers, interchange expense and processing fees. Cost of revenues for the six months ended June 30, 2014 was $6,873,580 as compared to $4,409,500 for the six months ended June 30, 2013. The year over year increase in cost of revenues of $2,464,080 is primarily a result of six months of operation in 2014 versus two and a half months of operation in 2013 offset by a $379,307 decrease of Russian costs due to a recovery of penalties in the current quarter. Operating expenses totaled $5,465,518 for the six months ended June 30, 2014, as compared to total operating expenses of $24,317,521 for the six months ended June 30, 2013. Total operating expenses for the six months ended June 30, 2014 consisted of general and administrative expenses ($5,687,731), provision of loan losses $(1,438,704) and depreciation and amortization ($1,216,491). For the six months ended June 30, 2013, general and administrative expenses were $6,265,775, or 26 % of total operating expenses. Loan losses for the six months ended June 30, 2013 were $6,199,072 and depreciation and amortization was $652,674. The components of our general and administrative expenses are discussed below. General and administrative expenses were $5,687,731 for the six months ended June 30, 2014 as compared to $6,265,775 for the six months ended June 30, 2013. General and administrative expenses for the six months ended June 30, 2014 and 2013 consisted of operating expenses not otherwise delineated in our Condensed Statements of Operations and Comprehensive Loss, including non-cash compensation expense, salaries and benefits, professional fees, rent, filing fees and other expenses required to run our business, as follows: Six months Six months ended ended Increase / Category June 30, 2014 June 30, 2013 (Decrease)

Non-cash compensation expense $ 752,518$ 150,000$ 602,518 Salaries, benefits, taxes and contractor payments 1,497,304

1,832,290 (334,986 ) Professional fees 1,397,017 2,388,278 (991,261 ) Rent 196,830 294,088 (97,258 ) Other expenses 1,844,062 1,601,119 242,943 Totals $ 5,687,731$ 6,265,775$ (578,044 ) Salaries, benefits, taxes and contractor payments were $1,497,304 for the six months ended June 30, 2014 as compared to $1,832,290 for the six months ended June 30, 2013, representing a decrease of $334,986 as follows: Salaries and Salaries and benefits benefits for the for the six months six months Variance ended ended Increase / Group June 30, 2014 June 30, 2013 (Decrease) Net Element (Corporate) $ 626,648$ 438,768$ 187,880 Yapik 0 6,300 (6,300 ) NetLab 134,678 475,055 (340,377 ) TOT GROUP 658,552 454,410 204,142 OOO Net Element Russia 77,426 457,757 (380,331 ) Total $ 1,497,304$ 1,832,290$ (334,986 ) The primary reasons for the decrease in salaries are the decrease in salaries in NetLabs in the amount of $340,377 is due to cost cutting measures and the elimination of salaries in Music in the amount of $182,089 due to the divesture of Music in third quarter of 2013, offset by an increase of $242,200 of salaries from TOT Payments (f/k/a Unified Payments, LLC) and Aptito, which were acquired subsequent to March 31, 2013. 28



Professional fees were $1,397,017 for the six months ended June 30, 2014 as compared to $2,388,278 for the six months ended June 30, 2013, representing a decrease of $991,261 as follows:

Six months Six months Variance ended ended Increase / June 30, 2014 June 30, 2013 (Decrease) General Legal $ (83,946 )$ 749,683$ (833,629 ) SEC Compliance Legal Fees 85,000 293,178 (208,178 ) Accounting and Auditing 214,980 785,133 (570,153 ) Tax Compliance and Planning 23,200 18,391 4,809 Consulting 1,157,783 541,893 615,890 Total $ 1,397,017$ 2,388,278$ (991,261 ) The most significant decreases in professional fees were attributable to general legal fees of $833,629, accounting / auditing fees of $570,153, SEC Compliance and Legal fees of $208,178 offset by an increase in consulting fees of $615,890. General legal expenses decreased $833,629 for six months ended June 30, 2014 versus the six months ended June 30, 2013 primarily due to a settlement of fees for amounts less than accrued in prior periods. During the six months ended June 30, 2013 we used additional outside legal counsel to assist in the reorganization of the Company after its merger transaction with Net Element. Accounting and auditing fees were $570,153 lower as we had additional work related to the mergers and acquisitions and deconsolidation during the six months ended June 30, 2013. Other general and administrative expenses were $1,844,061 for the six months ended June 30, 2014 as compared to $1,601,119 in other expenses for the six months ended June 30, 2013, representing an increase of $242,943. The primary reason for the increase is a $627,260 increase in foreign currency transaction losses, offset by decrease in Net Element Russia's expenses primarily due to cutting web development costs. We recorded a recovery in the provision for bad debts of $1,438,704 for the six months ended June 30, 2014 which consisted of a favorable adjustment to the bad debt allowance of $1,640,111 in the second quarter that was associated with Russian operations, offset by net ACH rejects of $201,407 in the normal course of operations. We had $6,199,072 for bad debts and unrecoverable advances for the six months ended June 30, 2013 due to a provision for advances to aggregators. Depreciation and amortization expense consists of depreciation expense on fixed assets in service and the amortization of merchant portfolios, client acquisition costs, IP software, intellectual property and employee non-compete agreements. Depreciation and amortization expense was $1,216,491 for the six months ended June 30, 2014, as compared with $652,674 for six months ended June 30, 2013. The $563,817 increase in depreciation and amortization expense was primarily due having a full six months of operations, instead of 4.5 months in 2013, resulting a larger amount of merchant portfolio amortization, as well as having a greater amount of client acquisition costs. Total interest expense, for the six months ended June 30, 2014 amounted to $2,831,736 versus $1,069,987 of interest expense, net for the six months ended June 30, 2013. The increase was primarily due to additional interest recognized due to amortizing the discounts on the Cayman Invest financing which amounted to $1,043,844, offset by a $193,942 decrease in interest as a result of restructuring the MBF Note and repayment of the RBL loans in April, and operations of Unified Payments, which resulted in interest expense of $624,791 for the six months ended June 30, 2014. In addition, interest expense also included $243,036 of interest on a factoring line that TOT Money has with Alfa Bank.

Interest expense, net of interest income, for the six months ended June 30, 2013, amounted to $652,674, was primarily due to TOT Group's assumption of $20.6 million of indebtedness in connection with its acquisition of the business operations of Unified Payments, which resulted in interest expense of $624,791 for the six months ended June 30, 2014. This includes $366,814 of interest expense on notes payables that had a total balance of $7,354,188 at June 30, 2014 and $448,519 of interest for the loan payable to Georgia Notes, LLC of $11,433,489 at June 30, 2014 (see Note 12 of the accompanying Notes to Condensed Consolidated Financial Statements), and was composed of interest expense incurred on the Alfa Bank factoring line. For the six months ended June 30, 2014, we recorded a gain on the change in fair value on the beneficial conversion derivative in the amount of $5,569,158 as a result of the conversion of the Cayman Invest loan to common stock. This was offset by a loss on debt payoff of the Cayman Invest loan in the amount of ($3,962,406) primarily due to the write-off of the remaining debt discount on the loan. There was no similar activity in 2013. Additionally, we had a $1,596,000 gain for the six months ended June 30, 2014 on the restructuring of the MBF loan, primarily due to the cancellation of $1,800,000 of debt, reducing the principal balance to $3,000,000, in exchanged for stock worth $204,000 at the date of the exchanged. There was no similar activity on 2013. We recognized a loss of $28,320 for the six months ended June 30, 2014 due to the disposal of assets. There were no disposals during the six months ended

June 30, 2013.



We had other expense, in the amount of $46,326 and $90,359 due to foreign taxes, for the six months ended June 30, 2014 and 2013, respectively.

29 The net loss attributable to noncontrolling interests amounted to $41,655 for the six months ended June 30, 2014 as compared to net income of $570,542 for the six months ended June 30, 2013. The $41,655 was primarily attributed to TOT Group's Aptito subsidiary. The noncontrolling interest of $570,542 for the six months ended June 30, 2013 was primarily comprised of TOT Group ($576,437) partially offset by a gain of $6,165 in Yapik. The noncontrolling interest reflects the results of operations of subsidiaries that are allocable to equity owners other than the Company. Discontinued Operations



For the three and six months ended June 30, 2013, we recorded a loss of $253,520 and $624,462, respectively, net of tax, from discontinued operations that primarily related to the divesture of its Openfilm, Legal Guru, Motorsport, Splinex and OOO Music1 subsidiaries.

Liquidity and Capital Resources

Our total assets at June 30, 2014 were approximately $16.6 million, a decrease of approximately $5.9 million from our total asset balance of approximately $22.5 million at December 31, 2013. This decrease is mainly attributable to losses sustained and repayment of borrowings.

At June 30, 2014, we had total current assets of approximately $6.5 million, including approximately $1.3 million of cash, $4.4 million of accounts receivable and $0.8 million of prepaid expenses and other assets. At December 31, 2013, we had total current assets of approximately $12.7 million, including approximately $0.1 million of cash, $10.6 million of accounts receivable, $1.1 million of advances to aggregators and $0.8 million of prepaid expenses and other assets. Our cash balance at June 30, 2014 was approximately $1.3 million, compared with a cash balance of approximately $0.1 million at December 31, 2013. The $1.2 million increase in our cash balance generally is attributable to positive operating cash flow activities, favorable impact on foreign currency translation from the functional currency of our Russia operations to our reporting currency offset by cash used in investing and financing activities. The operating cash inflows of approximately $3.2 million were mainly driven by collections in accounts receivable and aggregator advances of approximately $6.8 million offset by the net loss of $2.2 million. Cash flows used in investing activities used to purchase credit card portfolios were ($1.3) million for the six months ended June 30, 2014 as compared to cash flows provided by investing activities of $4.5 million for the six months ended June 30, 2013. The cash provided by investing activities for the six months ended June 30, 2013 was primarily due to collection from notes receivable. The financing cash flow activities of approximately ($3.7) million for the six months ended June 30, 2014 was primarily due to $8.9 million of proceeds from Cayman Invest loan offset by repayment of our factoring line in Russia as the facility expired on May 20, 2014 and $3.0 million repayment of loans from RBL ($2.5 million), MBF ($0.2 million) and Georgia Notes ($0.3 million). Net cash used by financing activities was $1.8 million for the six months ended June 30, 2013. Cash used for the repayments of notes was $5.2 million offset by cash provided through the release of $2.0 million in restricted cash, $2.0 million of cash provided from financing from K-1 loan and $1.0 million for cash provided by financing activities of discontinued entities. The $1.0 million of cash provided from financing activities of discontinued operations was due to the reduction in related party receivables in connection with the divesture of entertainment assets. We believe that our existing cash balance in connection with available funding sources will be sufficient to fund our planned operations through the remainder of 2014. We have reduced our operating costs and we continue to build portfolio cash flow through acquisitions and organic growth. The inability to timely receive $2.3 million subscription receivable may impact our ability to fully implement our business plan.



We also continue to develop our own mobile payment processing system and infrastructure. Previously we used and relied upon the payment processing systems of SDSP Group in Russia. Our arrangement was terminated unexpectedly with the onset of legal action by OOO-RM Invest (See Managements Report on Internal Control).

Effective June 30, 2014, we obtained a credit facility to borrow up to $10,000,000 from RBL Capital Group. As a result of this transaction a $11,200,000 convertible note was converted into approximately 5.6 million shares of common stock (see note 12).

We had a 300 million Ruble ($9.8 million) line of credit with Alfa-Bank, which expired May 2014. We do not plan to renew this facility.

We also had a 300 million Ruble ($9.8 million) factoring agreement with Alfa-Bank which expired May 2014. We are in the process of renewing this factoring facility. The inability to renew or replace this facility could impact our ability to fully execute our business plan.

Off-balance sheet arrangements

At June 30, 2014 we did not have any off-balance sheet arrangements as defined in Item 303(a) (4) of Regulation S-K.

Recently Issued and Adopted Accounting Guidance

In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09 ("ASU 2014-09"), Revenue from Contracts with Customers (Topic 606). Under ASU 2014-09, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 will be effective for the Company for annual reporting periods beginning after December 15, 2016 and early application of ASU 2014-09 is not permitted for public companies. The Company is evaluating ASU 2014-09 to determine if this guidance will have a material impact on the Company's condensed consolidated financial statements.



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