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SCIO DIAMOND TECHNOLOGY CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 19, 2014

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Information included in this Quarterly Report Form 10-Q contains forward-looking statements that reflect the views of the management of the Company with respect to certain future events. Forward-looking statements made by penny stock issuers such as the Company are excluded from the safe harbor in Section 21E of the Securities Exchange Act of 1934. Words such as "expects," "should," "may," "will," "believes," "anticipates," "intends," "plans," "seeks," "estimates" and similar expressions or variations of such words, and negatives thereof, are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. These forward-looking statements are based on assumptions that may be incorrect, and there can be no assurance that matters anticipated in our forward-looking statements will come to pass.

Forward-looking statements are subject to certain risks and uncertainties which could cause actual results to differ materially from those anticipated. Such risk and uncertainties include, without limitation, those described below under Item 1A - Risk Factors and the following: (1) the Company has limited cash resources and if it is not able to obtain further financing required for continuing operations, marketing, product development, and research its business operations will fail, (2) the Company has not generated substantial revenues, and as a result, faces a high risk of business failure, (3) the Company's lack of diversification and dependence on material customers increases the risks associated with the Company's business and an investment in the Company, and the Company's financial condition may deteriorate rapidly if it fails to succeed in developing the Company's business and expanding our customer base, (4) the Company may not effectively execute the Company's business plan or manage the Company's potential future business development, (5) the Company's business could be impaired if it fails to comply with applicable regulations, (6) the Company has had significant turnover in management and may not be able to attract and maintain key management personnel to manage the Company or laboratory scientists to carry out the Company's business operations, which could have a material adverse effect on the Company's business, (7) the market for lab-grown diamond may not develop as anticipated, (8) competition may adversely affect our business, (9) the Company may expend a substantial amount of time and resources in connection with the Securities and Exchange Commission's ("SEC") recent subpoena, potential inquiries or legal actions in connection with its filings with the SEC or otherwise, which may impair the Company's ability to raise capital and to operate its business, and (10) such other risks and uncertainties as have been disclosed or are hereafter disclosed from time to time in the Company's filings with the SEC, including, without limitations described under Risk Factors set forth in Part I, Item 1A of the Company's Form 10-K for the fiscal year ended March 31, 2014.

You are cautioned not to place undue reliance on forward-looking statements. You are also urged to review and consider carefully the various disclosures made in the Company's other filings with the Securities and Exchange Commission, including any amendments to those filings. Except as may be required by applicable laws, the Company undertakes no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

GENERAL Corporate History



We were incorporated on September 17, 2009 in the State of Nevada under the name Krossbow Holdings Corporation ("Krossbow"). Krossbow's original business plan was focused on offsetting carbon dioxide emissions through the creation and protection of forest-based carbon "sinks." Krossbow planned to assess carbon resource potentials, prescribe and implement ecosystem restorations to develop those resources, and thereby generate carbon offset products. However, we have since abandoned that original business plan and restructured our business to focus on man-made diamond technology development. We decided to acquire existing technology and to seek to efficiently and effectively produce man-made diamond. In connection with this change in business purpose, Krossbow changed its name to Scio Diamond Technology Corporation to reflect its new business direction.

On August 5, 2011, Edward S. Adams and Michael R. Monahan acquired control of the Company through the purchase of 2,000,000 shares of the Company's issued and outstanding common stock from Jason Kropp,

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Krossbow's sole director and executive officer at that time, in accordance with a common stock purchase agreement among Mr. Kropp, Mr. Adams and Mr. Monahan. Concurrent with the execution of the stock purchase agreement, Mr. Kropp resigned from all positions with Krossbow, including, but not limited to, that of President, Chief Executive Officer, Chief Financial Officer, Treasurer, Secretary and Director. Mr. Adams currently serves on the Company's Board of Directors and Mr. Monahan also served on the Board until his resignation on June 30, 2013.

On August 5, 2011, the Company executed an Asset Purchase Agreement (the "Scio Asset Purchase Agreement") with another privately-held Nevada corporation that also had the name "Scio Diamond Technology Corporation" ("Private Scio"). Under the terms of the Scio Asset Purchase Agreement, the Company purchased the name "Scio Diamond Technology Corporation" and acquired other rights from Private Scio for 13,000,000 newly issued shares of common stock of the Company. Messrs. Adams and Monahan were directors of Private Scio, and Joseph D. Lancia, our former President and Chief Executive Officer, was an officer of Private Scio, and Messrs. Adams, Monahan and Lancia owned 31.5%, 31.5% and 15.4%, respectively, of Private Scio. Messrs. Adams and Monahan each acquired, directly or indirectly, 4,100,000 shares of our common stock pursuant to the Scio Asset Purchase Agreement, and Mr. Lancia acquired 2,000,000 shares pursuant to the Scio Asset Purchase Agreement.

On August 31, 2011, the Company acquired certain assets of Apollo Diamond, Inc. ("ADI") (the "ADI Asset Purchase"), consisting primarily of diamond growing machines and intellectual property related thereto, for which the Company paid ADI an aggregate of $2,000,000 in a combination of cash and a promissory note to ADI with a September 1, 2012 maturity date. This promissory note had an outstanding balance of $125,000 at March 31, 2012 and was paid in full as of March 31, 2013. In connection with the ADI Asset Purchase, the Company also agreed to provide certain current and former stockholders of ADI qualifying as accredited investors the opportunity to acquire up to approximately 16 million shares of common stock of the Company for $0.01 per share (the "ADI Offering"). Both Mr. Adams, in an executive role, and Mr. Monahan previously served in various capacities with ADI through early 2011.

On June 5, 2012, the Company acquired substantially all of the assets of Apollo Diamond Gemstone Corporation ("ADGC") (the "ADGC Asset Purchase"), consisting primarily of lab-grown diamond gemstone-related know-how, inventory, and various intellectual property, in exchange for $100,000 in cash and the opportunity for certain current and former stockholders of ADGC qualifying as accredited investors to acquire up to approximately 1 million shares of common stock of the Company for $0.01 per share (the "ADGC Offering") with the intent that ADI Offering be conducted substantially concurrently with the ADGC Offering (collectively, the "ADI/ADGC Offering"). Mr. Adams and Mr. Monahan served in various capacities with ADGC through early 2011.

The ADI/ADGC Offering was completed in March 2013 and resulted in the issuance of an aggregate of 16,766,773 shares of the Company's common stock. In December, 2011, the Company began a build-out of its Greenville, South Carolina production facility. Construction was largely completed in March 2012 and equipment was moved from ADI's former facility in Massachusetts to South Carolina over the first calendar quarter of 2012. The Company began initial production with ten diamond growing machines in July 2012.

Since July 2012, the Company has been operational with ten diamond growing machines in our Greenville facility. Through March of 2013, the Company's production was focused on industrial cutting tool products supplied to a single customer. In March 2013, this customer notified the Company that due to the global supply chain restructuring of the ultimate end use of our product that they would not be purchasing additional materials. Subsequent to this, the Company has expanded its product focus to include Gemstone diamond material as well as industrial materials.

On September 16, 2013, the Company entered into a series of agreements with SAAMABA, LLC and S21 Research Holdings (the "Grace Rich Agreements") to form a joint venture ("Grace Rich LTD") with operations in the People's Republic of China ("PRC") to deploy 100 Company designed diamond growing machines. The agreements allow for the expansion of the joint venture to 400 machines. Under the Grace Rich Agreements, the Company has agreed to license its proprietary technology for the manufacture of diamond gemstones of agreed upon specifications. In exchange for the license, the Company will receive licensing and development revenue and a 30% ownership position in the joint venture. In addition to the licensed technology, the Grace Rich Agreements include obligations for the Company to provide and be compensated for technology consulting services to the joint venture

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to support the start-up of operations. The Company does not control the joint venture and is not required to make any on-going funding contributions to the joint venture and our ownership stake cannot be reduced from 30%.

Business Overview



The Company's primary mission is the development of profitable and sustainable commercial production of its diamond materials, which are suitable for known, emerging and anticipated industrial, technology and consumer applications. The Company intends to pursue progressive development of its core diamond materials technologies and related intellectual property that the Company hopes will evolve into product opportunities across various applications. We believe these opportunities may be monetized though a combination of end product sales, joint ventures and licensing arrangements with third parties, and through continued development of intellectual property. Anticipated application opportunities for the Company's diamond materials include the following: precision cutting devices, diamond gemstone jewelry, power switches, semiconductor processors, optoelectronics, geosciences, water purification, and MRI and other medical science technology.

As of June 30, 2014, nearly all of the Company's production capacity is being sold for use in precision cutting devices and gemstone materials. As of June 30, 2014 we had generated $2,754,427 in net revenue since inception. To date, over 60% of our product has been sold overseas and 100% of these sales have been to external customers. In the future, we expect continued development of an international market for our diamond materials.

RESULTS OF OPERATIONS



Three Month Period Ended June 30, 2014 Compared to the Three Month Period Ended June 30, 2013

During the three months ended June 30, 2014, we recorded net revenue of $454,338, compared to $258,980 in net revenue during the three months ended June 20, 2913. The increase in revenue is primarily due to the Company receiving $375,000 in development fees from the joint venture during the three months ended June 30, 2014 that were not in the prior period. Product revenues for the three months ended June 30, 1014 were $79,338 versus $258,980 in the prior period due to reduced sales and lower product prices during the three months ended June 30, 2014. We expect product revenues to increase as the fiscal year continues.

Cost of goods sold was $374,423 for the three months ended June 30, 2014 versus $694,110 for the three months ended June 30, 2013. This decrease was due to reduced product sales and lower direct and indirect labor expenses included in cost of goods sold during the three months ended June 30, 2014 versus the three months ended June 30, 2013. Although cost of good sold has decreased, we still have not attained operating maturity that allows us to predictably tie the quarterly changes in cost of good sold to revenue. We incurred a net amount of $260,235 in professional and consulting fees during the three months ended June 30, 2014. This figure includes reductions of $343,556 related to the reversal of expenses from the Settlement Agreement and a reduction of $82,650 for payments made for past legal fees by our insurance carrier. Without these adjustments, professional and consulting fees were $686,441 compared to $514,362 for the three months ended June 30, 2013. This increase in fees is the result of increased legal expenses. With the Settlement Agreement, the Company anticipates that future legal expenses will be reduced. Salary and benefit expenses including direct and indirect labor costs recorded in cost of goods sold were $493,773 during the three months ended June 30, 2014 and $411,891 during the three months ended June 30, 2013. This increase of $81,882 is the result of the Company accruing $275,000 as expected executive severance expenses which more than offsets reductions from lower headcount during the three months June 30, 2014 versus the three months ended June 30, 2013.

Depreciation expense of $155,040 and $172,352 was recorded in cost of goods sold during the three months ended June 30, 2014 and 2012, respectively.

We have continued to generate limited revenue to offset our expenses, and so we have incurred net losses. Our net loss for three month period ended June 30, 2014 was $1,008,227, compared to a net loss of $1,543,196 during the three months ended June 30, 2013. Our net loss per share for the three month period ended June 30, 2014 was $(0.02) per share, compared to a net loss per share of $(0.03) for the three months ended June 30, 2013. The

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weighted average number of shares outstanding was 50,697,993 and 48,316,097, respectively, for the three month periods ended June 30, 2014 and 2013.

FINANCIAL CONDITION



At June 30, 2014, we had total assets of $12,352,190, compared to total assets of $12,850,139 at March 31, 2014. We had cash of $2,046 at June 30, 2014 compared to cash of $47,987 at March 31, 2014.

Total liabilities at June 30, 2014 were $3,392,800, compared to total liabilities of $2,920,722 at March 31, 2014. Total liabilities at June 30, 2014 were comprised primarily of accounts payable, accrued expenses, customer deposits and notes payables. The increase in total liabilities is primarily due to our increased accounts payable. Accounts payable increased $365,325 largely due to accrued professional fees for legal services.

The Company had negative working capital (defined as current assets less current liabilities) of $(3,022,728) at June 30, 2014 versus $(2,402,369) at March 31, 2014. This decrease in working capital resulted from the Company's increase in current liabilities including accounts payable, accrued expenses and notes payable and the decrease in current assets including cash and prepaid expenses during the three months ended June 30, 2014.

Total shareholders' equity was $8,959,390 at June 30, 2014, compared to $9,929,390 at March 31, 2014. Shareholders' equity decreased $970,027 during the period due to our operating net loss offset by additional paid in capital from common stock issued for services.

CASH FLOWS Operating Activities



We have not generated positive cash flows from operating activities. For the three months ended June 30,2014, net cash flows used in operating activities were $(94,073) compared to $(484,494) for three months ended June 30, 2013. The net cash flow used in operating activities for the three months ended March 31, 2014 consists primarily of a net loss of $(1,008,227) offset by depreciation and amortization of $410,322, a decrease in other receivables of $89,192, increases in accounts payable of $365,325 and accrued expenses of $78,816, net increases in other current assets of $(103,075), and a net decrease in other current liabilities of $(21,337).

Investing Activities



For the three month periods ended June 30, 2014 and 2013, net cash flows used in investing activities were $13,152, and $15,407, respectively. These amounts consist of the purchase of property, plant and equipment and comparable for both periods since continue operations has not required substantial additional capital investment.

Financing Activities



We have financed our operations primarily through the issuance of equity and debt securities. For the three month periods ended June 30, 2014 and June 30, 2013, we generated $61,284 and $890,129, respectively, from financing activities. The $61,284 generated during the three months ended June 30, 2014 represent advances on the Platinum note for interest payable on the facility.

LIQUIDITY AND CAPITAL RESOURCES

We expect that working capital requirements will continue to be funded through a combination of our existing funds, further issuances of securities, and future credit facilities or corporate borrowings. Our working capital requirements are expected to increase in line with the growth of our business. Effective June 21, 2013, we entered into a $1,000,000 secured credit facility to provide near-term liquidity for working capital requirements. This credit facility was increased by an additional $500,000 of borrowing capacity on October 11, 2013 as described in Item 1, Note 3 - NOTES PAYABLE. The Platinum loans matured on June 20, 2014 and the Company went into default status on the loans. To date, Platinum has not taken any action related to this default, including adjusting the interest rate, as the Company continues to pursue additional financing alternatives.

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Existing cash of $2,046 as of June 30, 2014, is not adequate to meet our current obligations or fund our operations over the next fiscal year ending March 31, 2015. As of June 30, 2014, we had no additional lines of credit or other bank financing arrangements other than as described above. Generally, we have financed operations through June 30, 2014 through the proceeds of sales of our common stock and borrowings under our existing credit facilities. Thereafter, we expect to raise additional capital and generate revenues to meet operating requirements.

On July 15, 2014, the Board of Directors approved the issuance and sale of up to 2,000,000 shares of common stock to accredited investors at a price of $0.30. The Company may raise up to $600,000 from this offering and does not anticipate incurring any material expenses related to the offering. Through August 8, 2014, the Company has issued 750,000 shares under this offering and raised $225,000.

Additional issuances of equity or convertible debt securities will result in dilution to our current stockholders. Such securities might have rights, preferences or privileges senior to our common stock. Additional financing may not be available upon acceptable terms, or at all. If adequate funds are not available or are not available on acceptable terms, we may not be able to take advantage of prospective new business endeavors or opportunities, which could significantly and materially restrict our business operations and could result in the shutdown of operations.

We expect that working capital requirements will continue to be funded through a combination of our existing funds, further issuances of securities, and future credit facilities or corporate borrowings. Our working capital requirements are expected to increase in line with the growth of our business.

MATERIAL COMMITMENTS AND ARRANGEMENTS

On June 21, 2013, the Company entered into a loan agreement with Platinum Capital Partners, LP ("Platinum") providing for a $1 million secured revolving line of credit that the Company may draw on to fund working capital and other corporate purposes. The Company has utilized these funds to fund our ongoing operations. Borrowings under the loan agreement accrue interest at the rate of 18% per annum, payable monthly on or before the last calendar day of each month. The loan agreement also provides for payment of an accommodation fee of up to 10% of the commitment amount as provided in the loan agreement, and payment of a monthly collateral monitoring fee of $2,000 per month for the first six months and $1,000 per month for the last six months of the term of the loan agreement. The loan agreement contains a number of restrictions on our business, including restrictions on our ability to merge, sell assets, create or incur liens on assets, make distributions to our shareholders and sell, purchase or lease real or personal property or other assets or equipment. The loan agreement also contains affirmative covenants and events of default. The Company may prepay borrowings without premium or penalty upon notice to Platinum as provided in the loan agreement. Under a security agreement entered into in connection with the loan agreement, we granted Platinum a first priority security interest in the Company's inventory, equipment, accounts and other rights to payments and intangibles as security for the loan. This credit facility was increased by an additional $500,000 of borrowing capacity on October 11, 2013 as described in Item 1, Note 3 - NOTES PAYABLE. As of June 30, 2014, the total due under these facilities, including accrued fees, was $1,473,345. The credit facility matured on June 20, 2014 and since this date we have been in default on the agreement with Platinum. We are having discussions with Platinum on extending the term of the debt agreements and currently, Platinum has indicated they will not take any action related to this default as we pursue additional funding for our operations.

On September 16, 2013, the Company entered into the Grace Rich Agreements with SAAMABA, LLC and S21 Research Holdings to form a joint venture with operations in the PRC to deploy 100 Scio designed diamond growing machines. The agreements allow for the expansion of the joint venture to over 500 machines. Under the Grace Rich Agreements, the Company has agreed to license its proprietary technology for the manufacture of diamond gemstones of agreed upon specifications. In exchange for the license, the Company will receive licensing and development revenue and a minority ownership position in the joint venture. In addition to the licensed technology, the Grace Rich Agreements include obligations for the Company to provide and be compensated for technology consulting services to the joint venture to support the start-up of operations.

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OFF-BALANCE SHEET ARRANGEMENTS

As of the date of this Quarterly Report, we do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

CRITICAL ACCOUNTING POLICIES



We have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States ("GAAP"). We describe our significant accounting policies in the notes to our audited financial statements filed with our Form 10-K for the fiscal year ended March 31, 2014.

Some of the accounting policies involve significant judgments and assumptions by us that have a material impact on the carrying value of our assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors that we believe to be reasonable under the circumstances. Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates and could materially affect the carrying values of our assets and liabilities and our results of operations.

The following is a summary of the more judgmental estimates and complex accounting principles, which represent our critical accounting policies.

Property, Plant and Equipment



Depreciation of property, plant and equipment is on a straight line basis beginning at the time it is placed in service, based on the following estimated useful lives:

Years Machinery and equipment 3-15 Furniture and fixtures 3-10 Engineering equipment 5-12



Leasehold improvements are depreciated at the lesser of the remaining term of the lease or the life of the asset (generally three to seven years).

Expenditures for major renewals and betterments that extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred.

Intangible Assets



Intangible assets, such as acquired in-process research and development "IPRD" costs, are considered to have an indefinite useful life until such time as they are put into service at which time they will be amortized on a straight-line basis over the shorter of their economic or legal useful life. Management's estimate of useful life of any patents when placed in service is a critical judgment. Management evaluates indefinite life intangible assets for impairment on an annual basis and on an interim basis if events or changes in circumstances between annual impairment tests indicate that the asset might be impaired. The ongoing evaluation for impairment of its indefinite life intangible assets requires significant management estimates and judgment. Management reviews definite life intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. There were no impairment charges as of June 30, 2014.

The Company continues to classify the remaining patent portfolio as IPRD and believes that the IPRD has alternative future use and value. At such time that production begins and commercialization of this portion of the intellectual property portfolio begins, then the segmentation and bifurcation of the remaining IPRD asset to finite-lived commercialized intellectual property assets will be considered. Applicable accounting guidance requires an indefinite life for IPRD assets until such time as the commercialization can be reasonably estimated at which time

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the assets will be available for their intended use. At such time as those requirements are met, we believe that consideration of the legal life of the intellectual property protection should be of considerable importance in determining the useful life. Upon commercialization and determination of the useful life of the intellectual property assets, consideration will be given to the eventual expiration of the intellectual property rights underlying certain critical aspects of our manufacturing process.


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