**U.S. SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-KSB/A**

 

**AnnualReport Pursuant to Section 13 or 15(d) of the Securities Exchange Act of1934**

 

**For the Fiscal Year Ended December 31, 2003**

 

**Commissionfile number 000-33211**

 

**VITAL LIVING, INC.**

(Exact name of small business issuer as specified in its charter)

 
| **NEVADA**                                    |   | **3652**                                                   |   | **88-0485596**                       |
|-----------------------------------------------|--------|------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdictionof incorporation) |   | (Primary  Standard Industrial  Classification Code Number) |   | (I.R.S. Employer Identification No.) |

 

**VITAL LIVING, INC.**

**5080 N. 40TH STREET, SUITE 105**

**PHOENIX, ARIZONA 85018-2147**

**(602) 952-9909**

(Address andtelephone number of principal executive offices)

 

Securities registered under Section 12(b) of the Exchange Act:

**None**

 

Securities registered under Section 12(g) of the Exchange Act:

**CommonStock, $0.001 par value**

 

Checkwhether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the past12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.

 

YESý NO o

 

Checkif there is no disclosure of delinquent filers in response to Item 405 ofRegulation S-B is contained in this form, and no disclosure will becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form10-KSB or any amendment to this Form 10-KSB.

 

YESý NO o

 

Stateissuer’s revenue for the most recent fiscal year: $2,855,123.

 

Asof March 26, 2004, the aggregate market value of the voting and non-votingcommon stock held by non-affiliates of the issuer (based on the closing salesprice as reported by the OTC Bulletin Board) was $23,663,081 assuming allofficers and directors are deemed affiliates for this purpose).

 

Asof March 26, 2004, the issuer had 61,456,004 shares of its common stock,$0.001 par value, outstanding.

 

TransitionalSmall Business Disclosure Format (check one): Yes o No ý

 

The Registrant herebyamends the following items, financial statements, exhibits or other portions ofits Annual Report on Form 10-KSB for the year ended December 31, 2003as set forth in the pages attached hereto:

 

 

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**TABLE OFCONTENTS**

 
| ***PART I.***                                                                                                                   |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|
| **ITEM  1. DESCRIPTION OF BUSINESS**                                                                                            |   |
|                                                                                                                            |   |
| ***PART II.***                                                                                                                  |   |
| **ITEM  6. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**                                                     |   |
| **ITEM 7. FINANCIAL STATEMENTS**                                                                                                |   |
|                                                                                                                            |   |
| ***SIGNATURES***                                                                                                                |   |
| *Section 302  Certification of Principal Executive Officer and Chief Executive Officer*                                    |   |
| *Section 302  Certification of Principal Accounting Officer and Chief Financial Officer*                                   |   |
| *Certification  Pursuant to 18 U.S.C. Section 1350 As Adopted Pursuant to  Section 906 of Sarbanes-Oxley Act of 2002* |   |
| *Certification  Pursuant to 18 U.S.C. Section 1350 As Adopted Pursuant to  Section 906 of Sarbanes-Oxley Act of 2002* |   |

 

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**FORWARD-LOOKING STATEMENTS**

 

ThisAnnual Report on Form 10-KSB contains forward-looking statements withinthe meaning of the Private Securities Litigation Reform Act of 1995 that relateto possible future events, our future performance, and our future operations.In some cases, you can identify these forward-looking statements by the use ofwords such as “may,” “will,” “should,” “anticipates,” “believes,” “expects,”“plans,” “future,” “intends,” “could,” “estimate,” “predict,” “potential,”“continue,” or the negative of these terms or other similar expressions. Thesestatements are only our predictions. Our actual results could and likely willdiffer materially from these forward-looking statements for many reasons,including the risks described herein. We cannot guarantee future results,levels of activities, performance, or achievements. We are under no duty toupdate any of the forward-looking statements after the date of this document toconform them to actual results or to changes in our expectations.

 

**PART I.**

 

**ITEM1. DESCRIPTION OF BUSINESS**

 

**DESCRIPTION OF BUSINESS**

 

We were incorporated in the State of Nevada on January 22, 2001under the name Nutritional Systems, Inc. Effective May 7, 2001, we acquiredsubstantially all of the assets of Vital Living, Inc. and on May 20, 2001,changed our name to Vital Living, Inc. We then merged with VCM TechnologyLimited, a company reporting under the Securities and Exchange Act of 1934, onAugust 16, 2001. As set forth in the terms of the merger agreement, weacquired all of the outstanding shares of common stock of VCM from its solestockholder in exchange for 5,062 shares of our restricted common stock.Following the merger, we continued as the surviving corporation and commencedreporting under the Securities and Exchange Act of 1934 by assuming thereporting status of VCM. Our executive offices are located at 5080 North 40thStreet, Suite 105, Phoenix, Arizona 85018-2147 and its telephone number is(602) 952-9909.  Our Website iswww.vitalliving.com.

 

We develop orlicense nutraceuticals and pharmaceutical delivery systems (our GEOMATRIXtechnology) through our subsidiaries, marketing them for distribution throughphysicians, medical groups, chiropractic offices, and retail outlets. Inaddition, we formulate, market, and distribute vitamins, herbs, high qualitydietary supplements, and therapeutic and functional food products throughsimilar distribution channels.

 

Nutraceuticals areproducts that are isolated or purified from foods and generally sold inmedicinal forms not usually associated with foods, including tablets, capsules,or drops. These nutraceuticals may have physiological benefits or have theability to reduce the risk of chronic disease beyond basic nutritionalproducts. We develop and test our nutraceuticals in collaboration with leadingmedical experts in the nutraceuticals field. We have designed them to beincorporated by physicians into a standard physician-patient program in whichpatients supplement doctor-prescribed pharmaceuticals with our nutraceuticals.Our initial areas of focus are cardiovascular health and weight loss.

 

**BUSINESS STRATEGY**

 

Our business strategy isto capitalize on the growing complimentary and alternative medicine market bycreating scientifically proven and supported condition-specific formulations,offering a broad range of natural, general health nutraceuticals and functionalfoods and beverages, and exploring alternative distribution channels by gainingpractitioner confidence and support for our products. We plan to focusinitially on certain target conditions, providing the market with high quality,relevant products through key distribution channels. Our distribution channelscan be categorized into three primary areas:

 

•                  themedical/practitioner channel, which might include physicians, conditionspecialists, chiropractors, nutritionists, or trainers who promote or prescribeour products,

•                  retail,which may include health/nutrition stores, grocery stores, or other retailoutlets, and

•                  consumer-direct,such as call centers and websites.

 

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Our initial targetconditions, products, and distribution channels are summarized below:

 
| **Target Conditions** |   | **Current  Products Offered**                                                                                                                                                                                  |   | **Distribution  Channels**                    |
|-----------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------|
| Cardiovascular Health |   | Essentum®                                                                                                                                                                                                 |   | Medical/practitioner                          |
|                  |   |                                                                                                                                                                                                           |   |                                          |
| Weight Loss           |   | X-Fat®                                                                                                                                                                                                    |   | Retail  Consumer Direct                       |
|                  |   |                                                                                                                                                                                                           |   |                                          |
| General Health        |   | Christopher’s Original  Formulas® herbal line  Dr. Phil’s® and other functional food/beverage products  Boulder Bars®  Nature’s Dose® nutraceutical line  GreensFIRST® |   | Medical/practitioner  Retail  Consumer Direct |

 

A large part of ourstrategy relies on a growing patient and consumer interest in the use ofnutritional supplements and alternative medicines to complement traditionalhealth care routines in the United States and elsewhere. Use of vitamins,minerals, herbs, and other supplements continues to rise as consumers seeknutritional products to improve general health, increase longevity, and enhancethe overall quality of life. In this industry, sales generally occur throughindependent health food stores and chains, mail order and Internet sites, andmass-market food and drug outlets. While we have focused primarily on activities within the United States,we have begun to focus our attention on other countries.  For instance, we believe there is a growingmarket for our products in countries like China where there is a large, activepopulation that has historically accepted nutritional supplements and other alternativemedicines.  To this end, we sent adelegation to China in April 2004 that included our chairman of the board,our chief executive officer and our chief scientist to explore potentialopportunities including the licensing of our products to Chinese licensees formarketing and sales in China, forming new partnerships with Chinese medicinecompanies for manufacturing and selling of our products in China by Chinesepartners and exporting products of Chinese partners through our marketingchannels to the United States market.

 

There is also asubstantial and growing body of evidence showing that specific nutritionalprograms and properly formulated nutritional supplements have a significantpositive impact on patient health. Supplements that have demonstrated healthfulbenefits related to cardiovascular health, for example, in properly designedand controlled clinical trials include:

 

•                  Bvitamins, which have been shown to lower elevated homocysteine and promotecardiovascular health;

•                  Plantsterols such as phylochemeds, which have been shown to inhibit cholesterolformation and thereby lower “bad” cholesterol and total blood lipids; and

•                  Niacin(B3), which has been shown to promote “good” cholesterol levels.

 

Despite such examples andcontinued growth in the nutritional supplements market, physicians/practitionershave typically been unwilling or unable to respond to the trend, or to patientquestions on the subject matter, due in large part to doubt, or lack ofsubstantiation on supplement safety and efficacy, or a lack of knowledge in thearea. In the formulation, production, and marketing of our products, we haveattempted to address these concerns by:

 

•                  assemblinga panel of physicians and practitioners active in the fields in which we seekto sell our products who will endorse and create integrated treatmentprotocols;

•                  utilizingclinically proven ingredients in our creation of condition-specificformulations;

•                  providingpatient educational tools, logistical, and fulfillment support for our productsto physicians/practitioners, enabling them to focus on their core competencies;and

•                  creatinga business model similar to the well-established pharmaceutical model (i.e.,physicians/practitioners provide patients with prescriptions fulfilled by thirdparties), which is arguably the strongest and most profitable distributionmodel for drug therapies.

 

**ACQUISITION STRATEGY**

 

In connection with thesale of our Senior Secured Convertible Notes issued in December 2003, weagreed that, until the registration statement that we filed inJanuary 2004 has been declared effective by the Securities and ExchangeCommission, we would not enter into any acquisition agreements which, uponconsummation, would require us to file a Current Report on Form 8-K withaudited financial statements without the prior approval of the holders of suchSenior Secured Convertible Notes representing at least 50% of

 

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the principal amount ofnotes then outstanding.  Further, weagreed that, once the registration statement is declared effective, we wouldnot enter into an agreement for any material acquisition for a period of atleast 60 days unless the registration statement is on Form S-3 without theprior approval of the holders of Senior Secured Convertible Notes representingat least 50% of the principal amount of notes then outstanding.

 

Notwithstanding theforegoing, we believe there are many attractive acquisition candidates in ourindustry because of the highly fragmented composition of the marketplace, theindustry participants’ need for capital, and their owners’ desire forliquidity. If the restrictions described above are removed, we may pursue acontinued acquisition program to consolidate and enhance our position in ourcurrent markets and to acquire operations in new markets.

 

During 2003 and 2002, wecompleted the acquisition of four companies with complimentary business orproducts ranging from start-ups to revenue up to $2.5 million per year. Theseacquisitions are intended to shift our business toward established, highermargin products, or to expand into new product lines. These acquisitions alsoincreased our geographic presence with locations spanning the Southwest regionof the United States. The following information provides a summary of ouracquisitions:

 

*MAF BioNutritionals, LLC (“MAF”)*.On November 20, 2002, we acquired MAF for consideration of $4,100,000,consisting of 2,500,000 shares of common stock priced at $1.64 per share.  MAF formulates, markets, and distributesnatural and organic food-based, preventative nutraceuticals and therapeutic andfunctional food products designed to support proactive human cell maintenanceand rehabilitation, essential in the prevention and treatment of disease, aswell as overall optimal body performance and metabolic function. MAF’s productline includes various functional foods/beverages (Phil’s Bar®, Phil’s Shake®,Alma Bar®, Boulder Bars®) and Nature’s Dose®, a line of nutritional and dietarysupplements. We acquired MAF in an attempt to both broaden our product linesand gain distribution networks to help distribute our products. MAF generatedactual revenues of approximately $1,370,000 and annualized pro forma revenuesof approximately $1,676,000 during the years ended December 31, 2003 and2002, respectively.

 

*Christopher’s Original Formulas,Inc. (“COF”)*. On July 3, 2003, we acquired COFthrough a wholly owned subsidiary for consideration of $2,808,000, consistingof 2,600,000 shares of common stock priced at $1.08 per share and certainearn-out provisions. Through this acquisition, we gained the exclusive licensingand marketing rights to Christopher’s products, a complete line of over 300herbal formulas and products consisting primarily of naturally occurringorganic substances sold to professionals and at retail locations throughout theUnited States.  COF generated annualizedpro forma revenues of approximately $2,039,000 and $2,447,000 during the yearsended December 31, 2003 and 2002, respectively.

 

*E-Nutraceuticals, Inc. (“ENI”)*.On August 20, 2003, we acquired ENI for consideration of $40,623,159,consisting of 31,248,584 shares of common stock priced at $1.30 per share. ENIdevelops safe and effective alternatives to prescription medications fornon-life threatening chronic ailments, such as obesity and depression. Throughthe acquisition, we obtained worldwide patent and licensing rights to X-Fat®, adietary supplement utilized for weight loss. In addition, through acollaborative partnership with SkyePharma, PLC, (“Skye”), a UK pharmaceuticalscompany and major shareholder, we are now in the process of enhancing existingnutraceuticals via FDA-approved, proprietary delivery systems. Pursuant to anamended Development and License Agreement between the parties, we acquiredexclusive rights to Skye’s drug delivery technology, GEOMATRIX®, and marketingand royalty rights to pharmaceutical sales using GEOMATRIX® in the PeoplesRepublic of China, Taiwan, and Hong Kong. ENI generated annualized pro forma revenues of approximately $0 and$21,000 during the years ended December 31, 2003 and 2002, respectively.

 

*Doctors For Nutrition, Inc. (“DFN”)*.On October 14, 2003, we acquired DFN for consideration of $2,343,004,consisting of 1,650,003 shares of common stock priced at $1.42 per share. DFN’sproduct line includes GreensFIRST®, a highly concentrated formulation of fruitsand vegetables. One serving of the product has the antioxidant power of over 10servings of fruits and vegetables. Mixed with water, GreensFIRST® containscertified organic fruits, vegetables, and barley grass, which are first juicedand then spray-dried at low temperature, leaving all the important nutrientsand live enzymes intact. Benefits of usage include increased energy, improveddigestion, and enhanced immune response. DFN currently distributes GreensFIRST®through more than 1,000 practitioner offices throughout the United States.  DFN generated annualized pro forma revenuesof approximately $1,622,000 and $295,000 during the years endedDecember 31, 2003 and 2002, respectively.

 

Should we continue ouracquisition strategy in the future, we believe that companies with revenuesranging up to $5 million per annum may be receptive to our acquisition program,as often they are too small to be identified as acquisition targets of largerpublic companies or to independently attempt their own public offerings. Inparticular, we intend to focus on candidates that have strong relationshipswith key vendors or have established complimentary distribution channels orcustomers. We believe such an acquisition strategy could be successfullyimplemented due to:

 

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•                  thehighly fragmented composition of the market;

•                  ourstrategy for creating a national company, which should enhance the acquiredcompany’s ability to compete in local, regional, and national markets throughan expansion of customer base, distribution channel, and products offered andlower operating costs attained through synergies;

•                  theadditional capital that management anticipates will become available forinternal growth;

•                  thepotential for increased profitability as a result of our centralization ofcertain administrative functions, greater purchasing power, and economies ofscale;

•                  ourstatus as a public corporation;

•                  adecentralized management strategy, which should, in most cases, enable theacquired company’s management to remain involved in the operations; and

•                  theability to utilize our experienced management in identifying acquisitionopportunities.

 

**PRODUCTS**

 

*Product Lines*

 

*Essentum® and EssentumNP®*(collectively “Essentum”) are our proprietary, patent-pending supplements designedby cardiologists to meet specific nutritional needs for cardiovascular health.Cardiovascular disease affects nearly 60 million Americans and is one of theleading causes of death in the United States. The American Heart Associationestimates that 100 million Americans could benefit from improved dietary andexercise regimens to reduce their risk of heart attack. The nutrients inEssentum are clinically proven to support healthy levels of cholesterol,triglycerides, and homocysteine, as well as provide necessary vitamins andminerals. Because physicians formulated it, Essentum will not interact with, orreduce the effectiveness of, typical cardio-related prescription medications.

 

*X-Fat®* is ourpatented dietary supplement that uses Kytabsorbe®, a liquid form of the naturalfat fighter, chitosan. Chitosan has been studied extensively by the scientificcommunity and has been shown to bind to a variety of dietary fats. Unlike thepill form of chitosan, which takes hours to activate, Kytabsorbe® is fast actingand is quickly absorbed into the blood stream. Kytabsorbe® is all natural andderived solely from shellfish. X-Fat® is expected to result in weight loss andreduced serum lipid levels, which has been shown to result in a lowercholesterol count.   In connection with our acquisition of ENI inAugust 2003, we became party to a licensing agreement pursuant to which weobtained the exclusive, worldwide, perpetual license to X-Fat.  We spent much of the remainder of2003 planning and expending for a first quarter, 2004 product launch.  We anticipate that we will sell X-Fatprimarily via consumer-direct distribution channels in one-month supplies forapproximately $80 resulting in a gross profit to us of approximately 80% to90%.  However, we cannot assure you thatwe will actually realize these profits and actual results may differ from ourestimates.  Under the license agreement, we are required to pay royalties to theformer owner of the X-Fat patent equal to 10% of the first $1,000,000 of netproduct sales and 5% of net product sales in excess of $1,000,000, up to amaximum royalty of $1,250,000 per fiscal year. Of this percentage, Paul Leibowitz, our chief scientific officer, isentitled to 1% (up to a maximum of $125,000) in accordance with an agreement betweenMr. Leibowitz and the original owner of the patent.  We are also required to pay advanced royalties of $15,000 perquarter to be credited against future royalty payments.  If we fail to pay any of the amounts owedunder the agreement or default in any of our obligations under the licenseagreement without curing such default within 30 days, the agreement may beterminated by the owner of the patent. At December 31, 2003, we had prepaid royalties of $247,172.  To date, sales have been minimal;however, substantial sales and marketing efforts did not begin untilMarch 2004.

 

*GreensFIRST®*is a highly concentrated formulation of fruits and vegetables with natural,organic, whole foods and extracts, or “super foods,” prepared in a powder formixing with a variety of liquids. Super foods supply natural vitamins,minerals, plant enzymes, antioxidants, phytonutrients, and symbiotic intestinalflora for more optimal energy metabolism, fat burning, digestion,detoxification, immunity, repair, recovery, rejuvenation, and vital longevity.GreensFIRST® is currently distributed through more than 1,000 practitionerofficers throughout the United States.

 

*Christopher’s Original Formulas®*is our complete and exclusively licensed herbal remedy product line, consistingprimarily of naturally occurring, certified-organic substances that are safeand effective in the treatment of an array of specific conditions and generalhealth maintenance. A sampling of these products includes a variety ofcapsules, ointments, syrups, and extracts sold through retail locationsthroughout the United States, as well as through consumer-direct distributionchannels.

 

*Nature’s Dose®*represents all natural, certified organic, food-based nutraceuticals formulatedusing peer review-published scientific research and clinical experience.Specific patent-pending formulas include Anti-Inflammatory Complex, EPAFormula, and Flax Formula. This product line is distributed through ourpractitioner, retail, and consumer-direct distribution channels.

 

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*Nutritional Bars/Shakes*.We offer a variety of all-natural nutrition bars, including Phil’s Bar®, Phil’sShake®, Alma Bar®, and Boulder Bars®. Certified-organic and vegan versions ofsome of these products have recently and successfully been developed anddistributed into our markets. These products are distributed through ourpractitioner, retail, and consumer-direct distribution channels.

 

**SALES AND MARKETING**

 

As described above, ourdistribution channels can be categorized into three primary areas:

 

•                  themedical/practitioner channel, which might include physicians, conditionspecialists, chiropractors, nutritionists, or trainers who promote or prescribeour product,

•                  retail,which may include health/nutrition stores, grocery stores, or other retail outlets,and

•                  consumer-direct,such as call centers and websites.

 

Each of these channels isused for certain products and/or product lines and the sales and marketingefforts and methodologies vary.

 

*Medical/Practitioner*

 

We distribute a varietyof our products through the medical/practitioner distribution channel,including Essentum, GreensFIRST, and a variety of our Christopher’s OriginalFormulas and Nature’s Dose or other related products. While each of the latterthree is sold through established channels as acquired during 2003 and 2002,the uniqueness of Essentum has caused us to enter into the following agreementsin order to reach a specific market:

 

In August 2001, wesigned a three-year agreement with the Arizona Heart Institute (“AHI”), whichthrough its affiliates serves between 22,000 to 25,000 new patients each yearwith a database of over 150,000 heart patients to which AHI will market anddistribute Essentum. Under our agreement, we are obligated to pay royalties toAHI in the amount of 12% or 6% of our net sales of Essentum, depending on theirorigin. Sales of Essentum accounted for approximately 2% of total revenueduring the year ended December 31, 2003 and we paid AHI a commission ofapproximately $3,600. Also pursuant to the agreement, we issued to AHI anoption to purchase 1,000,000 shares of our common stock at an initial exerciseprice of $0.35 per share. Of the 1,000,000 options, the right to purchase600,000 shares vested when AHI agreed to endorse the logo material and theremainder vests as follows:

 

•                  theright to purchase 200,000 shares of common stock will vest when aggregate grosssales of our products by the Institute and its affiliated clinics totals $1.0million; and

•                  theright to purchase 200,000 shares of common stock will vest when aggregate grosssales of our products by the Institute and its affiliated clinics totals $1.5million.

 

In July 2003, weexecuted an amendment with AHI extending the term for an additional year,providing a “net exercise” provision for 100,000 shares of common stock, andvarious other minor provisions. AHI also agreed not to sell in excess of 25,000shares received in any rolling 30 day period. In October 2003, AHIexercised its rights under the net exercise provision and was issued 100,000 sharesof our common stock in exchange for 132,407 options.

 

In August 2001, we entered into a non-exclusive five-yeardistribution agreement with AHI Hong Kong, Ltd. (“AHIHK”), an affiliate of AHI,to market our cardiovascular medical food supplements regimen in China. AHIHKcurrently supplies products and equipment to treat cardiovascular disease toChinese physicians, hospitals, and clinics, and collaborated with the Chinesegovernment to build the first American-style heart hospital, which opened inBeijing in 2003. Under the terms of our agreement, AHIHK is to act in thecapacity of an exclusive distributor of our products in China, Taiwan, and HongKong. The products will be purchased by AHIHK at a designated premium over ourcost. In consideration, we issued AHIHK an option to purchase 1,000,000 sharesof our common stock at an exercise price of $0.35 per share, 300,000 of whichvested immediately, however, are subject to divestiture if gross aggregatesales of our products does not equal or exceed $2.0 million within the first 30months of the agreement. The remainder vests in installments based on attaininggross aggregate sales ranging from $5.0 to $15.0 million. DuringJuly 2003, as part of an amendment to its agreement, the Company agreed toprovide for the vesting of the 300,000 options without divestiture.

 

*Retail*

 

As a result of ouracquisition strategy during 2003 and 2002, we have access to an extensive andwell-established network, comprised of fifteen large distribution companies andnine natural-product brokerage firms, including such well-known

 

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names as United NaturalFoods and Tree of Life, companies we believe are among the largest distributionentities in the nutraceuticals industry. We have also engaged a third party tomanage our distributor and broker relationships and expand our marketingpresence via established networks and contacts in the industry.

 

*Consumer-Direct*

 

We also have a variety ofproducts that can be marketed and sold directly to consumers via call centers,websites, or other means. We have recently engaged a third party to update andconsolidate our various company and product websites in order to cross-sell ourproduct lines. While this project is still under way, we are now able to takeorders for a majority of our products via the Internet, including our completeline of Christopher’s Original Formulas®, Phil’s Bars/Shakes®, Alma® Bars,Boulder® Bars, and X-Fat®, from a single site, www.HerbShopConnection.com, orsites linked therein.

 

To this end, we executed a five-year marketingagreement in March 2004 with a reseller granting them exclusive rights tomarket and sell X-Fat® over the Internet, subject to certain limitedexceptions, and non-exclusive rights to market X-Fat through print ads, radio,and television. We have retained the rights to market X-Fat through our ownwebsites. The reseller must sell minimum levels of X-Fat within certain periodsor we have the right to terminate the exclusivity or the agreement. Inexchange, we issued the reseller an option to purchase 500,000 shares of commonstock, vesting 100,000 shares upon the sale of each $2.5 million in X-Fat salesup to a maximum of $12.5 million in sales. We also entered into an 18-month exclusive marketing agreement withIonic Marketing in December 2003 pursuant to which Ionic will market andsell X-Fat through radio and television features.  Ionic will also assist us in our media planning during our X-Fatproduct launch.  In exchange for theseservices, we agreed to pay Ionic a percentage of the rates actually paid tomedia outlets for the placement of our features, less charges for cancelled,unaired or rebated features.  IonicMarketing has indicated to us that, based on their experience, they believesales of X-Fat could reach $40-$50 million as our marketing activitiesincrease.  However, we cannot assure youthat these figures could be reached as they are simply estimates and our actualresults could be substantially below these figures.

 

We continue to exploreother possibilities with regard to the distribution of our products nationallyand in other countries and we will evaluate the regulatory and distributionstructures in Europe, Asia, and other major countries to determine the best wayto distribute our products in those markets.

 

**COMPETITION**

 

Our competitors vary by the nature of the distribution channel. Withrespect to the medical/practitioner channel, there exist a limited number ofcompanies selling supplements, including Douglas Labs, IntegrationTherapeutics, Phyto Pharmacia, Metagenics Standard Process, Allergy Research,and Enzymatic Therapy. With respect to the retail and consumer direct channel,there are hundreds of competitors, including companies that market herbalnutritional and homeopathic therapies, supplements, and remedies, such as HerbPharm, Giah Herbs, Natures Way, and Solaray. Furthermore, there are hundreds ofcompetitors, including companies marketing Power Bar, Cliff Bar, Balance Bar,and Odwalla, with whom we compete in the functional food and beverage category.Lastly, our X-Fat product will compete with many other existing products, aswell as a variety of weight-loss treatments, methodologies, or conceptsincluding such names as Trim Spa, Slim Fast, Jenny Craig, and Weight Watchers.

 

Although many of thesecompetitors are substantially larger than us and have greater financialresources, we believe that we will be able to compete favorably with thevitamin and nutritional supplement companies based primarily on our first tomarket, direct distribution approach through physicians who desire to have anutritional line of products to supplement the medical aspects of theirpractice. In addition, we believe the unique nature of certain of our products,including X-Fat and GEOMATRIX, will give us a competitive advantage in themarket.

 

**OTHER**

 

*Trademarks and Patents*

 

We and our subsidiariesown numerous trademarks registered with the U.S. Patent and Trademark Officeand with agencies in certain other major jurisdictions of the world, includingVital Living® (Serial Nos. 75849529, 75845668), Vital Living - The PhysicianNutraceutical Company® (plus a logo) (Serial Nos. 78166678, 78975112),Essentum® (Serial No. 76404891), Essentum For Cardiovascular Health® (plus alogo) (Serial Nos. 78975116, 78166675), X-Fat® (Serial No. 75629006), Phil’sBar® (plus logo) (Serial No. 76338490), Phil’s Shake® (plus logo) (Serial No.76338491), Alma Bar® (Serial No. 76375373), Boulder Bar® (Serial No. 75642792),Boulder Bar Endurance® (Serial No. 74648798), Boulder Bar Organic® (Serial No.78276682), Christopher’s Original Formulas® (Serial No. 76413473) andGreensFirst® (Serial No. 76256859).  Wealso have many common law, unregistered trademarks and a patent with respect toour liquid chitosan formula used in

 

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our X-Fat® product(Patent No. 6,323,189).

 

Federally registeredtrademarks have a perpetual life, as long as they are renewed on a timely basisand used properly as trademarks, subject to the rights of third parties to seekcancellation of the marks. We believe that our registered and unregisteredtrademarks, patents, and other proprietary rights are valuable assets and thatthey have significant value in the marketing of our products. Accordingly, weintend to vigorously protect our intellectual property against infringement.

 

*Research and Development*

 

Our efforts are focusedon developing, testing, and substantiating the efficacy of new products inresponse to what we perceive is a need in the traditional medical distributionchannel to complement existing medical conditions that are currently treatedsurgically or with prescription medications. We also intend to continuallyreformulate existing products in response to new clinical or scientificliterature. Our existing retail supplements are proven products that require nofurther testing to be saleable. New condition-specific products that we aredeveloping or producing are assembled by designated manufacturers utilizingproven ingredients that were not developed by us, but are uniquely blended toour specifications.

 

We believe that flexibilityand innovation with respect to new products are crucial factors in remainingcompetitive in the field of nutritional supplements and being able to producethe most effective products, which physicians will be willing to prescribe fortheir patients for specific conditions. By monitoring market trends andavoiding short-lived “fad” products, we will attempt to anticipate physiciandemand for certain product categories. Maintaining flexibility will enable usto capitalize on emerging sciences relative to nutritional products, as well asshifts in patient needs.

 

Researchand development costs amounted to $410,648 and $510,436 for the periods ended December 31, 2003 and 2002, respectively.Through December 31, 2003, research and development costs incurred sinceinception are $958,584.

 

*Raw Materials and Quality Control*

 

The principal rawmaterials used in the manufacture of our medical food supplements are naturalingredients purchased from manufacturers primarily in the United States, withcertain materials imported from other countries. We purchase these rawmaterials directly; therefore, together with our suppliers, we maintain theresponsibility for documenting all certificates of analysis for the materialsin accordance with good manufacturing practices (“GMP”) and guidelines. The rawmaterials are sent directly to us or our manufacturers for milling and otherfabrication. We believe that the materials purchased from suppliers are readilyavailable from numerous sources and that the loss of these suppliers would notadversely affect our operations. Our in-house manufacturing practices do notcurrently meet GMP guidelines; however, we are progressing toward suchcertification.

 

Historically, we have notexperienced difficulties obtaining raw ingredients for our products oncustomary terms. However, the supply of herbal products is subject to the samerisks normally associated with agricultural production, such as climaticconditions, insect infestations, and availability of manual labor or equipmentfor harvesting. Any significant delay in, or disruption of, the supply of rawmaterials could:

 

•                  substantiallyincrease the cost to us of these materials;

•                  requireus to reformulate and repackage our products;

•                  requireus to find new suppliers; or

•                  resultin a substantial reduction or termination by us of our sales of certainproducts.

 

If supply shortages wereto occur and we were unable to meet the demands of our customers, even if foronly a short time, the result could be a long-term decrease in the anticipatedsales of our products. We cannot assure you that, on a long-term basis, anadequate supply of ingredients will be available to us and on termscommercially reasonable in order for us to meet the supply obligations to ourcustomers.

 

Finished products areproduced and delivered from our manufacturers, which maintain modern qualitycontrol laboratories and testing facilities. It is our intent to pay only forthe actual milling of the product and its subsequent packaging. When productsare ready for packaging, automated equipment counts the tablets and capsules,inserts them into packets that are packed in a convenient dispensing box, whichis protected by a tamper-resistant outer safety seal. All of this is done byour manufacturers according to current GMP.

 

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*Government Regulation*

 

The formulation,manufacturing, packaging, labeling, advertising, distribution, and sale(hereafter, collectively “sale” or “sold”) of dietary and nutritionalsupplements such as those sold by us are subject to regulation by one or morefederal agencies, principally the Food and Drug Administration (“FDA”), theFederal Trade Commission (“FTC”), and to a lesser extent the Consumer ProductSafety Commission and United States Department of Agriculture. Our activities arealso regulated by various governmental agencies for the states and localitiesin which our products are sold, as well as by governmental agencies in certaincountries outside the United States. Among other matters, regulation by the FDAand FTC is concerned with product safety and claims made with respect to aproduct’s ability to provide health-related benefits.

 

Federal agencies,primarily the FDA and FTC, have a variety of procedures and enforcementremedies available to them, including:

 

•                  initiatinginvestigations,

•                  issuingwarning letters and cease and desist orders,

•                  requiringcorrective labeling or advertising,

•                  requiringconsumer redress such as requiring that a company offer to repurchase productspreviously sold to consumers,

•                  seekinginjunctive relief or product seizures,

•                  imposingcivil penalties or

•                  commencingcriminal prosecution.

 

In addition, certainstate agencies have similar authority. These federal and state agencies have inthe past used these remedies in regulating participants in the dietarysupplements industry, including the imposition by federal agencies of civilpenalties in the millions of dollars against a few industry participants. Wecannot assure you that the regulatory environment in which we operate will notchange or that such regulatory environment, or any specific action takenagainst us, will not result in a material adverse effect on our operations. Inaddition, increased sales of, and publicity about, dietary supplements mayresult in increased regulatory scrutiny of the dietary supplements industry.

 

The Dietary SupplementHealth and Education Act (“DSHEA”) was enacted in 1994, amending the FederalFood, Drug, and Cosmetic Act. We believe the DSHEA is generally favorable toconsumers and to the dietary supplement industry. DSHEA establishes a statutoryclass of “dietary supplements,” which includes vitamins, minerals, herbs, aminoacids, and other dietary ingredients for human use to supplement the diet.Dietary ingredients on the market as of October 15, 1994 do not requirethe submission by the manufacturer or distributor to the FDA of evidence of ahistory of use or other evidence of safety establishing that the ingredientwill reasonably be expected to be safe, but a dietary ingredient which was noton the market as of October 15, 1994 may need to be the subject of such asubmission to FDA at least 75 days before marketing. Among other things, theDSHEA prevents the FDA from regulating dietary ingredients in dietarysupplements as “food additives” and allows the use of statements of nutritionalsupport on product labels. The FDA has issued proposed and final regulations inthis area and indicates that further guidance and regulations are forthcoming.We cannot assure you that the FDA will accept the evidence of safety for anynew dietary ingredient that we may decide to use and the FDA’s refusal toaccept such evidence could result in regulation of such dietary ingredients asfood additives, requiring FDA pre-approval based on newly conducted, costlysafety testing. In addition, while the DSHEA authorizes the use of statementsof nutritional support in the labeling of dietary supplements, the FDA isrequired to be notified of such statements. We cannot assure you that the FDAwill not consider particular labeling statements used by us to be drug claimsrather than acceptable statements of nutritional support, thereby necessitatingapproval of a costly new drug application, or re-labeling to delete suchstatements.

 

In November 1998,the FTC announced new advertising guidelines specifically for the dietarysupplement industry, entitled “Dietary Supplements: An Advertising Guide forIndustry.” These guidelines reiterate many of the policies the FTC haspreviously announced over the years, including requirements for substantiationof claims made in advertising about dietary supplements.

 

The DSHEA also authorizesthe FDA to promulgate GMP guidelines for dietary supplements, which requirespecial quality controls for the manufacture, packaging, storage, anddistribution of supplements. We contractually require that any independentthird party manufacturers doing business with us comply with all existing, orto be promulgated, regulations. The DSHEA further authorizes the FDA topromulgate regulations governing the labeling of dietary supplements, includingclaims for supplements pursuant to recommendations made by the PresidentialCommission on Dietary Supplement Labels. These rules, which were issued on orafter September 23, 1997, entail specific requirements relative to thelabeling of our dietary supplements. The rules also require additional recordkeeping and claim substantiation, reformulation, or

 

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discontinuance of certainproducts, which would be a material expense to us.

 

The sale of our productsin countries outside the United States is regulated by the governments of thosecountries. We are not currently marketing our products outside of the UnitedStates except in China, Mexico, and the United Kingdom. Our plans to commenceor expand sales in those countries may be prevented or delayed by suchregulation. While compliance with such regulation will generally be undertakenby international distributors, we may assist with such compliance and incertain cases may be liable if a distributor fails to comply.

 

We cannot predict thenature of any future laws, regulations, interpretations, or applications, norcan we determine what effect such additional regulation, when and if it occurs,would have on our business in the future. Such additional regulation could require,however, any or all of the actions listed below, which could have a materialadverse effect on our operations:

 

•                  thereformulation of certain products to meet new standards,

•                  therecall or discontinuance of certain products,

•                  additionalrecord keeping,

•                  expandeddocumentation of the properties of certain products,

•                  revised,expanded or different labeling or

•                  additionalscientific substantiation.

 

**PERSONNEL**

 

As of March 15,2004, we employed 55 individuals, 45 of whom were full time. Of the total, 22were engaged in sales and marketing, 15 were engaged in production oroperational activities, and 18 were engaged in finance, administration, ormanagement functions. None of our employees is subject to any collectivebargaining agreements and we believe our relationship with our employees issatisfactory. Our future success will depend, in part, on our ability toattract, retain, and motivate highly qualified personnel.

 

**RISKFACTORS**

 

You should considercarefully the following risk factors and all other information contained hereinbefore purchasing our common stock. Investing in our common stock involves ahigh degree of risk. We have included in the risk factors set forth below adiscussion of each material risk that we have identified as of the date of thisdocument. If any of the following risks actually occur, our business, financialcondition or operating results will suffer. Moreover, the price of our commonstock could decline and you could lose all of your investment.

 

***Risk related to our operations***

 

**Our significant losses and negative cash flow raise questionsabout our ability to continue as a going concern.**

 

We have only a limitedoperating history and our business model has not yet been thoroughly tested inthe market place. Our annual report must be considered in light of the risks,expenses and difficulties frequently encountered in establishing a business inthe nutraceuticals industry, which is characterized by a large number of marketparticipants, intense competition, and a high failure rate. We incurred a netloss of approximately $27.94 million and $3.95 million for the years endedDecember 31, 2003 and 2002, respectively, and currently have a negativenet tangible worth. We cannot assure you that we will be able to achieve or sustainrevenue growth, profitability or positive cash flow on either a quarterly orannual basis or that profitability, if achieved, will be sustained. If we areunable to achieve or sustain profitability, we may not be financially viable inthe future and may have to curtail, suspend or cease operations. Because of ourrecurring operating losses and negative cash flow, the reports of ourindependent accountants relating to the financial statements for the fiscalyears ended December 31, 2003 and 2002 contain an explanatory paragraphstating that they have substantial doubt about our ability to continue as agoing concern.

 

**If we are unable to generate cash from operations, we mayneed to raise additional funds in the near future.**

 

Our capital requirementscontinue to be adversely affected by our inability to generate cash fromoperations. We had working capital (deficit) of $(97,979) and $783,705 atDecember 31, 2003 and 2002, respectively. Historically, we have beendependent on equity or debt financings to fund our development and workingcapital needs and completed offerings of $4,587,738 aggregate principal inSenior Secured Convertible Notes, which includes the conversion of $1,587,738 in Bridge Note principal andaccrued interest, during the fourth quarter of 2003, and an offering of 510,000 shares of ourcommon stock raising gross proceeds of $510,000 in the first quarter of 2004.  Our average net cash expenditures (cash fromoperations less expenses paid) from January to April 2004 wereapproximately $506,000 per month. However, these may vary greatly on a monthly basis and this average isnot necessarily indicative of future amounts. We need to raise additional capital in the very near future to fund ouroperations and are currently examining

 

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various sources ofadditional financings.  However, becauseour Senior Secured Convertible Notes are secured by substantially all of ourassets, we may have difficulty securing additional debt financing on termsfavorable to us or at all. We may not be able to consummate an equity financingeither, but if we do, it may be highly dilutive to existing stockholders. If wecontinue to be unable to generate cash flow from operations and are unable tofind sources of funding, it would have an adverse impact on our ability tomaintain our operations.

 

**We may lose our exclusive licensing rights to the GEOMATRIXtechnology if SkyePharma terminates the Development and License Agreement whichwe are a party to.**

 

We are party to aDevelopment and License Agreement with SkyePharma PLC pursuant to which we haveexclusive licensing rights to the GEOMATRIX technology.  We are in dispute with SkyePharma over theterms of the licensing agreement and have failed to make payments of $250,000 calledfor under the licensing agreement in January and in April 2004.  On April 6, 2004, we received a demandletter from SykePharma related to the past due payments under the Developmentand License Agreement, which triggered the 30 day negotiation period under theagreement.  This 30 day period is required before initiating formalcollection proceedings.  We arecurrently in discussions to modify both the terms and payment schedules underthe licensing agreement.  Although ourmanagement believes we will reach a settlement of the terms and conditions ofthe agreement with SkyePharma, we cannot assure you that these negotiationswill be successful and we will reach a satisfactory resolution of thismatter.  In the event a satisfactoryresolution can not be reached and SkyePharma exercises their rights oftermination under the agreement, we may lose substantial and possibly allrights gained under this and related contracts with SkyePharma.  However, until Skye exercises itstermination rights under the Development and License Agreement, the Company'srights under the agreements are deemed to be in full force and effect and therelated intangibles have not been impaired.

 

**Our potential acquisition strategy may subject us toadditional risks.**

 

While we recently agreedto forego acquisitions in the short-term in conjunction with obtaining ourDecember 2003 Senior Secured Convertible Notes, one of our potentialbusiness strategies is to achieve growth through acquisitions. Due to the earlystages of our acquisition program, we cannot assure you as to the long-termimpact of our acquisition strategy on our gross profits or net income. During2003, the acquisition strategy may have contributed towards our net loss inseveral respects. First, certain of the acquired companies have continued toincur losses from operations, or have required significant cash advances,which, in turn, has adversely affected our results of operations. Second, ouracquisition strategy has caused us to significantly increase our selling,general, and administrative expenses, which has also contributed negativelytoward our results of operations. As net sales continue to increase, however,our overhead will be spread over a larger revenue base, which is expected tohave a positive impact on our results of operations.

 

We anticipate that futureprofitability is likely to depend upon a combination of many factors, includingthe continued growth of our business through acquisitions, the management ofthat growth through integration of the businesses acquired, and the continuedexpansion of our higher margin service business. Continuation of our growthstrategy, however, is dependent upon a number of factors. First, we mustcontinue to have adequate capital resources to continue to finance theacquisitions. In view of our recent losses and limited available financing, ourability to finance cash acquisitions is presently limited. Second, thecontinued availability of an adequate supply of acquisition targets atreasonable purchase prices. Increased competition for acquisition candidates couldreduce the pool of available targets and could increase acquisition prices.

 

In addition, in order topursue our acquisition strategy in the long term, we may require additionalfinancing, which we could attempt to secure through a combination of traditionaldebt financing, the issuance of our shares, and the placement of debt andequity securities. To the extent acquisitions can be financed through oursecurities, the need for cash resources is somewhat mitigated. However, in theevent our common stock does not attain or maintain a sufficient market value,or potential acquisition candidates are otherwise unwilling to accept commonstock as part of the consideration for the sale of their businesses, we will berequired to utilize more of our cash resources, if available, in order tomaintain our acquisition program. If we do not have sufficient cash resources,our growth could be limited unless we are able to obtain additional capitalthrough debt or equity financing.

 

**If we are unable to repay our indebtedness and interestobligations when due, our operations may be materially adversely affected.**

 

In connection with thevarious acquisitions we completed during 2003 and 2002, we have assumed a totalof $1,478,928 of indebtedness. We also recently issued $4,587,738 aggregateprincipal amount of Senior Secured Convertible Notes, which includes the conversion of $1,587,738in Bridge Note principal and accrued interest, which are secured bysubstantially all of our assets. We cannot assure you that our operations willgenerate funds sufficient to repay these debt obligations as they come due.Additionally, although we have placed a portion of the proceeds from ouroffering of Senior Secured Convertible Notes into escrow to cover our firstyear of interest obligations due on such notes, we cannot assure you that wewill be able to repay future interest obligations as

 

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they come due. Ourfailure to repay our indebtedness and make interest payments as required bythese debt obligations could result in an event of default under the SeniorSecured Convertible Notes. If this happened, the holders of our Senior SecuredConvertible Notes could force us to sell our assets in order to repay debtowing under the notes.

 

**We may record future losses because continuing adverse marketconditions may require us to record an impairment of goodwill and otherintangibles.**

 

We had approximately $4.2million and $4.9 million of goodwill as of December 31, 2003 and 2002,respectively, and approximately $41.5 million and $330,000 of net intangibleassets at December 31, 2003 and 2002, respectively, cumulativelyaccounting for approximately 90% and 73% of our total assets atDecember 31, 2003 and 2002, respectively. We adopted Statement ofFinancial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,”and are required to analyze our goodwill and other intangible assets forimpairment issues on an annual basis or when events occur that would indicatethat an impairment had occurred. The value of our goodwill and other intangibleassets is exposed to future adverse changes if we experience declines inoperating results or experience significant negative industry or economictrends or if future performance is below historical trends. We periodicallyreview goodwill and intangible assets for impairment using the guidance ofapplicable accounting literature. We are subject to financial statement risk tothe extent that the goodwill and other intangible assets become impaired, andany impairment losses related to goodwill and other intangible assets mayresult in a non-cash charge to earnings.

 

**If we are unable to compete effectively with existing or newcompetitors, our existing business will decline and our anticipated businessplan will not be successfully implemented.**

 

We believe the market fornutritional products is continually evolving, and is highly dependent uponchanges in the demographic and social trends that have resulted in tremendousgrowth for the nutrition industry in the past few years. We will encounter aggressivecompetition from numerous competitors, many of whom have significantly greaterfinancial, technical, marketing, and other resources than we do. In makingdecisions regarding the development of new products and the enhancement andextension of our current products, we will be competing with our competitors,who will also be attempting to anticipate the needs and preferences ofconsumers, physicians, and nutritionists. Consumer preferences, particularly inthe health and nutraceuticals market, are continuously changing and aredifficult to predict. We believe we can compete effectively by reacting quicklyto expected and perceived customer requirements and desires and by maintainingrelationships with our existing strategic partners, and identifying andreaching agreements with new partners. However, we cannot assure you that ourassessment of the market place is correct, or that our products will beaccepted now or in the future.

 

**If we do not gain support from the medical community for ourproducts and services, our anticipated levels of sales would be significantlyreduced.**

 

We are marketingourselves as the “Physician Pharmaceuticals Company.” In connection with ouracquisition of ENI, we have obtained licenses for pharmaceutical products inChina, as well as other assets, and have built our business model around thebelief that doctors will eventually recommend our products in a manner similarto the prescription of medicine. In the United States, herbal dietarysupplements have been available for many years, but many physicians have shownreluctance to recommend them to their patients and there has been controversyabout their use and concerns about their interactions with pharmaceuticalproducts. Accordingly, we cannot assure you that our products will achieve orsustain market acceptance by either patients or the medical community. If themedical community does not embrace our concept, we will need to completelyre-evaluate our business model and consider other ways to market our products.

 

**Since we rely on third parties to market our products, we maybe adversely affected if these third parties are not effective in theirmarketing activities.**

 

Other than on ourwebsite, we do not directly market our own products.  Rather we utilize third parties to assist in marketing, selling,and distributing our products. However, even under our existing arrangementswith distributors, sales of our products are subject to all of the market risksassociated with the introduction of products in new distribution channels.Accordingly, although we intend to enter into additional third partyarrangements for our current or future products that we may develop or acquire,we cannot assure you that third parties will purchase, recommend, or market ourproducts at sufficient levels or provide our products with adequate support. Ifthe companies we rely on to market our products do not do so effectively, wewill not generate significant revenues or profits.

 

**If the Arizona Heart Institute withdraws support for ourproducts, our business plan could be severely impacted.**

 

We have an agreement withthe Arizona Heart Institute, Inc. (“AHI”), the nation’s first freestandingoutpatient clinic devoted solely to the prevention, detection, and treatment ofheart and blood vessel diseases, to distribute our product Essentum®. Under ouragreement with AHI, which began in August 2001, AHI agreed to act in thecapacity of a strategic partner in the distribution of our nutraceuticals

 

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products. Additionally,AHI has agreed not to promote or endorse any other line of nutritional productsrelative to cardiovascular disease. AHI also agreed to provide a marketingplatform for the sale of our nutritional products by assisting in clinicaltrials, in allowing us to use the AHI logo on our products and handling thedissemination of information through their existing database, in addition toother assistance (such as introductions to other heart institutes). AlthoughAHI has agreed not to promote any other products, it is possible that a competitiveproduct could be developed that it considers superior to ours. If this occurs,AHI may have an ethical obligation to recommend this product to its customers,notwithstanding the potential that this would be a breach of our agreement.

 

**If we are unable to obtain raw materials for our products,our business will be adversely affected.**

 

Historically, we have nothad any difficulties obtaining the raw ingredients for our products oncustomary terms. However, the supply of herbal products is subject to the samerisks normally associated with agricultural production, such as climaticconditions, insect infestations, and availability of manual labor or equipmentfor harvesting. Any significant delay in, or disruption of, the supply of rawmaterials could:

 

•                  substantiallyincrease the cost to us of these materials;

•                  requireus to reformulate and repackage our products;

•                  requireus to find new suppliers; or

•                  resultin a substantial reduction or termination by us of our sales of certainproducts.

 

If any of thesesituations occurred, it could have a material adverse effect on our businessand operations.

 

**Our failure to comply with current or future governmentalregulations could adversely affect our business.**

 

The formulation,manufacturing, packaging, labeling, advertising, distribution, and sale ofdietary supplements such as those sold by us are subject to regulation by anumber of federal, state and local agencies, principally, the Food & DrugAdministration (“FDA”) and the Federal Trade Commission (“FTC”), as well asforeign agencies in areas where we may operate. Among other matters, thisregulation is concerned with product safety and claims made with respect to aproduct’s ability to provide health-related benefits. These agencies have avariety of procedures and enforcement remedies available to them, including:

 

•                  initiatinginvestigations;

•                  issuingwarning letters and cease and desist orders;

•                  requiringcorrective labeling or advertising;

•                  requiringconsumer redress such as requiring that a company offer to repurchase productspreviously sold to consumers;

•                  seekinginjunctive relief or product seizures; and

•                  imposingcivil penalties or commencing criminal prosecution.

 

Federal and stateagencies have in the past used these remedies in regulating participants in thedietary supplements industry, including the imposition by federal agencies ofcivil penalties in the millions of dollars against a few industry participants.In addition, publicity related to dietary supplements may result in increased regulatoryscrutiny of the nutritional supplements industry.

 

Our failure to complywith applicable laws could subject us to severe legal sanctions, which couldhave a material adverse effect on our business and results of operations. Wecannot assure you that the regulatory environment in which we operate will notchange or that such regulatory environment, or any specific action takenagainst us, will not result in a material adverse effect on our business andoperations. We cannot assure you that a state will not interpret claimspresumptively valid under Federal law as illegal under that state’sregulations, or that future FDA regulations or FTC decisions will not restrictthe permissible scope of such claims. Additionally, we cannot assure you thatsuch proceedings or investigations or any future proceedings or investigationswill not have a material adverse effect on our business or operations.

 

**If weare deemed to be subject to the federal Medicare Anti-Kickback statutes orsimilar state statutes, it could have a material adverse effect on our businessand operations.**

 

The healthcare industryis subject to extensive federal and state regulation relating to licensure,conduct of operations, ownership of facilities, addition of facilities andservices, and payment for services. As Essentum® is not subject to Medicare orMedicaid reimbursement, we do not believe that our activities are subject toregulation under the federal Anti-Kickback statutes. The Anti-Kickback statutesgenerally prohibit persons from knowingly and willfully soliciting, receiving,offering or providing remuneration, directly or indirectly, to induce eitherthe referral of an individual, or the furnishing, recommending, or arrangingfor a good or service, for which payment may be made under a federal healthcareprogram such as the Medicare and Medicaid programs. However, the statute wasdrafted broadly and it has resulted in many arrangements and practices that arelawful in businesses outside of the

 

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healthcare industry to bedeemed unlawful. As a result, there has been a lack of uniform interpretationof the Anti-Kickback statutes, which make compliance even more difficult. Thepenalties for violating these statutes can be severe and include criminalpenalties and civil sanctions, fines, imprisonment and possible exclusion fromthe Medicare and Medicaid programs. Many states have adopted laws similar tothe federal Anti-Kickback statutes. Some of these state prohibitions apply toreferral of patients for healthcare services reimbursed by any source, not onlythe Medicare and Medicaid programs. Although we believe that we comply withboth federal and state anti-kickback laws, any finding of a violation of theselaws could subject us to criminal and civil penalties or possible exclusionfrom federal or state healthcare programs. Such penalties would adverselyaffect our financial performance and our ability to operate our business.

 

**Our insurance may be inadequate to cover us against productliability claims that may be brought against us.**

 

We maintain liabilityinsurance for us and our subsidiaries with policy limits generally of $1.0million per occurrence and $2.0 million in the aggregate. Our insurance programincludes property, casualty, comprehensive general liability, and products liabilitycoverage. We believe that our insurance coverage is adequate. The testing,marketing, and sale of health care products entail an inherent risk of productliability. We cannot assure you that product liability claims relating todietary supplement products will not be asserted against us, our licensees, orthird parties with whom we operate. Many claims related to dietary supplementshave already been brought against businesses in our industry, although noneagainst our products or us. Further, we cannot assure you that such insurancewill provide adequate coverage against any potential claims. A productliability claim or product recall could have a material adverse effect on ourbusiness, financial condition, or results of operations.

 

**We may have difficulty effectively managing our growth.**

 

Over the past severalyears, we have experienced significant growth in our business activitiesthrough a variety of transactions, including our acquisitions of MAF, COF, ENI,and DFN. Although we agreed with the holders of our Senior Secured ConvertibleNotes that we would not enter into certain acquisition agreements for specificperiods of time, we expect our business to continue to grow throughacquisitions in the future. Growth of this nature involves numerous risks suchas:

 

•                  difficultiesand expenses incurred in connection with the subsequent assimilation of theoperations and services or products of the acquired company;

•                  thepotential loss of key employees of the acquired company; and

•                  thediversion of management’s attention from other business concerns.

 

If we are unable toeffectively address these risks, we may be required to restructure the acquiredbusiness or write off the value of some or all of the assets of the acquiredbusiness. Further, this type of growth requires increased investments inmanagement personnel, financial and management systems and controls, andfacilities. We cannot assure you that we will experience parallel growth inthese areas. If these areas do not grow at the same time, our operating marginsmay decline from current levels.

 

**We depend on one of our key employees and the loss of hisservices could harm our business.**

 

We are heavily dependentupon Stuart A. Benson, our Chief Executive Officer and President. We haveentered into an employment agreement with Mr. Benson that provides for him tobe employed by us through August 2006. However, he may terminate theagreement at any time upon 60 days’ notice to us. The loss of Mr. Benson couldhave a material adverse effect on us. Under the terms of the employmentagreement, we are permitted to apply to obtain, and have made application withrespect thereto, for a “key-man” insurance policy for Mr. Benson in the amountof $1,000,000. We will be the beneficiary of this policy when and if theinsurance is obtained.

 

***Risks related to our common stock***

 

**Our existing stockholders will experience dilution if weissue additional securities.**

 

In December 2003,our Board of Directors and a majority of our stockholders approved an increasein our authorized capital from 100,000,000 shares of common stock to150,000,000 shares of common stock. As of March 26, 2004, we haveoutstanding 61,456,004 shares of common stock (excluding 1,242,887 shares ofcommon stock that is currently in the process of being issued for conversion ofour Series A Preferred Stock which occurred in December 2003), 2,500,000shares of preferred stock currently convertible into 2,500,000 shares of commonstock, options to purchase 3,831,483 shares of common stock, warrants topurchase shares of common stock and Senior Secured Convertible Notes initiallyconvertible into 4,587,738 shares of common stock. If we issue additionalshares, or if our existing stockholders exercise or convert their outstandingoptions, warrants, or notes, our other stockholders may find their holdingsdrastically diluted, which if it occurs, means that they will own a smallerpercentage of our company. Further, any issuance of additional securities tovarious persons or entities in lieu of cash payments will lead to furtherdilution. If all convertible instruments

 

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were converted and alloutstanding warrants and options were exercised, we would have 98,593,764shares of common stock outstanding.

 

**We are party to a voting agreement pursuant to which certainofficers, directors and stockholders can elect a majority of our Board ofDirectors.**

 

We are party to a votingagreement with Stuart A. Benson, our Chief Executive Officer, Donald C. Hannah,a member of our Board of Directors, and SkyePharma, PLC and Fifth AvenueCapital, Inc., both significant stockholders. Under this agreement, the partieshave the ability to elect a majority of our Board of Directors. As a result,they will be able to approve most, if not all, of our corporate actions, includingthe appointment of officers.

 

**Because the market price of our common stock is highlyvolatile, it is difficult to determine the true value of our company.**

 

Our common stock has beentraded on the OTC Bulletin Board since March 28, 2002. The market price ofour common stock has been highly volatile and may continue to be volatile inthe future. As a result of our share price volatility, it is difficult todetermine the true market value of our company. Significant volatility in themarket price of our common stock may arise due to factors such as:

 

•                  ourdeveloping business;

•                  acontinued negative cash flow;

•                  relativelylow price per share;

•                  relativelylow public float;

•                  variationsin quarterly operating results;

•                  generaltrends in the nutraceuticals and health care industry;

•                  thenumber of holders of our common stock; and

•                  theinterest of securities dealers in maintaining a market for our common stock.

 

As long as there is onlya limited public market for our common stock, the sale of a significant numberof shares of our common stock at any particular time could be difficult toachieve at the market prices prevailing immediately before such shares areoffered and could cause a severe decline in the price of our common stock.

 

**Because our common stock is subject to the SEC’s penny stockrules, broker-dealers may experience difficulty in completing customertransactions and trading activity in our securities may be adversely affected.**

 

Because we currently haveless than $5,000,000 of net tangible assets and the market price of our commonstock is less than $5.00 per share, transactions in our common stock aresubject to the “penny stock” rules promulgated under the Securities ExchangeAct of 1934. Under these rules, broker-dealers who recommend our securities topersons other than institutional accredited investors:

 

•                  mustmake a special written suitability determination for the purchaser;

•                  receivethe purchaser’s written agreement to a transaction prior to sale;

•                  providethe purchaser with risk disclosure documents which identify certain risksassociated with investing in “penny stocks” and which describe the market forthese “penny stocks” as well as a purchaser’s legal remedies; and

•                  obtaina signed and dated acknowledgment from the purchaser demonstrating that thepurchaser has actually received the required risk disclosure document before atransaction in a “penny stock” can be completed.

 

As a result of theserules, broker-dealers may find it difficult to effectuate customer transactionsand trading activity in our securities may be adversely affected. As a result,the market price of our securities may be depressed, and you may find it moredifficult to sell our securities.

 

**Our pending registration of certain shares of common stockmay affect the market price and liquidity of our common stock.**

 

In January 2004, wefiled a Registration Statement on Form SB-2 under the Securities Act of 1933 toregister approximately 45 million shares of common stock. Once thisregistration is effective, which we anticipate to occur during the secondquarter of 2004, the selling stockholders will be able to sell these shares inthe public market. The ability on the part of these selling stockholders tomake these sales may have an adverse impact on our ability to raise capital inthe public market and may affect the price and liquidity of our common stock inthe public market.

 

**No dividends have been paid on our common stock.**

 

To date, we have not paidany cash dividends on our common stock and we do not expect to declare or paydividends on the common

 

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stock in the foreseeablefuture. In addition, the payment of cash dividends is limited by the terms ofour outstanding preferred stock and Senior Secured Convertible Notes.

 

**PARTII.**

 

**ITEM6. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**

 

*Overview*

 

Through ouroperating subsidiaries, we develop or license nutraceuticals andpharmaceuticals, marketing them for distribution through physicians, medicalgroups, chiropractic offices, and retail outlets. In addition, we formulate,market, and distribute vitamins, herbs, high quality dietary supplements, andtherapeutic and functional food products through similar distribution channels.Nutraceuticals are products that are isolated or purified from foods andgenerally sold in medicinal forms not usually associated with foods, includingtablets, capsules, or drops. These nutraceuticals may have physiologicalbenefits or have the ability to reduce the risk of chronic disease beyond basicnutritional products. We develop and test our nutraceuticals in collaborationwith leading medical experts in the nutraceuticals field. We have designed themto be incorporated by physicians into a standard physician-patient program inwhich patients supplement doctor-prescribed pharmaceuticals with ournutraceuticals. Our initial areas of focus are cardiovascular health and weightloss.

 

Our business strategy isto capitalize on the growing complimentary and alternative medicine market bycreating scientifically proven and supported condition-specific formulations,offering a broad range of natural, general health nutraceuticals and functionalfoods/beverages, and exploring alternative distribution channels by gainingpractitioner confidence and support for our products. We plan to focusinitially on certain target conditions, including cardiovascular disease andobesity, providing the market with high quality, relevant products through keydistribution channels.

 

*Resultsof Operations*

 

The following sets forthselected financial data and its percentage of net sales for the years endedDecember 31:

 
|                                 |   | **2003**    |        | **2002** |   | **Increase** |   |
|--------------------------------------|--------|-------------|-------------|----------|--------|--------------|--------|
|                                 |   | **Amount**  |        | **%**    |   | **Amount**   |   | **%** |   | **(Decrease)** |   |
| Revenue                              |   | $           | 2,855,123   |     | 100.0  | %            | $      | 260,844 |   | 100.0 | % | $ | 2,594,279 |   |
| Cost  of goods sold                  |   | 1,723,013   |        | 60.3     | %      | 193,032      |   | 74.0 | % | 1,529,981 |   |
| Gross  profit                        |   | 1,132,110   |        | 39.7     | %      | 67,812       |   | 26.0 | % | 1,064,298 |   |
| Administrative  expenses             |   |        |        |     |   |         |   |   |   |   |   |
| Salaries  and benefits               |   | 11,998,759  |        | 420.3    | %      | 1,341,103    |   | 514.1 | % | 10,657,656 |   |
| Professional  and consulting fees    |   | 3,261,078   |        | 114.2    | %      | 1,607,621    |   | 616.3 | % | 1,653,457 |   |
| Selling,  general and administrative |   | 2,054,526   |        | 72.0     | %      | 510,013      |   | 195.5 | % | 1,544,513 |   |
| Research  and development            |   | 410,648     |        | 14.4     | %      | 510,436      |   | 195.7 | % | (99,788 | ) |
| Depreciation  and amortization       |   | 1,972,303   |        | 69.1     | %      | 52,959       |   | 20.3 | % | 1,919,344 |   |
| Impairment  of goodwill              |   | 6,777,480   |        | 237.4    | %      | —       |   | 0.0 | % | 6,777,480 |   |
| Total                                |   | 26,474,794  |        | 927.3    | %      | 4,022,132    |   | 1542.0 | % | 22,452,662 |   |
|                                 |   |        |        |     |   |         |   |   |   |   |   |
| Net  loss from operations            |   | (25,342,684 | )           | (887.6   | )%     | (3,954,320   | )      | (1516.0 | )% | (21,388,364 | ) |
| Other  income (expense)              |   |        |        |     |   |         |   |   |   |   |   |
| Other  expense                       |   | (43,249     | )           | (1.5     | )%     | —       |   | 0.0 | % | (43,249 | ) |
| Interest  income                     |   | 5,322       |        | 0.2      | %      | 13,077       |   | 5.0 | % | (7,755 | ) |
| Interest  expense                    |   | (2,554,421  | )           | (89.5    | )%     | (8,652       | )      | (3.3 | )% | (2,545,769 | ) |
| Net  loss                            |   | $           | (27,935,032 | )        | (978.4 | )%           | $      | (3,949,895 | ) | (1514.3 | )% | $ | (23,985,137 | ) |

 

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*Year Ended December 31, 2003 Compared to Year EndedDecember 31, 2002*

 

*Revenue*:  Total revenue for the years endedDecember 31, 2003 and 2002 was $2,855,123and $260,844, respectively, anincrease of $2,594,279. This increaseis attributable to our various acquisitions during late 2002 and throughout2003 of MAF, COF, and DFN, each contributing approximately $1,370,000,$987,000, and $438,000 in revenues during the year ended December 31,2003, respectively, compared to approximately $138,000 of MAF revenue in 2002.The increase is offset to a lesser extent by decrease in sales of Essentum® in2003.

 

*Cost of Goods Sold and Gross Profit*:Cost of goods sold for the years ended December 31, 2003 and 2002 was $1,723,013 and $193,032, respectively, an increase of $1,529,981. This increase corresponds to the increase in revenuesand is related primarily to our acquisitions of MAF, COF, and DFN, eachcontributing approximately $959,000, $525,000, and $239,000 in cost of goods soldduring the year ended December 31, 2003, respectively. The gross profitpercentage for the years ended December 31, 2003 and 2002 was 39.7% and 26.0%, respectively, an increase of approximately 14%. Thefavorable variance over prior year is substantially a result of a lower thannormal gross profit percentage in 2002 from higher than expected shipping andproduct storage costs that have not continued. The current year’s adjustedgross profit percentage of approximately 40%, which includes gross profit contributedfrom acquired companies, is more indicative of anticipated future results.

 

***AdministrativeExpense*s:**

 

***Salary and benefit costs*** for the yearsended December 31, 2003 and 2002 were $11,998,759 and $1,341,103,respectively, for an increase of $10,657,656.The increase is attributable to the following primary factors, which occurredand were recorded during 2003 without similar transactions in the prior year:1) issuance of 5,000,000 warrants in 2003 to one of our officers, valued at$6,800,000 and recorded as compensation expense; 2) granting of 1,300,000shares of restricted common stock in 2003 to one of our officers, valued at$1,781,000 and recorded as compensation expense, and 3) current year warrantrepricing adjustments in accordance with FIN No. 44(1) of $1,526,461related to 1,340,000 warrants issued to one of our officers in 2002. Theprimary remaining variance in salaries and benefits is attributable to anaggregate cost contribution of approximately $657,000 in 2003 from our variousacquisitions offset to a lesser extent by a decrease in contract labor costsduring 2003.

 

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(1)          Per FIN No. 44, anon-cash charge to compensation expense is required if the price of our commonstock on the last trading day of a reporting period is greater than theexercise price of certain stock options and warrants issued to officers oremployees. The requirements of FIN No. 44 may also result in a credit tocompensation expense to the extent that the trading price declines from thetrading price as of the end of previous reporting period, provided however thata credit is not recorded to the extent our common stock trades below theexercise price of the options or warrants. In accordance with FIN No. 44, weadjust compensation expense upward or downward on a monthly basis based on thetrading price at the end of each period.

 

***Professional and consulting fees***were$3,261,078 and $1,607,621 during the years endedDecember 31, 2003 and 2002, respectively, for an increase of $1,653,457. This increase is primarily aresult of costs associated with the three acquisitions (COF, ENI, and DFN),three preferred stock private placements (Series B, C, and D), and two debtofferings we transacted during 2003. Included in total professional andconsulting fees during 2003 and 2002 is $1,695,556 and $732,427, respectively,of non-cash charges for shares of restricted common stock, options, or warrantsissued in exchange for consulting services rendered in the aforementionedtransactions, accounting for a majority of the overall increase, with theremainder represented by additional cash fees associated with the transactions.

 

***Selling, general, and administrative expenses***for the years ended December 31, 2003 and 2002 were $2,054,526 and $510,013, respectively, for an increase of $1,544,513. A portion of the overallincrease can be attributed to an aggregate cost contribution from acquiredentities of approximately $906,000, which includes such charges as facilities,sales and marketing, and other general and administrative items. The remainingincrease is comprised of additional travel and entertainment costs over prioryear associated with our acquisition, private placement, and debt financingactivities of approximately $147,000, approximately $132,000 of non-cashcharges for common stock issued as a condition to an amendment to our agreementwith the Arizona Heart Institute, our distribution partner for Essentum®, andadditional marketing and advertising costs expended in the current year topromote our company and products.

 

***Research and development costs*** areexpensed as incurred and totaled $410,648and $510,436 for the years endedDecember 31, 2003 and 2002, respectively, decreasing $99,788. During 2002, research anddevelopment costs primarily included the salary of one employee no longeremployed by us, as well as various consulting and travel expenses. In addition,shares of

 

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restricted common stock,options, or warrants were issued during and prior to 2002 for research anddevelopment related consulting contracts for which the associated costs wereamortized over the life of the contracts. As most of these contracts expirednear the end of 2002 or throughout 2003, related amortization declined,resulting in total charges of approximately $257,000 and $274,000 during theyears ended December 31, 2003 and 2002, respectively.

 

***Depreciation and amortization expense***for the years ended December 31, 2003 and 2002 were $1,972,303 and $52,959, respectively, increasing $1,919,344. The increase is primarily attributable to amortizationof intangibles acquired or recorded as part of acquisitions, as well asincreased depreciation related to acquired intangible assets, of approximately$1,906,000.

 

***Impairment of Goodwill and Other Intangible Assets:***Goodwill and other intangibles created by our acquisitions are tested forimpairment at least annually, or upon occurrence of such events that mayindicate impairment exists, in accordance with SFAS No. 142. Due to lower thanexpected third and fourth quarter operating profits and cash flows, we revisedour earnings forecast for the next five years and, as a result, recorded agoodwill impairment loss of $6,777,480during the year ended December 31, 2003. The change in fair value of eachcomponent of goodwill and other intangibles were estimated using the expectedpresent value of future cash flows based on certain operational results andassumptions, as described below.

 

***MAF***.The gross value of goodwill related to the MAF Acquisition was $4,955,199.During the year ended December 31, 2003, we experienced operating incomeof approximately $16,000, before depreciation, amortization, and interestcharges and have been unable to generate positive cash flow from operations todate. We believe these results are due to increased marketplace competition andrelocation of operations from New Jersey to Utah, which caused a temporarydisruption in our focus on the continued growth of the business. Based on ourvarious initiatives, including consolidation of day-to-day operations ofacquired businesses, capitalization on subsidiary management expertise, andexpansion of products into existing distribution channels of other acquiredentities, while factoring in the continued increase in competition for similarproducts, we have projected MAF’s revenue for the next five years and computedthe fair value of the goodwill using the expected present fair value of futurecash flows. As a result, we determined the goodwill recorded because of the MAFAcquisition is impaired by $4,370,683, which has been recorded as goodwillimpairment expense during the year ended December 31, 2003.

 

***NSI***.The gross value of goodwill related to the COF Acquisition was $3,887,797.During the period ended December 31, 2003, we experienced an operatingloss of approximately $533,000, prior to depreciation, amortization, andinterest charges and the entity has been unable to generate positive cash flowfrom operations to date. In our opinion, NSI experienced these results dueprimarily to the use of inadequate manufacturing and distribution facilities,as well as changes in management subsequent to the acquisition. We haveundertaken various initiatives to improve NSI’s operating results, includingfurther consolidation of NSI’s manufacturing operations, increasing our use ofprofessional manufacturing representatives, where appropriate, and adopting amore strategic and cost-effectiveapproach to national tradeshows. We have also engaged an industry authorand radio talk show host with whom we will launch a website and certaincustom-labeled products for marketing and distribution to major metropolitanareas. Based on market conditions and our internal initiatives, we haveprojected NSI’s revenue for the next five years and computed the fair value ofthe goodwill using the expected present fair value of future cash flows. As aresult, we determined the goodwill recorded because of the COF Acquisition isimpaired by $2,406,797, which has beenrecorded as goodwill impairment expense during the year ended December 31,2003.

 

***DFN***.The gross value of goodwill related to the DFN Acquisition is $2,113,416.During the period ended December 31, 2003, we generated operating incomeof approximately $21,000, before depreciation, amortization, and interestcharges. We expect continued increasing net cash flows from operations, as we increase the national distribution ofGreensFIRST® by cross-selling into distribution channels currently served byother subsidiaries and expanding sales of GreensFIRST® into Mexico, Canada andoverseas. We also anticipate launching additional products currently underdevelopment. Based on our analysis, which includes detailed calculations ofprojected discounted future cash flows and assumptions discussed herein, webelieve the goodwill amount at December 31, 2003 is not impaired and havenot recorded an adjustment to the carrying value.

 

***ENI***. Our primary intangibles, outside of goodwilldiscussed above, were obtained in the ENI Acquisition and are comprised ofthree licensing and marketing agreements:

 

(1)          GEOMATRIX®, with an associated grossintangible value of $34,661,058 at December 31, 2003, is our licensedtechnology that will enable us to create time-released nutraceuticals. Pursuantto the terms of the license agreement, GEOMATRIX® is initially being tested insix nutraceuticals products, three of which successfully passed stabilitytesting in February 2004, two are anticipated during second quarter 2004,and the final is to be chosen for development beginning in June 2004. Weintend to utilize a licensing strategy to launch these products, rather thandirect manufacturing, due to the intense capital investment required in thelatter. We anticipate the first of these products to

 

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reachU.S. markets during 2004. Pursuant to the terms of the licensing agreement, wewere obligated to pay development fees of $250,000 in January 2004. We didnot make this payment and are currently in discussions to renegotiate the termsof the contract.

 

We are in dispute withSkyePharma over the terms of the Development and Licensing Agreement withSkyePharma and have failed to make payments of $250,000 called for under thelicensing agreement in January and in April 2004.  On April 6, 2004, we received a demandletter from SykePharma related to the past due payments under the Developmentand License Agreement, which triggered the 30 day negotiation period under theagreement.  This 30 day period is required before initiating formalcollection proceedings.  We arecurrently in discussions to modify both the terms and payment schedules underthe licensing agreement.  Although ourmanagement believes we will reach a settlement of the terms and conditions ofthe agreement with SkyePharma, we cannot assure you that these negotiationswill be successful and we will reach a satisfactory resolution of thismatter.  In the event a satisfactoryresolution can not be reached and SkyePharma exercises their rights oftermination under the agreement, we may lose substantial and possibly allrights gained under this and related contracts with SkyePharma.  Accordingly, amounts recorded as intangibleassets associated with these contracts, which represent substantially all ofour intangible assets, would be impaired. However, until Skye exercises its termination rights under theDevelopment and License Agreement, the Company's rights under the agreementsare deemed to be in full force and effect and the related intangibles have notbeen impaired.

 

(2)          X-Fat®, with a related gross intangible valueof $4,093,118 at December 31, 2003, is our licensed dietary supplementaimed at weight loss and was launched in test markets throughout the U.S. inearly March 2004. Marketing initiatives include radio and televisionadvertisements, as well as the launch of a retail website. Patent rights inmajor European countries have been secured, with expansion into theseterritories expected during the latter half of 2004 through partnerships withestablished companies.

 

(3)          The China Territory Pharmaceuticals marketingagreement, to which a gross intangible value of $4,304,438 is attributed atDecember 31, 2003, provides us with exclusive marketing rights androyalties on existing and future pharmaceuticals that use our licenseddrug-delivery technologies under certain terms defined therein. We areutilizing Stephen Chen, a shareholder and strategic consultant, to facilitatethe expansion into these markets by coordinating initial meetings andestablishing relationships with Chinese pharmaceutical companies. We held thefirst of these meetings in April 2004.

 

Fairvalue was determined at the date of acquisition based on a valuation studyperformed by an independent third party who primarily considered the discountedcash flow and guideline company method. At December 31, 2003, we performedadditional analyses, which include detailed calculations of projecteddiscounted future cash flows and assumptions discussed herein. Based on theseanalyses, we believe the intangibles recorded at December 31, 2003 are notimpaired.

 

***Other Income (Expense):***

 

***Interest Expense*** for the years ended December 31,2003 and 2002 was $2,554,421 and $8,652,respectively, for an increase of $2,545,769. While a small portion of theincrease relates to interest on debt assumed in our various acquisitions,approximately $1,807,000 relates to interest expense recorded for thebeneficial conversion feature, detachable warrants, and amortization ofdeferred debt charges from our December 2003 offering of $4,587,738aggregate principal amount of Senior Secured Convertible Notes. In addition, werecorded approximately $599,000 in interest charges related to shares of ourcommon stock that must be issued to shareholders as a penalty due to ourfailure to timely file and have declared effective a registration statement toregister the shares of common stock issued in our November 2002 privateplacement. The remaining increase is a result of interest incurred on oursenior convertible notes, which were fully converted into the Senior SecuredConvertible Notes referenced above, as well as other interim financing transactions.

 

***Net loss*:** Our net loss for the years endedDecember 31, 2003 and 2002 was $27,935,032 and $3,949,895, respectively,for an increase of $23,985,137. Of these losses, approximately $22,857,854 and$785,386 during 2003 and 2002, respectively, relates to non-cash chargesdescribed herein and as follows and includes only those items that would nothave been required to be settled in cash or other assets by their originalterms.

 
|                                                                                      |   | **2003**   |        | **2002** |   |
|-------------------------------------------------------------------------------------------|--------|------------|-------------|----------|--------|
| Net  loss                                                                                 |   | $          | (27,935,032 | )        | $      | (3,949,895 | ) |
| Non-cash  charges                                                                         |   |       |        |     |   |
| Officer  compensation for common stock, options, warrants and warrant amendments          |   | 10,362,461 |        | —   |   |
| Common  stock, options, and warrants issued for services, including amortization of  such |   | 1,695,556  |        | 732,427  |   |
| Impairment  loss                                                                          |   | 6,777,480  |        | —   |   |
| Interest  and other charges related to debt financing                                     |   | 2,050,054  |        | —   |   |
| Depreciation  and amortization                                                            |   | 1,972,303  |        | 52,959   |   |
| Total  non-cash charges                                                                   |   | 22,857,854 |        | 785,386  |   |
|                                                                                      |   |       |        |     |   |
| Net  loss excluding non-cash charges                                                      |   | $          | (5,077,178  | )        | $      | (3,164,509 | ) |

 

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*Liquidityand Capital Resources*

 

AtDecember 31, 2003, we had approximately $1.7 million in cash, primarily asa result of our December 2003 debt financing in the form of Senior SecuredConvertible Notes. In addition, we have approximately $550,000 of prepaid interestin escrow that will be used to make the 2004 interest payments on such debt.This restricted cash balance represents the significant increase in prepaidexpenses and other current assets on our balance sheet at December 31,2003.

 

Cashflows used in operating activities of approximately $4,722,000 and $2,974,000in 2003 and 2002, respectively, have increased substantially over prior yeardue to the operating expenditures of our acquisitions (MAF, COF, ENI, and DFN),which have not yet begun to generate positive cash flow from operations. Inconnection with these acquisitions, we assumed indebtedness of approximately$1.5 million to be serviced over the next three to four year period. Cash flowsused in investing activities of approximately $483,000 and $181,000 in 2003 and2002, respectively, relate primarily to the cost of our acquisitions, with theremainder representing capital expenditures. We anticipate a slight increase incapital expenditures during 2004 to facilitate the consolidation of our operationsand continued growth. Cash flowsfrom financing activities of approximately $5,560,000 and $4,571,000 in 2003and 2002, respectively, have been positively impacted by our debt and equityfinancings (as outlined below), offset by servicing of indebtedness assumed inour acquisitions.

 

Todate, we have funded our operations and acquisition activity primarily fromcash generated from private placements and with funds from borrowings undervarious debt instruments, as summarized in the table below, generatingan aggregate in net cash proceeds of $10,737,222 during 2003 and 2002.

 

Thefollowing summarizes private placement offerings completed during 2003 and2002:

 
| **Date**                       |   | **Description**      |   | **Shares or  Principal** |   | **Price Per  Share** |   | **Net Cash  Proceeds** |       | **Options  &  Warrants** |   | **Exercise  Price**  |   |
|--------------------------------|--------|----------------------|--------|--------------------------|--------|----------------------|--------|------------------------|------------|------------------------------|--------|----------------------|--------|
| June, 2002                     |   | Series A Preferred   |   | 3,712,000                |   | $                    | 1.00   |                   | $          | 3,593,807                    |   | 859,420(1) Series A  |   | $ | 2.00 |   |
|                           |   |                 |   |                     |   |                 |   |                   |       | 1,367,500 Series  B          |   | $                    | 1.65   |   |
| November, 2002                 |   | Common               |   | 1,367,500                |   | $                    | 1.00   |                   | $          | 1,197,115                    |   | 1,367,500 Series  C  |   | $ | 2.14 |   |
|                           |   |                 |   |                     |   |                 |   |                   |       | 1,000,000 Series  D          |   | $                    | 1.30   |   |
| April, 2003                    |   | Series B Preferred   |   | 1,000,000                |   | $                    | 1.00   |                   | $          | 875,000                      |   | 1,000,000 Series  E  |   | $ | 1.60 |   |
|                           |   |                 |   |                     |   |                 |   |                   |       | 500,000 Series D             |   | $                    | 1.30   |   |
| July, 2003                     |   | Series C Preferred   |   | 500,000                  |   | $                    | 1.00   |                   | $          | 437,500                      |   | 500,000 Series E     |   | $ | 1.60 |   |
| August, 2003                   |   | Series D Preferred   |   | 1,000,000                |   | $                    | 1.00   |                   | $          | 815,000                      |   | N/A                  |   | N/A |   |
|                           |   |                 |   |                     |   |                 |   |                   |       | 3,060,000 No  Series         |   | $                    | 1.00   |   |
| October -  December, 2003 |   | Bridge Notes(2)      |   | 1,530,000                |   | $                    | 1.00   |                   | $          | 1,316,400                    |   | 1,530,000 No  Series |   | $ | 1.50 |   |
| December, 2003                 |   | Senior Secured Notes |   | 4,587,738                | (3)    | $                    | 1.00   |                   | $          | 2,502,400                    |   | 4,587,738 No  Series |   | $ | 1.00 |   |
|                           |   |                 |   |                     |   |                 |   | $                      | 10,737,222 |                         |   |                 |   |   |

 

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(1)          Includes 117,021 warrants to be issued upon conversion of 585,111shares of Series A Preferred Stock issued as dividends.

(2)          Principal and accrued interest of $17,738 on the Bridge Notes convertedinto Senior Secured Notes.

(3)          Includes $1,547,738 ofprincipal and accrued interest invested through the conversion of the BridgeNotes referred to above.

 

In addition to the above offerings, during the fourth quarter of 2003, weentered into short-term notes payable with various shareholders and relatedparties (see ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS),borrowing an aggregate principal amount of $396,672. The notes generallymatured in 60 days and bore interest at stated rates ranging between 10% and28%, with 12 months of interest earned and payable immediately. The notes,including

 

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interest earned of $58,672, were paid in full prior toDecember 31, 2003.

 

*Going concern*

* *

Theaccompanying consolidated financial statements have been prepared assuming wewill continue on a going concern basis, which contemplates the realization ofassets and the satisfaction of liabilities in the normal course of business. Wehave suffered recurring losses from operations, have a working capital deficit,and are dependent on funding from sources other than operations. Sinceinception, we have been required to raise additional capital by the issuance ofboth equity and debt instruments. There are no commitments from prior fundingsources, debt or equity, should cash flows be insufficient to fund ongoingoperations and other cash commitments as they come due. These factors raise substantial doubt about our ability tocontinue as a going concern. We will be required to raise additional capital inthe near term through offerings of securities to fund operations, and willattempt to continue raising capital resources if we do not begin to generaterevenue sufficient to maintain our company as a viable entity. No assurance canbe given that such financing will be available or, if available, that it willbe on commercially favorable terms. Moreover, available financing may bedilutive to current investors.

 

Weare in the process of improving, acquiring, or developing products for salethat would generate revenue to sustain its operations, as well as consolidatingits operations in order to gain cost synergies and efficiencies. If successful, these actions will serve tomitigate the factors that have raised doubt about our ability to continue as agoing concern and increase the availability of resources for funding of ourcurrent operations and future market development. In addition, inMarch and April 2004 we entered into Purchase Agreements withinvestors and sold 510,000 shares of common stock at $1.00 per share withrights to receive a portion of net revenues, as defined therein, from the saleof X-Fat®. The consolidated financialstatements do not include any adjustments relating to the recoverability andclassification of recorded assets or liabilities that might be necessary shouldwe be unable to continue as a going concern.

 

*Critical Accounting Policies*

 

***Acquisitions***

* *

We account for acquisitions in accordance with Statement of FinancialAccounting Standards, (“SFAS”) No. 141 “*BusinessCombinations*” and accordingly apply the purchase method ofaccounting for all business combinations initiated after June 30, 2001 andseparately identify recognized intangible assets that meet the criteria andamortizes these assets over their determinable useful lives.

 

***Goodwill***

* *

Goodwillrepresents the excess of the aggregate price paid by us over the value of thenet equity acquired in an acquisition. In accordance with SFAS No. 142, “*Goodwill and Other Intangible Assets*,”management is no longer required to amortize goodwill, but is required toreview goodwill for impairment at least annually whenever events indicate thatthe carrying amount of the asset may not be recoverable in accordance with SFASNo. 144 “*Accounting for the Impairment orDisposal of Long-Lived Assets*.” As of December 31, 2003, eventshad occurred that would indicate goodwill had been impaired and, accordingly,an impairment loss was recorded.

 

**Intangible assets**

 

Our other intangibleassets include trademarks, patents, formulations, customer lists, and variousmarketing and license agreements. Intangible assets are amortized on astraight-line basis over the lesser of the correlating agreements or estimateduseful lives ranging from 2 to 14 years.

 

##### **Impairment of Long-livedassets**

 

Long-livedassets and identifiable other intangible assets to be held and used arereviewed for impairment at least annually whenever events or changes incircumstances indicate that the carrying amount may not be recoverable.Goodwill and other intangible assets arising from various acquisitions areevaluated for impairment on at least an annual basis or when events occur thatwould indicate that impairment had occurred. Impairment is measured bycomparing the carrying value of the long-lived asset to the estimatedundiscounted future cash flows expected to result from use of the assets andtheir eventual disposition.

 

Assumptionsused include estimates of (i) market share penetration, (ii) timing of productrollouts for new products, (iii)

 

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licensingroyalty percentages, (iv) manufacturing costs, (v) selling prices, (vi) volumessold and (vii) discount rates.  Anychanges in assumptions applied in the cash flow model used to evaluate goodwilland other intangibles for impairment may effect the outcome of theanalysis.  Unfavorable changes inassumptions may result in further impairments of goodwill and otherintangibles.

 

Asof December 31, 2003, events had occurred that would indicate goodwill hadbeen impaired; accordingly, an impairment loss was recorded.

 

***Stock based compensation***

 

We account for our stock option plans in accordance with the provisionsof SFAS No. 123, “*Accounting for Stock BasedCompensation,*” as amended by SFAS No. 148 *“Accounting for Stock-Based Compensation-Transition and Disclosure.”*SFAS No. 123 permits entities to recognize as expense over the vesting periodthe fair value of all stock-based awards on the date of grant. Alternatively,SFAS No. 123 also allows entities to apply the provisions of AccountingPrinciples Board (“APB”) Opinion No. 25, “*Accountingfor Stock Issued to Employees*,” and related interpretations andprovide pro forma net income or loss and pro forma earnings per sharedisclosures for employee stock option grants as if the fair-value-based methoddefined in SFAS No. 123 had been applied.

 

We are subject toreporting requirements of FASB Financial Interpretation No. (“FIN”) 44, “*Accounting for Certain Transactions Involving StockCompensation,*” which requires a non-cash charge to deferredcompensation expense if the price of our common stock on the last trading dayof each reporting period is greater than the exercise price of certain stockoptions. After the first such adjustment is made, each subsequent period isadjusted upward or downward to the extent that the trading price exceeds theexercise price of the options.

 

We account our Plansunder the recognition and measurement principles of Accounting Principles Board(“APB”) Opinion No. 25, “Accounting for Stock issued to Employees,” and relatedInterpretations.  No stock-basedemployee compensation (except that related to repriced warrants in accordancewith FIN No. 44) is reflected in net loss, as all options and warrants grantedhad an exercise price equal to or below the market value of the underlying commonstock at the date of grant.

 

*Recentaccounting pronouncements*

 

In May 2003, the FASB issued SFAS No. 150, “*Accounting for Certain Instruments withCharacteristics of Both Liabilities and Equity*.” SFAS No. 150clarifies the accounting for certain financial instruments with characteristicsof both liabilities and equity and requires that those instruments beclassified as liabilities in statements of financial position. Previously, manyof those financial instruments were classified as equity. SFAS No. 150 iseffective for financial instruments entered into or modified after May 31, 2003and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003. The adoption of SFAS No. 150 did not have amaterial effect on our financial condition or results of operations.

 

In April 2003, the FASB issued SFAS No.149, “*Amendment of Statement No. 133 onDerivative Instruments and Hedging Activities*.” SFAS No. 149 amendsand clarifies financial accounting and reporting for derivative instruments,including certain derivative instruments embedded in other contracts(collectively referred to as derivatives) and for hedging activities under SFASNo. 133, “*Accounting for DerivativeInstruments and Hedging Activities*.” This Statement is effective forcontracts entered into or modified after June 30, 2003. The adoption ofSFAS No. 149 did not have a material effect on our financial conditionor results of operations.

 

In January 2003, the FASB issuedInterpretation No. 46, “*Consolidation ofVariable Interest Entities*” (“FIN 46”). In general, a variableinterest entity is a corporation, partnership, trust, or any other legal entityused for business purposes that either (a) does not have equity investors withvoting rights or (b) has equity investors that do not provide sufficientfinancial resources for the entity to support its activities. FIN 46 requirescertain variable interest entities to be consolidated by the primarybeneficiary of the entity if the investors in the entity do not have thecharacteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additionalsubordinated financial support from other parties. The consolidationrequirements of FIN 46 apply immediately to variable interest entities createdafter January 31, 2003. The consolidation requirements apply to olderentities in the first fiscal year or interim period beginning afterJune 15, 2003. Certain of the disclosure requirements apply to allfinancial statements issued after January 31, 2003, regardless of when thevariable interest entity was established.

 

In December 2003,the FASB issued a revised Interpretation No. 46 (“FIN 46R”), “*Consolidation of Variable Interest Entities*.”FIN 46R requires companies to consider whether entities, in which they havefinancial interests, lack sufficient

 

23

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equity at risk to permitthat entity to finance its activities without additional subordinated financialsupport and to consolidate those entities where the company would absorb themajority of any losses. The consolidation requirements are effective forinterim and annual periods ending after March 15, 2004. We do not expectthe adoption of FIN 46 and FIN 46R to have a material effect on our futurefinancial condition or results of operations.

 

In June 2002, the FASB issued SFAS No.146, “*Accounting for Exit or DisposalActivities*.” SFAS No. 146 addresses significant issues regarding therecognition, measurement and reporting of disposal activities, includingrestructuring activities that are currently covered in EITF Issue No. 94-3, “*Liability Recognition for Certain EmployeeTermination Activity*.” The provisions of SFAS No. 146 are effectivefor exit or disposal activities initiated after December 31, 2002. Theadoption of SFAS No. 146 did not have a material effect on our financialcondition or results of operations.

 

In April 2002, the FASB issued SFAS No.145, “*Rescission of FASB Statements No. 4,44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections*.”This statement rescinds SFAS No. 4, “*ReportingGains and Losses from Extinguishment of Debt*,” which required allgains and losses from extinguishment of debt to be aggregated and, if material,classified as an extraordinary item, net of income taxes. As a result, thecriteria in APB No. 30 will now be used to classify those gains and losses. Anygain or loss on the extinguishment of debt that was classified as anextraordinary item in prior periods presented that does not meet the criteriain APB No. 30 for classification as an extraordinary item shall bereclassified. The provisions of this Statement are effective for fiscal yearsbeginning after January 1, 2003. The adoption of SFAS No. 145 did not havea material effect on our financial condition or results of operations.

 

In November 2002, the FASB issued FIN 45,“*Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers*,” an interpretation of FASB Statements No. 5, 57 and 107, andrescission of FIN 34, “*Disclosure ofIndirect Guarantees of Indebtedness of Others*.” FIN 45 elaborates onthe disclosures to be made by the guarantor in its interim and annual financialstatements about its obligations under certain guarantees that it has issued.It also requires that a guarantor recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing theguarantee. The initial recognition and measurement provisions of this interpretationare applicable on a prospective basis to guarantees issued or modified afterDecember 31, 2002, while the provisions of the disclosure requirements areeffective for financial statements for interim or annual periods ending afterDecember 15, 2002. The adoption of SFAS No. 145 did not have a materialeffect on our financial condition or results of operations.

 

**ITEM 7.FINANCIAL STATEMENTS**

 

Seeindex to Financial Statements and Financial Statements Schedules beginning onpage F-1 of this Form 10-KSB.

 

24

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**ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K.**

 
| (a)    | The  following documents are filed as part of this Report: |                                                                                                         |
|--------|------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------|
|   |                                                       |                                                                                                         |
|   | (1)                                                        | Financial  statements filed as part of this Report:                                                          |   |
|   |                                                       | Report of Pannell Kerr  Forster of Texas, P.C                                                                |   |
|   |                                                       | Consolidated  Balance Sheets as of December 31, 2003 and 2002                                           |   |
|   |                                                       | Consolidated Statements of Operations  Years Ended December 31, 2003 and 2002                           |   |
|   |                                                       | Consolidated Statements of Stockholders’ Equity  (Deficit)  Years Ended December 31, 2003 and 2002 |   |
|   |                                                       | Consolidated Statements of Cash Flows  Years Ended December 31, 2003 and 2002                           |   |
|   |                                                       | Notes  to Consolidated Financial Statements                                                                  |   |
|   |                                                       |                                                                                                         |   |
|   | (2)                                                        | Exhibits  filed as part of this Report:                                                                      |   |

 
| **Exhibit  No.** |   | **Description**                                                                                                                                |   | **No. in  Document** |
|------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|
| 2.1              |   | Acquisition Agreement and Plan of Merger, dated as of August 16,  2001, between Vital Living, Inc. and VCM Technology Limited             |   | (1)                  |
|             |   |                                                                                                                                           |   |                 |
| 2.2              |   | Certificate of Merger of Vital Living, Inc. and VCM Technology  Limited                                                                        |   | (1)                  |
|             |   |                                                                                                                                           |   |                 |
| 3.1              |   | Amended and Restated Articles of Incorporation for Vital Living, Inc.                                                                          |   | (1)                  |
|             |   |                                                                                                                                           |   |                 |
| 3.2              |   | Amended and Restated Bylaws for Vital Living, Inc.                                                                                             |   | (1)                  |
|             |   |                                                                                                                                           |   |                 |
| 4.1              |   | Form of Series A Warrant                                                                                                                       |   | (2)                  |
|             |   |                                                                                                                                           |   |                 |
| 4.2              |   | Form of Series B Warrant                                                                                                                       |   | (3)                  |
|             |   |                                                                                                                                           |   |                 |
| 4.3              |   | Form of Series C Warrant                                                                                                                       |   | (3)                  |
|             |   |                                                                                                                                           |   |                 |
| 4.4              |   | Form of Series D Warrant                                                                                                                       |   | (4)                  |
|             |   |                                                                                                                                           |   |                 |
| 4.5              |   | Form of Series E Warrant                                                                                                                       |   | (5)                  |
|             |   |                                                                                                                                           |   |                 |
| 4.6              |   | Form of Series F Warrant                                                                                                                       |   | (2)                  |
|             |   |                                                                                                                                           |   |                 |
| 4.7              |   | Certificate of Designation of Preferences, Rights and Limitations of  10% Series A Preferred Stock                                             |   | (20)                 |
|             |   |                                                                                                                                           |   |                 |
| 4.8              |   | Certificate of Designation, Preferences and Relative, Participating,  Optional or Other Special Rights of Series B Convertible Preferred Stock |   | (20)                 |
|             |   |                                                                                                                                           |   |                 |
| 4.9              |   | Certificate of Designation, Preferences and Relative, Participating,  Optional or Other Special Rights of Series C Convertible Preferred Stock |   | (20)                 |
|             |   |                                                                                                                                           |   |                 |
| 4.10             |   | Certificate of Designation, Preferences and Relative, Participating,  Optional or Other Special Rights of Series D Convertible Preferred Stock |   | (5)                  |

 

25

----

 
| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                                                                   |   | **No. in  Document** |
|------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|
| 4.11             |   | Stock Purchase Agreement, dated as of October 23, 2002, by and  among Vital Living, Inc., MAF BioNutritionals, LLC, William A. Coppel  (personally and as a representative of Kenneth Martin), Phillip B. Maffetone,  Leslie C. Quick, III, Thomas C. Quick and Kenneth Glah |   | (6)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.12             |   | Subscription Agreement for November 2002 private placement of  units                                                                                                                                                                                                         |   | (3)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.13             |   | Form of Subscription Agreement for Series B Convertible Preferred  Stock                                                                                                                                                                                                          |   | (4)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.14             |   | Form of Subscription Agreement for Series C Convertible Preferred  Stock                                                                                                                                                                                                          |   | (7)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.15             |   | Form of Subscription Agreement for Series D Convertible Preferred  Stock                                                                                                                                                                                                          |   | (5)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.16             |   | Registration Rights Agreement, dated as of November 20, 2002,  between Vital Living, Inc. and those persons listed on Exhibit A attached  thereto                                                                                                                            |   | (3)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.17             |   | Stockholders’ Agreement, dated, by and among Vital Living, Inc.,  Bradley D. Edson, Stuart A. Benson, Martin Gerst, Donald Hannah, William  Coppel, Kenneth Martin, Phil Maffetone, Leslie C. Quick, III, and Thomas C.  Quick                                               |   | (3)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.18             |   | Stockholders’ Agreement, dated August 20, 2003, by and between  Vital Living, Inc., Bradley D. Edson, Stuart A. Benson, Donald Hannah,  SkyePharma PLC, Fifth Avenue Capital, Inc. and Stephen Morris                                                                   |   | (5)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.19             |   | Registration Rights Agreement, dated as of August 20, 2003, by  and between Vital Living, Inc. and SkyePharma PLC                                                                                                                                                            |   | (5)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.20             |   | Lock Up Agreement, dated as of May 21, 2001, among Bradley D. Edson  Martin Gerst, Donald Hannah and Kenneth Lind                                                                                                                                                                 |   | (8)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.21             |   | Amendment No. 1 to Lock Up Agreement, dated as of May 21, 2001, among  Bradley D. Edson Martin Gerst, Donald Hannah and Kenneth Lind                                                                                                                                              |   | (8)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.22             |   | Form of Securities Purchase Agreement for  December 2003 private offering                                                                                                                                                                                                    |   | (9)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.23             |   | Form of Senior Secured Convertible Note  issued in December 2003 private offering                                                                                                                                                                                            |   | (9)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.24             |   | Form of Warrant issued in  December 2003 private offering                                                                                                                                                                                                                    |   | (9)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.25             |   | Form of Warrant issued in 2003 offering of  senior convertible promissory notes                                                                                                                                                                                                   |   | (9)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.26             |   | Form of Security Agreement for  December 2003 private offering                                                                                                                                                                                                               |   | (9)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.27             |   | Form of Registration Rights Agreement for  December 2003 private offering                                                                                                                                                                                                    |   | (9)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 4.28             |   | Form of Escrow Agreement for  December 2003 private offering                                                                                                                                                                                                                 |   | (9)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 10.1             |   | 2001 Stock Option Plan                                                                                                                                                                                                                                                            |   | (1)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 10.2             |   | Agreement, dated August 21, 2001, between Vital Living, Inc. and  Arizona Heart Institute, Inc.                                                                                                                                                                              |   | (8)                  |
|             |   |                                                                                                                                                                                                                                                                              |   |                 |
| 10.3             |   | Addendum, dated April 4, 2002, to Agreement between Vital  Living, Inc. and Arizona Heart Institute, Inc.                                                                                                                                                                    |   | (10)                 |

 

26

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| **Exhibit  No.** |   | **Description**                                                                                                                                                          |   | **No. in  Document** |
|------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|
| 10.4             |   | Amendment No. 1, dated July 15, 2003, to Agreement Vital Living,  Inc. and Arizona Heart Institute, Inc.                                                            |   | (11)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.5             |   | Distribution Agreement, dated August 21, 2001, between Vital  Living, Inc. and Advanced Medical China, Ltd.                                                         |   | (8)                  |
|             |   |                                                                                                                                                                     |   |                 |
| 10.6             |   | Amendment No. 1 to Distribution Agreement, dated February 26,  2002, between Vital Living, Inc. and Advanced Medical China, Ltd. and AHI  Management Hong Kong Ltd. |   | (12)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.7             |   | Employment agreement, dated October 1, 2001, between Vital  Living, Inc. and Bradley D. Edson                                                                       |   | (8)                  |
|             |   |                                                                                                                                                                     |   |                 |
| 10.8             |   | Amendment No. 1, dated October 1, 2002, to Employment Agreement  between Vital Living, Inc. and Bradley D. Edson                                                    |   | (3)                  |
|             |   |                                                                                                                                                                     |   |                 |
| 10.9             |   | Consultant Agreement, dated October 1, 2001, between Vital  Living, Inc. and Howard Wernick                                                                         |   | (8)                  |
|             |   |                                                                                                                                                                     |   |                 |
| 10.10            |   | Consulting Agreement, dated March 20, 2002, between Vital  Living, Inc. and Leslie D. Michelson                                                                     |   | (13)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.11            |   | Consulting Agreement, dated March 20, 2002, between Vital  Living, Inc. and Brian C. Smith                                                                          |   | (13)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.12            |   | Consulting Agreement, dated March 20, 2002, between Vital  Living, Inc. and Michael H. Davidson, M.D.                                                               |   | (13)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.13            |   | Form of Clinical Trial Agreement, between Vital Living, Inc. and the  City of Phoenix Fire Department                                                                    |   | (14)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.14            |   | Executive Services Agreement, dated as of November 20, 2002,  between Vital Living, Inc. and Stuart A. Benson                                                       |   | (3)                  |
|             |   |                                                                                                                                                                     |   |                 |
| 10.15            |   | Amendment No. 1 to Employment Agreement between Vital Living, Inc.  and Stuart A. Benson                                                                                 |   | (20)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.16            |   | Amendment No. 2 to Employment Agreement between Vital Living, Inc.  and Stuart A. Benson                                                                                 |   | (20)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.17            |   | Warrant Agreement, dated November 20, 2002, between Vital  Living, Inc. and Stuart A. Benson                                                                        |   | (10)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.18            |   | Amendment No. 1 to Warrant Agreement between Vital Living, Inc. and  Stuart A. Benson                                                                                    |   | (4)                  |
|             |   |                                                                                                                                                                     |   |                 |
| 10.19            |   | Amendment No. 2 to Warrant Agreement between Vital Living, Inc. and  Stuart A. Benson                                                                                    |   | (20)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.20            |   | Financial Advisor Services Agreement, dated July 29, 2002,  between Vital Living, Inc. and Peck and Grossman, LLC                                                   |   | (14)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.21            |   | Agreement, dated February 3, 2003, between Vital Living, Inc.  and CHG Allied Inc.                                                                                  |   | (14)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.22            |   | Agreement, dated September 30, 2002, between Vital Living, Inc.  and Medical Resource, LLC, National Provider Network                                               |   | (14)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.23            |   | Consulting Agreement, dated as of October 8, 2002, between Vital  Living, Inc. and  Martin Wallace                                                             |   | (14)                 |
|             |   |                                                                                                                                                                     |   |                 |
| 10.24            |   | Management Agreement, dated as of April 17, 2003, between Vital  Living, Inc. and Christopher’s Original Formulas, Inc.                                        |   | (4)                  |
|             |   |                                                                                                                                                                     |   |                 |
| 10.25            |   | Consulting Agreement, dated May 19, 2002, between Vital Living, Inc.  and Stephen Songsheng Chen                                                                         |   | (4)                  |

 

27

----

 
| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                              |   | **No. in  Document** |
|------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|
| 10.26            |   | Warrant Agreement, dated April 16, 2003, between Vital Living,  Inc. and Stephen Songsheng Chen                                                                                                                                         |   | (4)                  |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.27            |   | Scientific Advisory Board Agreement, dated May 15, 2002, between  Vital Living, Inc. and Dr. Dennis Sprecher                                                                                                                                 |   | (15)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.28            |   | Scientific Advisory Board Agreement, dated May 30, 2002, between  Vital Living, Inc. and John A. Sutherland                                                                                                                                  |   | (16)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.29            |   | Scientific Advisory Board Agreement, dated May 16, 2002, among Vital  Living, Inc.,  Thomas Allison and the  Mayo Foundation for Medical Education and Research                                                                         |   | (15)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.30            |   | Scientific Advisory Board Agreement, dated June 17, 2002,  between Vital Living, Inc. and Ronald M. Krauss                                                                                                                              |   | (17)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.31            |   | Scientific Advisory Board Agreement, dated May 7, 2002, between Vital  Living, Inc. and  Dr. David Maron                                                                                                                                |   | (4)                  |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.32            |   | Settlement and Release Agreement, dated June 25, 2003, between  Vital Living, Inc. and William Coppel                                                                                                                                   |   | (18)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.33            |   | Asset Purchase Agreement, dated as of June 20, 2003, among Vital  Living, Inc., Nature’s Systems, Inc., Christopher’s Original Formulas, Inc.,  Robert C. Scott and James R. Jeppson                                          |   | (18)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.34            |   | Form of Escrow Agreement, dated August 20, 2003, between Vital  Living, Inc., E-Nutraceuticals, Inc., Stephen Morris and Mercantile National  Bank – California, as escrow agent                                                   |   | (5)                  |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.35            |   | Development and License Agreement, dated as of December 28,  2001, between E-Nutraceuticals, Inc. and SkyePharma PLC                                                                                                                    |   | (5)                  |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.36            |   | Amendment No. 1, dated as of August 20, 2003, to Development and  License Agreement by and among Vital Living, Inc., E-Nutraceuticals, Inc.,  Jagotec AG and SkyePharma PLC                                                             |   | (5)                  |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.37            |   | Stock Purchase Agreement, dated as of October 14, 2003, among  Vital Living, Inc. and the shareholders set forth on the signature page  attached thereto                                                                                |   | (19)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.38            |   | Escrow Agreement, dated as of October 14, 2003, among Vital  Living, Inc., the shareholders of Doctors For Nutrition, Inc. and Mercantile  National Bank – California                                                              |   | (19)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.39            |   | Executive Services Agreement, dated as of October 14, 2003,  between Doctors For Nutrition, Inc. and Bruce Howe                                                                                                                         |   | (19)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.40            |   | Strategic Advisor Agreement, dated October 14, 2003, between  Vital Living, Inc. and Dr. Roger Howe                                                                                                                                     |   | (19)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.41            |   | Strategic Advisor Agreement, dated October 14, 2003, between  Vital Living, Inc. and Dr. Maynard Howe                                                                                                                                   |   | (19)                 |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.42            |   | Form of Indemnification Agreement between the Company and each of  Bradley D. Edson, Stuart A. Benson, Donald C. Hannah, Carson E. Beadle,  Leslie C. Quick, Robert J. Eide, David Allen, Marcus Feder, Mitchel Feinglas  and Michael Ashton |   | (2)                  |
|             |   |                                                                                                                                                                                                                                         |   |                 |
| 10.42.1          |   | Schedule of Indemnification Agreements in the form of Exhibit  10.42, including material detail in which such documents differ from Exhibit  10.42                                                                                      |   | (2)                  |

 

28

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| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                                                      |   | **No. in  Document** |
|------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|
| 10.43            |   | Amendment No. 1, dated as of January 13, 2004, to Stockholders’  Agreement, dated as of August 14, 2003, between each of the Company, Bradley  D. Edson, Stuart Benson, Donald Hannah, Stephen Morris, SkyePharma PLC and  Fifth Avenue Capital, Inc. |   | (20)                 |
|             |   |                                                                                                                                                                                                                                                                 |   |                 |
| 31.1             |   | Certification of Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002                                                                                                                                                             |   | Filed Herewith       |
|             |   |                                                                                                                                                                                                                                                                 |   |                 |
| 31.2             |   | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002                                                                                                                                                             |   | Filed Herewith       |
|             |   |                                                                                                                                                                                                                                                                 |   |                 |
| 32.1             |   | Certification of Chief Executive Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                                                                                                                                                             |   | Filed Herewith       |
|             |   |                                                                                                                                                                                                                                                                 |   |                 |
| 32.2             |   | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                                                                                                                                                             |   | Filed Herewith       |

 

----

(1)                                  CurrentReport on Form 8-K dated August 17, 2001 and filed with the SEC onOctober 1, 2001

(2)                                  RegistrationStatement on Form SB-2 (333-111921) filed with the SEC on January 14, 2004

(3)                                  CurrentReport on Form 8-K/A dated November 20, 2002 and filed with the SEC onDecember 5, 2002

(4)                                  AmendmentNo. 2 to Registration Statement on Form SB-2 (333-102106) filed onApril 28, 2003

(5)                                  CurrentReport on Form 8-K dated August 21, 2003 and filed with the SEC onSeptember 8, 2003

(6)                                  CurrentReport on Form 8-K dated October 23, 2002 and filed with the SEC onNovember 4, 2002

(7)                                  AmendmentNo. 3 to Registration Statement on Form SB-2 (333-102106) filed onJune 18, 2003

(8)                                  CurrentReport on Form 8-K dated August 17, 2001 and filed with the SEC onNovember 20, 2001

(9)                                  CurrentReport on Form 8-K dated December 15, 2003 and filed with the SEC onDecember 19, 2003

(10)                            CurrentReport on Form 8-K dated April 1, 2002 and filed with the SEC onApril 16, 2002

(11)                            AmendmentNo. 4 to Registration Statement on Form SB-2 (333-102106) filed onJuly 23, 2003

(12)                            CurrentReport on Form 8-K dated February 27, 2002 and filed with the SEC onFebruary 28, 2002

(13)                            AnnualReport on Form 10-KSB for the fiscal year ended December 31, 2001

(14)                            AmendmentNo. 1 to Registration Statement on Form SB-2 (333-102106) filed onMarch 7, 2003

(15)                            CurrentReport on Form 8-K dated May 15, 2002 and filed with the SEC on May 31, 2002

(16)                            CurrentReport on Form 8-K dated May 30, 2002 and filed with the SEC on June 13,2002

(17)                            CurrentReport on Form 8-K dated June 17, 2002 and filed with the SEC onJuly 2, 2002

(18)                            CurrentReport on Form 8-K dated July 2, 2003 and filed with the SEC onJuly 16, 2003

(19)                            CurrentReport on Form 8-K/A dated October 14, 2003 and filed with the SEC onDecember 5, 2003

(20)         Annual Report on Form 10-KSB for fiscalyear ended December 31, 2003.

 

(b)         We filed the following reports on Form 8-Kduring the quarter ended December 31, 2003.

 

(1)                                  AReport on Form 8-K was filed with the Securities and Exchange Commissionon December 19, 2003 relating to a private placement of Senior SecuredConvertible Notes.

(2)                                  A Report on Form 8-K/A was filed with the Securitiesand Exchange Commission on December 5, 2003 amending a Report on Form 8-Kfiled October 29, 2003 relating to the acquisition of Doctors ForNutrition, Inc.

(3)                                  A Report on Form 8-K/A was filed with the Securitiesand Exchange Commission on November 11, 2003 amending a Report on Form 8-Kfiled September 8, 2003 relating to a merger with E-Nutraceuticals, Inc.and a corresponding Series D Preferred Stock private placement.

 

29

----

 

**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Actof 1934, the Registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.

 
| Date:  May 17, 2004 |
|---------------------|
|                |
| By:                 | */s/ Stuart A. Benson* |   |
|                | Stuart  A. Benson, Chief Executive Officer |

 

30

----

 

Independent Auditor’s Report

 

Tothe Board of Directors andStockholders of Vital Living, Inc.

 

Wehave audited the accompanying consolidated balance sheets of Vital Living, Inc.and subsidiaries as of December 31, 2003 (Restated) and 2002 and therelated statements of operations, stockholders’ equity, and cash flows for theyears ended December 31, 2003 (Restated) and 2002. These financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

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

 

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of Vital Living, Inc. andsubsidiaries as of December 31, 2003 and 2002 and the results of theiroperations and their cash flows for the years then ended in conformity withaccounting principles generally accepted in the United States of America.

 

Theaccompanying financial statements have been prepared assuming that the Companywill continue as a going concern. As discussed in Note 2 to the financialstatements, the Company has suffered recurring losses from operations, has aworking capital deficit, and is dependent on funding sources from otherthan operations. Since inception, the Company has been required to raiseadditional capital by the issuance of both equity and debt instruments. Thereare no commitments from funding sources, debt or equity, in the event that cashflows are not sufficient to fund ongoing operations or other cash commitmentswhen they come due. These factors raisesubstantial doubt about the Company’s ability to continue as a going concern.Management’s plans regarding these matters are also described in Note 2. Thefinancial statements do not include any adjustments that might result from theoutcome of this uncertainty.

 

Asdescribed in Note 2, the Company restated its financial statements as of andfor the year ended December 31, 2003.

 
| /s/ Pannell  Kerr Forster of Texas, P.C.                                                                                                            |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                     |
| Houston,  Texas                                                                                                                                          |
| February 27,  2004                                                                                                                                  |
| (except  for Restatement of Financial Statements  described in Note 2 and subsequent events  described in Note 12 for which the date  is April 23, 2004) |

 

F-1

----

 

##### **VITALLIVING, INC**

**ConsolidatedBalance Sheets**

 
|                                                                                                                                              |   | **December  31,** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|------------|
|                                                                                                                                              |   | **2003**          |       | **2002** |   |
|                                                                                                                                              |   | **(Restated)**    |       |   |   |
| **Assets**                                                                                                                                        |   |              | ** ** |   | ** ** |
| Current assets                                                                                                                                    |   |              |       |   |   |
| Cash and cash equivalents                                                                                                                         |   | $                 | 1,729,311  |   | $ | 1,416,073 |   |
| Accounts receivable, trade; net of  allowance for doubtful accounts of $32,000 and $0, respectively                                               |   | 371,586           |       | 68,234 |   |
| Accounts receivable, related parties                                                                                                              |   | 67,000            |       | — |   |
| Inventory, net of reserve of $86,000 and  $0, respectively                                                                                        |   | 557,005           |       | 273,361 |   |
| Prepaid expenses and other current assets                                                                                                         |   | 1,099,767         |       | 25,833 |   |
| Total current assets                                                                                                                              |   | 3,824,669         |       | 1,783,501 |   |
| Other assets                                                                                                                                      |   |              |       |   |   |
| Deferred debt issuance costs, net of  accumulated amortization of $230,871                                                                        |   | 985,636           |       | — |   |
| Property and equipment, net                                                                                                                       |   | 169,107           |       | 172,295 |   |
| Goodwill                                                                                                                                          |   | 4,178,932         |       | 4,893,517 |   |
| License agreement - GEOMATRIX®, net                                                                                                          |   | 33,790,858        |       | — |   |
| License agreement – X-Fat®, net                                                                                                         |   | 3,990,504         |       | — |   |
| Marketing agreements, net                                                                                                                         |   | 3,533,226         |       | — |   |
| Other intangible assets, net                                                                                                                      |   | 188,992           |       | 327,498 |   |
| Other non-current assets                                                                                                                          |   | 46,308            |       | 2,807 |   |
| Total other assets                                                                                                                                |   | 46,883,563        |       | 5,396,117 |   |
|                                                                                                                                              |   |              |       |   |   |
| Total assets                                                                                                                                      |   | $                 | 50,708,232 |   | $ | 7,179,618 |   |
| **Liabilities and  Stockholders’ Equity**                                                                                                    |   |              | ** ** |   | ** ** |
| Current liabilities                                                                                                                               |   |              |       |   |   |
| Accounts payable, trade                                                                                                                           |   | $                 | 1,691,602  |   | $ | 428,287 |   |
| Accounts payable, related parties                                                                                                                 |   | —            |       | 22,500 |   |
| Accrued and other current liabilities                                                                                                             |   | 1,386,430         |       | 257,321 |   |
| Current portion of long-term debt                                                                                                                 |   | 584,571           |       | 291,688 |   |
| Notes payable, related parties                                                                                                                    |   | 260,045           |       | — |   |
| Total current liabilities                                                                                                                         |   | 3,922,648         |       | 999,796 |   |
|                                                                                                                                              |   |              |       |   |   |
| Long-term debt, net of unamortized debt  Discount                                                                                                 |   | 2,294,248         |       | 521,494 |   |
| Total liabilities                                                                                                                                 |   | 6,216,896         |       | 1,521,290 |   |
| Commitments and contingencies                                                                                                                     |   | —            |       | — |   |
| Stockholders’ equity                                                                                                                         |   |              |       |   |   |
| Preferred stock, $0.001 par value,  50,000,000 shares authorized:                                                                                 |   |              |       |   |   |
| Preferred stock - Series A, $0.001 par  value, 10,000,000 shares authorized; 3,410,325 and 3,712,000 shares issued  and outstanding, respectively |   | 3,410             |       | 3,712 |   |
| Preferred stock - Series B, $0.001 par  value, 1,000,000 shares authorized; 1,000,000 and 0 shares issued and  outstanding, respectively          |   | 1,000             |       | — |   |
| Preferred stock - Series C, $0.001 par  value, 3,000,000 shares authorized; 500,000 and 0 shares issued and  outstanding, respectively            |   | 500               |       | — |   |
| Preferred stock - Series D, $0.001 par  value, 1,000,000 shares authorized; 1,000,000 and 0 shares issued and  outstanding, respectively          |   | 1,000             |       | — |   |
| Additional paid-in capital - preferred                                                                                                            |   | 8,389,210         |       | 6,972,267 |   |
| Discount on preferred stock - unamortized                                                                                                         |   | (126,599          | )          | (1,146,653 | ) |
| Common stock, $0.001 par value, 150,000,000  shares authorized; 58,269,466 and 17,842,616 shares issued and outstanding,  respectively            |   | 58,269            |       | 17,843 |   |
| Additional paid-in capital - common                                                                                                               |   | 74,268,229        |       | 8,021,453 |   |
| Stock, options, and warrants - unamortized                                                                                                        |   | (597,042          | )          | (981,968 | ) |
| Treasury stock, 424,000 shares at cost                                                                                                            |   | (72,280           | )          | — |   |
| Accumulated other comprehensive income                                                                                                            |   | (42,640           | )          | — |   |
| Retained deficit                                                                                                                                  |   | (37,391,721       | )          | (7,228,326 | ) |
| Total stockholders’ equity                                                                                                                   |   | 44,491,336        |       | 5,658,328 |   |
|                                                                                                                                              |   |              |       |   |   |
| Total liabilities and stockholders’ equity                                                                                                   |   | $                 | 50,708,232 |   | $ | 7,179,618 |   |
|                                                                                                                                                   |        |                   |            |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidatedfinancial statements.

 

F-2

----

 

###### **VITAL LIVING,INC**

**ConsolidatedStatements of Operations**

 
|                                                                      |   | **Year Ended  December 31,** |        |
|---------------------------------------------------------------------------|--------|------------------------------|-------------|
|                                                                      |   | **2003**                     |        | **2002** |   |
|                                                                      |   | **(Restated)**               | ** **  |   | ** ** |
| Revenue                                                                   |   | $                            | 2,855,123   |   | $ | 260,844 |   |
| Cost of goods sold                                                        |   | 1,723,013                    |        | 193,032 |   |
| Gross profit                                                              |   | 1,132,110                    |        | 67,812 |   |
|                                                                      |   |                         |        |   |   |
| Administrative expenses                                                   |   |                         |        |   |   |
| Salaries and benefits                                                     |   | 11,998,759                   |        | 1,341,103 |   |
| Professional and consulting fees                                          |   | 3,261,078                    |        | 1,607,621 |   |
| Selling, general and administrative                                       |   | 2,054,526                    |        | 510,013 |   |
| Research and development                                                  |   | 410,648                      |        | 510,436 |   |
| Depreciation and amortization                                             |   | 1,972,303                    |        | 52,959 |   |
| Impairment of goodwill                                                    |   | 6,777,480                    |        | — |   |
| Total administrative expenses                                             |   | 26,474,794                   |        | 4,022,132 |   |
|                                                                      |   |                         | ** **  |   | ** ** |
| Net loss from operations                                                  |   | (25,342,684                  | )           | (3,954,320 | ) |
| Other income (expense)                                                    |   |                         |        |   |   |
| Other expense                                                             |   | (43,249                      | )           | — |   |
| Interest income                                                           |   | 5,322                        |        | 13,077 |   |
| Interest expense                                                          |   | (2,554,421                   | )           | (8,652 | ) |
| Net loss                                                                  |   | (27,935,032                  | )           | (3,949,895 | ) |
| Deemed dividend associated with beneficial  conversion of preferred stock |   | (1,643,252                   | )           | (2,235,519 | ) |
| Series A preferred stock dividend                                         |   | (585,111                     | )           | — |   |
| Net loss available to common stockholders                                 |   | $                            | (30,163,395 | ) | $ | (6,185,414 | ) |
|                                                                      |   |                         |        |   |   |
| Basic and diluted loss per share                                          |   | $                            | (0.87       | ) | $ | (0.28 | ) |
| Deemed dividend associated with beneficial  conversion of preferred stock |   | (0.05                        | )           | (0.15 | ) |
| Series A Preferred stock dividend                                         |   | (0.02                        | )           | — |   |
| Basic and diluted loss per share available  to common stockholders        |   | $                            | (0.94       | ) | $ | (0.43 | ) |
|                                                                      |   |                         |        |   |   |
| Weighted average basic and diluted common  stock outstanding              |   | 31,992,346                   |        | 14,278,129 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

F-3

----

 

**VITAL LIVING, INC**

**Consolidated Statements of Stockholders’ Equity**

 
|                                                                                   |   | **Preferred  Stock** |   | **Common  Stock** |   |
|----------------------------------------------------------------------------------------|--------|----------------------|--------|-------------------|--------|
|                                                                                   |   | **Shares**           |   | **Par Value**     |   | **Additional  Paid-  In Capital** |   | **Discount** |   | **Shares** |   | **Par Value** |   | **Additional  Paid-  In Capital** |   |
| Balance December 31, 2001                                                              |   | —               |   | $                 | — |   | $ | — |   | $ | — |   | 13,626,554 |   | $ | 13,627 |   | $ | 946,159 |   |
| Series A Preferred stock issued for cash, net of  offering costs of $118,193           |   | 3,712,000            |   | 3,712             |   | 3,590,095 |   | — |   | — |   | — |   | — |   |
| Series A Preferred stock beneficial conversion  feature                                |   | —               |   | —            |   | 3,382,172 |   | (3,382,172 | ) | — |   | — |   | — |   |
| Amortization of preferred stock beneficial  conversion feature                         |   | —               |   | —            |   | — |   | 2,235,519 |   | — |   | — |   | — |   |
| Common stock issued for services and settlements                                       |   | —               |   | —            |   | — |   | — |   | 343,500 |   | 343 |   | 554,652 |   |
| Common stock issued for cash, net of offering  costs of $170,385                       |   | —               |   | —            |   | — |   | — |   | 1,367,500 |   | 1,368 |   | 1,195,747 |   |
| Common stock issued for acquisition of VCM                                             |   | —               |   | —            |   | — |   | — |   | 5,062 |   | 5 |   | (5 | ) |
| Common stock issued for acquisition of MAF                                             |   | —               |   | —            |   | — |   | — |   | 2,500,000 |   | 2,500 |   | 4,097,500 |   |
| Options and warrants issued for services                                               |   | —               |   | —            |   | — |   | — |   | — |   | — |   | 1,227,400 |   |
| Amortization of restricted common stock, options,  and warrants issued for services    |   | —               |   | —            |   | — |   | — |   | — |   | — |   | — |   |
| Net loss                                                                               |   | —               |   | —            |   | — |   | — |   | — |   | — |   | — |   |
| Balance December 31, 2002                                                              |   | 3,712,000            |   | $                 | 3,712  |   | $ | 6,972,267 |   | $ | (1,146,653 | ) | 17,842,616 |   | $ | 17,843 |   | $ | 8,021,453 |   |
| Series A Preferred stock conversion                                                    |   | (682,163             | )      | $                 | (682   | ) | $ | (1,303,195 | ) | $ | — |   | 682,163 |   | $ | 682 |   | $ | 1,303,195 |   |
| Series A Preferred stock dividend, including  $204,623 dividends declared but not paid |   | 380,488              |   | 380               |   | 380,108 |   | — |   | — |   | — |   | — |   |
| Series B Preferred stock issued for cash, net of  offering costs of $133,086           |   | 1,000,000            |   | 1,000             |   | 803,420 |   | — |   | — |   | — |   | 70,580 |   |
| Series C Preferred stock issued for cash, net of  offering costs of $233,590           |   | 500,000              |   | 500               |   | 99,412 |   | — |   | 62,500 |   | 62 |   | 337,526 |   |
| Series C Preferred stock beneficial conversion  feature                                |   | —               |   | —            |   | 253,198 |   | (253,198 | ) | — |   | — |   | — |   |
| Series D Preferred stock issued for cash, net of  offering costs of $185,000           |   | 1,000,000            |   | 1,000             |   | 814,000 |   | — |   | — |   | — |   | — |   |
| Series D Preferred stock beneficial conversion  feature                                |   | —               |   | —            |   | 370,000 |   | (370,000 | ) | — |   | — |   | — |   |
| Amortization of preferred stock beneficial  conversion features                        |   | —               |   | —            |   | — |   | 1,643,252 |   | — |   | — |   | — |   |
| Common stock issued for services and settlements                                       |   | —               |   | —            |   | — |   | — |   | 1,424,600 |   | 1,424 |   | 1,714,665 |   |
| Common stock issued for compensation                                                   |   | —               |   | —            |   | — |   | — |   | 1,300,000 |   | 1,300 |   | 1,779,700 |   |
| Common stock issued for acquisition of COF                                             |   | —               |   | —            |   | — |   | — |   | 2,754,000 |   | 2,754 |   | 2,971,566 |   |
| Common stock issued for acquisition of ENI                                             |   | —               |   | —            |   | — |   | — |   | 32,398,584 |   | 32,399 |   | 42,339,698 |   |
| Common stock issued for acquisition of DFN                                             |   | —               |   | —            |   | — |   | — |   | 1,700,003 |   | 1,700 |   | 2,400,304 |   |
| Convertible debt beneficial conversion feature                                         |   | —               |   | —            |   | — |   | — |   | — |   | — |   | 2,189,663 |   |
| Convertible debt detachable warrants issued                                            |   | —               |   | —            |   | — |   | — |   | — |   | — |   | 2,072,053 |   |
| Options and warrants exercised                                                         |   | —               |   | —            |   | — |   | — |   | 105,000 |   | 105 |   | 26,445 |   |
| Options and warrants issued for services                                               |   | —               |   | —            |   | — |   | — |   | — |   | — |   | 459,640 |   |
| Options and warrants issued for compensation                                           |   | —               |   | —            |   | — |   | — |   | — |   | — |   | 6,800,000 |   |
| Warrants repriced for an employee                                                      |   | —               |   | —            |   | — |   | — |   | — |   | — |   | 1,526,461 |   |
| Warrant modification for a consultant                                                  |   | —               |   | —            |   | — |   | — |   | — |   | — |   | 255,000 |   |
| Amortization of restricted common stock, options,  and warrants issued for services    |   | —               |   | —            |   | — |   | — |   | — |   | — |   | — |   |
| Treasury stock purchase, 424,000 shares at cost                                        |   | —               |   | —            |   | — |   | — |   | — |   | — |   | 280 |   |
| Comprehensive Income:                                                                  |   |                 |   |              |   |   |   |   |   |   |   |   |   |   |   |
| Change in cumulative translation adjustment                                            |   | —               |   | —            |   | — |   | — |   | — |   | — |   | — |   |
| Net loss (Restated)                                                                    |   | —               |   | —            |   | — |   | — |   | — |   | — |   | — |   |
| Comprehensive Income (Restated)                                                        |   | —               |   | —            |   | — |   | — |   | — |   | — |   | — |   |
| Balance December 31, 2003 (Restated)                                                   |   | 5,910,325            |   | $                 | 5,910  |   | $ | 8,389,210 |   | $ | (126,599 | ) | 58,269,466 |   | $ | 58,269 |   | $ | 74,268,229 |   |

 
|                                                                                   |   | **Stock,  Options  and Warrants  Unamortized** |     | **Treasury  Stock** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Retained  Deficit** |    | **Stockholders’  Equity** |   |
|----------------------------------------------------------------------------------------|--------|------------------------------------------------|----------|---------------------|--------|------------------------------------------------------|--------|-----------------------|---------|--------------------------------|--------|
| Balance December 31, 2001                                                              |   | $                                              | —   |                | $      | —                                               |   | $                     | —  |                           | $      | (1,042,912 | ) | $ | (83,126 | ) |
| Series A Preferred stock issued for cash,  net of offering costs of $118,193           |   | —                                         |     | —              |   | —                                               |   | —                |    | 3,593,807                      |   |
| Series A Preferred stock beneficial  conversion feature                                |   | —                                         |     | —              |   | —                                               |   | —                |    | —                         |   |
| Amortization of preferred stock beneficial  conversion feature                         |   | —                                         |     | —              |   | —                                               |   | (2,235,519            | )       | —                         |   |
| Common stock issued for services and  settlements                                      |   | (341,870                                       | )        | —              |   | —                                               |   | —                |    | 213,125                        |   |
| Common stock issued for cash, net of  offering costs of $170,385                       |   | —                                         |     | —              |   | —                                               |   | —                |    | 1,197,115                      |   |
| Common stock issued for acquisition of VCM                                             |   | —                                         |     | —              |   | —                                               |   | —                |    |                           |   |
| Common stock issued for acquisition of MAF                                             |   | —                                         |     | —              |   | —                                               |   | —                |    | 4,100,000                      |   |
| Options and warrants issued for services                                               |   | (1,227,400                                     | )        | —              |   | —                                               |   | —                |    | —                         |   |
| Amortization of restricted common stock,  options, and warrants issued for services    |   | 587,302                                        |     | —              |   | —                                               |   | —                |    | 587,302                        |   |
| Net loss                                                                               |   | —                                         |     | —              |   | —                                               |   | (3,949,895            | )       | (3,949,895                     | )      |
| Balance December 31, 2002                                                              |   | $                                              | (981,968 | )                   | $      | —                                               |   | $                     | —  |                           | $      | (7,228,326 | ) | $ | 5,658,328 |   |
| Series A Preferred stock conversion                                                    |   | $                                              | —   |                | $      | —                                               |   | $                     | —  |                           | $      | — |   | $ | — |   |
| Series A Preferred stock dividend,  including $204,623 dividends declared but not paid |   | —                                         |     | —              |   | —                                               |   | (585,111              | )       | (204,623                       | )      |
| Series B Preferred stock issued for cash,  net of offering costs of $133,086           |   | —                                         |     | —              |   | —                                               |   | —                |    | 875,000                        |   |
| Series C Preferred stock issued for cash,  net of offering costs of $233,590           |   | —                                         |     | —              |   | —                                               |   | —                |    | 437,500                        |   |
| Series C Preferred stock beneficial  conversion feature                                |   | —                                         |     | —              |   | —                                               |   | —                |    | —                         |   |
| Series D Preferred stock issued for cash,  net of offering costs of $185,000           |   | —                                         |     | —              |   | —                                               |   | —                |    | 815,000                        |   |
| Series D Preferred stock beneficial  conversion feature                                |   | —                                         |     | —              |   | —                                               |   | —                |    | —                         |   |
| Amortization of preferred stock beneficial  conversion features                        |   | —                                         |     | —              |   | —                                               |   | (1,643,252            | )       | —                         |   |
| Common stock issued for services and  settlements                                      |   | (569,502                                       | )        | —              |   | —                                               |   | —                |    | 1,146,587                      |   |
| Common stock issued for compensation                                                   |   | —                                         |     | —              |   | —                                               |   | —                |    | 1,781,000                      |   |
| Common stock issued for acquisition of COF                                             |   | —                                         |     | —              |   | —                                               |   | —                |    | 2,974,320                      |   |
| Common stock issued for acquisition of ENI                                             |   | —                                         |     | —              |   | —                                               |   | —                |    | 42,372,097                     |   |
| Common stock issued for acquisition of DFN                                             |   | —                                         |     | —              |   | —                                               |   | —                |    | 2,402,004                      |   |
| Convertible debt beneficial conversion  feature                                        |   | —                                         |     | —              |   | —                                               |   | —                |    | 2,189,663                      |   |
| Convertible debt detachable warrants issued                                            |   | —                                         |     | —              |   | —                                               |   | —                |    | 2,072,053                      |   |
| Options and warrants exercised                                                         |   | —                                         |     | —              |   | —                                               |   | —                |    | 26,550                         |   |
| Options and warrants issued for services                                               |   | (16,017                                        | )        | —              |   | —                                               |   | —                |    | 443,623                        |   |
| Options and warrants issued for  compensation                                          |   | —                                         |     | —              |   | —                                               |   | —                |    | 6,800,000                      |   |
| Warrants repriced for an employee                                                      |   | —                                         |     | —              |   | —                                               |   | —                |    | 1,526,461                      |   |
| Warrant modification for a consultant                                                  |   | —                                         |     | —              |   | —                                               |   | —                |    | 255,000                        |   |
| Amortization of restricted common stock,  options, and warrants issued for services    |   | 970,445                                        |     | —              |   | —                                               |   | —                |    | 970,445                        |   |
| Treasury stock purchase, 424,000 shares at  cost                                       |   | —                                         |     | (72,280             | )      | —                                               |   | —                |    | (72,000                        | )      |
| Comprehensive Income:                                                                  |   |                                           |     |                |   |                                                 |   |                  |    |                           |   |
| Change in cumulative translation adjustment                                            |   | —                                         |     | —              |   | (42,640                                              | )      | —                |    | (42,640                        | )      |
| Net loss (Restated)                                                                    |   | —                                         |     | —              |   | —                                               |   | (27,935,032           | )       | (27,935,032                    | )      |
| Comprehensive Income (Restated)                                                        |   | —                                         |     | —              |   | —                                               |   | —                |    | (27,977,672                    | )      |
| Balance December 31, 2003 (Restated)                                                   |   | $                                              | (597,042 | )                   | $      | (72,280                                              | )      | $                     | (42,640 | )                              | $      | (37,391,721 | ) | $ | 44,491,336 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

F-4

----

 

###### **VITAL LIVING,INC**

**ConsolidatedStatements of Cash Flows**

 
|                                                                                                        |   | **Year Ended  December 31,** |        |
|-------------------------------------------------------------------------------------------------------------|--------|------------------------------|-------------|
|                                                                                                        |   | **2003**                     |        | **2002** |   |
|                                                                                                        |   | **(Restated)**               |        |   |   |
| Cash flows from operating activities:                                                                       |   |                         |        |   |   |
| Net loss                                                                                                    |   | $                            | (27,935,032 | ) | $ | (3,949,895 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                                |   |                         |        |   |   |
| Depreciation and amortization                                                                               |   | 1,972,303                    |        | 52,959 |   |
| Impairment of goodwill                                                                                      |   | 6,777,480                    |        | — |   |
| Warrants issued, beneficial conversion, and  amortization of costs associated with senior convertible notes |   | 2,050,054                    |        | — |   |
| Issuance of common stock for services                                                                       |   | 692,611                      |        | 145,125 |   |
| Issuance of common stock for shareholder  penalty                                                           |   | 156,136                      |        | — |   |
| Issuance of common stock for compensation                                                                   |   | 1,781,000                    |        | — |   |
| Issuance of warrants for services                                                                           |   | 32,500                       |        | — |   |
| Issuance of warrants for compensation                                                                       |   | 6,800,000                    |        | — |   |
| Repricing of and modifications to warrants                                                                  |   | 1,781,461                    |        | — |   |
| Amortization of restricted common stock,  options and warrants issued for services                          |   | 970,445                      |        | 587,302 |   |
| Allowance for bad debt                                                                                      |   | (32,000                      | )           | — |   |
| Inventory reserve                                                                                           |   | (86,000                      | )           | — |   |
| Loss on disposal of assets                                                                                  |   | 43,547                       |        | — |   |
| Change in operating assets and liabilities:                                                                 |   |                         |        |   |   |
| Accounts receivable                                                                                         |   | 20,460                       |        | (20,286 | ) |
| Accounts receivable, related parties                                                                        |   | (67,000                      | )           | 89,872 |   |
| Inventory                                                                                                   |   | 215                          |        | (164,689 | ) |
| Prepaid expenses and other current assets                                                                   |   | (849,875                     | )           | 9,897 |   |
| Accounts payable                                                                                            |   | 298,205                      |        | 81,842 |   |
| Accrued and other current liabilities                                                                       |   | 856,592                      |        | 193,821 |   |
| Cash used in operating activities                                                                           |   | (4,736,898                   | )           | (2,974,052 | ) |
| Cash flows from investing activities:                                                                       |   |                         |        |   |   |
| Purchases of property and equipment                                                                         |   | (51,292                      | )           | (126,811 | ) |
| Cost of acquisitions, net of cash acquired  of $291,277 and $78,091, respectively                           |   | (416,387                     | )           | (54,287 | ) |
| Cash used in investing activities                                                                           |   | (467,679                     | )           | (181,098 | ) |
|                                                                                                        |   |                         |        |   |   |
| Cash flows from financing activities:                                                                       |   |                         |        |   |   |
| Payment on notes and payables to related  parties, net                                                      |   | (57,428                      | )           | (208,926 | ) |
| Borrowings on long term debt, net                                                                           |   | 4,287,033                    |        | (10,952 | ) |
| Debt issuance costs                                                                                         |   | (751,200                     | )           | — |   |
| Purchase of treasury stock                                                                                  |   | (72,000                      | )           | — |   |
| Proceeds from exercise of options and  warrants                                                             |   | 26,550                       |        | — |   |
| Proceeds from sale of common stock, net of  offering costs                                                  |   | —                       |        | 1,197,115 |   |
| Proceeds from sale of preferred stock, net  of offering costs                                               |   | 2,127,500                    |        | 3,593,807 |   |
| Cash provided by financing activities                                                                       |   | 5,560,455                    |        | 4,571,044 |   |
|                                                                                                        |   |                         |        |   |   |
| Net increase in cash                                                                                        |   | 355,878                      |        | 1,415,894 |   |
| Effect of foreign exchange rates on cash                                                                    |   | (42,640                      | )           | — |   |
| Cash at beginning of period                                                                                 |   | 1,416,073                    |        | 179 |   |
| Cash at end of period                                                                                       |   | $                            | 1,729,311   |   | $ | 1,416,073 |   |
|                                                                                                        |   |                         |        |   |   |
| Supplemental cash flow information:                                                                         |   |                         |        |   |   |
| Cash paid for interest                                                                                      |   | $                            | 115,239     |   | $ | 3,786 |   |
|                                                                                                        |   |                         |        |   |   |
| Non-cash investing activities:                                                                              |   |                         |        |   |   |
| Common stock issued for acquisitions and  acquisition costs                                                 |   | $                            | 47,748,421  |   | $ | 4,100,000 |   |
|                                                                                                        |   |                         |        |   |   |
| Non-cash financing activities:                                                                              |   |                         |        |   |   |
| Common stock for services                                                                                   |   | $                            | 1,716,089   |   | $ | 554,995 |   |
| Common stock for compensation                                                                               |   | $                            | 1,781,000   |   | — |   |
| Common stock for Series C Preferred stock  offering costs                                                   |   | $                            | 73,750      |   | — |   |
| Preferred stock for preferred stock  dividend                                                               |   | $                            | 380,488     |   | — |   |
| Warrants and options for services                                                                           |   | $                            | 459,640     |   | $ | 1,227,400 |   |
| Warrants for compensation                                                                                   |   | $                            | 6,800,000   |   | — |   |
| Warrants for preferred stock offerings                                                                      |   | $                            | 228,992     |   | — |   |
| Warrants for preferred stock offering costs                                                                 |   | $                            | 105,426     |   |   |   |
| Warrants for convertible debt offering                                                                      |   | $                            | 2,072,053   |   | — |   |
| Repricing of and amendments to warrants                                                                     |   | $                            | 1,781,461   |   | — |   |
| Deemed dividend associated with beneficial  conversion of preferred stock                                   |   | $                            | 623,198     |   | $ | 3,382,172 |   |
| Conversion of preferred stock to common  stock                                                              |   | $                            | 1,303,877   |   | — |   |
| Conversion of senior notes and accrued  interest                                                            |   | $                            | 1,547,738   |   | — |   |
| Beneficial conversion of convertible debt                                                                   |   | $                            | 2,189,663   |   | — |   |

 

See accompanying notes to consolidated financial statements.

 

F-5

----

 

VITAL LIVING, INC.Notes to Consolidated FinancialStatements

 

**Note 1 – Organizationand Description of Business**

 

Vital Living, Inc. (the “Company” or “Vital Living”)was incorporated in the State of Nevada on January 22, 2001 underthe name Nutritional Systems, Inc. Effective May 7, 2001, the Companyacquired substantially all of the assets of Vital Living, Inc. and on May 20,2001, changed its name to Vital Living, Inc. The Company then merged with VCMTechnology Limited, a company reporting under the Securities and Exchange Actof 1934, on August 16, 2001. As set forth in the terms of the merger agreement,the Company acquired all of the outstanding shares of common stock of VCM fromits sole stockholder in exchange for 5,062 shares of its restricted commonstock. Following the merger, Vital Living continued as the survivingcorporation and commenced reporting under the Securities and Exchange Act of1934 by assuming the reporting status of VCM, which in turn provided the Company with the ability to file forquotation on the Over the Counter Bulleting Board under the ticker symbol“VTLV.”

 

Througha variety of subsidiaries acquired during 2003 and 2002, as described furtherbelow, Vital Living develops or licenses nutraceuticals and pharmaceuticaldrug-delivery systems, marketing them for distribution through physicians,medical groups, chiropractic offices, and retail outlets. In addition, theCompany formulates, markets, and distributes vitamins, herbs, high qualitydietary supplements, and therapeutic and functional food products throughsimilar distribution channels. Nutraceuticals are products that are isolated orpurified from foods and generally sold in medicinal forms not usuallyassociated with foods, including tablets, capsules, or drops. Thesenutraceuticals may have physiological benefits or have the ability to reducethe risk of chronic disease beyond basic nutritional products. The Companydevelops and tests its nutraceuticals in collaboration with leading medicalexperts in the nutraceuticals field. The Company’s initial areas of focus are cardiovascular health andweight loss.

 

InNovember 2002, Vital Living acquired MAF BioNutritionals, LLC (“MAF”). MAFformulates, markets, and distributes natural and organic food-based,preventative nutraceuticals and therapeutic and functional food productsdesigned to support proactive human cell maintenance and rehabilitation,essential in the prevention and treatment of disease, as well as overall optimalbody performance and metabolic function.

 

InJuly 2003, Vital Living completed the acquisition of the assets and assumptionof certain liabilities of Christopher’s Original Formulas, Inc. (“COF”).Through this acquisition, the Company gained the exclusive licensing andmarketing rights to Christopher’s products, a complete line of over 300 herbalformulas and products consisting primarily of naturally occurring organicsubstances and sold to professionals and at retail locations throughout theUnited States.

 

InAugust 2003, Vital Living completed the acquisition of E-Nutraceuticals, Inc.(“ENI”). ENI develops safe and effective alternatives to prescriptionmedications for non-life threatening chronic ailments, such as obesity anddepression. Through the acquisition, the Company obtained worldwide patent andlicensing rights to X-FatTM, a dietary supplement utilized for weight loss. Inaddition, through a collaborative partnership with SkyePharma, PLC, (“Skye”), aUK pharmaceuticals company and major shareholder, the Company is in the processof enhancing existing nutraceuticals via FDA-approved, proprietary deliverysystems. Pursuant to an amended Development and License Agreement between theparties, the Company acquired exclusive rights to Skye’s drug deliverytechnology, GEOMATRIXTM, and marketing and royalty rights to pharmaceuticalsales using GEOMATRIXTM in the Peoples Republic of China, Taiwan, and Hong Kong.

 

InOctober 2003, Vital Living completed the acquisition of Doctors For Nutrition,Inc. (“DFN”). DFN’s product line includes GreensFIRST®, a highly concentratedformulation of fruits and vegetables. One serving of the product has theantioxidant power of over 10 servings of fruits and vegetables.  DFN currently distributes GreensFIRST®through health practitioner offices throughout the United States.

 

**Note 2 – Summary ofSignificant Accounting Policies**

 

Restatement of financial statements

 

Subsequent to the issuance of the Company’s financial statements as ofDecember 31, 2003 and for the year then ended, the Company identified an errorin the previously reported financial statements. During 2003, the Companyborrowed an aggregate principal amount of $4,587,738 in the form of SeniorSecured Convertible Notes as described in Note 6. As part of the debt offeringthe Senior Secured Noteholders also received detachable warrants that had anexercise price that was less than the fair market value of the underlyingcommon stock. Additionally, imbedded within the senior secured notes was abeneficial conversion feature that had an exercise price that was below fairmarket value. The Senior Secured Notes were immediately convertible and thewarrants were fully vested at the date of issuance and both were charged tointerest expense immediately.  However,upon further consideration of EITF 00-27 “Application of Issue No. 98-5 toCertain Convertible Instruments,” the Company determined that it is required toamortize such charges over the life of the notes and that immediately expensingsuch amounts was not in accordance with GAAP. Accordingly, the Company hasrevised its financial statements as of December 31, 2003 and for the year thenended to record a debt discount and a reduction in interest expense by$2,686,190. The Company’s financial statements reflect a decrease in theretained deficit and a corresponding decrease in long-term debt for thisamount. This restatement decreased the net loss from $30,621,222 to $27,935,032and the net loss per share from $0.96 to $0.94 for the year ended December 31,2003.  All Notes to the financialstatements have been adjusted to conform with this restatement.

 

*Consolidation*

 

Theconsolidated financial statements include Vital Living, Inc. and its whollyowned domestic and foreign subsidiaries (collectively, “Vital Living” or the“Company”). Consolidated financial statements are financial statements of aparent company and its subsidiaries presented as if the entities were a singleeconomic unit. Although the assets, liabilities, revenues, and expenses of allentities are combined to provide a single set of financial statements, certaineliminations and adjustments are made. These eliminations are necessary toensure that only arm’s-length transactions between independent parties arereflected in the consolidated statements; transactions between related partiesare eliminated.

 

F-6

----

 

*Going concern*

 

Theaccompanying consolidated financial statements have been prepared assuming theCompany will continue on a going concern basis, which contemplates therealization of assets and the satisfaction of liabilities in the normal courseof business. The Company has suffered recurring losses from operations, has aworking capital deficit, and is dependent on funding from sources otherthan operations. Since inception, the Company has been required to raiseadditional capital by the issuance of both equity and debt instruments. Thereare no commitments from funding sources, debt or equity, in the event that cashflows are not sufficient to fund ongoing operations or other cash commitmentsas they come due. These factors raisesubstantial doubt about the Company’s ability to continue as a going concern.Management will be required to raise additional capital in the near termthrough offerings of securities to fund the Company’s operations, and willattempt to continue raising capital resources in the near term if the Companydoes not begin to generate revenue sufficient to maintain itself as a viableentity. No assurance can be given that such financing will be available or, ifavailable, that it will be on commercially favorable terms. Moreover, availablefinancing may be dilutive to current investors.

 

TheCompany is in the process of improving, acquiring, or developingproducts for sale that would generate revenue to sustain its operations, aswell as consolidating its operations in order to gain cost synergies andefficiencies. If successful,these actions will serve to mitigate the factors that have raised doubt aboutthe Company’s ability to continue as a going concern and increase theavailability of resources for funding of the Company’s current operations andfuture market development. In addition, in March 2004 the Companyentered into a Purchase Agreement with investors and sold 250,000 shares of itscommon stock at $1.00 per share with rights to receive a portion of netrevenues, as defined therein, from the sale of X-Fat®.  Theconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded assets or liabilities thatmight be necessary should the Company be unable to continue as a going concern.

 

*Reclassifications*

* *

Certain reclassifications of prior year amounts have been made toconform to current year presentation. These reclassifications had no effect on2002 net loss or stockholders’ equity.

 

*Financialinstruments*

* *

The Company’s financial instruments consist of cash, receivables,payables, and long-term debt. The carrying amount of cash, receivables, andpayables approximates fair value because of the short-term nature of theseitems. The carrying amount of long-term debt as of December 31, 2003 and 2002approximates fair value because interest rates are reflective of market rates.

 

*Concentrationsof credit risk*

* *

Financial instruments that potentially subject the Company toconcentrations of credit risk consist principally of cash. At various timesduring the year, the Company’s cash balances may be in excess of federallyinsured limits. The Company maintains its cash, which consists primarily ofdemand deposits, with high quality financial institutions, which the Companybelieves limits this risk.

 

*Acquisitions*

 

The Company accounts for acquisitions in accordance with Statement ofFinancial Accounting Standards, (“SFAS”) No. 141 “*Business Combinations*” and accordingly applies the purchasemethod of accounting for all business combinations initiated after June 30,2001 and separately identifies recognized intangible assets that meet thecriteria and amortizes these assets over their determinable useful lives.

 

*Cash and cashequivalents*

* *

The Company’s cash equivalents consist principally of any financialinstrument with maturities of three months or less and cash investments withhigh quality financial institutions. The Company’s investment policy limits theamount of credit exposure to any one financial institution.

 

F-7

----

 

*Inventories*

* *

Inventories are stated at the lower of cost (first-in, first-out method)or market and consist of products available for sale or Raw materials.

 

*Property andequipment*

* *

Property and equipment consists of office furniture, fixtures, andequipment, including computer hardware and software and various leaseholdimprovements. Property and equipment are recorded at cost. Depreciation isprovided on a straight-line basis over the lesser of correlating lease terms orestimated useful lives ranging from 3 to 10 years.

 

*Goodwill*

* *

Goodwillrepresents the excess of the aggregate price paid by the Company over the valueof the net equity acquired in an acquisition. In accordance with SFAS No. 142,“*Goodwill and Other Intangible Assets*,”management is no longer required to amortize goodwill, but is required toreview goodwill for impairment at least annually, or whenever events indicatethat the carrying amount of the asset may not be recoverable in accordance withSFAS No. 144 “*Accounting for the Impairmentor Disposal of Long-Lived Assets*.” As of December 31, 2003, eventshad occurred that would indicate goodwill had been impaired and, accordingly,an impairment loss was recorded (see Note 5).

 

*Intangibleassets*

* *

The Company’s other intangible assets include trademarks, patents,formulations, customer lists, and various marketing and license agreements.Intangible assets are amortized on a straight-line basis over the lesser of thecorrelating agreements or estimated useful lives ranging from 2 to14 years.

 

*Long-livedassets*

* *

Long-livedassets and identifiable other intangible assets to be held and used arereviewed for impairment at least annually, or whenever events or changes incircumstances indicate that the carrying amount may not be recoverable.Goodwill and other intangible assets arising from various acquisitions areevaluated for impairment on at least an annual basis or when events occur thatwould indicate that impairment had occurred. Impairment is measured bycomparing the carrying value of the long-lived asset to the estimatedundiscounted future cash flows expected to result from use of the assets and theireventual disposition. As of December 31, 2003, events had occurred that wouldindicate goodwill had been impaired; accordingly, an impairment loss wasrecorded (see Note 5).

 

*Deferredcharges*

* *

*The Company capitalizes costs associated withthe issuance of debt instruments. These costs are amortized on a straight-linebasis over the term of the debt instruments. Amortization expense for the yearended December 31, 2003 was $230,871 and is recorded as a component of InterestExpense.*

* *

*Accountingestimates*

* *

The preparation of financial statements in conformity with generallyaccepted accounting principles in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities at the date of the financial statements and thereported amounts of revenues and expenses during the reporting period. Some ofthe more significant estimates required to be made by management include thevaluation of inventory, intangible assets, and equity based transactions.Actual results could differ from such estimates.

 

*Income taxes*

* *

TheCompany accounts for income taxes in accordance with SFAS No. 109, “*Accounting for Income Taxes*.” Under theasset and liability approach specified by SFAS No. 109, a deferred taxasset or liability is determined based on the difference between the financialstatement and tax basis of assets and liabilities as measured by the enactedrates that will be in effect when these differences reverse. Deferred taxassets are recorded at their likely realizable amounts.

 

F-8

----

 

*Revenuerecognition*

* *

Revenue is recognized when products are shipped to customers. TheCompany’s return policy provides for an unconditional guarantee to itscustomers for a full refund of any unused product including product that hasexceeded its expiration date. All returns are subject to quality assurancereviews before acceptance. The Company provides an estimate of product returnsas an accrued liability and as a reduction of revenue. The Company offers, fromtime to time, volume and promotional discounts on the products it sells. Thesediscounts are recorded as a reduction of revenue.

 

*Comprehensive income*

* *

SFASNo. 130, “Reporting Comprehensive Income,” establishes standards for thereporting and display of comprehensive income and its components within thefinancial statements. Other comprehensive income is comprised of charges tostockholders’ equity, other than contributions from or distributions tostockholders, excluded from the determination of net income. The Company’sother comprehensive income is comprised of foreign currency translations.  The Company does not provide for U.S. incometaxes on foreign currency translation adjustments since it does not provide forsuch taxes on undistributed earnings of foreign subsidiaries.

 

*Foreign currency translation*

* *

Financialstatements of Vital Living’s foreign subsidiary is prepared using the localcurrency as the functional currency. Translation of these foreign operations toUnited States dollars occurs using the current exchange rate for balance sheetaccounts and a weighted average exchange rate for results of foreignoperations. Translation gains or losses are recognized in “accumulated othercomprehensive income (loss)” as a component of stockholders’ equity in theaccompanying consolidated balance sheets.

 

*Research anddevelopment*

* *

Researchand development costs relating to both present and future products are expensedwhen incurred. Research and development costs amounted to $410,648 and $510,436for the years ended December 31, 2003 and 2002, respectively.

 

*Net loss pershare*

* *

TheCompany accounts for its earnings per share (“EPS”) in accordance with SFAS No.128, “*Earnings Per Share*,” whichestablishes the requirements for presenting EPS. SFAS No. 128 requires thepresentation of “basic” and “diluted” EPS on the face of the income statement.Basic earnings per share begins with income (loss) applicable to commonshareholders (net income (loss) less preferred stock dividends) and is based onthe weighted average number of common shares outstanding during each periodpresented. Diluted EPS assumes the exercise of all stock options and warrantshaving exercise prices less than the average market price of the common stockusing the treasury stock method. In computing basic loss per share in 2003, netloss was increased by the issuance of 380,488 shares of Series A PreferredStock to satisfy cumulative dividends on Series A Preferred Stock, valued at$380,488, issued during the first and second quarter. Net loss was furtherincreased by $204,623 for cumulative dividends on Series A Preferred that havebeen declared but not paid for a total dividend of $585,111 for the year (animpact of $0.02 per common share). For the purpose of diluted earnings percommon share, and only if such calculation results in dilution, preferred stockdividends will not reduce earnings; however, the weighted average common sharesoutstanding would increase representing the amount of common shares into whichsuch preferred stock is currently convertible. During the years ended December31, 2003 and 2002, the Company reported a net loss, thus the effects ofdilutive securities were anti-dilutive, rendering basic and diluted loss pershare the same. Convertible preferred stock, warrants, and options to purchasecommon stock are included as common stock equivalents only when dilutive.

 

*Stock basedcompensation*

* *

The Company accounts for its stock option plans in accordance with theprovisions of SFAS No. 123, “*Accounting forStock Based Compensation,*” as amended by SFAS No. 148 *“Accounting for Stock-BasedCompensation-Transition and Disclosure.”* SFAS No. 123 permitsentities to recognize as expense over the vesting period the fair value of allstock-based awards on the date of grant. Alternatively, SFAS No. 123 alsoallows entities to apply the provisions of Accounting Principles Board (“APB”)Opinion No. 25, “*Accounting for Stock Issuedto Employees*,” and related interpretations and provide pro forma netincome or loss and pro forma earnings per share disclosures for employee stockoption grants as if the fair-value-based method defined in SFAS No. 123 hadbeen applied.

 

F-9

----

 

TheCompany is subject to reporting requirements of FASB Financial InterpretationNo. (“FIN”) 44, “*Accounting for CertainTransactions Involving Stock Compensation,*” which requires anon-cash charge to deferred compensation expense if the price of the Company’scommon stock on the last trading day of each reporting period is greater thanthe exercise price of certain stock options. After the first such adjustment ismade, each subsequent period is adjusted upward or downward to the extent thatthe trading price exceeds the exercise price of the options.

 

TheCompany accounts for its Plans under the recognition and measurement principlesof Accounting Principles Board (“APB”) Opinion No. 25, “*Accounting for Stock issued to Employees*,”and related Interpretations. No stock-based employee compensation (except thatrelated to repriced warrants in accordance with FIN No. 44) is reflected in netloss, as all options and warrants granted had an exercise price equal to orbelow the market value of the underlying common stock at the date of grant.

 

The fair value of the Company’s stock-based awards to employees wasestimated using the Black-Scholes option-pricing model. The Black-Scholes modelwas developed for use in estimating the fair value of traded options that haveno vesting restrictions and are fully transferable. In addition, theBlack-Scholes model requires the input of highly subjective assumptions,including the expected stock price volatility. Because the Company’sstock-based awards have characteristics significantly different from those oftraded options and because changes in the subjective input can materiallyaffect the fair value estimate, in management’s opinion, the existing models donot necessarily provide a reliable single measure of the fair value of itsstock-based awards to employees. The fair value of the Company’s stock-basedawards (including repriced warrants discussed above) was estimated assuming noexpected dividends and the following weighted average assumptions for the yearsended December 31:

 
|                                  |   | **2003** |   | **2002** |   |
|---------------------------------------|--------|----------|--------|----------|--------|
| Expected life in years                |   | 4.00     |   | 4.00     |   |
| Expected stock price volatility       |   | 33.49    | %      | 30.65    | %      |
| Risk-free interest rate               |   | 3.14     | %      | 3.98     | %      |
| Average fair value per option/warrant |   | $        | 0.68   |     | $      | 1.68 |   |
|                                       |        |          |        |          |        |  |  |

 

For pro forma purposes, the estimated fair value of the Company’sstock-based awards to employees is amortized over the respective vestingperiods.

 

Thefollowing table illustrates the effect on net loss and net loss per share ifthe Company had applied the fair value recognition provisions of Statement ofAccounting Standards (“SFAS”) No. 123, “*Accountingfor Stock-Based Compensation*,” to its stock-based employeecompensation for the years ended December 31:

 
|                                                                                                                    |   | **2003**       |        | **2002**   |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|----------------|-------------|------------|--------|
|                                                                                                                    |   | **(Restated)** |        |       |   |
| Net loss – as reported                                                                                             |   | $              | (27,935,032 | )          | $      | (3,949,895 | ) |
| Add:                                                                                                                    |   |           |        |       |   |
| Stock based compensation included in  determination of net loss                                                         |   | 1,526,461      |        | —     |   |
| Deduct:                                                                                                                 |   |           |        |       |   |
| Stock based employee compensation  determined under fair value based method for all awards, net of related tax  effects |   | (1,356,281     | )           | (170,180   | )      |
| Net loss – pro forma                                                                                               |   | (27,764,852    | )           | (4,120,075 | )      |
| Deemed dividend associated with beneficial  conversion of preferred stock                                               |   | (1,643,252     | )           | (2,235,519 | )      |
| Series A Preferred stock dividend                                                                                       |   | (585,111       | )           | —     |   |
| Net loss available to common stockholders –  pro forma                                                             |   | $              | (29,993,215 | )          | $      | (6,355,594 | ) |
| Basic and diluted loss per share – as  reported                                                                    |   | $              | (0.87       | )          | $      | (0.28 | ) |
| Basic and diluted loss per share available  to common stockholders – as reported                                   |   | $              | (0.94       | )          | $      | (0.43 | ) |
| Basic and diluted loss per share – pro  forma                                                                      |   | $              | (0.87       | )          | $      | (0.29 | ) |
| Basic and diluted loss per share available  to common stockholders – pro forma                                     |   | $              | (0.94       | )          | $      | (0.45 | ) |
| Weighted average basic and diluted common  stock outstanding                                                            |   | 31,992,346     |        | 14,278,129 |   |

 

F-10

----

 

*Recentaccounting pronouncements*

 

In May 2003, the FASB issued SFAS No. 150, “*Accounting for Certain Instruments with Characteristics of BothLiabilities and Equity*.” SFAS No. 150 clarifies the accounting forcertain financial instruments with characteristics of both liabilities andequity and requires that those instruments be classified as liabilities instatements of financial position. Previously, many of those financialinstruments were classified as equity. SFAS No. 150 is effective for financialinstruments entered into or modified after May 31, 2003 and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003. The adoption of SFAS No. 150 did not have a material effect on theCompany.

 

In April 2003, the FASB issued SFAS No. 149, “*Amendment of Statement No. 133 on Derivative Instruments and HedgingActivities*.” SFAS No. 149 amends and clarifies financial accountingand reporting for derivative instruments, including certain derivativeinstruments embedded in other contracts (collectively referred to asderivatives) and for hedging activities under SFAS No. 133, “*Accounting for Derivative Instruments and HedgingActivities*.” This Statement is effective for contracts entered intoor modified after June 30, 2003. The adoption of SFAS No. 149 did not have amaterial effect on the Company.

 

In January 2003, the FASB issued Interpretation No. 46, “*Consolidation of Variable Interest Entities*”(“FIN 46”). In general, a variable interest entity is a corporation,partnership, trust, or any other legal entity used for business purposes thateither (a) does not have equity investors with voting rights or (b) has equityinvestors that do not provide sufficient financial resources for the entity tosupport its activities. FIN 46 requires certain variable interest entities tobe consolidated by the primary beneficiary of the entity if the investors inthe entity do not have the characteristics of a controlling financial interestor do not have sufficient equity at risk for the entity to finance itsactivities without additional subordinated financial support from otherparties. The consolidation requirements of FIN 46 apply immediately to variableinterest entities created after January 31, 2003. The consolidationrequirements apply to older entities in the first fiscal year or interim periodbeginning after June 15, 2003. Certain of the disclosure requirements apply toall financial statements issued after January 31, 2003, regardless of when thevariable interest entity was established.

 

In December 2003, the FASB issued a revisedInterpretation No. 46 (FIN 46R), “*Consolidationof Variable Interest Entities*.” FIN 46R requires companies toconsider whether entities, in which they have financial interests, lacksufficient equity at risk to permit that entity to finance its activitieswithout additional subordinated financial support and to consolidate thoseentities where the company would absorb the majority of any losses. Theconsolidation requirements are effective for interim and annual periods endingafter March 15, 2004. The Company does not expect the adoption of FIN 46 andFIN 46R to have a material effect on the Company’s future financial conditionor results of operations.

 

In June 2002, the FASB issued SFAS No. 146, “*Accounting for Exit or Disposal Activities*.” SFAS No. 146addresses significant issues regarding the recognition, measurement andreporting of disposal activities, including restructuring activities that arecurrently covered in EITF Issue No. 94-3, “*LiabilityRecognition for Certain Employee Termination Activity*.” Theprovisions of SFAS No. 146 are effective for exit or disposal activitiesinitiated after December 31, 2002. The adoption of SFAS No. 146 did not have amaterial effect on the Company.

 

In April 2002, the FASB issued SFAS No. 145, “*Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASBStatement No. 13, and Technical Corrections*.” This statementrescinds SFAS No. 4, “*Reporting Gains andLosses from Extinguishment of Debt*,” which required all gains andlosses from extinguishment of debt to be aggregated and, if material,

 

F-11

----

 

classified as an extraordinary item, net of income taxes. As a result,the criteria in APB No. 30 will now be used to classify those gains and losses.Any gain or loss on the extinguishment of debt that was classified as anextraordinary item in prior periods presented that does not meet the criteriain APB No. 30 for classification as an extraordinary item shall bereclassified. The provisions of this Statement are effective for fiscal yearsbeginning after January 1, 2003. The adoption of SFAS No. 145 did not have amaterial effect on the Company.

 

In November 2002, the FASB issued FIN 45, “*Guarantor’s Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others*,” aninterpretation of FASB Statements No. 5, 57 and 107, and rescission of FIN 34,“*Disclosure of Indirect Guarantees ofIndebtedness of Others*.” FIN 45 elaborates on the disclosures to bemade by the guarantor in its interim and annual financial statements about itsobligations under certain guarantees that it has issued. It also requires thata guarantor recognize, at the inception of a guarantee, a liability for thefair value of the obligation undertaken in issuing the guarantee. The initialrecognition and measurement provisions of this interpretation are applicable ona prospective basis to guarantees issued or modified after December 31, 2002,while the provisions of the disclosure requirements are effective for financialstatements for interim or annual periods ending after December 15, 2002. Theadoption of SFAS No. 145 did not have a material effect on the Company.

 

**Note 3 – Mergers andAcquisitions**

 

During2003 and 2002, the Company acquired four companies. In each transaction, commonstock was used as consideration and the excess of the purchaseconsideration over the net assets or obligations assumed, after allocation torespective identifiable intangible assets, was recorded as goodwill assummarized below. A description of each business combination follows. 

 
|                                      |   | **MAF**    |      | **COF**    |   | **ENI**     |   | **DFN**   |       |
|-------------------------------------------|--------|------------|-----------|------------|--------|-------------|--------|-----------|------------|
| Purchase price paid                       |   | $          | 4,100,000 |       | $      | 3,051,614   |   | $         | 40,877,063 |   | $ | 2,343,004 |   |
| Less:                                     |   |       |      |       |   |        |   |      |       |
| Working capital (assets) liabilities, net |   | 119,400    |      | 163,764    |   | 405,216     |   | (314,325  | )          |
| Property and equipment, net               |   | (8,232     | )         | (70,293    | )      | (1,331      | )      | (7,215    | )          |
| Intangibles, net                          |   | (320,481   | )         | —     |   | (43,058,614 | )      | —    |       |
| Plus:                                     |   |       |      |       |   |        |   |      |       |
| Debt obligations assumed                  |   | 864,134    |      | 464,794    |   | 150,000     |   | —    |       |
| Acquisition costs                         |   | 200,378    |      | 277,918    |   | 1,627,666   |   | 91,952    |       |
| Goodwill at purchase                      |   | 4,955,199  |      | 3,887,797  |   | —      |   | 2,113,416 |       |
| Less: Impairment recorded (see Note 5)    |   | (4,370,683 | )         | (2,406,797 | )      | —      |   | —    |       |
| Goodwill at December 31, 2003             |   | $          | 584,516   |       | $      | 1,481,000   |   | $         | —     |   | $ | 2,113,416 |   |

 

*MAF BioNutritionals,LLC*

 

On November 22, 2002, the Company acquired 100% of members’ equity ofMAF, a privately held New Jersey limited liability company. The acquisitionpurchase price consisted of 2,500,000 shares of the Company’s restricted commonstock valued at $1.64 per share (the average fair market value per share of theCompany’s common stock for a reasonable period before and after the measurementdate, which was November 4, 2002), or $4,100,000, and other acquisition costsof $200,378. Included as other acquisition costs is 50,000 shares of commonstock issued to financial advisors with a fair value of $68,000.  The amortization period for intangibleassets acquired in this transaction is estimated to be approximately threeyears.  Goodwill recorded in thisacquisition is not deductible for federal income tax purposes.

 

*Christopher’s Original Formulas, Inc.*

* *

On July 3, 2003, the Company formed a new wholly owned corporation,Nature’s Systems, Inc. (“NSI”), and acquired certain assets and assumed certainliabilities of COF. The acquisition purchase price consisted of 2,600,000shares of the Company’s restricted common stock, of which 650,000 remain inescrow until June 2005 pending final purchase price adjustments, valued at$1.08 per share (the average fair market value per share of the Company’scommon stock for a reasonable period before and after the measurement date,which was June 25, 2003), or $2,808,000, the assumption of COF advances of$243,614 made by the Company prior to the closing, and other acquisition costsof $277,918. Included as other acquisition Goodwill recorded in thistransaction is fully deductible for federal income tax purposes.

 

F-12

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costs is 154,000 shares of common stock issued to financial advisorswith a fair value of $166,320.

 

Concurrentwith the acquisition, the Company executed the NSI Profit Sharing RestrictedStock Plan, which provides for up to 650,000 Bonus Shares of restricted commonstock to retained COF executives contingent on NSI achieving future performancetargets extending through June 2006.

 

*E-Nutraceuticals, Inc.*

 

On August 20, 2003, the Company acquired 100% of the outstanding commonstock of ENI, a privately held Delaware corporation. The acquisition purchase priceconsisted of 31,248,584 shares of the Company’s restricted common stock valuedat $1.30 per share (the average fair market value per share of the Company’scommon stock for a reasonable period before and after the measurement date,which was August 20, 2003), or $40,623,159, and other acquisition costs of$1,627,666. The purchase price also includes 251,390 options issued in exchangefor existing ENI options, which were estimated to have a fair value of$253,938. Other acquisition costs include 1,150,000 shares of the Company’scommon stock valued at $1.30 per share (or $1,495,000) issued to financialadvisors and $132,666 of legal and other related costs paid to professionaladvisors.

 

The total number of shares issued in this transaction, including theissuance of the Series D Preferred Stock (see Note 8), was 40% of the totalnumber of shares outstanding on a fully diluted basis, which contemplates thatall warrants, options, and various classes of preferred stock are converted tocommon stock.

 

The recording of the ENI Acquisition was based on a third partybusiness valuation and purchase price allocation provided by a reputable,independent, full service investment bank. The primary assets of ENI includedthe intangible value associated with the worldwide patent rights to X-Fat®, adietary supplement used in weight loss; licensing rights to GEOMATRIX®, atime-released drug delivery technology; and marketing rights to pharmaceuticalsales using GEOMATRIX® in the Peoples Republic of China, Taiwan, and Hong Kong.The purchase price allocation resulted in $43,058,614 being assigned to thevalue of these two agreements.  Theamortization period for the China Marketing agreement is approximately twoyears and the amortization period for the X-Fat agreement and the G-BOMATRIKagreement is approximately 14 years. These intangibles are fully deductible for income tax purposes.

 

Goodwill recorded in this acquisition is not deductible for Federalincome tax purposes.

 

*Doctors For Nutrition, Inc.*

 

On October 14, 2003, the Company acquired 100% of the outstanding commonstock of DFN, a privately held California corporation. The acquisition purchaseprice consisted of 1,650,003 shares of the Company’s restricted common stock,valued at $1.42 per share (the average fair market value per share of theCompany’s common stock for a reasonable period before and after the measurementdate, which was October 14, 2003), or $2,343,004, and other acquisition costsof $91,952. Included as other acquisition costs is 50,000 shares of commonstock issued to financial advisors with a fair value of $59,000.

 

Of the total shares issued, 650,000 are held in escrow contingent on DFNachieving certain minimum levels of future earnings (the “Earn Out Shares”),which are included as a component of the cost of the acquisition. In March2004, the Company’s Board of Directors approved that the stipulations of theEarn-Out Shares be lifted and the shares released from escrow as earned.

 

Concurrent with the acquisition, the Company executed an employmentagreement with a key executive, which provides for certain cash payments andoptions to acquire up to 300,000 shares of restricted common stock at $1.40 pershare contingent on DFN achieving future performance targets extending throughSeptember 2006.

 

*Acquisition proformas*

 

Theunaudited pro forma consolidated results of operations for the years endedDecember 31, 2003 and 2002 have been prepared assuming the acquisitions of MAF,COF, ENI, and DFN, and the corresponding issuance of 37,998,587 shares ofcommon stock issued as consideration in these acquisitions, had occurred as ofJanuary 1, 2002. Thus, the unaudited pro forma consolidated results ofoperations include the following periods of operation:

 

•                  Vital Living, Inc. for the years ended December31, 2003 and 2002.

•                  MAF for the period from January 1, 2002through November 22, 2002 (date of acquisition).

•                  Boulder Endurance Co., Inc. (“Boulder”) forthe period from January 1, 2002 through April 4, 2002 (the date of acquisitionby MAF).

 

F-13

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•                  COF for the period from January 1, 2003through July 3, 2003 (date of acquisition) and the year ended December 31,2002.

•                  ENI for the period from April 1, 2003 throughAugust 20, 2003 (date of acquisition) and the year ended March 31, 2003.

•                  DFN for the period from January 1, 2003through October 14, 2003 (date of acquisition) and the year ended December 31,2002.

 

Presented below are the unaudited pro forma consolidated results ofoperations for the years ended:

 
|                                                                      |   | **December  31,** |        |
|---------------------------------------------------------------------------|--------|-------------------|-------------|
|                                                                      |   | **2003**          |        | **2002** |   |
| Revenue                                                                   |   | $                 | 4,834,654   |   | $ | 4,562,579 |   |
| Cost of goods sold                                                        |   | 2,878,584         |        | 2,557,491 |   |
| Gross profit                                                              |   | 1,956,070         |        | 2,005,088 |   |
| Operating expenses and other                                              |   | 33,652,554        |        | 11,902,901 |   |
| Net loss                                                                  |   | (31,696,484       | )           | (9,897,813 | ) |
| Deemed dividend associated with beneficial  conversion of preferred stock |   | (1,643,252        | )           | (2,235,519 | ) |
| Series A preferred stock dividend                                         |   | (585,111          | )           | — |   |
| Net loss available to common stockholders                                 |   | $                 | (33,924,847 | ) | $ | (12,133,332 | ) |
|                                                                      |   |              |        |   |   |
| Basic and diluted loss per share                                          |   | $                 | (0.57       | ) | $ | (0.19 | ) |
| Deemed dividend associated with beneficial  conversion of preferred stock |   | (0.03             | )           | (0.04 | ) |
| Preferred stock dividend                                                  |   | (0.01             | )           | — |   |
| Basic and diluted loss per share available  to common stockholders        |   | $                 | (0.61       | ) | $ | (0.23 | ) |
|                                                                      |   |              |        |   |   |
| Weighted average basic and diluted common  stock outstanding              |   | 55,165,425        |        | 53,145,420 |   |

 

**Note 4 – Property and equipment**

 

Property and equipment consists of the following at December 31:  

 
|                           |   | **2003** |    | **2002** |   |
|--------------------------------|--------|----------|---------|----------|--------|
| Computer hardware and software |   | $        | 226,079 |     | $      | 191,782 |   |
| Office Furniture and fixtures  |   | 44,365   |    | 36,624   |   |
| Machinery and equipment        |   | 54,597   |    | 27,930   |   |
| Leasehold improvements         |   | 6,545    |    | 13,130   |   |
| Gross property and equipment   |   | 331,586  |    | 269,466  |   |
| Less accumulated depreciation  |   | (162,479 | )       | (97,171  | )      |
| Net property and equipment     |   | $        | 169,107 |     | $      | 172,295 |   |

 

Depreciation expense was $89,772 and $36,505 for the years endedDecember 31, 2003 and 2002, respectively.

 

F-14

----

 

**Note 5 – Intangible assets**

 

Intangible assets consist of the following at December 31:

 
|                                      |   | **2003**                     |       | **2002**                      |   |
|-------------------------------------------|--------|------------------------------|------------|-------------------------------|--------|
|                                      |   | **Gross  Carrying   Amount** |       | **Accumulated  Amortization** |   | **Gross  Carrying  Amount** |   | **Accumulated    Amortization** |   |
| License agreement – Geomatric®  |   | $                            | 34,661,058 |                          | $      | (870,200 | ) | $ | — |   | $ | — |   |
| License agreement – X–Fat® |   | 4,093,118                    |       | (102,614                      | )      | — |   | — |   |
| Marketing agreement                       |   | 4,304,438                    |       | (771,212                      | )      | — |   | — |   |
| Customer distribution lists               |   | 203,599                      |       | (118,766                      | )      | 203,599 |   | (50,900 | ) |
| Trademarks and patents                    |   | 142,641                      |       | (75,238                       | )      | 142,641 |   | (33,155 | ) |
| Formulations                              |   | 85,672                       |       | (48,916                       | )      | 85,672 |   | (20,359 | ) |
| Total amortizable intangible assets       |   | $                            | 43,490,526 |                          | $      | (1,986,946 | ) | $ | 431,912 |   | $ | (104,414 | ) |
| Unamortizable intangible assets           |   |                         |       |                          |   |   |   |   |   |
| Goodwill                                  |   | $                            | 4,178,932  |                          |   |   | $ | 4,893,517 |   |   |   |
|                                           |        |                              |            |                               |        |  |  |  |  |  |  |  |  |  |  |

 
|                             |   | **Aggregate  Amortization  Expense** |      | **Estimated  Amortization  Expense** |      |
|----------------------------------|--------|--------------------------------------|-----------|--------------------------------------|-----------|
|                             |   |                                 |      |                                 |      |
| For year ended December 31, 2002 |   | $                                    | 16,454    |                                 |      |   |
| For year ended December 31, 2003 |   | $                                    | 1,882,531 |                                 |      |   |
| For year ended December 31, 2004 |   |                                 |      | $                                    | 5,005,553 |   |
| For year ended December 31, 2005 |   |                                 |      | $                                    | 4,132,546 |   |
| For year ended December 31, 2006 |   |                                 |      | $                                    | 2,716,194 |   |
| For year ended December 31, 2007 |   |                                 |      | $                                    | 2,716,194 |   |
| For year ended December 31, 2008 |   |                                 |      | $                                    | 2,716,194 |   |

 

*ImpairmentAnalyses*

 

As required by SFAS No. 142, the Company tested goodwill or otherintangibles created by each acquisition for impairment in the fourthquarter.  These assets are tested forimpairment at least annually, or upon occurrence of such events that mayindicate impairment exists. Management revised the earnings forecast for thenext five years and evaluated the change in fair value of each component ofgoodwill using the expected present value of future cash flows. Impairment wasdue to a combination of factors including, acquisition price, increased marketcompetition, and operating performance. As a result of the Company’s annualreview, a goodwill impairment loss of $6,777,480 was recognized during the yearended December 31, 2003. The remaining goodwill of $4,178,932 is attributable to previous acquisitions asfollows:

 

| **Entity Acquired** |   | **Goodwill** |      |
|---------------------|--------|--------------|-----------|
| DFN                 |   | $            | 2,113,416 |   |
| COF                 |   | 1,481,000    |      |
| MAF                 |   | 584,516      |      |
| Total               |   | $            | 4,178,932 |   |

 

F-15

----

 

The Company’sprimary intangibles other than goodwill discussed above, with a grossintangible value of $43,058,614 at December 31, 2003, were obtained in theAugust 2003 acquisition of ENI and are comprised of licensing and marketingagreements related to three distinct products: X-Fat®, a dietary supplement forweight loss, time released nutraceuticals utilizing the licensed GEOMATRIX®technology, and certain marketing rights to pharmaceutical sales usingGEOMATRIX® in the Peoples Republic of China, Taiwan, and Hong Kong.. Theproducts or activities are scheduled for launch throughout 2004.

 

In order to testfor impairment of these long-lived assets, fair value was determined based on avaluation study performed by an independent third party that primarilyconsidered the discounted cash flow and guideline company method. As a resultof this review, performed in October 2003, none of these long-lived assets wasimpaired. At December 31, 2003, the Company’s management performed additionalanalyses, which include detailed calculations of projected discounted futurecash flows, which took into account delays in marketing initiatives for X-Fatexperienced in the fourth quarter of 2003, as well as risks associated with theCompany not making a required payment under the GEOMATRIX licensing agreementin January 2004. As of February 28, 2004, Management believes that theintangibles recorded at December 31, 2003 are not impaired.

 

**Note 6 – Long-Term Debt**

 

BetweenOctober and December 2003, the Company borrowed an aggregate principal amountof $1,530,000 in the form of Senior Convertible Notes (the “Bridge Notes”), dueApril 28, 2004, in a private placement subject to certain registration rights,generating cash proceeds of $1,316,400, net of cash debt issue costs of$213,600. Principal and interest at a rate of 10% per annum is payable in asingle installment on the maturity date in cash or the Company’s common stock,at the Company’s discretion, at a price equal to $1.00 per share. As part ofthe transactions, Bridge Note holders received 3,060,000 and 1,530,000 warrantsto purchase the Company’s common stock at an exercise price of $1.00 and $1.50per share, respectively. The fair value of these warrants of $987,833 has beenrecorded by the Company and charged immediately to interest expense as thewarrants were fully vested and the related notes fully convertible at the dateof issuance. In accordance with the terms of these Bridge Notes, because theCompany consummated a debt financing before the maturity date, the entireprincipal amount of the notes plus accrued interest totaling $1,547,738 hasbeen converted into the debt securities offered in the December 2003 SecuredNotes.

 

Debtissue costs related to this transaction of $654,826, including cash fees of$213,600, common stock issued valued at $297,840, and the fair value associatedwith warrants issued of $143,386 as discussed in Note 9, is recorded indeferred debt issuance costs, net of amounts charged to interest expense duringthe year ended December 31, 2003 totaling $219,801 before refinancing. Themarket value of the Company’s common stock on the dates the Bridge Notes wereissued ranged from $1.28 - $1.52 per share. In accordance with EITF 98-5, asamended by EITF 00-27, because the convertible debt was sold at a price lessthan market value, a beneficial conversion to holders of the Bridge Notesoccurred. Accordingly, a beneficial conversion amount of $542,165 was recordedto additional paid-in-capital and a corresponding amount recorded by theCompany to interest expense, as the debt was immediately convertible at theoption of the debt holder.

 

InDecember 2003, the Company borrowed an aggregate principal amount of $4,587,738in the form of Senior Secured Convertible Notes (the “Secured Notes”), dueDecember 17, 2008, in a private placement subject to certain registrationrights, therein converting the Bridge Notes as described above, generating cashproceeds of $2,502,400, net of cash debt issue costs of $537,600. The SecuredNotes bear interest at a rate of 12% per annum, 8% of which is payablesemi-annually in cash each June and December, while 4% per annum may be paid,at the Company’s discretion, in cash or the Company’s common stock at a priceequal to the ten day average trading price of the Company’s common stock fivebusiness days prior to the relevant interest payment date. A total of $549,862,or an amount equal to the first two semi-annual interest payments at 12%, hasbeen placed in an interest bearing escrow account as of December 31, 2003 andis recorded in Prepaid Expenses and Other Current Assets.

 

TheCompany may redeem the Secured Notes commencing December 15, 2004, provided theten-day average trading price of the Company’s common stock prior to theredemption is at least $3.00 per share. The Secured Notes are collateralized byassets of the Company, have priority in right of payment over all indebtednessof the Company, and include certain provisions related to change in control,reorganization, recapitalization, and other adjustments. In addition, SecuredNote holders received 4,587,738 warrants to purchase the Company’s common stockat an exercise price of $1.00 per share. The fair value of these warrants of$1,084,220 was recorded by the Company and previously charged immediately tointerest expense as the warrants were fully vested and the related notes fullyconvertible at the date of issuance.  Asdiscussed in Note 2, the Company has restated its financial results as ofDecember 31, 2003 to record a debt discount of $1,066,150, net of accumulatedaccretion of $18,070 of interest expense in accordance with EITF 00-27 and willamortize the remaining discount over the life of the Secured Notes.

 

F-16

----

 

Debtissue costs related to the Secured Notes of $741,130, including cash fees of$330,200 and the value associated with warrants issued of $167,275 as discussedin Note 9, is recorded in deferred debt issuance costs. Amounts charged tointerest expense during the year ended December 31, 2003 totals $254,846 andincludes $243,656 of cash and the fair value of warrants issued in conjunctionwith the refinancing of the Bridge Notes charged to expense in the periodincurred. The market value of the Company’s common stock on the date theSecured Notes were issued ranged from $1.15 - $1.23 per common share. Inaccordance with EITF 98-5, as amended by EITF 00-27, because the convertibledebt was sold at a price less than market value, a beneficial conversion toholders of the Secured Notes occurred. Accordingly, a beneficial conversionamount of $1,647,498 was recorded to additional paid-in-capital and acorresponding amount previously recorded by the Company to interest expense, asthe debt is immediately convertible at the option of the debt holder.  As discussed in Note 2, the Company hasrestated its financial results as of December 31, 2003 to record a debtdiscount of $1,620,040, net of accumulated accretion of interest expense of$27,458 in accordance with EITF 00-27 and will amortize the remaining discountover the life of the Secured Notes.

 

In connection with the Company’s acquisitions in 2003 and 2002, certainof the acquired companies’ long-term debt was assumed, the terms of which aredescribed further below. Long-term debt consists of the following atDecember 31:

 
|                                                                                                                                                                                                                                                                                                                              |   | **2003**   |      | **2002** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|-----------|----------|--------|
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| Senior Secured Convertible Notes                                                                                                                                                                                                                                                                                                  |   |       |      |     |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| $4,587,738  senior notes payable to shareholders; maturity December 2008; interest at 12%  per annum, (8% payable semi-annually in cash each June and December, 4% may  be paid in cash or the Company’s common stock); principal due at maturity                                                                            |   | $          | 4,587,738 |     | $      | — |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| Small Business Administration Loan                                                                                                                                                                                                                                                                                                |   |       |      |     |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| $650,000 note payable  to bank; maturity December 14, 2008; variable interest at prime plus 1.50%  (5.50% and 5.75% at December 31, 2003 and 2002, respectively); monthly  principal and interest payments of $9,970; secured by assets of the Company                                                                            |   | 481,363    |      | 574,537  |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| Manufacturing Agreement  Debt                                                                                                                                                                                                                                                                                                     |   |       |      |     |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| $346,400 balance of  various debt arrangements assumed as part of NSI Acquisition; maturity  October 25, 2004; interest rates range from 4.75% to 12.00%; monthly payments  primarily interest only and vary, totaling approximately $2,500 per month                                                                             |   | 342,063    |      | —   |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| Other NSI Acquisition  Debt                                                                                                                                                                                                                                                                                                       |   |       |      |     |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| $120,850 balance of  personal bank and other debt of former executives assumed; maturities range  from December 2003 through January 2004; interest rates range from 7.25% to  24.0% balances primarily due and payable immediately                                                                                               |   | 112,181    |      | —   |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| Promissory Notes –  Related Parties                                                                                                                                                                                                                                                                                          |   |       |      |     |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| $260,045 notes payable  to various related parties; interest rates range from prime to prime plus 2%  (6.00% and 6.25% at December 31, 2003 and 2002, respectively); principal and  interest due upon demand                                                                                                                      |   | 260,045    |      | —   |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| Notes Payable – Boulder  Bar                                                                                                                                                                                                                                                                                                 |   |       |      |     |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| $275,000 note payable  to individual; maturity April 8, 2004; interest at 7.00% payable in two  installments April 8, 2003 and 2004; principal payable at $25,000 per quarter  September 9, 2002 through January 8, 2003, $75,000 on April 8, 2002, and  monthly payments of $10,417 thereafter; secured by assets of the Company |   | 41,664     |      | 225,000  |   |
|                                                                                                                                                                                                                                                                                                                              |   |       |      |     |   |
| $40,935 note payable to  individual; maturity April 8, 2003; non interest bearing; monthly principal  payments of $3,411; secured by assets of the Company                                                                                                                                                                        |   | —     |      | 13,645   |   |
|                                                                                                                                                                                                                                                                                                                              |   | 5,825,054  |      | 813,182  |   |
| Less current portion                                                                                                                                                                                                                                                                                                              |   | (844,616   | )         | (291,688 | )      |
| Unamortized debt discount                                                                                                                                                                                                                                                                                                         |   | (2,686,190 | )         | —   |   |
|                                                                                                                                                                                                                                                                                                                              |   | $          | 2,294,248 |     | $      | 521,494 |   |

 

F-17

----

 

Aggregatematurities of long-term debt for the subsequent five years endingDecember 31 are as follows:

 
| 2004  |   | $         | 844,616   |   |
|-------|--------|-----------|-----------|--------|
| 2005  |   | 93,352    |      |
| 2006  |   | 100,600   |      |
| 2007  |   | 108,410   |      |
| 2008  |   | 4,678,076 |      |
| Total |   | $         | 5,825,054 |   |

 

**Note 7 – Commitmentsand contingencies**

 

Fromtime to time, the Company is party to a variety of legal proceedings arisingout of the normal course of business, including cases in which damages may besought. The Company believes it has valid defenses and is vigorously defendingany pending litigation. While the results of litigation cannot be predictedwith certainty, the Company believes that the outcome of these proceedings willnot have a material adverse effect on its consolidated financial position,results of operations, or cash flows.

 

OnMarch 8, 2004, an attorney representing a former employee notified the Companythat he was prepared to initiate litigation for alleged breach of hisemployment agreement. On March 15, 2004, the same attorney demanded that theCompany take certain remedial steps in connection with certain manufacturingprocesses and cure alleged breaches of certain agreements related to the COFAcquisition. As of March 30, 2004, formal lawsuits related to these matters hadnot been filed. The outcome of these actions is uncertain and an estimate ofthe amount of a settlement, if any, cannot be reasonably estimated at thistime.

 

Inconnection with the COF Acquisition, the Company became party to aManufacturing Agreement, a Marketing Agreement, and a Multi-Agreement Amendment(collectively, the “COF Agreements”), in which various minimum payments arerequired during the terms therein. In the aggregate, the COF Agreements requireroyalties of $0.25 per licensed product sold with a monthly minimum of $8,000extending through May 30, 2023 with automatic five-year renewals thereafter. Inaddition, the COF Agreements require broker commissions of 5% per invoice ofall raw materials and finished goods sourced by the parties thereto with amonthly minimum of $5,000 extending through December 31, 2006 with automaticfive-year renewals thereafter. Royalty and commission payments in excess ofthose earned as a result of the minimum requirements are cumulatively availablefor credit only to the extent future earned royalties exceed the monthlyminimums. To date, the Company has a cumulative balance in excess of earnedroyalties and commissions of approximately $50,000. Because the royalties andcommissions earned have historically not exceeded the minimum, the futurerealizable value of the asset is uncertain and, as such, has not been recorded.

 

InAugust 2001, the Company signed a three-year agreement with the Arizona HeartInstitute (“AHI”), which through its affiliates serves between 22,000 to 25,000new patients each year with a database of over 150,000 heart patients to whichAHI will market and distribute Essentum. Under the agreement, the Company mustpay royalties to AHI in the amount of 12% or 6% of our net sales of Essentum,depending on their origin.

 

F-18

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TheCompany leases office space and minor amounts of office equipment undernoncancellable operating leases that expire through 2008. Future minimum leasepayments under noncancellable operating leases for the subsequent five years endingDecember 31 are approximately as follows:

 
| 2004  |   | $      | 215,000 |   |
|-------|--------|--------|---------|--------|
| 2005  |   | 66,000 |    |
| 2006  |   | 60,000 |    |
| 2007  |   | 59,000 |    |
| 2008  |   | 54,000 |    |
| Total |   | $      | 454,000 |   |

 

Totalrent expense was $160,633 and $153,271 for the years ended December 31, 2003and 2002, respectively.

 

Inconnection with the ENI Acquisition, the Company became party to a Developmentand License Agreement and subsequent Amendment (collectively, the “ENIAgreements”) with SkyePharma, PLC (“Skye”). The ENI Agreements provide forcertain product identification and license exclusivity rights on nutraceuticalproducts utilizing Skye’s patented drug-delivery technologies, GEOMATRIX®, inexchange for various commitments as follows:

 

•                  In consideration for the Amendment anddevelopment services through 2004 and contingent on additional debt or equityfinancing of $3,000,000, the Company is obligated to pay Skye $1,000,000 infour equal installments beginning January 1, 2004 and each first day of eachcalendar quarter thereafter.

•                  The Company may retain its right to identifynew product candidates and license them exclusively through the later ofDecember 31, 2017 or the expiration of Skye’s corresponding patents, providedat least four such product candidates are identified by the Company andapproved by Skye, or Skye receives $1,000,000 in product development fees, percalendar year beginning January 1, 2005.

•                  The Company is obligated to pay Skye royaltiesequal to 10% of net sales generated from the products, as defined, quarterly inarrears.

 

Shouldthe Company fail to meet the above commitments, product selection and licenseexclusivity rights will terminate at the end of the respective calendar yearwithout effect on rights attained in prior years. As of March 30, 2004, theCompany successfully completed the aforementioned contingent financing,however, failed to make the initial $250,000 payment to Skye on January 1,2004. The Company is in process of renegotiating the related terms and paymentsin order to maintain its rights under the ENI Agreements despite the default.

 

TheENI Agreements also appointed the Company as Skye’s exclusive marketing partnerto pharmaceutical companies for licensing of all of Skye’s Technology in theChinese Territories, as defined therein. The Company is eligible to receive 5%of all gross revenues resulting directly from the Company’s marketing efforts.Receipt of such royalties is contingent, however, on such revenues reaching orexceeding $1,000,000, or in aggregate $2,000,000, by August 2004 and 2005,respectively. Should these revenue goals not be achieved, the Company’sexclusive marketing rights and Skye’s royalty obligation on newly establishedsales will terminate, provided however, that royalties on on-going grossrevenues resulting directly from the Company’s marketing efforts prior to theloss of such rights will continue to be due and payable.

 

Inconnection with the ENI Acquisition, the Company became party to a LicensingAgreement, granting it an exclusive, worldwide, perpetual license to dietarysupplements containing chitosan, or X-Fat® (the “X-Fat License”). The X-FatLicense requires the Company to pay royalties equal to 10% of the first$1,000,000 of net product sales and 5% of such net product sales in excess of$1,000,000, up to a maximum royalty of $1,250,000 per fiscal year. The Companyis required to pay advanced royalties of $15,000 per quarter to be creditedagainst future royalty payments. At December 31, 2003, the Company had prepaidroyalties of $247,172.

 

F-19

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**Note 8 – Capital Stock**

 

In December 2003, the board of directors and a majority of stockholdersapproved an amendment to the Company’s Articles of Incorporation to increasethe number of authorized shares of common stock from 100,000,000 to150,000,000, par value $.001 per share. The Company is currently authorized toissue up to 50,000,000 shares of preferred stock, par value $.001 per share. AtDecember 31, 2003, the Company’s capital stock consisted of:

 
| **Capital Stock**        |   | **Par Value** |   | **Authorized** |        | **Issued  & Outstanding** |       |
|--------------------------|--------|---------------|--------|----------------|-------------|-------------------------------|------------|
| Common Stock             |   | $             | .001   |           | 150,000,000 |                          | 58,269,466 |   |
| Series A Preferred Stock |   | $             | .001   |           | 10,000,000  |                          | 3,410,325  |   |
| Series B Preferred Stock |   | $             | .001   |           | 1,000,000   |                          | 1,000,000  |   |
| Series C Preferred Stock |   | $             | .001   |           | 3,000,000   |                          | 500,000    |   |
| Series D Preferred Stock |   | $             | .001   |           | 1,000,000   |                          | 1,000,000  |   |

 

*COMMON STOCK*

* *

Eachholder of common stock is entitled to one vote per share of common stock heldon all matters submitted to a vote of the Company stockholders. Holders of theCompany’s common stock have no preemptive rights and have no rights to converttheir common stock into any other securities. In the event of dissolution orliquidation or the winding-up of the Company’s business, holders of theCompany’s common stock will be entitled to share ratably in all assetsremaining after payment of all liabilities, subject to any preferentialpayments to the holders of any Senior Secured Convertible Notes and preferredstock then outstanding. Although the Company is restricted from paying cashdividends under the terms of the Senior Secured Convertible Notes, holders ofcommon stock are entitled to receive ratably such dividends as may be declaredby the Company’s board of directors out of funds legally available therefore.All of the Company’s outstanding common shares are fully paid andnonassessable.

 

*Common Stock Private Placements*

 

OnNovember 20, 2002, concurrent with the MAF Acquisition, the Company sold 19.54units, each unit consisting of 70,000 shares of common stock, 70,000 Series BWarrants, and 70,000 Series C Warrants, aggregating 1,367,500 shares of common stock at $1.00 pershare, 1,367,500 Series B Warrants at an exercise price of $1.65 per share, and1,367,500 Series C Warrants at an exercise price of $2.14 per share, generatingcash proceeds of $1,197,115, net of cash offering costs of $170,385.

 

*Common StockIssued to an Employee*

 

During the year ended December 31, 2003, the Company issued 1,300,000shares of common stock to an employee valued at $1,781,000 as compensationrelated to the closing of various 2003 acquisitions.

 

*Common StockIssued for Services and Settlements*

 

In order to fund operating activities, the Company, from time to time,issues common stock in lieu of cash in exchange for goods or services.

 

During the years ended December 31, 2003 and 2002, the Company issued692,000 and 102,500 shares of restricted common stock with a value of $748,610and $213,125, respectively, in consideration for consulting, investmentbanking, or other services rendered, compensation, release of debt, or variousother claims that parties may have had against the Company.

 

During the years ended December 31, 2003 and 2002, 395,000 and 241,000shares of common stock with a value of $513,500 and $341,870, respectively,were issued to directors for director services and to various consultants forvarious consultations and advisory services to be provided over a contract periodranging from 12 months to three years. These shares were originally capitalizedas a component of equity and amortized to expense over the vesting periods. Forthe years ended December 31, 2003 and 2002, $428,335 and $92,785 was amortizedto expense, respectively. The value of unamortized restricted common stockissued for services as of December 31, 2003 and 2002 was $390,250 and $249,085,respectively.

 

F-20

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During the years ended December 31, 2003 and 2002, a total of 1,354,000and 50,000 shares of common stock with an aggregate value of $1,720,320 and$68,000, respectively, were issued for financial advisory services related toour various subsidiary acquisitions. During 2003, 1,150,000 shares of commonstock with a market value of $1.30 per share were issued to financial advisorsin the ENI Acquisition (valued at $1,495,000), 154,000 shares of common stockwith a market value of $1.08 per share were issued to financial advisors in theCOF Acquisition (valued at $166,320) and 50,000 shares of common stock with amarket value of $1.18 per share were issued to a financial advisor in the DFNAcquisition (valued at $59,000).  During2002, 50,000 shares of common stock were issued to a financial advisor in theMAF Acquisition (valued at $68,000). These amounts were capitalized as acomponent of the overall purchase price of the respective entities acquired andallocated to the assets acquired, generally goodwill or intangible assets.

 

During the year ended December 31, 2003, 265,500 shares of common stockwith a value of $371,590 were issued for investment banking or other servicesrelated to private placements of both senior convertible debt and the Series CPreferred stock. The value of the shares were capitalized as a component ofequity if associated with Series C Preferred stock private placement ($73,750),or as deferred loan costs if associated with Senior Convertible Debt privateplacements ($297,840).

 

Pursuant to a registration rights agreement related to a November 2002private placement of 1,367,500 shares of common stock, the Company was requiredto file and have declared effective a registration statement to register theshares of common stock issued and shares that may be issued upon exercise of theSeries B Warrants and Series C Warrants from the private placement prior toMarch 20, 2003. The Company failed to have the registration statement declaredeffective by the deadline; as a result, the Company owes the investorsliquidation damages equal to 2% per month of the purchase price of saidsecurities, calculated on a pro rata basis to the date on which theregistration statement was ultimately declared effective. During 2003, theCompanny reached an agreement with some of the investors to pay such damages in328,200 shares of our common stock, valued at approximately $367,000. Of thetotal shares owed, 134,600 shares of restricted common stock were issued,valued at $156,136, related to the settlement agreements prior to December 31,2003 (see Note 11).

 

*TREASURY STOCK*

 

As part of a resignation agreement executed in July 2003, in which allseverance payments under a prior employment agreement were waived, 280,000shares of restricted common stock were returned at no cost and 144,000 sharesrepurchased by the Company at $0.50 per share from William Coppel, formerPresident, for total payments of $72,000 during 2003. These shares have beenreturned to and recorded as treasury stock as of December 31, 2003. The 280,000shares of common stock returned by Mr. Coppel were recorded at par value, or$280, with a corresponding adjustment to additional paid in capital.

 

*PREFERRED STOCK*

 

Preferred stock may be issued in one or more series, the terms of whichmay be determined at the time of issuance by the Company’s board of directors,without further action by stockholders, and may include voting rights(including the right to vote as a series on particular matters), preferences asto dividends and liquidation, conversion rights, redemption rights and sinkingfund provisions. The issuance of shares of preferred stock could adverselyaffect the rights of the holders of common stock and therefore, reduce thevalue of the common stock.

 

*Series A PreferredStock*

 

Between February and June 2002, the Company sold 3,712,000 shares of 10%Series A Preferred Stock at $1.00 per share, generating cash proceeds of$3,593,807, net of cash offering costs of $118,193. Holders may convert theirshares into a like amount of common stock at any time after the firstanniversary date of issuance and will convert by their terms after 18 months.Upon conversion, holders of Series A Preferred Stock will receive one Series AWarrant per five preferred shares converted to purchase one share of commonstock at an exercise price of $2.00 per share, exercisable one year from thedate of issuance. If all Series A Preferred Stock were to convert, it wouldrequire the Company to issue 742,400 Series A Warrants, excluding those to beissued upon conversion of Series A Preferred Stock issued as dividends.

 

Holders of Series A Preferred Stock have no voting rights, but areentitled to various rights, preferences, and restrictions that include, but arenot limited to: a 10% cumulative dividend payable in additional shares ofSeries A Preferred Stock at $1.00 per share; a preference upon a liquidation,dissolution, or winding up of the Company’s business; and privileges uponredemption during the first twelve months from the date of issuance equal to$1.50 per share.

 

F-21

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The market value of the Company’s common stock on the dates Series APreferred Stock was sold ranged between $1.25 - $3.40 per common share. Inaccordance with EITF 98-5, as amended by EITF 00-27, because the Series APreferred Stock was sold at a price less than market value of the underlyingcomponents of the security, a beneficial conversion to holders of the Series APreferred Stock occurred. Accordingly, during 2002 the Company recorded adiscount of $3,382,172 within shareholders’ equity and a corresponding amountto preferred stock additional paid-in-capital. The Series A Preferred Stock isconvertible into common stock at the option of the holder at any time after thefirst anniversary date of its issuance, thus the beneficial conversion isamortized over a one-year period. A total of $1,146,653 and $2,235,519 of theSeries A Preferred Stock discount was amortized during the years ended December31, 2003 and 2002, respectively. At December 31, 2003, the entire amount of theSeries A Preferred discount had been amortized.

 

During 2003, holders of 682,163 shares of Series A Preferred Stockconverted such shares into 682,163 shares of common stock. As a condition toconversion, the Company granted 136,433 warrants with an exercise price of$2.00 per share. The value of the converted Series A Preferred Stock was$1,303,877 and the value of the warrants was $55,025 using the Black-Scholesoption-pricing model. Dividends are cumulative and are to be paid every sixmonths from the date of issuance for a total of 18 months with no obligation topay dividends thereafter. During June 2003, 380,488 additional shares of SeriesA Preferred Stock valued at $380,488 were issued in satisfaction of dividendsowed to holders of Series A Preferred Stock and at December 31, 2003, declaredand unpaid dividends of $204,623 were accrued and will be paid by the issuanceof Series A Preferred Stock for a total dividend of $585,111 (or $0.02 pershare). At December 31, 2003, 3,410,325 shares of Series A Preferred Stockremain outstanding pending the issuance of a like amount of common stock.

 

*Series B PreferredStock*

 

On April 16, 2003, the Company sold to one investor 10 units, eachconsisting of 100,000 shares of non-voting 25% Series B Preferred Stock,100,000 Series D Warrants, and 100,000 Series E Warrants, aggregating 1,000,000shares of Series B Preferred Stock at $1.00 per share, 1,000,000 Series DWarrants at an exercise price of $1.30 per share, and 1,000,000 Series EWarrants at an exercise price of $1.60 per share, generating cash proceeds of$875,000, net of cash offering costs of $125,000. The combined fair value atthe date of grant of the Series D and Series E Warrants using the Black-Scholesoption-pricing model was $62,494.

 

The holder of the Series B Preferred Stock is entitled to a one-time adividend at a rate of 25% per annum, payable in cash or common stock on theone-year anniversary of the issuance date with no obligation to pay dividendsthereafter. Unpaid and/or undeclared dividends are cumulative. The total amountof dividends not declared at December 31, 2003 is $177,397 (or $0.01 per commonshare) and would total $250,000 on an annual basis (or $0.01 per common share).Each share of Series B Preferred Stock is convertible into one share of commonstock at the option of the holder at any time after the first anniversary ofthe date of issuance. In connection with this offering, 200,000 Series DWarrants with an exercise price of $1.30 per share (fair value of $8,086) and acash commission equal to 12.5% of the proceeds (or $125,000) were paid to ashareholder of the Company to facilitate the transaction, thus increasing thetotal offering costs to $133,086. The Series B Preferred Stock has no votingrights, liquidation preferences, or protective provisions.

 

*Series C PreferredStock*

 

On July 9, 2003, the Company sold to one investor 5 units, eachconsisting of 100,000 shares of non-voting 50% Series C Preferred Stock,100,000 Series D Warrants, and 100,000 Series E Warrants, aggregating 500,000shares of Series C Preferred Stock at $1.00 per share, 500,000 Series DWarrants at an exercise price of $1.30 per share, and 500,000 Series E Warrantsat an exercise price of $1.60 per share, generating cash proceeds of $437,500,net of cash offering cost of $62,500. The combined fair value at the date ofgrant of the Series D and Series E Warrants using the Black-Scholesoption-pricing model was $242,275.

 

The holder of the Series C Preferred Stock is entitled to a two-timedividend at the rate of 50% per annum, payable in cash or common stock on thefirst and second anniversary of the issuance date with no obligation to paydividends thereafter. Unpaid and/or undeclared dividends are cumulative. Thetotal amount of dividends not declared at December 31, 2003 is $119,863 (lessthan $0.01 per common share) and would total $250,000 on an annual basis (or$0.01 per common share). Each share of Series C Preferred Stock is convertibleinto one share of common stock at the option of the holder at any time afterthe first anniversary of the date of issuance.

 

In connection with this offering, 250,000 Series D Warrants with anexercise price of $1.30 per share (fair value of $71,510), a cash commissionequal to 12.5% of the proceeds (or $62,500), 62,500 shares of common stock(fair value of $73,750, or

 

F-22

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$1.18 per share), and an option to acquire 62,500 shares of common stockexercisable at $1.00 per share (fair value of $25,830) were granted, paid, orissued to a shareholder of the Company to facilitate the transaction, thusincreasing the total offering costs to $233,590. The Series C Preferred Stockhas no voting rights, liquidation preferences, or protective provisions.

 

The market value of the Company’s common stock on the date the Series CPreferred Stock was sold was $1.18 per common share. In accordance with EITF98-5, as amended by EITF 00-27, because the Series C Preferred Stock was soldat a price less than market value of the underlying components of the security,a beneficial conversion to holders of the Series C Preferred Stock occurred.Accordingly, during 2003 the Company recorded a discount of $253,198 withinshareholders’ equity and a corresponding amount to preferred stock additionalpaid-in-capital. The Series C Preferred Stock is convertible into common stockat the option of the holder at any time after the first anniversary date of itsissuance, thus the beneficial conversion is amortized over a one-year period. Atotal of $126,599 of the Series C Preferred Stock discount was amortized duringthe year ended December 31, 2003 leaving an unamortized balance of $126,599.

 

*Series D Preferred Stock*

 

On August 20, 2003, concurrent with the ENI Acquisition, the Companysold to a single investor 1,000,000 shares of Series D Preferred Stock at $1.00per share, generating cash proceeds of $815,000, net of cash offering costs of$185,000. Each share of Series D Preferred Stock is convertible into one shareof common stock at the option of the holder at any time.

 

The market value of the Company’s common stock on the date the Series DPreferred Stock was sold was $1.37 per common share. In accordance with EITF98-5, as amended by EITF 00-27, because the Series D Preferred Stock was soldat a price less than market value of the underlying components of the security,a beneficial conversion to holders of the Series D Preferred Stock occurred.Accordingly, during 2003 the Company recorded a discount of $370,000 withinshareholders’ equity and a corresponding amount to preferred stock additionalpaid-in-capital. The Series D Preferred Stock is convertible into common stockat the option of the holder at any time, thus the beneficial conversion wasrecorded as a dividend upon issuance.

 

The holder of the Series D Preferred Stock is entitled to variousrights, preferences, and restrictions that include, but are not limited to:

 

1.               *Voting*. The Series D Preferred Stockvotes on an as-converted basis with the common stock.

2.               *Dividends*. The holders of the Series DPreferred Stock are entitled to a like dividend or distribution, pro rata,should there be a cash or property dividend or distribution to any class ofcommon stock or preferred stock other than the Series A Preferred Stock,determined on an as converted basis. This does not include any dividends paidin shares of common stock to the holders of Series B Preferred Stock and SeriesC Preferred Stock outstanding as of the date of issuance.

3.               *Liquidation Preference*. The Series DPreferred Stock is senior to the Series B Preferred Stock and Series CPreferred Stock and the common stock upon liquidation and is entitled to anamount equal to the original $1.00 per share issue price plus any declared andunpaid dividends (as adjusted for stock dividends, combinations, splits,recapitalization, and the like with respect to such shares).

4.               *Redemption*. The Company has no rightsto redeem the Series D Preferred Stock.

5.               *Conversion*. The holders of Series DPreferred Stock shall have the right to convert into common stock at any time.Each share of Series D Preferred Stock is convertible into one share of commonstock subject to adjustment for declared and unpaid dividends, stock dividends,combinations, splits, recapitalization, and the like with respect to suchshares. The conversion price is initially set at $1.00. The conversion pricemay be decreased at the end of two years if the common Stock is trading at aprice below the conversion price then in effect. The floor for such adjustmentis $0.25 per share. The conversion price of the Series D Preferred Stock mayalso be reduced in certain situations if we issue additional options, warrants,or rights to purchase common stock at a price below the conversion price of theSeries D Preferred Stock. In such event, the conversion price will be decreasedby multiplying the conversion price then in effect by a fraction of which (i)the numerator will be the number of outstanding shares of common stock on thedate of issuance of the rights plus the number of shares of common stock whichcould be purchased at the then conversion price from the aggregate offeringprice of the rights and (ii) the denominator will be the shares of common stockoutstanding on the date of issuance of the rights plus the number of shares ofcommon stock so offered for subscription or purchase pursuant to such rights.

6.               *Protective Provisions*. So long as anyshares of Series D Preferred Stock are outstanding, the Company may not,without the prior affirmative consent or vote of the holders of at least two thirdsof the outstanding shares of the Series D Preferred Stock:

 

F-23

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a.               authorize, create, designate, establishor issue shares of, any class or series of capital stock ranking senior to oron parity with the Series D Preferred Stock or reclassify any shares of commonstock into shares having any preference or priority as to dividends or assetssuperior to any such preference or priority of Series D Preferred Stock; or

b.              amend, alter or repeal, whether by merger,consolidation or otherwise, the Company’s amended and restated articles ofincorporation or bylaws or the resolutions contained in the certificate ofdesignation of the Series D Preferred Stock and the powers, preferences,privileges, relative, participating, optional and other special rights andqualifications, limitations and restrictions thereof, which would adverselyaffect any right, preference, privilege or voting power of the Series DPreferred Stock, or which would increase the amount of authorized shares of theSeries D Preferred Stock or of any other series of preferred stock rankingsenior to the Series D Preferred Stock, with respect to the payment ofdividends (whether or not such series of preferred stock is cumulative ornon-cumulative as to payment of dividends) or liquidation.

 

**Note 9 – Stock Options and Warrants**

 

*Series A Warrants*

* *

Series A Warrants arose in connection with the June 2002 Series APreferred Stock private placement. Upon conversion of every five shares ofSeries A Preferred Stock into common stock, the Company will grant one Series AWarrant to purchase one share of the Company’s common stock, exercisable afterone year from the date of grant at an exercise price of $2.00 per share andexpiring on the second anniversary of the date of grant. The exercise price ofthe warrants is subject to adjustment for stock splits, dividends,reclassifications, and other adjustments.

 

Upon conversion of the 3,712,000 shares of Series A Preferred Stock andcorresponding stock dividends, the Company will ultimately issue 859,420 SeriesA Warrants. As of December 31, 2003, there are 208,433 Series A Warrantsoutstanding.

 

*Series B and SeriesC Warrants*

 

Series B and Series C Warrants arose in connection with the November2002 common stock private placement, concurrent with the MAF Acquisition. TheSeries B and Series C Warrants have an exercise price of $1.65 and $2.14,respectively, and may be exercised at the option of the holder at any time fora period of five years from the date of issuance. The exercise prices aresubject to adjustment for stock splits, dividends, reclassifications, and othertypical corporate actions. If the Company issues additional shares of commonstock at a price less than $1.00 per share, the exercise prices of the warrantsupon each such issuance shall be adjusted and reset to such issuance price;however, this reset feature does not apply to:

 

1.               any stock splits, dividends,reclassifications, or similar actions, or

2.               any issuance of shares of common stock(or shares of common stock issuable upon the exercise of securities convertibleinto shares of common stock with an exercise price or a conversion price lessthan $1.00) if such securities were issued to consultants, employees or otherservice providers, or to third party vendors to satisfy amounts owed; providedthat the Company may not issue to such individuals, in any rolling 12 monthperiod, more than 1,600,000 shares of common stock or 10% of the actual numberof shares of common stock issued and outstanding (assuming the conversion ofthe Series A Preferred Stock) and may not issue to any one individual more than500,000 shares of common stock.

 

Provided that a registration statement covering the shares underlyingthe warrants is effective, the Company may redeem any or all of the warrants,at any time, at $0.05 per warrant if:

 

1.               the closing price for the Company’scommon stock on any 20 trading days within a period of 30 consecutive tradingdays ending on the date of the notice of the call has been in excess of 150% ofthe then effective exercise price, and

2.               no less than four of such 20 days occurduring the last five trading days ending on the date of the notice of theredemption.

 

As of December 31, 2003, there are 1,367,500 Series B Warrants and 1,367,500Series C Warrants outstanding.

* *

*Series D and SeriesE Warrants*

* *

Series D and Series E Warrants arose in connection with the April 2003Series B Preferred Stock and July 2003 Series C Preferred Stock privateplacements. The Series D and Series E Warrants have an exercise price of $1.30and $1.60, respectively, and may be exercised at the option of the holder atany time for a period of five years from the date of issuance.

 

F-24

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The exercise prices are subject to adjustment for stock splits,dividends, reclassifications, and other typical corporate actions. As ofDecember 31, 2003, there are 1,950,000 Series D Warrants and 1,500,000 Series EWarrants outstanding.

 

*Series F Warrants*

* *

Series F Warrants arose in connection with the July 2003 amendment ofone of the Company’s strategic consulting agreements. The Series F Warrantshave an exercise price of $1.00 per share and may be exercised at the option ofthe holder at any time for a period of five years from the date of issuance.The exercise price is subject to adjustment for stock splits, dividends,reclassifications, and other typical corporate actions. As of December 31,2003, there are 125,000 Series F Warrants outstanding.

 

*Other Warrants*

* *

In connection with the Bridge Notes and Senior Secured Notes (see Note6) during 2003, the Company granted note holders an aggregate of 7,647,738 and1,530,000 warrants at an exercise price of $1.00 and $1.50 per share,respectively. The warrants may be exercised immediately, expire on the fifthanniversary of the date of issuance, and the exercise price is subject toadjustment for stock splits, dividends, reclassifications, and other typicalcorporate actions. As of December 31, 2003, there are 9,177,738 of these warrantsoutstanding.

 

Additionally, the Company granted 203,000 warrants to financialadvisors associated with the issuance of the Bridge Notes, which had a fairvalue of $143,326. Financial advisors associated with the Secured Notes weregranted 536,400 warrants with a fair value of $268,530. Of the warrants grantedin the Secured Notes, 200,000 warrants with a fair value of $101,256 wereissued in conjunction with the refinancing of the Bridge Notes.

 

*Stock OptionPlans*

 

On August 1, 2001, the Board of Directors adopted the Company’s2001 Stock Option Plan pursuant to which incentive stock options ornon-statutory stock options to purchase up to 2,500,000 shares of common stockcan be granted to employees, officers, directors, consultants, and independentcontractors or other service providers.

 

On May 3, 2002, the Board of Directors adopted the Company’s 2002Stock Option Plan pursuant to which incentive stock options or non-statutorystock options to purchase up to 2,000,000 shares of common stock can be grantedto employees, officers, directors, consultants, independent contractors, orother service providers.

 

On a combined basis, the plans had 3,831,483 and 3,385,000 optionsoutstanding at December 31, 2003 and 2002, respectively, with exercise prices rangingfrom $0.35 to $3.00. At December 31, 2003, there are an aggregate of 668,517options available under the plans for future grant.

 

*Options andWarrants Issued for Services*

 

In order to fund operating activities, the Company, from time to time,grants options or warrants to purchase common stock in lieu of cash inconsideration for consulting, investment banking, or other services rendered,compensation, release of debt, or various other claims which parties may haveagainst the Company. The Company granted options and warrants to purchasecommon stock during the years ended December 31, as follows:

 
|     |   | **2003**            |   | **2002**       |       |                |
|----------|--------|---------------------|--------|----------------|------------|---------------------|
|     |   | **Number  Granted** |   | **Fair Value** | ** ** | **Exercise  Price** | ** ** | **Number  Granted** | ** ** | **Fair Value** | ** ** | **Exercise  Price** | ** ** |
| Options  |   | 40,000              |   | $              | 16,018     |                | $ | 1.40 |   | 1,080,000 |   | $ | 554,360 |   | $  1.00 - $3.00 |   |
| Warrants |   | 743,400             |   | 443,622        |       | $                   | 1.00 |   | 1,180,000 |   | 673,040 |   | $ 1.00 - $2.05 |   |
|     |   | 783,400             |   | $              | 459,640    |                |   |   | 2,260,000 |   | $ | 1,227,400 |   |   |   |

 

The fair value of certain of these options and warrants are beingamortized over their respective vesting periods, which range from zero to 36months. For the years ended December 31, 2003 and 2002, $542,110 and $494,517was amortized to

 

F-25

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expense, respectively. The fair value of unamortized options andwarrants issued for services at December 31, 2003 and 2002 was $206,792 and$732,883, respectively.

 

During November and December 2003 in connection with the Bridge Notesand Senior Secured Notes, the Company granted an aggregate of 583,400 warrantsto acquire common stock, valued at $411,123, to various investment advisorswith an exercise price of $1.00 per share. The fair value of these warrants wascapitalized as component of deferred debt issuance costs and will be amortizedover the life of the debt instruments.

 

During September and October 2003, a total of 75,000 common stockoptions previously issued to three consultants were exercised, generating grossproceeds of $26,250.

 

During August 2003, the Board of Directors approved the repricing of anexisting warrant to acquire 120,000 shares of the Company’s common stock at anoriginal exercise price of $2.80 to $2.00 per share. The repricing of thiswarrant requires variable accounting as prescribed by FIN 44. The fair value ofthe repriced warrants was deemed to be lower than the original fair value of$138,274 using the Black-Scholes option-pricing model, thus no furtheradjustment to expense was required. As required by FIN 44, these warrants willbe subject to revaluation at each reporting period and, if the fair value ofthe underlying warrants were to exceed $138,274, an additional charge toexpense would be required.

 

During July 2003, the Company granted a Series F Warrant to acquire125,000 shares of the Company’s common stock with an exercise price of $1.00per share to one of the Company’s strategic consultants in conjunction with anamendment to an existing consulting agreement. The fair value of these warrants was calculated using the Black-Scholespricing model and was determined to be $32,500, which was recorded asconsulting expense.

 

In July 2003, the Company executed an amendment to an agreement withArizona Heart Institute, Inc. (“AHI”) extending the term for an additionalyear. In consideration for the extension, AHI received the right to exercise100,000 shares of common stock through a “net exercise” provision and theoption exercise period was extended to three years. AHI also agreed not to sellin excess of 25,000 shares in any rolling 30-day period. Consideration to bereceived would be in the form of relinquishment of the right by AHI to purchasea particular number of shares. In October 2003, AHI exercised its rights underthe net exercise provision and was issued 100,000 shares of common stock inexchange for 132,407 options.

 

In July 2003, the Company executed an amendment to an agreement withAHI Management Hong Kong, Ltd. (“AHIHK”) to provide the immediate vesting ofpreviously issued options to acquire 300,000 shares of our common stock at$0.35 per share and the eliminate any lock-up period relating thereto. Optionsrequire an outright purchase for cash consideration and are then subject to SECRule 144. In consideration for the amendment, AHIHK agreed to eliminate theirright to act as our exclusive distributor in China, enabling the Company toseek other distributors in the territory on a non-exclusive basis.

 

Per FIN No. 44, “*Accounting forCertain Transactions Involving Stock Compensation*,” a non-cashcharge to expense is required if the price of the Company’s common stock on thelast trading day of a reporting period is greater than the exercise price ofcertain stock options and warrants issued. The requirements of FIN No. 44 mayalso result in a credit to expense to the extent that the trading price declinesfrom the trading price as of the end of the previous reporting period, providedhowever that a credit is not recorded to the extent our common stock tradesbelow the exercise price of the options or warrants. In accordance with FIN No.44, the Company adjusts expense upward or downward on a monthly basis based onthe trading price at the end of each period. As a result, the Company recordedexpense of $255,000 during the year ended December 31, 2003, which representsthe fair value of the effective repricing of the options using theBlack-Scholes option-pricing model at the date of the amendments.

 

On April 3, 2003, the Board of Directors approved the granting of 35,000warrants to acquire common stock of the Company with an exercise price of $1.00per warrant to an agent who assisted in the private placement offering of1,367,500 shares of common stock completed during October 2002.  The fair value of the warrant was calculatedusing the Black-Scholes pricing model and was determined to be zero.

 

*Options andWarrants Issued to Employees*

 

During October 2003, the Company granted 300,000 options to an executivein conjunction with an employment agreement executed concurrent with the DFNAcquisition. The options have an exercise price of $1.40 per share, expire infive years, and vest based upon reaching certain performance milestones.

 

F-26

----

 

InApril 2003, the Board of Directors approved the repricing of 1,340,000 warrantsissued to an officer of the Company in connection with an April 2002 employmentagreement (the “Officer Warrants”). The warrants were 100% vested on the dateof grant and had an original exercise price of $1.50 per warrant. The warrantswere amended to include, among other things, a reduction of the exercise priceto $0.01, a full-ratchet dilution provision, as defined, a waiver of theCompany’s 50% funding obligation of the exercise price, and an extension of theterm of the warrant agreement for one additional year. The dilution provision providesthat, upon exercise of the warrant, the officer shall be able to acquire thesame percentage of common stock as that represented by the percentagecalculated as the number of shares which the officer would acquire on the dateof the amendment compared to the total number of actual shares of common stockoutstanding on such date.

 

In accordance with FIN No. 44, the Company adjusts expense upward ordownward on a monthly basis based on the trading price at the end of eachperiod. As a result, the Company recorded net compensation expense of$1,508,461 during the year ended December 31, 2003, and $18,000 of compensationexpense upon the exercise of 30,000 warrants by this executive during May 2003.

 

During August 2003, concurrent with the ENI Acquisition and the Series DPreferred Stock private placement, the Company executed a second amendment tothe Officer Warrants that provided for the granting of an additional 5,000,000warrants with an exercise price of $0.01 per share and eliminated the full-ratchetdilution provision, as defined. The new warrants were 100% vested on the dateof grant and had a fair value of $6,800,000, which was charged to compensationexpense during the year ended December 31, 2003.

 

In July 2002, the Company granted 30,000 options to an employeewith an exercise price of $2.40, vesting quarterly over a three-year periodcommencing October 17, 2002. The options were cancelled in 2002.

 

In January 2002, the Company issued 125,000 options to an employeeunder the Company’s 2001 Stock Option Plan. The options have an exercise priceof $1.00 per share, expire in four years, and vest quarterly, 40,000 in thefirst year, 45,000 in the second year, and 40,000 in the third year. The fairvalue of the options using the Black-Scholes option-pricing model wasdetermined to be zero.

 

*Summaryof Options and Warrants*

 

A summary of stock option activity for the yearsended December 31 is as follows:

 
|                                |   | **2003**   |       | **2002**                              |       |
|-------------------------------------|--------|------------|------------|---------------------------------------|------------|
|                                |   | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Outstanding  at beginning of period |   | 3,385,000  |       | $                                     | 0.87       |   | 2,180,000 |   | $ | 0.35 |   |
| Granted                             |   | 653,890    |       | $                                     | 1.21       |   | 1,235,000 |   | $ | 1.82 |   |
| Cancelled                           |   | —     |       | —                                |       | (30,000 | ) | $ | 2.40 |   |
| Exercised                           |   | (207,407   | )          | $                                     | 0.35       |   | — |   | — |   |
| Outstanding  at end of period       |   | 3,831,483  |       | $                                     | 0.93       |   | 3,385,000 |   | $ | 0.87 |   |
|                                |   |       |       |                                  |       |   |   |   |   |
| Exercisable  at end of period       |   | 1,763,516  |       | $                                     | 1.10       |   | 1,266,147 |   | $ | 0.71 |   |

 

F-27

----

 

Information about stock options outstanding atDecember 31, 2003 is as follows:

 
|                           |   | **Options  Outstanding** |   | **Options Exercisable**                            |   |
|--------------------------------|--------|--------------------------|--------|----------------------------------------------------|--------|
| **Range of   Exercise Prices** |   | **Shares  Outstanding**  |   | **Weighted  Average  Remaining  Contractual Life** |   | **Weighted  Average Exercise Price** |   | **Shares  Exercisable** |   | **Weighted  Average Exercise Price** |   |
| $ 0.35 - $1.00                 |   | 2,611,483                |   | 2.11                                               |   | $ | 0.51 |   | 1,426,483 |   | $ | 0.69 |   |
| $ 1.40 - $1.50                 |   | 840,000                  |   | 4.03                                               |   | $ | 1.46 |   | 3,700 |   | $ | 1.40 |   |
| $ 2.00 - $3.00                 |   | 380,000                  |   | 3.38                                               |   | $ | 2.65 |   | 333,333 |   | $ | 2.84 |   |
|                           |   | 3,831,483                |   |                                               |   | $ | 0.93 |   | 1,763,516 |   | $ | 1.10 |   |

 

A summary of warrant activity for the years ended December31 is as follows:

 
|                                |   |       | ** ** | **2003**   | ** ** | **2002**                              | ** ** |
|-------------------------------------|--------|------------|------------|------------|------------|---------------------------------------|------------|
|                                |   |       | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Outstanding at beginning of  period |   | 6,975,000  |       | $          | 1.32       |                                  | 1,750,000  |   | $ | 0.35 |   |
| Granted                             |   | 18,729,571 |       | $          | 0.87       |                                  | 5,255,000  |   | $ | 1.65 |   |
| Cancelled                           |   | —     |       | —     |       | (30,000                               | )          | $ | 2.05 |   |
| Exercised                           |   | (30,000    | )          | $          | 0.01       |                                  | —     |   | — |   |
| Outstanding at end of period        |   | 25,674,571 |       | $          | 0.91       |                                  | 6,975,000  |   | $ | 1.32 |   |
|                                |   |       |       |       |       |                                  |       |   |   |
| Exercisable at end of period        |   | 25,538,138 |       | $          | 0.91       |                                  | 6,686,120  |   | $ | 1.33 |   |

 

Information about warrants outstanding at December31, 2003 is as follows:

 
|                          |   | **Warrants  Outstanding** | ** ** | **Warrants  Exercisable**                          | ** ** |
|-------------------------------|--------|---------------------------|------------|----------------------------------------------------|------------|
| **Range of  Exercise Prices** |   | **Shares  Outstanding**   | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average Exercise  Price** | ** ** | **Shares  Exercisable** | ** ** | **Weighted  Average Exercise  Price** | ** ** |
| $ 0.01 - $0.35                |   | 8,060,000                 |       | 1.55                                               |       | $ | 0.08 |   | 8,060,000 |   | $ | 0.08 |   |
| $ 1.00                        |   | 9,191,138                 |       | 4.38                                               |       | $ | 1.00 |   | 9,191,138 |   | $ | 1.00 |   |
| $ 1.30 - $1.65                |   | 6,847,500                 |       | 3.65                                               |       | $ | 1.49 |   | 6,847,500 |   | $ | 1.49 |   |
| $ 2.00 - $2.14                |   | 1,575,933                 |       | 1.89                                               |       | $ | 2.12 |   | 1,439,500 |   | $ | 2.13 |   |
|                          |   | 25,674,571                |       |                                               |       | $ | 0.91 |   | 25,538,138 |   | $ | 0.91 |   |

 

F-28

----

 

**Note 10 – Income Taxes**

 

Components of the deferred tax asset (liabilities) as ofDecember 31 are as follows:

 
|                             |   | **2003**    |      | **2002**   |   |
|----------------------------------|--------|-------------|-----------|------------|--------|
| Net operating loss carryforwards |   | $           | 6,362,000 |       | $      | 1,706,886 |   |
| Deferred compensation            |   | 3,108,000   |      |       |   |
| Amortizable intangibles          |   | 1,079,000   |      | (9,332     | )      |
| Other temporary differences      |   | 61,000      |      |       |   |
|                             |   | 10,610,000  |      | 1,697,554  |   |
| Less valuation allowance         |   | (10,610,000 | )         | (1,697,554 | )      |
|                             |   | $           | —    |       | $      | — |   |

 

Net operating loss carryforwards are available to reduce future taxableincome.  However, a change in ownership,as defined by federal income tax regulations, could significantly limit theCompany’s ability to utilize its U.S. net operating loss carryforwards.Additionally, because federal tax laws limit the time during which the netoperating loss carryforwards may be applied against future taxes, if theCompany fails to generate taxable income prior to the expiration dates, it maynot be able to fully utilize the net operating loss caryforwards to reducefuture income taxes.

 

As the Company has had cumulative losses and there is no assurance offuture taxable income, valuation allowances have been recorded to fully offsetthe deferred tax asset at December 31, 2003 and 2002. The valuation allowanceincreased $8,912,446 during 2003 due to the Company’s current period netloss.  Due to this increase in thevaluation allowance, the effective tax rate has been reduced to 0% for theyears ended December 31, 2003 and 2002. As of December 31, 2003, theCompany has net operating loss carry forwards for federal income tax reportingpurposes of approximately $18,713,000, which expire through 2023. The utilizationof such operating losses may be limited.

 

**Note 11 – Related Party Transactions**

 

From time to time, the Company engages its directors, shareholders, orother related parties for consulting services related to investment,acquisition, or other activities in the normal course of business. Managementbelieves that all of these transactions are conducted at an “arms-length.”  Fair market value of securities issued inthese transactions, including stock, options, and warrants, is listed belowwhere applicable and calculated using the Black-Scholes Pricing Model as of thedate of issuance or grant.

 

*Officers andDirectors*

 

The Company has several agreements with Aegis Capital Corp. (“Aegis”)to provide consulting, investment, or financial services. Robert J. Eide, a memberof the Company’s Board of Directors from June 2002 through March 2004, is aprincipal, Chairman, and Chief Executive Officer of Aegis. During the yearsended December 31, 2003 and 2002, the Company paid the following amounts toAegis (or to Mr. Eide, where indicated) in exchange for such services:

 
| **Matter**           |   | **Year**            | ** ** | **Cash** | ** ** | **Stock** | ** ** | **Options  & Warrants** | ** ** | **Fair  Market  Value of  Securities** | ** ** |
|----------------------|--------|---------------------|------------|----------|------------|-----------|------------|-----------------------------|------------|----------------------------------------|------------|
| **Number**           |   | **Exercise  Price** |       |
| Other Services(1)    |   | 2003                |       | $        | 6,000      |      | 142,000    |                        | —     |                                   | N/A        |   | $ | 184,600 |   |
| Other Services(2)    |   | 2003                |       | —   |       | 58,000    |       | —                      |       | N/A                                    |       | $ | 75,400 |   |
| Other Services       |   | 2003                |       | $        | 216,335    |      | 150,000    |                        | 72,400     |                                   | $          | 1.00 |   | $ | 232 667 |   |
| Director Services(1) |   | 2003                |       | —   |       | 75,000    |       | —                      |       | N/A                                    |       | $ | 100,500 |   |
| Other Services       |   | 2002                |       | $        | 100,000    |      | 50,000     |                        | —     |                                   | N/A        |   | $ | 68,000 |   |
| Director Services(1) |   | 2002                |       | —   |       | 30,000    |       | —                      |       | N/A                                    |       | $ | 51,000 |   |
|                      |        |                     |            |          |            |           |            |                             |            |                                        |            |  |  |  |  |  |

 

F-29

----

----

(1)                    Paid or granted directly to Mr.Eide.

(2)                    Paid or granted to a designee ofAegis on its behalf.

 

During the years ended December 31, 2003 and 2002, the Company made thefollowing payments to Donald C. Hannah, Chairman of the Company’s Board ofDirectors, for services rendered as follows:

 
| **Matter**                  |   | **Year**            | ** ** | **Cash** | ** ** | **Stock** | ** ** |   | ** ** | **Fair  Market Value of Securities** | ** ** |
|-----------------------------|--------|---------------------|------------|----------|------------|-----------|------------|--------|------------|--------------------------------------|------------|
| **Options  & Warrants** |
| **Number**                  |   | **Exercise  Price** |
| Advisory Services           |   | 2003                |       | $        | 12,000     |      | —     |   | —     |                                 | N/A        |   | N/A |   |
| Director Services           |   | 2003                |       | —   |       | 75,000(1  | )          | — |       | N/A                                  |       | $ | 100,500 |   |
| Director Services           |   | 2002                |       | —   |       | 30,000(2  | )          | — |       | N/A                                  |       | $ | 51,000 |   |
|                             |        |                     |            |          |            |           |            |        |            |                                      |            |  |  |  |  |

 

----

(1)                    50,000 of which are subject todivestiture.

(2)                    10,000 of which remain unvested atDecember 31, 2003.

 

During2003, the Company issued 85,000, 85,000, and 25,000 shares of restricted commonstock to Carson Beadle, Leslie Quick, and David Allen, respectively, inexchange for director services for a combined fair market value of $245,500. Inaddition, the Company paid $15,000 to Elliot Speiser, a member of the Company’sBoard of Directors, for services rendered in a potential acquisition.

 

In2003, the Company had agreements with Mitch Feinglas, the Company’s ChiefOperating Officer and member of its Board of Directors, or various entities onhis behalf, to perform consulting or other services. During 2003, the Companypaid the following amounts to the parties indicated in exchange for suchservices: 

 
|                        |   |     |    |      |   | **Options  & Warrants** |   | **Fair  Market  Value of** |   |
|-----------------------------|--------|----------|---------|-----------|--------|-----------------------------|--------|----------------------------|--------|
| **Party**                   |   | **Cash** |    | **Stock** |   | **Number**                  |   | **Exercise  Price**        |   | **Securities** |   |
| Eurolink International, LTD |   | $        | 116,680 |      | — |                        | — |                       | N/A    |   | N/A |   |
| Equity International, LTD   |   | —   |    | 100,000   |   | —                      |   | N/A                        |   | $ | 134,000 |   |
|                             |        |          |         |           |        |                             |        |                            |        |  |  |  |  |

 

During 2003, the Company paid $10,000 to Silver Lining Realty, theprincipal of which is our former Chairman and Chief Executive Officer, BradEdson, for its realty services in connection with a new lease for our Utahoperations.

 

As part of a resignation agreement executed in July 2003, in which allseverance payments under a prior employment agreement were waived, 280,000shares of restricted common stock were returned at no cost and 144,000 shareswere repurchased by the Company at $0.50 per share from William Coppel, formerPresident, for total payments of $72,000 during 2003. These shares have beenreturned and recorded as treasury stock as of December 31, 2003.

 

On April 4, 2002, the Company entered into a three-year consultingagreement with Martin Gerst, former secretary, treasurer, and director, toprovide services related to capital formation, strategic relationships, andproduct branding. Under the terms of the agreement, Mr. Gerst, in additionto monthly payments of $2,000, received fully vested warrants to purchase500,000 shares of common stock at a price of $1.50 per share, valued at$280,580 at the date of grant. This agreement was terminated by the partieseffective December 31, 2002. The Company paid approximately $8,000 and $30,000related to this agreement during the fiscal year ended December 31, 2003 and2002, respectively.

 

F-30

----

 

During 2002, the following obligations to or from various formerofficers, directors, or entities controlled by former officers or directors,were relieved as follows:

 

•                  An unsecureddemand note payable to Brad Edson totaling $43,500 with interest accruing at10% was repaid;

•                  Payables to BradEdson, Kenneth Lind, and Eric Anderson totaling $147,926 for unpaid salariesand other reimbursable expenses were repaid;

•                  Severancecompensation of approximately $67,500 was paid to Kenneth Lind in connectionwith the termination of his employment in December 2002;

•                  Facility leaseand office costs of approximately $51,095 was paid to Camper Clubs of America,Inc., an entity controlled by Brad Edson and Martin Gerst;

•                  Advancesreceivable from Brad Edson and Martin Gerst totaling $52,500 with interestaccruing at 6% were repaid; and

•                  Receivables fromCamper Clubs of America, Inc., CCA Products, Inc., and a corporation previouslydoing business as Vital Living, entities controlled by Brad Edson andMartin Gerst, totaling $37,372 were written off.

 

*Shareholders*

* *

The Company is party to two voting agreements as follows:

 

*MAF Voting Agreement*. In connection withour November 2002 MAF Acquisition, we entered into a stockholders’ agreementwith Stuart A. Benson, Donald C. Hannah, Bradley D. Edson, Martin Gerst,William Coppel, Phil Maffetone, Kenneth Martin, Leslie C. Quick, III, andThomas C. Quick (the “MAF Voting Agreement”). Pursuant to the MAF VotingAgreement:

 

•                  for so long asMessrs. Edson, Benson, Hannah and Gerst beneficially own an aggregate of atleast 65% of the shares of common stock held by them on the date of theagreement, they shall be entitled to nominate and have elected four directorsacceptable to them in their sole discretion; and

•                  for so long asMessrs. Coppel, Maffetone, Quick and Quick beneficially own an aggregate of atleast 65% of the shares of common stock held by them on the date of theagreement, they shall be entitled to nominate and have elected three Directors.

 

Each of the parties to the MAF Voting Agreement hasagreed to vote the shares of common stock beneficially owned by them on thedate of the agreement in favor of the other group’s nominees. Each of theparties have further agreed that they will vote in favor of the other parties’nominee or nominees, and will not take any action, or cause us to take anyaction, to remove, with or without cause, a Director nominated by any of theparties. Because Messrs. Coppel, Maffetone, Quick, and Quick do not stillbeneficially own the required 65%, they no longer have the right to nominateand have elected any Directors.

 

*ENIVoting Agreement*. In connection with our August 2003 ENIAcquisition, we entered into a stockholders’ agreement with Stuart A. Benson,Donald C. Hannah, SkyePharma PLC, Stephen Morris, and Fifth Avenue Capital,Inc. (the “ENI Voting Agreement”). Pursuant to the ENI Voting Agreement, asamended:

 

•                  for so long as Messrs. Benson andHannah (the “Founders”) beneficially own an aggregate of at least 65% of theshares of common stock owned by them on the date of the agreement, they shallbe entitled to nominate three directors;

•                  for so long as Stephen Morris andFifth Avenue Capital beneficially own an aggregate of at least 65% of theshares of common stock owned by them on the date of the agreement, they shallbe entitled to nominate one director; and

•                  for so long as SkyePharmabeneficially owns an aggregate of at least 65% of the shares of common stockowned by it on the date of the agreement, it is entitled to nominate onedirector.

 

Each of the parties to the ENI Voting Agreement hasagreed to vote the shares of common stock beneficially owned by them on thedate of the agreement in favor of the other group’s nominees. Each of theparties have further agreed that they will vote in favor of the other parties’nominee or nominees, and will not take any action, or cause us to take anyaction, to remove, with or without cause, a Director nominated by any of theparties.

 

F-31

----

 

In October and November 2003, the Company entered into short-term notespayable with two shareholders, borrowing an aggregate principal amount of$125,000. The notes generally matured in 60 days and bore interest at a statedrate of 10%, with 12 months of interest earned and payable immediately. Thenotes, including interest earned of $12,500, were paid in full prior toDecember 31, 2003.

 

Concurrent with the MAF Acquisition in November 2002, the Companyexecuted a three-year consulting agreement with Phillip Maffetone, ashareholder and former owner of MAF, to provide product development andmarketing services in exchange for monthly fees of $8,333. We paidapproximately $80,000 and $8,000 to Phillip Maffetone under the terms of theagreement during the years ended December 31, 2003 and 2002, respectively. TheCompany has ceased payments under the contract and is currently renegotiatingits terms.

 

On October 14, 2003, the Closing Date of the DFN Acquisition, Messrs.Bruce Howe and Maynard Howe entered into a lock-up agreement, representingapproximately 65% of the 1,650,003 common shares exchanged as purchaseconsideration. Pursuant to the agreement, the parties collectively agreed to alock-up of the shares received in the DFN Acquisition, as listed below:

 
| **Reference**          |   | **Period**                                                |   | **Shares  Available for Disposition** |   |
|------------------------|--------|-----------------------------------------------------------|--------|---------------------------------------|--------|
| Initial Lock-Up Period |   | Up  to 6 months following Closing Date                    |   | None                                  |   |
| Second Lock-Up Period  |   | Up to 6 months following Initial Lock-Up Period           |   | Up to 50% shares received             |   |
| Third Lock-Up Period   |   | Up to 6 months following Second Lock-Up Period            |   | Up to 75% shares received             |   |
| Thereafter             |   | Immediately following Third Lock-Up Period and thereafter |   | Up to 100% shares received            |   |

 

The Company has several agreements with Fifth Avenue Capital, Inc.(“FAC”), a major shareholder, to provide consulting, investment, or financialservices. Stephen Morris, a shareholder and member of the ENI Voting Group, isthe President and sole Director of FAC. During 2003, the Company paid cash feesof $22,500 to FAC in exchange for such services and erroneously issued 25,000shares of restricted common stock, valued at $33,500, to Mr. Morris, which isrecorded as “accounts receivable, related parties” at December 31, 2003. Inaddition, the Company has a promissory note payable to FAC assumed as part ofthe ENI Acquisition in the amount of $100,000 outstanding at December 31, 2003,bearing interest at prime plus 2%.

 

The Company has a consulting arrangement with Stephen Chen, Chairmanand Chief Executive Officer of Strong International, Inc., the sole shareholderof the outstanding Series B and Series C Preferred Stock, to assist in creatingstrategic alliances in China. In 2003, Mr. Chen’s consulting agreement wasamended to extend the term of the agreement, providing certain payments inshares of common stock and warrants as consideration. Mr. Chen also assisted infacilitating the sale of the Series B and Series C Preferred Stock to StrongInternational, for which he received certain payments in cash, shares of commonstock, options, and warrants as commissions. During 2003, the Company madecumulative payments related to such matters to Mr. Chen as follows: 

 
| **Matter**                  |   | **Cash**            |    | **Stock** |    |   |    |   |           | **Fair  Market  Value of  Securities** |   |
|-----------------------------|--------|---------------------|---------|-----------|---------|--------|---------|--------|----------------|----------------------------------------|--------|
| **Options  & Warrants** |
| **Number**                  |   | **Exercise  Price** |
| Consulting Services         |   | $                   | 25,000  |      | 125,000 |   | 197,000 |   | $ 1.00 - $2.00 |                                   | $      | 180,000 |   |
| Investment Services         |   | $                   | 187,500 |      | 62,500  |   | 512,500 |   | $ 1.00 - $1.30 |                                   | $      | 195,426 |   |

 

F-32

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The Company has several agreements with HCFP/Brenner Securities, LLC(“Brenner”), a shareholder, to provide consulting, investment, or financialservices. During the years ended December 31, 2003 and 2002, the followingamounts were paid to Brenner in exchange for such services: 

 
|                |   |     |   |     |    |      |    | **Options  & Warrants** |    | **Fair  Market   Value of** |   |
|---------------------|--------|----------|--------|----------|---------|-----------|---------|-----------------------------|---------|-----------------------------|--------|
| **Matter**          |   | **Year** |   | **Cash** |    | **Stock** |    | **Number**                  |    | **Exercise  Price**         |   | **Securities** |   |
| Consulting Services |   | 2003     |   | $        | 34,245  |      | 235,000 |                        | —  |                        | N/A    |   | $ | 228,950 |   |
| Investment Services |   | 2003     |   | $        | 569,600 |      | 987,600 |                        | 345,600 |                        | $      | 1.00 |   | $ | 1,462,355 |   |
| Consulting Services |   | 2002     |   | $        | 60,000  |      | 48,000  |                        | —  |                        | N/A    |   | $ | 81,600 |   |
|                     |        |          |        |          |         |           |         |                             |         |                             |        |  |  |  |  |  |

 

The Company has several agreements with Atlas Capital Services, LLC(“Atlas”) to provide consulting, investment, or financial services, includingthe valuation related to the ENI Acquisition. During 2003, the followingamounts were paid to Atlas (or its designees) in exchange for such services: 

 
|                |   |   |   |     |   |      |   | **Options  & Warrants** |   | **Fair  Market   Value of** |   |
|---------------------|--------|--------|--------|----------|--------|-----------|--------|-----------------------------|--------|-----------------------------|--------|
| **Matter**          |   |   |   | **Cash** |   | **Stock** |   | **Number**                  |   | **Exercise  Price**         |   | **Securities** |   |
| Investment Services |   |   |   | $        | 30,000 |      | 54,000 |                        | 35,000 |                        | $      | 1.00 |   | $ | 58,320 |   |
|                     |        |        |        |          |        |           |        |                             |        |                             |        |  |  |  |  |  |

 

The Company has several agreements with Sloan Securities Corp (“Sloan”)to provide consulting, investment, or financial services. During 2003, thefollowing amounts were paid to Sloan (or its designees) in exchange for suchservices: 

 
|                |   |   |   |     |    |      |    | **Options  & Warrants** |    | **Fair  Market   Value of** |   |
|---------------------|--------|--------|--------|----------|---------|-----------|---------|-----------------------------|---------|-----------------------------|--------|
| **Matter**          |   |   |   | **Cash** |    | **Stock** |    | **Number**                  |    | **Exercise  Price**         |   | **Securities** |   |
| Investment Services |   |   |   | $        | 257,800 |      | 115,400 |                        | 315,400 |                        | $      | 1.00 |   | $ | 356,941 |   |
|                     |        |        |        |          |         |           |         |                             |         |                             |        |  |  |  |  |  |

 

Pursuant to a registration rights agreement related to a November 2002private placement of 1,367,500 shares of common stock, the Company was requiredto file and have declared effective a registration statement to register theshares of common stock issued and shares that may be issued upon exercise ofthe Series B Warrants and Series C Warrants from the private placement prior toMarch 20, 2003. The Company failed to have the registration statement declaredeffective by the deadline; as a result, the investors are owed liquidationdamages equal to 2% per month of the purchase price of said securities,calculated on a pro rata basis to the date on which the registration statementwas ultimately declared effective. During 2003, an agreement was reached withsome of the investors to pay such damages in shares of common stock at a ratioof two shares of common stock for every $1 of liquidation damage earned. Forthe period through August 21, 2003, the Company agreed to settle the penaltyamount owed by the issuance of 328,200 shares of our common stock, valued atapproximately $367,000. Of the total shares owed, 134,600 shares of ourrestricted common stock were issued, valued at $156,136, related to thesettlement agreements prior to December 31, 2003. As of December 31, 2003, theCompany owed a remaining 193,600 shares valued at $211,000 and has since issued94,000 of such shares and paid $18,900 in cash to relieve a portion of thisliability. It is expected that additional penalty shares will be issued afterthe Registration Statement, filed January 14, 2004, is declared effective. AtDecember 31, 2003, $442,573 has been accrued to settle the additional amountsowed.

* *

*Other RelatedParties*

* *

In October and November 2003, the Company entered into short-term notespayable with three individuals, each of whom are family members of the formerChairman and Chief Executive Officer, borrowing an aggregate principal amountof $271,672. The notes generally matured in 60 days and bore interest at statedrates ranging between 10% and 28%, with 12 months of interest earned andpayable immediately. The notes, including interest earned of $46,172, were paidin full as of December 31, 2003.

 

The Company has had various agreements with Michael Edson, a familymember of the former Chairman and Chief Executive Officer, under which heprovides consulting services, including prospecting, establishing, andservicing complementary and alternative healthcare practices and otherproprietary distribution channels. In addition, Mr. Edson assisted in variousshort-term financing activities, for which he received commissions. Paymentstotaling $63,985 and $42,118 were made during the years ended December 31, 2003and 2002, respectively, for said services and commissions.

 

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During 2003 and 2002, the Company paid $5,000 in contract fees and$25,000 as payroll, respectively, to Marie Hughes, a family member of theCompany’s current Chief Executive Officer and President, for various services.

 

**Note 12 – SubsequentEvents**

 

*ExecutiveManagement and Operational Changes*

 

In January 2004, the Company announced its plans toconsolidate its Phoenix, Arizona operations into its Salt Lake City, Utahfacility as part of a cost-saving strategy during the first half of 2004.Simultaneously, Brad Edson, the Company’s Chief Executive Officer and Chairman,voluntarily resigned from his positions with the Company to pursue other businessinterests. The Board of Directors immediately appointed Stuart Benson, theCompany’s President, into the role of Chief Executive Officer and Vice Chairmanand Donald Hanna, a Director, as Chairman of the Board of Directors. Inaddition, the board appointed Mitch Feinglas, previously a consultant to theCompany, to the positions of Chief Operating Officer and Director.

 

In connection with Mr. Edson’s departure, the Companyexecuted a severance agreement that provides for cash payments of $244,068($119,034 due within eight days of execution, $19,839 due on each first day ofJuly, August, and September 2004, and $21,839 due on each first day of October,November, and December 2004) and 600,000 shares of the Company’s common stock,due within eleven days of execution and included in a pending RegistrationStatement initially filed January 14, 2004. In addition, the Company agreed tocontinue to pay Mr. Edson’s medical benefits until the earlier of (i) July 31,2005, or (ii) the date he becomes eligible to be covered under another program.As of March 30, 2004, neither the first payment nor common shares initially duehas been paid or issued.

 

*Litigation*

* *

On March 8, 2004, an attorney representing a former employee notified usthat he was prepared to initiate litigation for alleged breach of hisemployment agreement. On March 15, 2004, we received a letter from the sameattorney demanding that we take certain remedial steps in connection with ourmanufacturing processes and that we cure alleged breaches of certain agreementsrelated to the COF Acquisition. As of March 30, 2004, formal lawsuits relatedto these matters had not been filed. The outcome of these actions is uncertainand an estimate of the amount of a settlement, if any, cannot be reasonablyestimated at this time.

* *

*Stock Issuances*

 

Between January 1 and March 26, 2004, the Company issued shares ofcommon stock and granted options or warrants as follows with their fair marketvalue as of the date of grant, where appropriate:

 
|                                                                       |   |      |   | **Options & Warrants** |   | **Fair  Market  Value of** |   |
|----------------------------------------------------------------------------|--------|-----------|--------|----------------------------|--------|----------------------------|--------|
| **Matter**                                                                 |   | **Stock** |   | **Number**                 |   | **Exercise Price**         |   | **Securities** |   |
| Series A Preferred Stock conversions and  required warrant dividend of 20% |   | 2,167,438 |   | 433,488                    |   | $                          | 2.00   |   | $ | 2,167,438 |   |
| Net warrant exercise                                                       |   | 765,100   |   | —                     |   | N/A                        |   | $ | — |   |
| Strategic Asset Management - settlement                                    |   | 140,000   |   | —                     |   | N/A                        |   | $ | 162,400 |   |
| Registration rights penalty shares                                         |   | 94,000    |   | —                     |   | N/A                        |   | $ | 92,120 |   |
| Consulting services                                                        |   | 20,000    |   | —                     |   | N/A                        |   | $ | 25,100 |   |
|                                                                       |   | 3,186,538 |   | 433,488                    |   |                       |   | $ | 2,447,058 |   |
|                                                                            |        |           |        |                            |        |                            |        |  |  |  |  |

 

*X-Fat Agreements*

 

In March 2004, the Company entered into a Purchase Agreement withinvestors and sold 250,000 shares of the Company’s common stock at $1.00 pershare with rights to receive a portion of the Company’s net revenues, asdefined therein, from the sale of X-Fat® (“the Royalty Rights”).  The investors shall receive Royalty

 

F-34

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Rights on a pro-rata basis of 10% and 3% on the first $15,000,000 andsubsequent $85,000,000 of X-Fat® net revenues, respectively, during thetwo-year period commencing April 1, 2004 and terminating March 31, 2006. 

 

Royalty payments on the first $15,000,000 and subsequent $85,000,000 ofnet revenues shall be made in cash and shares of common stock valued at $1.00per share, respectively. Cash payments must be made within 50 days after theend of each calendar quarter and within 105 days after the end of each year.Finder’s fees will be paid to certain individuals as compensation equal to cashof eight percent of monies raised and shares of the Company’s common stockequal to eight percent of the number of shares issued under the agreement.

 

In March 2004, the Company signed a Marketing Agreement with SciberHealth, LLC (“Reseller”) that grants certain exclusive rights to market andsell X-Fat® over the Internet and non-exclusive rights to market X-Fat throughprint ads, radio, and television. The Company has retained the rights to marketX-Fat through its own websites. Under the agreement, which has a five-yearterm, the Reseller must sell minimum levels of X-Fat within certain periods orthe Company has the right to terminate the exclusivity or the Agreement. Aspayment for reselling the product, the Reseller will receive 50% of the grosssales of the product, as defined therein. During the 18-month period followingexecution, the Company will grant the Reseller 100,000 stock options at $1.00per share for each $2,500,000 in gross sales received, up to a maximum of500,000 stock options should gross sales equal or exceed $12,000,000. The stockfor any stock options granted has registration rights as specified in theagreement. As of March 30, 2004, no gross sales subject to the agreement hadoccurred.

 

In March 2004 in a separate but related agreement, the Company executeda Call Center Agreement with Globex Marketing, LLC (“Globex”), under which theCompany has agreed to pay Globex 7% of all orders handled and processed, plus afee related to processing time. The Call Center Agreement has a one-year termwith automatic renewals unless cancelled 30 days prior to the renewal date. Asof March 30, 2004, there were no orders handled and processed by Globex.

 

On April 6, 2003, the Company received a demand letter from Syke relatedto certain payments past due under the Development and License Agreement inwhich Skye initiated the 30 day period for discussions in good faith.  This 30 day period is required beforeinitiating formal collection proceedings, in accordance with the terms of theagreement.  The Company is in disputewith Skye over the terms of the licensing agreement.  The Company has failed to make payments of $250,000 called forunder the licensing agreement in January and in April 2004.  The Company is currently in discussions tomodify both the terms and payment schedules under the licensing agreement.  Although management of the Company believesit will reach a settlement of the terms and conditions of the agreement withSkye, no assurances can be given that these negotiations will be successful andthe Company will reach a satisfactory resolution of this matter.  In the event a satisfactory resolution cannot be reached and Skye exercises their rights of termination under theagreement, the Company may lose substantial and possibly all rights gainedunder this and related contracts with Skye. Accordingly, amounts recorded as intangible assets associated with thesecontracts, which represent substantially all of the Company’s intangibleassets, would be impaired.  However,until Skye exercises its termination rights under the Development and LicenseAgreement, the Company's rights under the agreements are deemed to be in fullforce and effect and the related intangibles have not been impaired.

 

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