UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549





FORM 10-Q





☑ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934





For
the quarterly period ended September 30, 2016





OR





☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934





For the transition period from _______________ to
_______________





Commission File Number: 000-28107





GILLA INC.


(Exact
Name of Registrant as Specified in its Charter)





Nevada

88-0335710(State
or Other Jurisdiction of Incorporation or
Organization)

(I.R.S.
Employer Identification Number)





475 Fentress Blvd., Unit L,
Daytona Beach, Florida

32114(Address
of Principal Executive Offices)

(Zip
Code)





(416) 843-2881


Registrant’s telephone number, including area
code





Not Applicable


(Former
name, Former Address and Former Fiscal year, if changed since last
report.)





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 (or for
such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements
for the past 90 days. ☐  Yes  
☑  No





Indicate
by check mark whether the registrant has submitted electronically
and posted on its corporate Web site, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405
of Regulation S-T during the preceding 12 months (or for such
shorter period that the registrant was required to submit and post
such files). ☑  Yes   ☐ 
No





Indicate
by check mark whether the registrant is a large accelerated filer,
an accelerated filer, a non-accelerated filer, or a smaller
reporting company. See the definitions of “large accelerated
filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check
one):





Large
accelerated filer
☐
Accelerated
filer
☐Non-accelerated
filer
☐
Smaller
reporting company
☑(Do
not check if a smaller reporting company)





Indicate
by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Act). ☐ 
Yes  ☑  No





Indicate
the number of shares outstanding of each of the issuer’s
classes of common stock, as of the latest practicable
date.





100,753,638
Common Shares, $0.0002 Par Value, were issued and outstanding as of
November 13, 2016.














GILLA,
INC.





INDEX TO UNAUDITED CONDENSED CONSOLIDATED INTERIM FINANCIAL
STATEMENTS





PagePART I
- Financial InformationItem 1.
Interim
Financial Statements (Unaudited)
3Condensed
Consolidated Interim Balance Sheets as of September 30, 2016
(Unaudited) and December 31, 2015 (Audited)
3Unaudited
Condensed Consolidated Interim Statements of Operations and
Comprehensive Loss for the Three and Nine Months Ended September
30, 2016 and September 30, 2015
4Unaudited
Condensed Consolidated Interim Statement of Changes in
Shareholders’ Deficiency for the Nine Months Ended September
30, 2016
5Unaudited
Condensed Consolidated Interim Statements of Cash Flows for the
Nine Months Ended September 30, 2016 and September 30,
2015
6Notes
to Unaudited Condensed Consolidated Interim Financial
Statements
7Item 2.
Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
31Item 3.
Quantitative
and Qualitative Disclosures About Market Risk
42Item
4.
Controls
and Procedures
42PART
II - Other InformationItem 1.
Legal
Proceedings
43Item
1A.
Risk
Factors
43Item 2.
Unregistered
Sales of Equity Securities and Use of Proceeds
43Item 3.
Defaults
Upon Senior Securities
43Item 4.
Mine
Safety Disclosures
43Item 5.
Other
Information
43Item
6.
Exhibits
44SIGNATURES
45








2





Gilla Inc.


Condensed
Consolidated Interim Balance Sheets


(Amounts expressed in US Dollars)





September 30,
December 31,2016
2015(unaudited)
(audited)ASSETSCurrent
assetsCash
and cash equivalents
$166,740
$81,696Trade
receivables (net of allowance for doubtful accounts $20,615
(December 31, 2015: $20,370))
336,990
45,534Inventory
(note 6)
407,429
154,700Other
current assets (note 5)
585,479
322,326Total
current assets
1,493,638
604,256Long
term assetsProperty
and equipment (note 7)
116,620
150,349Website
development (note 8)
7,583
9,083Intangibles
(notes 4 and 8)
302,283
215,283Goodwill
(note 4)
889,497
1,252,084Total
long term assets
1,315,983
1,626,799Total
assets
$2,812,621
$2,231,055LIABILITIESCurrent
liabilitiesAccounts
payable
$1,711,999
$687,767Accrued
liabilities (note 9)
372,867
251,517Accrued
interest - related parties (note 16)
218,469
131,755Customer
deposits
54,224
372,500Loans
from shareholders (note 9)
918,618
27,528Due
to related parties (note 16)
1,724,945
996,939Promissory
notes (note 4a)
774,937
495,193Amounts
owing on acquisition (note 4d)
55,000
150,549Convertible
debentures (note 12)
50,000
80,658Credit
facility (note 10)
-
212,415Term
loan (note 11)
1,190,649
-Total
current liabilities
7,071,708
3,406,821Long
term liabilitiesDebentures
to be issued (note 12)
50,000
-Loans
from shareholders (note 9)
102,162
461,250Due
to related parties (note 16)
631,470
662,140Amounts
owing on acquisitions (note 4d)
-
196,127Promissory
notes (note 4a)
-
267,857Convertible
debentures (note 12)
45,338
6,500Total
long term liabilities
828,970
1,593,874Total
liabilities
7,900,678
5,000,695Going
concern (note 2)Related
party transactions (note 16)Commitments
and contingencies (note 17)Subsequent
events (note 20)STOCKHOLDERS’ DEFICIENCYCommon
stock: $0.0002 par value, 300,000,000 common shares authorized;
100,753,638 and 99,560,923 common shares issued and outstanding as
of September 30, 2016 and December 31, 2015, respectively (note
13)
$20,151
$19,913Additional
paid-in capital
6,728,554
5,581,585Shares
to be issued (note 15)
93,727
20,000Accumulated
deficit
(12,192,015)
(8,750,688)Accumulated
other comprehensive income
261,526
359,550Total
shareholders’ deficiency
(5,088,057)
(2,769,640)Total
liabilities and stockholders’ deficiency
$2,812,621
$2,231,055


The
accompanying notes are an integral part of these unaudited
condensed consolidated interim financial statements





3


Gilla Inc.


Unaudited Condensed Consolidated Interim Statements of Operations
and Comprehensive Loss


(Amounts expressed in US Dollars)





For the Three
Months Ended
September
30,
2016
For the Three
Months Ended
September
30,
2015
For the Nine
Months Ended
September
30,
2016
For the Nine
Months Ended
September
30,
2015Sales
revenue
$1,048,474
$816,610
$3,317,002
$824,251Cost of goods
sold
321,729
560,329
1,527,711
562,854Gross
profit
726,745
256,281
1,789,291
261,397Operating
expensesAdministrative
1,331,755
508,785
4,130,393
1,114,346Consulting fees -
related parties (note 16)
134,046
150,045
353,690
472,493Depreciation
16,472
7,652
44,982
8,511Amortization
19,500
4,999
74,500
14,998Bad debt
recovery
-
-
(1,198)
-Impairment of fixed
assets
70,142
-
70,142
-Impairment of
inventory
24,453
75,964
24,453
75,964Impairment of
goodwill (note 4d)
-
-
208,376
-(Gain) loss on
settlement (notes 4d and 13)
-
-
(245,625)
(16,344)Total operating
expenses
1,596,368
747,445
4,659,713
1,669,968Loss from
operations
(869,623)
(491,164)
(2,870,422)
(1,408,571)Other income
(expenses):Foreign
exchange
18,893
20,895
(70,199)
108,727Loss on settlement
of account receivable
-
-
-
(23,344)Amortization of
debt discount
(19,894)
(109,558)
(56,180)
(197,167)Interest expense,
net
(172,610)
(114,981)
(444,526)
(263,262)Total other
expenses
(173,611)
(203,644)
(570,905)
(375,014)Net loss before
income taxes
(1,043,234)
(694,808)
(3,441,327)
(1,783,585)Income
taxes
-
-
-
-Net
loss
$(1,043,234)
$(694,808)
$(3,441,327)
$(1,783,585)Loss per weighted
average number of shares outstanding (basic and
diluted)
$(0.010)
$(0.007)
$(0.034)
$(0.019)Weighted average
number of shares outstanding (basic and diluted)
100,753,638
95,552,198
100,067,872
93,933,387Comprehensive
loss:Net
loss
$(1,043,234)
$(697,808)
$(3,441,327)
$(1,783,585)Foreign exchange
translation adjustment
25,562
87,911
(98,024)
167,798Comprehensive
loss
$(1,017,672)
$(609,897)
$(3,539,351)
$(1,615,787)





The
accompanying notes are an integral part of these unaudited
condensed consolidated interim financial
statements





4


Gilla Inc.


Unaudited Condensed Consolidated Interim Statement of Changes in
Stockholders’ Deficiency


(Amounts expressed in US Dollars)








Common
Stock
Additional
Paid-In
Shares To
Be
Accumulated
Accumulated
Other
Comprehensive
Total
Stockholders’Shares
Amount
Capital
Issued
Deficit
Income
DeficiencyBalance, December
31, 2015
99,560,923
$19,913
$5,581,585
$20,000
$(8,750,688)
$359,550
$(2,769,640)Shares to be issued
on the conversion of convertible debentures (note 15)
-
-
-
23,000
-
-
23,000Shares issued for
settlement of deferred fees owing to a related party
480,000
96
76,704
-
-
-
76,800Shares issued for
settlement of consulting fees
562,715
112
78,668
(20,000)
-
-
58,780Shares issued for
employment income to a related party
150,000
30
20,970
-
-
-
21,000Shares to be issued
for settlement of consulting fees
(note
15)
-
-
-
70,727
-
-
70,727Issuance of
warrants
-
-
853,089
-
-
-
853,089Embedded conversion
feature of convertible debentures
-
-
117,538
-
-
-
117,538Foreign currency
translation gain
-
-
-
-
-
(98,024)
(98,024)Net
loss
-
-
-
-
(3,441,327)
-
(3,441,327)Balance,
September 30, 2016
100,753,638
$20,151
$6,728,554
$93,727
$(12,192,015)
$261,526
$(5,088,057)





The
accompanying notes are an integral part of these unaudited
condensed consolidated interim financial statements





5


Gilla Inc.


Unaudited Condensed Consolidated Interim Statements of Cash
Flows


(Amounts Expressed in US Dollars)


For the
Nine
Months
Ended
September
30,
2016
For the
Nine
Months
Ended
September
30,
2015CASH
FLOWS FROM OPERATING ACTIVITIES:Net
loss
$(3,441,327)
$(1,783,585)Items
not requiring an outlay of cashDepreciation
44,982
8,511Amortization
74,500
14,998Stock based
compensation
465,130
184,123Amortization of
debt discount
56,180
197,167(Gain) on
settlement of debt
(245,625)
(16,344)Loss on settlement
of accounts receivable
-
23,312Interest on amounts
owing on acquisition
9,583
-Bad debt
expense
(1,198)
-Interest on
promissory notes
31,392
21,042Impairment of
inventory
24,453
75,964Impairment of fixed
assets
70,142
-Impairment of
goodwill
208,376
-Changes
in operating assets and liabilitiesTrade
receivable
(303,522)
(97,488)Other current
assets
23,326
267,316Inventory
(273,142)
(19,578)Accounts
payable
1,033,815
224,085Accrued
liabilities
129,077
28,966Customer
deposits
(318,741)
20,000Amounts owing on
acquisition
(45,000)
-Due to related
parties
565,952
255,044Accrued
interest-related parties
86,714
62,822Net
cash used in operating activities
(1,804,933)
(533,645)CASH
FLOWS FROM INVESTING ACTIVITIES:Acquisition of
subsidiary
-
(225,000)Disposal (addition)
of capital assets
(89,612)
-Net
cash used in investing activities
(89,612)
(225,000)CASH
FLOWS FROM FINANCING ACTIVITIES:Net cash acquired
from acquisitions of subsidiaries
-
26,016Proceeds from short
term loan
21,000
-Proceeds from term
loan
783,629
-Repayments to term
loan
(27,323)
-Loans to subsidiary
prior to acquisition
-
(25,000)Repayments to
credit facility
-
(166,815)Shareholder loans
received
470,467
221,470Proceeds from
related parties
640,452
188,574Repayments to
related parties
(282,103)
-Proceeds from sale
of convertible debentures
351,500
-Repayment of
convertible debentures
(25,000)
-Net
cash provided by financing activities
1,932,622
244,245Effect of exchange
rate changes on cash
46,967
76,611Net
increase (decrease) in cash
85,044
(437,789)Cash
at beginning of period
81,696
496,724Cash
at end of period
$166,740
$58,935Supplemental
Schedule of Cash Flow Information:Cash
paid for interest
$94,816
$22,061Cash
paid for income taxes
$-
$-Non
cash financing activities:Debentures issued
for settlement of related party fees
$20,000
$-Debentures issued
for settlement of accounts payable
$10,000
$-Debentures issued
for settlement of related party loans
$35,000
$-Common stock issued
for payment of consulting fees payable
$-
$44,400Common stock issued
for settlement of interest payable
$-
$21,292Common stock issued
for settlement of accounts payable
$-
$44,946Common stock issued
in settlement of deferred related party fees
$48,000
$-


The
accompanying notes are an integral part of these unaudited
condensed consolidated interim financial statements


6





Gilla
Inc.


Notes to Unaudited Condensed Consolidated Interim Financial
Statements


September 30, 2016


(Amounts expressed in US Dollars)





1. NATURE OF OPERATIONS





Gilla
Inc. (“Gilla”, the “Company” or the
“Registrant”) was incorporated under the laws of the
state of Nevada on March 28, 1995 under the name of Truco,
Inc.





On July
1, 2015, the Company closed the acquisition of all the issued and
outstanding shares of E Vapor Labs Inc. (formerly, E Liquid
Wholesale, Inc.) (“E Vapor Labs”), a Florida based
E-liquid manufacturer. Pursuant to the share purchase agreement,
dated June 25, 2015, the Company paid a total purchase price of
$1,125,000 payable as (i) $225,000 in cash on closing and (ii)
$900,000 in unsecured promissory notes issued on closing, such
promissory notes issued in three equal tranches of $300,000 due
four, nine and eighteen months respectfully from the closing
date.





On July
14, 2015, the Company closed the acquisition of all the issued and
outstanding shares of E-Liq World, LLC (“VaporLiq”), an
E-liquid subscription based online retailer. Pursuant to the share
purchase agreement, dated July 14, 2015, the Company issued 500,000
Common Shares and warrants for the purchase of 500,000 Common
Shares of the Company exercisable over eighteen months with an
exercise price of $0.20 per Common Share.





On
November 2, 2015, the Company closed the acquisition of all of the
assets of 901 Vaping Company LLC (“901 Vaping”), an
E-liquid manufacturer, including all of the rights and title to own
and operate the Craft Vapes, Craft Clouds and Miss
Pennysworth’s Elixirs E-liquid brands (the “CV
Brands”). Pursuant to the asset purchase agreement, dated
October 21, 2015, the Company (i) issued to the vendor 1,000,000
Common Shares of the Company valued at $0.15 per share for a total
value of $150,000; (ii) paid cash consideration equal to 901
Vaping’s inventory and equipment of $23,207; and (iii) agreed
to a quarterly-earn out based on the gross profit stream derived
from product sales of the CV Brands commencing on the closing date
up to a maximum of 25% of the gross profit stream.





On December 2, 2015, the Company closed the acquisition of all of
the assets of The Mad Alchemist, LLC ( “TMA”), an
E-liquid manufacturer, including the assets, rights and title to
own and operate The Mad Alchemist and Replicant E-liquid brands
(the “TMA Brands”), pursuant to an asset purchase
agreement dated November 30, 2015. The total purchase price for the
assets was $500,000 including the issuance of (i) 819,672 Common
Shares valued at $0.122 per share for a total value of $100,000;
(ii) $400,000 in cash payable in 10 equal payments of $20,000 in
cash and $20,000 in Common Shares every 3 months following the
closing date; and (iii) agreed to a quarterly-earn out based on the
gross profit stream derived from product sales of the TMA Brands
commencing on the closing date up to a maximum of 25% of the gross
profit stream.





The
current business of the Company consists of the manufacturing,
marketing and distribution of generic and premium branded E-liquid,
which is the liquid used in vaporizers, E-cigarettes, and other
vaping hardware and accessories. E-liquid is heated by the atomizer
to deliver the sensation of smoking. Gilla’s product
portfolio includes Coil Glaze, The Drip Factory, Surf Sauce, Siren,
VaporLiq, Vapor’s Dozen, Craft Vapes, Craft Clouds, Vape
Warriors, Miss Pennysworth’s Elixirs, The Mad Alchemist,
Replicant and Crown E-liquid brands.





2. GOING CONCERN





These
unaudited condensed consolidated interim financial statements have
been prepared on a going concern basis, which contemplates the
realization of assets and the satisfaction of liabilities in the
normal course of business. As shown in these unaudited condensed
consolidated interim financial statements, at September 30, 2016,
the Company has an accumulated deficit of $12,192,015 and a working
capital deficiency of $5,578,070 as well as negative cash flows
from operating activities of $1,804,933 for the nine month period
ended September 30, 2016. These conditions represent material
uncertainty that cast significant doubt about the Company's ability
to continue as a going concern. The ability of the Company to
continue as a going concern is dependent upon achieving a
profitable level of operations or on the ability of the Company to
obtain necessary financing to fund ongoing operations. Management
believes that the Company will not be able to continue as a going
concern for the next twelve months without additional financing or
increased revenues.





To meet
these objectives, the Company continues to seek other sources of
financing in order to support existing operations and expand the
range and scope of its business. However, there are no assurances
that any such financing can be obtained on acceptable terms and in
a timely manner, if at all. Failure to obtain the necessary working
capital would have a material adverse effect on the business
prospects and, depending upon the shortfall, the Company may have
to curtail or cease its operations.





7





These
unaudited condensed consolidated interim financial statements do
not include any adjustments to the recorded assets or liabilities
that might be necessary should the Company have to curtail
operations or be unable to continue in existence.





3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





The accompanying unaudited condensed consolidated interim financial
statements have been prepared in accordance with accounting
principles generally accepted in the United States of America for
interim financial information and with the instructions to Form
10-Q. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in
the United States of America for complete consolidated financial
statements. In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for
a fair presentation have been included. Interim results are not
necessarily indicative of the results that may be expected for a
full year. These condensed consolidated interim financial
statements should be read in conjunction with the audited
consolidated financial statements and notes thereto included in the
Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2015, as filed with the U.S. Securities and Exchange
Commission.





The accounting policies of the Company are in accordance with
accounting principles generally accepted in the United States of
America. Outlined below are those policies considered particularly
significant:





(a)
 Basis of
Consolidation





These
condensed consolidated interim financial statements include the
accounts of the Company and its wholly owned subsidiaries; Gilla
Operations, LLC (“Gilla Operations”); E Vapor Labs
Inc.; E-Liq World, LLC; Charlie’s Club, Inc.
(“Charlie’s Club”); Gilla Enterprises Inc. and
its wholly owned subsidiary Gilla Europe Kft.; Gilla Operations
Worldwide Limited (“Gilla Worldwide”); Gilla
Franchises, LLC and its wholly owned subsidiary Legion of Vape,
LLC.; and Snoke Distribution Canada Ltd. and its wholly owned
subsidiary Snoke Distribution USA, LLC. All inter-company accounts
and transactions have been eliminated in preparing these condensed
consolidated interim financial statements.





(b)
 Advertising
Costs





In
accordance with ASC 720, the Company expenses the production costs
of advertising the first time the advertising takes place. The
Company expenses all advertising costs as incurred. During the nine
month period ended September 30, 2016, the Company expensed
$223,597 (September 30, 2015: $159,236) as corporate promotions,
these amounts have been recorded as administrative
expense.





(c)
 Recent Accounting
Pronouncements





The
Company has reviewed all recently issued, but not yet effective,
accounting pronouncements and other than the below, does not expect
the future adoption of any such pronouncements to have a
significant impact on its results of operations, financial
condition or cash flow.





In May
2014, the Financial Accounting Standards Board (“FASB”)
issued Accounting Standards Update (“ASU”)
No. 2014-09, Revenue from
Contracts with Customers (“ASU 2014-09”),
requiring an entity to recognize revenue when it transfers promised
goods or services to customers in an amount that reflects the
consideration to which the entity expects to be entitled to in
exchange for those goods or services. ASU 2014-09 will supersede
nearly all existing revenue recognition guidance under U.S. GAAP
when it becomes effective. In August 2015, the FASB issued ASU No.
2015-14, Revenue from Contracts
with Customers, deferring the effective date for ASU 2014-09
by one year, and thus, the new standard will be effective for us
beginning on February 1, 2018 with early adoption permitted on or
after February 1, 2017. This standard may be adopted using either
the full or modified retrospective methods. Management of the
Company is currently evaluating adoption methods and the impact of
this standard on the consolidated financial
statements.





In
November 2015, the FASB issued ASU No. 2015-17, Income Taxes (Topic 740): Balance Sheet
Classification of Deferred Taxes (“ASU
2015-17”). ASU 2015-17 simplifies the presentation of
deferred income taxes by eliminating the separate classification of
deferred income tax liabilities and assets into current and
noncurrent amounts in the consolidated balance sheet statement of
financial position. The amendments in the update require that all
deferred tax liabilities and assets be classified as noncurrent in
the consolidated balance sheet. The amendments in this update are
effective for annual periods beginning after December 15, 2016, and
interim periods therein and may be applied either prospectively or
retrospectively to all periods presented. Early adoption is
permitted. Management of the Company is currently evaluating
adoption methods and the impact of this standard on the
consolidated financial statements.





8





On
February 25, 2016, the Financial Accounting Standards Board
(“FASB”) issued Accounting Standards Update
(“ASU”) 2016-02,
Leases (Topic 842). This update will require organizations
that lease assets to recognize on the balance sheet the assets and
liabilities for the rights and obligations created by those leases.
The new guidance will also require additional disclosures about the
amount, timing and uncertainty of cash flows arising from leases.
The provisions of this update are effective for annual and interim
periods beginning after December 15, 2018. The Company is
currently evaluating the impact the adoption of this ASU will have
on the Company’s financial position and results of
operations.





On
March 30, 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation
(Topic 718). This update
requires that all excess tax benefits and tax deficiencies arising
from share-based payment awards should be recognized as income tax
expense or benefit on the income statement. The amendment also
states that excess tax benefits should be classified along with
other income tax cash flows as an operating activity. In addition,
an entity can make an entity-wide accounting policy election to
either estimate the number of awards expected to vest or account
for forfeitures as they occur. The provisions of this update are
effective for annual and interim periods beginning
after December 15, 2016. The Company is currently evaluating
the impact the adoption of this standard will have on its financial
statements.





In
April 2016, the FASB issued ASU No. 2016-10 Revenue from Contracts with Customers
(Topic 606), Identifying Performance Obligations and
Licensing (“ASU 2016-10”). ASU 2016-10 clarifies
the following two aspects of Topic 606: identifying performance
obligations and the licensing implementation guidance, while
retaining the related principles for those areas. The provisions of
this update are effective for annual and interim periods beginning
after December 15, 2017, with early application permitted. The
Company is currently evaluating the impact the adoption of this
standard will have on its financial statements.





In May
2016, the FASB issued ASU No. 2016-12 Revenue from Contracts with Customers (Topic
606), Narrow-Scope
Improvements and Practical Expedients (“ASU
2016-12”). The core principal of ASU 2016-12 is the
recognition of revenue to depict the transfer of promised goods or
services to customers in an amount that reflects the consideration
to which the entity expects to be entitled in exchange for those
goods or services.  The provisions of this update are
effective for annual and interim periods beginning
after December 15, 2017, with early application permitted. The
Company is currently evaluating the impact the adoption of this
standard will have on its financial statements.





In June
2016, the FASB issued ASU No. 2016-13 Financial Instruments – Credit Losses
(Topic 326), Measurement of Credit Losses on Financial
Instruments (“ASU 2016-13”), which requires
financial assets measured at amortized cost be presented at the net
amount expected to be collected. The allowance for credit losses is
a valuation account that is deducted from the amortized cost basis.
The measurement of expected losses is based upon historical
experience, current conditions, and reasonable and supportable
forecasts that affect the collectability of the reported amount.
This guidance is effective for fiscal years beginning
after December 15, 2019, with early adoption permitted. We are
evaluating the guidance and have not yet determined the impact on
our consolidated financial statements.





In
August 2016, the FASB issued Accounting Standard Update (ASU) No.
2016-15 Statement of Cash Flows
(Topic 230), Classification of Certain Cash Receipts and Cash
Payments (a consensus of the Emerging Issues Task Force)
(“ASU 2016-15”), which clarifies how certain cash
receipts and cash payments are presented and classified in the
statement of cash flows. Among other clarifications, the guidance
requires that cash proceeds received from the settlement of
corporate-owned life insurance (COLI) policies be classified as
cash inflows from investing activities and that cash payments for
premiums on COLI policies may be classified as cash outflows for
investing activities, operating activities or a combination of
both. The guidance is effective for fiscal years beginning
after December 15, 2017, with early adoption permitted.
Retrospective application is required. We are evaluating the
guidance and do not expect it to have a material impact on our
consolidated financial statements.





9





4. BUSINESS COMBINATIONS





(a) On
July 1, 2015, the Company closed the acquisition of all the issued
and outstanding shares of E Vapor Labs, a Florida based E-liquid
manufacturer. The Company purchased E Vapor Labs in order to
procure an E-liquid manufacturing platform allowing the Company to
secure large private label contracts as well as manufacture its own
brands going forward. The following summarizes the fair value of
the assets acquired, liabilities assumed and the consideration
transferred at the acquisition date:





Assets
acquired:
Allocation
Measurement
Period Adjustments
Final
AllocationCash
$22,942
-
$22,942Receivables
48,356
(1,705)
46,651Other current
assets
21,195
-
21,195Inventory
122,309
4,428
126,737Fixed
assets
118,867
7
118,874Intangible
assets
-
160,000
160,000Goodwill
847,265
(154,235)
693,030Total
assets acquired
$1,180,934

$1,189,429Liabilities
assumed:Accounts
payable
$206,252
-
$206,252Accrued
liabilities
-
28,000
28,000Loan
payable
25,000
-
25,000Total
liabilities assumed
$231,252

$259,252Consideration:Cash
$225,000
-
$225,000Promissory Notes A,
unsecured and non-interest bearing, due November 1,
2015
196,026
(19,505)
176,521Promissory Notes B,
unsecured and non-interest bearing, due April 1, 2016
275,555
-
275,555Promissory Notes C,
unsecured and non-interest bearing, due January 1,
2017
253,101
-
253,101Total
consideration
$949,682

$930,177





In
consideration for the acquisition, the Company paid to the vendors,
$225,000 in cash on closing and $900,000 in unsecured promissory
notes issued on the closing (collectively, the “Promissory
Notes”). The Promissory Notes were issued in three equal
tranches of $300,000 due four (4), nine (9) and eighteen (18)
months respectfully from the closing (individually,
“Promissory Notes A”, “Promissory Notes B”,
and “Promissory Notes C” respectively). The Promissory
Notes are all unsecured, non-interest bearing, and on the maturity
date, at the option of the vendors, up to one third (1/3) of each
tranche of the Promissory Notes can be repaid in Common Shares of
the Company, calculated using the 5 day weighted average closing
market price of the Company prior to the maturity of the Promissory
Notes. The Promissory Notes, are all and each subject to
adjustments as outlined in the share purchase agreement (the
“SPA”), dated June 25, 2015.





At
December 31, 2015, the Company adjusted the Promissory Notes A for
$116,683 which is the known difference in the working capital
balance at closing of the acquisition from the amount specified in
the SPA. Further, a 12% discount rate has been used to calculate
the present value of the Promissory Notes based on the
Company’s estimate of cost of financing for comparable notes
with similar term and risk profiles. Over the term of the
respective Promissory Notes, interest will be accrued at 12% per
annum to accrete the Promissory Notes to their respective principal
amounts. During the nine month period ended September 30, 2016, the
Company recorded $23,246 in interest expense related to the
accretion of the Promissory Notes. The present value of the
Promissory Notes was $774,937 (December 31, 2015: $763,050) at
September 30, 2016.





The
Promissory Notes A were due on November 1, 2015. The Company
provided notice to the Promissory Note holders on October 30, 2015
indicating its intention to repay such Promissory Notes, however,
such inability to accurately determine the required adjustments
pursuant to the SPA has forced the Company to defer repayment of
such Promissory Notes until such time where the principal amount of
the Promissory Notes can be accurately determined (note
17).





10





Intangible assets
consist primarily of customer relationships and brands. Brand
intangibles represents the estimated fair value of the trade names
acquired. Customer relationship intangibles relates to the ability
to sell existing and future products to E Vapor Lab’s
existing and potential customers. The estimated useful life and
fair values of the identifiable intangible assets are as
follows:


Estimated Useful
Life
(in
years)
AmountBrands
5
$20,000Customer
relationships
5
140,000$160,000








The
results of operations of E Vapor Labs have been included in the
interim condensed consolidated statements of operations from the
acquisition date. The following table presents pro forma results of
operations of the Company and E Vapor Labs as if the companies had
been combined as of January 1, 2015. The pro forma condensed
combined financial information is presented for informational
purposes only. The unaudited pro forma results of operations are
not necessarily indicative of results that would have occurred had
the acquisition taken place at the beginning of the earliest period
presented, or of future results.





September
30,
2016
September
30,
2015Pro forma
revenue
$3,317,002
$1,341,022Pro forma loss from
operations
$(2,870,422)
$(1,595,198)Pro forma net
loss
$(3,441,327)
$(1,953,868)





(b) On
July 14, 2015, the Company closed the acquisition of all the issued
and outstanding shares of VaporLiq, a private E-liquid subscription
based online retailer. The Company purchased VaporLiq mainly to
access industry relationships and knowhow of various E-liquid
brands that VaporLiq transacts with. The following summarizes
the fair value of the assets acquired, liabilities assumed and the
consideration transferred at the acquisition date:





Assets
acquired:Cash
$5,381Website
10,000Inventory
2,150Goodwill
109,444Total
assets acquired
$126,975Total
liabilities assumed
$-Consideration:500,000 Common
Shares at $0.17 per share
$85,000500,000
warrants
41,975Total
consideration
$126,975





The
warrants are exercisable over eighteen (18) months with an exercise
price of $0.20 per Common Share.





The
goodwill is attributable to business acumen and access to key
E-liquid brands that the Company may leverage for further
acquisitions.





The
results of operations of VaporLiq have been included in the interim
condensed consolidated statements of operations from the
acquisition date, though revenue and net income from VaporLiq were
not material for the nine month period ended September 30, 2016.
Pro forma results of operations have not been presented because the
acquisition was not material to the results of
operations.





11





(c) On November 2, 2015, the Company closed the acquisition
of all of the assets of 901 Vaping, an E-liquid manufacturer,
including all of the rights and title to own and operate the Craft
Vapes, Craft Clouds and Miss Pennysworth’s Elixirs E-liquid
brands. The following summarizes the fair value of the assets
acquired and the consideration transferred at the acquisition
date:





Assets
acquired:Inventory
$11,335Equipment
11,872Intangibles
63,000Goodwill
87,000Total
assets acquired
$173,207Consideration:Cash
$23,2071,000,000 Common
Shares at $0.15 per share
150,000Total
consideration
$173,207





In
consideration for the acquisition, the Company issued 1,000,000
Common Shares of the Company valued at $0.15 per share, paid cash
consideration of $23,207 and agreed to a quarterly earn-out based
on the gross profit stream derived from product sales of the
acquired brands. The earn-out commences on the closing date and
pays up to a maximum of 25% of the gross profit stream. As of September 30, 2016, no
amounts have been accrued or paid in relation to the quarterly
earn-out.





Intangible assets
consist primarily of customer relationships and brands. Brand
intangibles represents the estimated fair value of the trade names
acquired. Customer relationship intangibles relates to the ability
to sell existing and future products to 901 Vaping’s existing
and potential customers. The estimated useful life and fair values
of the identifiable intangible assets are as follows:


Estimated Useful Life
(in years)
AmountBrands
5
$30,000Customer
relationships
5
33,000$63,000





The
results of operations of 901 Vaping have been included in the
interim condensed consolidated statements of operations from the
acquisition date, though revenue and net income from 901 Vaping
were not material for the nine month period ended September 30,
2016. Pro forma results of operations have not been presented
because the acquisition was not material to the results of
operations.





(d) On December 2, 2015, the
Company acquired all of the assets of TMA, an E-liquid
manufacturer, including the assets, rights and title to own and
operate The Mad Alchemist and Replicant E-liquid brands. The
following summarizes the fair value of the assets acquired and the
consideration transferred at the acquisition date:





Assets
acquired:Inventory
$41,462Equipment
36,579Intangibles
157,000Goodwill
208,376Total
assets acquired
$443,417Consideration:819,672 Common
Shares at $0.122 per share
$100,000Deferred
payments
343,417Total
consideration
$443,417





On the
closing date, the Company issued 819,672 Common Shares valued at
$0.122 per share for a total value of $100,000; agreed to pay a
total of $400,000 in deferred payments (the “Amounts Owing on
Acquisition”), payable in ten (10) equal payments of $20,000
in cash and $20,000 in common stock every three (3) months
following the closing date, and agreed to a quarterly earn-out
based on the gross profit stream derived from product sales of the
acquired brands. The earn-out commences on the closing date and
pays up to a maximum of 25% of the gross profit stream. The number
of Common Shares issuable will be calculated and priced using the
weighted average closing market price of the Company, as quoted by
the OTC Markets Group, for the five trading days prior to each
issuance date. Further, a 12% discount rate has been used to
calculate the present value of the Amounts Owing on Acquisition.
Over the term of the respective deferred payments, interest will be
accrued at 12% per annum to accrete the payments to their
respective principal amounts. During the nine month period ended
September 30, 2016, the Company recorded $9,582 in interest expense
related to the accretion of the Amounts Owing on
Acquisition.





12





Intangible assets
consist primarily of customer relationships and brands. Brand
intangibles represents the estimated fair value of the trade names
acquired. Customer relationship intangibles relates to the ability
to sell existing and future products to TMA’s existing and
potential customers. The estimated useful life and fair values of
the identifiable intangible assets are as follows:


Estimated Useful Life
(in years)
AmountBrands
5
$60,000Customer
relationships
5
97,000$157,000





The
results of operations of TMA have been included in the interim
condensed consolidated statements of operations from the
acquisition date, though revenue and net income from TMA were not
material for the nine month period ended September 30, 2016. Pro
forma results of operations have not been presented because the
acquisition was not material to the results of
operations.





On
April 15, 2016, the Company entered into a settlement agreement
(the “Settlement Agreement”) with TMA and the Pennington family, being Joshua
Pennington, Nicole Pennington and Mike Simon (collectively, the
“Pennington Family”). Subject to the terms and
conditions of the Settlement Agreement, the parties settled: (i)
any and all compensation and expenses owing by the Company to the
Pennington Family and (ii) all remaining consideration payable by
the Company to TMA under the asset
purchase agreement totaling $400,000 which was due in cash
and common stock in exchange for the Company paying to TMA and the
Pennington Family a total consideration of $133,163 payable as
$100,000 in cash and $33,163 in assets as payments in kind. Of the
$100,000 payable in cash, $45,000 was paid upon execution of the
Settlement Agreement, $27,500 was payable thirty days following the
execution of the Settlement Agreement and the remaining $27,500
payable at the later of (i) sixty days following the execution of
the Settlement Agreement, or (ii) the completion of the historical
audit of TMA. As a result of the Settlement Agreement, the Company
has recorded a gain on settlement in the amount of $274,051. As at
September 30, 2016, $55,000 (December 31, 2015: $346,676) remains
payable to TMA and the Pennington Family. In addition, the
employment agreements between the Company and Joshua Pennington and
Nicole Pennington were mutually terminated and all amounts were
fully settled pursuant to the Settlement Agreement. Due to change
in circumstance, the Company tested goodwill for impairment and as
a result, the Company has fully impaired goodwill related to TMA in
the amount of $208,376 which formerly represented the value of
workforce and business acumen acquired.





5. OTHER CURRENT ASSETS





Other
current assets consist of the following:





September
30,
2016
December
31,
2015Vendor
deposits
$6,094
$175,700Prepaid
expenses
464,629
88,274Trade
currency
45,000
45,000Other
receivables
69,756
13,352$585,479
$322,326





Other
receivables include VAT receivable, HST receivable and holdback
amounts related to the Company’s merchant services
account.





13





6. INVENTORY





Inventory
consists of the following:





September
30,
2016
December 31,
2015E-liquid bottles -
finished goods
$140,210
$65,247E-liquid
components
107,630
57,988Hardware
70,335
-Bottles and
packaging
89,254
31,465$407,429
$154,700





During
the nine month period ended September 30, 2016, the Company wrote
off $24,453 in obsolete inventory that it was unable to sell.
During the year ended December 31, 2015, the Company wrote off
$75,964 in obsolete E-cigarette inventory recorded in
Charlie’s Club, an e-commerce website of the Company, and
Gilla Operations, the Company’s primary operating subsidiary
in the United States.





At
September 30, 2016, the full amount of the Company’s
inventory serves as collateral for the Company’s secured
borrowings (note 9).





7. PROPERTY AND EQUIPMENT





Property
and equipment consists of the following:





September
30,
2016
December
31,
2015Cost
Accumulated
Depreciation
Net
NetFurniture and
equipment
$59,440
$12,801
$46,639
$1,156Computer
hardware
44,383
9,230
35,153
5,525Manufacturing
equipment
51,656
16,828
34,828
143,668$155,479
$38,859
$116,620
$150,349





Depreciation
expense for the three and nine month periods ended September 30,
2016 amounted to $16,472 and $44,982, respectively. Depreciation
expense for the three and nine month periods ended September 30,
2015 amounted to $7,652 and $8,511, respectively. During the nine
month period ended September 30, 2016, the Company wrote off
$70,142 of manufacturing equipment that was not in working order
and that the Company has not been able to sell.





At
September 30, 2016, the full amount of the Company’s property
and equipment serves as collateral for the Company’s secured
borrowings (note 9).





8. INTANGIBLE ASSETS AND WEBSITE DEVELOPMENT





Website
development consists of the following:





September
30,
2016
December
31,
2015Cost
Accumulated
Amortization
Net
NetVaporLiq
website
$10,000
$2,417
$7,583
$9,083





Amortization
expense on website development for the three and nine month periods
ended September 30, 2016 amounted to $500 and $1,500, respectively.
Amortization expense on website development for the three and nine
month periods ended September 30, 2015 amounted to $4,999 and
$14,998, respectively. During the year ended December 31, 2015, the
Company impaired the Charlie’s Club website as it was
determined to be obsolete due to the shift in direction the Company
has pursued from the sale of E-cigarettes to the manufacturing and
sale of E-liquid.





The
estimated amortization expense for the next 4 years ending December
31, 2016, 2017, 2018 and 2019 approximates $2,000 per year. For the
year ending December 31, 2020 it approximates $1,083.





14





Intangible
assets consist of the following:





September
30,
2016
December
31,
2015Cost
Accumulated
Amortization
Net
NetBrands
$110,000
$20,500
$89,500
$88,000Customer
relationships
270,000
57,217
212,783
127,283$380,000
$77,717
$302,283
$215,283





Amortization
expense on intangible assets for the three and nine month periods
ended September 30, 2016 amounted to $19,000 and $73,000
respectively. Amortization expense on intangible assets for the
three and nine month periods ended September 30, 2015 amounted to
nil. The estimated amortization expense for the next 4 years ending
December 31, 2016, 2017, 2018 and 2019 approximates $76,000 per
year. For the year ending December 31, 2020 it approximates
$55,283.





9. LOANS FROM SHAREHOLDERS





The
Company has outstanding current loans from shareholders as
follows:


September
30,
2016
December
31,
2015Non-interest
bearing, unsecured, no specific terms of repayment
$5,000
$5,000Bears interest of
1.5% per month on a cumulative basis, unsecured, no specific terms
of repayment (i)
23,772
22,528Bears interest of
10% per annum on a cumulative basis, secured by the assets of the
Company, matures on July 1, 2017 (ii)
381,200
-Bears interest of
10% per annum on a cumulative basis, secured by the assets of the
Company, matures on July 1, 2017 (iii)
100,000
-Bears interest of
6% per annum on a cumulative basis, secured by the assets of the
Company, matures on March 2, 2018 (v)
408,646
-$918,618
$27,528





(i)   
During the three and nine month period ended September 30, 2016,
the Company accrued interest of $1,527 and $4,324 on this
shareholder loan (September 30, 2015: $1,846 and $5,191). Total
accrued interest owing on the shareholder loan at September 30,
2016 is $11,476 (December 31, 2015: $6,686) which is included in
accrued liabilities.





(ii)  On
February 13, 2014, the Company entered into a secured promissory
note (the “Secured Note”) with a shareholder, whereby
the Company agreed to pay the party the aggregate unpaid principal
amount of CAD $500,000 (USD $381,200) (December 31, 2015: CAD
$500,000; USD $361,250) on or before August 13, 2014, bearing
interest at a rate of 10% per annum, such interest will accrue
monthly and be added to the principal. The Secured Note is secured
by a general security agreement over the assets of the Company.
During the year ended December 31, 2014, the Company and the
shareholder extended the maturity date of the Secured Note to
January 1, 2016. During the year ended December 31, 2015, the
Company and the shareholder extended the maturity date of the
Secured Note to July 1, 2017.





The
Company accrued interest of $11,336 and $32,721 during the three
and nine month periods ended September 30, 2016 (September 30,
2015: $10,782 and $29,968), respectively, on the Secured Note.
Accrued interest owing on the Secured Note at September 30, 2016 is
$83,704 (December 31, 2015: $47,617) which is included in accrued
liabilities.





(iii)  On
July 15, 2014, the Company entered into a secured promissory note
(the “Secured Note No.2”) with a shareholder, whereby
the Company agreed to pay the party the aggregate unpaid principal
amount of $100,000 on or before July 18, 2014, bearing interest at
a rate of 10% per annum, such interest will accrue monthly and be
added to the principal. The Secured Note No.2 is secured by the
general security agreement issued with the Secured Note. During the
year ended December 31, 2014, the Company and the shareholder
extended the maturity date of the Secured Note No.2 to January 1,
2016. During the year ended December 31, 2015, the Company and the
shareholder extended the maturity date of the Secured Note No.2 to
July 1, 2017.





15





The
Company accrued interest of $3,002 and $8,786 during the three and
nine month periods ended September 30, 2016 (September 30, 2015:
$2,717 and $7,953) on the Secured Note No.2. Accrued interest owing
on the Secured Note No.2 at September 30, 2016 is $22,074 (December
31, 2015: $13,289) which is included in accrued
liabilities.





(iv)   
On June 29, 2015, the Company entered into a secured promissory
note (the “Secured Note No.3”) with a shareholder,
whereby the Company agreed to pay the party the aggregate unpaid
principal amount of CAD $300,000 (USD $240,180) on or before
January 1, 2016, bearing interest at a rate of 10% per annum, such
interest will accrue monthly and be added to the principal. The
Secured Note No.3 is secured by the general security agreement
issued with the Secured Note. In connection to the Secured Note
No.3, the Company issued 500,000 warrants to purchase Common Shares
of the Company exercisable over one year with an exercise price of
$0.15 per Common Share, see note 14(c). The Company accrued
interest of $5,667 on this note during the nine month periods ended
September 30, 2015. On December 31, 2015, the Secured Note No.3 and
all accrued interest owing with the issuance of $227,000 of
Convertible Debenture Units.





(v)  On March 2, 2016, the Company entered into a loan agreement with a
shareholder (the “Loan Agreement”), whereby the
shareholder would make available to the Company the aggregate
principal amount of CAD $670,000 (the “Shareholder
Loan”) for capital expenditures, marketing expenditures and
working capital. Under the terms of the Loan Agreement, the
Shareholder Loan was made available to the Company in two equal
tranches of CAD $335,000 (USD $259,357), for a total loan amount of
CAD $670,000 (USD $518,714), with the first tranche (“Loan
Tranche A”) received on the closing date and the second
tranche (“Loan Tranche B”) received on April 14, 2016.
At September 30, 2016, CAD $52,000 (USD $39,645) of the Loan
Tranche B is being held in trust by the shareholder to be released
on the incurrence of specific expenses. The Shareholder Loan bears
interest at a rate of 6% per annum, on the outstanding principal,
and shall mature on March 2, 2018, whereby any outstanding
principal together with all accrued and unpaid interest thereon
shall be due and payable. The Company shall also repay 5% of the
initial principal amount of Loan Tranche A and 5% of Loan Tranche
B, monthly in arrears, with the first principal repayment beginning
on June 30, 2016. At September 30, 2016, $408,646 of the amounts
owing on the Loan Agreement have been recorded as current
liabilities to reflect the monthly principal payments due over the
next year. The Company may elect to repay the outstanding principal
of the Shareholder Loan together with all accrued and unpaid
interest thereon prior to maturity without premium or penalty. The
Company also agreed to service the Shareholder Loan during the term
prior to making any payments to the Company’s Chief Executive
Officer, Chief Financial Officer and Board of Directors. The
Shareholder Loan is secured by a general security agreement over
the assets of the Company.





The
Company accrued interest of $7,759 and $15,894 during the three and
nine month periods ended September 30, 2016 (September 30, 2015:
nil), respectively, on the Shareholder Loan. Accrued interest owing
on the Shareholder Loan at September 30, 2016 is $16,044 (December
31, 2015: nil) which is included in accrued liabilities. At
September 30, 2016, the Company owes the lender $102,162 in
principal payments.





The
Company has outstanding long term loans from shareholders as
follows:


September
30,
2016
December
31,
2015Bears interest of
10% per annum on a cumulative basis, secured by the assets of the
Company, matures on July 1, 2017 (ii)
$-
$361,250Bears interest of
10% per annum on a cumulative basis, secured by the assets of the
Company, matures on July 1, 2017 (iii)
-
100,000Bears interest of
6% per annum on a cumulative basis, secured by the assets of the
Company, matures on March 2, 2018 (v)
102,162
-$102,162
$461,250





10. CREDIT FACILITY





On
August 1, 2014, the Company entered into a revolving credit
facility (the “Credit Facility”) with an unrelated
party acting as an agent to a consortium of participants (the
“Lender”), whereby the Lender would make a revolving
credit facility in the aggregate principal amount of CAD $500,000
for the exclusive purpose of purchasing inventory for sale in the
Company’s ordinary course of business to approved customers.
The Credit Facility shall bear interest at a rate of 15% per annum
on all drawn advances and a standby fee of 3.5% per annum on the
undrawn portion of the Credit Facility. The Credit Facility shall
mature on August 1, 2015 whereby the outstanding advances together
with all accrued and unpaid interest thereon shall be due and
payable. On August 1, 2014, and in connection to the Credit
Facility, the Company issued 250,000 warrants to purchase Common
Shares of the Company exercisable over two years with an exercise
price of $0.30 per Common Share. The Company’s Chief
Executive Officer and Chief Financial Officer are both participants
of the consortium of participants of the Credit Facility, each
having committed to provide ten percent of the principal amount of
the Credit Facility. The Credit Facility is secured by all of the
Company’s inventory and accounts due relating to any
inventory as granted in an intercreditor and subordination
agreement by and among the Company, the Secured Note holder and the
Lender to establish the relative rights and priorities of the
secured parties against the Company and a security agreement by and
between the Company and the Lender.





16





During
the year ended December 31, 2014, the Company was advanced $387,110
(CAD $449,083) from the Credit Facility for the purchase of
inventory including $77,453 (CAD $89,852) of advances from the
Company’s Chief Executive Officer and Chief Financial Officer
as their participation in the Credit Facility.





On
February 11, 2015, the Company fully repaid the amounts advanced
from the Credit Facility.





On
April 24, 2015, the Company was advanced $89,590 (CAD $124,000)
from the Credit Facility including $17,918 (CAD $24,800) of
advances from the Company’s Chief Executive Officer and Chief
Financial Officer as their participation in the Credit
Facility.





On
September 1, 2015, the Company was advanced $122,825 (CAD $170,000)
from the Credit Facility including $24,565 (CAD $34,000) of
advances from the Company’s Chief Executive Officer and Chief
Financial Officer as their participation in the Credit
Facility.





During
the three and nine month periods ended September 30, 2016, the
Company expensed $2,189 (September 30, 2015: $21,084) of interest
and standby fees as a result of the Credit Facility.





On
January 18, 2016, and in connection to the Term Loan (note 11), the
Company and the Lender entered into a loan termination agreement
whereby the Company and the Lender terminated and retired the
Credit Facility. As a result, the CAD $294,000 in amounts advanced
from the Credit Facility and the CAD $3,093 in accrued interest
owing on the Credit facility were rolled into the Term
Loan.





11. TERM LOAN





On
January 18, 2016, the Company entered into a term loan (the
“Term Loan”) with the Lenders, a consortium of
participants that includes two of the Company’s senior
executive officers, whereby the Lenders would loan the Company the
aggregate principal amount of CAD $1,000,000 for capital
expenditures, marketing expenditures and working capital. The agent
who arranged the Term Loan was not a related party of the Company.
The Term Loan bears interest at a rate of 16% per annum, on the
outstanding principal, and shall mature on July 3, 2017, whereby
any outstanding principal together with all accrued and unpaid
interest thereon shall be due and payable. The Term Loan is subject
to a monthly cash sweep, calculated as the total of (i) CAD $0.50
for every E-liquid bottle, smaller than 15ml, sold by the Company
within a monthly period; and (ii) CAD $1.00 for every E-liquid
bottle, greater than 15ml, sold by the Company within a monthly
period (the “Cash Sweep”). The Cash Sweep will be
disbursed to the Lenders in the following priority: first, to pay
the monthly interest due on the Term Loan; and second, to repay any
remaining principal outstanding on the Term Loan. The Company may
elect to repay the outstanding principal of the Term Loan together
with all accrued and unpaid interest thereon prior to the maturity,
subject to an early repayment penalty of the maximum of (i) 3
months interest on the outstanding principal; or (ii) 50% of the
interest payable on the outstanding principal until maturity. The
Term Loan shall be immediately due and payable at the option of the
Lenders if there is a change in key personnel meaning the
Company’s current Chief Executive Officer and Chief Financial
Officer. On January 18, 2016 and in connection to the Term Loan,
the Company issued warrants for the purchase of 250,000 Common
Shares of the Company exercisable until December 31, 2017 with an
exercise price of $0.20 per Common Share. In addition, the Company
also extended the expiration date of the 250,000 warrants (note 14
(h))issued on August 1, 2014 in connection with the Credit Facility
until December 31, 2017, with all other terms of the warrants
remaining the same.





The
Company’s Chief Executive Officer and Chief Financial Officer
are both participants of the consortium of participants of the Term
Loan, each having committed to provide ten percent of the principal
amount of the Term Loan. Neither the Chief Executive Officer nor
the Chief Financial Officer will participate in the warrants issued
or warrants extended in connection with the Term Loan and both
parties have been appropriately abstained from voting on the Board
of Directors to approve the Term Loan, where
applicable.





On July
15, 2016, the Company and the Lenders of the Term Loan entered into
a Term Loan Amendment (the “Term Loan Amendment”) in
which the Lenders agreed to extend to the Company an additional CAD
$600,000 in principal to increase the Term Loan facility up to the
aggregate principal amount of CAD $1,600,000. The parties also
extended the maturity date of the Term Loan to July 2, 2018 with
all other terms of the Term Loan remaining the same. The
Company’s Chief Executive Officer and its Chief Financial
Officer are both beneficial investors in the consortium and have
each committed to provide CAD $150,000 of the principal amount of
the initial principal of the Term Loan and the additional principal
of the Term Loan pursuant to the Term Loan Amendment. Neither the
Chief Executive Officer nor the Chief Financial Officer shall
participate in the warrants issued or warrants extended in
connection with the Term Loan Amendment.





17





On July
15, 2016 and in connection to the Term Loan Amendment, the Company
issued 300,000 warrants (note 14 (p)) for the purchase of Common
Stock at an exercise price of $0.20 per share, such warrants
expiring on December 31, 2018. The Company also extended the
expiration dates of i) the 250,000 warrants (note 14 (i)) issued on
January 18, 2016 in connection to the Term Loan and ii) the 250,000
warrants (note 14 (h)) issued on August 1, 2014 and extended on
January 18, 2016 in connection to the Term Loan both until December
31, 2018, with all other terms of the warrants remaining the
same.


During
the nine month period ended September 30, 2016, the Company was
advanced $1,219,840 (CAD $1,600,000) from the Term Loan including
the CAD $294,000 and CAD $3,093 rolled in from the Credit Facility
(note 10) as well as CAD $240,581 of advances from the
Company’s Chief Executive Officer and Chief Financial
Officer.





During
the three and nine month periods ended September 30, 2016, the
Company expensed $44,570 and $97,409 (September 30, 2015: nil),
respectively, in interest as a result of the Term Loan. Pursuant to
the Cash Sweep, during the nine month period ended September 30,
2016, the Company paid $127,328 to the Lender consisting of $82,724
in interest and $44,604 in principal payments and at September 30,
2016, the Company owes the lender $42,736 consisting of $15,413 in
interest and $27,323 in principal payments, which have subsequently
been paid.





12. CONVERTIBLE DEBENTURES





On
September 3, 2013, December 23, 2013 and February 11, 2014, the
Company issued $425,000, $797,000 and $178,000 of unsecured
subordinated convertible debentures (the “Convertible
Debentures”), respectively. The Convertible Debentures mature
on January 31, 2016 and bear interest at a rate of 12% per annum,
which is payable quarterly in arrears. The Convertible Debentures
are convertible into Common Shares of the Company at a fixed
conversion rate of $0.07 per share at any time prior to the
maturity date. Of the $178,000 Convertible Debentures issued on
February 11, 2014, $3,000 were issued in settlement of loans from
shareholders and $50,000 were issued in settlement of loans from
related parties.





On
December 31, 2015, the Company issued 650 unsecured subordinated
convertible debenture units (the “Convertible Debenture
Units”) for proceeds of $650,000. Each Convertible Debenture
Unit consisted of an unsecured subordinated convertible debenture
having a principal amount of $1,000 (the “Convertible
Debentures No.2”) and warrants exercisable for the purchase
of 5,000 Common Shares of the Company (note 14). The Convertible
Debentures No.2 mature on January 31, 2018 and bear interest at a
rate of 8% per annum, which is payable quarterly in arrears. The
Convertible Debentures No.2 are convertible into Common Shares of
the Company at a fixed conversion rate of $0.10 per share at any
time prior to the maturity date. The Company will have the option
to force conversion of the Convertible Debentures No.2 at any time
after six months from issuance and prior to the maturity date of
January 31, 2018. Of the $650,000 Convertible Debentures No.2
issued, $276,000 were issued in settlement of loans from related
parties (note 16), $10,000 were issued in settlement of related
party consulting fees (note 16), $20,000 were issued in settlement
of consulting fees owing to an unrelated party and $227,000 were
issued in settlement of loans from shareholders.





On May
20, 2016, the Company issued 375 unsecured subordinated convertible
debenture units (the “Convertible Debenture Units
No.2”) for proceeds of $375,000. Each Convertible Debenture
Unit No.2 consisted of an unsecured subordinated convertible
debenture having a principal amount of $1,000 (the
“Convertible Debentures No.3”) and warrants exercisable
for the purchase of 10,000 Common Shares of the Company (note
14(n)). The Convertible Debentures No.3 mature on January 31, 2018
and bear interest at a rate of 8% per annum, which is payable
quarterly in arrears. The Convertible Debentures No.3 are
convertible into Common Shares of the Company at a fixed conversion
rate of $0.10 per share at any time prior to the maturity date. The
Company will have the option to force conversion of the Convertible
Debentures No.3 at any time after six months from issuance and
prior to the maturity date of January 31, 2018. For Canadian
purchasers, the Company may only force conversion of the
Convertible Debentures No.3 at such time that the Company is a
reporting issuer within the jurisdiction of Canada. Of the $375,000
Convertible Debentures No.3 issued, $55,000 were issued in
settlement of amounts owing to related parties (note 16), and
$10,000 were issued in settlement of amounts owing to an employee.
The Company incurred costs of $22,725 as a result of the
Convertible Debentures No.3.





The
Company evaluated the terms and conditions of the Convertible
Debentures, Convertible Debentures No.2 and Convertible Debentures
No. 3 under the guidance of ASC 815, Derivatives and Hedging. The conversion
feature met the definition of conventional convertible for purposes
of applying the conventional convertible exemption. The definition
of conventional contemplates a limitation on the number of shares
issuable under the arrangement. The instrument was convertible into
a fixed number of shares and there were no down round protection
features contained in the contracts.





18





Since a
portion of the Convertible Debentures, Convertible Debentures No.2
and Convertible Debentures No. 3 were issued as an exchange of
nonconvertible instruments at the nonconvertible instruments
maturity date, the guidance of ASC 470-20-30-19 & 20 was
applied. The fair value of the newly issued Convertible Debentures
was equal to the redemption amounts owed at the maturity date of
the original instruments. Therefore there was no gain or loss on
extinguishment of debt recorded. After the exchange occurred, the
Company was required to consider whether the new hybrid contracts
embodied a beneficial conversion feature
(“BCF”).





For the
face value $425,000 Convertible Debentures that were issued on
September 3, 2013, the calculation of the effective conversion
amount did not result in a BCF because the effective conversion
price was greater than the Company’s stock price on the date
of issuance, therefore no BCF was recorded. However, for the face
value $797,000 Convertible Debentures that were issued on December
23, 2013 and the face value $178,000 Convertible Debentures that
were issued on February 11, 2014, the calculation of the effective
conversion amount did result in a BCF because the effective
conversion price was less than the Company’s stock price on
the date of issuance and a BCF in the amounts of $797,000 and
$178,000, respectively, were recorded in additional paid-in
capital. The BCF results in a debt discount which is accreted over
the life of the loan using the effective interest rate. For the
three and nine month period ended September 30, 2016, the Company
recorded interest expense in the amount of $17,342 (September 30,
2015: $109,558 and $197,167) related to debt discount.





For the
face value $650,000 Convertible Debenture Units, the relative fair
value of the warrants included in the Convertible Debenture Units
of $287,757 was calculated using the Black-Scholes option pricing
model. The resulting fair value of the Convertible Debentures No.2
was calculated to be $362,243. The calculation of the effective
conversion resulted in a BCF because the effective conversion price
was less than the Company’s stock price on the date of
issuance and a BCF in the amount of $133,657 was recorded in
additional paid-in capital. The BCF and the fair value of the
warrants, which represents debt discount, is accreted over the life
of the loan using the effective interest rate. For the three and
nine months ended September 30, 2016, the Company recorded interest
expense in the amount of $14,483 and $27,613 (September 30, 2015:
nil) related to debt discount.





For the
face value $375,000 Debenture Units No.2, the relative fair value
of the warrants included in the Convertible Debenture Units No.2 of
$234,737 was calculated using the Black-Scholes option pricing
model. The resulting fair value of the Convertible Debentures No.3
was calculated to be $140,263. The calculation of the effective
conversion resulted in a BCF because the effective conversion price
was less than the Company’s stock price on the date of
issuance and a BCF in the amount of $117,538, which is net of
transaction costs, was recorded in additional paid-in capital. The
BCF and the fair value of the warrants, which represents debt
discount, is accreted over the life of the loan using the effective
interest rate. For the three and nine months ended September 30,
2016, the Company recorded interest expense in the amount of $5,411
and $11,225 (September 30, 2015: nil) related to debt
discount.





Since
issuance of the Convertible Debenture Units and Convertible
Debenture Units No.2, the Company has accreted $34,113 and $11,225,
respectively, related to discount for a total amount of $45,338
which has been recorded as a long term liability on the balance
sheet.





The
Company received forms of election whereby holders of the
Convertible Debentures elected to convert into Common Shares of the
Company at $0.07 per share pursuant to the terms of the Convertible
Debentures. As at September 30, 2016, the Company received the
following forms of elections from holders of the Convertible
Debentures:





Date
Form of Election
Received
Convertible
Debentures Converted
Number
of
Common
Shares IssuedApril 15,
2014
$50,000
714,286September 30,
2014
800,000
11,428,572November 10,
2014
275,000
3,928,571March 9,
2015
52,000
742,857July 15,
2015
105,000
1,500,000September 1,
2015
20,000
285,714$1,302,000
18,600,000





On
January 25, 2016, the Company received a form of election to
convert $23,000 of Convertible Debentures, such Common Shares
remain unissued. On March 10, 2016, the Company settled $25,000 in
principal of the outstanding Convertible Debentures with a cash
payment. On September 30, 2016, the Company was in default on the
remaining $50,000 of the Convertible Debentures that matured as of
January 31, 2016. On July 6, 2016, the Company settled the
remaining $50,000 in principal of the Convertible Debentures and
agreed to pay to the holders such principal in monthly payments
ending on November 1, 2016.





19





During
the nine month period ended September 30, 2016, the Company
received $50,000 from unrelated parties for the purchase of
Convertible Debenture Units No.2. The debentures are recorded as
debentures to be issued under long term liabilities on the balance
sheet.





During
the three and nine month periods ended September 30, 2016, the
Company recorded interest expense in the amount of $21,714 and
$53,494 (September 30, 2015: $4,448 and $18,881) on the Convertible
Debentures.





On
March 9, 2015, the Company settled interest payable on the
Convertible Debentures in the amount of $1,096 with the issuance of
Common Shares at $0.15 per share, of which, $358 of interest
payable on the Convertible Debentures was settled with a Director
of the Company (note 17).





13. COMMON STOCK





During
the nine month period ended September 30, 2016, the
Company:





●
 Issued
480,000 Common Shares at $0.10 per share for settlement of $48,000
in deferred fees owing to a related party (note 16). The amount
allocated to Shareholders’ Deficiency, based on the fair
value, amounted to $76,800. The balance of $28,000 has been
recorded as a loss on settlement of debt;


●
 Issued
562,715 Common Shares at an average price of $0.141 per share for
settlement of $79,154 in consulting fees. The amount allocated to
Shareholders’ Deficiency, based on the fair value, amounted
to $78,780. The balance of $374 has been recorded as a gain on
settlement of debt; and


●
 Issued
150,000 Common Shares at $0.14 per share for $21,000 in related
party employment income (note 16).





During
the nine month period ended September 30, 2015, the
Company:





●
 Issued
201,945 Common Shares at $0.10 per share for settlement of $20,195
in interest payable on a Convertible Debenture to an unrelated
party;


●
 Issued
60,000 Common Shares at $0.19 per share for settlement of $11,400
in consulting fees to an unrelated party;


●
 Issued
500,000 Common Shares valued at $8,025 for the acquisition of a
subsidiary;


●
 Issued
2,299,999 Common Shares at $0.07 per share as a result of the
conversion of $161,000 of Convertible Debentures;


●
 Issued
4,918 Common Shares at $0.15 per share for settlement of $738 in
interest payable on Convertible Debentures to unrelated
parties;


●
 Issued
2,385 Common Shares at $0.15 per share for settlement of $358 in
interest payable to a Director of the Company;


●
 Issued
228,572 Common Shares at $0.07 per share to a Director of the
Company as a result of the conversion of $16,000 of Convertible
Debentures;


●
 Issued
300,000 Common Shares at $0.11 per share as compensation for
$33,000 in consulting fees to an unrelated party; and


●
 Issued
408,597 Common Shares valued at a fair value of $0.11 per share for
settlement of $61,290 in marketing costs owing to an unrelated
party. The amount allocated to Shareholders’ Deficiency,
based on the fair value, amounted to $44,946. The balance of
$16,344 has been recorded as a gain on settlement of
debt.





20





14. WARRANTS





The
following schedule summarizes the outstanding
warrants:





September
30, 2016
December 31,
2015Warrants
Outstanding
Weighted
Average Exercise Price
Weighted
Average Life Remaining (yrs)
Warrants
Outstanding
Weighted Average
Exercise Price
Weighted Average Life
Remaining (yrs)Beginning of
year
8,177,373
$0.25
1.39
1,510,640
$0.25
1.87Issued
8,935,000
0.22
2.04
6,677,373
0.25
1.73Cancelled
(187,500)
0.25
-
-
-
-Expired
(951,945)
0.17
-
(10,640)
0.15
-End of
year
15,972,928
$0.24
1.25
8,177,373
$0.25
1.39





(a) On
January 30, 2015, and in connection to a supply and distribution
agreement, the Company issued 250,000 warrants to purchase Common
Shares of the Company exercisable over 2 years with an exercise
price of $0.30 per Common Share.


The
fair value of these issued warrants of $38,719 was determined using
the Black Scholes option-pricing model with the following weighted
average assumptions:





Stock
price
$0.16Risk-free interest
rate
0.71%Expected
life
2
yearsEstimated
volatility in the market price of the Common Shares
320%Dividend
yield
Nil





The
Company fully expensed the value of the warrants in stock based
compensation which has been recorded as an administrative
expense.





(b) On
May 29, 2015, and in connection to a commission agreement, the
Company issued 1,000,000 warrants to purchase Common Shares of the
Company exercisable over 2 years. The warrants vest in 4 tranches
of 250,000 warrants each. Tranche 1 has an exercise price of $0.40
and vested upon execution of the agreement. Tranche 2 has an
exercise price of $0.50 and will vest upon the sales agent
delivering $500,001 in sales revenue to Gilla Worldwide. Tranche 3
has an exercise price of $0.60 and will vest upon the sales agent
delivering $1,000,001 in sales revenue to Gilla Worldwide. Tranche
4 has an exercise price of $0.70 and will vest upon the sales agent
delivering $1,500,001 in sales revenue Gilla
Worldwide.





The
fair value of these issued warrants of $140,185 was determined
using the Black Scholes option-pricing model with the following
weighted average assumptions:





Stock
price
$0.15Risk-free interest
rate
0.85%Expected
life
2
yearsEstimated
volatility in the market price of the Common Shares
298%Dividend
yield
Nil





The
Company booked the value of the vested warrants in the amount of
$35,362 as prepaid to be expensed over the 2 year life of the
commission agreement. During the nine month period ended September
30, 2016, the Company expensed $13,261 in stock based compensation
which has been recorded as an administrative expense. No portion of
the value of the unvested warrants has been expensed as the sales
agent had not yet delivered any sales revenue to Gilla
Worldwide.





(c) On
June 29, 2015, and in connection to the Secured Note No.3, the
Company issued 500,000 warrants to purchase Common Shares of the
Company exercisable over one year with an exercise price of $0.15
per Common Share. The fair value of these issued warrants of
$40,643 was determined using the Black Scholes option-pricing model
with the following weighted average assumptions:





Stock
price
$0.14Risk-free interest
rate
0.51%Expected
life
1
yearEstimated
volatility in the market price of the Common Shares
166%Dividend
yield
Nil





The
Company booked the value of the warrants as prepaid to be expensed
over six months which is the life of the Secured Note No.3. No
amounts were expensed related to this prepaid during the nine month
periods ended September 30, 2016. During the nine month period
ended September 30, 2015, the Company recorded $20,321 in interest
expense related to these warrants.


21





(d) On
July 14, 2015, as part of the consideration for the acquisition of
VaporLiq, the Company issued 500,000 warrants to purchase Common
shares of the Company exercisable over 18 months with an exercise
price of $0.20 per Common Share.





The
fair value of these issued warrants of $41,975 was determined using
the Black Scholes option-pricing model with the following weighted
average assumptions:





Stock
price
$0.17Risk-free interest
rate
0.51%Expected
life
1.5
yearsEstimated
volatility in the market price of the Common Shares
219%Dividend
yield
Nil





(e) On
July 15, 2015, and in connection with a private placement, the
Company issued 201,945 warrants to purchase Common Shares of the
Company exercisable over twelve (12) months with an exercise price
of $0.20 per Common Share.





The
fair value of these issued warrants of $11,047 was determined using
the Black Scholes option-pricing model with the following weighted
average assumptions:





Stock price
$0.11Risk-free interest
rate
0.52%Expected
life
1
yearEstimated
volatility in the market price of the Common Shares
174%Dividend
yield
Nil





No
stock based compensation expense was recorded since the warrants
were issued as part of a private placement of common
stock.





(f) On
December 30, 2015, and in connection to the Secured Note and
Secured Note No.2 (together, the “Secured Notes”), the
Company issued 250,000 warrants to purchase Common Shares of the
Company exercisable over 18 months with an exercise price of $0.20
per Common Share.





The
fair value of these issued warrants of $26,822 was determined using
the Black Scholes option-pricing model with the following weighted
average assumptions:





Stock
price
$0.15Risk-free interest
rate
0.88%Expected
life
1.5
yearsEstimated
volatility in the market price of the Common Shares
190%Dividend
yield
Nil





The
Company booked the value of the warrants as prepaid to be expensed
over the life of the Secured Notes. During the nine month period
ended September 30, 2016, the Company expensed $13,387 in financing
fees which has been recorded as interest expense.





(g) On
December 31, 2015, and in connection to the Debenture Units, the
Company issued 3,250,000 warrants to purchase Common Shares of the
Company exercisable over 24 months with an exercise price of $0.20
per Common Share.





The
fair value of these issued warrants of $516,343 was determined
using the Black Scholes option-pricing model with the following
weighted average assumptions:





Stock
price
$0.17Risk-free interest
rate
1.19%Expected
life
2
yearsEstimated
volatility in the market price of the Common Shares
265%Dividend
yield
Nil





22





The
value of the warrants along with the BCF represents debt discount
on the Convertible Debentures No.2 and is accreted over the life of
the loan using the effective interest rate. For the nine month
period ended September 30, 2016, the Company recorded interest
expense in the amount of $27,613 related to debt discount which
includes accretion of the BCF (note 12).





(h) On
January 18, 2016, and in connection to the Term Loan (note 11), the
Company extended the expiration date of the warrants issued on
August 1, 2014, for the purchase of 250,000 Common Shares of the
Company to be exercisable until December 31, 2017 with an exercise
price of $0.30 per Common Share. On July 15, 2016, the Company
further amended the Term Loan and extending the expiration date of
these warrants to December 31, 2018, with all other terms of the
warrants remaining the same.





The
fair value of the extensions of these warrants of $42,325 was
determined using the Black Scholes option-pricing model with the
following weighted average assumptions:





Stock
price
$0.18Risk-free interest
rate
0.91%Expected
life
2.46
yearsEstimated
volatility in the market price of the Common Shares
263%Dividend
yield
Nil





The
Company booked the value of the warrants in the amount of $42,325
as prepaid financing fee to be expensed over the life of the Term
Loan. During the nine month period ended September 30, 2016, the
Company expensed $13,724 of the financing fee which has been
recorded as interest expense.





(i) On
January 18, 2016 and in connection to the Term Loan (note 11), the
Company issued warrants for the purchase of 250,000 Common Shares
of the Company exercisable until December 31, 2017 with an exercise
price of $0.20 per Common Share. On July 15, 2016 and in connection
to the Term Loan the Company extended the expiration date of these
warrants to December 31, 2018, with all other terms of the warrants
remaining the same.





The
fair value of these issued warrants and the extension of $51,598
was determined using the Black Scholes option-pricing model with
the following weighted average assumptions:





Stock
price
$0.18Risk-free interest
rate
0.91%Expected
life
2.46
yearsEstimated
volatility in the market price of the Common Shares
263%Dividend
yield
Nil





The
Company booked the value of the warrants in the amount of $51,598
as prepaid financing fee to be expensed over the life of the Term
Loan. During the nine month period ended September 30, 2016, the
Company expensed $18,077 of the financing fee which has been
recorded as interest expense.





(j) On
February 18, 2016 in relation to a consulting agreement, the
Company issued warrants for the purchase of 300,000 Common Shares
of the Company exercisable until February 17, 2018 with an exercise
price of $0.25 per Common Share. The warrants shall vest quarterly
in eight equal tranches, with the first tranche vesting immediately
and the final tranche vesting on November 18, 2017. If the
consulting agreement is terminated prior to the expiration of the
warrants, any unexercised fully vested warrants shall expire thirty
calendar days following the effective termination date and any
unvested warrants shall be automatically canceled.





The
fair value of these issued warrants of $30,501 was determined using
the Black Scholes option-pricing model with the following weighted
average assumptions:





Stock
price
$0.11Risk-free interest
rate
0.80%Expected
life
2
yearsEstimated
volatility in the market price of the Common Shares
275%Dividend
yield
Nil





23





During
the nine month period ended September 30, 2016, the Company
expensed $16,511 as stock based compensation in relation to the
above warrants which has been recorded as an administrative
expense. On August 31, 2016, the Company terminated the above
consulting agreement. As a result of the termination, the 187,500
unvested warrants have been cancelled.





(k) On
February 18, 2016, in relation to a consulting agreement, the
Company issued warrants for the purchase of 1,500,000 Common Shares
of the Company exercisable until February 17, 2018 with an exercise
price of $0.25 per Common Share. The warrants shall vest quarterly
in eight equal tranches, with the first tranche vesting immediately
and the final tranche vesting on November 18, 2017. If the
consulting agreement is terminated prior to the expiration of the
warrants, any unexercised fully vested warrants shall expire thirty
calendar days following the effective termination date and any
unvested warrants shall be automatically canceled.





The
fair value of these issued warrants of $152,503 was determined
using the Black Scholes option-pricing model with the following
weighted average assumptions:





Stock
price
$0.11Risk-free interest
rate
0.80%Expected
life
2
yearsEstimated
volatility in the market price of the Common Shares
275%Dividend
yield
Nil





During
the nine month period ended September 30, 2016, the Company
expensed $108,656, as stock based compensation in relation to the
above warrants which has been recorded as an administrative
expense.





(l) On
March 2, 2016 and in connection to the Shareholder Loan (note 9),
the Company issued warrants for the purchase of 1,000,000 Common
Shares of the Company exercisable over 24 months with an exercise
price of $0.20 per Common Share, with 500,000 of such purchase
warrants vesting upon the close of Loan Tranche A and the remaining
500,000 purchase warrants vesting upon the close of Loan Tranche B.
On March 3, 2016 and April 14, 2016, the Company closed Loan
Tranche A and Loan Tranche B, respectively, at which dates the
purchase warrants became fully vested and exercisable.





The
fair value of these issued warrants of $158,995 was determined
using the Black Scholes option-pricing model with the following
weighted average assumptions:





Stock
price
$0.17Risk-free interest
rate
0.91%Expected
life
2
yearsEstimated
volatility in the market price of the Common Shares
271%Dividend
yield
Nil





The
Company booked the value of the vested warrants in the amount of
$158,995 as a prepaid to be expensed over the life of the
Shareholder Loan. During the nine month period ended September 30,
2016, the Company expensed $42,619 which has been recorded as
interest expense.





(m) On
April 13, 2016, the Company entered into a consulting agreement and
issued warrants for the purchase of 1,750,000 Common Shares of the
Company exercisable until April 12, 2018 with an exercise price of
$0.25 per Common Share. Forty percent of the warrants vested
immediately with the remaining sixty percent vesting in equal
tranches of fifteen percent on September 30, 2016, December 31
2016, June 30, 2017 and December 31, 2017. If the consulting
agreement is terminated prior to the expiration of the warrants,
any unexercised fully vested warrants shall expire ninety calendar
days following the effective termination date and any unvested
warrants shall be automatically cancelled.





The
fair value of these issued warrants of $241,754 was determined
using the Black Scholes option-pricing model with the following
weighted average assumptions:





Stock
price
$0.15Risk-free interest
rate
0.88%Expected
life
2
yearsEstimated
volatility in the market price of the Common Shares
264%Dividend
yield
Nil





24





During
the nine month period ended September 30, 2016, the Company
expensed $180,242 as stock based compensation in relation to the
above warrants which has been recorded as an administrative
expense.





(n) On
May 20, 2016, and in connection to the Convertible Debenture Units
No.2, the Company issued 3,750,000 warrants to purchase Common
Shares of the Company exercisable over 24 months with an exercise
price of $0.20 per Common Share.





The
relative fair value of these issued warrants of $234,737 was
determined using the Black Scholes option-pricing model with the
following weighted average assumptions:





Stock
price
$0.18Risk-free interest
rate
1.03%Expected
life
2
yearsEstimated
volatility in the market price of the Common Shares
259%Dividend
yield
Nil





The
value of the warrants along with the BCF represents debt discount
on the Convertible Debentures No.3 and is accreted over the life of
the loan using the effective interest rate. For the nine month
period ended September 30, 2016, the Company recorded interest
expense in the amount of $11,225 related to debt discount which
includes accretion of the BCF (note 12).





(o) On
May 20, 2016, and as commission payment related to the issuance of
the Convertible Debenture Units No.2, the Company issued 85,000
warrants to purchase Common Shares of the Company exercisable over
24 months with an exercise price of $0.20 per Common
Share.





The
fair value of these issued warrants of $14,225 was determined using
the Black Scholes option-pricing model with the following weighted
average assumptions:





Stock
price
$0.18Risk-free interest
rate
1.03%Expected
life
2
yearsEstimated
volatility in the market price of the Common Shares
259%Dividend
yield
Nil





The
value of the warrants were recorded as a reduction to the proceeds
received for the Convertible Debentures No.3 (note
12).





(p) On
July 15, 2016, and in connection to the Term Loan (note 11), the
Company issued warrants for the purchase of 300,000 Common Shares
of the Company exercisable until December 31, 2018 with an exercise
price of $0.20 per Common Share.





The
fair value of these issued warrants of $45,799 was determined using
the Black Scholes option-pricing model with the following weighted
average assumptions:





Stock
price
$0.16Risk-free interest
rate
0.91%Expected
life
2.46
yearsEstimated
volatility in the market price of the Common Shares
263%Dividend
yield
Nil





The
Company booked the value of the warrants in the amount of $45,799
as prepaid financing fee to be expensed over the life of the Term
Loan. During the nine month period ended September 30, 2016, the
Company expensed $4,855 of the financing fee which has been
recorded as interest expense.





15. SHARES TO BE ISSUED





As at
September 30, 2016, the Company had $93,727 in shares to be issued
consisting of the following:





●
 328,571 Common
Shares, valued at $0.07 per share, to be issued on conversion of
$23,000 of Convertible Debentures;


●
 423,077 Common
Shares, valued at an average of $0.142 per share, to be issued on
the settlement of $60,000 in consulting fees owing to a
shareholder; and


●
 71,881 Common
Shares, valued at an average of $0.149 per share, to be issued on
the settlement of $10,727 in consulting fees owing to unrelated
parties.





25





The
above Common Shares have not yet been issued.





As at
December 31, 2015, the Company had $20,000 in shares to be issued
consisting of the following:





●
 151,745 Common
Shares, valued at $0.132 per share, to be issued on settlement of
consulting fees owing to unrelated parties.





16. RELATED PARTY TRANSACTIONS





Transactions
with related parties are incurred in the normal course of business
and are measured at the exchange amount, which is the amount of
consideration established and agreed to between the related
parties.





(a)
 The
Company’s current and former officers and shareholders have
advanced funds on an unsecured, non-interest bearing basis to the
Company, unless stated otherwise below, for travel related and
working capital purposes. The Company has not entered into any
agreement on the repayment terms for these advances.





Advances
from related parties were as follows:


September
30,
2016
December
31,
2015Advances by and
amounts payable to Officers of the Company, two of which are also
Directors
$617,901
$242,758Advances by and
consulting fees payable to a corporation owned by two Officers of
the Company, one of which is also a Director
309,598
196,581Consulting fees
owing to persons related to Officers who are also Directors of the
Company
45,853
37,028Advances by
Officers of the Company, one of which is also a Director, bears
interest at 1.5% per month
524,737
355,802Amounts payable to
a corporation formerly related by virtue of a common Officer of the
Company
8,376
30,294Amounts payable to
a corporation related by virtue of common Officers and a common
Director of the Company
85,752
50,976Consulting fees and
director fees payable to Directors of the Company
132,728
83,500$1,724,945
$996,939





At
September 30, 2016, the Company had deferred amounts of $631,470
(December 31, 2015: $662,140) owing to related parties. The
deferred amounts consist of $250,271 (December 31, 2015: $300,890)
owing to Officers of the Company, two of which are also Directors
and amounts of $381,199 (CAD $500,000) (December 31, 2015:
$361,250; CAD $500,000) owing to a corporation owned by two
Officers of the Company, one of which is also a Director. The
amounts are non-interest bearing and payable on April 1, 2017.
During the nine month period ended September 30, 2016, the Company
settled $48,000 of the deferred amounts owing to an Officer and
Director of the Company with 480,000 Common Shares of the Company
(note 13).





26





(b)
 Interest accrued
to related parties were as follows:


September
30,
2016
December
31,
2015Interest accrued on
advances by Officers of the Company, one of which is also a
Director
$198,165
$129,729Advances by and
consulting fees payable to a corporation owned by two Officers of
the Company, one of which is also a Director
20,304
2,026$218,469
$131,755





(c) Transactions with
related parties were as follows:





During
the nine month period ended September 30, 2016, the Company
expensed $72,659 (September 30, 2015: $32,317) in rent expense
payable to a corporation related by virtue of a common Officer and
a common Director of the Company.





During
the nine month period ended September 30, 2016, the Company
expensed $21,252 (September 30, 2015: $22,631) in costs related to
a vehicle for the benefit of two Officers who are also Directors of
the Company and for the benefit of a person related to an Officer
and Director of the Company. The Company also expensed $178,749
(September 30, 2015: $78,434) in travel and entertainment expenses
incurred by Officers and Directors of the Company.





On
February 2, 2016, the Company settled $48,000 in consulting fees
payable to a related party and agreed to issue 480,000 Common
Shares at a price of $0.10 per Common Share. These Common Shares
were issued on May 19, 2016 (note 13).





On May
20, 2016, the Company issued $55,000 of Convertible Debentures No.3
to related parties consisting of $10,000 to a person related to an
Officer and Director for settled of fees payable, $10,000 to a
Director of the Company for settlement of Director fees payable and
$35,000 to a corporation owned by two Officers of the Company, one
of which is also a Director, for settlement of loans
payable.





On May
20, 2016, the Company issued $15,000 of Convertible Debentures No.2
to two Directors of the Company for cash.





On June
17, 2016, the Company issued 150,000 Common Shares at a price of
$0.14 per Common Share to a person related to an Officer and
Director of the Company on the signing of a new employment
agreement.





During
the nine month period ended September 30, 2015, the Company settled
$358 of interest payable on Convertible Debentures with a Director
of the Company at $0.15 per share, and the Common Shares were
issued on April 13, 2015.





During
the nine month period ended September 30, 2015, the Company issued
228,572 Common Shares at $0.07 per share to a Director of the
Company as a result of the conversion of $16,000 of Convertible
Debentures, and the shares were issued on April 13,
2015.





The
Company expensed consulting fees payable to related parties as
follows:


September
30,
2016
September
30,
2015Directors
$-
$74,250Officers
248,040
191,498Corporation
formerly related by virtue of common Officers and a common
Director
-
63,540Corporation owned
by two Officers, one of which is also a Director
-
94,138Persons related to
a Director
105,650
47,067$353,690
$470,493





The
Company’s Chief Executive Officer and Chief Financial Officer
are both participants of the consortium of participants of the
Credit Facility, each having committed to provide ten percent of
the principal amount of the Credit Facility and Term Loan (notes 10
and 11).





27





17. COMMITMENTS AND CONTINGENCIES





a)
Premises Lease





Effective
January 1, 2015, a subsidiary of the Company entered into an
operating lease agreement for a rental premises in Daytona Beach,
Florida, USA. The terms of this agreement are to be for a period of
36 months and ending on December 31, 2017 with payments made
monthly. Minimum annual lease payments are as follows:





2016
$14,0282017
56,110$70,138





b)
Litigation





The
Company is subject to certain legal proceedings and claims, which
arise in the ordinary course of its business. Although occasional
adverse decisions or settlements may occur, the Company believes
that the final disposition of such matters should not have a
material adverse effect on its financial position, results of
operations or liquidity.





On
January 6, 2016, Yaron Elkayam, Pinchas Mamane and Levent Dimen
filed a three count complaint against the Company in the Circuit
Court of Hillsborough County, Florida alleging (i) breach of
contract, (ii) breach of implied covenant of good faith and fair
dealing, and (iii) fraud in the inducement seeking damages in the
amount of approximately $900,000 of Promissory Notes issued on July
1, 2015 as a result of the acquisition of E Vapor Labs. On February
23, 2016, the Company filed a motion to dismiss the complaint on
the basis of failure to allege sufficient jurisdictional facts and
failure to satisfy constitutional due process requirements to
exercise jurisdiction.





c)
Employment Agreements





Pursuant
to certain employment agreements with the Company’s
management, the Company has agreed to pay termination amounts in
the first year of up to twelve months of annual entitlements under
such agreements, less any amounts paid during the first year,
ending on December 1, 2016.





d)
Charitable Sales Promotion





On
January 21, 2016, the Company entered into an agreement with
Wounded Warriors Family Support Inc. in which the Company agreed to
make a donation of $1.00 for each sale of its “Vape
Warriors” E-liquid product during the period from January 1,
2016 to December 31, 2016, with a minimum donation of $50,000.
During the nine month period ended September 30, 2016 the Company
has accrued $37,500 in charitable contributions regarding this
agreement.





e)
Royalty Agreement





On June
14, 2016, the Company entered into a royalty agreement related to
an E-liquid recipe purchased from an unrelated party in which the
Company agreed to pay to the recipe developer, a royalty of $0.25
per 60ml of E-liquid sold that contains the recipe, up to a maximum
of $100,000. Although the Company has the ability to sell the
E-liquid globally, the royalty is paid only on the E-liquid sold
within the United States. During the nine month period ended
September 30, 2016, the Company has paid $7,646 and owes $843
related to the royalty agreement.





18. FINANCIAL INSTRUMENTS





(i)
Credit Risk





Credit
risk is the risk of financial loss to the Company if a customer or
counterparty to a financial instrument fails to meet its
contractual obligations. The Company’s credit risk is
primarily attributable to fluctuations in the realizable values of
its cash and trade receivable. Cash accounts are maintained with
major international financial institutions of reputable credit and
therefore bear minimal credit risk. In the normal course of
business, the Company is exposed to credit risk from its customers
and the related accounts receivable are subject to normal
commercial credit risks. A substantial portion of the
Company’s accounts receivable are concentrated with a limited
number of large customers all of which the Company believes are
subject to normal industry credit risks. At September 30, 2016, the
Company booked an allowance of bad debt of $20,615 (December 31,
2015: $20,370) in regards customers with past due
amounts.For
the nine month period ended September 30, 2016, 73% (December 31,
2015: 38%) of the Company’s trade receivables are due from
one customer and 81% of the trade receivables are due from two
customers. During the nine month period ended September 30, 2016,
27% of the Company’s sales were to one customer and 54% of
the Company’s sales were from three customers.





(ii)
Liquidity Risk





Liquidity
risk is the risk that the Company will not be able to meet its
financial obligations as they fall due. The Company’s
approach to managing liquidity risk is to ensure, as far as
possible, that it will have sufficient liquidity to meet its
liabilities when due, under both normal and stressed conditions,
without incurring unacceptable losses or risking damage to the
Company’s reputation. The Company manages liquidity risk by
closely monitoring changing conditions in its investees,
participating in the day to day management and by forecasting cash
flows from operations and anticipated investing and financing
activities. At September 30, 2016, the Company had liabilities due
to unrelated parties through its financial obligations over the
next five years in the aggregate principal amount of $5,875,194
(December 31, 2015: $1,987,967). Of such amount, the Company has
obligations to repay $4,698,032 over the next twelve months with
the remaining $1,177,162 becoming due within the following four
year period.


28





(iii) Foreign
Currency Risk





Currency
risk is the risk that the fair value or future cash flows of a
financial instrument will fluctuate because of changes in foreign
exchange rates. The risks and
fluctuations are related to cash and accounts payable and accrued
liabilities that are denominated in CAD and
HUF.





Analysis by currency in Canadian and Hungarian equivalents is as
follows:





September 30, 2016
Accounts Payable
Accounts Receivable
CashCAD
$174,165
$-
$3,029HUF
$311,552
$11,477
$100,551





The
effect of a 10% strengthening of the United States dollar against
the Canadian dollar and Hungarian Forint at the reporting date on
the CAD and HUF-denominated trade receivables and payables carried
at that date would, had all other variables held constant, have
resulted in an increase in profit for the year and increase of net
assets of $17,114 and $19,952, respectively. A 10% weakening in the
exchange rate would, on the same basis, have decreased profit and
decreased net assets by $17,114 and $19,952, respectively. During
the nine month period ended September 30, 2016, amounts denominated
in Euros were minimal and did not subject the Company to
significant currency risk.





The
Company purchases inventory in a foreign currency, at September 30,
2016, the Company included $191,495 (December 31, 2015: $146) in
inventory purchased in a foreign currency on its condensed
consolidated interim balance sheet. The Company does not use
derivative financial instruments to reduce its exposure to this
risk.





(iv)
Interest Rate Risk





Interest
rate risk is the risk that the fair value or future cash flows of a
financial instrument will fluctuate because of changes in market
interest rates. The Company is exposed to interest rate risk on its
fixed interest rate financial instruments. These fixed-rate
instruments subject the Company to a fair value risk. The interest
rates on all of the Company’s existing interest bearing debt
are fixed. Sensitivity to a plus or minus 25 basis points change in
rates would not significantly affect the fair value of this
debt.





19. SEGMENTED
INFORMATION





The
Company currently operates in only one business segment, namely,
manufacturing, marketing and distributing of E-liquid, vaporizers,
E-cigarettes, and vaping accessories in North America and
Europe. Total long-lived assets by geographic location are as
follows:





September
30,
2016
December
31,
2015Canada
$938
$-United
States
1,276,743
1,624,669Europe
38,302
2,130$1,315,983
$1,626,799





29





Total
sales by geographic location are as follows:


September
30,
2016
September 30,
2015Canada
$-
$-United
States
2,394,711
824,251Europe
922,291
-$3,317,002
$824,251





20. SUBSEQUENT EVENTS





Gilla
Operations Europe s.r.o. (“Gilla Operations Europe”)
was incorporated on October 7, 2016 under the laws of the Slovak
Republic. Gilla Operations Europe is a wholly-owned subsidiary of
Gilla Enterprises Inc., a wholly-owned subsidiary of the
Company.





On
February 18, 2016, the Company entered into a consulting agreement
and issued warrants for the purchase of 1,500,000 Common Shares of
the Company exercisable until February 17, 2018 with an exercise
price of $0.25 per Common Share (note 14 (k)). The warrants shall
vest quarterly in eight equal tranches, with the first tranche
vesting immediately and the final tranche vesting on November 18,
2017. If the consulting agreement is terminated prior to the
expiration of the warrants, any unexercised fully vested warrants
shall expire thirty calendar days following the effective
termination date and any unvested warrants shall be automatically
canceled. On October 25, 2016, the Company terminated the
consulting agreement and the 937,500 unvested warrants were
cancelled.





30





ITEM 2.   
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTSOF OPERATION





The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the
financial statements and the related notes thereto included
elsewhere in this Quarterly Report on Form 10-Q (this
“Report”). This Report contains certain forward-looking
statements and the Company's future operating results could differ
materially from those discussed herein. Our disclosure and analysis
included in this Report concerning our operations, cash flows and
financial position include forward-looking statements. Statements
that are predictive in nature, that depend upon or refer to future
events or conditions, or that include words such as
“expect”, “anticipate”,
“intend”, “plan”, “believe”,
“estimate”, “may”, “project”,
“will likely result”, and similar expressions are
intended to identify forward-looking statements. Such
forward-looking statements include (i) the ability to raise
additional capital; and (ii) expectations regarding anticipated
growth. Such forward-looking statements are subject to certain
risks, uncertainties and assumptions, and are more fully described
under “Part I, Item 1A - Risk Factors” of our Annual
Report on Form 10-K for the year ended December 31, 2015. New risks
and uncertainties arise from time to time, and it is impossible for
us to predict these events or how they may affect us. In any event,
these and other important factors, including those set forth in
Item 1A – “Risk Factors” of our Annual Report on
Form 10-K for the year ended December 31, 2015 may cause actual
results to differ materially from those indicated by our
forward-looking statements. We assume no obligation to update or
revise any forward-looking statements we make in this Report,
except as required by applicable securities laws.





Except as otherwise stated or required by the context, references
in this document to “Gilla” the
“Registrant”, the “Company,”
“we,” and “our” refer to Gilla
Inc.





Overview





Gilla
Inc. (the “Company”, the “Registrant” or
“Gilla”) was incorporated under the laws of the state
of Nevada on March 28, 1995 under the name of Truco, Inc. The
Company later changed its name to Web Tech, Inc., and then to
Cynergy, Inc., Mercantile Factoring Credit Online Corp.,
Incitations, Inc., Osprey Gold Corp. and to its present name. The
Company adopted the present name, Gilla Inc., on February 27, 2007.
Gilla’s address is 475 Fentress Blvd., Unit L, Daytona Beach,
Florida 32114.





The
current business of the Company consists of the manufacturing,
marketing and distribution of generic and premium branded E-liquid,
which is the liquid used in vaporizers, E-cigarettes, and other
vaping hardware and accessories. E-liquid is heated by the atomizer
to deliver the sensation of smoking. Gilla’s product
portfolio includes Coil Glaze, The Drip Factory, Surf Sauce, Siren,
VaporLiq, Vapor’s Dozen, Craft Vapes, Craft Clouds, Vape
Warriors, Miss Pennysworth’s Elixirs, The Mad Alchemist,
Replicant and Crown E-liquid brands.





Recent Developments





On May
10, 2016, the U.S. Federal Food & Drug Administration
(“FDA”) finalized a new rule, captioned, the
“Deeming Tobacco Products To Be Subject to the Federal Food,
Drug, and Cosmetic Act”, which extends the FDA’s
authority to include the regulation of electronic nicotine delivery
systems (such as e-cigarettes and vape pens), all cigars, hookah
(waterpipe) tobacco, pipe tobacco and nicotine gels, among others.
Going forward, the FDA will be able to review new nicotine products
not yet on the market; regulate claims by nicotine product
manufacturers and distributers; require evaluation and reporting of
the ingredients of nicotine products and how they are made; and
require disclosures regarding risks of nicotine products. The final
rule went into effect on August 8, 2016. The Company is assessing
the impact of the new FDA rule. Prospective investors are directed
to the “Risk Factors” contained in the Company’s
Annual Report filed with the U.S. Securities and Exchange
Commission for the fiscal year ended December 31,
2015.





On July
15, 2016, the Company entered into a term loan amendment (the
“Term Loan Amendment”) with a consortium of
participants that includes two of the Company’s senior
executive officers (the “Lender”) to amend certain
terms and conditions of the term loan (the “Term
Loan”), entered into on January 18, 2016. Pursuant to the
Term Loan Amendment, the Lender agreed to extend to the Company an
additional six hundred thousand Canadian dollars (CAD $600,000) in
principal to increase the Term Loan facility up to the aggregate
principal amount of one million six hundred thousand Canadian
dollars (CAD $1,600,000). The parties also extended the maturity
date of the Term Loan to July 2, 2018 with all other terms of the
Term Loan remaining the same. On July 15, 2016 and in connection to
the Term Loan Amendment, the Company issued 300,000 warrants for
the purchase of Common Shares of the Company at an exercise price
of $0.20 per Common Share, such warrants expiring on December 31,
2018. The Company also extended the expiration dates of i) the
250,000 warrants issued on January 18, 2016 in connection to the
Term Loan and ii) the 250,000 warrants issued on August 1, 2014 and
extended on January 18, 2016 in connection to the Term Loan both
until December 31, 2018, with all other terms of the warrants
remaining the same. The Company’s Chief Executive Officer and
its Chief Financial Officer are both beneficial investors in the
consortium and have each committed to provide a total of one
hundred and fifty thousand Canadian dollars (CAD $150,000) of the
principal amount of the initial principal of the Term Loan and the
additional principal of the Term Loan pursuant to the Term Loan
Amendment. Neither the Chief Executive Officer nor the Chief
Financial Officer shall participate in the warrants issued or
warrants extended in connection with the Term Loan
Amendment.





31





On
February 18, 2016, the Company entered into a consulting agreement
and issued warrants for the purchase of 300,000 Common Shares of
the Company exercisable until February 17, 2018 with an exercise
price of $0.25 per Common Share. The warrants shall vest quarterly
in eight equal tranches, with the first tranche vesting immediately
and the final tranche vesting on November 18, 2017. If the
consulting agreement is terminated prior to the expiration of the
warrants, any unexercised fully vested warrants shall expire thirty
calendar days following the effective termination date and any
unvested warrants shall be automatically canceled. On August 31,
2016, the Company terminated the consulting agreement and the
187,500 unvested warrants were cancelled.





On
September 30, 2016, the Company agreed to issue 230,769 Common
Shares at a price of $0.130 per Common Share, as a settlement of
$30,000 in consulting fees owed to unrelated parties. These Common
Shares remain unissued.





On
September 30, 2016, the Company agreed to issue 54,511 Common
Shares at an average price of $0.147 per Common Share, as a
settlement of $8,017 in consulting fees owed to unrelated parties.
These Common Shares remain unissued.





Subsequent Events





Gilla
Operations Europe s.r.o. (“Gilla Operations Europe”)
was incorporated on October 7, 2016 under the laws of the Slovak
Republic. Gilla Operations Europe is a wholly-owned subsidiary of
Gilla Enterprises Inc., a wholly-owned subsidiary of the
Company.





On
February 18, 2016, the Company entered into a consulting agreement
and issued warrants for the purchase of 1,500,000 Common Shares of
the Company exercisable until February 17, 2018 with an exercise
price of $0.25 per Common Share. The warrants shall vest quarterly
in eight equal tranches, with the first tranche vesting immediately
and the final tranche vesting on November 18, 2017. If the
consulting agreement is terminated prior to the expiration of the
warrants, any unexercised fully vested warrants shall expire thirty
calendar days following the effective termination date and any
unvested warrants shall be automatically canceled. On October 25,
2016, the Company terminated the consulting agreement and the
937,500 unvested warrants were cancelled.





RESULTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER
30, 2016 AND 2015





Revenue





For the
three month period ended September 30, 2016, the Company generated
$1,048,474 in sales from E-liquids, vaporizers, E-cigarettes and
accessories (collectively, “E-liquid”) as compared to
$816,610 in sales for the three
month period ended September 30, 2015.





For the
nine month period ended September 30, 2016, the Company generated
$3,317,002 in sales from E-liquid as compared to $824,251 in sales for the nine month period
ended September 30, 2015. For the nine month period ended September
30, 2016, E-liquid sales of $2,394,711 were generated in the United
States and $922,291 were generated in Europe. For the nine month
period ended September 30, 2015, E-liquid sales of $824,251 were
generated in the United States and nil were generated in
Europe.





The
Company’s cost of goods sold for the three month period ended
September 30, 2016 was $321,729 which represents E-liquid, bottles,
hardware and the related packaging as compared to $560,329 for the three month period ended
September 30, 2015. Gross profit for the three month period ended
September 30, 2016 was $726,745 as compared to $256,281 for the
comparative period in 2015.





The
Company’s cost of goods sold for the nine month period ended
September 30, 2016 was $1,527,711 which represents E-liquid,
bottles, hardware and the related packaging as compared to
$562,854 for the nine month
period ended September 30, 2015. Gross profit for the nine month
period ended September 30, 2016 was $1,789,291 as compared to
$261,397 for the comparative period in 2015.





Operating Expenses





For the
three month period ended September 30, 2016, the Company incurred
an administrative expense of $1,331,755, consulting fees to related
parties of $134,046, depreciation expense of $16,472, amortization
expense of $19,500, impairment of fixed assets of $70,142 and an
impairment of inventory of $24,453. For the three month period
ended September 30, 2015, the Company incurred an administrative
expense of $508,785, consulting fees to related parties of
$150,045, depreciation expense of $7,652, amortization expense of
$4,999 and an impairment of inventory of $75,964. Total operating
expenses for the three month period ended September 30, 2016 were
$1,596,368 as compared to $747,445 for the three month period ended
September 30, 2015.





32





Administrative
costs were primarily comprised of rent, legal and audit fees,
marketing fees, travel expenses, consulting fees and employee
wages. The increase in administrative expenses of $822,970 is
attributable to increased operations as a result of the acquired
businesses and organic growth during the period. The decrease in
consulting fees due to related parties of $15,999 is attributable
to the effects of foreign exchange translation. The impairment of
fixed assets is attributable to a write off of $70,142 in
manufacturing equipment that was not in working order and that the
Company has not been able to sell. The impairment of inventory is
attributable to a write off of obsolete inventory that the Company
was unable to sell.





For the
nine month period ended September 30, 2016, the Company incurred an
administrative expense of $4,130,393, consulting fees to related
parties of $353,690, depreciation expense of $44,982, amortization
expense of $74,500, bad debt recovery of $1,198, impairment of
fixed assets of $70,142, impairment of inventory of $24,453,
impairment of goodwill of $208,376 and a gain on settlement of
$245,625. For the nine month period ended September 30, 2015, the
Company incurred an administrative expense of $1,114,346,
consulting fees to related parties of $472,493, depreciation
expense of $8,511, amortization expense of $14,998, impairment of
inventory of $75,964 and a gain on settlement of $16,344. Total
operating expenses for the nine month period ended September 30,
2016 were $4,659,713 as compared to $1,669,968 for the nine month
period ended September 30, 2015.





Loss from Operations





For the
three month period ended September 30, 2016, the Company incurred a
loss from operations of $869,623 as compared to a loss from
operations of $491,164 for the three month period ended September
30, 2015 due to the reasons discussed above.





For the
nine month period ended September 30, 2016, the Company incurred a
loss from operations of $2,870,422 as compared to a loss from
operations of $1,408,571 for the nine month period ended September
30, 2015 due to the reasons discussed above.





Other Expenses





For the
three month period ended September 30, 2016, the Company incurred a
foreign exchange gain of $18,893, amortization of debt discount of
$19,894 and interest expense of $172,610. For the three month
period ended September 30, 2015, the Company incurred a foreign
exchange gain of $20,895, amortization of debt discount of $109,558
and interest expense of $114,981. For the three month period ended
September 30, 2016, the Company incurred total other expenses of
$173,611 as compared to $203,644 for the three month period ended
September 30, 2015.





For the
nine month period ended September 30, 2016, the Company incurred a
foreign exchange loss of 70,199, amortization of debt discount of
$56,180 and interest expense of $444,526. For the nine month period
ended September 30, 2015, the Company incurred a foreign exchange
gain of $108,727, amortization of debt discount of $197,167,
interest expense of $263,262 and a loss on settlement of account
receivable of $23,344. For the nine month period ended September
30, 2016, the Company incurred total other expenses of $570,905 as
compared to $375,014 for the nine month period ended September 30,
2015.





Net Loss and Comprehensive Loss





Net
loss amounted to $1,043,234 for the three month period ended
September 30, 2016 compared to a loss of $694,808 for the three
month period ended September 30, 2015.





Net
loss amounted to $3,441,327 for the nine month period ended
September 30, 2016 compared to a loss of $1,783,585 for the nine
month period ended September 30, 2015.





Comprehensive
loss amounted to $1,017,672 for the three month period ended
September 30, 2016 compared to a comprehensive loss of $609,897 for
the three month period ended September 30, 2015. The change in
comprehensive loss compared to net loss was due to foreign currency
translation adjustments resulting from the Company’s
translation of financial statements from Canadian dollars, Euros
and Hungarian Forints to U.S. dollars.





Comprehensive
loss amounted to $3,539,351 for the nine month period ended
September 30, 2016 compared to a comprehensive loss of $1,615,787
for the nine month period ended September 30, 2015. The change in
comprehensive loss compared to net loss was due to foreign currency
translation adjustments resulting from the Company’s
translation of financial statements from Canadian dollars, Euros
and Hungarian Forints to U.S. dollars.





33





Liquidity and Capital Resources





As at
September 30, 2016, the Company had total assets of $2,812,621
(compared to total assets of $2,231,055 at December 31, 2015)
consisting of cash and cash equivalents of $166,740, trade
receivables of $336,990, inventory of $407,429, other current
assets of $585,479, property and equipment of $116,620, website
development of $7,583, intangibles of $302,283 and goodwill of
$889,497. The assets are primarily the result of the acquisitions
of E Vapor Labs (see “Acquisition of E Vapor Labs”),
VaporLiq and the assets of the Craft Vapes E-liquid brand (see
“Acquisition of CV Brands”) and The Mad Alchemist
E-liquid brand (see “Acquisition of TMA
Brands”).





As at
September 30, 2016, the Company had total liabilities of $7,900,678
(compared to total liabilities of $5,000,695 at December 31, 2015)
consisting of accounts payable of $1,711,999, accrued liabilities
of $372,867, accrued interest due to related parties of $218,469,
customer deposits of $54,224, loans from shareholders of $918,618,
due to related parties of $1,724,945, promissory notes of $774,937,
amounts owing on acquisition of $55,000, convertible debentures of
$50,000, term loan of $1,190,649, long term debentures to be issued
of $50,000, long term loans from shareholders of $102,162, long
term due to related parties of $631,470 and long term convertible
debentures of $45,338.





At
September 30, 2016, the Company had negative working capital of
$5,578,070 and an accumulated deficit of $12,192,015.





As at
December 31, 2015, the Company had total assets of $2,231,055
consisting of cash and cash equivalents of $81,696, trade
receivables of $45,534, inventory of $154,700, other current assets
of $322,326, property and equipment of $150,349, website
development of $9,083, intangibles of $215,283 and goodwill of
$1,252,084.





As at
December 31, 2015, the Company had total liabilities of $5,000,695
consisting of accounts payable of $687,767, accrued liabilities of
$251,517, accrued interest due to related parties of $131,755,
customer deposits of $372,500, loans from shareholders of $27,528,
due to related parties of $996,939, promissory notes of $495,193,
amounts owing on acquisitions of $150,549, convertible debentures
of $80,658, advances on credit facility of $212,415, long term
loans from shareholders of $461,250, long term due to related
parties of $662,140, long term amounts owing on acquisitions of
$196,127, long term promissory notes of $267,857 and long term
convertible debentures of $6,500.





At
December 31, 2015, the Company had negative working capital of
$2,802,565 and an accumulated deficit of $8,750,688.





Net cash used in operating activities





For the
nine month period ended September 30, 2016, the Company used cash
of $1,804,933 (compared to $533,645 of cash used in operating
activities during the nine month period ended September 30, 2015)
in operating activities to fund administrative, marketing and
sales. The increase is attributable to the results of operations
and changes in the operating assets and liabilities as discussed
above.





Net cash used in investing activities





For the
nine month period ended September 30, 2016, net cash used in
investing activities was $89,612 relating to the addition of
capital assets as compared to $225,000 relating to the acquisition
of a subsidiary (see “Acquisition of E Vapor Labs”) for
the nine month period ended September 30, 2015.





Net cash flow from financing activities





For the
nine month period ended September 30, 2016, net cash provided by
financing activities was $1,932,622 (see “Term Loan”,
“Shareholder Loan” and “Convertible
Debentures”) compared to net cash provided by financing
activities of $244,245 for the nine month period ended September
30, 2015.





34





Acquisition of E Vapor Labs





On July
1, 2015, the Company closed the acquisition of all the issued and
outstanding shares of E Vapor Labs Inc. (“E Vapor
Labs”), a Florida based E-liquid manufacturer. The Company
purchased E Vapor Labs in order to procure an E-liquid
manufacturing platform allowing the Company to secure large private
label contracts as well as manufacture its own brands going
forward. The following summarizes the fair value of the assets
acquired, liabilities assumed and the consideration transferred at
the acquisition date:





Assets
acquired:
Allocation
Measurement
Period Adjustments
Final
AllocationCash
$22,942
-
$22,942Receivables
48,356
(1,705)
46,651Other current
assets
21,195
-
21,195Inventory
122,309
4,428
126,737Fixed
assets
118,867
7
118,874Intangible
assets
-
160,000
160,000Goodwill
847,265
(154,235)
693,030Total
assets acquired
$1,180,934

$1,189,429Liabilities
assumed:Accounts
payable
$206,252
-
$206,252Accrued
liabilities
-
28,000
28,000Loan
payable
25,000
-
25,000Total
liabilities assumed
$231,252

$259,252Consideration:Cash
$225,000
-
$225,000Promissory Notes A,
unsecured and non-interest bearing, due November 1,
2015
196,026
(19,505)
176,521Promissory Notes B,
unsecured and non-interest bearing, due April 1, 2016
275,555
-
275,555Promissory Notes C,
unsecured and non-interest bearing, due January 1,
2017
253,101
-
253,101Total
consideration
$949,682

$930,177





In
consideration for the acquisition, the Company paid to the vendors,
$225,000 in cash on closing and $900,000 in unsecured promissory
notes issued on the closing (collectively, the “Promissory
Notes”). The Promissory Notes were issued in three equal
tranches of $300,000 due four (4), nine (9) and eighteen (18)
months respectfully from the closing (individually,
“Promissory Notes A”, “Promissory Notes B”,
and “Promissory Notes C” respectively). The Promissory
Notes are all unsecured, non-interest bearing, and on the maturity
date, at the option of the vendors, up to one third (1/3) of each
tranche of the Promissory Notes can be repaid in Common Shares of
the Company, calculated using the 5 day weighted average closing
market price of the Company prior to the maturity of the Promissory
Notes. The Promissory Notes, are all and each subject to
adjustments as outlined in the share purchase agreement (the
“SPA”), dated June 25, 2015.





At
December 31, 2015, the Company adjusted the Promissory Notes A for
$116,683 which is the known difference in the working capital
balance at closing of the acquisition from the amount specified in
the SPA. Further, a 12% discount rate has been used to calculate
the present value of the Promissory Notes based on the
Company’s estimate of cost of financing for comparable notes
with similar term and risk profiles. Over the term of the
respective Promissory Notes, interest will be accrued at 12% per
annum to accrete the Promissory Notes to their respective principal
amounts. During the nine month period ended September 30, 2016, the
Company recorded $23,246 in interest expense related to the
accretion of the Promissory Notes. The present value of the
Promissory Notes was $774,937 (December 31, 2015: $763,050) at
September 30, 2016.





The
Promissory Notes A were due on November 1, 2015. The Company
provided notice to the Promissory Note holders on October 30, 2015
indicating its intention to repay such Promissory Notes, however,
such inability to accurately determine the required adjustments
pursuant to the SPA has forced the Company to defer repayment of
such Promissory Notes until such time where the principal amount of
the Promissory Notes can be accurately determined.





35





Intangible
assets consist primarily of customer relationships and brands.
Brand intangibles represents the estimated fair value of the trade
names acquired. Customer relationship intangibles relates to the
ability to sell existing and future products to E Vapor Lab’s
existing and potential customers. The estimated useful life and
fair values of the identifiable intangible assets are as
follows:





Estimated Useful
Life
(in
years)
AmountBrands
5
$20,000Customer
relationships
5
140,000$160,000





The
results of operations of E Vapor Labs have been included in the
interim condensed consolidated statements of operations from the
acquisition date. The following table presents pro forma results of
operations of the Company and E Vapor Labs as if the companies had
been combined as of January 1, 2015. The pro forma condensed
combined financial information is presented for informational
purposes only. The unaudited pro forma results of operations are
not necessarily indicative of results that would have occurred had
the acquisition taken place at the beginning of the earliest period
presented, or of future results.





September
30,
2016
September
30,
2015Pro forma
revenue
$3,317,002
$1,341,022Pro forma loss from
operations
$(2,870,422)
$(1,595,198)Pro forma net
loss
$(3,441,327)
$(1,953,868)








Acquisition of CV Brands





On
November 2, 2015, the Company closed the acquisition of all of the
assets of 901 Vaping Company LLC (“901 Vaping”), an
E-liquid manufacturer, including all of the rights and title to own
and operate the Craft Vapes, Craft Clouds and Miss
Pennysworth’s Elixirs E-liquid brands. The following
summarizes the fair value of the assets acquired and the
consideration transferred at the acquisition date:





Assets
acquired:Inventory
$11,335Equipment
11,872Intangibles
63,000Goodwill
87,000Total
assets acquired
$173,207Consideration:Cash
$23,2071,000,000 Common
Shares at $0.15 per share
150,000Total
consideration
$173,207





In
consideration for the acquisition, the Company issued 1,000,000
Common Shares of the Company valued at $0.15 per share, paid cash
consideration of $23,207 and agreed to a quarterly earn-out based
on the gross profit stream derived from product sales of the
acquired brands. The earn-out commences on the closing date and
pays up to a maximum of 25% of the gross profit stream. As of
September 30, 2016, no amounts have been accrued or paid in
relation to the quarterly earn-out.





36





Intangible
assets consist primarily of customer relationships and brands.
Brand intangibles represents the estimated fair value of the trade
names acquired. Customer relationship intangibles relates to the
ability to sell existing and future products to 901 Vaping’s
existing and potential customers. The estimated useful life and
fair values of the identifiable intangible assets are as
follows:





Estimated Useful
Life
(in
years)
AmountBrands
5
$30,000Customer
relationships
5
33,000$63,000





The
results of operations of 901 Vaping have been included in the
interim condensed consolidated statements of operations from the
acquisition date, though revenue and net income from 901 Vaping
were not material for the nine month period ended September 30,
2016. Pro forma results of operations have not been presented
because the acquisition was not material to the results of
operations.





Acquisition of TMA Brands





On
December 2, 2015, the Company acquired all of the assets of The Mad
Alchemist, LLC (“TMA”), an E-liquid manufacturer,
including the assets, rights and title to own and operate The Mad
Alchemist and Replicant E-liquid brands. The following summarizes
the fair value of the assets acquired and the consideration
transferred at the acquisition date:





Assets
acquired:Inventory
$41,462Equipment
36,579Intangibles
157,000Goodwill
208,376Total
assets acquired
$443,417Consideration:819,672 Common
Shares at $0.122 per share
$100,000Deferred
payments
343,417Total
consideration
$443,417





On the
closing date, the Company issued 819,672 Common Shares valued at
$0.122 per share for a total value of $100,000; agreed to pay a
total of $400,000 in deferred payments (the “Amounts Owing on
Acquisition”), payable in ten (10) equal payments of $20,000
in cash and $20,000 in common stock every three (3) months
following the closing date, and agreed to a quarterly earn-out
based on the gross profit stream derived from product sales of the
acquired brands. The earn-out commences on the closing date andpays
up to a maximum of 25% of the gross profit stream. The number of
Common Shares issuable will be calculated and priced using the
weighted average closing market price of the Company, as quoted by
the OTC Markets Group, for the five trading days prior to each
issuance date. Further, a 12% discount rate has been used to
calculate the present value of the Amounts Owing on Acquisition.
Over the term of the respective deferred payments, interest will be
accrued at 12% per annum to accrete the payments to their
respective principal amounts. During the nine month period ended
September 30, 2016, the Company recorded $9,582 in interest expense
related to the accretion of the Amounts Owing on
Acquisition.





37





Intangible
assets consist primarily of customer relationships and brands.
Brand intangibles represents the estimated fair value of the trade
names acquired. Customer relationship intangibles relates to the
ability to sell existing and future products to TMA’s
existing and potential customers. The estimated useful life and
fair values of the identifiable intangible assets are as
follows:





Estimated Useful
Life
(in
years)
AmountBrands
5
$60,000Customer
relationships
5
97,000$157,000





The
results of operations of TMA have been included in the interim
condensed consolidated statements of operations from the
acquisition date, though revenue and net income from TMA were not
material for the nine month period ended September 30, 2016. Pro
forma results of operations have not been presented because the
acquisition was not material to the results of
operations.





On
April 15, 2016, the Company entered into a settlement agreement
(the “Settlement Agreement”) with TMA and the
Pennington family, being Joshua Pennington, Nicole Pennington and
Mike Simon (collectively, the “Pennington Family”).
Subject to the terms and conditions of the Settlement Agreement,
the parties settled: (i) any and all compensation and expenses
owing by the Company to the Pennington Family and (ii) all
remaining consideration payable by the Company to TMA under the
asset purchase agreement totaling $400,000 which was due in cash
and common stock in exchange for the Company paying to TMA and the
Pennington Family a total consideration of $133,163 payable as
$100,000 in cash and $33,163 in assets as payments in kind. Of the
$100,000 payable in cash, $45,000 was paid upon execution of the
Settlement Agreement, $27,500 was payable thirty days following the
execution of the Settlement Agreement and the remaining $27,500
payable at thelater of (i) sixty days following the execution of
the Settlement Agreement, or (ii) the completion of the historical
audit of TMA. As a result of the Settlement Agreement, the Company
has recorded a gain on settlement in the amount of $274,051. As at
September 30, 2016, $55,000 (December 31, 2015: $346,676) remains
payable to TMA and the Pennington Family. In addition, the
employment agreements between the Company and Joshua Pennington and
Nicole Pennington were mutually terminated and all amounts were
fully settled pursuant to the Settlement Agreement. Due to change
in circumstance, the Company tested goodwill for impairment and as
a result, the Company has fully impaired goodwill related to TMA in
the amount of $208,376 which formerly represented the value of
workforce and business acumen acquired.





Term Loan





On
January 18, 2016, the Company entered into a term loan (the
“Term Loan”) with the Lenders, a consortium of
participants that includes two of the Company’s senior
executive officers, whereby the Lenders would loan the Company the
aggregate principal amount of CAD $1,000,000 for capital
expenditures, marketing expenditures and working capital. The agent
who arranged the Term Loan was not a related party of the Company.
The Term Loan bears interest at a rate of 16% per annum, on the
outstanding principal, and shall mature on July 3, 2017, whereby
any outstanding principal together with all accrued and unpaid
interest thereon shall be due and payable. The Term Loan is subject
to a monthly cash sweep, calculated as the total of (i) CAD $0.50
for every E-liquid bottle, smaller than 15ml, sold by the Company
within a monthly period; and (ii) CAD $1.00 for every E-liquid
bottle, greater than 15ml, sold by the Company within a monthly
period (the “Cash Sweep”). The Cash Sweep will be
disbursed to the Lenders in the following priority: first, to pay
the monthly interest due on the Term Loan; and second, to repay any
remaining principal outstanding on the Term Loan. The Company may
elect to repay the outstanding principal of the Term Loan together
with all accrued and unpaid interest thereon prior to the maturity,
subject to an early repayment penalty of the maximum of (i) 3
months interest on the outstanding principal; or (ii) 50% of the
interest payable on the outstanding principal until maturity. The
Term Loan shall be immediately due and payable at the option of the
Lenders if there is a change in key personnel meaning the
Company’s current Chief Executive Officer and Chief Financial
Officer. On January 18, 2016 and in connection to the Term Loan,
the Company issued warrants for the purchase of 250,000 Common
Shares of the Company exercisable until December 31, 2017 with an
exercise price of $0.20 per Common Share. In addition, the Company
also extended the expiration date of the 250,000 warrants issued on
August 1, 2014 in connection with the Credit Facility until
December 31, 2017, with all other terms of the warrants remaining
the same.





38





The
Company’s Chief Executive Officer and Chief Financial Officer
are both participants of the consortium of participants of the Term
Loan, each having committed to provide ten percent of the principal
amount of the Term Loan. Neither the Chief Executive Officer nor
the Chief Financial Officer will participate in the warrants issued
or warrants extended in connection with the Term Loan and both
parties have been appropriately abstained from voting on the Board
of Directors to approve the Term Loan, where
applicable.





On July
15, 2016, the Company and the Lenders of the Term Loan entered into
a Term Loan Amendment (the “Term Loan Amendment”) in
which the Lenders agreed to extend to the Company an additional CAD
$600,000 in principal to increase the Term Loan facility up to the
aggregate principal amount of CAD $1,600,000. The parties also
extended the maturity date of the Term Loan to July 2, 2018 with
all other terms of the Term Loan remaining the same. The
Company’s Chief Executive Officer and its Chief Financial
Officer are both beneficial investors in the consortium and have
each committed to provide CAD $150,000 of the principal amount of
the initial principal of the Term Loan and the additional principal
of the Term Loan pursuant to the Term Loan Amendment. Neither the
Chief Executive Officer nor the Chief Financial Officer shall
participate in the warrants issued or warrants extended in
connection with the Term Loan Amendment.





On July
15, 2016 and in connection to the Term Loan Amendment, the Company
issued 300,000 warrants for the purchase of Common Stock at an
exercise price of $0.20 per share, such warrants expiring on
December 31, 2018. The Company also extended the expiration dates
of i) the 250,000 warrants issued on January 18, 2016 in connection
to the Term Loan and ii) the 250,000 warrants issued on August 1,
2014 and extended on January 18, 2016 in connection to the Term
Loan both until December 31, 2018, with all other terms of the
warrants remaining the same.





During
the nine month period ended September 30, 2016, the Company was
advanced $1,219,840 (CAD $1,600,000) from the Term Loan including
the CAD $294,000 and CAD $3,093 rolled in from the Credit Facility
as well as CAD $240,581 of advances from the Company’s Chief
Executive Officer and Chief Financial Officer.





During
the three and nine month periods ended September 30, 2016, the
Company expensed $44,570 and $97,409 (September 30, 2015: nil),
respectively, in interest as a result of the Term Loan. Pursuant to
the Cash Sweep, during the nine month period ended September 30,
2016, the Company paid $127,328 to the Lender consisting of $82,724
in interest and $44,604 in principal payments and at September 30,
2016, the Company owes the lender $42,736 consisting of $15,413 in
interest and $27,323 in principal payments, which have subsequently
been paid.





Shareholder Loan





On
March 2, 2016, the Company entered into a loan agreement with a
shareholder (the “Loan Agreement”), whereby the
shareholder would make available to the Company the aggregate
principal amount of CAD $670,000 (the “Shareholder
Loan”) for capital expenditures, marketing expenditures and
working capital. Under the terms of the Loan Agreement, the
Shareholder Loan was made available to the Company in two equal
tranches of CAD $335,000 (USD $259,357), for a total loan amount of
CAD $670,000 (USD $518,714), with the first tranche (“Loan
Tranche A”) received on the closing date and the second
tranche (“Loan Tranche B”) received on April 14, 2016.
At September 30, 2016, CAD $52,000 (USD $39,645) of the Loan
Tranche B is being held in trust by the shareholder to be released
on the incurrence of specific expenses. The Shareholder Loan bears
interest at a rate of 6% per annum, on the outstanding principal,
and shall mature on March 2, 2018, whereby any outstanding
principal together with all accrued and unpaid interest thereon
shall be due and payable. The Company shall also repay 5% of the
initial principal amount of Loan Tranche A and 5% of Loan Tranche
B, monthly in arrears, with the first principal repayment beginning
on June 30, 2016. At September 30, 2016, $408,646 of the amounts
owing on the Loan Agreement have been recorded as current
liabilities to reflect the monthly principal payments due over the
next year. The Company may elect to repay the outstanding principal
of the Shareholder Loan together with all accrued and unpaid
interest thereon prior to maturity without premium or penalty. The
Company also agreed to service the Shareholder Loan during the term
prior to making any payments to the Company’s Chief Executive
Officer, Chief Financial Officer and Board of Directors. The
Shareholder Loan is secured by a general security agreement over
the assets of the Company.





39





The
Company accrued interest of $7,759 and $15,894 during the three and
nine month periods ended September 30, 2016 (September 30, 2015:
nil), respectively, on the Shareholder Loan. Accrued interest owing
on the Shareholder Loan at September 30, 2016 is $16,044 (December
31, 2015: nil) which is included in accrued liabilities. At
September 30, 2016, the Company owes the lender $102,162 in
principal payments.





Convertible Debentures





On May
20, 2016, the Company issued 375 unsecured subordinated convertible
debenture units (the “Convertible Debenture Units
No.2”) for proceeds of $375,000. Each Convertible Debenture
Unit No.2 consisted of an unsecured subordinated convertible
debenture having a principal amount of $1,000 (the
“Convertible Debentures No.3”) and warrants exercisable
for the purchase of 10,000 Common Shares of the Company. The
Convertible Debentures No.3 mature on January 31, 2018 and bear
interest at a rate of 8% per annum, which is payable quarterly in
arrears. The Convertible Debentures No.3 are convertible into
Common Shares of the Company at a fixed conversion rate of $0.10
per share at any time prior to the maturity date. The Company will
have the option to force conversion of the Convertible Debentures
No.3 at any time after six months from issuance and prior to the
maturity date of January 31, 2018. For Canadian purchasers, the
Company may only force conversion of the Convertible Debentures
No.3 at such time that the Company is a reporting issuer within the
jurisdiction of Canada. Of the $375,000 Convertible Debentures No.3
issued, $55,000 were issued in settlement of amounts owing to
related parties, and $10,000 were issued in settlement of amounts
owing to an employee. The Company incurred costs of $22,725 as a
result of the Convertible Debentures No.3.





Satisfaction of Our Cash Obligations for the Next 12
Months





These
unaudited condensed consolidated interim financial statements have
been prepared on a going concern basis, which contemplates the
realization of assets and the satisfaction of liabilities in the
normal course of business. As shown in these unaudited condensed
consolidated interim financial statements, at September 30, 2016,
the Company has an accumulated deficit of $12,192,015 and a working
capital deficiency of $5,578,070 as well as negative cash flows
from operating activities of $1,804,933 for the nine month period
ended September 30, 2016. These conditions represent material
uncertainty that cast significant doubt about the Company's ability
to continue as a going concern. The ability of the Company to
continue as a going concern is dependent upon achieving a
profitable level of operations or on the ability of the Company to
obtain necessary financing to fund ongoing operations. Management
believes that the Company will not be able to continue as a going
concern for the next twelve months without additional financing or
increased revenues.





To meet
these objectives, the Company continues to seek other sources of
financing in order to support existing operations and expand the
range and scope of its business. However, there are no assurances
that any such financing can be obtained on acceptable terms and in
a timely manner, if at all. Failure to obtain the necessary working
capital would have a material adverse effect on the business
prospects and, depending upon the shortfall, the Company may have
to curtail or cease its operations.





These
unaudited condensed consolidated interim financial statements do
not include any adjustments to the recorded assets or liabilities
that might be necessary should the Company have to curtail
operations or be unable to continue in existence.





Off-Balance Sheet Arrangements





The
Company has no off-balance sheet arrangements.





Recent Accounting Pronouncements





The
Company has reviewed all recently issued, but not yet effective,
accounting pronouncements and other than the below, does not expect
the future adoption of any such pronouncements to have a
significant impact on its results of operations, financial
condition or cash flow.





40





In May
2014, the Financial Accounting Standards Board (“FASB”)
issued Accounting Standards Update (“ASU”) No. 2014-09,
Revenue from Contracts with
Customers (“ASU 2014-09”), requiring an entity
to recognize revenue when it transfers promised goods or services
to customers in an amount that reflects the consideration to which
the entity expects to be entitled to in exchange for those goods or
services. ASU 2014-09 will supersede nearly all existing revenue
recognition guidance under U.S. GAAP when it becomes effective. In
August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers,
deferring the effective date for ASU 2014-09 by one year, and thus,
the new standard will be effective for us beginning on February 1,
2018 with early adoption permitted on or after February 1, 2017.
This standard may be adopted using either the full or modified
retrospective methods. Management of the Company is currently
evaluating adoption methods and the impact of this standard on the
consolidated financial statements.





In
November 2015, the FASB issued ASU No. 2015-17, Income Taxes (Topic 740): Balance Sheet
Classification of Deferred Taxes (“ASU
2015-17”). ASU 2015-17 simplifies the presentation of
deferred income taxes by eliminating the separate classification of
deferred income tax liabilities and assets into current and
noncurrent amounts in the consolidated balance sheet statement of
financial position. The amendments in the update require that all
deferred tax liabilities and assets be classified as noncurrent in
the consolidated balance sheet. The amendments in this update are
effective for annual periods beginning after December 15, 2016, and
interim periods therein and may be applied either prospectively or
retrospectively to all periods presented. Early adoption is
permitted. Management of the Company is currently evaluating
adoption methods and the impact of this standard on the
consolidated financial statements.





On
February 25, 2016, the Financial Accounting Standards Board
(“FASB”) issued Accounting Standards Update
(“ASU”) 2016-02, Leases (Topic 842). This update will
require organizations that lease assets to recognize on the balance
sheet the assets and liabilities for the rights and obligations
created by those leases. The new guidance will also require
additional disclosures about the amount, timing and uncertainty of
cash flows arising from leases. The provisions of this update are
effective for annual and interim periods beginning after December
15, 2018. The Company is currently evaluating the impact the
adoption of this ASU will have on the Company’s financial
position and results of operations.





On
March 30, 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic
718). This update requires that all excess tax benefits and
tax deficiencies arising from share-based payment awards should be
recognized as income tax expense or benefit on the income
statement. The amendment also states that excess tax benefits
should be classified along with other income tax cash flows as an
operating activity. In addition, an entity can make an entity-wide
accounting policy election to either estimate the number of awards
expectedto vest or account for forfeitures as they occur. The
provisions of this update are effective for annual and interim
periods beginning after December 15, 2016. The Company is currently
evaluating the impact the adoption of this standard will have on
its financial statements.





In
April 2016, the FASB issued ASU No. 2016-10 Revenue from Contracts with Customers (Topic
606), Identifying
Performance Obligations and Licensing (“ASU
2016-10”). ASU 2016-10 clarifies the following two aspects of
Topic 606: identifying performance obligations and the licensing
implementation guidance, while retaining the related principles for
those areas. The provisions of this update are effective for annual
and interim periods beginning after December 15, 2017, with early
application permitted. The Company is currently evaluating the
impact the adoption of this standard will have on its financial
statements.





In May
2016, the FASB issued ASU No. 2016-12 Revenue from Contracts with Customers (Topic
606), Narrow-Scope
Improvements and Practical Expedients (“ASU
2016-12”). The core principal of ASU 2016-12 is the
recognition of revenue to depict the transfer of promised goods or
services to customers in an amount that reflects the consideration
to which the entity expects to be entitled in exchange for those
goods or services. The provisions of this update are effective for
annual and interim periods beginning after December 15, 2017, with
early application permitted. The Company is currently evaluating
the impact the adoption of this standard will have on its financial
statements.





In June
2016, the FASB issued ASU No. 2016-13 Financial Instruments – Credit Losses
(Topic 326), Measurement of
Credit Losses on Financial Instruments (“ASU
2016-13”), which requires financial assets measured at
amortized cost be presented at the net amount expected to be
collected. The allowance for credit losses is a valuation account
that is deducted from the amortized cost basis. The measurement of
expected losses is based upon historical experience, current
conditions, and reasonable and supportable forecasts that affect
the collectability of the reported amount. This guidance is
effective for fiscal years beginning after December 15, 2019, with
early adoption permitted. We are evaluating the guidance and have
not yet determined the impact on our consolidated financial
statements.





In
August 2016, the FASB issued Accounting Standard Update (ASU) No.
2016-15 Statement of Cash Flows
(Topic 230), Classification
of Certain Cash Receipts and Cash Payments (a consensus of the
Emerging Issues Task Force) (“ASU 2016-15”),
which clarifies how certain cash receipts and cash payments are
presented and classified in the statement of cash flows. Among
other clarifications, the guidance requires that cash proceeds
received from the settlement of corporate-owned life insurance
(COLI) policies be classified as cash inflows from investing
activities and that cash payments for premiums on COLI policies may
be classified as cash outflows for investing activities, operating
activities or a combination of both. The guidance is effective for
fiscal years beginning after December 15, 2017, with early adoption
permitted. Retrospective application is required. We are evaluating
the guidance and do not expect it to have a material impact on our
consolidated financial statements.





41





CRITICAL ACCOUNTING POLICIES





The
accompanying unaudited condensed consolidated interim financial
statements have been prepared in accordance with accounting
principles generally accepted in the United States of America for
interim financial information and with the instructions to Form
10-Q. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in
the United States of America for complete consolidated financial
statements. In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for
a fair presentation have been included. Interim results are not
necessarily indicative of the results that may be expected for a
full year. These condensed consolidated interim financial
statements should be read in conjunction with the audited
consolidated financial statements and notes thereto included in the
Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2015, as filed with the U.S. Securities and Exchange
Commission.





The
accounting policies of the Company are in accordance with
accounting principles generally accepted in the United States of
America. Outlined below are those policies considered particularly
significant:





Basis of Consolidation





These
condensed consolidated interim financial statements include the
accounts of the Company and its wholly owned subsidiaries; Gilla
Operations, LLC (“Gilla Operations”); E Vapor Labs
Inc.; E-Liq World, LLC; Charlie’s Club, Inc.
(“Charlie’s Club”); Gilla Enterprises Inc. and
its wholly owned subsidiary Gilla Europe Kft.; Gilla Operations
Worldwide Limited (“Gilla Worldwide”); Gilla
Franchises, LLC and its wholly owned subsidiary Legion of Vape,
LLC.; and Snoke Distribution Canada Ltd. and its wholly owned
subsidiary Snoke Distribution USA, LLC. All inter-company accounts
and transactions have been eliminated in preparing these condensed
consolidated interim financial statements.





Advertising Costs





In
accordance with ASC 720, the Company expenses the production costs
of advertising the first time the advertising takes place. The
Company expenses all advertising costs as incurred. During the nine
month period ended September 30, 2016, the Company expensed
$223,597 (September 30, 2015: $159,236) as corporate promotions,
these amounts have been recorded as administrative
expense.





ITEM 3.   
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





This
item is not applicable to smaller reporting companies.





ITEM 4.    DISCLOSURE
CONTROLS AND PROCEDURES





Evaluation
of Disclosure Controls and Procedures





We
maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our filings
with the Securities and Exchange Commission (SEC) is recorded,
processed, summarized and reported within the time period specified
in the SEC’s rules and forms, and that such information is
accumulated and communicated to management, including our Chief
Executive Officer and Chief Financial Officer, as appropriate, to
allow timely decisions regarding required disclosure based on the
definition of “disclosure controls and procedures” as
defined in Rule 13a-15(e) promulgated under the Securities Exchange
Act of 1934, as amended (the “Exchange
Act”).





As of
the end of the period covered by this Report, and under the
supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, we
evaluated the effectiveness of the design and operation of the
Company’s disclosure controls and procedures. Based on this
evaluation, we believe that disclosure controls and procedures were
not effective as of June 30, 2016, due to our limited resources and
staff.





Limitations
on Effectiveness of Controls and Procedures





Our
management, including our Chief Executive Officer (Principal
Executive Officer) and Chief Financial Officer (Principal Financial
Officer), does not expect that our disclosure controls and
procedures or our internal controls will prevent all errors and all
fraud. A control system, no matter how well conceived and operated,
can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Further, the design of a
control system must reflect the fact that there are resource
constraints and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in all
control systems, no evaluation of controls can provide absolute
assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations
include, but are not limited to, the realities that judgments in
decision-making can be faulty and that breakdowns can occur because
of simple error or mistake. Additionally, controls can be
circumvented by the individual acts of some persons, by collusion
of two or more people, or by management override of the control.
The design of any system of controls also is based in part upon
certain assumptions about the likelihood of future events and there
can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions. Over time,
controls may become inadequate because of changes in conditions, or
the degree of compliance with the policies or procedures may
deteriorate. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud
may occur and not be detected.





Changes
in Internal Controls





During
the quarter ended September 30, 2016, there have been no changes in
our internal control over financial reporting that have materially
affected or are reasonably likely to materially affect our internal
controls over financial reporting.





42





PART II - OTHER INFORMATION





ITEM
1.    LEGAL PROCEEDINGS





On
January 5, 2016, Yaron Elkayam, Pinchas Mamane and Levent Dikmen
filed a three count complaint against the Company in the Circuit
Court of Hillsborough County, Florida alleging (i) breach of
contract, (ii) breach of implied covenant of good faith and fair
dealing, and (iii) fraud in the inducement seeking damages in the
amount of approximately $900,000 of Promissory Notes issued on July
1, 2015 as a result of the acquisition of E Vapor Labs. On February
23, 2016, the Company filed a motion to dismiss the complaint on
the basis of failure to allege sufficient jurisdictional facts and
failure to satisfy constitutional due process requirements to
exercise jurisdiction. There can be no assurance that the outcome
of this complaint would not have a material adverse effect on the
business, results of operations and financial condition. The legal
proceeding has been brought in Circuit Court of the Thirteenth
Judicial Circuit in and for Hillsborough County, State of Florida,
Civil Division under the following caption: Yaron Elkayam, Pinchas
Mamane, Levent Dikmen, Plaintiffs, v. Gilla, Inc., Case No.
16-CA-0047, Division H, filed January 5, 2016.





ITEM
1A.    RISK FACTORS





There
have been no material changes in the Company’s risk factors
from those disclosed in Part I, Item 1A of our Annual Report on
Form 10-K for the fiscal year ended December 31, 2015.





ITEM
2.    UNREGISTERED SALES OF EQUITY SECURITIES AND
USE OF PROCEEDS





During
the period covered by this Report, we did not have any sales of
securities in transactions that were not registered under the
Securities Act of 1933, as amended, (the “Securities
Act”) that have not been previously reported in a Form 8-K,
Form 10-Q or Form 10-K, except for the following:





On
September 30, 2016, the Company agreed to issue 230,769 Common
Shares at a price of $0.130 per Common Share, as a settlement of
$30,000 in consulting fees owed to unrelated parties, pursuant to
the exemption from the registration requirements of the Securities
Act provided by Regulation S of the Securities Act. These Common
Shares remain unissued.





On
September 30, 2016, the Company agreed to issue 54,511 Common
Shares at an average price of $0.147 per Common Share, as a
settlement of $8,017 in consulting fees owed to unrelated parties,
pursuant to the exemption from the registration requirements of the
Securities Act provided by Regulation S of the Securities Act.
These Common Shares remain unissued.





ITEM
3.    DEFAULTS UPON SENIOR SECURITIES





None.





ITEM
4.    MINE SAFETY DISCLOSURES





Not
applicable.





ITEM
5.    OTHER INFORMATION





None.





43





ITEM
6.    EXHIBITS





Incorporated by
ReferenceExhibit
Number

Exhibit
Description

Filed
Herewith

Form

Exhibit

Filing Date31.1

Certification
of Chief Executive Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.

X31.2

Certification
of Chief Financial Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.

X32.1

Certification
of Chief Executive Officer Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.*

X32.2

Certifications
of Chief Financial Officer Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.*

X101.INS

XBRL
Instance Document

X101.SCH

XBRL
Taxonomy Extension Schema

X101.CAL

XBRL
Taxonomy Extension Calculation Linkbase

X101.DEF

XBRL
Taxonomy Definition Linkbase

X101.LAB

XBRL
Taxonomy Extension label Linkbase

X101.PRE

XBRL
Taxonomy Extension Presentation Linkbase

X





* This
certification is deemed not filed for purposes of Section 18 of the
Securities Exchange Act of 1934, as amended (the “Exchange
Act”), or otherwise subject to the liability of that section,
nor shall it be deemed incorporated by reference into any filing
under the Securities Act or the Exchange Act.





44





SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this Report to be signed on its behalf
by the undersigned, thereunto duly authorized.





GILLA
INC.(Registrant)November 14,
2016
By:
/s/
J.
Graham SimmondsName: J. Graham
SimmondsTitle:
Chief
Executive Officer and DirectorBy:
/s/ Ashish
KapoorName: Ashish
KapoorTitle: Chief
Financial Officer and Chief Accounting
Officer








45