**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

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** **

**FORM 10-K**

 

**Annual Report Pursuant to Section 13 or 15(d) ofthe**

**Securities Exchange Act of 1934**

 

**Forthe fiscal year ended December 31, 2002**

** **

**CommissionFile Number: 33-7106-A**

 

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** **

**NATURADE, INC**.

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                    |   | **23-2442709**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **14370  Myford Road, Irvine, CA**                              |   | **92606**                             |
|  (Address of principal executive offices)                  |   | (Zip code)                            |

 

Registrant’stelephone number, including area code: **(714) 573-4800**

 

Securitiesregistered pursuant to Section 12(b) of the Act:

**None**

 

Securitiesregistered pursuant to Section 12 (g) of the Act:

**None**

 

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Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past90 days. Yes ý  No o

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. ý

 

As of June 28, 2002, 43,813,494 shares of theregistrant’s Common Stock were outstanding and the aggregate market value ofsuch Common Stock held by non-affiliates as of that date was $170,527 based onthe average of the bid and asked price on that date.

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Act).  Yes oNo ý

 

 

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**TABLEOF CONTENTS**

 
| PART I    |                                                                                            |
|-----------|-------------------------------------------------------------------------------------------------|
|      |                                                                                            |
| Item 1.   | Business                                                                                        |
|      |                                                                                            |
| Item 2.   | Properties                                                                                      |
|      |                                                                                            |
| Item 3.   | Legal Proceedings                                                                               |
|      |                                                                                            |
| Item  4.  | Submission  of Matters to a Vote of Security Holders                                            |
|      |                                                                                            |
| PART II   |                                                                                            |
|      |                                                                                            |
| Item  5.  | Market  for the Registrant’s Common Equity and Related Stockholder Matters                 |
|      |                                                                                            |
| Item 6.   | Selected Financial Data                                                                         |
|      |                                                                                            |
| Item  7.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations     |
|      |                                                                                            |
| Item  7A. | Quantitative  and Qualitative Disclosures About Market Risk                                     |
|      |                                                                                            |
| Item  8.  | Financial  Statements and Supplementary Data                                                    |
|      |                                                                                            |
| Item  9.  | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure           |
|      |                                                                                            |
| PART III. |                                                                                            |
|      |                                                                                            |
| Item 10.  | Directors and  Executive Officers of the Registrant                                             |
|      |                                                                                            |
| Item 11.  | Executive Compensation                                                                          |
|      |                                                                                            |
| Item 12.  | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters |
|      |                                                                                            |
| Item 13.  | Certain Relationships and Related Transactions                                                  |
|      |                                                                                            |
| Item  14. | Controls and Procedures                                                                         |
|      |                                                                                            |
| PART IV.  |                                                                                            |
|      |                                                                                            |
| Item 15.  | Exhibits, Financial Statement Schedules and  Reports on Form 8-K                           |

 

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Forward Looking Information

 

This Annual Reporton Form 10-K contains forward-looking statements within the meaning of thatterm in the Private Securities Litigation Reform Act of 1995 (Section 27A ofthe Securities Act of 1933 and Section 21E of the Securities Exchange Act of1934).  Additional written or oralforward-looking statements may be made by the Company from time to time, infilings with the Securities Exchange Commission or otherwise.  Statements contained herein that are nothistorical facts are forward-looking statements.  In addition, when used herein, the words “anticipates,”“expects,” “intends,” “plans,” variations thereof and similar expressions areintended to identify forward-looking statements.  All such forward-looking statements are made pursuant to the safeharbor provisions of the Private Securities Litigation Reform Act of 1995.

 

Forward-lookingstatements are inherently subject to risks and uncertainties, some of whichcannot be predicted or quantified. Consequently, future events and actualresults could differ materially from those set forth in, contemplated by, orunderlying the forward-looking statements contained in this Annual Report.Statements in this Annual Report on Form 10-K, particularly in “Item 1.Business,” “Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations,” and the “Notes to Financials Statements” describecertain factors that could contribute to or cause such differences, including,but not limited to, unanticipated developments in any one or more of thefollowing areas: the fact that our accountants have expressed doubt about ourability to continue as a going concern, our expectation of further losses, ourdependence on key customers, our need for additional financing and access toborrowing, possible interruptions in our business resulting from the U.S.Government’s response to terrorism, government regulations that could affectour products, labeling or promotion, the pace of technological change, ourdependence on third-party manufacturers, competition, our dependence on keypersonnel, variability of quarterly results, product liability exposure, ourability to identify suitable strategic partners, risks associated with the massmarket, reduced sales in the dietary supplement industry, the effect of adversepublicity, our ability to protect our intellectual property, the rate ofconsumer acceptance of new product introductions, stock price volatility, theeffect of closely controlled stock and other risk factors which may be detailedfrom time to time in the Company’s Securities and Exchange Commission filings.

 

Readers arecautioned not to place undue reliance on any forward-looking statementcontained herein, which speak only as of the date hereof. The Companyundertakes no obligation to publicly release the result of any revisions tothese forward-looking statements that may be made to reflect events orcircumstances after the date hereof or to reflect the occurrence of unexpectedevents.

 

 

NATURADE®, NATURADE TOTAL SOY®, THE DELICIOUS WAY TO GIVE HEART DISEASETHE SHAKETM THE DELICIOUS CHOLESTEROL FIGHTER!®, NATURADE 100% SOYTM, NATURADE100% WHEYTM, NATURADE VEGTM, NATURADE SOY-FREE VEGTM, NATURADE MILK & EGGTM,NATURADE N-R-GTM, NATURADE ORGANIC SOYTM, ALOE VERA 80®, POWER SHAKE®, QUICKFIZZTM, RIBOTEINTM, and EXPEC® are trademarks or service marks of Naturade, Inc..

 

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**PART I**

 

**Item 1. Business**

 

**General**

 

Naturade, Inc.(the “Company” or “Naturade”) was originally founded in 1926. The Company is aleading marketer of scientifically supported natural products formulated toimprove the health and well-being of consumers and sold to supermarkets, massmerchandisers, club stores and drug stores (collectively, the “mass market”),health food stores and natural food supermarkets (collectively, the “healthfood market”) and the military. The Company’s products are generally marketedunder the trademarks Naturade®, Naturade Total Soy® and Aloe Vera 80® and arefound in over 15,000 retail stores throughout the United States. The Companyalso markets its products aggressively in the health food market and massmarket in Canada and selectively in other international markets.

 

Naturade has longheld the leading market share of soy protein booster powders sold throughhealth food distributors. In 2000, Naturade also became the number one brand ofsoy protein powders sold in the mass market. In 2002, Naturade continues to build its lead as the leading brand namein soy protein powders for all trade classes combined. Naturade Total Soy®, itsleading meal replacement brand, was built on the Company’s strong knowledge ofsoy protein and the significant sales and marketing expertise in consumerpackaged goods of the Naturade management team.

 

The Company’s AloeVera 80® brand is widely distributed in virtually all of the over 5,000independent retailers serviced by Naturade’s U.S. health food distributors.Aloe Vera 80® is the only complete line of hair, skin and personal care to usealoe vera gel in place of water as the main ingredient. In addition, theCompany markets all-natural lines of aloe vera gel concentrate drinks, sportsnutrition powders, cough/cold products, laxatives/digestive aids andeffervescent supplements.

 

Naturade has longsought to distinguish itself by bringing new products to market, havingpioneered the soy protein powder category in 1950 and the aloe vera personalcare category in 1980. The Company attributes its inital success in attainingits number one share of natural soy protein powders in the mass market to itsentrepreneurial response to the 1999 FDA announcement of a heart disease healthclaim for soy protein and its ability to quickly develop and launch NaturadeTotal Soy® as a new brand with 16 different stock keeping units (“SKUs”),including ready-to-drink shakes, bars and shake mix powders.  In 2002, the Company undertook a majorinitiative to build its market leadership by offering an improved, bettertasting powder formula and repositioning the product for use in weight loss aswell as for reduced risk of heart disease.

 

On January 2,2002, the Company (i) sold Series B Convertible Preferred Stock andWarrants to Westgate Equity Partners, L.P. for a total of $2.5 million,(ii) issued 36 million shares of Common Stock in exchange for thecancellation of $5.3 million of outstanding debt and 1.3 millionshares of outstanding Series A Convertible Preferred Stock and(iii) amended its bank credit facility. The Series B ConvertiblePreferred Stock is convertible into 13.5 million shares of Common Stock(subject to adjustment) and bears dividends at the rate of 10% per annum. TheWarrants entitle the holder to purchase for $3.5 million additional sharesof Series B Convertible Preferred Stock convertible into 33.6 millionshares of Common Stock (subject to adjustment).  

 

After thecompletion of the Private Equity Transaction, Westgate asserted that theCompany’s representations and warranties concerning the Company’scapitalization in the Purchase Agreement were inaccurate in that they omittedto disclose the fact that certain outstanding promissory notes of the Companyin an amount of $252,345 (the “Convertible Notes”) were convertible into sharesof the Common Stock of the Company at the market price of the Common Stock onthe date of conversion.  ConvertibleNotes in the amount of $50,000 have been converted into 720,392 shares ofCommon Stock to date, and $202,345 in Convertible Notes remain outstanding andwere convertible into 3,372,417 shares as of April 14, 2003.

 

The Company andWestgate have agreed to resolve this dispute by adjusting the conversionformula for the Series B Convertible preferred Stock.  In addition, Westgate and health Holdings have agreed that (i)the Company may issue additional options to purchase up to 1,250,000 shares ofCommon Stock to employees in accordance with the Naturade, Inc. 1998 IncentiveStock Option Plan, and (ii) Health Holdings will grant to Westgate a proxy tovote 1.041 shares of Common Stock owned by Health Holdings for each share ofCommon Stock issued on exercise of the new options.  For a description of this settlement, see “Item 1.Business-Private Equity Transaction.”

 

On April 14,2003, the Company entered into a loan agreement (the “Loan Agreement”) withHealth Holdings and Botanicals, LLC, a principal stockholder of the Company,and David A. Weil, a director and stockholder (the “Lender Group”), pursuant towhich the Lender Group has agreed to lend the Company $450,000 and, subject tothe discretion of the Lender Group, up to an additional $300,000.  All advances under the Loan Agreement bearinterest at the rate of 15% per annum, are due on December 31, 2004, aresecured by substantially all of the assets of the Company, and are subordinatedto the Company’s indebtedness to Wells Fargo Business Credit, Inc. (“Wells Fargo”).  The advances under the Loan Agreement willbe used for the Company for working capital and general corporatepurposes.  For a more completedescription of this transaction, see “Item 1.  Business – Loan Agreement.” In consideration of the extension of credit under the Loan Agreement,Wells Fargo waived all defaults of the Company as of December 31, 2002

 

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under the Credit and Security Agreement dated as of February 27, 2000 and amended the agreement to, among otherthings, reduce the covenants regarding minimum net income and minimum book networth and increased the interest rate. For a description of the amended bank credit facility, see “Item 7.  Management’s Discussion and analysis ofFinancial Condition and Results of Operations — Liquidity.”  

 

**History and Recent Developments**

 

Until 1999, theCompany focused on sales in health food stores and natural supermarkets. InMarch 1998, a new investor group, Health Holdings and Botanicals, LLC(“Health Holdings”), recruited Bill Stewart, a veteran consumer productsleader, as Chief Executive Officer to re-invent Naturade as a multi-channelcompany that could compete effectively in both the health food market and themass market. Under his direction, the Company embarked on an ambitiousrestructuring program, which generated over $8 million in operating losses andcharges related to legal settlements and restructuring in 1998 and 1999, butwhich was intended to build a solid platform for future growth. In 1999,Naturade entered the mass market with the introduction of its first line ofmeal replacement products, Naturade Total Soy®.

 

InOctober 1999, the U.S. Food and Drug Administration (“FDA”) authorized aheart health claim for soy protein that allows qualifying products to claim ontheir label that: “25 grams of soy protein daily, in a diet low in saturatedfat and cholesterol, may reduce the risk of heart disease.” Naturade beganshipping products that prominently featured this claim on the first day allowedby the FDA and believes that it has materially benefited from the FDA decisionthrough increased shelf distribution and increased consumer trials. Naturadecurrently markets 34 different SKUs featuring this claim, including its largestbrand, Naturade Total Soy®.

 

**BusinessStrategy**

 

The mission of theCompany is to market innovative natural products that nourish and improve thehealth and well-being of consumers. Naturade focuses on building consumerbrands that can be marketed in both the mass market and the health food marketand for which there is strong scientific support of efficacy. Naturade’smanagement is committed to profitable growth through the following businessstrategies.

 

***Maintain focus on Naturade Total Soy®***

 

Continued growthof the Naturade Total Soy® brand through communication of both our new weightloss strategy and our core “reduce heart disease” message is the key focus ofour strategy. The Company believes significant growth potential exists in themeal replacement category with over fifty clinical studies demonstrating thatsoy protein reduces cholesterol, while consumer awareness of this importantbenefit remains well below 50%. The FDA, the American Heart Association and theMayo Clinic all support daily intake of 25 grams of soy protein as part of adiet low in saturated fat and cholesterol. Naturade is the only company exploiting the weight loss benefits of soyprotein in the meal replacement category in retail stores.  More than ten human clinical studiesdemonstrate weight management benefits for soy protein as part of a reducedcalorie diet including improved satiety (greater feeling of fullness),increased lean muscle mass and protection against oxidative stress (aparticular concern to people involved in athletic performance).

 

###### ***Excel in relationships withconsumers and retailers***

 

The Company hasused its expertise in consumer packaged goods to build a strong relationshipwith its retail customers. Naturade complements its broad sales and marketingefforts with programs focused on direct-to-consumer communication to generatetrial, cross-promote products and build brand loyalty.

 

***Pursue innovation through science-based new products***

 

Naturade continuesto emphasize new products as a long-term growth strategy.  These include further exploitation of soyprotein’s demonstrated ability to lower cholesterol, support weight loss,reduce bone loss, reduce hot flashes and enhance performance, in addition tofuture products based on other promising health benefits verified by scientificinvestigations. The Company’s marketing and research and developmentdepartments spearhead new product developments, overseeing product formulation,testing and sample production runs carried out by the Company’s third partymanufacturers.

 

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***Focus promotional spending to improve profitability byaccount***

 

Account by accountprofit and loss budgets are maintained to improve the efficiency of promotionalspending.  Spending plans are tied toeach account’s potential and promotional programs are then developed that willoptimize sales growth while limiting Naturade’s brand expense.  In 2002, this effort led to a $775,000reduction in brand expense versus 2001. New distribution is pursued selectively where initial investment instart-up costs has a strong expectation of delivering a near-term payback.  Similarly, management has elected to exitaccounts where minimum profit standards cannot be met.  As a result, Naturade is selling to aconsolidated U.S. account base of approximately 15,000 stores compared toapproximately 33,000 in 2001. Expansion into the Canadian market with astreamlined offering of best selling products is being pursued with the sametargeted spending strategy.

 

***Identify and solicit strategic partners for growth***

 

External growthwill be a new focus for the Company, making use of the resources of Westgateand Health Holdings, our major investors, to help identify beneficial strategicalliances. Although, we are not currently negotiating any such alliances, theeffort to identify additional funding in support of internal growth is ongoing.

 

**Brandsand Product Lines**

 

Approximately 55%of Naturade’s net sales in 2002 were derived from meal replacement products,while 20% of net sales were generated by Naturade’s protein powders, and 12% bysales of aloe vera based products, with private label and other productsaccounting for 13% of net sales. Finally, the emphasis on powders and soyprotein in particular is reflected in the fact that 68% of Naturade’s 2002 netsales came from powder products, of which 83% of such sales are soy proteinbased.

 

Naturade is thenumber one brand in the overall soy protein powder category with an estimatedmarket share of 37%.  In the massmarket, Information Resources, Inc. (“IRI”) reports that Naturade has a 24.5%market share of the soy protein powder category (including Slim Fast) for the52 weeks ended December 29, 2002. IRI reported a 3.9% dollar sales increase for Naturade for this periodand a 1.2% share increase.  Given thenew weight loss positioning for Naturade Total Soy®, Naturade is now includingSlim Fast in its competitive comparison. Naturade’s IRI share for the 52-week period ending December 29, 2002,excluding Slim Fast, was 33.1% as compared to 37.7% for the 52 weeks endedDecember, 2001.  The IRI dataunderstates the overall market in which Naturade competes since it does notinclude sales by major Naturade customers, such as Sam’s Club, Costco, BJ’sWholesale, Wal*mart and health food stores, which carry Naturade Total Soy® butdo not report to IRI.

 

***Meal replacements***

 

Naturade TotalSoy® is the largest Naturade brand and is distributed in virtually all of theretail outlets serviced by Naturade or its distributors. Naturade Total Soy®offers a full line of nutritionally complete meal replacements designed to helpconsumers “reduce cholesterol and manage your weight.” As “the deliciouscholesterol fighter!®” these products help consumers get 25 grams of soyprotein daily by offering a variety of good-tasting products with highconcentrations of soy protein. These products include four shake mix powderproducts (original powder, Naturade Total Soy® Calcium 1000TM, Naturade TotalSoy PLUSTM and Naturade Total SoyTM Menopause ReliefTM, two soy protein bar flavorsand two ready-to-drink flavors. Naturade’s other meal replacement brandsinclude: Naturade Organic SoyTM, the only widely distributed meal replacementpowder made with certified organic ingredients, and two soy protein basednutritional supplement products positioned as energy enhancers, Ribo-teinTM andnew Power Shake®.

 

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***Protein booster and sports nutrition powders***

 

First introducedin 1950, Naturade’s protein boosters are high protein powders with little or nocarbohydrate, which allow consumers to add protein to drinks and foods theyalready prepare at home.  In recentyears, the appeal of these products has broadened to include low carbohydratedieters.  Naturade markets three brandsof protein boosters in which soy protein is the primary ingredient, includingNaturade 100% SoyTM, Naturade VegTM and Naturade N-R-GTM. In addition, the Companyoffers a broad selection of protein booster powders based on alternate proteinsources, including Naturade 100% WheyTM, Naturade Soy-Free VegTM and NaturadeMilk & EggTM. Naturade also offers a complete line of all-naturalsports nutrition products.

 

***Aloe vera-based products***

 

The Company seeksto distinguish itself from its competitors by offering a wider range of aloevera products incuding Aloe Vera 80® products for hair care, facial care, handand body care and bath and cleansing care, as well as an aloe drink line,Naturade concentrated aloe gel drink dietary supplements. These lines are soldalmost exclusively in independent health food stores and natural supermarkets..Naturade Stomach Formula is a best seller in the aloe drinks category throughhealth food distributors and the leading item in the Naturade aloe vera geldrink line. Unlike most competitive juice products, Naturade aloe gel drinksare concentrated, with higher levels of active solids per serving (less water).The line also includes new Naturade Joint Formula with Glucosamine, NaturadeEnergy Formula and Naturade Detox Formula. The Aloe Vera 80® brand is the onlybroad aloe vera-based line of personal care products available in retail storesin which every item in the line uses aloe vera gel in place of water as themain ingredient.

 

***Other products and private label***

 

The Company offersadditional all-natural brands and product lines including laxatives, digestiveaids and cough/cold products and a new line of effervescent supplements, QuickFizzTM.  These are distributed almostexclusively through independent health food stores and natural supermarkets. Inaddition, the Company provides private label products to a limited number of customers.

 

**Industry and Competition**

 

Naturade hassought to position itself for long-term growth by designing products thataddress specific conditions where strong scientific evidence of tangible healthbenefits has created marketing opportunities. There are also a number ofdemographic trends that support the Company’s belief that the current growthfor the categories in which it competes will be long-lived, including thefollowing:

 

•                                          Theaging of the US population

 

•                                          Theneeds and tastes of 76.1 million “baby boomers”

 

•                                          Thehigher disposable income among older consumers

 

•                                          Thetrend towards healthier, more active lifestyles

 

•                                          Theincreasing popularity of preventative/alternative medicines and therapies

 

•                                          Theincreasing number and credibility of scientific studies and clinical trialssupporting the efficacy of non-drug health products

 

•              Thehighly favorable regulatory environment for functional foods and dietarysupplements

 

There can,however, be no assurance that these trends will result in greater sales revenuefor the Company.

 

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Naturade competesin the overall category for natural, nutritional supplement and functional foodproducts. *Nutrition Business Journal*(“NBJ”), a San Diego-based research publication that specializes in thisindustry, estimates that in 2001 sales for the overall “supplement” categorywas $17.6 billion.  Naturadeprimarily competes in the $9.9 billion dollar segment defined by NBJ as SportsNutrition and Weight Loss, that is broken down as follows:

 
|                                |   | **Sales**          |   |                                                                          |
|-------------------------------------|--------|--------------------|--------|-------------------------------------------------------------------------------|
|                                |   | **(In  billions)** |   |                                                                          |
| Sports and Energy Drinks            |   | $                  | 2.9    |                                                                          | (Includes Gatorade and  AllSport) |
| Weight Loss Meal Supplements        |   | 2.0                |   | (Includes Naturade Total Soy® and Slim Fast powders  and ready-to-drink) |
| Weight Loss Pills                   |   | 1.9                |   | (Includes Metabolife and Xenadrine)                                           |
| Sports Powders                      |   | 1.5                |   | (Includes Naturade protein booster/ sports powders)                           |
| Nutrition Bars                      |   | 1.4                |   | (Includes Naturade Total Soy® bars)                                      |
| Sports Pills and Hardcore Beverages |   | 0.2                |   | (Includes hormone precursors)                                                 |
|                                |   | $                  | 9.9    |                                                                          |   |

 

The overallindustry has matured since the passage of the Dietary Supplement Health andEducation Act (“DSHEA”) in 1994, but has experienced significant weakness overthe last four years. For example, sales in the vitamin category have been flat,while sales in the herbal category have experienced double-digit declinessince 1998, following several years of dramatic growth. While these trends arenot expected to change significantly in the near-term, the Company believessignificant opportunities remain within the overall market. Among the mostpromising market segments have been soy protein products, joint health productsand products for women’s health. Naturade has products in each of these areas.

 

The primarysegment in which Naturade competes is the market for soy protein mealreplacements and protein boosters in the mass market and the health foodmarket.  Two brands are majorcompetitors in the mass powder segment, Slim Fast® from Unilever, Inc. andGenisoy® form MLO products, Inc. Naturade holds the leading share in the mass market for soy proteinpowders after including volume from Sam’s Club, Costco, BJ’s Wholesale andWal*Mart.  Many other companies haveentered the category in the last three years but hold only small market shares(less than 7%), including: Health Source (Abbott Labs), Twinlab, Amerifit,Kashi, Balance, EAS, Natrol, Rexall Sundown, Schiff (Weider) and Country Life(Hain). Naturade does not purchase syndicated data for other categories or forthis category in the health food market. Naturade also competes with Genisoy® and Kashi in the health foodsegment where the Company believes that it holds the leading share.  Naturade also competes indirectly withSpiru-tein®, a brand from Nature’s Plus, Inc., in health food stores.  Unlike Naturade, Spiru-tein® does notemphasize soy protein content in marketing its products and positions them asenergy boosters rather than products for weight loss or cholesterol reduction,like Naturade Total Soy®.  Spiru-tein®holds a substantial lead over Naturade’s entries in the energy category, PowerShake® and Ribo-teinTM.

 

While no otherpersonal care brand offers a complete aloe-vera-based line like Aloe Vera 80®,several competitors vie for the natural product consumer’s attention in healthfood stores, including: Jason, Kiss My Face, Avalon, Rachel Perry and Nature’sGate. Other brands offering aloe gel concentrate drinks include Nature’s Gateand Lily of the Desert.

 

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**Sales,Marketing and Distribution**

 

In fiscal 2002,the breakdown of Naturade sales by channel was 47.4% to the mass market, 51.1%to the health food market and 1.5% in international channels. Naturade’sproducts are sold to both the health food market and the mass market using asales management team augmented by independent brokers. Health food sales areprimarily through distributors, while most mass market sales are direct toretailers. Naturade sales and distribution in Canada is handled through asingle distributor. The Company’s major customers by class of trade include:

 

Major Customers byTrade Class

 
|                                      |                                                    |
|-------------------------------------------|---------------------------------------------------------|
| Supermarkets                              | Kroger, Albertson’s,  Safeway, Fred Meyer          |
| Mass  Merchandisers/ Drug Stores          | Wal*Mart, Kmart,  American Drug                         |
| Club  Stores                              | Sam’s Club, Costco,  BJ’s Wholesale           |
| Natural  Supermarkets/ Health Food Stores | Whole Foods, Wild Oats,  The Vitamin Shoppe             |
| Health  Food Distributors                 | Tree of Life, United  Natural Foods, Nature’s Best |

 

Naturade’s directsales force supervises broker sales organizations in the health food market andmass market. While headquarters sales calls are primarily the responsibility ofNaturade’s sales management, follow-up calls and retail activity are carriedout by over 60 health food broker personnel and an additional 50 mass marketbroker personnel. Naturade maintains brokerage agreements with its health foodand mass market brokers throughout the U. S. These agreements have a term ofone year and may be terminated on 30 days prior written notice by eitherparty. In addition, these agreements grant the brokers exclusive territories torepresent Naturade and receive commissions on sales generated in theseterritories. Brokers do not take title to the Company’s products.

 

Naturade sells itsproducts in the health food market through a network of 20 key distributors andapproximately 15 smaller distributors, who together service approximately 5,000retail health food stores and natural supermarkets in the United States. Thesedistributors take title to the Company’s products, combining these productswith other companies’ products to serve the health food stores in theirgeographic area. Eight of these key distributors are divisions of UnitedNatural Foods, Inc. (UNFI), a national health food distributor, whoseaggregate purchases during fiscal 2002 represented approximately 16% of theCompany’s total sales. Seven other distributors are divisions of Tree of Life,Inc, another national health food distributor, whose aggregate purchases during2002 represented approximately 17% of the Company’s total sales. Often theCompany’s direct sales force along with brokers will solicit business fromhealth food stores who then pull the Company’s products from thesedistributors. While each of these national health food distributors arecorporate legal entities, their divisions independently make purchasingdecisions on the Company’s products and are separately invoiced by the Company.Accordingly, in “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations,” the Company treats these divisions as separatecustomers for purposes of determining the top 40 customers.

 

The mass marketproducts are sold directly to mass market retailers or their designateddistributors. One mass market customer, Wal*Mart-Sam’s Clubs, representedapproximately 18% of the Company total sales in 2002. While Wal*Mart and Sam’sClubs are part of a single corporate legal entity, they are independentoperations, have separate buying departments and are separately invoiced by theCompany. Thus, in “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations,” the Company treats them as separatecustomers for purposes of determining the top 40 customers.

 

The loss of anyone of these customers could have a material adverse effect on the Company.

 

**Third-Party Manufacturers**

 

Since the Companyoutsourced its production of its products in 1999, the Company has becomesignificantly dependent on third-party manufacturers. The decision tooutsource was based upon the Company’s desire to concentrate its financialresources on product development, sales, marketing and distribution. Naturadecurrently contracts with third-party manufacturers who specialize in powder,liquid, tablet/capsule, bar and over-the counter pharmaceutical (“OTC”)production. Naturade selects its third-party manufacturers based upon severalcriteria, including quality, capacity, location and cost. Under the directionof the Company’s new product development team, these third-partymanufacturers create product formulations and develop sample production runs ofprototype products. Naturade requires that every batch of product received froma third-party manufacturer be accompanied by a certificate of analysis thatindicates tested levels of key microbiological measures.

 

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**RawMaterial Supplies**

 

Due to outsourcingof production, Naturade has eliminated most of its raw material inventorywhich, at December 31, 2002, approximated $224,000. This amount includesbottles, labels, corrugated boxes and shippers. The Company believes that theraw materials used by its third-party manufacturers are readily availablefrom multiple supply sources.  TheCompany has not experienced significant delays due to supply problems.

 

**Quality Control**

 

The Company has establishedquality control standards for its third-party manufacturers, includinglists of approved raw material suppliers, agreed upon production batch sizes,microbiological and other contaminant testing criteria, utilization of industry-specificindependent laboratories for sample analysis and a formal incubation period forfinished products, among other requirements. In addition, the Company has onretainer a former FDA examiner to inspect third-party manufacturingproduction facilities and to draft new quality control procedures to adhere toevolving FDA guidelines.

 

**Seasonal Fluctuations**

 

As the NaturadeTotal Soy® brand has emphasized weight loss in connection with its mealreplacement products, sales have become somewhat more seasonal, affected by higherDecember and first quarter demand due to intense consumer interest in dietingand healthy lifestyle following the holiday season, with a softening of salesin the beginning of the fourth quarter. Because individual products have seasonal variations, as the Company’sproduct mix changes, the Company may experience more seasonality in the future.In addition, international sales tend to fluctuate depending upon economicconditions, seasonal patterns and cultural differences within each country.

 

**Trademarks,Copyrights and Other Intellectual Property**

 

Naturade maintainsregistrations on 18 trademarks with the United States Patent and TrademarkOffice, in addition to a California registration on one trademark. Naturadealso maintains trademark registrations for a variety of marks in approximatelyeleven foreign countries. In addition, Naturade holds other intellectualproperty rights. Federally registered trademarks have perpetual life, providedthey are renewed on a timely basis and used properly as trademarks, subject tothe rights of third parties to seek cancellation of the marks.  The Company regards its trademarks and otherproprietary rights as valuable assets and believes that they have significantvalue in the marketing of its products. Because of its limited financialresources, the Company cannot in all cases exhaustively monitor the marketplacefor trademark violations. It will evaluate and pursue potential infringementson a case-by-case basis in accordance with its business needs and financial resources.If the Company is not aware of some infringing uses or elects not to pursuethem, the value of its trademarks could be substantially weakened.

 

**PrivateEquity Transaction**

 

During fiscal2001, the Company spent significant time seeking additional financing tosupport its working capital requirements and general corporate purposes. OnJanuary 2, 2002, the Company sold to Westgate Equity Partners, L.P.(“Westgate”) 13.5 million shares (the “Shares”) of Series BConvertible Preferred Stock (the “Preferred Stock”) for $2 million andwarrants (the “Warrants”) to purchase an additional 33.6 million shares ofSeries B Convertible Preferred Stock for $500,000 with an aggregateexercise price of $3.5 million (the “Private Equity Transaction”) pursuantto the terms of a Securities Purchase Agreement dated as of December 20, 2001(the “Purchase Agreement”).

 

After thecompletion of the Private Equity Transaction, Westgate asserted that theCompany’s representations and warranties concerning the Company’s capitalizationin the Purchase Agreement were inaccurate in that they omitted to disclose thefact that certain outstanding promissory notes of the Company in an amount of$252,345 (the “Convertible Notes”) were convertible into shares of the CommonStock of the Company at the market price of the Common Stock on the date ofconversion.  Convertible Notes in theamount of $50,000 have been converted into 720,392 shares of Common Stock todate, and $202,345 in Convertible notes remain outstanding and were convertibleinto 3,372,417 shares as of April 14, 2003.

 

The Company andWestgate have agreed to resolve this dispute by entering into a Consent andMutual Release, dated as of April 14, 2003 (the “Consent and Release”).  The Consent and Release provides for an adjustmentto the conversion formula for the Series B Convertible Preferred Stock.  If the Company issues, or is obligated toissue, more than 537,242 shares of Common Stock when the Convertible Notes areconverted, the number of shares of Common Stock issuable on conversion of theSeries B Convertible Preferred Stock will increase.  The adjustment is intended to provide that if Westgate exercisesall of its Warrants, the Common Stock issued on conversion of the Series BConvertible Preferred Stock will increase by 1.041 shares for each share ofCommon Stock issued or issuable on conversion of the Convertible Notes inexcess of 537,242.  The adjustment inthe conversion price is to be accomplished by an amendment to the Certificateof Designation of the Series B Convertible Preferred Stock.  In addition, the Company intends to amendthe Certificate of Incorporation to increase the authorized Common Stock from100 million to 150 million shares to provide sufficient shares for anyconversion of the Series B Convertible Preferred Stock and for generalcorporate purposes.

 

The Consent andRelease also provides that Westgate consents to the issuance by the Company ofnew incentive options to purchase up to 1,250,000 shares of Common Stock.  Under the Purchase Agreement, the Companycannot issue additional shares of voting Common Stock without the consent ofWestgate.  Westgate has consented to theissuance of options to purchase up to 1,250,000 shares of Common Stock, to begranted to employees in accordance with the Naturade, Inc. 1998 Incentive StockOption Plan.  In consideration of thisconsent, Health Holdings granted to Westgate an irrevocable proxy (the “Proxy”)giving Westgate the power to vote 1.041 shares of Common Stock owned by HealthHoldings for each share of Common Stock issued on exercise of the newoptions.   The Proxy is exercisable onlyif Westgate exercises all of its Warrants.

 

This summary ofthe Consent and Release is qualified in its entirety by reference to the fulltext of the Consent and Release, a copy of which is attached as Exhibit 10.37to this Report, and to the Proxy, a copy of which is attached  as Exhibit 10.39.

 

 

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The PreferredStock bears dividends at a rate of 10% per annum, which will accumulate andcompound semi-annually if not paid in cash. On the seventh anniversary of itsissuance, the Preferred Stock will be automatically redeemed by the Company atthe original issuance price plus accrued and unpaid dividends, provided theCompany is legally able to do so. Two members of the Board of Directors of theCompany will be elected exclusively by the holders of the Preferred Stockvoting as a separate class.

 

The Company mayredeem the Series B Convertible Preferred Stock at any time prior toDecember 31, 2004 if the Company receives a bona fide offer from a thirdparty to invest equity capital in the Company and the holders of the Series BConvertible Preferred Stock do not make a Qualified Counter Offer. A “QualifiedCounter Offer” is a written offer for an equity investment in the Company thatwill yield gross proceeds in excess of the third party’s offer (but need notexceed $3,500,000), and which either (A) is accomplished through theexercise of some or all of the Warrants, or (B) will provide capital onthe same or better terms as the third party offer.

 

As part of thePrivate Equity Transaction, Health Holdings & Botanicals, L.L.C.(“Health Holdings”), a majority shareholder, converted all of the Company’soutstanding debt to Health Holdings in an amount of approximately$5.3 million, and surrendered all of Health Holdings’ Series AConvertible Preferred Stock, comprising approximately 1.3 million shares,for cancellation without conversion, in exchange for 36 million shares ofNaturade’s Common Stock.

 

If Westgateexercises the Warrants in full, Westgate would hold a total of47.1 million shares of Convertible Preferred Stock, which would beconvertible into the same number of shares of Common Stock (subject toadjustment to prevent dilution), or 51% of Naturade’s outstanding Common Stockon a fully diluted basis. Furthermore, Naturade has agreed not to issueadditional voting securities without Westgate’s consent, except on the exerciseof outstanding options to purchase Common Stock. Naturade also entered into aManagement Services Agreement, under which certain principals of Westgate willprovide management and consulting services to the Company.

 

OnDecember 20, 2001, Wells Fargo Business Credit, Inc. (“Wells Fargo”)agreed to modify the terms of its Credit and Security Agreement with Naturade,to among other things, waive the enforcement of existing defaults, increase thecredit available to the Company to a maximum of $4,500,000, increase thefloating interest rate to the prime rate plus 2% and extend the maturity dateto December 31, 2003, provided Westgate completed the Private EquityTransaction.

 

The net proceedsof these transactions have been used by Naturade for working capital andgeneral corporate purposes. The terms of the sale of the securities, theconversion of indebtedness owed to Health Holdings, the surrender of HealthHoldings’ Series A Convertible Preferred Stock and the amendment of theCompany’s bank credit facility are more fully described in the Company’s CurrentReport on Form 8-K filed with the Securities and Exchange Commission onJanuary 3, 2002.

 

TheCompany has entered into a loan agreement, dated April 14, 2003 (the “LoanAgreement”), whereby a group currently comprised of Health Holdings and DavidA. Weil (the “Lender Group”), may lend up to $750,000 to the Company.  The funds will be used for working capitaland general corporate purposes.  Aninitial advance of $450,000 will be made and additional advances, if any, willbe at the sole discretion of the Lender Group. The loans will be evidenced by secured promissory notes issued to theLender Group, which will be secured by a lien on all of the assets of theCompany.  The notes will bear interestat an annual rate of 15%, payable quarterly, with a rate of 17% on interestpayments that are not made on time. Principal and any unpaid interest will be due and payable on December31, 2004.  The notes are not convertibleinto equity securities.

 

Theobligations of the Company under the Loan Agreement and the related lien aresubordinated to the interest of Wells Fargo Business Credit, Inc. (“WellsFargo”) under the Credit and Security Agreement between the Company and WellsFargo dated as of February 27, 2000 (as amended) (the “Credit Agreement”).  Wells Fargo consented to the Company’sentering into the Loan Agreement, and in consideration of the extension ofcredit by the Lender Group agreed to waive all defaults of the Company underthe Credit Agreement as of December 31, 2002 and amended the agreement to, among otherthings, reduce the covenants regarding minimum net income and minimum book networth and increased the interest rate. For a description of the amended bank credit facility, see “Item 7.  Management’s Discussion and analysis ofFinancial Condition and Results of Operations — Liquidity.”

 

TheLoan Agreement does not have any financial covenants, but events of defaultinclude (i) the failure to pay interest or principal when due, (ii) theCompany’s bankruptcy, receivership or general inability to pay its debts whendue, (iii) the Company’s default on any other obligation (other than to WellsFargo) and the expiration of any cure period, and (iv) the acceleration of theCompany’s indebtedness to

 

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any other party, if not waived, rescinded or reversedwithin 30 days.  Any of these events ofdefault will give the Lender Group the right to accelerate the notes anddeclare them immediately payable in full.

 

HealthHoldings & Botanicals, LLC is a principal stockholder of the Company andtwo of its affiliates serve on the board of directors.  David A. Weil also serves on the board ofdirectors.  The Loan Agreement providesthat additional persons may be added in the future to participate as lenders.

 

The Company wasrequired to obtain the consent of Westgate, as holder of the Series BConvertible Preferred Stock., to the Loan Agreement.  In consideration of the extension of credit by the Lender Group,Westgate agreed to waive the accrual of preferential dividends on the Series BConvertible Preferred Stock during 2003. The preferential dividends forgone by Westgate are computed at 10%,compounding semi-annually on an original purchase price of $2,000,000.

 

**FinancialInformation About Industry Segments**

 

Operating segmentsare defined as components of an enterprise about which separate financialinformation is available that is evaluated regularly by the Company’s chiefoperating decision-maker, or decision-making group, in deciding howto allocate resources and in assessing performance. Commencing inJanuary 1999, the Company’s reportable operating segments include healthfood and mass market distribution channels. The Company does not allocateoperating expenses to these segments, nor does it allocate specific assets tothese segments. Therefore, segment information reported includes only sales,cost of sales and gross profit. The financial information for the Company ispresented in the financial statements accompanying this report.

 

Effective January 1, 2002, the Company adoptedEmerging Issues Task Force (“EITF”) issue No. 01-9, Accounting forConsideration Given by a Vendor to a Customer or a Reseller of the Vendor’sProducts (“EITF 01-9”).  Upon adoptionof EITF 01-9, the Company was required to classify certain payments to itscustomers as a reduction of sales.  TheCompany previously classified certain of these payments as brand expenses, acomponent of selling, general and administrative expenses in the statement of operations.  Upon the adoption of EITF 01-9, priorperiods amounts were reclassified and resulted in a reduction of sales (and anoffsetting reduction of selling expenses) of $454,552 in 2001 and $129,056 in2000.  In addition, the Companyreclassified coupon and rebate redemptions from selling, general andadministrative expenses to net sales of $55,265 in 2001 and $39,256 in2000.  New store openings, wasreclassified to cost of goods sold of $125,198 in 2001 and $44,775 in 2000.

 

The Company hadachieved sales growth in the mass market in fiscal 2001, 2000 and 1999.However, in 2002 the Company had net sales of $14,416,351, representing a$2,224,758 or 13.4% decrease from 2001. During 2002, mass market (includinginternational) net sales decreased $1,306,828, or 15.6%, to $7,050,218 from$8,357,046 for 2001. For 2002, health food net sales decreased $917,930 or11.1%, to $7,366,133 from $8,284,063 for 2001. The mass market segment(including international) represented 48.9% of sales with health foodrepresenting 51.1% of sales.

 

For 2001, the Companyhad net sales of $16,641,109, representing a 7.3% increase over fiscal 2000.During 2001, mass market (including international) net sales increased$2,796,872, or 47.7%, to $8,357,046 from $5,860,174 for 2000. For 2001, healthfood net sales decreased $1,658,945, or 16.7%, to $8,284,063 from $9,943,008for 2000. Due to this mass market growth, mass market (including international)represented 50.2% of sales with health food representing 49.8% of sales.

 

For 2000, theCompany had net sales of $15,503,182, representing a 29.8% increase over 1999.During 2000, mass market (including international) net sales increased$3,701,639 or 199%, to $5,560,174 from $1,858,535 for 1999. For 2000, healthfood net sales decreased $145,159, or 1.4%, to $9,943,008 from $10,088,167 for1999. As a percent of total sales, mass market (including international)represented 35.9%, whereas health food represented 64.1% of total sales.

 

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Sales for 2002 inthe United States are broken down by geographic regions as follows:

 

|                   |   | **%**  |   |
|------------------------|--------|--------|--------|
|                   |   |   |   |
| Northeast Region       |   | 20.2   |   |
|                   |   |   |   |
| Southeast Region       |   | 15.2   |   |
|                   |   |   |   |
| Southwest Region       |   | 8.3    |   |
|                   |   |   |   |
| Mid-West Region        |   | 16.1   |   |
|                   |   |   |   |
| Rocky Mountain  Region |   | 9.4    |   |
|                   |   |   |   |
| California and  Hawaii |   | 19.5   |   |
|                   |   |   |   |
| Northwest Region       |   | 11.3   |   |
|                   |   |   |   |
|                   |   | 100    |   |

 

**RegulatoryMatters**

 

The Company’sproducts are subject to regulation by numerous governmental agencies,principally the U.S. Food and Drug Administration (the “FDA”). The Company’sproducts are also subject to regulation by the Consumer Product SafetyCommission, the U.S. Department of Agriculture, and the EnvironmentalProtection Agency. Advertising of the Company’s products is subject toregulation by the U.S. Federal Trade Commission. The Company’s products arealso regulated by various state and local agencies as well as each foreigncountry in which the Company distributes its products.

 

Many Naturadeproducts, including Naturade Total Soy® and protein powders, are food productsthat are not subject to regulation by the FDA’s drug regulations or the DSHEAof 1994. These food products are regulated under the general FDA foodregulations and may use “structure/function” claims or health claims underappropriate circumstances, but unlike dietary supplements, are not required tocarry a disclaimer regarding an FDA evaluation or disease. EffectiveOctober 26, 1999, the FDA approved a health claim for soy protein allowingthe following product label claim:

 

**“25grams of soy protein daily, in a diet low in saturated fat and cholesterol, mayreduce the risk of heart disease.”**

 

To carry thisclaim, one serving of a product must deliver at least 6.25 grams of soy proteinwith no more than three grams of fat and no more than one gram of saturatedfat. The Company is currently shipping products that carry this heart diseaseclaim under the brand names of Naturade Total Soy®, Naturade 100% SoyTM,Naturade VegTM, Naturade N-R-GTM, Naturade Organic SoyTM, Ribo-teinTM and PowerShake®.

 

Beginning in 2002,the FDA implemented a new regulation requiring non-prescription,over-the-counter (“OTC”) drugs to include a “Drug Facts” box on the label. Thisregulation was designed to make OTC drug labels easier to read. This regulationhas now been implemented on all of Naturade’s OTC products where requiredincluding Herbal Expectorant, Sugar-Free Herbal Expectorant, Children’s HerbalExpectorant and Herbal Laxative.

 

The USDAimplemented new labeling regulations on all organic products beginning inNovember 2002.  Naturade revised thelabels on all applicable products containing organic ingredients to comply withthese new regulations.

 

The Company’sproducts currently comply with the latest regulations in product labeling,including food (Nutritional Labeling Education Act of 1991 or NLEA), dietary supplement(DSHEA), over-the-counter drug (OTC Monographs) and cosmetic packagingguidelines. The Company retains control of all labels in-house and manageslabel development and usage as an element of quality assurance. In addition,all formula specifications are developed under the direction of Naturade’smanagement.

 

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**Backlog**

 

Naturade typicallydoes not carry significant backlog orders and generally maintains a sufficientsupply of its products to meet customer demands. The Company’s policy is toship product within seven days of the order being placed.

 

**Product Research andDevelopment**

 

The Companydevotes substantial resources to new product development and reformulation. TheCompany initiates new product development efforts with third-partymanufacturers who create product formulations, test and develop sampleproduction runs of prototype products. Due to industry practice, these costsare often absorbed by the third-party manufacturers who then negotiatewith the Company on final lot sizes and production costs. Consequently, theCompany’s direct expenses in this area do not reflect the full cost of productresearch and development.

 

Naturade’s directproduct research and development expenses were $181,985,  $196,456 and $251,717 in the fiscal yearsended December 31, 2002, 2001 and 2000, respectively.

 

New productsintroduced in 2002 include Power ShakeTM protein supplement and Quick FizzTMJoint Ease and Stomach Soother effervescent supplements.

 

Power ShakeTM wasdeveloped to address the growing opportunity in the energy category.  Power Shake is a soy-protein-based powderthat provides at least 100% of the daily value for 15 vitamins and minerals andcontains a blend of herbal and green food ingredients intended to supportincreased energy.

 

The Companydeveloped Quick FizzTM to make use of a technology that facilitates theincorporation of nutraceutical-based ingredients into a “flake” base, allowingfor easy dispersion when mixed with water. Quick FizzTM Stomach Soother includes aloe vera powder andfructooligosaccharides (FOS), which help relieve temporary stomach upset andoccasional heartburn.  Each packet ofQuick FizzTM Joint Ease contains the recommended 1,500 mg dose of glucosamine tohelp support normal joint health.  BothQuick FizzTM products contain sodium bicarbonate, which provides effervescentaction when added to water.

 

Naturade TotalSoy® original shake mix powder, the Company’s leading brand, was repositionedin 2002 to improve taste and reduce cost, while the label was redesigned to adda new focus on weight loss in addition to the long standing benefit ofcholesterol reduction. This project was undertaken in response to informationreceived from consumer surveys, as well as from a competitive analysis, whichshowed that Naturade Total Soy® was priced significantly higher thancompetitive products in the meal replacement category.

 

**Employees**

 

As of December 31, 2002, Naturade employed 30 people,including two in administration, eleven in sales and marketing, three inproduct development, eight in finance, accounting and information technologyand six in warehouse and distribution. The Company considers its relations withits employees to be good.

 

**RiskFactors**

 

The short andlong-term success of the Company is subject to certain risks, many of which aresubstantial in nature. Shareholders and prospective shareholders in the Companyshould consider carefully the following risk factors, in addition to otherinformation contained herein. This Annual Report on Form 10-K containsforward-looking statements, which are subject to a variety of risks anduncertainties. The Company’s actual results could differ materially from thoseanticipated in these forward-looking statements as a result of various factors,including those set forth below.

 

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***Future losses and ability to continue as a going concern***

 

Naturade’sindependent accountants have qualified their opinion on the Company’s financialstatements, expressing substantial doubt concerning the Company’s ability tocontinue as a going concern. At December 31, 2002, the Company had anaccumulated deficit of $20,937,224, net working capital deficit of $1,429,771and a stockholders’ capital deficiency of $1,945,301. The Company anticipatesthat it will incur a net losses for the foreseeable future and will need accessto additional financing for working capital and to expand its business.Moreover, as of December 31, 2002, the Company was in default of the minimumbook net worth and minimum net income covenants in the Credit and SecurityAgreement with its principal lender and only recently received a written waiverof such default. Without a waiver of any future defaults that may occur, or amodification of the Credit and Security Agreement, the lender could terminatethe agreement and demand immediate payment of the full amount of indebtedness.Management has taken a number of steps to address this situation, including thePrivate Equity Transaction completed on January 2, 2002, the LoanAgreement entered into on April 14, 2003 under which the Company can borrow,subject to certain conditions, $450,000 and can borrow up to an additional$300,000 at the discretion of the lenders and efforts to decrease operatinglosses by expanding sales and reducing costs. Nevertheless, the Company expectsto incur operating losses for some time in the future and cannot give assurancethat additional financing will be available when needed or that it will obtainneeded waivers or modifications of the Credit and Security Agreement. Ifunsuccessful in those efforts, Naturade could be forced to cease operations andinvestors in Naturade’s Common Stock could lose their entire investment. Basedon this situation, the Company’s independent accountants qualified theiropinion on the Company’s December 31, 2002 financial statements to by includingan explanatory paragraph in which they expressed substantial doubt about theCompany’ ability to continue as a going concern.

 

***Dependence on current and ongoing financing***

 

The Company’ssuccess is dependent on its current financing as well as new financing tosupport its working capital requirements and fund its operating losses. As ofDecember 31, 2002, the Company was not in compliance with the minimum networth and minimum net income covenant of the Credit and Security Agreement withits principal lender. Subsequently, the Company obtained a written waiver ofsuch default.  See “Item 7. Management’sDiscussion and Analysis of Financing Condition and Results ofOperations—Liquidity and Capital Resources” and Note 4 to the FinancialStatements. Starting in 2000, the Company embarked on a strategy to rollout theNaturade Total Soy® product line to the mass market, which requires a high levelof marketing expenditures. Although the Company obtained $2.5 million aspart of the Private Equity Transaction on January 2, 2002, and enteredinto the Loan Agreement as of April 14, 2003 under which the Company can borrow$450,000 and can borrow up to an additional $300,000 at the discretion of thelenders, the Company may not have adequate financial resources to fund thisstrategy. Further, no assurance can be given that the Company will have accessto additional funds or, if funds can be obtained, that the terms on which theycan be obtained will be satisfactory. In such event, the Company’s business andresults of operations, and its ability to continue as a going concern, will bematerially adversely affected.

 

***Future Sales of Equity Securities Could Dilute the Company’sCommon Stock***

 

The Company mayseek to obtain new financing from various sources, including the sale of itssecurities. Future sales of Common Stock or securities convertible into CommonStock at or below recent market prices could result in dilution of the CommonStock. In addition, the conversion of the 13.5 million shares ofSeries B Convertible Preferred Stock originally sold to Westgate EquityPartners, L.P. (“Westgate”), for $2 million, together with conversion ofthe 35,989,555 shares of Series B Convertible Preferred Stock issuable onexercise of warrants held by Westgate, which have an exercise price ofapproximately $0.104 per share (and, including the original cost of thewarrant, a total consideration of approximately $0.119 per share), has resultedin dilution of the Common Stock. The perceived risk of dilution may cause someof the Company’s stockholders to sell their shares, which could further reducethe market price of the Common Stock.

 

***Naturade may face interruption of production and servicesdue to increased security measures in response to terrorism***

 

Naturade’sbusiness depends on the free flow of products and services through the channelsof commerce. Recently, in response to terrorist activities and threats aimed atthe U.S., transportation, mail, financial and other services have been slowedor stopped altogether. Further delays or stoppages in transportation, mail,financial or other services could have a material adverse effect on theCompany’s business, results of operations and financial condition. Furthermore,the Company may experience an increase in operating costs, such as costs fortransportation, insurance and security, as a result of the terrorist activitiesand potential activities. The Company may also experience delays in receivingpayments from payers that have been affected by terrorist activities andpotential activities. The U.S.

 

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economy in general isbeing adversely affected by the terrorist activities and potential activitiesand any economic downturn could adversely impact the Company’s results ofoperations, impair its ability to raise capital or otherwise adversely affectits ability to grow its business.

 

***Impact of government regulation***

 

The Company’soperations, properties and products are subject to regulation by variousforeign, federal, state and local government entities and agencies, includingthe FDA and FTC. See “Government Regulation.” Among other matters, suchregulation is concerned with statements and claims made in connection with thepackaging, labeling, marketing and advertising of the Company’s products. Thegovernmental agencies have a variety of processes and remedies available tothem, including initiating investigations, issuing warning letters and ceaseand desist orders, requiring corrective labeling or advertising, requiringconsumer redress, seeking injunctive relief or product seizure, imposing civilpenalties and commencing criminal prosecution.

 

As a result of theCompany’s efforts to comply with changes in applicable statutes andregulations, the Company has from time to time reformulated, eliminated orrelabeled certain of its products and revised certain aspects of its sales,marketing and advertising programs. The Company may be subject in the future toadditional laws or regulations administered by federal, state, local or foreignregulatory authorities, the repeal or amendment of laws or regulations whichthe Company considers favorable, such as DSHEA, or more stringent interpretationsof current laws or regulations. The Company cannot predict the nature of futurelaws, regulations, interpretations or applications, nor can the Company predictwhat effect additional governmental regulations or administrative orders, when andif promulgated, would have on the Company’s business in the future. Such futurelaws and regulations could, however, require the reformulation of products tomeet new standards, the recall or discontinuance of products that cannot bereformulated, the imposition of additional record keeping requirements,expanded documentation of product efficacy, expanded or modified labeling andscientific substantiation, including health warnings or restrictions onbenefits described for our products. Any of or all of such requirements couldhurt sales of our products or increase our costs, resulting in material harm tothe Company’s results of operations and financial condition. See “GovernmentRegulation.”

 

***Technological changes***

 

The Companycurrently is engaged in developing nutraceuticals, which are characterized byextensive and costly research efforts and rapid technological progress andchange. New process developments are expected to continue at a rapid pace inboth industry and academia. The Company’s future success will depend on itsability to develop and commercialize its existing product candidates and todevelop new products. There can be no assurance that the Company willsuccessfully complete the development of any of its existing product candidatesor that any of its future products will be commercially viable or achievemarket acceptance. In addition, research and development and discoveries byothers could render some or all of the Company’s programs or potential productcandidates uncompetitive or obsolete.

 

***Dependence on continued business from the Company’s keycustomers***

 

The Company’sthree largest customers together account for 51% of sales revenue. One massmarket customer, Wal*Mart and Sam’s Club, represented approximately 18% ofNaturade’s total sales in 2002, and two health food distributors accounted for33% of total sales in 2002. The loss of such customers could have a materialadverse effect on the Company’s results of operations. From time to time, majorcustomers of Naturade have experienced financial difficulties. Naturade doesnot have long-term contracts with any of its customers and, accordingly, therecan be no assurance that any customer will continue to place orders withNaturade to the same extent it has in the past, or at all.

 

***Dependence on third-party manufacturers***

 

The use ofcontract manufacturers and the resulting loss of direct control over productioncould result in the Company’s failure to receive timely delivery of products ofacceptable quality. Although the Company believes that alternative sources ofcontract manufacturing services are available, the loss of one or more contractmanufacturers could have a material adverse effect on the Company’s results ofoperations until an alternative source is located and has commenced producingthe Company’s products.

 

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Although theCompany requires that its contract manufacturers comply with FDA manufacturingguidelines, Naturade cannot assure that these third-party companies will alwaysact in accordance to these regulations. If the manufacturing facilities used bythe Company’s third-party manufacturers did not meet those standards, theproduction of the Company’s products could be delayed until the necessarymodifications are made to comply with those standards or alternatemanufacturers are located. Furthermore, the potential exists for circumstancesto arise which would require Naturade to seek out alternate manufacturers whooperate in compliance with the FDA’s requirements.

 

***Competition***

 

The market fornutraceutical products is highly competitive. Many of the Company’s competitorshave substantially greater capital resources, research and developmentcapabilities, and manufacturing and marketing resources, capabilities andexperience than the Company. The Company’s competitors may succeed indeveloping products that are more effective or less costly than any productsthat may be developed by the Company.

 

***Dependence on qualified personnel***

 

The Company’ssuccess is dependent upon its ability to attract and retain qualified sales,marketing, scientific and executive management personnel. To commercialize itsproducts and product candidates, the Company must maintain and expand itspersonnel, particularly in the areas of product sales and marketing. TheCompany faces intense competition for such personnel from other companies,academic institutions, government entities and other research organizations.There can be no assurance that the Company will be successful in hiring orretaining qualified personnel. Moreover, managing the integration of such newpersonnel could pose significant risks to the Company’s development andprogress and increase its operating expenses.

 

***Variability of quarterly results***

 

The Company hasexperienced, and expects to continue to experience, variations in its net salesand operating results from quarter to quarter. The Company believes that thefactors which influence this variability of quarterly results include thetiming of the Company’s introduction of new product lines, the level ofconsumer acceptance of each product line, general economic and industryconditions that affect consumer spending and retailer purchasing, theavailability of manufacturing capacity, the timing of trade shows, the productmix of customer orders, the timing of placement or cancellation of customerorders, the weather, transportation delays, the occurrence of chargebacks inexcess of reserves and the timing of expenditures in anticipation of increasedsales and actions of competitors. Accordingly, a comparison of the Company’sresults of operations from period to period is not necessarily meaningful, andthe Company’s results of operations for any period are not necessarilyindicative of future performance.

 

***Product liability exposure***

 

Product liabilityrisk is inherent in the testing, manufacture, marketing and sale of theCompany’s products and product candidates, and there can be no assurance thatthe Company will be able to avoid significant product liability exposure. TheCompany may be subject to various product liability claims, including, amongothers, that its products include inadequate instructions for use or inadequatewarnings concerning possible side effects and interactions with othersubstances. The Company currently maintains a general liability insurancepolicy and a product liability insurance policy. There can be no assurance thatthe Company will be able to maintain insurance in sufficient amounts to protectthe Company against such liabilities at a reasonable cost. Any future productliability claim against the Company could result in the Company payingsubstantial damages, which may not be covered by insurance and may have amaterial adverse effect on the business and financial condition of the Company.

 

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***Naturade may not be able to identify suitable strategicpartners to realize the Company’s growth strategy.***

 

In addition tointernal expansion of its existing business, Naturade has a strategy to expandits business externally by identifying compatible companies for strategicalliances and strategic investments in Naturade. Naturade may not succeed inidentifying these potential strategic partners or may be unable to concludeagreements with them. If so, Naturade’s future growth may be limited, and itmay be unable to achieve profitability.

 

***Expanding the Company’s sales in themass market has increased branding costs and resulted in less stable demand forthe Company’s products.***

 

Naturade,traditionally a marketer for the health food market, has recently built apresence in the mass market. While yielding increased revenue, selling to themass market has also resulted in significant new costs and risks forNaturade.  Mass market sales requiregreater expenditures for branding. While the Company reduced mass market brand expenses to $1,365,644 in2002, for a reduction of 28.1% compared to 2001, mass market brand expenseswere 20.0% of net sales as compared to health food brand expenses of $799,117or only 10.8% of net sales.  Compared tosales in the health food market, the aggregate volume of mass market orders canvary significantly from period to period and tends to be more sensitive toshort term or local variations in market conditions. The instability can makeplanning difficult and can cause unexpected reductions in sales, or in ordersthat exceed Naturade’s short-term capacity, in either case resulting in lostrevenue. Failure to manage the costs and risks associated with the mass marketcould cause material adverse harm to Naturade’s business.

 

***The dietary supplement industry as a whole is experiencing adecline in sales.***

 

Naturade’sbusiness consists primarily of selling natural products and functional foods,including soy protein based products. While Naturade’s sales decreased in 2002,the soy foods category as a whole has recently experienced increased sales.Other categories of dietary supplements have experienced reduced sales inrecent periods after several years of dramatic growth. In particular, revenuesin both the herbal and health food store categories have significantlydeclined. There can be no assurance that this general consumer trend will notbe experienced by Naturade’s product categories as well. Even if Naturade issuccessful in increasing sales within its market category, a decline in theoverall market for natural products or functional foods could have a materialadverse affect on Naturade’s business.

 

***Effect of adverse publicity***

 

The Company’sproducts are formulated with vitamins, minerals, herbs and other ingredientsthat the Company regards as safe when taken as suggested by the Company andthat scientific studies have suggested may involve health benefits. While theCompany conducts extensive quality control testing on its products, the Companygenerally does not conduct or sponsor clinical studies relating to the benefitsof its products. The Company is highly dependent upon consumers’ perception ofthe overall integrity of its business, as well as the safety and quality of itsproducts and similar products distributed by other companies which may notadhere to the same quality standards as the Company. The Company could beadversely affected if any of the Company’s products, or any similar productsdistributed by other companies, should prove or be asserted to be harmful toconsumers or should scientific studies provide unfavorable findings regardingthe effectiveness of such products. The Company’s ability to attract and retaindistributors could be adversely affected by negative publicity relating to itor to other direct sales organizations or by the announcement by anygovernmental agency of investigatory proceedings regarding the businesspractices of the Company or other direct sales organizations.

 

***Intellectual Property Protection***

 

Our successdepends in part on our ability to preserve our trade secrets and know-how, andoperate without infringing on the property rights of third parties. The Companydoes not have any patents, and as a result another company could replicate oneor more of Naturade’s products. The Company’s policy is to pursue registrationsfor all of the trademarks associated with its key products. The Company relieson common law trademark rights to protect its unregistered trademarks as wellas its trade dress rights. Common law trademark rights generally are limited tothe geographic area in which the trademark is actually used, while a U.S.federal registration of a trademark enables the registrant to stop theunauthorized use of the trademark by any third party anywhere in the U. S. TheCompany intends to register its trademarks in certain foreign jurisdictionswhere the Company’s products are sold. However, the protection available,

 

18

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if any, in suchjurisdictions may not be as extensive as the protection available to theCompany in the U.S.

 

Currently, theCompany has 18 U.S. trademarks as well as a California registration of onetrademark. The Company also maintains trademark registrations in approximatelyeleven foreign countries. Because of its limited financial resources, theCompany cannot in all cases exhaustively monitor the marketplace for trademarkviolations. It will evaluate and pursue potential infringement on acase-by-case basis in accordance with its business needs and financialresources. If the Company is not aware of some infringing uses or elects not topursue them, the value of its trademarks could be substantially weakened. Ifthe Company takes action to enforce its property rights, litigation may benecessary. Any such litigation could be very costly and could distract theCompany’s personnel. Due to limited financial resources, Naturade may be unableto pursue some litigation matters. In matters it does pursue, Naturade canprovide no assurance of a favorable outcome. An unfavorable outcome in anyproceeding could have a material adverse effect on the Company’s business,financial condition and results of operations.

 

***Introduction of new products***

 

Each year, theCompany introduces new products to meet consumer demands and countercompetitive threats. These new products include product line extensions, suchas new flavors to currently existing products, as well as new formulations orconfigurations, such as ready-to-drink products and bars. The Companyexperiences significant costs in formulating new products, designing packagingand merchandising. While the Company conducts extensive market research todetermine consumer trends in both the mass market and health food market, therecan be no assurance that the Company’s new products will be accepted byconsumers and retailers. In addition, there can be no assurance that once newproducts are initially distributed to mass market and health food retailers,there will be repeat orders for these new products. Furthermore, expensiveintroductory retailer charges for additional shelf space may negate any initialincrease in sales.

 

***Stock Price***

 

The market priceof the Company’s Common Stock is likely to be volatile and could be subject tosignificant fluctuations in response to the factors such as quarterlyvariations in operating results, operating results which vary from theexpectations of securities analysts and investors, changes in financialestimates, changes in market valuations of competitors, announcements by theCompany or its competitors of a material nature, loss of one or more customers,additions or departures of key personnel, future sales of Common Stock andstock market price and volume fluctuations. Also, general political andeconomic conditions such as recession, or interest rate or currency ratefluctuations may adversely affect the market price of the Company’s CommonStock.

 

***Closely Controlled Stock***

 

At March ,2003, Westgate Equity Partners, L.P. beneficially owned approximately 51.1% ofthe Company’s Common Stock, Health Holdings beneficially owned 44.5% of theCompany’s Common Stock, and executive officers and directors of the Company asa group beneficially owned 97.2% of the Company’s Common Stock. Shares“beneficially owned” include shares that a person owns or has a right toacquire within 60 days, either directly or through affiliates.Accordingly, Westgate Equity Partners, LLC and Health Holdings have the abilityto control the outcome on all matters requiring stockholder approval,including, but not limited to, the election and removal of directors, anymerger, sale, consolidation or sale of substantially all of the assets of theCompany, and to control the Company’s management and affairs.

 

**Item 2.  Properties**

 

InDecember 1998, the Company signed a 7 1/2 year leasefor a facility including new executive offices, sales and marketing offices andwarehouse located in Irvine, California. This 50,000 square foot facilityincludes a 40,000 square foot finished goods warehouse area configured with ahigh-density steel rack and frame storage floor plan. This maximum cubic spaceutilization provides the Company with reasonably sufficient warehousingcapacity for the term of the lease, specifically in light of the Company’sdecision to outsource production, thereby eliminating the need for anymanufacturing space. The rent expense related to this lease for fiscal yearended December 31, 2002 was $457,230. The lease agreement includes anapproximate 9% rent increase after the second, fourth and sixth year of thelease period, with a 60-month extension after the initial lease term at theprevailing market rental rate. Detailed information relating to this lease ispresented in the footnotes to the financial statements accompanying this report.

 

19

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**Item 3.  Legal Proceedings**

 

From time to time,the Company is party to various other claims and litigation that arise in theordinary course of business. While any litigation contains an element of uncertainty,management believes that the ultimate outcome of these claims and litigationwill not have a material effect on the Company’s results of operations orfinancial condition.

 

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

 

None

 

**PART II**

 

**Item5.  Market for the Registrant’s CommonEquity and Related Stockholder Matters**

 

**MarketInformation**

 

The Company’sCommon Stock began trading on the over-the-counter securities market in thethird quarter of 1991 under the symbol NRDC. The over-the-counter marketquotations reflect interdealer bid prices, without retail markup, markdown orcommission, and may not necessarily represent actual transactions. The pricesappearing below were obtained from the National Quotation Bureau.

 
| **Fiscal  2003**                     |   | **High** |   | **Low** |   |
|--------------------------------------|--------|----------|--------|---------|--------|
|                                 |   |     |   |    |   |
| 1st  Quarter.                        |   | $        | .07    |    | $      | .06 |   |
| 2nd  Quarter (through April 8, 2003) |   | $        | .07    |    | $      | .06 |   |

 
| **Fiscal 2002** |   | **High** |   | **Low** |   |
|-----------------|--------|----------|--------|---------|--------|
|            |   |     |   |    |   |
| 1st  Quarter    |   | $        | .40    |    | $      | .12 |   |
| 2nd  Quarter    |   | .12      |   | .07     |   |
| 3rd  Quarter    |   | .10      |   | .07     |   |
| 4th  Quarter    |   | .10      |   | .06     |   |
|                 |        |          |        |         |        |  |  |

 
| **Fiscal 2001** |   | **High** |   | **Low** |   |
|-----------------|--------|----------|--------|---------|--------|
|            |   |     |   |    |   |
| 1st  Quarter    |   | $        | .45    |    | $      | .44 |   |
| 2nd  Quarter    |   | .50      |   | .32     |   |
| 3rd  Quarter    |   | .60      |   | .25     |   |
| 4th  Quarter    |   | .60      |   | .25     |   |
|                 |        |          |        |         |        |  |  |

 

On April 8, 2003,the last reported price for the Company’s Common Stock was $0.06. Shareholdersare urged to obtain current market quotations for the Company’s Common Stock.

 

**Holders**

 

To the bestknowledge of the Company, the number of registered record holders of CommonStock as of December 31, 2002, was

 

20

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547. According to informationobtained by the Company, approximately 700 additional shareholders hold theCompany’s Common Stock in “street name.”

 

**Dividends**

 

The Company didnot pay a cash dividend on its Common Stock during 2001 and 2002, and theCompany does not anticipate paying any cash dividends in the foreseeablefuture. As of the date of this Annual Report on Form 10-K, the Companyintends to follow a policy of retaining any future earnings to provide fundsfor the expansion of its business. The declaration and payment of cashdividends in the future will depend upon the Company’s earnings, financialcondition, capital needs and other factors deemed relevant by the Board ofDirectors. The Company’s ability to pay dividends is limited by the provisionsof Delaware law, by its Credit and Security Agreement with Wells Fargo BusinessCredit and under the Certificate of Designation of the Series BConvertible Preferred Stock.

 

**Recent Sales of Unregistered Securities**

 

***Series B Convertible Preferred Stock and Warrants***

 

On January 2, 2002, the Company sold13,540,723 shares of Series B Convertible Preferred Stock (the “Shares”)for $2 million, and sold for $500,000 warrants (the “Warrants”) topurchase an additional 33,641,548 shares of Series B Convertible PreferredStock. The Warrants have an aggregate exercise price of $3.5 million. Thistransaction is described more fully in “Item 1.  Business-Private Equity Transaction” and Note 5 to the FinancialStatements.  The Company sold the Sharesand Warrants directly, without the services of an underwriter, in a privateplacement made in reliance on Rule 506 of Regulation D under theSecurities Act of 1933. The purchaser was an accredited investor within themeaning of Regulation D. The Company received net proceeds ofapproximately $2,316,000 after expenses related to the placement.

 

Eachshare of Series B Convertible Preferred Stock is convertible into oneshare of Naturade’s Common Stock at the option of the holder plus an additionalamount to adjust for issuances in connection with certain convertible notes(subject to adjustment to protect against dilution). The proceeds of the saleof the Shares and Warrants have been used for working capital and generalcorporate purposes.

 

***Issuance of Common Stock on conversion of debt***

 

On January 2,2002, the Company issued 35,989,855 shares of Common Stock to Health Holdings,in consideration of the conversion by Health Holdings of all of the Company’soutstanding debt to Health Holdings, in an amount of approximately$5.3 million, and the surrender by Health Holdings of 1,250,024 shares ofNaturade’s Series A Convertible Preferred Stock for cancellation withoutconversion.  The Company issued theshares of Common Stock directly, without the services of an underwriter, in aprivate placement made in reliance on Rule 506 of Regulation D under theSecurities Act of 1933.  The purchaserwas an accredited investor within the meaning of Regulation D.  The Company received no net proceeds fromthe issuance and sale of the Common Stock.

 

On August 31,2002, the Company issued 720,392 shares of Common Stock to Wald Holdings, LLC,in consideration of the conversion by Wald Holdings, LLC of the Company’soutstanding debt to Wald Holdings, LLC, in the amount of $50,000. The Companyissued the shares of Common Stock directly, without the services of anunderwriter, in a private placement made in reliance on Rule 506 ofRegulation D under the Securities Act of 1933. The purchaser was anaccredited investor within the meaning of Regulation D. The Company receivedno net proceeds from the issuance and sale of the Common Stock.

 

21

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**Item 6. Selected Financial Data**

 

The followingtables summarize certain selected financial data for the periods presented andshould be read in conjunction with the more detailed information and financialstatements, including notes thereto, presented elsewhere herein.

 

**STATEMENT OF OPERATIONS DATA**

** **
|                                                                                           |   | **Years  Ended December 31** |       | **Three  Months  Ended  December 31,** |   | **Year  Ended  September 30,** |   |
|------------------------------------------------------------------------------------------------|--------|------------------------------|------------|----------------------------------------|--------|--------------------------------|--------|
|                                                                                           |   | **2002**                     |       |                                   |   | **2001**                       |   |   |   | **2000** |   |   |   | **1999 (1)** |   | **1998** |   | **1998** |   |
|                                                                                           |   |                         | ** ** |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net sales                                                                                      |   | $                            | 14,416,351 |                                   | 100.0  | %                              | $      | 16,641,109 |   | 100.0 | % | $ | 15,503,182 |   | 100.0 | % | $ | 11,946,702 |   | $ | 3,597,155 |   | $ | 13,506,972 |   |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gross profit                                                                                   |   | 6,258,744                    |       | 43.4                                   | %      | 7,350,882                      |   | 44.2 | % | 7,157,279 |   | 46.2 | % | 4,569,798 |   | 1,327,205 |   | 5,712,883 |   |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general  and administrative expenses                                                  |   | 8,069,382                    |       | 56.0                                   | %      | 9,522,932                      |   | 57.2 | % | 8,626,072 |   | 55.6 | % | 8,923,832 |   | 1,975,550 |   | 8,928,723 |   |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other operating  expenses                                                                      |   | 0                            |       | 0.0                                    | %      | 0                              |   | 0.0 | % | 0 |   | 0.0 | % | 2,844,344 |   | 0 |   | 0 |   |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating loss                                                                                 |   | (1,810,638                   | )          | 0                                      |   | (2,172,050                     | )      | 0 |   | (1,468,793 | ) |   |   | (7,198,378 | ) | (648,345 | ) | (3,215,840 | ) |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other loss                                                                                     |   | (85,180                      | )          | 0                                      |   | (549,172                       | )      | 0 |   | (661,499 | ) |   |   | (2,497,635 | ) | (298,328 | ) | (858,525 | ) |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss before  provision for income taxes                                                        |   | (1,895,818                   | )          | 0                                      |   | (2,721,222                     | )      | 0 |   | (2,130,292 | ) |   |   | (9,696,013 | ) | (946,673 | ) | (4,074,365 | ) |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Provision for  income tax                                                                      |   | 800                          |       | 0.0                                    | %      | 5,931                          |   | 0.0 | % | 800 |   | 0.0 | % | 800 |   | 0 |   | 35,450 |   |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                       |   | (1,896,618                   | )          | 0                                      |   | (2,727,153                     | )      | 0 |   | (2,131,092 | ) |   |   | (9,696,813 | ) | (946,673 | ) | (4,109,815 | ) |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic and diluted  net loss per share                                                          |   | $                            | (0.05      | )                                      |   |                           | $      | (0.36 | ) |   |   | $ | (0.30 | ) |   |   | $ | (1.81 | ) | $ | (0.18 | ) | $ | (0.84 | ) |
|                                                                                           |   |                         |       |                                   |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average  number of shares used in computation of basic and diluted net loss per share |   | 44,000,000                   |       |                                   |   | 7,600,000                      |   |   |   | 7,000,000 |   |   |   | 5,346,000 |   | 5,227,000 |   | 4,874,000 |   |
|                                                                                                |        |                              |            |                                        |        |                                |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)           Commencing January 1, 1999, theCompany changed its fiscal year to end December 31.

 

22

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**BALANCESHEET DATA**

** **
|                                 |   | **As of  December 31,** |       | **As of  September 30,** |   |
|--------------------------------------|--------|-------------------------|------------|--------------------------|--------|
|                                 |   | **2002**                |       | **2001**                 |   | **2000** |   | **1999** |   | **1998** |   | **1998** |   |
|                                 |   |                    |       |                     |   |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents           |   | $                       | 722,583    |                     | $      | 55,388 |   | $ | 202,648 |   | $ | 1,056,240 |   | $ | 842,029 |   | $ | 1,975,513 |   |
| Working capital  (deficiency)        |   | (1,429,771              | )          | (1,864,116               | )      | 226,869 |   | (649,929 | ) | 2,219,645 |   | 3,116,309 |   |
| Total assets                         |   | 4,222,224               |       | 3,993,495                |   | 5,389,819 |   | 5,102,950 |   | 8,523,589 |   | 9,548,470 |   |
| Long term debt                       |   | 37,735                  |       | 5,507,382                |   | 5,049,770 |   | 3,778,528 |   | 1,964,324 |   | 2,011,523 |   |
| Total  stockholders equity (deficit) |   | $                       | (3,659,587 | )                        | $      | (7,009,373 | ) | $ | (4,472,397 | ) | $ | (4,002,962 | ) | $ | 3,459,019 |   | $ | 4,328,192 |   |

 

**Item7. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

The followingdiscussion and analysis of Naturade’s financial condition and results ofoperations should be read in conjunction with “Item 6. Selected Financial Data”and the financial statements and related notes attached to this report. Thisdiscussion and analysis contains forward-looking statements that involverisks, uncertainties and assumptions. Naturade’s actual results may differmaterially from those anticipated in these forward-looking statements asa result of certain factors, including, but not limited, to those set forthunder “Item 1. Business—Risk Factors Affecting the Company” and elsewhere inthis report.

 

**General**

 

The Company is abranded natural products marketing company focused on growth throughinnovative, scientifically supported products designed to nourish the healthand well being of consumers. The Company concentrates on the rapidly expandingsoy foods market which reached almost $2.5 billion in 2000 and is expected togrow 15% to 20% per year reaching $5 to $6 billion in 2005 according toSoyatech market research dated February 2001. Within the broad soyfoods market, segments such as meal replacementdrinks, soymilk and bars have outperformed other categories.  With many brands entering the market andreduced spending by Slim Fast®, the soy protein powder category flattened in2002.  The Company’s products includeNaturade Total Soy®, a full line of nutritionally complete meal replacementsfor weight loss and cholesterol reduction available in several flavors ofpowders, ready-to-drink products and bars, Naturade® protein powders, Aloe Vera80® health and beauty care products and other niche dietary supplements. TheCompany’s products are sold in supermarkets (e.g., Kroger, Fred Meyer, Safeway,Albertson’s and Ahold), mass merchandisers (e.g., Wal*Mart, Kmart and Shopko),club stores (e.g., Sam’s Clubs, Costco and BJ’s Wholesale), drug stores (e.g.,American Drug and Snyder Drug), natural food supermarkets (e.g., Whole Foodsand Wild Oats) and over 5,000 independent health food stores.

 

On January 2,2002, the Company (i) sold Series B Convertible Preferred Stock andWarrants to Westgate for a total of $2.5 million, (ii) issued36 million shares of Common Stock in exchange for the cancellation of$5.3 million of outstanding debt and 1.3 million shares ofoutstanding Series A Convertible Preferred Stock and (iii) amendedits bank credit facility. The Series B Convertible Preferred Stock isconvertible into 13.5 million shares of Common Stock (subject toadjustment) and bears dividends at the rate of 10% per annum. The Warrantsentitle the holder to purchase for $3.5 million additional shares ofSeries B Convertible Preferred Stock convertible into 33.6 millionshares of Common Stock (subject to adjustment). The net proceeds from theinvestment have been used by Naturade for working capital and general corporatepurposes. For a more complete description of this transaction, see “Item 1.Business—Private Equity Transaction.”

 

After the completion of the Private Equity Transaction, Westgateasserted that the Company’s representations and warranties concerning theCompany’s capitalization in the Purchase Agreement were inaccurate in that theyomitted to disclose the fact that certain outstanding promissory notes of theCompany in an amount of $252,345 (the “Convertible Notes”) were convertibleinto shares of the Common Stock of the Company at the market price of theCommon Stock on the date of conversion. Convertible Notes in the amount of $50,000 have been converted into720,392 shares of Common Stock to date, and $202,345 in Convertible Notesremain outstanding and were convertible into 3,372,417 shares as of April 14,2003.

 

The Company andWestgate have agreed to resolve this dispute by adjusting the conversionformula for the Series B Convertible preferred Stock.  In addition, Westgate and health Holdings have agreed that (i)the Company may issue additional options to purchase up to 1,250,000 shares ofCommon Stock to employees in accordance with the Naturade, Inc. 1998 IncentiveStock Option Plan, and (ii) Health Holdings will grant to Westgate a proxy tovote 1.041 shares of Common Stock owned by Health Holdings for each share ofCommon Stock issued on exercise of the new options.  For a description of this settlement, see “Item 1.Business-Private Equity Transactions.”

 

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OnApril 14, 2003, the Company entered into a loan agreement (the “LoanAgreement”) with Health Holdings and Botanicals, LLC, a principal shareholderof the Company, and certain other lenders (the “Lender Group”), pursuant towhich the Lender Group has agreed to lend the Company $450,000 and, subject tothe discretion of the Lender Group, up to an additional $300,000.  All advances under the Loan Agreement bearinterest at the rate of 15% per annum, are due on December 31, 2004, aresecured by substantially all of the assets of the Company, and are subordinatedto the Company’s indebtedness to Wells Fargo Business Credit, Inc. (“WellsFargo”).  The advances under the LoanAgreement will be used for the Company for working capital and generalcorporate purposes.  For a more completedescription of this transaction, see “Item 1.  Business — Loan Agreement.” In consideration of the extension of credit under the Loan Agreement,Wells Fargo waived all defaults of the Company as of December 31, 2002 underthe Credit and Security Agreement dated as of February 27, 2000 and amended the agreement to, among otherthings, reduce the covenants regarding minimum net income and minimum book networth and increased the interest rate. For a description of the amended bank credit facility, see “Item 7.  Management’s Discussion and analysis ofFinancial Condition and Results of Operations — Liquidity.”

** **

**CriticalAccounting Policies and Use of Estimates**

 

The Company’s significantaccounting policies are described in Note 1 of the Company’s FinancialStatements for the year ended December 31, 2002, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates. In preparing the financial statements, the Company is required to makeestimates and judgments which affect the results of its operations and thereported value of assets and liabilities. Actual results may differ from theseestimates. The Company believes that the following summarizes criticalaccounting policies which require significant judgments and estimates in thepreparation of its financial statements.

 

***Revenue Recognition***. Sales are recognized upon shipment and passage oftitle. The Company accrues for estimated returns at the time of sale. InDecember 1999, the Securities and Exchange Commission issued StaffAccounting Bulletin 101, Revenue Recognition (“SAB 101”). SAB 101 summarizescertain of the SEC staff’s views in applying generally accepted accountingprinciples to selected revenue recognition issues in financial statements.Implementation of SAB 101 was required by the fourth quarter of 2000. Theimplementation of SAB 101 did not have a material impact on the Company’sfinancial condition or results of operations.

 

***Inventory Valuation***. Merchandise inventories are stated at the lower ofcost (first-in, first-out basis) or market. The Company considers cost to includethe direct cost of finished goods provided by co-packers as well as the cost ofthose components supplied to the co-packers. The Company regularly reviews agedand excess inventories to determine if the carrying value of such inventoriesexceeds market value with a reserve recorded to reduce the carrying value tomarket value if necessary.

 

***Accounts Receivable Valuation***. Accounts receivable is stated net ofapplicable reserves for returns and allowances, billbacks and doubtfulaccounts. The Company regularly reviews accounts receivable to determine if thereserve amounts are appropriate by considering historical customer buyingpatterns, invoice aging, specific promotions and seasonal factors.

 

**Majortrends occurring in 2002 included:**

 

1)                                      Continueddouble-digit growth in soy foods and meal replacement drinks with an absence ofgrowth in the soyprotein powder category and in overall dietary supplements;

2)                                      Reducedsales of Naturade lines sold through health food stores due to the ongoingshift from health food stores towards the mass market as consumers opt forshopping convenience and lower pricing and mass retailers increasingly focus onnatural products and natural store-within-a-store planagrams;

3)                                      Reducedannual sales of Naturade Total Soy®, which accounted for 53% of sales in fiscal2002, as pipeline orders from new distribution ended in 2001 and the Companyelected to drop unprofitable accounts;

4)                                      Strongfourth quarter growth of Naturade Total Soy® in club stores driven by the newweight loss positioning and improved formula and by initial second halfdistribution in a major warehouse club customer;

5)                                      Significantreduction in interest expense ($443,000) due to the Private Equity Transaction;

6)                                      Significantreduction in brand expenses ($775,252);

7)                                      Reducednet loss by $830,535; and

8)                                      Continueduse of the proceeds of the Private Equity Transaction for working capital andoperating purposes; and

9)                                      Exitedaccounts where minimum profit standards were not met, resulting in a reductionin the Company's account base from 33,000 stores to approximately 15,000stores.

 

24

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**Results of Operations**

 

Effective January 1, 2002, the Company adoptedEmerging Issues Task Force (“EITF”) issue No. 01-9, Accounting forConsideration Given by a Vendor to a Customer or a Reseller of the Vendor’sProducts (“EITF 01-9”).  Upon adoptionof EITF 01-9, the Company was required to classify certain payments to itscustomers as a reduction of sales.  TheCompany previously classified certain of these payments as brand expenses, acomponent of selling, general and administrative expenses in the statement ofoperations.  Upon the adoption of EITF01-9, prior periods amounts were reclassified and resulted in a reduction ofsales (and an offsetting reduction of selling expenses) of $454,552 in 2001 and$129,056 in 2000.  In addition, theCompany reclassified coupon and rebate redemptions from selling, general andadministrative expenses to net sales of $55,265 in 2001 and $39,256 in 2000.New store openings were reclassified to cost of goods sold of $125,198 in 2001and $44,775 in 2000.

 

***2002 Compared to 2001***

 

The year 2002 was plagued by a continuing stalled economy,much like the previous year. This overall softness was seen in both the healthfood market and mass market.  In fiscal2002, the top 25 customers accounted for over $12.4 million or 75.5% ofnet sales and the top 25 SKUs accounted for 73.2% of net sales, up from 70.3%in 2001.

 

***Net Sales***—Net sales for 2002 decreased$2,224,758, or 13.4%, to $14,416,351 from $16,641,109 for 2001 reflecting thesoftness in the overall economies of the U.S. and Canada.  Domestic sales for 2002 decreased$2,096,502, or 12.9%, to $14,194,058 from $16,290,560 for 2001.  International sales for 2002 decreased$128,256, or 36.6%, to $222,293 from $350,549 for 2001

 

Mass Market netsales (excluding international) for 2002 decreased $1,178,572, or 14.7%, to$6,827,925 from $8,006,497 for 2001. This decrease was primarily a result of(i) the decrease in new distribution sales in 2002 as compared to2001,  (ii) Kmart’s financialdifficulties and the corresponding 45% reduction in sales to this account, and(iii) management’s decision to exit unprofitable accounts, all offset by amodest increase in turn business.

 

For 2002, thepercentage of mass market net sales (excluding international) to the Company’stotal net sales basis remained similar to the results seen in 2001. For 2002,mass market net sales represented 47.4% of total net sales, compared to 48.1%of net sales for 2001 and 32.8% of net sales for 2000.

 

The following tableillustrates mass market net sales (excluding international) for 2002 and 2001:

 

Mass Market NetSales

($ In thousands)

 

|             |   | **Fiscal  Year Ended December 31,** |    | **Change** |   |
|------------------|--------|-------------------------------------|---------|------------|--------|
|             |   | **2002**                            |    | **2001**   |   | **$** |   | **%** |   |
|             |   |                                |    |       |   |   |   |   |   |
| New Distribution |   | $                                   | 508.0   |       | $      | 1,436.0 |   | $ | (928.0 | ) | (64.6 | )% |
| Channel Shift    |   | 108.8                               |    | 684.4      |   | (575.6 | ) | (84.1 | )% |
| Turn Business    |   | 6,211.0                             |    | 5,886.1    |   | 324.9 |   | 5.5 | % |
|             |   |                                |    |       |   |   |   |   |   |
| Total            |   | $                                   | 6,827.8 |       | $      | 8,006.5 |   | $ | (1,178.7 | ) | (14.7 | )% |

 

The growth in theturn business is indicative of the successful conversion of 2001 newdistribution sales into repeat business and the greater brand awareness of theCompany’s products.

 

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For 2002, healthfood net sales decreased $917,930, or 11.1%, to $7,366,133 from $8,284,063 for2001.

 

For 2002, the top40 customers accounted for $13,857,300, or 96.1%, of net sales, with 22 healthfood customers contributing $7,155,200, or 49.6%, of net sales, 17 mass marketcustomers contributing $6,603,600, or 45.8%, of net sales, and oneinternational customer contributing $98,500, or 0.7%, of net sales.

 

For 2001, the top40 customers accounted for $15,916,400, or 95.7%, of net sales, with 23 healthfood customers contributing $7,921,800, or 47.6%, of net sales, 16 mass marketcustomers contributing $7,814,100, or 47.0%, of net sales, and oneinternational customer contributing $180,500, or 1.1%, of net sales.

 

For 2000, the top40 customers accounted for $14,413,300, or 92.9%, of net sales, with 24 healthfood customers contributing $8,980,500, or 57.9%, of net sales, 14 mass marketcustomers contributing $5,120,200, or 33.0%, of net sales, and twointernational customers contributing $312,600, or 2.0%, of net sales.

 

For all threeperiods, the Company considers the eight UNFI divisions and the seven Tree ofLife divisions as separate customers for purposes of this top 40 list, becauseof their ability to make independent purchasing decisions regarding theCompany’s products once Naturade products have been approved at the corporatelevel. Also, although Wal*Mart and Sam’s Club are one corporate legal entity,they operate independently with separate buying departments and, thus, theCompany considers them separate customers for purposes of this top 40 list.This analysis differs from that shown in “Item 1. Business—General” in whichthe divisions of these three entities are combined under their corporate parentto reflect three major customers.

 

For 2002, the top40 products represented $12,129,900, or 84.1%, of net sales, with 17 NaturadeTotal Soy® products contributing $7,555,700, or 52.4%, of net sales, 13 proteinpowders contributing $3,015,600, or 20.9%, of net sales and ten aloe vera andother products representing $1,558,600, or 10.8%, of net sales.

 

For 2001, the top40 products represented $13,507,000, or 81.2%, of net sales, with 18 NaturadeTotal Soy® products contributing $8,790,100, or 52.8%, of net sales, 13 proteinpowders contributing $3,238,900, or 19.5%, of net sales and nine aloe vera andother products representing $1,478,000, or 8.9%, of net sales.

 

For 2000, the top40 products represented $11,410,100, or 73.6%, of net sales with elevenNaturade Total Soy® products contributing $5,678,600, or 36.6%, of net sales,15 protein powders contributing $3,729,700, or 24.1%, of net sales and 14 aloevera and other products representing $2,001,800, or 12.9%, of net sales.

 

***Gross Margin***—Gross profit as apercentage of sales for 2002 decreased slightly to 43.4% from 44.2% in 2001.This decline in gross profit percentage is primarily due to price increasesfrom several key vendors offset slightly by gains made in the reformulation ofseveral products.

 

***Selling, General and Administrative Expenses****—*Selling, general and administrativeexpenses for the fiscal year ended December 31, 2002 decreased $1,453,550,or 15.3%, to $8,069,382, or 56.0% of net sales, from $9,522,932, or 57.2%, ofnet sales, for 2001. Approximately 53.3% of this decrease or $775,252 isattributable to decreases in brand expenses and 10.8% is due to Health FoodSales (HFS) other costs.  For 2002,brand expenses decreased $775,252, or 25.9%, compared to 2001, to $2,213,650,or 15.4% of net sales for 2002 from $2,988,902, or 18.0%, of net sales for2001. The reduced spending in mass trade promotions and print advertisingrepresented the bulk of this decrease. Mass trade promotions costs equaling $1,099,166, or 15.6%, of massmarket net sales, a $219,837, or 16.7%, decrease over the 2001 spending of$1,319,003 or 15.8% of mass market net sales. As part of the overall effort to reduce spending, advertising costsdecreased $314,822, or 99.0%, compared to 2001.  The balance of the decrease in brand expenses is attributable toHFS trade promotions, which decreased $142,680, or 16.9%, compared to2001.  Decreases in HFS All OtherNaturade other costs in 2002 for payroll (including related taxes and employeebenefits) decreased 28,991, or 5.6% compared to 2001; commissions decreased$50,145, or 14.0%; compared to 2001; recruiting decreased $24,650, or 100.0%,compared to 2001 and all other costs decreased $11,500, or 6.6% compared to2001.

 

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***Other Income (Expense)—***Other income(expense) consists of two components, interest expense and other expense.

 

Interest expense consists of bank and other interestrelated to notes shown in Note 4 to the Financial Statements. For 2002,interest expense decreased $442,599 compared to 2001 to $113,480, or .8% of netsales, for 2001, from $556,079 or 3.3% of net sales as a result of the PrivateEquity Transaction.

 

The other expensecategory consists of unusual or non-recurring charges net of other income. For2002 this other income was $28,300 compared to other income for 2001 of $6,907for a net increase of $21,393.

 

***2001 Compared to 2000***

 

2001 was adverselyaffected by the retail recession starting in mid-year, which was intensified bythe tragic events of September 2001. This softness continued through thebalance of the year as retailers were cautious about stocking inventory andseveral experienced severe business downturns. While the soy protein categoryreflected this overall weakness, the Company was able to solidify its positionwith several retailers by achieving new distribution and broadening its productselection in certain areas. In fiscal 2001, the top 25 customers accounted forover $14.3 million or 85.9% of net sales and the top 25 SKUs accounted for70.3% of net sales.

 

***Net Sales***—Net sales for 2001 increased$1,137,927, or 7.3%, to $16,641,109 from $15,503,182 for 2000. The increase insales is primarily due to the continued successful launch of Naturade Total Soyproducts for the mass market. Domestic sales for 2001 increased $1,266,099, or8.4%, to $16,290,560 from $15,024,461 for 2000. International sales for 2001decreased $128,172, or 26.8%, to $350,548 from $478,720 for 2000.

 

For 2001, massmarket net sales (excluding international) increased $2,925,043, or 57.9%, to$8,006,497 from $5,081,454 for 2000. This increase in mass market net sales wasprimarily a result of (i) the conversion of new distribution sales in 2000into repeat (turn) business in 2001, (ii) new distribution sales in 2001with the addition of accounts such as Safeway and KMart, (iii) the introductionof additional products in 2001 to existing mass market customers such as Krogerand Albertson’s, (iv) a channel shift as certain mass market customersswitched their buying patterns from purchasing through health food distributors(classified as health food sales) to direct purchases (classified as massmarket sales) and (iv) a greater brand awareness of Naturade Total Soyproducts.

 

The followingtable illustrates mass market (excluding international) net sales for 2001 and2000:

 

Mass Market Net Sales

($ in thousands)

 

|             |   | **Fiscal  Year Ended December 31,** |    | **Change** |   |
|------------------|--------|-------------------------------------|---------|------------|--------|
|             |   | **2001**                            |    | **2000**   |   | **$** |   | **%** |   |
|             |   |                                |    |       |   |   |   |   |   |
| New Distribution |   | $                                   | 1,436.0 |       | $      | 950.2 |   | $ | 485.8 |   | 51.1 | % |
| Channel Shift    |   | 684.4                               |    | 0.0        |   | 684.4 |   |   |   |
| Turn Business    |   | 5,886.1                             |    | 4,131.2    |   | 1,754.9 |   | 42.5 | % |
|             |   |                                |    |       |   |   |   |   |   |
| Total            |   | $                                   | 8,006.5 |       | $      | 5,081.4 |   | $ | 2,925.2 |   | 57.6 | % |

 

The growth in thecore turn business is indicative of the successful conversion of 2000 newdistribution sales into repeat business and the greater brand awareness of theCompany’s products. For 2001, mass market turn business net sales increased$1,754,900 or 42.5%, to $4,131,200 from $4,131,200 for 2000.

 

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For 2001, healthfood net sales decreased $1,658,945, or 16.7% %, to $8,284,063 from $9,943,008for 2000.

 

In 2001, theCompany discontinued products that accounted for $480,000 in sales for 2000. Byfactoring in the channel shift from health food distributors to direct massmarket purchases as shown in the above table, sales lost in 2001 due to theCompany’s decision to discontinue these products and the decline ininternational sales, which are reported in the health channel, a differentpicture emerges. For 2001, core health food net sales were up 1.2% compared to2000. These trends compare to a category decline of 7% from year 2000 saleslevels.

 

On a percent ofnet sales basis, 2001 reflects the continuing growth in the Company’s salesresulting from expansion of the mass market (not including international)channel. For 2001, the mass market net sales represented 48.1% of total netsales compared to 32.8% of net sales for 2000.

 

For 2001, the top40 customers accounted for $15,916,400, or 95.7%, of net sales, with 23 healthfood customers contributing $7,921,800, or 47.6%, of net sales, 16 mass marketcustomers contributing $7,814,100, or 47.0%, of net sales, and oneinternational customer contributing $180,500, or 1.1%, of net sales.

 

For 2000, the top40 customers accounted for $14,413,300, or 92.9%, of net sales, with 24 healthfood customers contributing $8,980,500, or 57.9%, of net sales, 14 mass marketcustomers contributing $5,120,200, or 33.0%, of net sales, and twointernational customers contributing $312,600, or 2.0%, of net sales.

 

For both periods,the Company considers the seven United Natural Food divisions and six Tree ofLife divisions as separate customers for purposes of this top 40 list, becauseof their ability to make independent purchasing decisions regarding theCompany’s products once Naturade products have been approved at the corporatelevel. Also, although Wal*Mart and Sam’s Club are one corporate legal entity,they operate independently with separate buying departments, and accordinglythe Company considers them separate customers for purposes of this top 40 list.This analysis differs from that shown in “Item 1. Business—General” in whichthe divisions of these three entities are combined under their corporate parentto reflect three major customers.

 

For 2001, the top40 products represented $13,507,000, or 81.2%, of net sales, with 18 NaturadeTotal Soy products contributing $8,790,100, or 52.8%, of net sales, 13 proteinpowders contributing $3,238,900, or 19.5%, of net sales and nine aloe vera andother products representing $1,478,000, or 8.9%, of net sales.

 

For 2000, the top40 products represented $11,410,100, or 73.6%, of net sales with elevenNaturade Total Soy products ontributing $5,678,600, or 36.6%, of net sales, 15protein powders contributing $3,729,700, or 24.1%, of net sales and 14 aloevera and other products representing $2,001,800, or 12.9%, of net sales.

 

During 2001, theCompany continued its successful rollout of Naturade Total Soy products, with20 powder products contributing $7,447,000, or 44.8%, of net sales. During2001, the Company continued the rollout of product line extensions in theNaturade Total Soy family including Naturade Total Soy bars and Naturade TotalSoy ready-to-drink, which combined, contributed $2,327,400, or 14.0%, of netsales. This compares favorably with sales for the twelve Naturade Total Soypowder products of $6,023,400, or 38.9%, of net sales, for 2000.

 

***Gross Margin—***Gross profit as apercentage of sales for 2001 decreased slightly to 44.2% from 46.2% in 2000.This decline in gross profit percentage is primarily due to additional reservesfor slow moving inventory and expanded private label business that carries alower gross margin than branded products

 

***Selling, General and Administrative Expenses—***Selling,general and administrative expenses for the fiscal year ended December 31,2001 increased $896,860, or 10.4%, to $9,522,932, or 57.2%, of net sales, from$8,626,072, or 55.6%, of net sales, for 2000. Approximately 90.3% of thisincrease or $810,223 is attributable to increases in brand expenses. For 2001,brand expenses increased $810,223, or 37.2%, compared to 2000, to $2,988,902,or 17.9%, of net sales for 2001 from $2,178,678, or 14.0%, of net sales for2000. The heavy spending in mass trade promotions represented the bulk of thisincrease with 2001 costs equaling $1,319,003, or 15.7%, of mass market netsales, a $684,584, or 107.9%, increase over the 2000 spending of $634,419 or11.4% of mass market net sales. The balance of the increase came from consumerpromotions and print advertising which increased 245.5% and 151%, respectively,compared to 2000.

 

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Partially offsettingthese increases was a decline in product development as the Companystrategically decided against introducing an abundance of new products, butrather concentrated on expanding sales opportunities for its core products.

 

***Other Income (Expense)—***Other income(expense) consists of two components, interest expense and other expense.

 

Interest expenseconsists of bank and other interest related to notes shown in Note 4 tothe Financial Statements. For 2001, these interest expenses decreased $104,490compared to 2000 to $556,079, or 3.3% of net sales, for 2001, from $660,569, or4.3% of net sales, for 2000.

 

The other expensecategory consists of unusual or non-recurring charges net of other income. For2001 this other income was $6,907 compared to an expense for 2000 of $930 for anet increase of $7,837.

 

**Liquidityand Capital Resources**

 

The Company usedcash of $1,467,530 in operating activities for 2002 compared to the use of cashof $782,666 in operating activities for 2001.

 

The Company’sworking capital increased from ($1,864,116) at December 31, 2001 to($1,429,771) at December 31, 2002. This increase was due to a $527,624increase in inventory as the Company expanded it’s product lines, a decrease innet accounts receivable of $270,140 reflecting the Company’s lower sales inDecember 2002 versus December 2001, an decrease in accounts payableand accrued expenses of $54,734, a decrease in prepaid expenses of $252,711 andthe Company’s operating losses for 2002.

 

Cash used ininvesting activities for 2002 totaled $7,579 compared to cash used in investingactivities for 2001 of $136,718. This decrease was largely due to the Company’sreduced investment in advanced hardware and software in 2002 for the Company’sreceiving and shipping operations.

 

The Company’s cashprovided by financing activities of $2,142,304 for 2002 was the net result ofproceeds from issuance of equity (See “Item 1. Business-Private Equity Transaction” and Note 5 to the FinancialStatements-Private Equity Transaction) and borrowings under the line of credit(See Note 4 to the Financial Statements), offset by payments of long-termobligations.

 

***Impact of Contractual Obligations andCommercial Commitments***

 

The followingsummarizes the Company’s contractual obligations at December 31, 2002 andthe effects such obligations are expected to have on liquidity and cash flow infuture periods.

 
|                                             |   | **Payments  Due by Period** |      |
|--------------------------------------------------|--------|-----------------------------|-----------|
| **Contractual  Obligations**                     |   | **Total**                   |      | **Less  than 1 Year** |   | **1-3  Years** |   | **4-5  Years** |   | **After  5 Years** |   |
|                                             |   |                        |      |   |   |   |   |   |   |   |   |
| Long-Term  Debt                                  |   | $                           | 2,056,742 |   | $ | 2,019,007 |   | $ | 37,735 |   | $ | 0 |   | $ | 0 |   |
| Capital  Lease Obligations                       |   | $                           | 0         |   |   |   |   |   |   |   |   |   |
|                                             |   |                        |      |   |   |   |   |   |   |   |   |
| Operating  Leases                                |   | $                           | 1,559,010 |   | $ | 434,021 |   | $ | 1,124,989 |   | $ | 0 |   | $ | 0 |   |
| Unconditional  Purchase Obligations              |   | $                           | 0         |   |   |   |   |   |   |   |   |   |
| Other  Long-Term Obligations                     |   | $                           | 0         |   |   |   |   |   |   |   |   |   |
| Total  Contractual Cash Obligations              |   | $                           | 3,615,752 |   | $ | 2,453,028 |   | $ | 1,162,724 |   | $ | 0 |   | $ | 0 |   |
| Series  B Convertible Redeemable Preferred Stock |   | $                           | 2,000,000 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 2,000,000 |   |

 

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On January 2,2002, the Company (i) sold Series B Convertible Preferred Stock andWarrants to Westgate for a total of $2.5 million, (ii) issued36 million shares of Common Stock in exchange for the cancellation of$5.3 million of outstanding debt and 1.3 million shares ofoutstanding Series A Convertible Preferred Stock and (iii) amendedits bank credit facility. The Series B Convertible Preferred Stock isconvertible into 13.5 million shares of Common Stock (subject toadjustment for antidilution) and bears dividends at the rate of 10% per annum.The Warrants entitle the holder to purchase for $3.5 million additionalshares of Series B Convertible Preferred -Stock convertible into33.6 million shares of Common Stock (subject to adjustment forantidilution) The net proceeds from the investment have been used by Naturadefor working capital and general corporate purposes. For a more completedescription of this transaction, see “Item 1. Business—Private EquityTransaction” and Note 5 to the Financial Statements -Private EquityTransaction.

 

OnJanuary 27, 2000, the Company entered into a three year Credit andSecurity Agreement with Wells Fargo Business Credit (“Wells Fargo”) whichinitially provided for a $3 million secured line of credit at the primerate (4.75% at December 31, 2001) plus 1.5% to be used for workingcapital, including inventory and receivables. On December 20, 2001, the termsof the Credit and Security Agreement were modified to include waiving theenforcement of existing defaults, increasing the credit available to theCompany to a maximum of $4,500,000 with an inventory maximum subline of$2,000,000, increasing the floating rate to the prime rate plus 2% andextending the maturity date to December 31, 2003. On September 19, 2002, the terms of theCredit and Security Agreement were modified to include waiving the enforcementof existing defaults, reducing the credit availability of the Company to amaximum of $4,325,000, requiring that the Company maintain certain minimumlevels of cash, and reducing the covenants regarding minimum net income andminimum book net worth.  On March 24, 2003,the terms of the Credit and Security Agreement were further amended to includewaiving the enforcement of existing defaults, increasing the floating rate tothe prime rate plus 4.5% and reducing the covenants regarding minimum netincome and minimum book net worth. Borrowings under this agreementtotaled $1,786,998 at December 31, 2002. 

 

The financialstatements accompanying this Annual Report on Form 10-K have been preparedon a going-concern basis, which contemplates the realization of assetsand the satisfaction of liabilities in the normal course of business. AtDecember 31, 2002, the Company had an accumulated deficit of $20,937,224,net working capital deficit of $1,429,771 and a stockholders’ capitaldeficiency of $1,945,301, has incurred recurring net losses and was in violationof two of its debt covenants (which violation subsequently was waived). Thesefactors, has among others, raise substantial doubt about the Company’s abilityto continue as a going concern. In addition, the Company’s independentcertified public accountants have issued a going concern opinion. The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 

In response tothese conditions, the Company entered into a Private Equity Transaction inJanuary 2002, raising $2.5 million and the Loan Agreement in April2003 pursuant to which the Company can borrow $450,000 and up to an additional$300,000 at the discretion of the lenders. See “Item 1. Business—Private EquityTransaction” and Note 4 to the Financial Statements. The net proceeds ofthese transactions will be used for working capital and general corporatepurposes, including continued penetration of the mass market. In addition, theCompany has made certain financial and organizational changes in light of the softeningeconomy, including focusing its sales force on the growth-oriented massmarket retail segment and stabilizing the health food segment, reducingoverhead costs and expanding the sales of previously-developed productline extensions in the rapidly growing soy protein category, specifically inthe ready-to-drink market segment.

 

Based on thecurrent operating plan, the Company believes that its existing cash balancesand financing arrangements will provide it with sufficient funds to finance itsoperations for at least the next twelve months. In the past, the Company hasutilized both operating and capital lease financing for certain equipment usedin our operations and expect to continue to selectively do so in the future.The Company may in the future require additional funds to support its workingcapital requirements or for other purposes, and may seek to raise suchadditional funds through the sale of public or private equity and/or debtfinancings or from other sources. No assurance can be given that additionalfinancing will be available in the future or that if available, such financingwill be obtainable on terms favorable to us or our stockholders when we mayrequire it.

 

**Impactof Inflation**

 

While the Company does experience price increases fromthird-party manufacturers, these increases cannot always be passed on tothe Company’s customers. However, these price increases have not had a materialimpact on the Company’s historical operations or profitability.

 

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**NewAccounting Pronouncements**

 

In January 2003, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 46, *Consolidation of Variable Interest Entities*, aninterpretation of Accounting Research Bulletins (“ARB”) No. 51, ConsolidatedFinancial Statements (“FIN 46”).  FIN 46clarifies the application of ARB No. 51 to certain entities in which equityinvestors do not have the characteristics of a controlling financial interest ordo not have sufficient equity at risk for the entity to finance its activitieswithout additional subordinated financial support from other parties.  The Company does not believe the adoption ofFIN 46 will have a material impact its financial position and results ofoperations.

 

In December 2002, the FASB issued Statement ofFinancial Accounting Standards (“SFAS”) No. 148, *Accounting for Stock-Based Compensation — Transition and Disclosure*(“FAS 148”), which amends Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation*(“FAS 123”). FAS 148 provides alternative methods of transition for a voluntarychange to the fair value based method of accounting for stock-based employeecompensation. In addition, FAS 148 amends the disclosure requirements of FAS123 to require more prominent and more frequent disclosures in financialstatements of the effects of stock-based compensation. The transition guidanceand annual disclosure provisions of FAS 148 are effective for fiscal yearsending after December 15, 2002. The interim disclosure provisions are effectivefor financial reports containing condensed financial statements for interimperiods beginning after December 15, 2002. The adoption of FAS 148 is notexpected to have a material impact on the Company’s consolidated balance sheetor results of operations. The Company will provide the interim disclosuresrequired by FAS 148 beginning in the first quarter of 2003.

 

In November 2002, the FASB issued Interpretation No.45, *Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness toOthers*, an interpretation of FASB Statements No. 5, 57 and 107 and arescission of FASB Interpretation No. 34. This interpretation elaborates on thedisclosures to be made by a guarantor in its interim and annual financialstatements about its obligations under guarantees issued. The interpretationalso clarifies that a guarantor is required to recognize, at inception of aguarantee, a liability for the fair value of the obligation undertaken. Theinitial recognition and measurement provisions of the interpretation areapplicable to guarantees issued or modified after December 31, 2002 and are notexpected to have a material effect on the Company’s financial statements. Thedisclosure requirements are effective for financial statements of interim andannual periods ending after December 31, 2002.

 

In June 2002, the FASB issued SFAS No. 146, *Accounting for Costs Associated with Exit or Disposal Activities*,which addresses accounting for restructuring and similar costs. SFAS No. 146supersedes previous accounting guidance, principally Emerging Issues Task Force(EITF) Issue No. 94-3. The Company will adopt the provisions of SFAS No. 146for restructuring activities initiated after December 31, 2002. SFAS No. 146requires that the liability for costs associated with an exit or disposalactivity be recognized when the liability is incurred. Under EITF No. 94-3, aliability for an exit cost was recognized at the date of a company’s commitmentto an exit plan. SFAS No. 146 also establishes that the liability shouldinitially be measured and recorded at fair value. Accordingly, SFAS No. 146 mayaffect the timing of recognizing future restructuring costs as well as theamount recognized.

 

In May 2002, the FASB issued SFAS 145, *Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections*. SFAS 145 eliminates Statement 4 (and Statement 64, as it amends Statement 4), which requires gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, and thus, also the exception to applying Opinion 30 is eliminated as well. This statement is effective for years beginning after May,-2002 for the provisions related to the rescission of Statements 4 and 64, and for all transactions entered into beginning May-2002 for the provision related to the amendment of Statement 13.  The adoption of SFAS 145 will not have a material impact on the Company’s operations and financial position.

 

In October2001, the FASB issued Statement of Financial Accounting Standard SFAS 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*. SFAS 144 requires that those long-lived assets bemeasured at the lower of carrying amount or fair value less cost to sell,whether reported in continuing operations or in discontinued operations.Therefore, discontinued operations will no longer be measured at netrealizable value or include amounts for operating losses that have not yet occurred.SFAS 144 is effective for financial statements issued for fiscal yearsbeginning after December 15, 2001 and, generally, is to be appliedprospectively. The Company adopted this Statement as of January 1, 2002 and ithad no material impact on its financial statements.

 

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In August 2001, the FASBissued SFAS 143, *Accounting for Asset Retirement Obligations.* SFAS No. 143requires the fair value of a liability for an asset retirement obligation to berecognized in the period in which it is incurred if a reasonable estimate offair value can be made. The associated asset retirement costs are capitalizedas part of the carrying amount of the long-lived asset. SFAS No. 143 iseffective for fiscal years beginning after June 15, 2002. The Company believesthe adoption of this Statement will have no material impact on its financialstatements.

 

**Item7A.  Quantitative and QualitativeDisclosure About Market Risk**

 

In the normalcourse of business, the Company is exposed to a variety of risks includingmarket risk associated with interest rate movements. The Company’s exposure tomarket risk for changes in interest rates relates primarily to the Company’slong-term debt.

 

The Company’slong-term debt primarily consists of a (i) $4.5 million line of creditwith Wells Fargo originally entered into on January 27, 2000 and amendedon December 20, 2001, September 19, 2002 and March 24, 2003, (ii) $202,345outstanding under a Loan Agreement with investors entered into on August 31,2000 and (ii) $450,000 available under a Loan Agreement with investors enteredinto on April 14, 2003.  After givingeffect to the Health Holdings, debt-to-equity conversion on January 2,2002 as part of the Private Equity Transaction, a $4 million CreditAgreement with Health Holdings was converted into equity on January 2,2002 as part of the Private Equity Transaction. The line of credit bearsinterest at prime rate plus 2%. The Loan Agreement bears interest at 8% perannum with a due date of August 2003, and the 2003 Loan Agreement bearsinterest at 15% per annum with a due date of December 31, 2004. Given the fixedinterest rate on the Loan Agreements, interest rate changes generally will haveno effect on the interest rates under the Loan Agreements or on the Company’sresults of operations. However, given the variable interest rate on the line ofcredit, the impact of interest rate changes on the line of credit could have amaterial impact on the Company’s results of operations. For the fiscal yearended December 31, 2002, the interest expense on the line of credit was$86,131. If the interest rate on the line of credit was increased by onepercent, this would result in an interest expense of $103,958 for the fiscalyear ended December 31, 2002.

 

**Item8.  Financial Statements andSupplementary Data**

 

Attached asexhibits are the financial statements and the supplementary financialinformation as required.  See "Item14. Exhibits."

 

**Item 9.  Changes in and Disagreements with Accountants on Accounting andFinancial Disclosure.**

 

None

 

**PART III**

 

**Item 10.Directors and Executive Officers**

 

The names and agesof the directors and executive officers of the Company as of March 7,2003, are as follows:

 
| **Name**                  |   | **Age** |   | **Position**                                                |   | **Since**          |
|---------------------------|--------|---------|--------|-------------------------------------------------------------|--------|--------------------|
|                      |   |    |   |                                                        |   |               |
| Bill D. Stewart           |   | 60      |   | Director, Chairman of  the Board and Chief Executive Office |   | 1998               |
| Lionel P. Boissiere,  Jr. |   | 44      |   | Director                                                    |   | 1997               |
| William B. Doyle, Jr.     |   | 43      |   | Director                                                    |   | 1997               |
| David A. Weil             |   | 64      |   | Director                                                    |   | 1999               |
| Jay W. Brown              |   | 57      |   | Director                                                    |   | February 2002 |
| Robert V. Vitale          |   | 37      |   | Director                                                    |   | February 2002 |
| Stephen M. Kasprisin      |   | 49      |   | Chief Financial Officer                                     |   | 2003               |

 

32

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The directorsserve until the next annual meeting of shareholders, or until their successorsare elected.

 

* Bill D. Stewart.*  Mr. Stewart served from 1989 to 1997 asPresident of The Thompsons Minwax Company. Mr. Stewart served as VicePresident of Sales with Thompsons from 1986 to 1989. Prior to joiningThompsons, Mr. Stewart served for 16 years with pharmaceutical companyRichardson Vicks in various capacities.

 

 *Lionel P.Boissiere, Jr.*  During thepast eight years, Mr. Boissiere has been an investor and advisor to middlemarket companies. From 1993 through 1995, he worked with Govett Ltd., andsince 1995, Mr. Boissiere has been a Managing Member at Doyle &Boissiere LLC.

 

 *William B.Doyle, Jr.*  Since 1995,Mr. Doyle has served as a Managing Member of Doyle & BoissiereLLC. Prior to such time, Mr. Doyle was with Govett Ltd.Mr. Doyle is an investor and an advisor to middle market companies.

 

 *David A.Weil.*  Mr. Weil has beenan investor and advisor to early stage companies during the past five years.Mr. Weil currently serves as co-Chief Executive Officer of two privatecompanies. Until June 1998, Mr. Weil also served as co-ChiefExecutive Officer of Frontline Capital, Inc., a broker-dealer whichspecialized in working with early stage companies. Mr. Weil holdsengineering and law degrees from Washington University and an LLM degree fromNew York University.

 

 *Jay W. Brown.*  For the last five years, Mr. Brown hasbeen a principal with Westgate Group, LLC, a related entity to Westgate EquityPartners, LLC. Prior to forming Westgate, Mr. Brown was a senior executivewith the Ralston Purina Company, running several divisions of that multi-dimensionalfood and agribusiness company. From 1995 to 1998, Mr. Brown was Presidentand Chief Executive Officer of Protein Technologies International, Inc.,the world’s supplier of soy-based protein to the food and paper processingindustries. Prior to that, Mr. Brown was Chairman and Chief ExecutiveOfficer of Continental Baking Company from 1984 to 1995 and President of VanCamp Seafood Company from 1983 to 1984.

 

 *Robert V.Vitale.*  Mr. Vitale is aprincipal with Westgate Group, LLC with primary responsibility for acquisitionsand divestitures. From 1994 to 1996, Mr. Vitale was a Vice President ofthe Boatmen’s Capital Markets and of NationsBank (after NationsBank’s 1997acquisition of Boatmen’s). At Boatmen’s, Mr. Vitale was responsible forcorporate finance activities including private placements of senior andsubordinated debt as well as multi-tiered bank debt financing.Previously, Mr. Vitale was a Senior Associate with KPMG Peat Marwick from1988 to 1993 where he was responsible for merger and acquisition engagements.Mr. Vitale is a certified public accountant.

 

*Stephen M. Kasprisin.*  Mr. Kasprisin served as Chief FinancialOfficer of Outsource Merchandising Corporation, a distributor of consumerproducts to grocery and drug stores, from 1999 to 2001.  From 1989 to 1999, he served as ChiefFinancial Officer of Acorn Products, Inc., a public consumer productsmanufacturer.  Mr. Kasprisin is aCertified Public Accountant and was on the audit staff of Coopers & Lybrandnow PriceWaterhouseCoopers from 1976 to 1980. He has a Bachelor of Arts from Baldwin-Wallace College, with a major inBusiness Administration.

 

33

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**Item 11. Executive Compensation**

 

The followingtable sets forth, as the Chief Executive Officer and as to the one other mosthighly compensated officers whose compensation exceeded  $100,000 during the last fiscal year (the“Named Executive Officers”), information concerning all cash and non-cashcompensation awarded, earned or paid for services to the Company in allcapacities for each of the three years ended December 31, 2002, 2001 and 2000.

 

**SummaryCompensation Table**

 
|                                                                      |     |                     |    |            |   |           |   |                                 |   | **Long  Term Compensation**         |   |                                         |   |
|---------------------------------------------------------------------------|----------|--------------------------|---------|-----------------|--------|----------------|--------|--------------------------------------|--------|-------------------------------------|--------|----------------------------------------------|--------|
|                                                                      |     | **Annual  Compensation** |    | **Awards**      |   | **Payouts**    |   |                                 |   |
| **Name  and  Principal  Position**                                        |     | **Year**                 |    | **Salary  ($)** |   | **Bonus  ($)** |   | **Other  Annual  Compensation  ($)** |   | **Restricted  Stock Award(s)  ($)** |   | **Securities  Underlying  Options/SAR  ($)** |   | **LTIP  Payouts  ($)** |   | **All  Other  Compensation** |   |
| Bill Stewart,  Chief Executive Officer (1)                                |     | 12/31/00                 |    | 200,000         |   |           |   | 12,000                               |   |                                |   | 60,000                                       | (3)    |   |   | 16,121  | (5) |
|                                                                      |     | 12/31/01                 |    | 218,667         |   |           |   | 30,000                               |   |                                |   | 50,000                                       | (3)    |   |   | 16,124 | (5) |
|                                                                      |     | 12/31/02                 |    | 225,000         |   |           |   | -0-                                  |   |                                |   | -0-                                          |   |   |   | 15,114 | (5) |
|                                                                      |     |                     |    |            |   |           |   |                                 |   |                                |   |                                         |   |   |   |   |   |
| Lawrence Batina,  Chief Financial Officer and Chief Operating Officer (2) |     | 12/31/00                 |    | 144,996         |   |           |   |                                 |   |                                |   | 15,000                                       | (4)    |   |   | 1,184 | (6) |
|                                                                      | 12/31/01 |                     | 151,830 |            |   |           |   |                                 |   |                                | 15,000 | (4)                                          |   |   | 1,594 | (6) |
|                                                                      |     | 12/31/02                 |    | 166,000         |   |           |   |                                 |   |                                |   | -0-                                          |   |   |   | 1,640 | (6) |

 

----

(1)                                  Fora description of the employment agreements between certain Named ExecutiveOfficers and the Company, see “Employment Contracts, Termination of Employmentand Change in Control Arrangements.”

 

(2)                                  Mr.Batina resigned as the Chief Financial Officer and Chief Operating Officer asof February 21, 2003.

 

(3)                                  Suchamounts represent stock options which were granted by the Company toMr. Stewart during 2000 with an exercise price of $0.875 per share and2001 with an exercise price of $0.44 per share. On January 2, 2002, theseoptions were repriced to $0.1477 per share, the purchase price in the PrivateEquity Transaction, and fully vested. They expire seven years from the initial grant date.

 

(4)                                  Suchamounts represent stock options that were granted by the Company toMr. Batina during 2000 with an exercise price of $0.875 per share and 2001with an exercise price of $0.4375 per share. These options vest in four equalannual installments at the anniversary date of the initial grant date andexpire seven years from the initial grant date. As a result of Mr. Batina’sresignation on February 21, 2003, these options will expire unless exercised onor before May 21, 2003.

 

In addition,Mr. Stewart and Mr. Batina participated with other full-timeemployees in the Company’s group health and life insurance program.

 

(5)           Such amount represents automobilelease payments and life insurance premiums, respectively, paid on behalf of Mr.Stewart.

 

(6)           Such amount represents Companycontributions to the Company's 401(k) Plan and life insurance premiums, paid onbehalf of Mr. Batina

 

34

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**Options/SARGrants In Last Fiscal Year**

 

No options weregranted to officers or directors during fiscal 2002.

 

**Reporton Repricing of Options (and SARs)**

 

In December 2001,the Board of Directors recognized the extraordinary efforts Mr. Stewarthad made to consummate the Private Equity Transaction and to implement theCompany’s new business strategy.  TheBoard further desired to provide Mr. Stewart with incentives for continuedservice to the Company and an opportunity to participate in the Company’sfuture success.  In light of the recenttrading prices of the Company’s Common Stock, the Board determined that Mr.Stewart’s stock options, then having exercise prices of $1.13 per share, $0.875per share and $0.4375 per share, were unlikely to provide such incentives, evenif the Company’s performance began to improve as a result of his efforts.  Accordingly, the Board decided that it wasin the best interest of the Company and its stockholders to reduce the exerciseprice of Mr. Stewart’s options.  TheBoard further decided that an appropriate exercise price was the purchase priceof the Series B Preferred Stock (on an as-converted-to-Common-Stock basis) thathad been negotiated with Westgate in the Private Equity Transaction, which was$0.1477 per share.  The repricing tookeffect on January 2, 2002, the effective date of the Private EquityTransaction.

 

Submitted on behalf of the Board of Directors:

 

Lionel P. Boissiere, Jr.

Jay W. Brown

William B. Doyle, Jr.

Robert V. Vitale

David Weil

 

35

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The following table setsforth certain information concerning the unexercised options held by the NamedExecutive Officers as of December 31, 2002.

 

**Ten-YearOption/SAR Repricings**

 

| **Name**                                        |   | **Date** |   | **Number  of  securities  underlying   options/SARs  repriced or  amended  (#)** |   | **Market  price   of stock at  time of  repricing or  amendment   ($)** |   | **Exercise  price at time   of repricing  or amendment  ($)** |   | **New  exercise  price ($)** |   | **Length  of  original  option term  remaining  at date of  repricing or  amendment** |   |
|-------------------------------------------------|--------|----------|--------|----------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------|--------|--------------------------------------------------------------------|--------|------------------------------|--------|---------------------------------------------------------------------------------------|--------|
| Bill D. Stewart  Chief Executive Officer        |   | 10/14/99 |   | 255,000                                                                          |   | 1.03                                                                    |   | 4.00                                                               |   | 1.13                         |   | 65 mos                                                                                |   |
|                                            |   | 1/2/02   |   | 255,000                                                                          |   | 0.40                                                                    |   | 1.13                                                               |   | 0.1477                       |   | 38 mos                                                                                |   |
|                                            |   | 1/2/02   |   | 60,000                                                                           |   | 0.40                                                                    |   | 0.875                                                              |   | 0.1477                       |   | 61 mos                                                                                |   |
|                                            |   | 1/2/02   |   | 50,000                                                                           |   | 0.40                                                                    |   | 0.44                                                               |   | 0.1477                       |   | 71 mos                                                                                |   |
|                                            |   |     |   |                                                                             |   |                                                                    |   |                                                               |   |                         |   |                                                                                  |   |
| Lawrence J.  Batina, Chief Financial Officer    |   | 10/14/99 |   | 100,000                                                                          |   | 1.03                                                                    |   | 2.37                                                               |   | 1.13                         |   | 41 mos                                                                                |   |
|                                            |   |     |   |                                                                             |   |                                                                    |   |                                                               |   |                         |   |                                                                                  |   |
| Mindy Paris,  Vice President Sales, Health Food |   | 10/14/99 |   | 6,000                                                                            |   | 1.03                                                                    |   | 3.75                                                               |   | 1.13                         |   | 22 mos                                                                                |   |

 

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(1)                               Asa result of Mr. Batina’s resignation on February 21, 2003, these options willexpire on May 21, 20003 unless exercised.

 

**AggregatedOption/SAR Exercises in Last Fiscal Year and Fiscal Year End Option/SAR Values**

 
|                 |   |                                   |   | **Number  of Securities Underlying Unexercised  Options/SARs at FY-End(#)** |   | **Value  of Unexercised In-the-Money   Options/SARs at FY-End ($)(1)** |   |
|----------------------|--------|----------------------------------------|--------|-----------------------------------------------------------------------------|--------|------------------------------------------------------------------------|--------|
| **Name**             |   | **Shares  Acquired on   Exercise (#)** |   | **Value  Realized ($)**                                                     |   | **Exercisable/Unexercisable**                                          |   | **Exercisable/Unexercisable** |   |
|                 |   |                                   |   |                                                                        |   |                                                                   |   |   |   |
| Bill  Stewart        |   | —                                 |   | —                                                                      |   | 365,000/0                                                              |   | $0/$0 |   |
| Lawrence  Batina (2) |   | —                                 |   | —                                                                      |   | 86,250/43,750                                                          |   | $0/$0 |   |

 

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(1)          The value of unexercised“in-the-money” options is the difference between the closing sale price ofCommon Stock on December 31, 2002 ($0.06 per share) and the exercise priceof the option, multiplied by the number of shares subject to the option.

 

(2)          Pursuant to Mr. Batina’sresignation on February 21, 2003, these options will expire on May 21, 2003unless exercised.

 

36

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The following table setsforth certain information as of December 31, 2002 with respect to allcompensation plans under which equity securities of  the Company maybe issued.

 

**EquityCompensation Plan Information**

 
| **Plan category**                                           |   | **Number of securities to be  issued upon exercise of  outstanding options,   warrants and rights   (a)** |   | **Weighted-average   exercise price of   outstanding options,   warrants and rights   (b)** |   | **Number of securities  remaining available for future  issuance under equity  compensation plans (excluding  securities reflected in column (a)).  (c)** |      |
|-------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|-----------|
| Equity  compensation plans approved by security holders     |   | 724,500                                                                                                   |   | $                                                                                           | 0.45   |                                                                                                                                                      | 1,275,500 |   |
| Equity  compensation plans not approved by security holders |   | 107,500                                                                                                   |   | 1.45                                                                                        |   | 0                                                                                                                                                         |      |
| **Total**                                                   |   | 832,000                                                                                                   |   | $                                                                                           | 0.59   |                                                                                                                                                      | 1,275,000 |   |
|                                                             |        |                                                                                                           |        |                                                                                             |        |                                                                                                                                                           |           |  |  |

 

**Compensationof Directors**

 

Effective June 2002,all non-management directors except Messrs. Boissiere, Doyle, Brown andVitale received directors’ fees of $3,000 for each meeting attended.

 

**EmploymentContracts, Termination of Employment and Change-In-Control Arrangements**

 

OnFebruary 18, 1998, the Company and Bill D. Stewart entered into anemployment agreement under which the Company retained Mr. Stewart as ChiefExecutive Officer and a member of the Company’s Board of Directors for aninitial term  of 48 months. Underthe employment agreement, as amended, Mr. Stewart receives an annualsalary of $225,000, automobile lease payments and life insurance payable asdirected by Mr. Stewart.

 

On March 2,1998, the Company granted to Mr. Stewart, pursuant to the Company’s 1998Incentive Stock Option Plan, options to acquire up to 255,000 shares of CommonStock at $4.00 per share (the average closing bid price of the shares of CommonStock on the NASDAQ OTC Bulletin Board as quoted by Bloomberg, LP for the five(5) day trading period ending on March 2, 1998). These options wererepriced to 110% of the market price of the Common Stock on October 14,1999 ($1.13). On February 1, 2000, the Company granted toMr. Stewart, pursuant to the Company’s 1998 Incentive Stock Option Plan,options to acquire up to 60,000 shares of Common Stock at $0.875 per share (theclosing bid price of the shares of Common Stock on the NASDAQ OTC BulletinBoard, as quoted by Bloomberg, LP). Furthermore, on January 26, 2001, theCompany granted to Mr. Stewart, pursuant to the Company’s 1998 IncentiveStock Option Plan, options to acquire up to 50,000 shares of Common Stock at$0.44 per share (the closing bid price of the shares of Common Stock on theNASDAQ OTC Bulletin Board, as quoted by Bloomberg, LP). All options will vestin four equal portions on each of the first four anniversaries of the grantdate, subject to any limitations on exercise contained in the 1998 IncentiveStock Option Plan and provided that the term of Mr. Stewart’s employmentwith the Company shall not have ended prior to such anniversary. In the eventof any sale (including, pursuant to either a tender offer or a merger of theCompany which results in the shareholders of the Company holding less thanfifty percent (50%) of the stock of the surviving corporation) of the Companyduring such term, subject to certain limitations, all of Mr. Stewart’soptions not then vested shall immediately vest.

 

37

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As part of thePrivate Equity Transaction on January 2, 2002, as described more fully inNote 5 to the Financial Statements and “Item 1. Business—Private EquityTransaction,” the employment agreement with Mr. Stewart was amended andrestated to extend the term until December 31, 2003 and allow for the immediatevesting of options to purchase 365,000 shares of Common Stock, 297,500 of whichwould have vested by March 2, 2002, the four-year anniversary of theoriginal employment agreement, at an exercise price reduced to $0.1477 pershare, the purchase price in the Private Equity Transaction. The amended andrestated employment agreement also reconfirmed the understanding that alloptions become fully vested in the event of any sale of the Company andextended the term of employment to December 31, 2003.

 

InFebruary 1999, Mr. Batina entered into an employment agreement withthe Company that can be terminated without cause by either party upon30 days’ notice. Pursuant to the employment agreement, as amended,Mr. Batina is entitled to a base salary of $166,000 per year and a bonus ofup to 30% of his base salary. In addition, Mr. Batina has been grantedoptions to purchase up to 100,000 shares of Common Stock, which options vest inequal annual amounts on each of the first four anniversaries of his employment.These options were repriced to 110% of the market price of the Common Stock onOctober 14, 1999 ($1.13). On February 1, 2000, the Company granted toMr. Batina, pursuant to the Company’s 1998 Incentive Stock Option Plan,options to acquire up to 15,000 shares of Common Stock at $0.875 per share (theclosing bid price of the shares of Common Stock on the NASDAQ OTC BulletinBoard, as quoted by Bloomberg, LP). Furthermore, on March 9, 2001, theCompany granted to Mr. Batina, pursuant to the Company’s 1998 IncentiveStock Option Plan, options to acquire up to 15,000 shares of Common Stock at$0.4375 per share (the closing bid price of the shares of Common Stock on theNASDAQ OTC Bulletin Board, as quoted by Bloomberg, LP).   Mr. Batina resigned as of February 21,2003, thereby terminating his employment agreement with the Company, and as aresult of to Mr. Batina’s resignation on February 21, 2003, these options willexpire on May 21, 2003 unless exercised.

 

**IncentiveStock Option Plan**

 

In 1998, theCompany adopted the 1998 Incentive Stock Option Plan (the “Incentive Plan”).The Incentive Plan provides for the issuance of incentive stock options withinthe meaning of Section 422 of the Internal Revenue Code of 1986, asamended (the “Code”). The purpose of the Incentive Plan is to enable theCompany to attract, retain and motivate its employees by providing forperformance-based benefits. At the 2000 annual stockholders’ meeting, thenumber of shares of the Company’s Common Stock, which may be subject to awardsgranted under the Incentive Plan, was increased to 850,000. At the 2001 annualstockholders’ meeting, the number was further increased to 2,000,000. As ofDecember 31, 2002, options to purchase under the Incentive Plan there were724,500 shares of the Company’s Common Stock subject to outstanding options, ofwhich options to purchase 564,000 shares (subject to adjustment to preventdilution) had vested and 1,275,500 shares were available for future awardsunder the Incentive Plan.

 

The Incentive Planis administered by a committee of the Board of Directors, consisting of threemembers who shall be members of the Board, or administered by the full Board ofDirectors. The Committee has the power to construe and interpret the IncentivePlan and, subject to provisions of the Incentive Plan, to determine the personsto whom and the dates on which awards will be granted, the number of shares tobe subject to each award, the times during the term of each award within whichall or a portion of such award may be exercised, the exercise price, the typeof consideration and other terms and conditions of such award. The exercise ofstock options under the Incentive Plan may not be less than the fair marketvalue of the Common Stock subject to the option on the date of the option grantand in some cases may not be less that 110% of fair market value. The maximumterm of the Incentive Plan is ten years, except that the Board may terminatethe Incentive Plan earlier. The term of each individual award will depend uponthe written agreement between the Company and the grantee setting forth theterms of the awards.

 

In addition tooptions issued under the Incentive Stock Option Plan, options to purchase140,000 shares of Common Stock have been issued to directors and a consultantof the Company.

 

**401(k) Plan**

 

The Companymaintains a 401(k) profit sharing plan (“401(k) Plan”) for the benefit of allemployees who meet certain age and length of service requirements. The 401(k)Plan provides for Company matching contributions equal to 25% of each employeeparticipant’s contribution not to exceed 6% of the employee participant’scompensation.

 

38

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**Item 12.****  SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters**

 

The followingtable sets forth information regarding beneficial ownership, as of December 31,2002 of the Company’s outstanding Common Stock by (i) any person who isknown to the Company to be the beneficial owner of more than 5% of theCompany’s voting securities, (ii) each director and each of the NamedExecutive Officers, and (iii) by the directors and executive officers ofthe Company as a group. Beneficial ownership is determined in accordance withthe rules of the Securities and Exchange Commission. In computing the number ofshares beneficially owned by a person and the percentage of ownership of thatperson, shares of Common Stock subject to options or warrants held by thatperson that are currently exercisable or will become exercisable within60 days are deemed outstanding but are not deemed to be outstanding as toany other person.

 

The Company’sSeries B Convertible Preferred Stock votes with the Common Stock on allmatters presented to the stockholders on as as-converted-to-Common Stock basis.Each share of Series B Convertible Preferred Stock is convertible into oneshare of Common Stock (subject to adjustment for antidilution), at any time atthe option of the holder. Accordingly, each share of Series B PreferredStock has been treated as one share of Common Stock for purposes of calculatingpercent of beneficial ownership.

 
| **Name  and Address********of Beneficial Owner(1)**                                                       |   | **Class********of Stock** |   | **Amount  and Nature  of********Beneficial Owner** |   | **Percent********of Class (2)** |        |
|-----------------------------------------------------------------------------------------------------------|--------|---------------------------|--------|----------------------------------------------------|--------|---------------------------------|-------------|
|                                                                                                      |   |                      |   |                                               |   |                            | ** **  |
| Lawrence  J. Batina                                                                                       |   | Common                    |   | 119,250                                            | (7)    |                            | *** ** |
| Lionel  P. Boissiere, Jr.                                                                                 |   | Common                    |   | 41,054,267                                         | (3)    | **44.5**                        | **%**       |
| Jay  W. Brown                                                                                             |   | Series B Preferred   |   | 47,182,271                                         | (4)    | **51.1**                        | **%**       |
| William  B. Doyle, Jr.                                                                                    |   | Common                    |   | 41,054,267                                         | (3)    | **44.5**                        | **%**       |
| Health  Holdings and Botanicals, LLC. Suite 500 330 Primrose Rd. Burlingame, CA 94010                     |   | Common                    |   | 41,054,267                                         | (3)    | **44.5**                        | **%**       |
| Bill  D. Stewart                                                                                          |   | Common                    |   | 365,000                                            | (6)    |                            | *****       |
| Robert  V. Vitale                                                                                         |   | Series B Preferred   |   | 47,182,271                                         | (4)    | **51.1**                        | **%**       |
| David  Weil                                                                                               |   | Common                    |   | 1,093,517                                          | (5)    |                            | *****       |
| Westgate  Equity Partners, L.P. One Magna Place Suite 650 1401 South Brentwood Blvd.  St. Louis, MO 63144 |   | Series B Preferred   |   | 47,182,271                                         | (4)    | **51.1**                        | **%**       |
| Executive  officers and directors as a group (7 persons)                                                  |   | Common                    |   | 89,814,305                                         | (8)    | **97.2**                        | **%**       |

 

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| *      |   | Less than 1%                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| (1)    |   | Except as otherwise  indicated, the address of each person named in the above table is in care of  Naturade, Inc., 14370 Myford Road, Irvine, CA. 92606.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| (2)    |   | Common Stock, including  Series B Convertible Preferred Stock on as as-converted-to-Common Stock  basis.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| (3)    |   | Total includes  5,064,412 shares of Common Stock owned by Health Holdings and 35,989,855  shares of Common Stock received in exchange for $5,315,702 owed under the  Company’s Credit Agreement and Loan Agreement as discussed under Item 13 and  as more fully explained under Note 4 to the Financial Statements. Under  the terms of the Private Equity Transaction, the 600,000 shares of Common  Stock exercisable under warrants related to the Company’s Finance Agreement  were modified to make the warrants exercisable for Non-Voting Common Stock  rather than Common Stock as discussed under Item 13. Common shares of Health  Holdings are held by (i) Doyle & Boissiere Fund I, LLC, a  Delaware limited liability company (of which Messrs. William B. Doyle,  Jr. and Lionel P. Boissiere, directors of the Company, are principals and  managing members), (ii) Mr. Anders Brag and (iii) Taishan  Holdings, Inc., a British Virgin Islands corporation (of which  Messrs. William S. Doyle (no relation to William B. |

 

39

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|   |   | Doyle, Jr.) and Anders  Brag hold equity interests). Messrs. William B. Doyle, Jr. and Lionel P.  Boissiere each disclaim beneficial ownership of the Company’s Common Stock  and Preferred Stock held by Health Holdings. The list of shares in their name  in the table shall not be construed as an admission of beneficial ownership  interest.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (4)    |   | Total includes  13,540,723 shares of Series B Convertible Preferred Stock and warrants  to purchase an additional 33,641,548 shares of Series B Convertible  Preferred Stock. Each share of Series B Convertible Preferred Stock is  convertible into one share of Common Stock at the option of the holder  (subject to adjustment to prevent dilution). The Series B Convertible  Preferred Stock is held by Westgate Equity Partners, L.P. of which  Messrs. Brown and Vitale are principals, a related company to Westgate  Group, LLC. Messrs. Brown and Vitale each disclaim beneficial ownership  of the Company’s Common Stock and Preferred Stock held by Westgate Equity  Partners, L.P. The list of shares in their name in the table shall not be  construed as an admission of beneficial ownership interest. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (5)    |   | Total includes 85,000 shares of Common Stock solely  owned by Mr. Weil, 238,125 shares of Common Stock owned by a company of  which Mr. Weil is a 50% owner, 50,000 shares of Common Stock which can  be purchased under presently exercisable options and 720,392 shares of Common  Stock issued upon conversion of a $50,000 note which is part of the Loan  Agreement as discussed under Item 13.                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (6)    |   | Total includes 365,000  shares of Common Stock which can be purchased under presently exercisable  options.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (7)    |   | Total includes 118,750  shares of Common Stock which can be purchased under presently exercisable  options. As a result of to Mr. Batina’s resignation on February 21, 2003,  these options will expire on May 21, 2003 unless exercised.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (8)    |   | Total includes shares  of Common Stock beneficially owned by Health Holdings and Common Stock  beneficially owned by Westgate Equity Partners; see note 3 and  note 4 above, respectively. See also notes 5, 6, and 7 above with  respect to additional shares of Common Stock included in this total.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |

 

**Item 13.****Certain Relationships and Related Transactions**

 

InMarch 1999, the Company entered into a Finance Agreement (the “FinanceAgreement”) with Health Holdings. The Finance Agreement provided that theCompany may borrow up to $1.0 million at a per annum interest rate of 8%.The Finance Agreement further provided that for each dollar borrowed, theCompany shall issue a warrant (“Warrant”) to Health Holdings to purchasethree-tenths (0.3) of a share of Common Stock of the Company at an exerciseprice of $2.125 per share, subject to adjustment. The Warrants are exerciseablefor a period of ten years commencing on the date of grant. In June 1999,the Finance Agreement was amended (the “Amendment”) to increase the amount ofavailable borrowings to $1.6 million at an interest rate of 8% per annum.The Amendment further provided that for each dollar borrowed over$1.0 million, the Company shall issue a Warrant to Health Holdings topurchase one-half (0.5) of a share of Common Stock of the Company at anexercise price of $1.00 per share. Further, the exercise price of the 300,000Warrants previously issued under the Finance Agreement prior to the Amendmentwas reset to $1.00 per share, subject to adjustment. As of December 31,1999, the Company borrowed $1,600,000 under the Finance Agreement and theAmendment and issued a total of 600,000 Warrants to Health Holdings.

 

InMarch 2000, the Company and Health Holdings signed a further Amendment tothe Finance Agreement whereby the advances of $1,600,000 plus accrued interestof $23,145 were converted into Common Stock of the Company as provided for inthe Agreement. Per the Agreement, the debt was converted at $0.8125 per share,which resulted in 1,997,717 shares of restricted Common Stock being issued toHealth Holdings. Effective with the conversion, the Finance Agreementterminated and is no longer in effect.

 

As more fullyexplained under “Item 1.  Business –Private Equity Transaction” and in Note 5 to the Financial Statements, theWarrants issued under the Finance Agreement were modified to be exercisable forNon-Voting Common Stock rather than Common Stock

 

As of December 12,1997 the Company entered into a Consulting Agreement with Doyle & BoissiereLLC (“D&B”), an affiliate of Health Holdings.  Under the Consulting Agreement, as long as affiliates of D &B own at least 25% of the outstanding equity interests of the Company, D&Bwill provide consulting services to the Company and receive a total annual feeof 

 

40

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$300,000, payable quarterly.

 

InAugust 1999, the Company entered into a Credit Agreement (the “CreditAgreement”) with Health Holdings, a majority stockholder of the Company. TheCredit Agreement allows for advances (the “Advances”) of $4 million at aninterest rate of 8% per annum with a due date of July 31, 2004. During2001, Health Holdings agreed to convert interest earned from October 1,2000 to September 30, 2001 of $342,406 to the outstanding principal amountas a payment-in-kind resulting in a balance at December 31, 2001 of$4,496,194. As part of the Private Equity Transaction on January 2, 2002as described more fully in Note 5, Health Holdings agreed to convert allof the Company’s Credit Agreement debt due to Health Holdings, plus accruedinterest of $67,012, for a total debt conversion of $4,563,206.

 

InAugust 2000, the Company entered into a Loan Agreement (the “LoanAgreement”) with Health Holdings and other investors (the “Lender Group”). TheLoan Agreement allows for advances (the “Loan Advances”) of up to$1.2 million at an interest rate of 8% per annum. During 2001, the LoanAgreement was amended to allow for a one year term for $50,000 advanced fromDavid Weil, a member of the Board of Directors. This amendment did not changethe terms of the remaining Loan Agreement amounts. Thus, as ofDecember 31, 2001, amounts due under the Loan Agreement included $50,000due on September 12,2002 to David Weil and with the remaining balanceoutstanding due August 31, 2003. Interest only payments are required on aquarterly basis. On June 13, 2001, two investors converted their totaldebt of $150,000 plus accrued interest of $2,400 into Common Stock, receiving atotal of 476,250 shares of the Company’s Common Stock based on the then fairmarket value of $0.32. As of December 31, 2001, the Company had borrowed$993,790 under this facility. Of this amount, $741,445 is debt owed to HealthHoldings. As part of the Private Equity Transaction on January 2, 2002 asdescribed more fully in “Item 1. Business-Private Equity Transaction” and Note 5, Health Holdingsagreed to convert all of the Company’s Loan Agreement debt due to HealthHoldings, plus accrued interest of $11,051, for a total debt conversion of$752,496. The Loan Agreement further provides that the Lender Group may electto convert all or any part of the Loan Advances into shares of the Company’sCommon Stock at a conversion price equal to the lower of (a) the averageclosing bid of the Company’s Common Stock for the ten trading days prior to themaking of a Loan Advance or (b) the average closing bid of the Company’sCommon Stock for the ten trading days prior to the date of receipt of notice ofconversion.

 

On January 2,2002, as part of the Private Equity Transaction, the Company entered into aManagement Services Agreement with Westgate Group, LLC, an affiliate ofWestgate (“Westgate Group”).  Under theManagement Services Agreement, as long as Westgate owns 10% or more of theoutstanding voting securities of the Company, four principals of Westgate Groupprovide management and consulting services to the Company and receive a totalannual fee of $100,000, payable quarterly. The agreement extends until December 31, 2006, and is automaticallyrenewed for one-year terms unless terminated by either party.

 

On April 14,2003, the Company entered into a loan agreement (the “Loan Agreement”) withHealth Holdings and Botanicals, LLC, a principal stockholder of the Company,and David A. Weil, a director and stockholder of the Company (the “LenderGroup”), pursuant to which the Lender Group has agreed to lend the Company$450,000 and, subject to the discretion of the Lender Group, up to anadditional $300,000.  All advances underthe Loan Agreement bear interest at the rate of 15% per annum, are due onDecember 31, 2004, are secured by substantially all of the assets of theCompany, and are subordinated to the Company’s indebtedness to Wells Fargo.  The advances under the Loan Agreement willbe used for the Company for working capital and general corporatepurposes.  For a more completedescription of this transaction, see “Item 1.  Business – Loan Agreement.” In consideration of the extension of credit under the Loan Agreement,Wells Fargo waived all defaults of the Company as of December 31, 2002 underthe Credit and Security Agreement dated as of February 27, 2000 and amended the agreement to, among otherthings, reduce the covenants regarding minimum net income and minimum book networth and increased the interest rate. For a description of the amended bank credit facility, see “Item 7.  Management’s Discussion and analysis ofFinancial Condition and Results of Operations — Liquidity.”

 

**Item14.****  Controls and Procedures**

 

Within the 90 days prior to the filing date of thisreport, the Chief Executive Officer and the Chief Financial Officer of theCompany, with the participation of the Company’s management, carried out anevaluation of the effectiveness of the Company’s disclosure controls andprocedures pursuant to Exchange Act Rule 13a-14.  Based upon that evaluation, the Chief Executive Officer and theChief Financial Officer believe that, as of the date of the evaluation, theCompany’s disclosure controls and procedures are effective in making known tothem material information relating to the Company (including its consolidatedsubsidiaries) required to be included in this report.

 

Disclosure controls and procedures no matter how welldesigned and implemented, can provide only reasonable assurance of achieving anentity’s disclosure objectives.  Thelikelihood of achieving such objections is affected by limitations inherent indisclosure 

 

41

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controls and procedures.  Theseinclude the fact that human judgment in decision-making can be faulty and thatbreakdowns in internal control can occur because of human failures such assimple errors or mistakes or international circumvention of the establishedprocess.

 

There were no significant changes in the Company’sinternal controls or in other factors that could significantly affect internalcontrols, known to the Chief Executive Officer or the Chief Financial Officer,subsequent to the date of the evaluation.

 

**PART IV**

 

**Item15.****Exhibits,Financial Statement Schedules and Reports on Form 8-K**

 
| (a)    |   | Financial Statements  and Schedules. Reference is made to the Index to Financial Statements on page  47 for a list of financial statements and the financial statement schedule  filed as part of this report. Financial statement schedules are omitted  because they either are not applicable or the required information is shown  in the Company’s financial statements or the related notes thereto. |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                            |
| (b)    |   | Reports on  Form 8-K: None                                                                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                            |
| (c)    |   | Exhibits: The following  is a list of exhibits filed as a part of this report:                                                                                                                                                                                                                                                                                                                                  |

 
| **Exhibit  No.** |   | **Document**                                                                                                                                                                                                                                                                                                                                                                                            |
|------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                    |
| 2                |   | Stock Purchase  Agreement, dated as of December 15, 1997 (the “Stock Purchase Agreement”), by  and among the Company, Allan Schulman, L.S. Smith, Dallas Gold & Silver  Exchange, Inc. (“DGSE”), Barry M. Zwick and Health Holdings and Botanicals,  Inc., incorporated by reference to Exhibit 2 to the Company’s Current Report  on Form 8-K filed on December 23, 1997. |
| 3.1              |   | Certificate of  Incorporation of Naturade, Inc., together with Amendments and Certificate of  Designations relating thereto, incorporated by reference to the Company’s  Annual Report on Form 10-K filed for fiscal 1997 and the exhibits and  attachments thereto.                                                                                                                               |
| 3.2              |   | Amended and Restated  Bylaws of Naturade, Inc., as amended December 7, 2001, incorporated by  reference to Exhibit 3.6 to the Company’s Current Report on Form 8-K filed on  January 3, 2002.                                                                                                                                                                                                      |
| 3.3              |   | Certificate of  Amendment to Certificate of Incorporation of Naturade, Inc. dated December 20,  2001, incorporated by reference to Exhibit 3.3 to the Company’s Current  Report on Form 8-K filed on January 3, 2002.                                                                                                                                                                              |
| 3.4              |   | Certificate of  Amendment to Certificate of Incorporation of Naturade, Inc., dated December  28, 2001, incorporated by reference to Exhibit 3.4 to the Company’s Current  Report on Form 8-K filed on January 3, 2002.                                                                                                                                                                             |
| 3.5              |   | Certificate of  Designation of Series B Convertible Preferred Stock, dated December 20, 2001,  incorporated by reference to Exhibit 3.5 to the Company’s Current Report on  Form 8-K filed on January 3, 2002.                                                                                                                                                                                     |
| 4.1              |   | Registration Rights  Agreement, dated as of December 15, 1997, by and between the Company and  Health Holdings & Botanicals, Inc., incorporated by reference to Exhibit  4 to the Company’s Current Report on Form 8-K as filed on December 23, 1997.                                                                                                                                          |
| 4.2              |   | Form of Class B Warrant  Certificate, incorporated by reference to the Company’s Annual Report on Form  10-K filed for fiscal 1991 and the exhibits and attachments thereto.                                                                                                                                                                                                                       |
| 4.3              |   | Form of Series B  Convertible Preferred Stock Warrant Certificate, incorporated by reference to  Exhibit 4.3 to the Company’s Current Report on Form 8-K filed on January 3,  2002.                                                                                                                                                                                                                |
| 10.1*            |   | Consulting Agreement  dated as of December 12, 1997, by and between the Company and Doyle &  Boissiere LLC, incorporated by reference to Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed December 23, 1997.                                                                                                                                                                    |
| 10.2*            |   | Mutual Option  Agreement, dated as of December 15, 1997, by and between the Company and  Allan Schulman, incorporated by reference to Exhibit 10.3 to the Company’s  Current Report on Form 8-K as filed December 23, 1997.                                                                                                                                                                        |
| 10.3*            |   | Employment, Consulting  and Non-Competition Agreement, dated as of December 12, 1997, by and between  the Company and Allan Schulman, incorporated by reference to Exhibit 10.4 to the  Company’s Current Report on Form 8-K as filed December 23, 1997.                                                                                                                                           |

 

42

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| 10.4   |   | Form of Option  Agreement for Purchase of Naturade, Inc. Common Stock for Directors,  incorporated by reference to the Company’s Annual Report on Form 10— K filed  for fiscal 1995 and the exhibits and attachments thereto.                                                                                                                                                                                                                                                       |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5   |   | Form of Broker  Agreement between NPI and Domestic Brokers, incorporated by reference to the  Company’s Annual Report on Form 10-K filed for fiscal 1991 and the exhibits  and attachments thereto.                                                                                                                                                                                                                                                                                      |
| 10.8   |   | Amendment dated May 2,  1995 to Agreement For Purchase of Stock and Real Property dated January 1,  1995, incorporated by Reference to the Company’s Quarterly Report on Form  10-Q filed for period ended December 31, 1994 and Exhibits and Attachments  thereto.                                                                                                                                                                                                                      |
| 10.13  |   | Lease Agreement between  NPI and Messrs. Schulman and Becker, incorporated by reference to the  Company’s Annual Report on Form 10-K filed for Fiscal 1991 and the Exhibits  and Attachments thereto, and the First Amendment to Lease, dated as of  December 15, 1997, by and among Allan Schulman and the Registrant  (collectively as landlord) and the Company (as tenant), incorporated by  reference to the Company’s Current Report on Form 8-K as filed December 23,  1997. |
| 10.15* |   | Naturade, Inc. 1998  Incentive Stock Option Plan, as amended, incorporated by reference to Exhibit  10.17 to the Company’s Quarterly Report on Form 10-Q for the period ended  March 31, 1998.                                                                                                                                                                                                                                                                                           |
| 10.16* |   | Incentive Stock Option  Plan with Bill D. Stewart dated March 2, 1998, incorporated by reference to  Exhibit 10.18 to the Company’s Quarterly Report on Form 10-Q filed for the  period ended March 31, 1998.                                                                                                                                                                                                                                                                            |
| 10.17* |   | Incentive Stock Option  Plan with Ronald Ahrens dated April 20, 1998, incorporated by reference to  Exhibit 10.19 to the Company’s Quarterly Report on Form 10-Q filed for the  period ended March 31, 1998.                                                                                                                                                                                                                                                                             |
| 10.19  |   | Finance Agreement by  and Between Naturade, Inc. and Health Holdings and Botanicals, Inc. dated as  of March 17, 1999, incorporated by reference to Exhibit 10. 2 to the  Company’s Quarterly Report on Form 10-Q filed for the period ended March 31,  1999.                                                                                                                                                                                                                            |
| 10.20  |   | Amendment No. 1 to  Finance Agreement by and between Naturade, Inc. and Health Holdings and  Botanicals, Inc. dated June 1, 1999, incorporated by reference to Exhibit  10.1 to the Company’s Quarterly Report on Form 10-Q filed for the period  ended June 30, 1999.                                                                                                                                                                                                                   |
| 10.21  |   | Credit Agreement by and  Between Naturade, Inc. and Health Holdings and Botanicals, Inc. dated as of  August 9, 1999, incorporated by reference to Exhibit 10.2 to the Company’s  Quarterly Report on Form 10-Q filed for the period ended June 30, 1999                                                                                                                                                                                                                                 |
| 10.22  |   | Settlement Agreement  between Naturade, Inc. and the PNI Trustee, August 1999, incorporated by  reference to Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q  filed for the period ended June 30, 1999.                                                                                                                                                                                                                                                                      |
| 10.23* |   | Employment Contract  with Lawrence J. Batina, COO/CFO dated as of February 1, 1999, incorporated  by reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  filed for the period ended March 31, 1999.                                                                                                                                                                                                                                                                |
| 10.24  |   | Credit and Security  Agreement by and Between Naturade, Inc. and Wells Fargo Business Credit, Inc.  dated as of January 27, 2000, incorporated by reference to Exhibit 10.24 to  the Company’s Annual Report on Form 10-K filed for fiscal 1999.                                                                                                                                                                                                                                         |
| 10.25  |   | Amendment No. 2 to  Finance Agreement by and between Naturade, Inc. and Health Holdings and  Botanicals, LLC dated as of March 17, 2000, incorporated by reference to  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q filed for the  period ended March 31, 2000.                                                                                                                                                                                                           |
| 10.26  |   | Industrial Lease dated  as of December 23, 1998 between the Company and The Irvine Company,  incorporated by reference to Exhibit 10.25 to the Company’s Quarterly Report  on Form 10-Q filed for the period ended June 30, 2000.                                                                                                                                                                                                                                                        |
| 10.27  |   | Loan Agreement by and  Between Naturade, Inc. and Health Holdings and Botanicals, LLC. and Wald  Holdings, LLC. dated as of August 31, 2000, incorporated by reference to  Exhibit 99.1 to the Company’s Current Report on Form 8-K filed on September  20, 2000.                                                                                                                                                                                                                        |
| 10.28  |   | Securities Purchase  Agreement among Naturade, Inc., Westgate Equity Partners, L.P., and Health  Holdings & Botanicals, LLC, dated as of December 20, 2001, incorporated  by reference to Exhibit 10.28 to the Company’s Current Report on Form 8-K  filed January 3, 2002.                                                                                                                                                                                                          |
| 10.29  |   | Registration Rights  Agreement between Naturade and Westgate Equity Partners, L.P., dated as of  January 2, 2002, incorporated by reference to Exhibit 10.29 to the Company’s  Current Report on Form 8-K filed January 3, 2002.                                                                                                                                                                                                                                                         |
| 10.30* |   | Management Services  Agreement between Westgate Group, LLC and Naturade, Inc. dated as of January  2, 2002, incorporated by reference to Exhibit 10.30 to the Company’s Current  Report on Form 8-K filed January 3, 2002.                                                                                                                                                                                                                                                               |
| 10.31  |   | Voting Agreement  between Westgate Equity Partners, L.P. and Health Holdings & Botanicals,  LLC, dated as of January 2, 2002, incorporated by reference to Exhibit 10.31  to the Company’s Current Report on Form 8-K filed January 3, 2002.                                                                                                                                                                                                                                         |

 

43

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| 10.32* |   | Amended and Restated  Employment Agreement between Naturade, Inc. and Bill D. Stewart, dated as of  January 2, 2002, incorporated by reference to Exhibit 10.31 to the Company’s  Current Report on Form 8-K filed January 3, 2002.                                                       |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.33  |   | Fourth Amendment to  Credit and Security Agreement and Waiver of Defaults between Naturade, Inc.  and Wells Fargo Business Credit, Inc., dated as of December 20, 2001,  incorporated by reference to Exhibit 10.33 to the Company’s Current Report on  Form 8-K filed January 3, 2002.   |
| 10.34  |   | Amendment No. 3 to  Finance Agreement between Naturade, Inc. and Health Holdings &  Botanicals, LLC, dated as of January 2, 2002, incorporated by reference to  Exhibit 10.34 to the Company’s Current Report on Form 8-K filed January 3,  2002.                                     |
| 10.35  |   | Letter agreement of  Wells Fargo Business Credit, Inc. waiving rights arising from the Company’s  defaults of covenants under the Credit and Security Agreement dated as of  January 27, 2000.                                                                                            |
| 10.36  |   | Sixth Amendment to  Credit and Security Agreement between Naturade, Inc. and Wells Fargo Business  Credit Inc., dated as of March 24, 2003.                                                                                                                                                    |
| 10.37  |   | Consent and Mutual  Release dated as of April 14, 2003, among the Company, Westgate Equity  Partners, LLP and Health Holdings and Botanicals, LLC.                                                                                                                                             |
| 10.38  |   | Fifth Amendment to  Credit and Security Agreement between Naturade, Inc. and Wells Fargo Business  Credit Inc., dated as of September 19, 2002 incorporated by reference to  Exhibit 10.35 to the Company’s quarterly Report on Form 10-Q filed for the  period ended September 30, 2002. |
| 10.39  |   | Irrevocable Proxy  between Health Holdings and Botanicals, LLC and Westgate Equity Partners, LLP  dated April 14, 2003.                                                                                                                                                                        |
| 10.40  |   | Loan Agreement by and  between Naturade, Inc., Health Holdings and Botanicals, LLC and David A. Weil  dated April 14, 2003.                                                                                                                                                                    |
| 10.41  |   | Waiver of Preferential  Dividends by Holders of Series B Convertible Preferred Stock by Westgate  Equity Partners, L.P dated April 14, 2003.                                                                                                                                                   |
| 99.1   |   | Certification pursuant  to 18 U.S.C. 1350, Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act  of 2002.                                                                                                                                                                                 |

 

----

* Management contracts orcompensatory plan or arrangement.

 

44

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**SIGNATURES**

 

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| NATURADE, INC.  |
|----------------------|
| Date: April 15, 2003 |   |
|                 |   | /s/ Bill D. Stewart |
|                 |   | Bill D. Stewart, |
|                 |   | Chief Executive Officer |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has been dulysigned below by the following persons on behalf of the registrant and in thecapacities and dates indicated.

 
| **Signature**             |   | **Title**                            |   | **Date**       |
|---------------------------|--------|--------------------------------------|--------|----------------|
|                      |   |                                 |   |           |
| /s/ BILL D. STEWART       |   | Director and Chief Executive Officer |   | April 15, 2003 |
| Bill D. Stewart           |   | (Principal Executive Officer)        |   |           |
|                      |   |                                 |   |           |
| /s/ STEPHEN M.  KASPRISIN |   | Chief Financial Officer              |   | April 15, 2003 |
| Stephen M.  Kasprisin     |   | (Principal Accounting  Officer)      |   |           |
|                      |   |                                 |   |           |
| /s/ LIONEL P. BOISSIERE   |   | Director                             |   | April 15, 2003 |
| Lionel P. Boissiere       |   |                                 |   |           |
|                      |   |                                 |   |           |
| /s/ WILLIAM B.  DOYLE, JR |   | Director                             |   | April 15, 2003 |
| William B.  Doyle, Jr.    |   |                                 |   |           |
|                      |   |                                 |   |           |
| /s/ DAVID A.  WEIL        |   | Director                             |   | April 15, 2003 |
| David A. Weil             |   |                                 |   |           |
|                      |   |                                 |   |           |
| /s/ JAY BROWN             |   | Director                             |   | April 15, 2003 |
| Jay Brown                 |   |                                 |   |           |
|                      |   |                                 |   |           |
| /s/ ROBERT V.  VITALE     |   | Director                             |   | April 15, 2003 |
| Robert V. Vitale          |   |                                 |   |           |

 

45

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**CERTIFICATION**

 
|   | I, Bill D. Stewart, certify that:                                                                                                                                                                                                                                                                                                                                                         |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                      |
| 1.     | I have reviewed this annual report on Form 10-K  of Naturade, Inc.;                                                                                                                                                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 2.     | Based on my knowledge, this annual report does not  contain any untrue statement of a material fact or omit to state a material  fact necessary to make the statements made, in light of the circumstances  under which such statements were made, not misleading with respect to the  period covered by this annual report;                                                              |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 3.     | Based on my knowledge, the financial statements, and  other financial information included in this annual report, fairly present in  all material respects the financial condition, results of operations and cash  flows of the registrant as of, and for, the periods presented in this annual  report;                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 4.     | The registrant’s other certifying officers and I are  responsible for establishing and maintaining disclosure controls and procedures  (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and  have:                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
|   | a)                                                                                                                                                                                                                                                                                                                                                                                        | designed such disclosure controls and procedures to  ensure that material information relating to the registrant, including its  consolidated subsidiaries, is made known to us by others within those  entities, particularly during the period in which this annual report is being  prepared; |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
|   | b)                                                                                                                                                                                                                                                                                                                                                                                        | evaluated the effectiveness of the registrant’s  disclosure controls and procedures as of a date within 90 days prior to the  filing date of this annual report (the “Evaluation Date”); and |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
|   | c)                                                                                                                                                                                                                                                                                                                                                                                        | presented in this annual report our conclusions  about the effectiveness of the disclosure controls and procedures based on  our evaluation as of the Evaluation Date; |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 5.     | The registrant’s other certifying officers and I  have disclosed, based on our most recent evaluation, to the registrant’s  auditors and the audit committee of registrant’s board of directors (or  persons performing the equivalent functions):                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
|   | a)                                                                                                                                                                                                                                                                                                                                                                                        | all significant deficiencies in the design or  operation of internal controls which could adversely affect the registrant’s  ability to record, process, summarize and report financial data and have  identified for the registrant’s auditors any material weaknesses in internal  controls; and |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
|   | b)                                                                                                                                                                                                                                                                                                                                                                                        | any fraud, whether or not material, that involves  management or other employees who have a significant role in the registrant’s  internal controls; and |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 6.     | The registrant’s other certifying officers and I  have indicated in this annual report whether there were significant changes  in internal controls or in other factors that could significantly affect  internal controls subsequent to the date of our most recent evaluation,  including any corrective actions with regard to significant deficiencies and  material weaknesses. |

 

 
| Date:  April 15, 2003 | /s/ Bill D. Stewart     |   |
|---------------------------------|-------------------------|--------|
|                            | Bill D. Stewart         |
|                            | Chief Executive Officer |

 

46

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**CERTIFICATION**

 
|   | I, Stephen M. Kasprisin, certify that:                                                                                                                                                                                                                                                                                                                                                    |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 1.     | I have reviewed this annual report on Form 10-K  of Naturade, Inc.;                                                                                                                                                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 2.     | Based on my knowledge, this annual report does not  contain any untrue statement of a material fact or omit to state a material  fact necessary to make the statements made, in light of the circumstances  under which such statements were made, not misleading with respect to the  period covered by this annual report;                                                              |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 3.     | Based on my knowledge, the financial statements, and  other financial information included in this annual report, fairly present in  all material respects the financial condition, results of operations and cash  flows of the registrant as of, and for, the periods presented in this annual  report;                                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 4.     | The registrant’s other certifying officers and I are  responsible for establishing and maintaining disclosure controls and  procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the  registrant and have:                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
|   | a)                                                                                                                                                                                                                                                                                                                                                                                        | designed such disclosure controls and procedures to  ensure that material information relating to the registrant, including its  consolidated subsidiaries, is made known to us by others within those  entities, particularly during the period in which this annual report is being  prepared; |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
|   | b)                                                                                                                                                                                                                                                                                                                                                                                        | evaluated the effectiveness of the registrant’s  disclosure controls and procedures as of a date within 90 days prior to the  filing date of this annual report (the “Evaluation Date”); and |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
|   | c)                                                                                                                                                                                                                                                                                                                                                                                        | presented in this annual report our conclusions  about the effectiveness of the disclosure controls and procedures based on  our evaluation as of the Evaluation Date; |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 5.     | The registrant’s other certifying officers and I  have disclosed, based on our most recent evaluation, to the registrant’s  auditors and the audit committee of registrant’s board of directors (or  persons performing the equivalent functions):                                                                                                                         |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |
|   | a)                                                                                                                                                                                                                                                                                                                                                                                        | all significant deficiencies in the design or  operation of internal controls which could adversely affect the registrant’s  ability to record, process, summarize and report financial data and have  identified for the registrant’s auditors any material weaknesses in internal  controls; and |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
|   | b)                                                                                                                                                                                                                                                                                                                                                                                        | any fraud, whether or not material, that involves  management or other employees who have a significant role in the registrant’s  internal controls; and |
|   |                                                                                                                                                                                                                                                                                                                                                                                      |   |
| 6.     | The registrant’s other certifying officers and I  have indicated in this annual report whether there were significant changes  in internal controls or in other factors that could significantly affect  internal controls subsequent to the date of our most recent evaluation,  including any corrective actions with regard to significant deficiencies and  material weaknesses. |

 
| Date:  April 15, 2003 | /s/ Stephen M. Kasprisin |   |
|---------------------------------|--------------------------|--------|
|                            | Stephen M. Kasprisin     |
|                            | Chief Financial Officer  |

 

47

----

 

**NATURADE, INC.**

 

**INDEX OF FINANCIAL STATEMENTS**

 
| REPORT  OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS                                                   |
|-------------------------------------------------------------------------------------------------------|
| REPORT OF PRIOR  INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS                                             |
| FINANCIAL  STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2002, DECEMBER 31, 2001 AND  DECEMBER 31, 2000 |
| Balance Sheets                                                                                        |
| Statements  of Operations                                                                             |
| Statements of Stockholders’  Deficit                                                             |
| Statements  of Cash Flows                                                                             |
| Notes to Financial  Statements                                                                        |

 

48

----

 

**Report of Independent Certified Public Accountants**

 

Tothe Board of Directors and Stockholders of

Naturade, Inc.

 

Wehave audited the accompanying balance sheets of Naturade, Inc. as ofDecember 31, 2002 and 2001 and the related statements of operations,stockholders’ equity (deficit), and cash flows for the two years then ended.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States of America. Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

Inour opinion, such financial statements present fairly, in all materialrespects, the financial position of the Company as of December 31, 2002and 2001 and the results of its operations and its cash flows for the yearsthen ended in conformity with accounting principles generally accepted in theUnited States of America.

 

Theaccompanying financial statements have been prepared assuming that the Companywill continue as a going concern. As discussed in Note 1 to the financialstatements, the Company’s recurring losses from operations and stockholders’capital deficiency raise substantial doubt about its ability to continue as agoing concern. Management’s plans concerning these matters are also describedin Note 1. The financial statements do not include any adjustments thatmight result from the outcome of this uncertainty.

 
| /s/  BDO Seidman, LLP                           |   |   |
|-------------------------------------------------|--------|--------|
|                                            |
| Los  Angeles, California                        |
|                                            |
| February  21, 2003 (except for Note 12 which is |
| dated  April 14, 2003.                          |

 

49

----

 

**INDEPENDENTAUDITORS’ REPORT**

 

Tothe Board of Directors and Stockholders of

Naturade,Inc.:

 

Wehave audited the accompanying balance sheet of Naturade, Inc. as of December31, 2000, and the related statements of operations, stockholders’ equity (deficit),and cash flows for each of the two years in the period ended December 31,2000.  These financial statements arethe responsibility of the Company’s management.  Our responsibility is to express an opinion of these financialstatements based on our audits.

 

Weconducted our audits in accordance with auditing standards generally acceptedin the United States of America.  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

Inour opinion, such financial statements present fairly, in all materialrespects, the financial position of the Company as of December 31, 2000, andthe results of its operations and its cash flows for each of the two years inthe period ended December 31, 2000 in conformity with accounting principlesgenerally accepted in the United States of America.

 

The accompanyingfinancial statements have been prepared assuming that the Company will continueas a going concern.  As discussed inNote 1 to the financial statements, the Company’s recurring losses fromoperations and stockholders’ capital deficiency raise substantial doubt aboutits ability to continue as a going concern. Management’s plans concerning these matters are also described in Note1.  The financial statements do not includeany adjustments that might result from the outcome of this uncertainty.

 
| /s/  DELOITTE & TOUCHE LLP |   |   |
|--------------------------------|--------|--------|
|                           |
| DELOITTE  & TOUCHE LLP     |
| Costa  Mesa, California        |
| March  9, 2001                 |

 

50

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**NATURADE, INC.**

 

**Balance Sheets**

**As ofDecember 31, 2002 and December 31, 2001**

 
|                                                                                                                                                                                                                                                                           |   | **2002**    |      | **2001**    |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|-----------|-------------|--------|
| ASSETS                                                                                                                                                                                                                                                                         |   |        |      |        |   |
| Current assets:                                                                                                                                                                                                                                                                |   |        |      |        |   |
| Cash and cash  equivalents                                                                                                                                                                                                                                                     |   | $           | 722,583   |        | $      | 55,388 |   |
| Accounts  receivable, net                                                                                                                                                                                                                                                      |   | 1,427,058   |      | 2,039,617   |   |
| Inventories                                                                                                                                                                                                                                                                    |   | 1,689,131   |      | 1,178,519   |   |
| Prepaid expenses  and other current assets                                                                                                                                                                                                                                     |   | 105,135     |      | 357,846     |   |
| Total current  assets                                                                                                                                                                                                                                                          |   | 3,943,907   |      | 3,631,370   |   |
|                                                                                                                                                                                                                                                                           |   |        |      |        |   |
| Property and  equipment, net                                                                                                                                                                                                                                                   |   | 228,723     |      | 307,362     |   |
| Other assets                                                                                                                                                                                                                                                                   |   | 49,594      |      | 54,763      |   |
| Total assets                                                                                                                                                                                                                                                                   |   | $           | 4,222,224 |        | $      | 3,993,495 |   |
|                                                                                                                                                                                                                                                                           |   |        |      |        |   |
| LIABILITIES,  REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS’ DEFICIT                                                                                                                                                                                                        |   |        |      |        |   |
|                                                                                                                                                                                                                                                                           |   |        |      |        |   |
| Current liabilities:                                                                                                                                                                                                                                                           |   |        |      |        |   |
| Accounts payable                                                                                                                                                                                                                                                               |   | $           | 2,750,477 |        | $      | 2,833,120 |   |
| Accrued expenses                                                                                                                                                                                                                                                               |   | 604,194     |      | 654,774     |   |
| Current portion  of Note Payable to Related Party                                                                                                                                                                                                                              |   | 202,345     |      | 50,000      |   |
| Current portion  of long-term debt                                                                                                                                                                                                                                             |   | 1,816,662   |      | 1,957,592   |   |
| Total current  liabilities                                                                                                                                                                                                                                                     |   | 5,373,678   |      | 5,495,486   |   |
|                                                                                                                                                                                                                                                                           |   |        |      |        |   |
| Long-term  portion of Notes Payable to Related Parties, less current maturities                                                                                                                                                                                                |   | 0           |      | 5,439,983   |   |
| Long-term debt,  less current maturities                                                                                                                                                                                                                                       |   | 37,735      |      | 67,399      |   |
| Total  liabilities                                                                                                                                                                                                                                                             |   | 5,411,413   |      | 11,002,868  |   |
|                                                                                                                                                                                                                                                                           |   |        |      |        |   |
| COMMITMENTS AND  CONTINGENCIES (Notes 5 & 7)                                                                                                                                                                                                                               |   |        |      |        |   |
|                                                                                                                                                                                                                                                                           |   |        |      |        |   |
| REDEEMABLE  CONVERTIBLE PREFERRED STOCK                                                                                                                                                                                                                                        |   |        |      |        |   |
|                                                                                                                                                                                                                                                                           |   |        |      |        |   |
| Redeemable  convertible preferred stock Series B, less discount of $1,714,286 at December  31, 2002. Par value $0.0001 per share; authorized 48,000,000 shares; issued  and outstanding 13,540,723 at December 31, 2002 ($2,000,000 redemption  value), 0 at December 31, 2001 |   | 256,112     |      | 0           |   |
|                                                                                                                                                                                                                                                                           |   |        |      |        |   |
| WARRANT                                                                                                                                                                                                                                                                        |   | 500,000     |      | 0           |   |
|                                                                                                                                                                                                                                                                           |   |        |      |        |   |
| STOCKHOLDERS’  DEFICIT:                                                                                                                                                                                                                                                   |   |        |      |        |   |
| Common stock,  par value $0.0001 per share; authorized, 100,000,000 shares; issued and  outstanding, 44,533,886 at December 31, 2002 and 7,823,639 at December 31,  2001                                                                                                       |   | 4,453       |      | 783         |   |
| Preferred stock,  Series A, par value $0.0001 per share; authorized, 2,000,000 shares; issued  and outstanding, 0 at December 31, 2002 and 1,250,024 at December 31, 2001                                                                                                      |   | 0           |      | 125         |   |
| Non-Voting  Common stock, par value $0.0001 per share; authorized 2,000,000 shares;  issued and outstanding, 117,284 at December 31,  2002 and 0 at December 31, 2001                                                                                                     |   | 12          |      | 0           |   |
| Additional  paid-in capital                                                                                                                                                                                                                                                    |   | 18,987,458  |      | 11,539,611  |   |
| Accumulated  deficit                                                                                                                                                                                                                                                           |   | (20,937,224 | )         | (18,549,892 | )      |
| Total  stockholders’ deficit                                                                                                                                                                                                                                              |   | (1,945,301  | )         | (7,009,373  | )      |
| Total  liabilities, redeemable preferred stock and stockholders’ deficit                                                                                                                                                                                                  |   | $           | 4,222,224 |        | $      | 3,993,495 |   |

 

See accompanying notes tofinancial statements.

 

51

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**NATURADE, INC**

 

**Statementsof Operations for the Years Ended December 31, 2002, 2001 and 2000**

 
|                                                                                           |   | **Year Ended  December 31, 2002** |       | **Year Ended  December 31, 2001** |   | **Year Ended  December 31, 2000** |   |
|------------------------------------------------------------------------------------------------|--------|-----------------------------------|------------|-----------------------------------|--------|-----------------------------------|--------|
|                                                                                           |   |                              |       |                              |   |                              |   |
| Net sales                                                                                      |   | $                                 | 14,416,351 |                              | $      | 16,641,109                        |   | $ | 15,503,182 |   |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Cost of sales                                                                                  |   | 8,157,607                         |       | 9,290,227                         |   | 8,345,903                         |   |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Gross profit                                                                                   |   | 6,258,744                         |       | 7,350,882                         |   | 7,157,279                         |   |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Costs and  expenses:                                                                           |   |                              |       |                              |   |                              |   |
| Selling, general  and administrative expenses                                                  |   | 8,069,382                         |       | 9,522,932                         |   | 8,626,072                         |   |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Total operating  costs and expenses                                                            |   | 8,069,382                         |       | 9,522,932                         |   | 8,626,072                         |   |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Operating loss                                                                                 |   | (1,810,638                        | )          | (2,172,050                        | )      | (1,468,793                        | )      |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Other expense:                                                                                 |   |                              |       |                              |   |                              |   |
| Interest expense                                                                               |   | 113,480                           |       | 556,079                           |   | 660,569                           |   |
| Other expense  (Income)                                                                        |   | (28,300                           | )          | (6,907                            | )      | 930                               |   |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Loss before  provision for income taxes                                                        |   | (1,895,818                        | )          | (2,721,222                        | )      | (2,130,292                        | )      |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Provision for  income taxes                                                                    |   | 800                               |       | 5,931                             |   | 800                               |   |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Net loss                                                                                       |   | $                                 | (1,896,618 | )                                 | $      | (2,727,153                        | )      | $ | (2,131,092 | ) |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Less:                                                                                          |   |                              |       |                              |   |                              |   |
| Preferred Stock  Dividends                                                                     |   | (205,000                          | )          | 0                                 |   | 0                                 |   |
| Deemed Dividend                                                                                |   | (285,714                          | )          | 0                                 |   | 0                                 |   |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Net Loss  Attributable to Common Shareholders                                                  |   | $                                 | (2,387,332 | )                                 | $      | (2,727,153                        | )      | $ | (2,131,092 | ) |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Basic and  Diluted Net Loss per share                                                          |   | $                                 | (0.05      | )                                 | $      | (0.36                             | )      | $ | (0.30 | ) |
|                                                                                           |   |                              |       |                              |   |                              |   |
| Weighted Average  Number of Shares used in Computation of Basic and Diluted Net Loss per share |   | 44,000,000                        |       | 7,600,000                         |   | 7,000,000                         |   |

 

See accompanying notes tofinancial statements

 

52

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**NATURADE, INC.**

 

**Statementsof Stockholders****’ Deficit for the Years Ended December 31, 2002,  2001 and 2000**

 
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      | **Additional  Paid-In  Capital** |   |        |       |       |      |
|---------------------------------------------------------------|--------|------------|--------|------------------------|--------|---------------|---------|------------|----------------------------|------------|--------|------------|-----------|----------------------------------|--------|-------------|------------|------------|-----------|
|                                                          |   | **Common** |   | **Common(Non-Voting)** |   | **Preferred** |    |       | **(Accumulated  Deficit)** |       |   |       |
|                                                          |   | **Shares** |   | **Amount**             |   | **Shares**    |    | **Amount** |                       | **Shares** |   | **Amount** |      |                             |   | **Total**   |       |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| BALANCE, DECEMBER 31, 1999                                    |   | 5,349,084  |   | $                      | 535    |          |    |       | $                          |       |   | $          | 1,250,024 |                             | $      | 125         |       | $          | 9,688,025 |   | $ | (13,691,647 | ) | $ | (4,002,962 | ) |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Conversion of debt into common stock and exercise of warrants |   | 1,998,305  |   | 200                    |   |          |    |       |                       |       |   |       |      | 1,623,679                        |   |        |       | 1,623,879  |      |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Issuance of common stock options                              |   |       |   |                   |   |          |    |       |                       |       |   |       |      | 37,778                           |   |        |       | 37,778     |      |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Net loss for the year                                         |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   | (2,131,092  | )          | (2,131,092 | )         |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| BALANCE, DECEMBER 31, 2000                                    |   | 7,347,389  |   | 735                    |   |          |    |       |                       | 1,250,024  |   | 125        |      | 11,349,482                       |   | (15,822,739 | )          | (4,472,397 | )         |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Conversion of debt into common stock                          |   | 476,250    |   | 48                     |   |          |    |       |                       |       |   |       |      | 152,352                          |   |        |       | 152,400    |      |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Issuance of common stock options                              |   |       |   |                   |   |          |    |       |                       |       |   |       |      | 37,777                           |   |        |       | 37,777     |      |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Net loss for the year                                         |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   | (2,727,153  | )          | (2,727,153 | )         |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| BALANCE, DECEMBER 31, 2001                                    |   | 7,823,639  |   | 783                    |   |          |    |       |                       | 1,250,024  |   | 125        |      | 11,539,611                       |   | (18,549,892 | )          | (7,009,373 | )         |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Conversion of debt and preferred stock into common stock      |   | 36,710,247 |   | 3,670                  |   | 117,284       |    | 12         |                       | (1,250,024 | )      | (125       | )         | 5,410,070                        |   |        |       | 5,413,627  |      |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Issuance of common stock options                              |   |       |   |                   |   |          |    |       |                       |       |   |       |      | 37,777                           |   |        |       | 37,777     |      |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Preferred stock dividends                                     |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   | (205,000    | )          | (205,000   | )         |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Preferred stock discount                                      |   |       |   |                   |   |          |    |       |                       |       |   |       |      | 2,000,000                        |   |        |       | 2,000,000  |      |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Deemed dividend                                               |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   | (285,714    | )          | (285,714   | )         |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| Net loss for the year                                         |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   | (1,896,618  | )          | (1,896,618 | )         |
|                                                          |   |       |   |                   |   |          |    |       |                       |       |   |       |      |                             |   |        |       |       |      |
| BALANCE, DECEMBER 31, 2002                                    |   | 44,533,886 |   | $                      | 4,453  |          | 117,284 |       | $                          | 12         |   | 0          |      | $                                | 0      |        | 18,987,458 |       | $         | (20,937,224 | ) | $ | (1,945,301 | ) |
|                                                               |        |            |        |                        |        |               |         |            |                            |            |        |            |           |                                  |        |             |            |            |           |  |  |  |  |  |  |  |

 

See accompanyingnotes to financial statements

 

53

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**NATURADE, INC**

 

**Statementsof Cash Flows****for the Years Ended December 31, 2002, 2001 and 2000**

 
|                                                                                            |   | **Year Ended  December 31, 2002** |       | **Year Ended  December 31, 2001** |       | **Year Ended  December 31, 2000** |       |
|-------------------------------------------------------------------------------------------------|--------|-----------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| Cash flows from  operating activities:                                                          |   |                              |       |                              |       |                              |       |
| Net loss                                                                                        |   | $                                 | (1,896,618 | )                                 | $          | (2,727,153                        | )          | $ | (2,131,092 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:                    |   |                              |       |                              |       |                              |       |
| Depreciation and  amortization                                                                  |   | 86,218                            |       | 95,774                            |       | 83,549                            |       |
| Provision for  bad debt expense                                                                 |   | 342,419                           |       | 419,056                           |       | 207,474                           |       |
| Provision for  excess and obsolete inventories                                                  |   | 17,062                            |       | 188,264                           |       | 189,867                           |       |
| Gain (loss) from  sale of property & equipment                                              |   | —                            |       | —                            |       | 7,573                             |       |
| Writeoff of debt  discount for debt conversions                                                 |   | —                            |       | —                            |       | 173,746                           |       |
| Expense for  stock options, warrants and convertible debt                                       |   | 37,777                            |       | 37,777                            |       | 37,778                            |       |
| Changes in  assets and liabilities:                                                             |   |                              |       |                              |       |                              |       |
| Accounts  receivable                                                                            |   | 270,140                           |       | 23,135                            |       | (1,471,959                        | )          |
| Inventories                                                                                     |   | (527,674                          | )          | 749,876                           |       | (81,237                           | )          |
| Prepaid expenses  and other current assets                                                      |   | 252,711                           |       | (119,646                          | )          | (59,597                           | )          |
| Other assets                                                                                    |   | 5,169                             |       | 29,323                            |       | 15,092                            |       |
| Accounts payable  and accrued expenses                                                          |   | (54,734                           | )          | 520,928                           |       | 385,930                           |       |
| Net cash used in  operating activities:                                                         |   | (1,467,530                        | )          | (782,666                          | )          | (2,642,876                        | )          |
|                                                                                            |   |                              |       |                              |       |                              |       |
| Cash flows from  investing activities:                                                          |   |                              |       |                              |       |                              |       |
| Purchase of  property and equipment                                                             |   | (7,579                            | )          | (136,718                          | )          | (32,473                           | )          |
| Proceeds from  sale of property and equipment                                                   |   | —                            |       | —                            |       | 1,250                             |       |
| Net cash used in  investing activities:                                                         |   | (7,579                            | )          | (136,718                          | )          | (31,223                           | )          |
|                                                                                            |   |                              |       |                              |       |                              |       |
| Cash flows from  financing activities:                                                          |   |                              |       |                              |       |                              |       |
| Net borrowings  (repayment) under line of credit                                                |   | (142,011                          | )          | 118,475                           |       | 830,226                           |       |
| Proceeds from  issuance of debt to related party                                                |   | —                            |       | 686,195                           |       | 1,303,788                         |       |
| Payments of  long-term debt, including capital lease                                            |   | (28,583                           | )          | (32,546                           | )          | (314,242                          | )          |
| Proceeds from  issuance of redeemable preferred stock                                           |   | 2,312,898                         |       | —                            |       | —                            |       |
| Proceeds from  exercise of stock options/warrants                                               |   | —                            |       | —                            |       | 735                               |       |
| Net cash provided  by financing activities:                                                     |   | 2,142,304                         |       | 772,124                           |       | 1,820,507                         |       |
|                                                                                            |   |                              |       |                              |       |                              |       |
| Net increase  (decrease) in cash and cash equivalents                                           |   | 667,195                           |       | (147,260                          | )          | (853,592                          | )          |
| Cash and cash  equivalents, beginning of period                                                 |   | 55,388                            |       | 202,648                           |       | 1,056,240                         |       |
| Cash and cash equivalents,  end of period                                                       |   | $                                 | 722,583    |                              | $          | 55,388                            |       | $ | 202,648 |   |
|                                                                                            |   |                              |       |                              |       |                              |       |
| **Supplemental  Disclosures of Cash Flow Information**                                          |   |                              |       |                              |       |                              |       |
| **Cash  paid during the period for:**                                                           |   |                              | ** ** |                              | ** ** |                              | ** ** |
| Interest                                                                                        |   | $                                 | 116,433    |                              | $          | 180,539                           |       | $ | 347,864 |   |
| Income taxes                                                                                    |   | $                                 | 800        |                              | $          | 800                               |       | $ | 800 |   |
| Non-cash  financing transactions:                                                               |   |                              |       |                              |       |                              |       |
| Conversion of  notes payable and accrued interest to related party into common stock            |   | $                                 | 5,413,627  |                              | $          | 152,400                           |       |   |   |
| Surrender of  preferred stock for cancellation without conversion in exchange for common  stock |   | $                                 | 125        |                              | $          | 0                                 |       | $ | 0 |   |
| Discount related  to redeemable convertible preferred stock                                     |   | $                                 | 2,000,000  |                              | $          | 0                                 |       | $ | 0 |   |
| Preferred stock  dividend accrued                                                               |   | $                                 | 205,000    |                              | $          | 0                                 |       | $ | 0 |   |
| Deemed dividend                                                                                 |   | $                                 | 285,714    |                              | $          | 0                                 |       | $ | 0 |   |
| Issuance of  non-voting common stock in connection with private equity transaction              |   | $                                 | 47,500     |                              | $          | 0                                 |       | $ | 0 |   |

 

See accompanying notes tofinancial statements

 

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**NATURADE,INC.**

 

**NOTESTO FINANCIAL STATEMENTS**

**YEARSENDED DECEMBER 31, 2002, 2001 AND 2000**

 

**1.ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES**

 

***Organization -***Naturade,Inc., a Delaware corporation (the “Company” or “Naturade”), is a brandednutraceuticals marketing company focused on high growth, innovative naturalproducts that nourish the health and well being of consumers. The Company’sproducts include low carbohydrate, high protein powders, aloe vera based healthand beauty aids, nutritional supplements, aloe drinks and soy protein basedpowders, bars and ready-to-drink products. Its products are sold to the healthfood and mass market channels through distributors and directly to retailers inthe United States and overseas.

 

***Basis of Presentation –***Theaccompanying financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America.

 

***Going Concern –***Theaccompanying financial statements have been prepared on a going-concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business. At December 31, 2002, the Companyhas an accumulated deficit of $20,937,224, a net working capital deficit of$1,429,771, a stockholders’ capital deficiency of $1,945,301, has incurredrecurring net losses and was not in compliance with two of its bank debtcovenants but subsequently received a waiver. These factors, among others,raise substantial doubt about the Company’s ability to continue as a goingconcern.

 

The financial statements do not include any adjustments relating to therecoverability and classification of recorded asset amounts or the amounts andclassification of liabilities that might be necessary should the Company beunable to continue as a going concern. As described in Note 4, the Company isnot in compliance with a certain provision of its bank debt agreement. TheCompany only recently received a written waiver of such default from its lenderfor non-compliance. The Company’s continuation as a going concern is dependentupon its ability to generate sufficient cash flow to meet its obligations on atimely basis, to comply with the terms and covenants of its financingagreements, to obtain additional financing or refinancing as may be requiredand ultimately to attain successful operations.

 

In response to these conditions, the Company entered into a PrivateEquity Transaction in January 2002, raising $2.5 million, as more fullydescribed in Note 5. The Company also entered into a loan agreement as of April14, 2003, under which the Company can borrow $450,000 and can borrow up to anadditional $300,000 at the discretion of the lenders. During 2002, thisadditional financing helped the Company meet its obligations and sustainoperations. In addition management has made certain financial andorganizational changes and updated the detailed analysis of the Company’s corecompetencies, the nutraceutical market, competitors and specific productcategories in light of the softening economy during the year. Based on thisanalysis, the management team has focused its sales force on thegrowth-oriented mass market retail segment and stabilizing the health foodsegment, taken action to reduce overhead costs and expanded the sales ofpreviously-developed product line extensions in the rapidly growing soy proteincategory, specifically in the ready-to-drink market segment. No assurance canbe given that management’s plans will be successful.

 

***Cash and Cash Equivalents –***The Company considers all highly liquid investments with maturities of threemonths or less when purchased to be cash equivalents.

 

***Use of Estimates and Assumptions –***Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ materially from those estimates.

 

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***Concentration of Credit Risk –***Financial instruments that subject Naturade to concentration of credit riskconsist primarily of cash, accounts receivables, and notes receivable. Creditrisk with respect to trade accounts receivable is generally diversified due tothe large number of entities comprising the Company’s customer base and theirgeographic dispersion. Naturade performs ongoing credit evaluations of itscustomers and maintains an allowance for estimated credit losses. The Companymaintains cash balances with financial institutions that are in excess offederally insured limits.

 

***Fair Value of Financial Instruments –***The Company’s balance sheets include the following financial instruments: cashand cash equivalents, trade accounts receivable, trade accounts payable andlong-term debt. The Company considers the carrying amounts in the financialstatements to approximate fair value of these financial instruments due to therelatively short period of time between the origination of the instruments andtheir expected realization or the interest rates which approximate currentmarket rates.

 

***Accounts Receivable –***Accounts receivable are presented net of an allowance for doubtful accounts of$70,000 and $242,224 at December 31, 2002 and December 31, 2001, respectively,net of an allowance for returns of $253,042 and $380,562 at December 31, 2002and December 31, 2001, respectively, net of allowance for billbacks of $553,375and $291,773 at December 31, 2002 and December 31, 2001, respectively, and netof allowance for slotting of $10,625 and $33,891 at December 31, 2002 andDecember 31, 2001, respectively. The allowance for doubtful accounts, returns,billbacks and slotting includes the following:

 

| Balance as of  December 31, 1999                                  |   | $        | 516,866 |   |
|-------------------------------------------------------------------|--------|----------|---------|--------|
| Provision for  doubtful accounts, returns, billbacks and slotting |   | 207,474  |    |
| Deductions                                                        |   | (194,946 | )       |
| Balance as of  December 31, 2000                                  |   | 529,394  |    |
| Provision for  doubtful accounts, returns, billbacks and slotting |   | 419,056  |    |
| Deductions                                                        |   | 0        |    |
| Balance as of  December 31, 2001                                  |   | 94,850   |    |
| Provision for  doubtful accounts, returns, billbacks and slotting |   | 342,419  |    |
| Deductions                                                        |   | (403,826 | )       |
| Balance as of  December 31, 2002                                  |   | $        | 887,042 |   |

 

***Inventories –***Inventoriesare valued at the lower of cost or market. The weighted average method is usedto determine cost. The reserve for excess and obsolete inventories includes thefollowing:

 

| Balance as of  December 31, 1999             |   | $        | 594,467 |   |
|----------------------------------------------|--------|----------|---------|--------|
| Provision for  excess and obsolete inventory |   | 189,867  |    |
| Write-offs                                   |   | (514,716 | )       |
| Balance as of  December 31, 2000             |   | 269,618  |    |
| Provision for  excess and obsolete inventory |   | 188,264  |    |
| Write-offs                                   |   | (99,964  | )       |
| Balance as of  December 31, 2001             |   | 357,918  |    |
| Provision for  excess and obsolete inventory |   | 17,062   |    |
| Write-offs                                   |   | (302,879 | )       |
| Balance as of  December 31, 2002             |   | $        | 72,101  |   |

 

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***Property and Equipment –***Propertyand equipment are stated at cost, less accumulated depreciation andamortization computed using the straight-line method over the estimated usefullives of the related assets ranging from five to ten years. Leaseholdimprovements are amortized on a straight-line basis over the lesser of thelease term or estimated useful life. Expenditures for maintenance and repairsare charged to operations as incurred.

 

***Impairment of Long-Lived Assets –***In accordance SFAS No. 144, *Accounting forthe Impairment or Disposal of Long-Lived Assets*, the Company reviewslong-lived assets for impairment whenever events or changes in circumstancesindicate that the carrying value of such assets may not be recoverable. Iflong-lived assets become impaired, the Company recognizes an impairment lossmeasured as the amount by which the carrying value of the assets exceeds theestimated fair value of the assets.

 

***Income Taxes –*** TheCompany accounts for income taxes under the provisions of SFAS 109, *Accounting for Income Taxes*. Under thismethod, deferred income taxes are recognized for the tax consequences in futureyears of differences between the tax bases of assets and liabilities and theirfinancial reporting amounts at each year-end based on enacted tax laws andstatutory rates applicable to the periods in which the differences are expectedto affect taxable income. Valuation allowances are established, when necessary,to reduce deferred tax assets to the amount expected to be realized.

 

***Revenue Recognition –***Salesare recognized upon shipment and passage of title. The Company accrues forestimated returns at the time of sale. In December 1999, the Securities andExchange Commission issued Staff Accounting Bulletin 101, Revenue Recognition(“SAB 101”). SAB 101 summarizes certain of the SEC staff’s views in applyinggenerally accepted accounting principles to selected revenue recognition issuesin financial statements. Implementation of SAB 101 was required by the fourthquarter of 2000. The implementation of SAB 101 did not have a material impacton the Company’s financial condition or results of operations.

 

***Net Income (Loss) Per Share –***Basic earnings (loss) per share (EPS) excludes dilution and is computed bydividing net income or loss attributable to common stockholders by the weightedaverage of common shares outstanding for the period. Diluted EPS reflects thepotential dilution that could occur if securities or other contracts to issuecommon stock (i.e. convertible preferred stock, warrants to purchase commonstock and common stock options using the treasury stock method) were exercisedor converted into common stock. Potentially dilutive securities, representingwarrants and options to purchase 34,473,548, 1,515,000 and 1,365,000 shares ofcommon stock for the years ended December 31, 2002, 2001 and 2000 are excludedin EPS as their effect would be antidilutive.

 

***Research and Development –***Researchand development costs are expensed when incurred and amounted to $181,985,  $196,456 and $251,717 for the years endedDecember 31, 2002, 2001 and 2000.

 

***Advertising andPromotion******–*** Effective January 1, 2002, the Company adoptedEmerging Issues Task Force (“EITF”) issue No. 01-9, *Accounting for Consideration Given by a Vendor to a Customer or aReseller of the Vendor’s Products* (EITF 01-9).  Upon adoption of EITF 01-9, the Company wasrequired to classify certain payments to its customers as a reduction of sales.  The Company previously classified certain ofthese payments as brand expenses, a component of selling, general andadministrative expenses in the statement of operations.  Upon the adoption of EITF 01-9, priorperiods amounts were reclassified and resulted in a reduction of sales (and anoffsetting reduction of selling expenses) of $454,552 in 2001 and $129,056 in2000.  In addition, the Companyreclassified coupon and rebate redemptions from selling, general andadministrative expenses to net sales of $55,265 in 2001 and $39,256 in2000.  New store openings, wasreclassified to cost of goods sold of $125,198 in 2001 and $44,775 in 2000.

 

***Advertising –***TheCompany expenses the cost of advertising as incurred. Advertising expensesamounted to $559,797, $951,529 and $231,194 for the years ended December 31,2002, 2001 and 2000.

 

***Deferred Rent –***Deferredrent totaling $110,243 and $97,079 at December 31, 2002 and 2001, respectively,is included in accrued expenses. Deferred rent represents rental expense (recordedon a straight-line basis) in excess of actual rental payments to date.

 

57

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***Major Customers –***Duringthe fiscal years ended December 31, 2002, 2001 and 2000, the Company had salesto three customers in excess of 10% of the Company’s total net sales as shownin the following table. .

 

Major Customers Table

 

| **Customer  One**  |   | **Customer  Two** |      | **Customer  Three**                              |   |
|--------------------|--------|-------------------|-----------|--------------------------------------------------|--------|
|               |   | **Sales**         |      | **Accounts  Receivable  Balance 2002  Year-end** |   | **Sales** |   | **Accounts  Receivable  Balance 2001  Year-end** |   | **Sales** |   | **Accounts  Receivable  Balance 2000  Year-end** |   |
| December 31,  2000 |   | $                 | 2,859,864 |                                             | $      | 266,250 |   | $ | 2,374,395 |   | $ | 169,223 |   | $ | 1,923,833 |   | $ | 290,216 |   |
| December 31,  2001 |   | $                 | 2,236,700 |                                             | $      | 183,175 |   | $ | 2,545,400 |   | $ | 213,548 |   | $ | 2,574,416 |   | $ | 354,822 |   |
| December 31,  2002 |   | $                 | 2,342,300 |                                             | $      | 185,439 |   | $ | 2,352,400 |   | $ | 241,539 |   | $ | 2,546,900 |   | $ | 438,200 |   |
|                    |        |                   |           |                                                  |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The loss of any one of these customers could have a material adverseeffect on the Company’s results of operations. The Company does not havelong-term contracts with any of its customers and, accordingly, there can be noassurance that any customer will continue to place orders with the Company tothe same extent it has in the past, or at all.

 

***Accounting for Stock-Based Compensation –***SFAS123, *Accounting for Stock-Based Compensation*,requires disclosure of the fair value method of accounting for stock optionsand other equity instruments. Under the fair value method, compensation cost ismeasured at the grant date based on the fair value of the award and is recognizedover the service period which is usually the vesting period. The Company haschosen, under the provisions of SFAS 123, to continue to account for employeestock-based transactions using the intrinsic value method under AccountingPrinciples Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees.*

 

**New Accounting Pronouncements**

 

In January 2003, the FASB issued FASB InterpretationNo. 46, *Consolidation of Variable InterestEntities,* an interpretation of Accounting Research Bulletins (“ARB”)No. 51, *Consolidated Financial Statements*(“FIN 46”).  FIN 46 clarifies theapplication of ARB No. 51 to certain entities in which equity investors do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties.  The Company does not believe the adoption ofFIN 46 will have a material impact its financial position and results ofoperations.

 

In December 2002, the FASB issued Statement ofFinancial Accounting Standards No. 148, *Accountingfor Stock-Based Compensation — Transition and Disclosure* (“FAS148”), which amends Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation*(“FAS 123”). FAS 148 provides alternative methods of transition for a voluntarychange to the fair value based method of accounting for stock-based employeecompensation. In addition, FAS 148 amends the disclosure requirements of FAS123 to require more prominent and more frequent disclosures in financialstatements of the effects of stock-based compensation. The transition guidanceand annual disclosure provisions of FAS 148 are effective for fiscal yearsending after December 15, 2002. The interim disclosure provisions are effectivefor financial reports containing condensed financial statements for interimperiods beginning after December 15, 2002. The adoption of FAS 148 is notexpected to have a material impact on the Company’s consolidated balance sheetor results of operations as the Company intends to continue to account for itsequity based compensation plans using the intrinsic method.  The Company will provide the interimdisclosures required by FAS 148 beginning in the first quarter of 2003.

 

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In November 2002, the FASB issued Interpretation No.45, *Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness toOthers*, an interpretation of FASB Statements No. 5, 57 and 107 and arescission of FASB Interpretation No. 34. This interpretation elaborates on thedisclosures to be made by a guarantor in its interim and annual financialstatements about its obligations under guarantees issued. The interpretationalso clarifies that a guarantor is required to recognize, at inception of aguarantee, a liability for the fair value of the obligation undertaken. Theinitial recognition and measurement provisions of the interpretation areapplicable to guarantees issued or modified after December31, 2002 and are notexpected to have a material effect on the Company’s financial statements. Thedisclosure requirements are effective for financial statements of interim andannual periods ending after December 31, 2002.

 

In June 2002, the FASB issuedSFAS No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities*, which addressesaccounting for restructuring and similar costs. SFAS No. 146 supersedesprevious accounting guidance, principally Emerging Issues Task Force (EITF)Issue No. 94-3. The Company will adopt the provisions of SFAS No. 146 forrestructuring activities initiated after December 31, 2002. SFAS No. 146requires that the liability for costs associated with an exit or disposal activitybe recognized when the liability is incurred. Under EITF No. 94-3, a liabilityfor an exit cost was recognized at the date of a companys commitment to an exitplan. SFAS No. 146 also establishes that the liability should initially bemeasured and recorded at fair value. Accordingly, SFAS No. 146 may affect thetiming of recognizing future restructuring costs as well as the amountrecognized.

 

In May 2002, the FASB issued SFAS 145, *Rescission of FASB Statements No. 4, 44, and 64,Amendment of FASB Statement No. 13, and Technical Corrections.* SFAS145 eliminates Statement 4 (and Statement 64, as it amends Statement 4), whichrequires gains and losses from extinguishments of debt to be aggregated and, ifmaterial, classified as an extraordinary item, and thus, also the exception toapplying Opinion 30 is eliminated as well. This statement is effective foryears beginning after May, 2002 for the provisions related to the rescission ofStatements 4 and 64, and for all transactions entered into beginning May, 2002for the provision related to the amendment of Statement 13.  The adoption of SFAS 145 will not have amaterial impact  on the Company’soperations and financial position.

 

In October 2001, the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting Standard (SFAS) 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets.*SFAS 144requires that those long-lived assets be measured at the lower of carryingamount or fair value less cost to sell, whether reported in continuingoperations or in discontinued operations. Therefore, discontinued operationswill no longer be measured at net realizable value or include amounts foroperating losses that have not yet occurred. SFAS 144 is effective forfinancial statements issued for fiscal years beginning after December 15, 2001and, generally, is to be applied prospectively. The Company adopted thisStatement as of January 1, 2002 and it had no material impact on its financialstatements.

 

In August 2001, the FASBissued SFAS 143, *Accounting for Asset Retirement Obligations.* SFAS No. 143requires the fair value of a liability for an asset retirement obligation to berecognized in the period in which it is incurred if a reasonable estimate offair value can be made. The associated asset retirement costs are capitalizedas part of the carrying amount of the long-lived asset. SFAS No. 143 iseffective for fiscal years beginning after June 15, 2002. The Company believesthe adoption of this Statement will have no material impact on its financialstatements.

 

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**2.INVENTORIES**

 

Inventories are stated at the lower of weighted average cost or market.Weighted average cost is determined on a first-in, first-out basis. Inventoriesat December 31, 2002 and December 31, 2001 consisted of the following:

 
|                                               |   | **December  31, 2002** |      | **December  31, 2001** |   |
|----------------------------------------------------|--------|------------------------|-----------|------------------------|--------|
| Raw Materials                                      |   | $                      | 224,033   |                   | $      | 195,351 |   |
| Finished Goods                                     |   | 1,537,199              |      | 1,341,086              |   |
|                                               |   |                   |      |                   |   |
| Subtotal                                           |   | 1,761,232              |      | 1,536,437              |   |
| Less: Reserve  for Excess and Obsolete Inventories |   | (72,101                | )         | (357,918               | )      |
|                                               |   | $                      | 1,689,131 |                   | $      | 1,178,519 |   |

 

**3.PROPERTY AND EQUIPMENT**

 

Property and equipment at December 31, 2002 and December 31, 2001consisted of the following:

 
|                                            |   | **December  31, 2002** |    | **December  31, 2001** |   |
|-------------------------------------------------|--------|------------------------|---------|------------------------|--------|
| Building and improvements                       |   | $                      | 160,196 |                   | $      | 160,196 |   |
| Machinery and  equipment                        |   | 550,939                |    | 543,368                |   |
| Automobiles                                     |   | 83,980                 |    | 83,980                 |   |
|                                            |   |                   |    |                   |   |
| Total                                           |   | 795,115                |    | 787,544                |   |
| Less accumulated  depreciation and amortization |   | (566,392               | )       | (480,182               | )      |
|                                            |   |                   |    |                   |   |
| Property and  equipment, net                    |   | $                      | 228,723 |                   | $      | 307,362 |   |

 

Depreciation expenses amounted to $86,218,$95,774 and $83,549 for the fiscal years ended December 31, 2002, 2001 and2000.

 

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**4. DEBT**

 

Long-term debt consists of the following at December 31, 2002 and 2001.

 
|                                                                                                                                    |   | **December  31, 2002** |      | **December  31, 2001** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|------------------------|--------|
|                                                                                                                                    |   |                   |      |                   |   |
| Line of Credit                                                                                                                          |   | $                      | 1,786,998 |                   | $      | 1,929,009 |   |
| Credit Agreement  with majority shareholder                                                                                             |   |                   |      | 4,496,193              |   |
| Loan Agreement  with majority shareholder and other investors                                                                           |   | 202,345                |      | 993,790                |   |
| Notes Payable  due to a former stockholder’s estate; borrowings bear interest at 8% and are  due in monthly installments of $2,832 |   | 67,399                 |      | 94,790                 |   |
| Other notes  payable                                                                                                                    |   | 0                      |      | 1,192                  |   |
| Total                                                                                                                                   |   | 2,056,742              |      | 7,514,974              |   |
| Less line of  credit and current portion of long-term debt                                                                              |   | (2,019,007             | )         | (2,007,592             |   |
| Long-term debt                                                                                                                          |   | $                      | 37,735    |                   | $      | 5,507,382 |   |

 

A summary oflong-term debt maturities as of December 31, 2002 is as follows:

 

| **Year Ending December 31** |   | **Amount** |      |
|-----------------------------|--------|------------|-----------|
| 2003                        |   | $          | 2,019,007 |   |
| 2004                        |   | 32,126     |      |
| 2005                        |   | 5,609      |      |
| Total                       |   | $          | 2,056,742 |   |

 

***Line of Credit –***OnJanuary 27, 2000, the Company entered into a three year Credit and SecurityAgreement with Wells Fargo Business Credit, Inc. (Wells Fargo) that initiallyallowed for maximum borrowings of up to $3,000,000, based on certainpercentages of eligible accounts receivable and inventories as defined. As morefully described in Note 5, *Private EquityTransaction*, on December 20, 2001, terms of the Credit and SecurityAgreement were modified to include waiving the enforcement of existing defaultsas of December 20, 2001, increasing the credit available to the Company to amaximum of $4,500,000 with an inventory maximum subline of $2,000,000,increasing the floating rate to the prime rate plus 2% and extending thematurity date to December 31, 2003. OnSeptember 19, 2002, the terms of the Credit and Security Agreement weremodified to include waiving the enforcement of existing defaults, reducing thecredit availability of the Company to a maximum of $4,325,000, requiring thatthe Company maintain certain minimum levels of cash, and reducing the covenantsregarding minimum net income and minimum book net worth.  Borrowings under the Credit andSecurity Agreement, which totaled $1,786,998 at December 31, 2002, are collateralizedby substantially all assets of the Company. At December 31, 2002 the prime ratewas 4.25% and the interest charge under the Credit and Security Agreement was6.25%. The Credit and Security Agreement contains covenants which, among otherthings, require that certain financial ratios are met. As of December 31, 2002,the Company was not in compliance with the minimum book net worth and minimumnet income covenants. The Company has received a written waiver of such defaultfrom its lender for non-compliance. Available borrowings under the Credit and Security Agreement were$345,804 at December 31, 2002.

 

***Credit Agreement with Majority Shareholder–***In August 1999, the Company entered into a CreditAgreement (the “Credit Agreement”) with Health Holdings and Botanicals, LLC(“Health Holdings”), the majority stockholder of the Company. The CreditAgreement allowed for advances (the “Advances”) of $4 million at an interestrate of 8% per annum with a due date of July 31, 2004. As part of the Private EquityTransaction**on January 2, 2002 asdescribed more fully in Note 5, Health Holdings converted into common stock allof the Company’s Credit Agreement debt due to Health Holdings which included anoutstanding principal amount of $4,496,193 plus accrued interest of $67,012 fora total debt conversion of $4,563,206.

 

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***Finance Agreement with Majority Shareholder–***In March 1999, the Company entered into a FinanceAgreement (the “Finance Agreement”) with Health Holdings. The Finance Agreementprovided that the Company could borrow up to $1 million at an interest rate of8% per annum. The Finance Agreement further provided that for each dollarborrowed, the Company would issue a warrant to Health Holdings to purchasethree-tenths (0.3) of a share of common stock of the Company at an exerciseprice of $2.125 per share. As of June 30, 1999, the Company had issued 300,000warrants under the Finance Agreement prior to the Amendment referred to below.The warrants are exercisable for a period of ten years commencing on the dateof grant.

 

In June 1999, the Finance Agreement was amended (the “Amendment”) toincrease the amount of available borrowings to $1.6 million also at an interestrate of 8% per annum. The Amendment further provides that for each dollarborrowed over $1 million; the Company would issue a warrant to Health Holdingsto purchase one-half (1/2) of a share of common stock of the Company at anexercise price of $1.00 per share. Further, the exercise price of the 300,000warrants previously issued under the Finance Agreement prior to the Amendmentwas reset to $1.00 per share. All borrowings under the Finance Agreement weresecured by the assets of the Company. As of December 31,1999, the Company borrowed$1,600,000 under the Finance Agreement and the Amendment and had issued a totalof 600,000 warrants to Health Holdings. The Company recorded the fair value ofthe warrants issued as a debt discount and will amortize this discount over thelife of the debt.  The Finance Agreementfurther provided that at any time upon written notice, Health Holdings couldconvert any portion of the Advances into shares of the Company’s common stockat a conversion price equal to the lower of $1.00 per share or the then fairmarket value of the Company’s common stock.

 

In March 2000, Health Holdings converted the entire outstanding balanceunder the Finance Agreement of $1,600,000 plus accrued interest of $23,145 into1,997,717 shares of restricted common stock of the Company based on the thenfair market value of the Company’s common stock of $0.812. The unamortized debtdiscount was written off to interest expense in accordance with EITF 98-5 *Accountingfor Convertible Securities with Beneficial Conversion Features or ContingentlyAdjustable Conversion Ratios.* Effective with this conversion, theFinance Agreement terminated and is no longer in effect.

 

***Loan Agreement with Majority Shareholderand Other Investors –***In August 2000, the Company enteredinto a Loan Agreement (the “Loan Agreement”) with Health Holdings and otherinvestors (the “Lender Group”). The Loan Agreement allowed for advances (the“Loan Advances”) of up to $1.2 million at an interest rate of 8% per annum withdue dates of September 11, 2002 for $50,000 and August 31, 2003 for theremaining balance outstanding. Interest only payments were to be required on aquarterly basis. On June 13, 2001, two investors converted their total debt of$150,000 plus accrued interest of $2,400 into common stock, receiving a totalof 476,250 shares of the Company’s Common Stock based on the then fair marketvalue of $0.32. As of December 31, 2001, the Company had borrowed $993,790under this facility. Of this amount, $741,445 was debt owed to Health Holdings.As part of the Private Equity Transaction**onJanuary 2, 2002 as described more fully in Note 5, Health Holdings convertedinto common stock all of the Company’s Loan Agreement debt due to HealthHoldings, plus accrued interest of $11,051 for a total debt conversion of $752,496.The Loan Agreement further provided that the Lender Group could elect toconvert all or any part of the Loan Advances into shares of the Company’scommon stock at a conversion price equal to the lower of (a) the averageclosing bid of the Company’s common stock for the ten trading days prior to themaking of a Loan Advance or (b) the average closing bid of the Company’s commonstock for the ten trading days prior to the date of receipt of notice ofconversion.

 

On August 8, 2002, one investor (a member of the Board of Directors)converted his total debt of $50,000 which was due September 11, 2002 plusaccrued interest of $427 into Common Stock, receiving a total of 720,392 sharesof the Company’s common Stock based on the then fair market value of $0.07.

 

**5.PRIVATE EQUITY TRANSACTION**

 

On January 2,2002, the Company privately sold 13,540,723 shares of Series B ConvertiblePreferred Stock (the “shares”) for $2 million, and warrants to purchase anadditional 33,641,548 shares of Series B Convertible Preferred Stock at anaggregate exercise price of $3.5 million (the “Warrants”), for $500,000. Theshares and Warrants were purchased by Westgate Equity Partners, L.P.(“Westgate”). The Series B Convertible Preferred Stock bears dividends at arate of 10% per annum, which will accumulate and compound semi-annually if notpaid in cash. On the seventh anniversary of its issuance, the Series BConvertible Preferred Stock will be automatically redeemed by the Company atthe original issuance price plus accrued and unpaid dividends, provided theCompany is legally able to do so. Two members of the Board of Directors of theCompany were elected exclusively by the holders of the Series B ConvertiblePreferred Stock voting as a separate class.

 

62

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The Company mayredeem the Series B Convertible Preferred Stock at any time prior to December31, 2004 if the Company receives a bona fide offer from a third party to investequity capital in the Company and the holders of the Series B ConvertiblePreferred Stock do not make a Qualified Counter-Offer.  A “Qualified Counter-Offer” is a writtenoffer for an equity investment in the Company that will yield gross proceeds inexcess of the third party’s offer (but need not exceed $3,500,000), and whicheither (A) is accomplished through the exercise of some or all of the Warrants,or (B) will provide capital on the same or better terms as the third partyoffer.  The Series B ConvertiblePreferred Stock had a beneficial conversion feature of $2,000,000 which wasrecorded as a discount and is being amortized over seven years.

 

As part of thistransaction, Health Holdings agreed to convert all of the Company’s outstandingdebt to Health Holdings, including accrued interest (approximately $5,316,000),and to surrender all of Health Holdings’ Series A Convertible Preferred Stock(1,250,024 shares) for cancellation without conversion, in exchange for35,989,855 shares of the Company’s common stock. Furthermore, the warrants thatHealth Holdings holds to purchase up to 600,000 shares of Common Stock havebeen modified to be exercisable for Non-Voting Common Stock at an exerciseprice of $1 per share.

 

As part of thistransaction, the Company entered into a Management Services Agreement underwhich certain principals of Westgate or its affiliates will provide managementand consulting services to the Company and amended and extended the employmentagreement with the Company’s CEO. Also, on December 20, 2001 as part of thistransaction and effective on its completion, Wells Fargo agreed to modify termsof its Credit and Security Agreement with the Company, to include waiving theenforcement of existing defaults, increasing credit available to the Company toa maximum of $4,500,000, increasing the floating rate to the prime rate plus 2%and extending the maturity date to December 31, 2003, as more fully describedunder Footnote 4.

 

Under the terms ofthe Private Equity Transaction, if Westgate exercises the warrants in full,Westgate would hold a total of 47,182,271 shares of Series B ConvertiblePreferred Stock which would be convertible into the same number of shares ofCommon Stock, or 51% of the Company’s Common Stock on a fully diluted basis.

 

After the completion of the Private Equity Transaction, Westgateasserted that the Company’s representations and warranties concerning theCompany’s capitalization in the Purchase Agreement were inaccurate in that theyomitted to disclose the fact that certain outstanding promissory notes of theCompany in an amount of $252,345 (the “Convertible Notes”) were convertibleinto shares of the Common Stock of the Company at the market price of theCommon Stock on the date of conversion. Convertible Notes in the amount of $50,000 have been converted into720,392 shares of Common Stock to date, and $202,345 in Convertible Notesremain outstanding and were convertible into 3,372,417 shares as of April 14,2003.

 

The Company andWestgate have agreed to resolve this dispute by adjusting the conversionformula for the Series B Convertible preferred Stock.  In addition, Westgate and health Holdings have agreed that (i)the Company may issue additional options to purchase up to 1,250,000 shares ofCommon Stock to employees in accordance with the Naturade, Inc. 1998 IncentiveStock Option Plan, and (ii) Health Holdings will grant to Westgate a proxy tovote 1.041 shares of Common Stock owned by Health Holdings for each share ofCommon Stock issued on exercise of the new options.  For a description of this settlement, see “Item 1.Business-Private Equity Transactions.”

 

The net proceedsof the transactions have been used by the Company for working capital andgeneral corporate purposes.

 

**6.STOCKHOLDERS’ EQUITY**

 

***Convertible Preferred Stock –***Duringfiscal year ended September 30, 1998, the Company issued 1,250,024 shares ofSeries A Convertible Preferred Stock (the “shares”) to Health Holdings. Theshares paid dividends except in the event of a liquidation or reorganization ofthe Company. While convertible, the preferred shares had voting rightsequivalent to the common stock on as “as converted’ basis. As described morefully in Note 5, *Private Equity Transaction*,Health Holdings surrendered the shares January 3, 2002.

 

***Employee Stock Option Plan –***InFebruary 1998, the Company adopted an Incentive Stock Option Plan (the “Plan”)to enable participating employees to acquire shares of the Company’s commonstock. The Plan provided for the granting of incentive stock options up to anaggregate of 850,000 shares, as amended. In October 2001, the Company amendedthe Plan by increasing to 2,000,000 the number of shares of the Company’scommon stock which may be subject to awards granted pursuant to the Plan. Theactual amount of incentive stock options that may be granted to employees isdetermined by the Compensation Committee based on the parameters set forth inthe Plan. Under the terms of the Plan, incentive stock options may be grantedat not less than 100% of the fair market value at the date of the grant (110%in the case of 10% shareholders). Incentive options granted under the Plan vestover a four-year period from the date of grant. The Company has granted 832,000incentive options under the Plan at the weighted average exercise price pershare of $0.45 as of December 31, 2002. These options expire seven years fromthe date of grant.

 

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***Director Stock Options –***In October 1999, 87,500 options were issued to each of two then new boardmembers at an exercise price of $1.03.

 

***Warrants –***On January 2,2002, the Company sold warrants to purchase 33,641,548 shares of Series BConvertible Common Stock. The aggregate purchase price of the warrants was$500,000 and the aggregate exercise price is $3.5 million. This transaction isdescribed more fully in Note 5, *Private Equity Transaction.*

 

In 1999, the Company granted 600,000 warrants in conjunction withcertain financing agreements. These warrants expire ten years from the date ofgrant. As part of the *Private EquityTransaction* described in Note 5, the holders of the warrants agreedthey would be exercisable for Non-Voting Common Stock.

 

As part of a restructuring of the Company in 1991, equity holdersexchanged their shares for new common stock and Class A and Class B Warrants.The Class A Warrants expired at December 31, 1996. The Class B Warrants allowedfor the purchase of one share of common stock for $1.25 per share. BetweenDecember 31, 1999 and January 14, 2000, 588 warrants were exercised. On January15, 2000, the remaining 324,520 unexercised Class B warrants expired.

 

A summary of the Company’s outstanding stock options and warrantsactivity is as follows:

 
|                              |   | **Number of  Shares** |   | **Weighted  Average  Exercise Price  per Share** |   | **Number  Exercisable** |       | **Weighted  Average  Exercise  Price** |   |
|-----------------------------------|--------|-----------------------|--------|--------------------------------------------------|--------|-------------------------|------------|----------------------------------------|--------|
|                              |   |                  |   |                                             |   |                    |       |                                   |   |
| Outstanding at  January 1, 2000   |   | 1,875,108             |   | $                                                | 1.10   |                    | 1,330,358  |                                   | $      | 1.12 |   |
|                              |   |                  |   |                                             |   |                    |       |                                   |   |
| Granted                           |   | 140,000               |   | $                                                | 0.83   |                    |       |                                   |   |   |
| Exercised                         |   | (588                  | )      | $                                                | 1.25   |                    |       |                                   |   |   |
| Expired                           |   | (649,520              | )      | $                                                | 1.30   |                    |       |                                   |   |   |
|                              |   |                  |   |                                             |   |                    |       |                                   |   |
| Outstanding at  December 31, 2000 |   | 1,365,000             |   | $                                                | 1.04   |                    | 962,750    |                                   | $      | 1.04 |   |
|                              |   |                  |   |                                             |   |                    |       |                                   |   |
| Granted                           |   | 170,000               |   | $                                                | 0.39   |                    |       |                                   |   |   |
| Exercised                         |   | (0                    | )      | $                                                | — |                    |       |                                   |   |   |
| Expired                           |   | (20,000               | )      | $                                                | 1.18   |                    |       |                                   |   |   |
|                              |   |                  |   |                                             |   |                    |       |                                   |   |
| Outstanding at  December 31, 2001 |   | 1,515,000             |   | $                                                | 0.98   |                    | 1,052,750  |                                   | $      | 1.08 |   |
|                              |   |                  |   |                                             |   |                    |       |                                   |   |
| Granted                           |   | 33,641,548            |   | $                                                | .104   |                    |       |                                   |   |   |
| Exercised                         |   | (0                    | )      | $                                                | — |                    |       |                                   |   |   |
| Expired                           |   | (683,000              | )      | $                                                | 1.01   |                    |       |                                   |   |   |
|                              |   |                  |   |                                             |   |                    |       |                                   |   |
| Outstanding at  December 31, 2002 |   | 34,473,548            |   | $                                                | 0.12   |                    | 34,321,423 |                                   | $      | 0.11 |   |

 

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The following table summaries information about stock options andwarrants outstanding at December 31, 2002

 
| **Range of  Exercise Prices** |   | **Options  and  Warrants  Outstanding** |   | **Weighted  Average  Remaining  Contract Life  In Years** |   | **Weighted  Average  Exercise  Price** |   | **Options and  Warrants  Exercisable** |       | **Weighted  Average  Exercise Price  for Exercisable  Options and  Warrants** |   |
|-------------------------------|--------|-----------------------------------------|--------|-----------------------------------------------------------|--------|----------------------------------------|--------|----------------------------------------|------------|-------------------------------------------------------------------------------|--------|
| $0.104                        |   | 33,641,548                              |   | 2                                                         |   | $                                      | 0.10   |                                   | 33,641,548 |                                                                          | $      | 0.10 |   |
| $0.15-.875                    |   | 589,500                                 |   | 2                                                         |   | $                                      | 0.31   |                                   | 469,625    |                                                                          | $      | 0.26 |   |
| $1.03 -1.13                   |   | 222,500                                 |   | 1                                                         |   | $                                      | 1.08   |                                   | 190,250    |                                                                          | $      | 1.11 |   |
| $3.30-3.30                    |   | 20,000                                  |   | 1                                                         |   | $                                      | 3.30   |                                   | 20,000     |                                                                          | $      | 3.30 |   |
|                          |   | 34,473,548                              |   |                                                      |   | $                                      | 0.12   |                                   | 34,321,423 |                                                                          | $      | 0.11 |   |

 

The estimated weighted average fair value of options or warrantsgranted during the years ended December 31, 2001 and 2000 are $0.001,and $0.50,respectively. Pursuant to SFAS 123, the Company has elected to continue usingthe intrinsic value method of accounting for stock-based awards granted toemployees and directors in accordance with APB Opinion No. 25 and relatedinterpretations in accounting for its stock option plan. Had the compensationcost for the Company stock option plan been determined based on the fair valueat the grant dates for awards under the plan consistent with the method of SFAS123, the Company’s net loss and loss per share would have been the pro formaamounts presented below:

 
|                                                                                                                                                |        | **Year Ended  December 31, 2002** |       | **Year Ended  December 31, 2001** |   | **Year Ended  December 31, 2000** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|-------------|-----------------------------------|------------|-----------------------------------|--------|-----------------------------------|------------|
|                                                                                                                                                |        |                              |       |                              |   |                              |       |
| Net loss: As  reported                                                                                                                              |        | $                                 | (4,101,618 | )                                 | $      | (2,727,153                        | )          | $ | (2,131,092 | ) |
|                                                                                                                                                |        |                              |       |                              |   |                              |       |
| Add:  Stock-based employee compensation expense  included in reported net loss, net of related tax effects                                     |        | 0                                 |       | 0                                 |   | 0                                 |       |
| Deduct:  Total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects |        | (333,710                          | )          | (333,710                          | )      | (319,290                          | )          |
|                                                                                                                                                |        |                              |       |                              |   |                              |       |
|                                                                                                                                                | Pro forma   |                              | $          | (4,434,328                        | )      | $                                 | (3,059,863 | ) | $ | (2,450,382 | ) |
|                                                                                                                                                |        |                              |       |                              |   |                              |       |
| Basic and  Diluted net loss per share:                                                                                                              | As reported |                              | $          | (0.05                             | )      | $                                 | (0.36      | ) | $ | (0.30 | ) |
|                                                                                                                                                | Pro forma   |                              | $          | (0.05                             | )      | $                                 | (0.40      | ) | $ | (0.35 | ) |

 

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The fair value for each option grant was estimated on the date of grantusing the Black-Scholes option pricing model with the following assumptions:

 
|                                          |   | **Year Ended  December 31, 2002** |   | **Year Ended  December 31, 2001** |   | **Year Ended  December 31, 2000** |   |
|-----------------------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|
|                                          |   |                              |   |                              |   |                              |   |
| **Weighted Average Risk-Free Interest  Rate** |   | not applicable                    |   | 4.41 to 5.21                      | %      | 6.71                              | %      |
|                                          |   |                              |   |                              |   |                              |   |
| **Expected Life of an Option**                |   | not applicable                    |   | 7 years                           |   | 7 years                           |   |
|                                          |   |                              |   |                              |   |                              |   |
| **Expected Stock Volatility**                 |   | not applicable                    |   | 177                               | %      | 45                                | %      |

 

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**7.INCOME TAXES**

 

The provision for income taxes for the years ended December 31, 2001,2000 and 1999 consists of the following:

 

|            |   | **Year Ended  December 31, 2002** |   | **Year Ended  December 31, 2001** |   | **Year Ended  December 31, 2000** |   |
|-----------------|--------|-----------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|
|            |   |                              |   |                              |   |                              |   |
| Current         |   |                              |   |                              |   |                              |   |
| Federal         |   | $                                 | 0      |                              | $      | 5,131                             |   | $ | 0 |   |
| State           |   | 800                               |   | 800                               |   | 800                               |   |
|            |   |                              |   |                              |   |                              |   |
| Total current   |   | $                                 | 800    |                              | $      | 5,931                             |   | $ | 800 |   |
|            |   |                              |   |                              |   |                              |   |
| Deferred        |   |                              |   |                              |   |                              |   |
| Federal         |   | 0                                 |   | 0                                 |   | 0                                 |   |
| State           |   | 0                                 |   |                              |   |                              |   |
|            |   |                              |   |                              |   |                              |   |
| Total deferred  |   | 0                                 |   | 0                                 |   | 0                                 |   |
|            |   |                              |   |                              |   |                              |   |
| Total provision |   | $                                 | 800    |                              | $      | 5,931                             |   | $ | 800 |   |

 

The income tax provision differs from the amount of income taxdetermined by applying the U.S. federal income tax rate to income before incometaxes due to the following:

 

|                                                 |   | **Year Ended  December 31, 2002** |     | **Year Ended  December 31, 2001** |   | **Year Ended  December 31, 2000** |   |
|------------------------------------------------------|--------|-----------------------------------|----------|-----------------------------------|--------|-----------------------------------|--------|
|                                                 |   |                              |     |                              |   |                              |   |
| Computed tax  (benefit) expense                      |   | $                                 | (644,578 | )                                 | $      | (925,215                          | )      | $ | (720,219 | ) |
| Increase  (decrease) in income taxes resulting from: |   |                              |     |                              |   |                              |   |
| Nondeductible  expenses                              |   | 1,783                             |     | 3,438                             |   | 3,555                             |   |
| State income  taxes, net of federal tax benefit      |   | 528                               |     | 528                               |   | 528                               |   |
| State NOL  disallowance and others                   |   | (285,207                          | )        | (137,721                          | )      | (576,751                          | )      |
| Change in  valuation allowance                       |   | (927,474                          | )        | 1,064,901                         |   | 1,293,687                         |   |
|                                                 |   |                              |     |                              |   |                              |   |
|                                                 |   | $                                 | 800      |                              | $      | 5,931                             |   | $ | 800 |   |

 

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Deferred income taxes reflect the net tax effects of temporarydifferences between the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts used for income tax purposes. Thesignificant components of the net deferred tax assets and liabilities were asfollows:

 

|                                           |   | **Year Ended  December 31, 2002** |   | **Year Ended  December 31, 2001** |   |
|------------------------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|
|                                           |   |                              |   |                              |   |
| Current deferred  tax assets (liabilities)     |   |                              |   |                              |   |
| Uniform  capitalization                        |   | $                                 | 55,124 |                              | $      | 68,836 |   |
| Accounts  Receivable                           |   | 354,816                           |   | 379,380                           |   |
| Accrued vacation                               |   | 33,528                            |   | 28,996                            |   |
| Inventory  reserve                             |   | 30,040                            |   | 665,146                           |   |
| State taxes                                    |   | 272                               |   | 272                               |   |
| Disallowed  interest                           |   | —                            |   | 1,005,912                         |   |
| Other                                          |   | 64,695                            |   | 57,668                            |   |
| Valuation  allowance                           |   | (538,476                          | )      | (2,206,210                        | )      |
| Total current                                  |   | —                            |   | —                            |   |
|                                           |   |                              |   |                              |   |
| Noncurrent  deferred tax assets (liabilities): |   |                              |   |                              |   |
| Net operating  losses and credit carryforwards |   | 7,656,335                         |   | 5,342,467                         |   |
| Depreciation                                   |   | (24,317                           | )      | (77,230                           | )      |
| Stock option                                   |   | 80,325                            |   | 80,325                            |   |
| Other                                          |   | (4,003                            | )      | (4,003                            | )      |
| Valuation  allowance                           |   | (7,708,340                        | )      | (5,341,559                        | )      |
| Total noncurrent                               |   | —                            |   | —                            |   |
|                                           |   |                              |   |                              |   |
| Total                                          |   | $                                 | — |                              | $      | — |   |

 

As of December 31, 2002, the Company had federal net operating losscarryforwards of approximately $20,565,000 that begin expiring in December 2017and state net operating loss carryforwards of $11,068,000, which begin expiringin December 2002.  A valuation allowancefor the full amount of net deferred taxes has been provided because it is morelikely than not that the deferred taxes will not be realized. Under Federal TaxLaw IRC Section 382, certain significant changes in ownership that the Companyis currently undertaking may restrict the future utilization of these tax losscarryforwards.

 

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**8.COMMITMENTS, CONTINGENCIES, AND RELATED PARTY TRANSACTIONS**

 

***Employment Agreements –***TheCompany has a four-year employment agreement with its chief executive officer(CEO) that began in March 1998. As amended, the agreement provides for an annualsalary of $225,000. As part of the *PrivateEquity Transaction*on January 2, 2002 as described more fully inNote 5, the employment agreement with the Company’s CEO was amended to allowfor the immediate vesting of options to purchase 365,000 shares of CommonStock, 297,500 of which would have vested by March 2, 2002, at an exerciseprice reduced to $0.1477 per share, which equals terms of the Private EquityTransaction. Furthermore, the employment agreement was extended to December 31,2003.

 

***Consulting Agreements –***TheCompany is a party to a consulting agreement with an affiliate of its majoritystockholder, Health Holdings, for $300,000 per year payable quarterly. Theagreement is automatically renewable for successive one-year terms so long asHealth Holdings or any of its affiliates owns 25% or more of the Company. Aspart of the Private Equity Transaction**onJanuary 2, 2002 as described more fully in Note 5, the Company entered into amanagement and consulting services agreement with Westgate, a principalstockholder, or its affiliates for $100,000 per year payable quarterly for aninitial period of five years ending December 31, 2006.

 

***Operating Leases –***The Company rents property and equipment under certain noncancellable operatingleases expiring in various years through 2006. Future minimum commitments underoperating leases as of December 31, 2002 are as follows:

 
| **Year Ending December 31** |   | **Amount** |      |
|-----------------------------|--------|------------|-----------|
|                        |   |       |      |
| 2003                        |   | 434,021    |      |
| 2004                        |   | 414,309    |      |
| 2005                        |   | 427,624    |      |
| 2006                        |   | 283,056    |      |
|                        |   |       |      |
| Total                       |   | $          | 1,559,010 |   |
|                             |        |            |           |  |

 

Rent expense charged to operations was $457,230, $431,091 and $446,881for the years ended December 31, 2002, 2001 and 2000, respectively.

 

**LegalProceedings** .

 

From time to time, the Company is party to various other claims andlitigation that arise in the normal course of business.  While any litigation contains an element ofuncertainty, management believes that the ultimate outcome of these claims andlitigation will not have a material adverse effect on the Company’s results ofoperations or financial condition.

 

**9.  401(k) PLAN**

 

The Company has a 401(k) plan that is available to all employees of theCompany who meet certain age and length of service requirements. The planprovides for Company matching contributions equal to 25% of each employee participant’scontribution not to exceed 6% of the employee participant’s compensation. TheCompany’s contribution to the plan was $13,763, $12,728 and $12,621 for theyears ended December 31, 2002, 2001 and 2000, respectively.

 

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**10.  SEGMENT REPORTING**

 

Operating segments are defined as components of an enterprise aboutwhich separate financial information is available that is evaluated regularlyby the Company’s chief operating decision-maker, or decision-making group, indeciding how to allocate resources and in assessing performance. The Company’schief operating decision maker is the CEO.

 

The Company’s reportable operating segments include health foodspecialty stores and mass market categories. The Company does not allocateoperating expenses to these segments, nor does it allocate specific assets tothese segments. Therefore, segment information reported includes only sales,cost of sales and gross profit. Operating segment data for the years ended December31, 2002, 2001 and 2000 are as follows:

 

DistributionChannels

 
|                          |   | **Health  Food** |      | **Mass**  |   | **Total** |   |
|-------------------------------|--------|------------------|-----------|-----------|--------|-----------|--------|
| Year ended  December 31, 2002 |   |             |      |      |   |      |   |
| Sales                         |   | $                | 7,366,133 |      | $      | 7,050,218 |   | $ | 14,416,351 |   |
| Cost of Sales                 |   | 4,067,120        |      | 4,090,487 |   | 8,157,607 |   |
| Gross Profit                  |   | $                | 3,299,013 |      | $      | 2,959,731 |   | $ | 6,258,744 |   |

 
|                          |   | **Health  Food** |      | **Mass**  |   | **Total** |   |
|-------------------------------|--------|------------------|-----------|-----------|--------|-----------|--------|
| Year ended  December 31, 2001 |   |             |      |      |   |      |   |
| Sales                         |   | $                | 8,284,063 |      | $      | 8,357,046 |   | $ | 16,641,109 |   |
| Cost of Sales                 |   | 4,714,076        |      | 4,576,151 |   | 9,290,227 |   |
| Gross Profit                  |   | $                | 3,569,987 |      | $      | 3,780,895 |   | $ | 7,350,882 |   |

 
|                          |   | **Health  Food** |      | **Mass**  |   | **Total** |   |
|-------------------------------|--------|------------------|-----------|-----------|--------|-----------|--------|
| Year ended  December 31, 2000 |   |             |      |      |   |      |   |
| Sales                         |   | $                | 9,943,008 |      | $      | 5,560,174 |   | $ | 15,503,182 |   |
| Cost of Sales                 |   | 5,510,859        |      | 2,835,044 |   | 8,345,903 |   |
| Gross Profit                  |   | $                | 4,432,149 |      | $      | 2,725,130 |   | $ | 7,157,279 |   |

 

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**11.QUARTERLY FINANCIAL DATA (UNAUDITED)**

 

Summary unaudited quarterly financial data from continuing operationsfor 2002 and 2001 is as follows:

 
| **Fiscal year ended December 31,  2002**                |   | **First  Quarter** |      | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |      |
|---------------------------------------------------------|--------|--------------------|-----------|---------------------|--------|--------------------|--------|---------------------|-----------|
|                                                    |   |               |      |                |   |               |   |                |      |
| Net Sales                                               |   | $                  | 3,373,016 |                | $      | 3,235,269          |   | $                   | 3,597,557 |   | $ | 4,210,509 |   |
| Gross Margin                                            |   | 1,487,903          |      | 1,261,076           |   | 1,579,849          |   | 1,929,916           |      |
| Operating Loss                                          |   | (645,415           | )         | (639,252            | )      | (459,414           | )      | (66,557             | )         |
| Net loss                                                |   | (665,811           | )         | (660,298            | )      | (480,558           | )      | (89,951             | )         |
| Net loss per  share, basic and diluted                  |   | $                  | (0.02     | )                   | $      | (0.02              | )      | $                   | (0.01     | ) | $ | (0.00 | ) |
| Weighted average  shares outstanding, basic and diluted |   | 43,813,494         |      | 43,813,494          |   | 44,236,333         |   | 44,533,886          |      |

 
| **Fiscal year ended December 31,  2001**                |   | **First  Quarter** |      | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |      |
|---------------------------------------------------------|--------|--------------------|-----------|---------------------|--------|--------------------|--------|---------------------|-----------|
|                                                    |   |               |      |                |   |               |   |                |      |
| Net Sales                                               |   | $                  | 4,189,437 |                | $      | 4,292,233          |   | $                   | 3,652,376 |   | $ | 4,507,063 |   |
| Gross Margin                                            |   | 1,975,809          |      | 1,909,232           |   | 1,521,517          |   | 1,944,324           |      |
| Operating Loss                                          |   | (493,665           | )         | (592,049            | )      | (751,716           | )      | (334,620            | )         |
| Net loss                                                |   | (637,013           | )         | (742,662            | )      | (890,767           | )      | (456,711            | )         |
| Net loss per  share, basic and diluted                  |   | $                  | (0.09     | )                   | $      | (0.10              | )      | $                   | (0.11     | ) | $ | (0.06 | ) |
| Weighted average  shares outstanding, basic and diluted |   | 7,347,389          |      | 7,441,592           |   | 7,823,639          |   | 7,823,639           |      |

 

**12.SUBSEQUENT EVENT**

 

On April 14, 2003,the Company entered into a loan agreement (the “Loan Agreement”) with HealthHoldings and Botanicals, LLC, a principal shareholder of the Company, andcertain other lenders (the “Lender Group”), pursuant to which the Lender Grouphas agreed to lend the Company $450,000 and, subject to the discretion of theLender Group, up to an additional $300,000. All advances under the Loan Agreement bear interest at the rate of 15%per annum, are due on December 31, 2004, are secured by substantially all ofthe assets of the Company, and are subordinated to the Company’s indebtednessto Wells Fargo Business Credit, Inc. (“Wells Fargo”).  The advances under the Loan Agreement will be used for theCompany for working capital and general corporate purposes.  In consideration of the extension of creditunder the Loan Agreement, Wells Fargo waived all defaults of the Company as ofDecember 31, 2002 under the Credit and Security Agreement dated as of February27, 2000 and amended the agreement to, among other things, reduce the covenantsregarding minimum net income and minimum book net worth and increased theinterest rate to the prime rate plus 4.5%.

 

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