**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

**ý****  QUARTERLY REPORT PURSUANT TO SECTION 13 OR15 (d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period Ended June 30, 2003**

 

**o****  TRANSITION REPORT PURSUANT SECTION 13 OR 15(d)OF SECURITIES EXCHANGE ACT OF 1934**

 

**For the Transition Period From                  to                  **

 

**Commission File Number 333-13287**

 

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**EARTHSHELLCORPORATION**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                                                                                                                                      |   |   |   | **77-0322379**                        |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                                                                                                                   |   |   |   | (I.R.S. Employer  Identification No.) |
|                                                                                                                                                                              |   |   |   |                                  |
| **800 Miramonte Drive, Santa Barbara, California 93109**                                                                                                                          |
| (Address of principal executive  office)                     (Zip  Code) |
|                                                                                                                                                                              |   |   |   |                                  |
| **(805) 897-2294**                                                                                                                                                                |
| (Registrant’s telephone number, including  area code)                                                                                                                        |

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15 (d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý Noo

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Exchange ActRule 12b-2).  Yes ýNo o

 

The number ofshares outstanding of the Registrant’s Common Stock as of August 8, 2003 is160,030,264.

 

 

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**EARTHSHELLCORPORATION**

 

**FORM10-Q**

 

**Forthe Quarter Ended June 30, 2003**

 

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES**

 
| ***Part I. Financial  Information*** |
|--------------------------------------|
|                                 |
| Item 1.                              | Consolidated Financial Statements |   |
|                                 |   |
|                                 | a) | Consolidated Balance Sheets as of June 30, 2003 (unaudited) and  December 31, 2002 | 3 |
|                                 |   |   |
|                                 | b) | Consolidated Statements of Operations for  the three and six months ended June 30, 2003 and June 30, 2002 (unaudited)  and for the period from November 1, 1992 (inception) through June 30, 2003  (unaudited) | 4 |
|                                 |   |   |
|                                 | c) | Consolidated Statements of Stockholders’  (Deficit) Equity for the period from November 1, 1992 (inception) to June 30,  2003 (unaudited) | 5 |
|                                 |   |   |
|                                 | d) | Consolidated Statements of Cash Flows for  the six months ended June 30, 2003 and June 30, 2002 (unaudited) and for the  period from November 1, 1992 (inception) through June 30, 2003 (unaudited) | 6 |
|                                 |   |   |
|                                 | e) | Notes to Consolidated Financial Statements  (unaudited) | 8 |
|                                 |   |   |
| Item 2.                              | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 13 |
|                                 |   |
| Item 3.                              | Quantitative and Qualitative Disclosures  About Market Risk | 20 |
|                                 |   |
| Item 4.                              | Controls and Procedures | 20 |
|                                 |   |
| ***Part II. Other Information***     |   |
|                                 |
| Item 1.                              | Legal Proceedings | 21 |
|                                 |   |
| Item 2.                              | Changes in Securities and Use of Proceeds | 21 |
|                                 |   |
| Item 3.                              | Defaults Upon Senior Securities | 21 |
|                                 |   |
| Item 4.                              | Submission of Matters to a Vote of Security  Holders | 21 |
|                                 |   |
| Item 5.                              | Other Information | 21 |
|                                 |   |
| Item 6                               | Exhibits and Reports on Form 8-K | 21 |
|                                 |   |
| ***Signature***                      |   | 22 |
|                                      |  |  |  |  |  |

 

2

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**EARTHSHELLCORPORATION**

**(ADevelopment Stage Enterprise)**

**CONSOLIDATED BALANCESHEETS**

 
|                                                                                                                                                                                    |   | **June 30,  2003** |       | **December  31,  2002** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|-------------------------|------------|
|                                                                                                                                                                                    |   | **(Unaudited)**    |       |                    |       |
| **ASSETS**                                                                                                                                                                              |   |               | ** ** |                    | ** ** |
| **CURRENT ASSETS**                                                                                                                                                                      |   |               |       |                    |       |
| Cash and cash equivalents                                                                                                                                                               |   | $                  | 3,616,879  |                    | $          | 111,015 |   |
| Restricted cash                                                                                                                                                                         |   | 4,009,000          |       | 12,500,000              |       |
| Prepaid expenses and other current assets                                                                                                                                               |   | 690,763            |       | 570,802                 |       |
| Total current assets                                                                                                                                                                    |   | 8,316,642          |       | 13,181,817              |       |
|                                                                                                                                                                                    |   |               |       |                    |       |
| **PROPERTY AND EQUIPMENT, NET**                                                                                                                                                         |   | 4,250,018          |       | 4,476,174               |       |
| **INVESTMENT IN JOINT VENTURE**                                                                                                                                                         |   | 217,755            |       | 366,012                 |       |
|                                                                                                                                                                                    |   |               |       |                    |       |
| **TOTALS**                                                                                                                                                                              |   | $                  | 12,784,415 |                    | $          | 18,024,003 |   |
|                                                                                                                                                                                    |   |               |       |                    |       |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIT**                                                                                                                                          |   |               |       |                    |       |
| **CURRENT LIABILITIES**                                                                                                                                                                 |   |               |       |                    |       |
| Accounts payable and accrued expenses                                                                                                                                                   |   | $                  | 5,470,170  |                    | $          | 7,904,957 |   |
| Payable to related party                                                                                                                                                                |   | —             |       | 578,779                 |       |
| Accrued purchase commitment                                                                                                                                                             |   | 3,500,000          |       | 3,500,000               |       |
| Notes payable to related party                                                                                                                                                          |   | —             |       | 1,745,000               |       |
| Convertible debentures                                                                                                                                                                  |   | 447,063            |       | 7,767,953               |       |
| Total current liabilities                                                                                                                                                               |   | 9,417,233          |       | 21,496,689              |       |
|                                                                                                                                                                                    |   |               |       |                    |       |
| **PAYABLES TO RELATED PARTY**                                                                                                                                                           |   | 968,801            |       | —                  |       |
| **WARRANT OBLIGATION**                                                                                                                                                                  |   | 486,659            |       | —                  |       |
| **CONVERTIBLE DEBENTURES**                                                                                                                                                              |   | 7,851,057          |       | —                  |       |
| **NOTES PAYABLE TO RELATED PARTY**                                                                                                                                                      |   | 2,485,202          |       | —                  |       |
| Total liabilities                                                                                                                                                                       |   | 21,208,952         |       | 21,496,689              |       |
|                                                                                                                                                                                    |   |               |       |                    |       |
| **STOCKHOLDERS’ DEFICIT**                                                                                                                                                          |   |               |       |                    |       |
| Preferred stock, $.01 par value, 10,000,000  shares authorized;  9,170,000 Series A shares designated; no shares issued and outstanding  as of June 30, 2003 and December 31, 2002 |   | —             |       | —                  |       |
| Common stock, $.01 par value, 200,000,000  shares authorized;  158,426,205 and 144,655,641 shares issued and outstanding as of June 30, 2003  and December 31, 2002, respectively  |   | 1,584,262          |       | 1,446,556               |       |
| Additional paid-in common capital                                                                                                                                                       |   | 296,236,735        |       | 290,931,330             |       |
| Deficit accumulated during the development  stage                                                                                                                                       |   | (306,212,851       | )          | (295,833,940            | )          |
| Accumulated other comprehensive loss                                                                                                                                                    |   | (32,683            | )          | (16,632                 | )          |
| Total stockholders’ deficit                                                                                                                                                        |   | (8,424,537         | )          | (3,472,686              | )          |
|                                                                                                                                                                                    |   |               |       |                    |       |
| **TOTALS**                                                                                                                                                                              |   | $                  | 12,784,415 |                    | $          | 18,024,003 |   |

 

See Notes to Consolidated FinancialStatements.

 

3

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##### **EARTHSHELLCORPORATION**

**(ADevelopment Stage Enterprise)**

##### **CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                             |   | **For the  Three Months  Ended June 30,** |      | **For the  Six Months  Ended June 30,** |   | **November  1,  1992 (inception)  through June 30,  2003** |   |
|------------------------------------------------------------------|--------|-------------------------------------------|-----------|-----------------------------------------|--------|------------------------------------------------------------|--------|
|                                                             |   | **2003**                                  |      | **2002**                                |   | **2003**                                                   |   | **2002** |   |   |
| Operating Expenses:                                              |   |                                      |      |                                    |   |                                                       |   |   |   |   |   |
| Related party license fee and research and  development expenses |   | $                                         | 304,667   |                                    | $      | 468,313                                                    |   | $ | 658,467 |   | $ | 768,313 |   | $ | 70,537,375 |   |
| Other research and development expenses                          |   | 1,707,507                                 |      | 3,809,063                               |   | 3,604,493                                                  |   | 10,476,222 |   | 137,882,148 |   |
| Related party general and administrative  Expenses               |   | —                                    |      | (6,111                                  | )      | (4,074                                                     | )      | (12,222 | ) | 2,187,540 |   |
| Other general and administrative expenses                        |   | 1,193,342                                 |      | 2,122,397                               |   | 3,047,044                                                  |   | 4,599,871 |   | 65,469,729 |   |
| Depreciation and amortization                                    |   | 103,636                                   |      | 795,352                                 |   | 216,276                                                    |   | 1,590,705 |   | 22,677,706 |   |
| Related party patent expenses                                    |   | —                                    |      | —                                  |   | —                                                     |   | — |   | 8,693,105 |   |
| Total operating expenses                                         |   | 3,309,152                                 |      | 7,189,014                               |   | 7,522,206                                                  |   | 17,422,889 |   | 307,447,603 |   |
|                                                             |   |                                      |      |                                    |   |                                                       |   |   |   |   |   |
| Other Expenses (Income):                                         |   |                                      |      |                                    |   |                                                       |   |   |   |   |   |
| Interest income                                                  |   | (24,299                                   | )         | (20,977                                 | )      | (64,251                                                    | )      | (42,914 | ) | (10,873,884 | ) |
| Related party interest expense                                   |   | 94,932                                    |      | —                                  |   | 170,234                                                    |   | — |   | 5,007,564 |   |
| Other interest expense                                           |   | 344,970                                   |      | 872                                     |   | 922,737                                                    |   | 872 |   | 2,911,355 |   |
| Gain on sales of property and equipment                          |   | (7,000                                    | )         | (9,500                                  | )      | (63,000                                                    | )      | (9,500 | ) | (504,413 | ) |
| Other expenses (income)                                          |   | (109,571                                  | )         | —                                  |   | 86,958                                                     |   | — |   | 86,958 |   |
| Loss on extinguishment of debentures                             |   | —                                    |      | —                                  |   | 1,697,380                                                  |   | — |   | 1,697,380 |   |
| Debenture conversion costs                                       |   | —                                    |      | —                                  |   | 105,847                                                    |   | — |   | 426,817 |   |
| Loss before income taxes                                         |   | 3,608,184                                 |      | 7,159,409                               |   | 10,378,111                                                 |   | 17,371,347 |   | 306,199,380 |   |
|                                                             |   |                                      |      |                                    |   |                                                       |   |   |   |   |   |
| Income taxes                                                     |   | —                                    |      | —                                  |   | 800                                                        |   | 800 |   | 13,471 |   |
| Net loss                                                         |   | 3,608,184                                 |      | 7,159,409                               |   | 10,378,911                                                 |   | 17,372,147 |   | 306,212,851 |   |
| Preferred dividends                                              |   | —                                    |      | —                                  |   | —                                                     |   | — |   | 9,926,703 |   |
| Net loss available to common stockholders                        |   | $                                         | 3,608,184 |                                    | $      | 7,159,409                                                  |   | $ | 10,378,911 |   | $ | 17,372,147 |   | $ | 316,139,554 |   |
| Basic and diluted loss per common share                          |   | $                                         | 0.02      |                                    | $      | 0.05                                                       |   | $ | 0.07 |   | $ | 0.13 |   | $ | 3.22 |   |
| Weighted average number of common shares  outstanding            |   | 156,161,546                               |      | 133,773,696                             |   | 152,256,270                                                |   | 129,101,672 |   | 98,163,806 |   |

 

See Notes to Consolidated FinancialStatements.

 

4

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**EARTHSHELLCORPORATION(A Development Stage Enterprise)CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ (DEFICIT) EQUITY**

**(Unaudited)**

 
|                                                                      |       | **Cumulative  Convertible  Preferred Stock Series A** |       | **Additional  Paid-In  Preferred  Capital** |   | **Common  Stock** |   | **Additional  Paid-In  Common  Capital** |   | **Deficit  Accumulated  during  Development  Stage** |   | **Accum-  ulated  Other  Compre-  hensive  Loss** |      | **Totals**   |       |
|---------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|---------------------------------------------|--------|-------------------|--------|------------------------------------------|--------|------------------------------------------------------|--------|---------------------------------------------------|-----------|--------------|------------|
|                                                                      |       |                                                  |       |                                        |   |              |   |
|                                                                      |       |                                                  |       |                                        |   |              |   |
|                                                                      |       |                                                  |       |                                        |   |              |   |
|                                                                      |       |                                                  |       |                                        |   |              |   |
|                                                                      | **Shares** |                                                  | **Amount** |                                        |   | **Shares**        |   | **Amount**                               |   |                                                 |   |                                              |      |
|                                                                      |       |                                                  |       |                                        |   |              |   |                                     |   |                                                 |   |                                              |      |         |       |   |   |   |   |
| **ISSUANCE OF COMMON STOCK AT INCEPTION**                                 |       | —                                                |       | —                                      |   | —            |   | 82,530,000                               |   | $                                                    | 3,150  |                                              | $         | 6,850        |       | — |   | — |   | $ | 10,000 |   |
| Sale of preferred stock, net                                              |       | 6,988,850                                             |       | $                                           | 267    |              | $      | 24,472,734                               |   | —                                               |   | —                                            |      | —       |       | — |   | — |   | 24,473,001 |   |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | $            | (7,782,551 | ) | — |   | (7,782,551 | ) |
| **BALANCE, DECEMBER 31, 1993**                                            |       | 6,988,850                                             |       | 267                                         |   | 24,472,734        |   | 82,530,000                               |   | 3,150                                                |   | 6,850                                             |      | (7,782,551   | )          | — |   | 16,700,450 |   |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | (16,582,080  | )          | — |   | (16,582,080 | ) |
| **BALANCE, DECEMBER 31, 1994**                                            |       | 6,988,850                                             |       | 267                                         |   | 24,472,734        |   | 82,530,000                               |   | 3,150                                                |   | 6,850                                             |      | (24,364,631  | )          | — |   | 118,370 |   |
| Contribution to equity                                                    |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | 1,117,723                                         |      | —       |       | — |   | 1,117,723 |   |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | (13,914,194  | )          | — |   | (13,914,194 | ) |
| **BALANCE, DECEMBER 31, 1995**                                            |       | 6,988,850                                             |       | 267                                         |   | 24,472,734        |   | 82,530,000                               |   | 3,150                                                |   | 1,124,573                                         |      | (38,278,825  | )          | — |   | (12,678,101 | ) |
| Contribution to equity                                                    |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | 650,000                                           |      | —       |       | — |   | 650,000 |   |
| Issuance of stock warrants                                                |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | 246,270                                           |      | —       |       | — |   | 246,270 |   |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | (16,950,137  | )          | — |   | (16,950,137 | ) |
| **BALANCE, DECEMBER 31, 1996**                                            |       | 6,988,850                                             |       | 267                                         |   | 24,472,734        |   | 82,530,000                               |   | 3,150                                                |   | 2,020,843                                         |      | (55,228,962  | )          | — |   | (28,731,968 | ) |
| Compensation related to stock options, warrants  and stock grants         |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | 3,156,659                                         |      | —       |       | — |   | 3,156,659 |   |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | (18,992,023  | )          | — |   | (18,992,023 | ) |
| **BALANCE, DECEMBER 31, 1997**                                            |       | 6,988,850                                             |       | 267                                         |   | 24,472,734        |   | 82,530,000                               |   | 3,150                                                |   | 5,177,502                                         |      | (74,220,985  | )          | — |   | (44,567,332 | ) |
| 262 to 1 stock split                                                      |       | —                                                |       | 69,621                                      |   | (69,621           | )      | —                                   |   | 822,150                                              |   | (822,150                                          | )         | —       |       | — |   | — |   |
| Conversion of preferred stock into common stock                           |       | (6,988,850                                            | )          | (69,888                                     | )      | (24,403,113       | )      | 6,988,850                                |   | 69,888                                               |   | 24,403,113                                        |      | —       |       | — |   | — |   |
| Issuance of common stock                                                  |       | —                                                |       | —                                      |   | —            |   | 10,526,316                               |   | 105,263                                              |   | 205,883,493                                       |      | —       |       | — |   | 205,988,756 |   |
| Preferred stock dividends                                                 |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | (9,926,703                                        | )         | —       |       | — |   | (9,926,703 | ) |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | (26,620,052  | )          | — |   | (26,620,052 | ) |
| **BALANCE, DECEMBER 31, 1998**                                            |       | —                                                |       | —                                      |   | —            |   | 100,045,166                              |   | 1,000,451                                            |   | 224,715,255                                       |      | (100,841,037 | )          | — |   | 124,874,669 |   |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | (44,188,443  | )          | — |   | (44,188,443 | ) |
| **BALANCE, DECEMBER 31, 1999**                                            |       | —                                                |       | —                                      |   | —            |   | 100,045,166                              |   | 1,000,451                                            |   | 224,715,255                                       |      | (145,029,480 | )          | — |   | 80,686,226 |   |
| Issuance of common stock                                                  |       | —                                                |       | —                                      |   | —            |   | 4,457,169                                |   | 44,572                                               |   | 10,477,216                                        |      | —       |       | — |   | 10,521,788 |   |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | (48,911,605  | )          | — |   | (48,911,605 | ) |
| **BALANCE, DECEMBER 31, 2000**                                            |       | —                                                |       | —                                      |   | —            |   | 104,502,335                              |   | 1,045,023                                            |   | 235,192,471                                       |      | (193,941,085 | )          | — |   | 42,296,409 |   |
| Issuance of common stock                                                  |       | —                                                |       | —                                      |   | —            |   | 13,520,719                               |   | 135,208                                              |   | 30,418,832                                        |      | —       |       | — |   | 30,554,040 |   |
| Compensation related to stock options, warrants  and stock grants         |       | —                                                |       | —                                      |   | —            |   | 300,000                                  |   | 3,000                                                |   | 984,119                                           |      | —       |       | — |   | 987,119 |   |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | (62,301,511  | )          | — |   | (62,301,511 | ) |
| **BALANCE, DECEMBER 31, 2001**                                            |       | —                                                |       | —                                      |   | —            |   | 118,323,054                              |   | 1,183,231                                            |   | 266,595,422                                       |      | (256,242,596 | )          | — |   | 11,536,057 |   |
| Issuance of common stock                                                  |       | —                                                |       | —                                      |   | —            |   | 24,308,236                               |   | 243,082                                              |   | 21,658,634                                        |      | —       |       | — |   | 21,901,716 |   |
| Common stock warrants issued in connection with  convertible debentures   |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | 1,521,046                                         |      | —       |       | — |   | 1,521,046 |   |
| Conversion of convertible debentures to common  stock                     |       | —                                                |       | —                                      |   | —            |   | 2,024,351                                |   | 20,243                                               |   | 979,757                                           |      | —       |       | — |   | 1,000,000 |   |
| Debentures conversion costs                                               |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | 176,471                                           |      | —       |       | — |   | 176,471 |   |
| Net loss                                                                  |       |                                                  |       |                                        |   |              |   |                                     |   |                                                 |   |                                              |      | (39,591,344  | )          |   |   | (39,591,344 | ) |
| Foreign currency translation adjustment                                   |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | —       |       | $ | (16,632 | ) | (16,632 | ) |
| Comprehensive loss                                                        |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | —       |       | — |   | (39,607,976 | ) |
| **BALANCE, DECEMBER 31, 2002**                                            |       | —                                                |       | —                                      |   | —            |   | 144,655,641                              |   | 1,446,556                                            |   | 290,931,330                                       |      | (295,833,940 | )          | (16,632 | ) | (3,472,686 | ) |
| Interest paid in common stock                                             |       | —                                                |       | —                                      |   | —            |   | 166,375                                  |   | 1,664                                                |   | 73,203                                            |      | —       |       | — |   | 74,867 |   |
| Conversion of convertible debentures to common  stock                     |       | —                                                |       | —                                      |   | —            |   | 6,357,192                                |   | 63,572                                               |   | 2,591,265                                         |      | —       |       | — |   | 2,654,837 |   |
| Issuance of common stock                                                  |       | —                                                |       | —                                      |   | —            |   | 7,246,997                                |   | 72,470                                               |   | 1,977,415                                         |      | —       |       | — |   | 2,049,885 |   |
| Issuance of stock warrants                                                |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | 303,522                                           |      | —       |       | — |   | 303,522 |   |
| Beneficial conversion value due to change in  debentures conversion price |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | 360,000                                           |      | —       |       | — |   | 360,000 |   |
| Net loss                                                                  |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | (10,378,911  | )          | — |   | (10,378,911 | ) |
| Foreign currency translation adjustment                                   |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | —       |       | (16,051 | ) | (16,051 | ) |
| Comprehensive loss                                                        |       | —                                                |       | —                                      |   | —            |   | —                                   |   | —                                               |   | —                                            |      | —       |       | — |   | (10,394,962 | ) |
| **BALANCE, JUNE 30, 2003**                                                |       | —                                                |       | $                                           | — |              | $      | —                                   |   | 158,426,205                                          |   | $                                                 | 1,584,262 |         | $          | 296,236,735 |   | $ | (306,212,851 | ) | $ | (32,683 | ) | $ | (8,424,537 | ) |

 

See Notes to Consolidated FinancialStatements

 

5

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**EARTHSHELLCORPORATION(A Development Stage Enterprise)CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**

 
|                                                                                                          |     | **Six Months  Ended  June 30,** |        | **November  1,  1992 (inception)  through  June 30, 2003** |   |
|---------------------------------------------------------------------------------------------------------------|----------|---------------------------------|-------------|------------------------------------------------------------|--------|
|                                                                                                          |     |                            |
|                                                                                                          |     |                            |
|                                                                                                          | **2003** |                            | **2002**    |                                                       |   |
| **CASH FLOWS FROM OPERATING ACTIVITIES**                                                                      |     |                            |        |                                                       |   |   |   |
| Net loss                                                                                                      |     | $                               | (10,378,911 | )                                                          | $      | (17,372,147 | ) | $ | (306,212,851 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                                  |     |                            |        |                                                       |   |   |   |
| Depreciation and amortization                                                                                 |     | 216,276                         |        | 1,590,705                                                  |   | 22,677,706 |   |
| Compensation related to issuance of stock,  stock options and warrants to directors, consultants and officers |     | —                          |        | —                                                     |   | 4,848,641 |   |
| Amortization and accretion of debt issue  costs                                                               |     | 482,973                         |        | —                                                     |   | 898,750 |   |
| Debentures issuance and conversion costs                                                                      |     | 105,847                         |        | —                                                     |   | 426,817 |   |
| Loss on change in fair value of warrant  obligation                                                           |     | 86,958                          |        | —                                                     |   | 86,958 |   |
| Loss on extinguishment of debentures                                                                          |     | 1,697,380                       |        | —                                                     |   | 1,697,380 |   |
| Beneficial conversion value due to change  in debentures conversion price                                     |     | 360,000                         |        | —                                                     |   | 360,000 |   |
| (Gain) Loss on sale, disposal, or  impairment of property and equipment                                       |     | (63,000                         | )           | (9,500                                                     | )      | 47,150,540 |   |
| Equity in the losses of joint venture                                                                         |     | 148,257                         |        | 30,000                                                     |   | 297,683 |   |
| Accrued purchase commitment                                                                                   |     | —                          |        | —                                                     |   | 3,500,000 |   |
| Net loss on sale of investments                                                                               |     | —                          |        | —                                                     |   | 32,496 |   |
| Accretion of discounts on investments                                                                         |     | —                          |        | —                                                     |   | (410,084 | ) |
| Other non-cash expense items                                                                                  |     | (2,124                          | )           | —                                                     |   | (2,124 | ) |
| Changes in operating assets and  liabilities:                                                                 |     |                            |        |                                                       |   |   |   |
| Prepaid expenses and other current assets                                                                     |     | (120,135                        | )           | (351,369                                                   | )      | (690,937 | ) |
| Accounts payable and accrued expenses                                                                         |     | (2,403,817                      | )           | (1,214,833                                                 | )      | 5,455,494 |   |
| Payable to related party                                                                                      |     | 344,376                         |        | 619,186                                                    |   | 968,801 |   |
| Net cash used in operating activities                                                                         |     | (9,525,920                      | )           | (16,707,958                                                | )      | (218,914,730 | ) |
|                                                                                                          |     |                            |        |                                                       |   |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES**                                                                      |     |                            |        |                                                       |   |   |   |
| Purchase of investments in U.S. government  securities                                                        |     | —                          |        | —                                                     |   | (52,419,820 | ) |
| Purchase of restricted time deposit in  connection with purchase commitment                                   |     | —                          |        | —                                                     |   | (3,500,000 | ) |
| Proceeds from sales and redemption of  investments                                                            |     | —                          |        | —                                                     |   | 52,797,408 |   |
| Proceeds from sales of property and  equipment                                                                |     | 74,200                          |        | 9,500                                                      |   | 849,436 |   |
| Investment in joint venture                                                                                   |     | —                          |        | —                                                     |   | (515,438 | ) |
| Purchase of property and equipment                                                                            |     | (1,320                          | )           | (988,906                                                   | )      | (75,799,435 | ) |
| Net cash provided by (used in) investing  activities                                                          |     | 72,880                          |        | (979,406                                                   | )      | (78,587,849 | ) |
|                                                                                                          |     |                            |        |                                                       |   |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES**                                                                      |     |                            |        |                                                       |   |   |   |
| Proceeds from issuance of common stock                                                                        |     | —                          |        | 16,689,758                                                 |   | 284,040,180 |   |
| Common stock issuance costs                                                                                   |     | —                          |        | —                                                     |   | (15,178,641 | ) |
| Proceeds from issuance of common stock and  convertible debentures                                            |     | 8,656,982                       |        | —                                                     |   | 8,656,982 |   |
| Proceeds from issuance of convertible  debentures                                                             |     | —                          |        | —                                                     |   | 10,000,000 |   |
| Purchase of restricted time deposit in  connection with issuance of convertible debentures                    |     | —                          |        | —                                                     |   | (10,000,000 | ) |
| Proceeds from release of restricted time  deposit upon conversion of convertible debentures into common stock |     | 1,291,000                       |        | —                                                     |   | 2,291,000 |   |
| Repayment of convertible debentures                                                                           |     | (5,200,000                      | )           | —                                                     |   | (5,200,000 | ) |
| Proceeds from release of restricted cash  for repayment of convertible debentures                             |     | 5,200,000                       |        | —                                                     |   | 5,200,000 |   |
| Proceeds from release of restricted cash  upon exchange of convertible debentures                             |     | 2,000,000                       |        | —                                                     |   | 2,000,000 |   |
| Proceeds from issuance of notes payable to  related party                                                     |     | 1,010,000                       |        | 350,000                                                    |   | 20,105,000 |   |
| Repayment of notes payable to related party                                                                   |     | —                          |        | —                                                     |   | (15,325,651 | ) |
| Proceeds from drawings on line of credit  with bank                                                           |     | —                          |        | —                                                     |   | 14,000,000 |   |
| Repayment of line of credit with bank                                                                         |     | —                          |        | —                                                     |   | (14,000,000 | ) |
| Preferred dividends paid                                                                                      |     | —                          |        | —                                                     |   | (9,926,703 | ) |
| Proceeds from issuance of preferred stock                                                                     |     | —                          |        | —                                                     |   | 25,675,000 |   |
| Preferred stock issuance costs                                                                                |     | —                          |        | —                                                     |   | (1,201,999 | ) |
| Net cash provided by financing activities                                                                     |     | 12,957,982                      |        | 17,039,758                                                 |   | 301,135,168 |   |
| Effect of exchange rate changes on cash and  cash equivalents                                                 |     | 922                             |        | —                                                     |   | (15,710 | ) |
|                                                                                                          |     |                            |        |                                                       |   |   |   |
| **INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS**                                                         |     | 3,505,864                       |        | (647,606                                                   | )      | 3,616,879 |   |
|                                                                                                          |     |                            |        |                                                       |   |   |   |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF  PERIOD**                                                           |     | 111,015                         |        | 828,007                                                    |   | — |   |
|                                                                                                          |     |                            |        |                                                       |   |   |   |
| **CASH AND CASH EQUIVALENTS, END OF PERIOD**                                                                  |     | $                               | 3,616,879   |                                                       | $      | 180,401 |   | $ | 3,616,879 |   |

 

 

6

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| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION**                                       |   |      |   |   |   |      |   |
|--------------------------------------------------------------------------------------------|--------|-----------|--------|--------|--------|-----------|--------|
| Cash paid for:                                                                             |   |      |   |   |   |      |   |
| Income taxes                                                                               |   | $         | — |   | $      | 800       |   | $ | 12,671 |   |
| Interest                                                                                   |   | 28,203    |   | — |   | 3,077,501 |   |
| Common stock warrants issued in connection  with convertible debentures                    |   | 745,562   |   | — |   | 2,572,776 |   |
| Conversion of convertible debentures into  common stock                                    |   | 3,141,000 |   | — |   | 4,141,000 |   |
| Transfer of property from EKI                                                              |   | —    |   | — |   | 28,745    |   |
| Interest paid in Common Stock                                                              |   | 74,867    |   | — |   | 74,867    |   |
| Commission paid in common stock                                                            |   | 29,500    |   | — |   | 29,500    |   |
| Common stock issued to service providers in  connection with the March 2003 financing |   | 484,500   |   | — |   | 484,500   |   |
| Conversion of preferred stock to common  stock                                             |   | —    |   | — |   | 69,888    |   |
|                                                                                            |        |           |        |        |        |           |        |  |  |  |

 

See Notes to Consolidated FinancialStatements.

 

7

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**EARTHSHELLCORPORATION(A Development Stage Enterprise)NOTES TO CONSOLIDATED FINANCIALSTATEMENTS***(Unaudited)***June 30, 2003**

 

**Presentation ofFinancial Information**

 

The foregoing interim financial information is unaudited and has beenprepared from the books and records of EarthShell Corporation.  EarthShell Corporation’s consolidatedfinancial statements include the accounts of its wholly-owned subsidiary,EarthShell GmbH.  All significantintercompany balances and transactions have been eliminated inconsolidation.  Both EarthShellCorporation and its subsidiary (collectively “EarthShell” or the “Company”) aredevelopment stage enterprises.  In theopinion of management, the financial information reflects all adjustmentsnecessary for a fair presentation of the financial condition, results ofoperations and cash flows of the Company in conformity with generally acceptedaccounting principles.  All suchadjustments were of a normal recurring nature for interim financialreporting.  Certain reclassificationshave been made to the 2002 financial statements to conform to the 2003presentation.

 

The accompanying unaudited consolidated financial statements and thesenotes do not include certain information and footnote disclosures required byaccounting principles generally accepted in the United States, which wereincluded in the Company’s consolidated financial statements for the year endedDecember 31, 2002.  The information includedin this Form 10-Q should be read in conjunction with Management’s Discussionand Analysis of Financial Condition and Results of Operations and the Company’sconsolidated financial statements and notes thereto for the year ended December31, 2002 included in the Company’s Annual Report on Form 10-K/A.

 

The accompanying consolidated financial statements have been preparedon a going concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business.  During the period from November 1, 1992(inception) to June 30, 2003, the Company has incurred a cumulative net loss of$306,212,851 and has a stockholders’ deficit of $8,424,537 at June 30,2003.  These factors among others mayindicate that the Company will be unable to continue as a going concern for areasonable period of time.

 

The consolidated financial statements do not include any adjustmentsrelating to the recoverability and classification of recorded asset amounts orthe amounts and classification of liabilities that might be necessary shouldthe Company be unable to continue as a going concern.  The Company’s continuation as a going concern is dependent uponits ability to generate sufficient cash flow to meet its obligations on atimely basis, to obtain additional financing or refinancing as may be required,and ultimately to attain successful operations.

 

Basic loss per common share is computed by dividing net loss availableto common stockholders by the weighted-average number of common sharesoutstanding during the period.  Dilutedloss per common share is computed by dividing net loss available to commonstockholders by the weighted-average number of common shares outstanding plusan assumed increase in common shares outstanding for potentially dilutivesecurities, which consist of options and warrants to acquire common stock andconvertible debentures.  Potentiallydilutive shares are excluded from the computation in loss periods, as theireffect would be anti-dilutive.  Thedilutive effect of options and warrants to acquire common stock is measuredusing the treasury stock method.  Thedilutive effect of convertible debentures is measured using the if-convertedmethod.  Basic and diluted loss percommon share is the same for all periods presented because the impact ofpotentially dilutive securities is anti-dilutive.

 

Since March 5, 2003 theCompany’s common stock has traded on the NASDAQ SmallCap Market under thesymbol “ERTH.”

 

 

8

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**Related PartyTransactions**

 

E. Khashoggi Industries LLC and its wholly owned subsidiaries (“EKI”)own approximately 30% of the Company’s outstanding shares, and may be deemed tobe a controlling stockholder.  Inconnection with the formation of the Company, the Company entered into a MasterLicense Agreement with EKI (the “EKI License Agreement”), pursuant to which theCompany has an exclusive, worldwide, royalty-free license to use and licensethe EKI technology to manufacture and sell disposable, single-use containersfor packaging or serving food or beverages intended for consumption within ashort period of time (less than 24 hours). Effective January 1, 2001, EKI granted to the Company priorityrights to license certain product applications on an exclusive basis fromBiotec, a wholly owned subsidiary of EKI, in consideration for payment by theCompany of a $100,000 monthly licensing fee to Biotec.  In addition, Biotec agreed to rendertechnical services to the Company, as required, at Biotec’s cost plus 5%.  Effective July 29, 2002, the Companyrestated its agreements with Biotec in a definitive License & InformationTransfer Agreement with Biotec to utilize the Biotec technology for foodserviceapplications, including food wraps and cutlery (the “Biotec LicenseAgreement”).  Under the terms of theBiotec License Agreement, the Company paid or accrued $304,667 and $468,313during the three months ended June 30, 2003 and 2002, respectively, and$658,467 and $768,313 during the six months ended June 30, 2003 and 2002,respectively, consisting of the $100,000 per month licensing fee plus materialsand services provided by EKI, which vary based upon the Company’s requirements.

 

In September 2002, the Company entered into a Loan Agreement with EKIwhereby EKI agreed to extend certain loans to the Company at EKI’s solediscretion, at interest rates of 7% to 10%. As of December 31, 2002 the outstanding principal amount of outstanding loans was $1,745,000.  In January 2003, the Company borrowed anadditional $1,010,000 from EKI under the Loan Agreement, bringing the totaloutstanding principal amount of the loans to $2,755,000.  As part of the new convertible debenturefinancing completed in March 2003 (see *Convertible Debentures*), repayment ofthese loans and related interest was subordinated to the new debentures withstrict covenants governing their repayment. Therefore, at June 30, 2003, the loans totaling $2,755,000 and relatedinterest of $182,155 are classified as noncurrent liabilities.  In March 2003, the Company issued to EKI awarrant, which is immediately exercisable, to purchase 1,000,000 shares of theCompany’s common stock at $0.50 per share in connection with the subordinationof the loans totaling $2,755,000.  Thefair value of the warrant was estimated to be approximately $303,522 using theBlack-Scholes option pricing model and was recorded as a discount on theoutstanding loans.

 

****Convertible Debentures****

 

On March 5, 2003, the Company received proceeds of approximately $9.0million, net of financing costs of approximately $1.5 million, from theissuance to a group of institutional investors of 5,000,000 shares of commonstock and $10.55 million in aggregate principal amount of secured convertibledebentures due in 2006 (the “2006 Debentures”).  The 2006 Debentures bear interest at a rate of 2.0% per annum,payable quarterly in arrears on each January 31, April 30, July 31 and October31.  The holders of the 2006 Debentureshave the right to convert such debentures into the Company’s common stock at aconversion price of $0.50 per share. While the 2006 Debentures are outstanding, the conversion price issubject to adjustment in certain instances, such as a result of stock dividendsand splits, distributions of property to common stockholders, the sale of substantiallyall of the Company’s assets, the consummation of a merger, or sales of commonstock or common stock equivalents for per share prices lower than theconversion price in effect.  In additionto the holders’ conversion option, after the first anniversary of the issuanceof the 2006 Debentures the Company has the right to force conversion of all ora portion of the outstanding principal amount of the 2006 Debentures if certainconditions are met, including a requirement that the closing price of thecommon stock has been equal to or greater than 300% of the conversion price forat least the 10 consecutive days immediately preceding the conversion.  The principal amount of the 2006 Debenturesis due and payable on March 5, 2006; however, earlier repayment may occur ifthe Company receives cash proceeds in excess of $2.65 million (the “ExcessAmount”) from the sale of debt or equity securities, equipment sales tounrelated third parties, operating revenues, or any cash that becomes availableto the Company as a result of a reduction in a $3.5 million letter of creditthe Company issued to a third party in 1998. If the Excess Amount arises, the holders of the 2006 Debentures canelect to require one third of such

 

9

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amount to be applied as a 102% prepayment of principal and interest ofthe 2006 Debentures.

 

In accordancewith Accounting Principles Board Opinion No. 14, “Accounting for ConvertibleDebt and Debt Issued with Stock Purchase Warrants,” the Company allocated thenet proceeds of $9.0 million to the 2006 Debentures and the common stock basedtheir relative fair values.  A discounton the 2006 Debentures of $3.4 million and a discount on the common stock of$604,000 resulted from the fair value allocation.  Based on the conversion price of the 2006 Debentures relative tothe fair market value for a share of the Company’s common stock at the date ofissue, the conversion feature of the 2006 Debentures was determined to have nointrinsic value to the holders.  Ifsubsequent to the issuance date the conversion price of the 2006 Debentures isadjusted downward, the value of the conversion feature will be re-measured todetermine if any beneficial conversion value should be recorded as of the datethe conversion price is adjusted.  Theprincipal amount of the 2006 Debentures of $10.55 million was recorded as anoncurrent liability, net of a $3.4 million discount.  The total discount on the 2006 Debentures of $3.4 million, whichis being amortized to interest expense over the 36-month term of the 2006Debentures using the effective interest method, may be subject to downwardadjustments to the extent partial conversions of the 2006 Debenturesoccur.  These adjustments, if required,would reduce the discount and reduce additional paid-in capital.

 

In addition to the $1.5 million of financing costs, the Company alsoincurred approximately $646,000 of non-cash costs attributable to 650,000shares of common stock issued to the lead purchaser of the 2006 Debentures andtwo warrants issued to a placement agent, both of whom received the instrumentsas compensation for their services rendered in connection with thetransaction.  The fair value of the650,000 shares of common stock issued to the lead purchaser was determined tobe $247,000, based on the closing price of $0.38 per share of the Company’scommon stock on the NASDAQ SmallCap Market on March 5, 2003.  The fair value of approximately $42,000 ofthe first of the two warrants issued to the placement agent, which expires inMarch 2006 and is immediately exercisable by the placement agent to purchase345,724 shares of the Company’s common stock for $0.84 per share, was estimatedusing the Black Scholes option-pricing model and is reflected in theaccompanying financial statements as an increase in additional paid-in capitaland as a component of the $4.0 million aggregate discount on the 2006Debentures and common stock issued in the March 2003 transaction.  The second of the two warrants issued to theplacement agent, which expires in March 2006, is immediately exercisable by theplacement agent to purchase $1.055 million in aggregate principal amount of the2006 Debentures and 500,000 shares of the Company’s common stock, except if,prior to exercise of the warrant, all of the 2006 Debentures have beenredeemed, repurchased or converted, in which case the portion of the warrantexercisable into the 2006 Debentures becomes exercisable into common stock asif the 2006 Debentures included in the warrant had been converted to commonstock.  The exercise price of theconvertible debenture portion of the warrant is $1,200 for each $1,000 ofprincipal and is subject to adjustment consistent with the provisions of the2006 Debentures.  The exercise price ofthe common stock portion of the warrant is $0.60 per share.  The estimated fair value of this warrant isreflected in the accompanying financial statements as a warrant obligation andas a component of the $4.0 million aggregate discount on the 2006 Debenturesand common stock issued in the March 2003 financing transaction.  The warrant is reflected as a noncurrentliability because it is immediately exercisable into a noncurrent debtsecurity.

 

In connection with the March 2003 financingtransactions, the Company prepaid $5.2 million of the $8.2 million principalamount outstanding of the convertible debentures due in 2007 (the “2007Debentures”), resulting in a prepayment penalty of $208,000.  The Company also issued to the holders ofthe 2007 Debentures 625,000 shares of common stock, valued at $237,500 basedupon the closing price of the Company’s common stock on the NASDAQ SmallCapMarket of $0.38 per share on March 5, 2003. In addition, one of the holders of the 2007 Debentures exchanged $2.0million aggregate principal amount of 2007 Debentures for $2.0 millionaggregate principal amount of 2006 Debentures and 947,867 shares of commonstock valued at approximately $360,000 based upon the closing price of theCompany’s common stock of $0.38 per share on March 5, 2003.  In connection with the prepayment andexchange transactions, the Company incurred cash transaction costs ofapproximately $296,000, excluding the prepayment penalty.  The Company recognized a $1.7 million lossupon extinguishment of the 2007 Debentures through the prepayment andexchange.  The prepayment of the 2007Debentures and the debenture exchange resulted in the release to the Company of$2.0 million of restricted cash.

 

10

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The issuance of the 2006 Debentures, prepayment of the2007 Debentures (from restricted cash) and the debenture exchange provided theCompany with aggregate net proceeds of approximately $11.0 million.  The Company’s use of these proceeds issubject to a number of restrictions, including a restriction not to use morethan $4.0 million of the proceeds to pay accounts payable existing as of March5, 2003.

 

During thequarter ended March 31, 2003, $1.0 million of the 2006 Debenture principal wasconverted into 2,000,000 shares of common stock resulting in the carryingamount of the 2006 Debentures converted of approximately $665,000 beingtransferred to common stock.

 

During the quarter ended June 30, 2003, $850,000 ofthe 2006 Debenture principal was converted into 1,700,000 shares of commonstock resulting in the carrying amount of the 2006 Debentures converted ofapproximately $773,000 being transferred to common stock.

 

In January and February 2003, the Company forced the conversion of$800,000 of the 2007 Debentures for 1,675,192 shares of common stock, resultingin the release to the Company of $800,000 of restricted cash.  In June 2003, the holders converted $491,000of 2007 Debentures for 982,000 shares of common stock, resulting in the releaseto the Company of $491,000 of restricted cash.

 

At June 30, 2003, the outstanding principal balance of 2006 Debentureswas $10.7 million, which is reflected on the accompanying balance sheet net ofan unamortized discount of $2.8 million. At June 30, 2003, the outstanding principal balance of 2007 Debentureswas $509,000, which is reflected on the accompanying balance sheet net of anunamortized discount of $61,937.  The2007 Debentures are classified as current liabilities as the holders can redeemthe debentures on demand.

 

Subsequent to June 30, 2003, the Company forced conversion of theremaining $509,000 of 2007 Debentures for 1,590,624 shares of common stock,resulting in the release to the Company of $509,000 of restricted cash.

 

In connection with the March 2003 financing transactions, EKI agreed tosubordinate the repayment of its outstanding loans totaling $2,755,000 to theCompany’s payment obligations under the 2006 Debentures.  In addition, EKI and Biotec agreed tosubordinate certain payments to which they were otherwise entitled under theBiotec License Agreement (other than their respective percentages of anyroyalties received by the Company) to the satisfaction of the Company’s paymentobligations under the 2006 Debentures. They further agreed not to assert any claims against the Company forbreaches of the Biotec License Agreement (other than the assertion of certainequitable remedies to enjoin the Company from, for example, selling productsoutside its field of use) until such time as the Company’s obligations underthe 2006 Debentures are satisfied in full. EKI and Biotec also agreed to allow the Company to pledge theirrespective interests in the EKI and Biotec License Agreements to secure theCompany’s obligations under the 2006 Debentures, and certain additional concessionswere made by EKI and Biotec to permit the Company greater flexibility inselling its rights under the EKI and Biotec License Agreements to third partiesin an insolvency context.  These rightsterminate upon the satisfaction in full of the obligations under the 2006Debentures.  In consideration for itswillingness to subordinate the payments and advances that are owed to it, inMarch 2003 the Company issued to EKI a warrant, expiring in ten years, toacquire 1,000,000 shares of the Company’s common stock for $0.50 pershare.  The fair value of the warrantwas estimated to be approximately $303,522 using the Black-Scholes optionpricing model and was recorded as a discount on the outstanding loans.

 

****Commitments****

 

During 1998, EKI entered into certain agreements with an equipmentmanufacturer providing for the purchase by EKI of certain technology applicableto starch-based disposable packaging. EKI licenses such technology to the Company on a royalty-free basis pursuantto the License Agreement.  In connectionwith the purchase, and pursuant to the terms of a letter agreement with EKI,the Company agreed to pay the seller of the technology $3.5 million on orabout December 31, 2003, which obligation is secured by a letter ofcredit, which in turn is secured by $3.5 million of the Company’s restrictedcash.  The Company’s obligation 

 

11

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to the seller of the technology will be reduced by 5% of the purchaseprice of any equipment purchased from the seller of the technology by EKI, theCompany or their respective licensees prior to the obligation paymentdate.  While the Company believes demandfor such equipment will arise in the future, it is unable to estimate when suchdemand will occur or if such demand will result in any reduction of thisobligation.  As a result of theseuncertainties and since the obligation will become payable on or aboutDecember 31, 2003, the Company established a liability as of December 31,2002 for the $3.5 million commitment.

 

In addition, the Company would be required to pay the seller$3.0 million over the five-year period commencing January 1, 2004 ifEKI, the Company or their respective licensees make active use of thetechnology and have not purchased, by December 31, 2003, at least$35.0 million of equipment from the seller.  As of June 30, 2003, the Company and its respective licenseeshave neither actively used the technology nor purchased equipment from theseller.  The Company does not plan tomake active use of the technology during the year ending December 31,2003.  EKI has agreed to indemnify theCompany to the extent the Company is required to pay any portion of this$3.0 million obligation solely as a result of EKI’s or its licensees’active use of such patents and related technology (other than use by theCompany or its sublicensees).  The$3.0 million obligation to the seller of the technology is subject toreduction in an amount equal to 5% of the purchase price of any equipmentpurchased from the seller by EKI, the Company or their sublicensees during thefive-year period commencing January 1, 2004.

 

**Property andEquipment**

 

The cost and accumulated depreciation of property and equipment at June30, 2003 and December 31, 2002 were as follows:

 
|                                                   |   | **June 30,  2003** |      | **December  31,  2002** |   |
|--------------------------------------------------------|--------|--------------------|-----------|-------------------------|--------|
| Commercial Manufacturing Equipment                     |   |               |      |                    |   |
| Goettingen, Germany                                    |   | $                  | 4,000,000 |                    | $      | 4,000,000 |   |
|                                                   |   |               |      |                    |   |
| Other Property and Equipment                           |   |               |      |                    |   |
| Product development center                             |   | 2,023,956          |      | 2,077,438               |   |
| Office furniture and equipment                         |   | 744,251            |      | 742,931                 |   |
| Leasehold improvements                                 |   | 50,108             |      | 521,187                 |   |
|                                                   |   | 2,818,315          |      | 3,341,556               |   |
|                                                   |   |               |      |                    |   |
| Total cost                                             |   | 6,818,315          |      | 7,341,556               |   |
|                                                   |   |               |      |                    |   |
| Less:   Accumulated depreciation and amortization |   | (2,568,297         | )         | (2,865,382              | )      |
|                                                   |   |               |      |                    |   |
| Property and equipment – net                      |   | $                  | 4,250,018 |                    | $      | 4,476,174 |   |

 

The commercial production line in Goettingen, Germany is being financedand constructed by the Company for the Company’s joint venture with HuhtamäkiOyj (“Huhtamäki”).  During the thirdquarter of 2002 the company obtained quotations from various machinerysuppliers and determined that the cost to build an identical line wasapproximately $4.0 million.  The Companywrote the carrying value of the line down to its estimated replacement cost.

 

In connection with the Company’s move from the Goleta, Californiafacility at the expiration of the lease on May 31, 2003, the Company removed$471,079 of fully amortized leasehold improvements from both the Leaseholdimprovements and Accumulated amortization accounts.

 

**Stock Options**

 

The Company accounts for stock options in accordance with theprovisions of Accounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees,” and complies with the disclosure 

 

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provisions of Statement of Financial Accounting Standards (“SFAS”)No. 123, “Accounting for Stock-Based Compensation.”  Under APB Opinion No. 25, compensationexpense is based on the difference, if any, on the date of grant, between thefair value of the Company’s common stock and the exercise price of theoption.  For disclosure purposes, tomeasure stock-based compensation in accordance with SFAS No. 123,“Accounting for Stock-Based Compensation,” the fair value of each option grantis estimated on the date of grant using the Black-Scholes option-pricingmodel.  The fair value of each optiongrant is then amortized as pro forma compensation expense over the vestingperiod of the options.  The followingtable sets forth the pro forma net loss and loss per share resulting fromapplying SFAS No. 123.

 
|                                                                                                               |   | **Three  Months  Ended June 30,** |      | **Six Months  Ended June 30,** |   |
|--------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|-----------|--------------------------------|--------|
|                                                                                                               |   | **2003**                          |      | **2002**                       |   | **2003** |   | **2002** |   |
| Net Loss as reported                                                                                               |   | $                                 | 3,608,184 |                           | $      | 7,159,409 |   | $ | 10,378,911 |   | $ | 17,372,147 |   |
| Deduct: Stock-based employee compensation  expense included in reported net loss, net of tax                       |   | —                            |      | —                         |   | — |   | — |   |
| Add: Total stock-based employee  compensation determined under fair value based method for all awards, net of  tax |   | 102,772                           |      | 145,155                        |   | 182,162 |   | 232,718 |   |
| Pro forma net loss                                                                                                 |   | $                                 | 3,710,956 |                           | $      | 7,304,564 |   | $ | 10,561,073 |   | $ | 17,604,865 |   |
|                                                                                                               |   |                              |      |                           |   |   |   |   |   |
| Net loss per common share                                                                                          |   |                              |      |                           |   |   |   |   |   |
| As reported                                                                                                        |   | $                                 | 0.02      |                           | $      | 0.05 |   | $ | 0.07 |   | $ | 0.13 |   |
| Pro forma                                                                                                          |   | 0.02                              |      | 0.05                           |   | 0.07 |   | 0.14 |   |

 

In December 2002, the Financial Accounting Standards Board issued SFASNo. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure -An Amendment of FASB Statement No. 123.” SFAS No. 148 provides alternative methods of transition for a voluntarychange to the fair value based method of accounting for stock-based employeecompensation and requires prominent disclosures in both annual and interimfinancial statements about the method of accounting for stock-based employeecompensation and the effect of the method used on reported results.  The Company has elected not to adopt therecognition and measurement provisions of SFAS No. 123 and continues to accountfor its stock-based employee compensation plans under APB Opinion No. 25 andrelated interpretations and therefore the transition provisions will not havean impact on the Company’s financial position or results of operations.  The required expanded interim disclosuresare provided above.

 

**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

**ForwardLooking Statements**

 

Information contained in this Quarterly Report on Form 10-Q, including“Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” contains forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995, as amended.  These statements may be identified by theuse of forward-looking terminology such as “may,” “will,” “expect,”“anticipate,” “estimate,” or “continue,” or the negative thereof or othercomparable terminology.  Any one factoror combination of factors could cause the Company’s actual operatingperformance or financial results to differ substantially from those anticipatedby management that are described herein. Investors should carefully review the risk factors set forth in otherCompany reports or documents filed with the Securities and Exchange Commission,including Forms 10-Q, 10-K, 10-K/A and 8-K. Factors influencing the Company’s operating performance and financialresults include, but are not limited to, changes in the general economy, theavailability of financing, governmental regulations concerning, but not limitedto, environmental issues, and other risks and unforeseen circumstancesaffecting the Company’s business.  ThisQuarterly Report on Form 10-Q should be read in conjunction with the Company’sAnnual Report on Form 10-K/A for the fiscal year ended December 31, 2002.

 

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**Critical AccountingPolicies**

 

The preparation of financial statements and related disclosures in conformitywith generally accepted accounting principals requires management to makejudgments, assumptions and estimates that affect the amounts reported in theCompany’s financial statements and the accompanying notes.  The amounts of assets and liabilities reportedin the Company’s balance sheet and the amounts of expenses reported for eachfiscal period are affected by estimates and assumptions which are used for, butnot limited to, the accounting for asset impairments.  Actual results could differ from these estimates.  The following critical accounting policiesare significantly affected by judgments, assumptions and estimates used in thepreparation of the consolidated financial statements.

 

*Estimated NetRealizable Value of Property and Equipment.*  The Company has been engaged in thedevelopment of manufacturing equipment to validate acceptance of EarthShellproducts and their pricing.  To this endthe Company has developed manufacturing lines in Owings Mills, Maryland, inGoleta, California and in Goettingen, Germany. The Company evaluates the recoverability of property and equipmentwhenever events or changes in circumstances indicate that the carrying value ofan asset may not be recoverable.  Ifthere is an indication that the carrying value of an asset may not berecoverable and the estimated future cash flows (undiscounted and withoutinterest charges) from the use of the asset are less than the carrying value, awrite-down is recorded to reduce the related asset to its estimated fair value.

 

The Company’s business plans for 2003 call for the transfer ofoperational and financial control of the manufacturing line in Germany to theCompany’s manufacturing licensee, PolarCup EarthShell ApS.  At such time as the machinery isdemonstrated to perform at an agreed upon level, the Company expects to receivereimbursement for the replacement value of the line.  The Company is carrying the equipment at its expected replacementvalue based on quotations from various equipment suppliers for the cost of anidentical line.  Failure of theequipment to perform at a level satisfactory to the licensee or failure toconclude the transfer of the line to the licensee may require the Company toconsider alternative approaches to utilize the equipment, such as finding an alternatelicensee to take over, relocating the equipment, or dismantling the line.  Any one of these alternative could have anegative economic impact on the carrying value of the equipment.

 

*Accrued PurchaseCommitment.*  AtMarch 30, 1998, a certificate of deposit for $3.5 million was openedas collateral for the letter of credit related to the Company’s obligationsunder a letter agreement between the Company’s controlling stockholder, EKI,and the Company relating to a patent purchase agreement between EKI and a thirdparty, as discussed in the *Commitments* note, and is classified asrestricted cash on the balance sheet at December 31, 2002 and June 30,2003.  As of December 31, 2002 andJune 30, 2003, the $3.5 million certificate of deposit and the relatedaccrued purchase commitment are both classified as current in the accompanyingbalance sheet since the obligation will become payable on or aboutDecember 31, 2003.

 

*Fair Value ofWarrant Obligation.* In connection with the March 2003 financing transactions, theCompany issued to a placement agent a warrant, which expires in March 2006,that is immediately exercisable by the placement agent to purchase $1.055million in aggregate principal amount of the 2006 Debentures and 500,000 sharesof the Company common stock, except if, prior to exercise of the warrant, allof the 2006 Debentures have been redeemed, repurchased or converted, in whichcase the portion of the warrant exercisable into the 2006 Debentures becomesexercisable into common stock as if the 2006 Debentures included in the warranthad been converted to common stock.  Theexercise price of the convertible debenture portion of the warrant is $1,200for each $1,000 of principal and is subject to adjustment consistent with theprovisions of the 2006 Debentures.  Theexercise price of the common stock portion of the warrant is $0.60 pershare.  The estimated fair value of thiswarrant is reflected in the accompanying financial statements as a warrantobligation and as a component of the $4.0 million aggregate discount on the2006 Debentures and common stock issued in the March 2003 financingtransaction.  The warrant is reflectedas a noncurrent liability because it is immediately exercisable into anoncurrent debt security.

 

*Basis of FinancialStatement Presentation. *InMarch 2003, the Company completed financing transactions involving the issuanceof the 2006 Debentures.  Thesetransactions provided the Company with cash of approximately $11.0 million;however, use of these proceeds is subject to a number of restrictions,including

 

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a restriction not to use more than $4.0 million of the proceeds to payaccounts payable existing as of the date of the transactions.  While the Company is continuing to reduceits operating expenses and is working to cause one or more of its licensees topurchase and install equipment to manufacture EarthShell PackagingÒin order to generate royalty revenue to the Company, the Company may need toraise additional financing to meet its current obligations and to coveroperating expenses through the year ending December 31, 2003.  The Company cannot be certain thatadditional financing will be available to it, or, if available, that the termswill be satisfactory, or that it will be able to negotiate mutually agreeableterms for the transfer of the manufacturing lines to its operatingpartners.  If the Company is notsuccessful in reducing expenses, transferring the manufacturing lines orraising additional capital, it may not be able to continue as a going concernfor a reasonable period of time.  Theconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or the amountsand classification of liabilities that might be necessary should the Company beunable to continue as a going concern.* *(See *Liquidity and Capital Resources at June 30, 2003*)

 

*Revenuerecognition. *TheCompany has been manufacturing and selling initial quantities of commercialproduct in cooperation with its strategic partners as it has worked todemonstrate the commercial viability of its products and manufacturingprocesses.  During its developmentphase, the Company has recorded the proceeds from such sales since its inceptionas an offset to the cost of the demonstration manufacturing operations.  As the Company transitions the commercialmanufacturing of its products to its licensees and begins to earn royaltiesunder its license agreements, it intends to reevaluate its revenue recognitionpolicy.  During the three and six monthsended June 30, 2003, the Company manufactured and sold product with anaggregate in-market value of approximately $160,000 and $295,000, respectively.  Under its licensing model, the Company wouldhave recognized royalty revenue of approximately $32,000 and $59,000,respectively, had the product been produced by a licensee at full productionrates.  This information is presentedfor illustrative purposes only.

 

The key accounting estimates and policies are reviewed with the AuditCommittee of the Board of Directors.

 

**Overview ofOperations**

 

Organized in November 1992 as a Delaware corporation, the Company isengaged in the commercialization of composite material technology for themanufacture of foodservice disposable packaging designed with the environmentin mind.  EarthShell Packaging is basedon patented composite material technology (collectively, the “EarthShellTechnology”), licensed on an exclusive, worldwide basis from EKI.

 

The EarthShell Technology has been developed over many years inconsultation with leading material scientists and environmental experts toreduce the environmental burdens of foodservice disposable packaging throughthe careful selection of raw materials, processes, and suppliers.  EarthShell Packaging, including hinged-lidsandwich containers, plates, bowls, and cups, is primarily made from commonlyavailable natural raw materials such as natural ground limestone and potatostarch.  The Company believes thatEarthShell Packaging has comparable or superior performance characteristics andcan be commercially produced and sold at prices that are competitive withcomparable paper and plastic foodservice disposable packaging.

 

**Three Months EndedJune 30, 2003 Compared with the Three Months Ended June 30, 2002.**

 

The Company’s net loss decreased $3.6 million to $3.6 millionfrom $7.2 million for the three months ended June 30, 2003 compared to thethree months ended June 30, 2002, respectively.

 

***Total Research andDevelopment Expenses.* **Total research and development expenses are comprised of *Relatedparty license and research and development expenses* and *Otherresearch and development expenses.* Total research and developmentexpenses for the development of EarthShell Packaging® decreased$2.3 million to $2.0 million from $4.3 million for the threemonths ended June 30, 2003 compared to the three months ended June 30, 2002,respectively.

 

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•                  *Relatedparty license and research and development expenses* are comprised ofthe $100,000 monthly licensing fee for the use of the EarthShellTechnology and technical services, both of which were payable to EKI.  Related party research and developmentexpenses decreased $0.2 million to $0.3 million from $0.5 million for the threemonths ended June 30, 2003 compared to the three months ended June 30, 2002,respectively. This decrease is entirely due to a reduction in technicalservices provided to the Company by Biotec.

 

•                  *Otherresearch and development expenses* are comprised of personnel costs,travel and direct overhead for development and demonstration production, aswell as impairment charges on manufacturing property and equipment constructedfor demonstration production purposes. Other research and development expensesdecreased $2.1 million to $1.7 million from $3.8 million for the three monthsended June 30, 2003 compared to the three months ended June 30, 2002,respectively. The decrease in other research and development expenses was primarilydue to concluding the demonstration manufacturing of hinged-lid containers inOwings Mills, Maryland at the end of the second quarter of 2002.  While the majority of the expenses incurredin the second quarter of 2002 related to the Owings Mills demonstrationmanufacturing, it also included expenses related to the commencement ofdemonstration manufacturing of bowls and plates in Goleta, California.  In the second quarter of 2003, expenses wereinitially related to the ongoing demonstration manufacturing in Goleta throughmid-April and subsequently to the start-up in mid-May of a new manufacturingline for plates and bowls built and financed by Detroit Tool and EngineeringCompany (DTE) at their Lebanon, Missouri facility.  The second quarter of 2003 also included expenses incurred tovacate the Goleta facility at the expiration of the lease on May 31.  There were no impairment charges in eitherperiod.

 

***Other General andAdministrative Expenses. **** Other general and administrative expenses*arecomprised of personnel costs, travel and direct overhead for marketing, financeand administration.  Total general andadministrative expenses decreased $0.9 million to $1.2 million from $2.1million for the three months ended June 30, 2003 compared to the three monthsended June 30, 2002, respectively. This was primarily the result of efforts tosignificantly reduce general and administrative expenses in 2003, whichresulted in reductions in the following expenses: personnel costs by $0.1million, travel costs by $0.1 million, facility costs by $0.1 million andprofessional fees and services by $0.2 million.  In addition, in the second quarter of 2003 the Company began aprogram to satisfy vendors for outstanding aged invoices.  As a result of negotiations, the Companysettled and paid outstanding accounts payable of approximately $0.7 million ata discount of approximately $0.4 million.

 

***Depreciation andAmortization Expense. ****Depreciationand amortization expense* decreased $0.7 million to$0.1 million from $0.8 million for the three months ended June 30,2003 compared to the three months ended June 30, 2002, respectively. Thedecrease in depreciation expense is primarily attributable to the write down infixed assets as a result of the impairment of equipment to net realizable valueduring 2002.

 

***InterestExpense. ****Interestexpense* is comprised of *Related party interest expense*and *Otherinterest expense.*

 

•                  *Related party interest expense*of $0.1 million for the three monthsended June 30, 2003 is primarily interest accrued on outstanding loans made tothe Company by EKI under the Loan Agreement (see *Related Party Transactions*),plus accretion of the discount related to the warrants issued in conjunctionwith the March 2003 financing transactions.

 

•                  *Other interest expense* of $0.3 million for the three months ended June 30,2003 is primarily accretion of the discount on the 2006 Debenture, but alsoincludes accretion of the discount on the 2007 Debentures and interest accruedon the 2006 and 2007 Debentures.

 

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**Six Months Ended June30, 2003 Compared with the Six Months Ended June 30, 2002.**

 

The Company’s net loss decreased $7.0 million to$10.4 million from $17.4 million for the six months ended June 30,2003 compared to the six months ended June 30, 2002, respectively.

 

***Total Research andDevelopment Expenses. ***Totalresearch and development expenses are comprised of *Related party license and research anddevelopment expenses* and *Other research and development expenses.* Totalresearch and development expenditures for the development of EarthShellPackaging decreased $6.9 million to $4.3 million from$11.2 million for the six months ended June 30, 2003 compared to the sixmonths ended June 30, 2002, respectively.

 

•                  *Relatedparty license and research and development expenses* are comprised ofthe $100,000 monthly licensing fee for the use of the EarthShellTechnology and technical services, both of which were payable to EKI. Relatedparty research and development expenses decreased $0.1 million to $0.7 millionfrom $0.8 million for the six months ended June 30, 2003 compared to the sixmonths ended June 30, 2002, respectively. This decrease is entirely due to areduction in technical services provided to the Company by Biotec.

 

•                  *Otherresearch and development expenses* are comprised of personnel costs,travel and direct overhead for development and demonstration production, aswell as impairment charges on manufacturing property and equipment constructedfor demonstration production purposes. Other research and development expensesdecreased $6.9 million to $3.6 million from $10.5 million for the six monthsended June 30, 2003 compared to the six months ended June 30, 2002,respectively. The decrease in other research and development expenses wasprimarily due to concluding the demonstration manufacturing of hinged-lidcontainers in Owings Mills, Maryland at the end of the second quarter of2002.  While the majority of theexpenses incurred in the six months ended June 30, 2002 related to the OwingsMills demonstration manufacturing, it also included expenses related to thecommencement of demonstration manufacturing of bowls and plates in Goleta,California.  Other research anddevelopment expenses for the six months ended June 30, 2003 related to theongoing demonstration manufacturing in Goleta through mid-April and to thestart-up in mid-May of a new manufacturing line for plates and bowls built andfinanced by Detroit Tool and Engineering Company (DTE) at their Lebanon, Missourifacility. The six months ended June 30, 2003 also included expenses incurred tovacate the Goleta facility at the expiration of the lease on May 31.  There were no impairment charges in eitherperiod.

 

***Other General andAdministrative Expenses. ****Other generaland administrative expenses*are comprised of personnel costs, traveland direct overhead for marketing, finance and administration.  Total general and administrative expensesdecreased $1.6 million to $3.0 million from $4.6 million for the six monthsended June 30, 2003 compared to the six months ended June 30, 2002,respectively. This was primarily the result of efforts to significantly reducegeneral and administrative expenses in 2003, which resulted in reductions inthe following expenses: personnel costs by $0.2 million, travel costs by $0.2million, facility costs by $0.2 million and professional fees and services by$0.5 million.  In addition, in thesecond quarter of 2003 the Company began a program to satisfy vendors foroutstanding invoices.  As a result ofnegotiations, the Company settled and paid outstanding accounts payable ofapproximately $0.7 million at a discount of approximately $0.4 million.

 

***Depreciation andAmortization Expense.**** Depreciation and amortization expense* decreased $1.4 millionto $0.2 million from $1.6 million for the six months ended June 30,2003 compared to the six months ended June 30, 2002, respectively. The decreasein depreciation expense is primarily attributable to the write down in fixedassets as a result of the impairment of equipment to net realizable valueduring 2002.

 

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***InterestExpense. ****Interestexpense* is comprised of *Related party interest expense*and *Otherinterest expense.*

 

•                  *Related party interest expense*of $0.2 million for the six months endedJune 30, 2003 is primarily interest accrued on outstanding loans made to theCompany by EKI under the Loan Agreement (see *Related Party Transactions*),plus accretion of the discount related to the warrants issued in conjunctionwith the March 2003 financing transactions. Although the outstanding loans will accrue approximately $0.3 million inannual interest expense, payment of the interest is subordinated to the 2006Debentures.  Therefore, the related partyinterest expense will not be paid in cash until the 2006 Debentures have beenconverted or the obligation satisfied in full.

 

•                  *Otherinterest expense* of $0.9 million for the six months ended June 30,2003 is primarily comprised of accretion of the discount on the 2006 Debenturesand a beneficial conversion charge in the amount of $360,000 due to a change inthe 2007 Debentures conversion price. In addition, Other interest expense for the six months ended June 30,2003 also included accretion of the discount on the 2007 Debentures andinterest accrued on the 2006 and 2007 Debentures.  Interest expense from accretion of the discount and accruedinterest payable on the 2006 Debentures will be approximately $1.3 million peryear until they expire or are converted into common stock

 

***Loss onExtinguishment of Debentures.***  In connection with the March 2003 financingtransactions, the Company prepaid $5.2 million of the outstanding $8.2 millionprincipal amount of the 2007 Debentures, resulting in a prepayment penalty of$208,000.  The Company also issued theholders of the 2007 Debentures 625,000 shares of common stock, valued at$237,500 based upon the closing price of the Company’s common stock of $0.38per share on March 5, 2003.  Inaddition, one of the holders of the 2007 Debentures exchanged $2.0 millionaggregate principal amount of 2007 debentures for $2.0 million aggregateprincipal amount of 2006 Debentures and 947,867 shares of common stock valuedat approximately $360,000 based upon the closing price of the Company’s commonstock of $0.38 per share on March 5, 2003. In connection with the prepayment and exchange transactions, the Companyincurred cash transaction costs of approximately $321,000, excluding the prepaymentpenalty.  In addition, the Companyincurred a charge of approximately $0.9 million for the prorated portion of theoriginal discount attributed to the $7.2 million of the 2007 Debentures repaidand exchanged.  Therefore, the Companyrecognized a $1.7 million loss upon extinguishment of the 2007 Debenturesthrough the prepayment and exchange.

 

***Debenture ConversionCosts****.*  *Debentureconversion costs* of $0.1 million for the six months ended June 30,2003 represent the prorated portion of the original discount attributed to the$800,000 of the 2007 Debentures converted during the three months ended March31, 2003.

 

**Liquidity and CapitalResources at June 30, 2003**

 

*Cash Flow.*  The Company’s principal use of cash for thesix months ended June 30, 2003 was to fund operations.  Net cash used in operations was$9.5 million for the six months ended June 30, 2003. Net cash provided byinvesting activities was $0.1 million for the six months ended June 30, 2003.Net cash provided by financing activities was $13.0 million for the sixmonths ended June 30, 2003. As of June 30, 2003 the Company had unrestrictedcash and related cash equivalents totaling $3.6 million.

 

*Capital Requirements.*  The Company paid or accrued $1,320 incapital expenditures for the six months ended June 30, 2003. Construction of thecommercial line installed in cooperation with Huhtamäki at its Goettingen,Germany facility was largely completed in 2002. Therefore the Company does notexpect to make significant capital expenditures in the year 2003.

 

*Sources of Capital.*  As part of the Company’s initial publicoffering on March 27, 1998, the Company issued 10,526,316 shares of commonstock, for which it received net proceeds of $206 million. OnApril 18, 2000 and January 4, 2001, the Company filed shelf registrationsstatements for 5 million and 15 million

 

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shares, respectively, of the Company’s common stock. During the yearsended December 31, 2002, 2001 and 2000 the Company sold approximately1.7 million, 13.5 million and 4.5 million shares of common stockin private transactions under such registration statements and received netproceeds from such sales of approximately $2.3 million $30.5 millionand $10.5 million, respectively. All shares available under such registrationstatements have been sold as of December 2002.

 

In December of 2001 the Company filed a shelf registration statementproviding for the sale of up to $50 million of securities, includingsecured or unsecured debt securities, preferred stock, common stock, and warrants.These securities may be offered, separately or together, in distinct series,and in amounts, at prices and on terms to be set forth in the prospectuscontained in the registration statement, and in subsequent supplements to theprospectus. During the year ended December 31, 2002, the Company sold22.6 million shares of common stock in negotiated transactions under suchregistration statement and received net proceeds from such sales of$19.6 million.

 

On August 12, 2002 the Company issued $10 million inaggregate principal amount of the 2007 Debentures to institutional investors.These debentures bear interest at a rate of 1.5% per annum. The holders ofthese debentures had the right to convert the debentures into the Company’scommon stock at an initial conversion price of $1.30 per share, which has beenreduced to $0.50 per share as a result of anti-dilution adjustments. Based onthe conversion price relative to the fair market value of the common stock atthe date of issue, the debentures were deemed to have no beneficial conversionfeature. The proceeds from the debentures are held in restricted accountslinked to irrevocable letters of credit in favor of the debenture holders suchthat unrestricted access to the proceeds from the sale of the debentures occursonly upon conversion of the debentures into shares of the Company’s commonstock. In addition to the holders’ conversion option, under certaincircumstances, the Company has the right to force conversion of up to $500,000of the debentures per week at a 15% discount to the market price of theCompany’s stock. Subject to certain conditions set forth in the debentures, theCompany may prepay the debentures upon twenty business days notice for 104% ofthe outstanding principal balance of the debentures. If during any consecutive90 day period following August 12, 2002, the holders of the debentures or theCompany have not converted more than an aggregate of $3.0 million of theoriginal principal amount of $10.0 million or, on August 12, 2003 the holdersof the debentures or the Company have not converted more that an aggregate of$7.5 million of the original principal amount of $10.0 million, the holder ofthe debenture may require the Company to prepay all or a portion of thedebentures for an amount in cash equal to the principal amount of the debentureto be prepaid, plus all accrued and unpaid interest, such amount being payableon the 20th trading day following the Company’s receipt of aprepayment notice.  During the thirdquarter of 2002, the Company forced conversion of $1.0 million of thedebentures for 2.0 million shares of common stock, reducing theoutstanding balance to $9.0 million. In the first quarter of 2003 theCompany forced conversion of an additional $800,000 of the debentures forapproximately 1.7 million shares of common stock.  In March 2003, as part of a newconvertible debenture financing, the Company repaid $5.2 million of thedebentures, and also exchanged $2.0 million of these debentures for new2006 Debentures which are not secured by cash, thereby releasing the relatedcash. In connection with this restructuring, the Company issued approximately0.6 million shares of common stock to the original debenture holders.  In the second quarter of 2003 the holdersconverted $491,000 of the debentures for 982,000 shares of common stock.  As of June 30, 2003 there was an aggregatebalance of $509,000 of the 2007 Debentures outstanding.  In July 2003 the holders converted theremaining $509,000 of the debentures for 1,590,624 shares of common stock.

 

During 2002, the Company’s largest shareholder, EKI, made varioussimple interest working capital loans to the Company. These loans bear interestat a rate of 7% or 10% per annum, and are payable on demand. As ofDecember 31, 2002, the outstanding principal balance of these loans was$1,745,000. In January 2003, EKI made additional working capital loans tothe Company totaling $1,010,000. Some of these loans were not repaid at theirstated maturity, and thereby became convertible, at EKI’s election, into sharesof the Company’s common stock. As part of the issuance and sale of the 2006Debentures completed in March 2003, repayment of these loans totaling$2,755,000 has been subordinated to the 2006 Debentures with strict covenantsgoverning repayment of such loans.

 

InMarch 2003, the Company issued and sold $10.55 million in aggregateprincipal amount of the 2006 Debentures to a group of institutional investors.After transaction fees, the Company realized net proceeds of

 

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approximately$9.0 million, which, together with the $2.0 million realized as aresult of the exchange of such amount of the 2006 Debentures for a like amountof the 2007 Debentures discussed above, means that the Company gained netproceeds of approximately $11.0 million from the two transactions.  In the first quarter of 2003, $1.0 millionof the 2006 Debenture principal was converted into 2,000,000 shares of commonstock.  During the quarter ended June30, 2003, $850,000 of the 2006 Debenture principal was converted into 1,700,000shares of common stock.  As of June 30,2003 there was an aggregate balance of $10.7 million of the 2006 Debenturesoutstanding.

 

Management’s plans include continuing to reduce operating expenses andraising cash through the transfer of the manufacturing lines to its licenseesto meet its current obligations and to cover operating expenses through theyear ending December 31, 2003.  Whilethe Company is reducing its operating expenses and is working to cause one ormore of its licensees to purchase and install equipment to manufactureEarthShell Packaging in order to generate royalty revenue to the Company, theCompany may need to raise additional financing to meet its current obligationsand to cover operating expenses through the year ending December 31, 2003.The Company cannot be certain that its expense reduction programs will besuccessful, that it will be able to negotiate mutually agreeable terms for thetransfer of its manufacturing lines to its licensees, or that additionalfinancing will be available to it, or, if available, that the terms will besatisfactory.  If the Company is notsuccessful in reducing expenses, transferring the manufacturing lines orraising additional capital, it may not be able to continue as a going concernfor a reasonable period of time.

 

In early August 2003, the Company discontinued its day-to-day supportof manufacturing activities at DTE.  Inkeeping with its business model, the Company will hereafter focus primarily onthe licensing of its foam analog material and other technologies, and allfuture manufacturing and production will be the responsibility of current ornew licensees as they install and run equipment to produce EarthShell Packagingin their own facilities.  In conjunctionwith the discontinuation of manufacturing activities at DTE, the Company isreducing it's staff by approximately 40%. The Company expects that operating expense reductions due to eliminationof these manufacturing activities and reductions in personnel costs will bringthe monthly cash operating expenses to below $500,000 per month.

 

###### **Item 3.  Quantitative and**Qualitative Disclosures About Market Risk

 

The Company’s treasury function controls all decisions and commitmentsregarding cash management and financing arrangements.  Treasury operations are conducted within a framework that hasbeen authorized by the board of directors.

 

The Company is exposed to interest rate risk on its fixed rateconvertible debentures and notes payable. As of June 30, 2003, these fixed rate debt obligations totaled$14.0 million.  The 2007 Debenturesbear interest at a fixed rate of 1.5% per annum and the 2006 Debentures bearinterest at a fixed rate of 2% per annum. The notes payable bear interest at a fixed rate of 10% per annum.  While generally an increase in marketinterest rates will decrease the value of this debt, and decreases in rateswill have the opposite effect, we are unable to estimate the impact thatinterest rate changes will have on the value of the substantial majority ofthis debt as there is no active public market for this debt.

 

###### **Item 4.  Controls and** Procedures

 

*Evaluation ofdisclosure controls and  procedures.*The Company's Chief Executive Officerand  Chief Financial Officer evaluatedthe effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined inRules  13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the "Exchange Act")) pursuant to Rule 13a-15 of theExchange  Act.  Based upon that evaluation, the Company's Chief Executive Officer and Chief Financial Officerconcluded that  the Company's disclosurecontrols and procedures are effective to ensure that  the Company is able to collect, process and disclose theinformation it is  required to disclosein the reports it files with the Securities and Exchange  Commission within the required time periods*.*

* *

*Changes in internalcontrol over  financial reporting. *The Company maintains a system of internalcontrol over financial  reporting (asdefined in Rules 13a-15(f) and 15d-15(f) under the Exchange  Act). No significant changes in the Company's internal control over financial reporting have come tomanagement's  attention during theCompany's last fiscal quarter that have materially  affected, or are likely to materially affect, the Company'sinternal control  over financialreporting.   Notwithstanding theforegoing, effective July 1, 2003, the Company hired  Michael Hawks as the Company's Controller.   Prior to this time, Mr. Hawks was engagedon a consulting basis.  Along with othermembers of the  Company's seniormanagement team, Mr. Hawks' participates in the development and  maintenance of internal control overfinancial  reporting.

 

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**Part II. OtherInformation**

 

### **Item1.  Legal Proceedings**

 

Not applicable

 

##### **Item 2.**        Changes in Securities and Use of Proceeds

 

Not applicable

 

##### **Item 3.  Defaults Upon Senior Securities**

 

Not applicable

 

##### **Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

The Annual Meeting of Stockholders of the Company was held June 3,2003, and the following actions were taken:

 

1)              Re-elected the entire membership of theBoard of Directors, as listed in the company's Proxy Statement datedApril 30, 2003, until the next Annual Meeting of Stockholders. Voting forthe individual nominees was as follows:

 
| **Nominee**            |   | **Votes For** |   | **Votes Withheld**

**or Against** |
|------------------------|--------|---------------|--------|------------------------------------|
| Mr. Essam Khashoggi    |   | 139,021,718   |   | 4,100,584                          |
| Mr. Simon K. Hodson    |   | 138,458,253   |   | 4,664,049                          |
| Mr. John Daoud         |   | 138,593,371   |   | 4,528,931                          |
| Mr. Hamlin M. Jennings |   | 139,418,974   |   | 3,703,328                          |
| Ms. Layla Khashoggi    |   | 138,642,868   |   | 4,479,434                          |
| Mr. A. J. Moyer        |   | 138,793,277   |   | 4,329,025                          |
| Mr. George W. Roland   |   | 138,968,832   |   | 4,153,470                          |

 

 

2)              Approved an amendment to the Company’sCertificate of Incorporation which shall effect, upon filing, a reverse splitof the Company’s outstanding Common Stock at a ratio of not less thanone-for-ten and not more than one-for-twenty, and a change in the number ofauthorized shares of Common Stock from 200,000,000 to 25,000,000 shares, andauthorized the Board of Directors to file such amendment in its discretion atany time before the 2004 Annual Meeting of Stockholders. The votes were cast asfollows:

 
| Votes for                 |   | 136,250,701 |
|---------------------------|--------|-------------|
| Votes withheld or against |   | 6,700,574   |
| Abstentions               |   | 171,027     |
| Broker non-votes          |   | 0           |

 

 

3)              Approved an amendment to the Company’s1995 Stock Incentive Plan to increase the number of shares of common stockavailable thereunder from 10,000,000 to 15,000,000 shares. The votes were castas follows:

 
| Votes for                 |   | 129,156,540 |
|---------------------------|--------|-------------|
| Votes withheld or against |   | 13,618,568  |
| Abstentions               |   | 347,194     |

 

 

##### **Item 5.  Other Information**

 

Not applicable

 

##### **Item 6.  Exhibits and Reports on Form 8-K**

 

The Company filed three reports on Form 8-K and one report onForm 8-K/A during the quarter ended June 30, 2003, and one report on Form8-K subsequent to June 30, 2003 but prior to the filing of this Form10-Q.  Information regarding the itemsreported on is as follows:

 

| **Date**       |   | **Item  Reported On**                                                                                                                        |
|----------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------|
|           |   |                                                                                                                                         |
| April 18, 2003 |   | Press Release of the Company dated April 18, 2003, relating to the  Company’s Form 10-K for the year ended December 31, 2002.           |
|           |   |                                                                                                                                         |
| May 19, 2003   |   | Press Release of the Company dated May 19, 2003, relating to the  Company’s Earnings Release for the three months ended March 31, 2003. |
|           |   |                                                                                                                                         |
| June 26, 2003  |   | Resignation of Deloitte & Touche LLP as the Company’s independent  public accountants.                                              |

 

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| June 26, 2003 |   | Letter from Deloitte & Touche LLP to the Securities and Exchange  Commission regarding change in independent public accountants. |
|--------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------|
|               |   |                                                                                                                                 |
| July 31, 2003      |   | Engagement of Farber & Hass LLP as the Company’s independent  public accountants.                                           |

 

31                                    CertificationPursuant to 18 U.S.D. Section 1350, as Adopted Pursuant to the Sarbanes-OxleyAct of 2002.

 

32                                    CertificationPursuant to 18 U.S.D. Section 1350, as Adopted Pursuant to the Sarbanes-OxleyAct of 2002.

 

 

**SIGNATURE**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned.

 
|                  |   |   |   | EarthShell Corporation                                                    |
|-----------------------|--------|--------|--------|---------------------------------------------------------------------------|
|                  |   |   |   |                                                                      |
|                  |   |   |   |                                                                      |
| Date: August 13, 2003 |   |   | By:    | /s/ D. Scott Houston                                                      |   |
|                  |   |   |   | D. Scott Houston                                                          |
|                  |   |   |   | Chief Financial Officer                                                   |
|                  |   |   |   |                                                                      |
|                  |   |   |   | (Principal Financial and Accounting Officer  and Duly Authorized Officer) |

 

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