UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
DC 20549











FORM
10-Q





---







(MARK
      ONE)x
            QUARTERLY REPORT UNDER
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
  1934For
      the quarterly period ended December 31, 2009ORo
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACTFor
      the transition period from  ______________ to
      ______________





Commission File No. 001-33531





AEROGROW
INTERNATIONAL, INC.


(Exact
Name of Registrant as specified in its charter)





NEVADA
            46-0510685(State
      or other jurisdictionof
      incorporation or organization)
            (IRS
      EmployerIdentification
      Number)








6075 Longbow Drive, Suite 200, Boulder,
      Colorado
            80301(Address
      of principal executive offices)
            (Zip
      Code)





(303)
444-7755


(Registrant's
telephone number, including area code)





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
file such reports), and (2) has been subject to such filing requirements for the
past 90 days.   Yes  x
      No   o





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes x No o





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definition of “large accelerated filer,” “accelerated
filer,” and “smaller reporting company” in rule 12b-2 of the Exchange
Act.





Large
      accelerated filer   o
            Accelerated
      filer   oNon-accelerated
      filer   o(Do not check if
      smaller reporting company)
            Smaller
      reporting company x





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





Number
of shares of issuer's common stock outstanding as of January 31,
2009:  12,398,249





Table of Contents





AeroGrow
International, Inc.


TAB LE OF CONTENTS


FORM
10-Q REPORT


December
31, 2009





PART
      I   Financial InformationItem
      1.
            Financial
      Statements
            1Condensed Balance Sheets as of
      December 31, 2009 (Unaudited) and March 31,
2009
            1Condensed
      Statements of Operations for the Three and Nine Months Ended December 31,
      2009 and December 31, 2008 (Unaudited)
            2Condensed
      Statements of Cash Flows for the Nine Months Ended December 31, 2009 and
      December 31, 2008 (Unaudited)
            3Notes to
      the Condensed Financial Statements
    (Unaudited)
            5Item
      2.
            Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
            17Item
      3.
            Quantitative and
      Qualitative Disclosures about Market Risk
            32Item
      4.
            Controls and
      Procedures
            32PART
      II  Other InformationItem
      1.
            Legal
      Proceedings
            33Item
      1A.
            Risk
      Factors
            33Item
      2.
            Unregistered Sales
      of Equity Securities and Use of Proceeds
            39Item
      3.
            Defaults Upon
      Senior Securities
            39Item
      4.
            Submission of
      Matters to Vote of Security Holders
            39Item
      5.
            Other
      Information
            39Item
      6.
            Exhibits
            40Signatures
            41








i
 Table of Contents








Item 1.Condensed Financial Statements





AEROGROW
INTERNATIONAL, INC.


CONDENSED
BALANCE SHEETS





December
      31,
            
            
            March
      31,2009
            
            
            2009ASSETS
            
            (Unaudited)Current
      assetsCash
            
            $
            553,463
            
            
            $
            332,698Restricted
      cash
            
            
            438,507
            
            
            
            438,331Accounts
      receivable, net of allowance for doubtful accounts of $211,824 and
      $1,423,508 at
              December
      31, 2009 and March 31, 2009, respectively
            
            
            2,768,121
            
            
            
            2,278,052Other
      receivables
            
            
            164,905
            
            
            
            332,059Inventory
            
            
            5,158,972
            
            
            
            8,350,135Prepaid
      expenses and other
            
            
            489,924
            
            
            
            565,454Total
      current assets
            
            
            9,573,892
            
            
            
            12,296,729Property
      and equipment, net of accumulated depreciation of $2,322,608 and
      $1,675,148 at
              December
      31, 2009 and March 31, 2009, respectively
            
            
            1,195,201
            
            
            
            1,768,369Other
      assetsIntangible
      assets, net of $5,898 and $3,515 of accumulated amortization at December
      31, 2009
              and
      March 31, 2009, respectively
            
            
            268,476
            
            
            
            231,590Deposits
            
            
            173,840
            
            
            
            110,776Deferred
      debt issuance costs, net of accumulated amortization of $420,356 and
      $243,937 at
              December
      31, 2009 and March 31, 2009,  respectively
            
            
            112,806
            
            
            
            201,726Total
      other assets
            
            
            555,122
            
            
            
            544,092Total
      assets
            
            $
            11,324,215
            
            
            $
            14,609,190LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      liabilitiesCurrent
      portion  - long-term debt
            
            $
            4,052,697
            
            
            $
            1,099,060Current
      portion - long-term debt-related party
            
            
            672,558
            
            
            
            -Accounts
      payable
            
            
            3,874,286
            
            
            
            8,338,559Accrued
      expenses
            
            
            1,413,497
            
            
            
            2,318,670Customer
      deposits
            
            
            459,869
            
            
            
            246,728Deferred
      rent
            
            
            44,901
            
            
            
            57,283Total
      current liabilities
            
            
            10,517,808
            
            
            
            12,060,300Long-term
      debt, net of current portion
            
            
            1,442,502
            
            
            
            5,547,144Long-term
      debt-related party, net of current portion
            
            
            -
            
            
            
            1,233,371Stockholders'
      equityPreferred
      stock, $.001 par value, 20,000,000 shares authorized,7,586
      and -0-
              shares
      issued and outstanding at December 31, 2009 and March 31, 2009,respectively
            
            
            8
            
            
            
            -Common
      stock, $.001 par value, 75,000,000 shares authorized, 12,398,249 and
      13,342,877 shares
              issued
      and outstanding at December 31, 2009 and March 31, 2009,
      respectively
            
            
            12,398
            
            
            
            13,343Additional
      paid-in capital
            
            
            52,830,750
            
            
            
            45,696,630Accumulated
      (deficit)
            
            
            (53,479,251
            )
            
            
            (49,941,598
            )Total
      stockholders' equity (deficit)
            
            
            (636,095
            )
            
            
            (4,231,625
            )Total
      liabilities and stockholders' equity (deficit)
            
            $
            11,324,215
            
            
            $
            14,609,190




See
accompanying notes to the condensed financial statements.





1
 Table of Contents





AEROGROW
INTERNATIONAL, INC.


CONDENSED
STATEMENTS OF OPERATIONS


(Unaudited)


Three
      Months ended
                
                
                Nine
      Months endedDecember
      31,
                
                
                December
      31,2009
                
                
                2008
                
                
                2009
                
                
                2008RevenueProduct
      sales
                
                $
                7,939,248
                
                
                $
                11,010,885
                
                
                $
                14,204,890
                
                
                $
                31,585,896Operating
      expensesCost
      of revenue
                
                
                4,830,387
                
                
                
                7,558,322
                
                
                
                8,970,748
                
                
                
                19,271,470Research
      and development
                
                
                318,046
                
                
                
                703,133
                
                
                
                610,598
                
                
                
                1,845,326Sales
      and marketing
                
                
                2,369,726
                
                
                
                4,704,912
                
                
                
                4,777,624
                
                
                
                11,030,524General
      and administrative
                
                
                864,105
                
                
                
                2,037,797
                
                
                
                3,719,147
                
                
                
                5,458,622Total
      operating expenses
                
                
                8,382,264
                
                
                
                15,004,164
                
                
                
                18,078,117
                
                
                
                37,605,942(Loss)
      from operations
                
                
                (443,016
                )
                
                
                (3,993,279
                )
                
                
                (3,873,227
                )
                
                
                (6,020,046
                )Other
      (income) expense, netInterest
      (income)
                
                
                (94
                )
                
                
                (939
                )
                
                
                (235
                )
                
                
                (2,443
                )Interest
      expense
                
                
                259,864
                
                
                
                409,882
                
                
                
                644,618
                
                
                
                783,598Other
      (income)
                
                
                7,881
                
                
                
                -
                
                
                
                (979,957
                )
                
                
                -Total
      other (income)expense, net
                
                
                267,651
                
                
                
                408,943
                
                
                
                (335,574
                )
                
                
                781,155Net
      (loss)
                
                $
                (710,667
                )
                
                $
                (4,402,222
                )
                
                $
                (3,537,653
                )
                
                $
                (6,801,201
                )Net
      (loss) per share, basic and diluted
                
                $
                (0.06
                )
                
                $
                (0.35
                )
                
                $
                (0.28
                )
                
                $
                (0.56
                )Weighted
      average number of common shares outstanding, basic and
    diluted
                
                
                12,398,249
                
                
                
                12,546,780
                
                
                
                12,618,432
                
                
                
                12,250,693




See
accompanying notes to the condensed financial statements.




2
 Table of Contents




AEROGROW
INTERNATIONAL, INC.


CONDENSED STATEMENTS OF CASH FLOWS


(Unaudited)




Nine
      months ended December 31,2009
            
            
            2008Cash
      flows from operating activities:Net
      (loss)
            
            $
            (3,537,653
            )
            
            $
            (6,801,201
            )Adjustments
      to reconcile net (loss) to cash provided (used) by
    operations:Issuance
      of common stock and options under equity compensation
plans
            
            
            418,825
            
            
            
            538,552Issuance
      of warrants related to debt
            
            
            29,802
            
            
            
            -Depreciation
      and amortization expense
            
            
            649,843
            
            
            
            655,443Allowance
      for bad debt
            
            
            (1,211,684
            )
            
            
            (333,752
            )Amortization
      of debt issuance costs
            
            
            176,420
            
            
            
            166,250Gain
      on forgiveness of accounts payable
            
            
            (807,310
            )
            
            
            -Change
      in assets and liabilities:(Increase)
      decrease in accounts receivable
            
            
            721,615
            
            
            
            (3,419,083
            )Decrease
      in other receivable
            
            
            167,154
            
            
            
            197,056(Increase)
      decrease in inventory
            
            
            3,191,163
            
            
            
            (6,352,978
            )(Increase)
      decrease in other current assets
            
            
            75,530
            
            
            
            (123,692
            )(Increase)
      in prepaid debt issuance costs
            
            
            -
            
            
            
            (423,527
            )(Increase)
      in deposits
            
            
            (63,064
            )
            
            
            -Increase
      (decrease) in accounts payable
            
            
            (1,227,923
            )
            
            
            5,810,465Increase
      (decrease) in accrued expenses
            
            
            (905,173
            )
            
            
            2,089,531Increase
      in accrued interest
            
            
            75,965
            
            
            
            -(Decrease)
      in accrued interest-related party
            
            
            (15,813
            )
            
            
            -Increase
      in customer deposits
            
            
            213,141
            
            
            
            240,055(Decrease)
      in deferred rent
            
            
            (12,382
            )
            
            
            (4,502
            )Net
      cash (used) by operating activities
            
            
            (2,061,544
            )
            
            
            (7,761,383
            )Cash
      flows from investing activities:Increase
      in restricted cash
            
            
            (176
            )
            
            
            (345,323
            )Purchases
      of equipment
            
            
            (74,292
            )
            
            
            (635,089
            )Patent
      expenses
            
            
            (39,269
            )
            
            
            (187,575
            )Net
      cash (used) by investing activities
            
            
            (113,737
            )
            
            
            (1,167,987
            )Cash
      flows from financing activities:(Increase)
      in prepaid debt issuance costs
            
            
            (87,500
            )
            
            
            -(Decrease)
      in amount due to factor
            
            
            -
            
            
            
            (1,480,150
            )Proceeds
      from long-term debt borrowings
            
            
            11,010,924
            
            
            
            8,822,948Proceeds
      from long-term debt borrowings-related party
            
            
            655,000
            
            
            
            -Repayment
      of long-term debt borrowings
            
            
            (13,538,418
            )
            
            
            -Proceeds
      from exercise of warrants
            
            
            -
            
            
            
            898,289Proceeds
      from the exercise of stock options
            
            
            20
            
            
            
            51,643Proceeds
      from the issuance of preferred stock
            
            
            4,441,537
            
            
            
            -Principal
      payments on capital leases
            
            
            (85,517
            )
            
            
            (88,971
            )Net
      cash provided (used) by financing activities
            
            
            2,396,046
            
            
            
            8,203,759Net
      increase (decrease) in cash
            
            
            220,765
            
            
            
            (725,611
            )Cash,
      beginning of period
            
            
            332,698
            
            
            
            1,559,792Cash,
      end of period
            
            $
            553,463
            
            
            $
            834,181





3
 Table of Contents





Supplemental
      disclosure of non-cash investing and financing activities:Interest
      paid
            
            $
            485,951
            
            
            $
            354,825Income
      taxes paid
            
            $
            --
            
            
            $
            --Proceeds
      from capital lease
            
            $
            --
            
            
            $
            --Conversion
      of related party debt to equity
            
            $
            1,200,000
            
            
            $
            --Conversion
      of accounts payable to equity
            
            $
            1,043,000
            
            
            $
            --Increase
      of notes  receivable for equity
            
            $
            139,000
            
            
            $
            --Increase
      of notes receivable, related party for equity
            
            $
            762,000
            
            
            $
            --Decrease
      of notes receivable, related party for equity as debt
    payment
            
            $
            150,000
            
            
            $
            --Modification
      of accrued expenses to equity
            
            $
            89,000
            
            
            $
            --Modification
      of accounts payable to long-term debt
            
            $
            1,386,040
            
            
            $
            --Common
      Stock returned upon issuance of preferred shares
            
            $
            949
            
            
            $
            --







See
accompanying notes to the condensed financial statements.





4
 Table of Contents




AEROGROW
INTERNATIONAL INC.


NOTES TO THE CONDENSED FINANCIAL STATEMENTS


(Unaudited)








1.
            Description
      of the Business





AeroGrow
International, Inc. (the “Company”) was incorporated in the State of Nevada on
March 25, 2002.  On January 12, 2006, the Company and Wentworth I,
Inc., a Delaware corporation (“Wentworth”), entered into an Agreement and Plan
of Merger (the “Merger Agreement”), which was consummated on February 24,
2006.  Under the Merger Agreement, Wentworth merged with and into the
Company, and the Company was the surviving corporation (the
“Merger”).  The Merger, for accounting and financial reporting
purposes, has been accounted for as an acquisition of Wentworth by the
Company.  As such, the Company was the accounting acquirer in the
Merger, and the historical financial statements of the Company will be the
financial statements for the Company following the Merger.


The
Company’s principal business is developing, marketing, and distributing advanced
indoor aeroponic and hydroponic garden systems designed and priced to appeal to
the consumer gardening, cooking, and small indoor appliance markets
worldwide.  The Company’s principal activities from its formation
through March 2006 consisted of product research and development, market
research, business planning, and raising the capital necessary to fund these
activities.  In December 2005, the Company commenced pilot production
of its AeroGarden system and in March 2006, began shipping these systems to
retail and catalogue customers.  The Company manufactures,
distributes, and markets over 11 different models of its AeroGarden systems in
multiple colors, as well as over 50 varieties of seed kits and a full line of
accessory products through multiple channels including retail, catalogue, and
direct-to-consumer sales in the United States as well as selected countries in
Europe, Asia, and Australia.


2.
            Liquidity
      and Basis of Presentation





Interim Financial
Information


The
unaudited interim financial statements of the Company included herein have been
prepared in accordance with the rules and regulations of the Securities and
Exchange Commission (“SEC”) for interim reporting including the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X. These condensed statements
do not include all disclosures required by accounting principles generally
accepted in the United States of America (“U.S. GAAP”) for annual audited
financial statements and should be read in conjunction with the Company’s
audited consolidated financial statements and related notes included in the
Company’s Annual Report on Form 10-K for the year ended March 31, 2009, as filed
with the SEC.


In the
opinion of management, the accompanying unaudited interim financial statements
reflect all adjustments, including normal recurring accruals, necessary to
present fairly the financial position of the Company at December 31, 2009, the
results of operations for the three and nine months ended December 31, 2009 and
2008, and the cash flows for the nine months ended December 31, 2009 and
2008.  The results of operations for the three and nine months ended
December 31, 2009, are not necessarily indicative of the expected results of
operations for the full year or any future period.  The balance sheet
as of March 31, 2009, is derived from the Company’s audited financial
statements.


The
Company has incurred net losses since its inception, including a net loss for
the nine months ended December 31, 2009 of $3,537,653.  Sources of
funding to meet prospective cash requirements include the Company’s existing
cash balances, cash flow from operations, and borrowings under the Company’s
revolving credit facility and other debt arrangements.  To supplement
these sources of funding, the Company is currently seeking to raise the
additional funds necessary to support the cash requirements of its short term
and long term operating plans.  In the event additional funds are not
raised in sufficient amounts or on a timely basis, the Company projects that its
current sources of funding are sufficient to support its operations, without
taking actions to reduce its scale of operations, for approximately three to
four months.  In the event the Company takes actions to reduce its
scale of operations, there can be no assurance that such actions will be
sufficient, or on a timely basis, to allow the Company to meet its liquidity
requirements.  The Company’s liquidity projections are predicated on a
variety of assumptions including, but not limited to, access to sufficient
funding, the level of customer and consumer demand, the impact of cost reduction
programs, and the state of the general economic environment in which the Company
operates.  There can be no assurances that these assumptions will
prove to be accurate in all material respects, or that the Company will be able
to successfully execute its plan.




5
 Table of Contents




As
discussed below in Note 4 to the Condensed Financial Statements, the Company is
not in compliance with certain debt covenants under its revolving credit
facility.  The lender has agreed to temporarily forbear its rights
related to the covenant non-compliance.  In order to raise additional
capital, the Company may need to seek additional waivers and/or forbearances
from its lenders.  Moreover, the amount available under the revolving
credit facility varies from day to day, depending on the level of sales,
accounts receivable collections, and inventory on-hand levels.  There
can be no assurance that the Company will have access to sufficient capital,
under its revolving credit facility or from other sources, to enable it to meet
its short-term cash requirements.





Use of
estimates


The
preparation of financial statements in conformity with U.S. GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period.  Actual results could differ
from those estimates.  It is reasonably possible that a change in the
Company’s estimates with regards to return reserves, inventory obsolescence, and
the allowance for bad debts will occur in the near term.





Net Income (Loss) per Share
of Common Stock


The
Company computes net income (loss) per share of common stock in accordance with
ASC 260 (prior authoritative guidance:  Statement of Financial
Accounting Standards (“SFAS”) No. 128, Earnings per Share, and SEC
Staff Accounting Bulletin No. 98).  ASC 260 requires companies with
complex capital structures to present basic and diluted Earnings per Share
(“EPS”).  Basic EPS is measured as the income or loss available to
common stock shareholders divided by the weighted average shares of common stock
outstanding for the period. Diluted EPS is similar to basic EPS but presents the
dilutive effect on a per share basis of potential common stock (e.g.,
convertible securities, options, and warrants) as if they had been converted at
the beginning of the periods presented. Potential shares of common stock that
have an anti-dilutive effect (i.e., those that increase income per share or
decrease loss per share) are excluded from the calculation of diluted
EPS.





Reclassifications


Certain
prior period amounts have been reclassified to conform to current year
presentation.




Concentrations of
Risk


ASC
825-10-50-20 (prior authoritative guidance:  SFAS No. 105, Disclosure of Information About
Financial Instruments with Off-Balance Sheet Risk and Financial Instruments with
Concentrations of Credit Risk), requires disclosure of significant
concentrations of credit risk regardless of the degree of such
risk.  Financial instruments with significant credit risk include cash
and accounts receivable.





Customers:


The
Company maintains a credit insurance policy on many of its trade accounts
receivables. For the three months ended December 31, 2009, the Company had three
customers who represented ­­­20.2%, 8.5%, and 5.1% of the Company’s
net product sales.  For the three months ended December 31, 2008, the
Company had one customer who represented 10.7% of the Company’s net product
sales.  For the nine months ended December 31, 2009, the Company had
three customers who represented 16.1%, and 7.9% and 5.6% of net product
sales.  For the nine months ended December 31, 2008, the Company had
one customer who represented 12.0% of net product sales.





Suppliers:


The
Company maintains a credit insurance policy on many of its trade accounts
receivables.  For the three months ended December 31, 2009, the
Company had three customers who represented ­­­20.2%, 8.5%, and 5.1%
of the Company’s net product sales.  For the three months ended
December 31, 2008, the Company had one customer who represented 10.7% of the
Company’s net product sales.  For the nine months ended December 31,
2009, the Company had three customers who represented 16.1%, and 7.9% and 5.6%
of net product sales.  For the nine months ended December 31, 2008,
the Company had one customer who represented 12.0% of net product
sales.


The
Company’s primary contract manufacturers are located in China.  As a
result, the Company may be subject to political, currency, regulatory, and
weather/natural disaster risks.  Although the Company believes
alternate sources of manufacturing could be obtained, these risks could have an
adverse impact on operations.




6
 Table of Contents




Fair Value of Financial
Instruments


The
carrying value of financial instruments including cash, receivables, accounts
payable, accrued expenses and debt, approximates their fair value at December
31, 2009 and March 31, 2009 due to the relatively short-term nature of these
instruments.  In February 2008, the FASB issued ASC 820-10-55 (prior
authoritative guidance: FSP 157-2/Statement 157, Fair Value
Measurements).  ASC 820-10-55 delayed the effective date for
all non-financial assets and non-financial liabilities, except those that are
recognized or disclosed at fair value in the financial statements on a recurring
basis (at least annually).  On April 1, 2008 the Company adopted the
portion of ASC 820-10-55 that was not delayed as it applies to non-financial
assets and liabilities.  As a result of the delay, ASC 820-10-55 was
applied to the Company’s non-financial assets and liabilities effective on April
1, 2009. ASC 820-10-55 defines fair value as the price that would be received
upon the sale of  an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date (also
referred to as an exit price).  ASC 820-10-55 also establishes a
three-level fair value hierarchy for classifying financial instruments that is
based on whether the inputs to the valuation techniques used to measure fair
value are observable or unobservable.  The three levels of the ASC
820-10-55 fair value hierarchy are described below:


Level
      1:
            Quoted
      prices (unadjusted) in active markets for identical assets or
      liabilities.Level
      2:
            Observable
      market-based inputs, other than quoted prices in active markets for
      identical assets. or liabilities.Level
      3:
            Unobservable
      inputs.





As of
December 31, 2009 and March 31, 2009, the Company did not have any financial
assets or liabilities that were required to be adjusted to their fair value on a
recurring basis subsequent to initial recognition.





Accounts Receivable and
Allowance for Doubtful Accounts


The
Company sells its products to retailers and consumers. Consumer transactions are
paid primarily by credit card. Retailer sales terms vary by customer, but are
generally net 30 days.  Accounts receivable are reported at net
realizable value and net of the allowance for doubtful accounts.  The
Company uses the allowance method to account for uncollectible accounts
receivable.  The Company also maintains a credit insurance policy
which insures against losses from most retailer accounts.  The
Company's allowance estimate is based on a review of the current status of trade
accounts receivable, which resulted in an allowance of $211,824 and $1,423,508
at December 31, 2009 and March 31, 2009, respectively.


Other
Receivables


In
conjunction with the Company’s processing of credit card transactions and for
its direct-to-consumer sales activities and as security with respect to the
Company’s performance for required credit card refunds and chargebacks, the
Company is required to maintain a cash reserve with Litle and Company, the
Company’s credit card processor.  This reserve is equal to 5% of the
credit card sales processed during the previous six months.  As of
December 31, 2009 and March 31, 2009, the balance in this reserve account was
$164,905 and $332,059, respectively.


Inventory


Inventories
are valued at the lower of cost, determined by the first-in, first-out method,
or market. Included in inventory costs where the Company is the manufacturer are
raw materials, labor, and manufacturing overhead. The Company records the raw
materials at delivered cost. Standard labor and manufacturing overhead costs are
applied to the finished goods based on normal production capacity as prescribed
under ASC 330 (prior authoritative guidance:  Accounting Research
Bulletin (“ARB”) No. 43, Chapter 4, Inventory
Pricing).  A majority of the Company’s products are
manufactured overseas and are recorded at cost.


December
      31,
              
              
              March
      31,2009
              
              
              2009Finished
      goods
              
              $
              4,129,514
              
              
              $
              6,799,996Raw
      materials
              
              
              1,029,458
              
              
              
              1,550,139$
              5,158,972
              
              
              $
              8,350,135





The
Company determines an inventory obsolescence reserve based on management’s
historical experience and establishes reserves against inventory according to
the age of the product.  As of December 31, 2009 and March 31, 2009,
the Company had reserved $170,134 and $335,705, respectively, for inventory
obsolescence.


Revenue
Recognition


The
Company recognizes revenue from product sales, net of estimated returns, when
persuasive evidence of a sale exists as determined by the following factors: a
product is shipped under an agreement with a customer; risk of loss and title
has passed to the customer; the fee is fixed or determinable; and collection of
the resulting receivable is reasonably assured. Accordingly, the Company did not
record $3,201 and $430 of revenue as of December 31, 2009 and December 31, 2008,
respectively, related to the unpaid balance due for orders shipped in
conjunction with the Company’s direct-to-consumer sales, because the consumer
has 36 days to evaluate the product, and is required to pay only the shipping
and handling costs for such products before making the required installment
payments after the expiration of the 36-day trial period. The Company also did
not record $1,139 and $131 as of December 31, 2009 and December 31, 2008,
respectively, of product costs associated with the foregoing revenue because the
customer is required to return the product and the Company is therefore able to
recover these costs through resale of the goods.  The 36-day trial
period is only offered from time to time by the Company.  The
liability for sales returns is estimated based upon historical experience of
return levels.


7
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Additionally,
the Company did not record $459,869 and $475,112 of revenue as of December 31,
2009 and December 31, 2008, respectively, related to the wholesale sales value
of inventory held by its retail shopping channel customers as these sales are
contingent upon the shopping channels selling the goods.  Deferred
payments for these goods are charged to Customer Deposits.  The
Company also deferred, as of December 31, 2009 and December 31, 2008,
recognition of $307,798 and $196,395, respectively, of product and freight costs
associated with these sales, which have been included in inventory.


The
Company records estimated reductions to revenue for customer and distributor
programs and incentive offerings, including promotions, rebates, and other
volume-based incentives. Certain incentive programs require the Company to
estimate based on industry experience the number of customers who will actually
redeem the incentive. At December 31, 2009 and December 31, 2008, the Company
had accrued $347,860 and $698,130, respectively, as its estimate for the
foregoing deductions and allowances.





Advertising and Production
Costs


The
Company expenses all production costs related to advertising, including, print,
television, and radio advertisements when the advertisement has been broadcast
or otherwise distributed.  The Company records media costs related to
its direct-to-consumer advertisements, inclusive of postage and printing costs
incurred in conjunction with mailings of direct-response catalogues, and related
direct-response advertising costs, in accordance with the ASC 340-20-25 (prior
authoritative guidance: Statement of Position (“SOP”) No. 93-7, Reporting on Advertising
Costs).  ASC 340-20-25 requires companies to report direct
response advertising costs as assets and amortize them over the estimated period
of the benefits, based on the proportion of current period revenue from the
advertisement to probable future revenue.  As of December 31, 2009 and
December 31, 2008, the Company had deferred $38,869 and $359,665, respectively,
related to such media costs. Advertising expenses for the three and nine months
ended December 31, 2009 were $1,221,286 and $1,870,455, respectively, and for
the three and nine months ended December 31, 2008 were $2,094,269 and
$3,911,012, respectively.





Warranty and Return
Reserves


The
Company records warranty liabilities at the time of sale for the estimated costs
that may be incurred under its basic warranty program.  The specific
warranty terms and conditions vary depending upon the product sold but generally
include technical support, repair parts, and labor for periods up to one
year.  Factors that affect the Company’s warranty liability include
the number of installed units currently under warranty, historical and
anticipated rates of warranty claims on those units, and cost per claim to
satisfy the Company’s warranty obligation.  Based upon the foregoing,
the Company has recorded a provision for potential future warranty costs of
$61,621and $69,587, as of December 31, 2009 and March 31, 2009,
respectively.


The
Company reserves for known and potential returns from customers and associated
refunds or credits related to such returns based upon historical experience. In
certain cases, customers are provided an allowance to cover returned goods,
usually in the 1% to 2% range, that is deducted from payments from such
customers. As of December 31, 2009 and March 31, 2009, the Company has recorded
a reserve for customer returns of $147,282 and $101,743,
respectively.





New Accounting
Pronouncements




In
January 2010, the FASB issued a new accounting standard which updates some new
disclosures and clarifies some existing disclosure requirements about fair value
measurements codified within ASC 820, “Fair Value Measurements and
Disclosures.”  The majority of the provisions of this update are
effective for interim and annual reporting periods beginning after December 15,
2009.  We do not expect the adoption will have a material impact on
our financial statements.


In
October 2009, the FASB issued a new accounting standard which provides guidance
for arrangements with multiple deliverables.  Specifically, the new
standard requires an entity to allocate arrangement consideration at the
inception of an arrangement to all of its deliverables based on their relative
selling prices.  In addition, the new standard eliminates the use of the
residual method of allocation and requires the relative-selling-price method in
all circumstances in which an entity recognizes revenue for an arrangement with
multiple deliverables.  In October 2009, the FASB also issued a new
accounting standard which changes revenue recognition for tangible products
containing software and hardware elements.  Specifically, if certain
requirements are met, revenue arrangements that contain tangible products with
software elements that are essential to the functionality of the products are
scoped out of the existing software revenue recognition accounting guidance and
will be accounted for under the multiple-element arrangements revenue
recognition guidance discussed above. We do not expect the adoption will have a
material impact on our financial statements.  This guidance is
effective prospectively for revenue entered into or materially modified in
fiscal years beginning after June 15, 2010.


In August
2009, the FASB issued a new accounting standard which provides additional
guidance on the measurement of liabilities at fair value. Specifically,
when a quoted price in an active market for the identical liability is not
available, the new standard requires that the fair value of a liability be
measured using one or more of the valuation techniques that should maximize the
use of relevant observable inputs and minimize the use of unobservable
inputs. In addition, an entity is not required to include a separate input
or adjustment to other inputs relating to the existence of a restriction that
prevents the transfer of a liability.  Adoption does not have a material
impact on our financial statements.


8
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In June
2009, the FASB issued ASC 105, Generally Accepted Accounting Principles (prior
authoritative guidance: SFAS No. 168, The FASB Accounting Standards
CodificationTM and the
Hierarchy of Generally Accepted Accounting Principles).ASC
105 establishes the FASB ASC as the single source of authoritative
nongovernmental U.S. GAAP, except for SEC rules and interpretive releases, which
are sources of authoritative GAAP for SEC registrants.  The standard
is effective for interim and annual periods ending after September 15,
2009.  The Company adopted the provisions of the standard on September
30, 2009, which did not have a material impact on our financial
position





In May
2009, the FASB issued ASC 855, Subsequent Events(prior
authoritative guidance: SFAS No. 165, Subsequent Events). ASC 855
establishes general accounting standards and disclosures of events that occur
after the balance sheet date but before financial statements are issued or are
available to be issued.  It requires the disclosure of the date
through which an entity has evaluated subsequent events and the basis for that
date.  This Statement is effective for interim and annual periods
ending after June 15, 2009, and as such, adopted this standard in the first
quarter of our fiscal year ending March 31, 2010.  The adoption of ASC
855 did not have a material effect on our financial position, results of
operations or cash flows.  We have performed an evaluation of
subsequent events through February 17, 2010, which is the date the financial
statements were issued.


In April
2009, the FASB issued ASC 825-10-65, Financial Instruments (prior authoritative
guidance: Financial Staff Position (“FSP”) No. FAS 107-1 and Accounting
Principles Board (“APB”) Opinion No. 28-1, Interim Disclosures about Fair Value
of Financial Instruments). ASC 825-10-65 requires disclosures about fair values
of financial instruments for interim reporting periods as well as in annual
financial statements.  ASC 825-10-65 enhances consistency in financial
reporting by increasing the frequency of fair value disclosures and is effective
for interim and annual period ending after June 15, 2009, and is to be applied
prospectively.  The adoption of ASC 825-10-65 did not have a material
impact on our financial statements.





In
October 2008, the FASB issued ASC 820-10-35-15A (prior authoritative guidance:
FSP No. FAS 157-3, Determining the Fair Value of a
Financial Asset in a Market That is Not Active), which clarifies the
application of ASC 820 when the market for a financial asset is inactive.
Specifically, ASC 820-10-35-15A clarifies how (1) the internal assumptions
should be considered in measuring fair value when observable data are not
present, (2) observable market information from an inactive market should
be taken into account, and (3) the use of broker quotes or pricing services
should be considered in assessing the relevance of observable and unobservable
data to measure fair value.  The guidance in ASC 820-10-35-15A was
effective immediately.  The adoption of ASC 820-10-35-15A did not have
a material effect on our financial statements.


In May
2008, the FASB issued ASC 944-20 (prior authoritative guidance: SFAS No. 163,
Accounting for Financial
Guarantee Insurance Contracts-an interpretation of FASB Statement No.
60).  Diversity exists in practice in accounting for financial
guarantee insurance contracts by insurance enterprises under FASB Statement No.
60, Accounting and Reporting by Insurance Enterprises.  This results
in inconsistencies in the recognition and measurement of claim liabilities. This
Statement requires that an insurance enterprise recognize a claim liability
prior to an event of default (insured event) when there is evidence that credit
deterioration has occurred in an insured financial obligation.  This
Statement requires expanded disclosures about financial guarantee insurance
contracts. The accounting and disclosure requirements of the Statement will
improve the quality of information provided to users of financial
statements.  ASC 944-20 is effective for financial statements issued
for fiscal years beginning after December 15, 2008, and interim periods within
those fiscal years. The adoption of ASC 944-20 did not have a material impact on
our financial position.


In March
2008, the FASB issued ASC 815-10-50 (prior authoritative guidance: SFAS
No. 161, Disclosures
about Derivative Instruments and Hedging Activities—An Amendment of FASB
Statement No. 133).  ASC 815-10-50 establishes the
disclosure requirements for derivative instruments and for hedging activities
with the intent to provide financial statement users with an enhanced
understanding of the entity’s use of derivative instruments, the accounting of
derivative instruments, and related hedged items under ASC 815-10-50 and its
related interpretations, and the effects of these instruments on the entity’s
financial position, financial performance, and cash flows.  This statement
is effective for financial statements issued for fiscal years beginning after
November 15, 2008.  The adoption of ASC 815-10-50 did not have a
material impact on our financial position disclosures.


In
December 2007, the FASB issued ASC 805 (prior authoritative guidance: SFAS No.
141(R), Business
Combinations), which amends SFAS No. 141, and provides revised guidance
for recognizing and measuring identifiable assets and goodwill acquired,
liabilities assumed, and any non-controlling interest in the
acquiree.  It also provides disclosure requirements to enable users of
the financial statements to evaluate the nature and financial effects of the
business combination. ASC 805 is effective for fiscal years beginning on or
after January 1, 2009, and is to be applied prospectively.  The
adoption of ASC 805 did not have a material impact on our financial
position.


In
December 2007, the FASB issued ASC 810-10 (prior authoritative guidance: SFAS
No. 160, Non-controlling
Interests in Consolidated Financial Statements – an amendment of ARB No.
51), which establishes accounting and reporting standards pertaining to
ownership interests in subsidiaries held by parties other than the parent, the
amount of net income attributable to the parent and to the non-controlling
interest, changes in a parent's ownership interest, and the valuation of any
retained non-controlling equity investment when a subsidiary is deconsolidated.
ASC 810-10 also establishes disclosure requirements that clearly identify and
distinguish between the interests of the parent and the interests of the
non-controlling owners. ASC 810-10 is effective for fiscal years beginning on or
after January 1, 2009.  The adoption of ASC 810-10 did not have a
material impact on our financial position.


9
 Table of Contents




In
February 2007, the FASB issued ASC 825-10 (prior authoritative guidance: SFAS
No. 159, The Fair Value Option
for Financial Assets and Financial Liabilities—including an amendment of FASB
Statement 157).  The Company adopted ASC 825-10 beginning April
1, 2008. The adoption of ASC 825-10 did not have a material effect on our
financial position.





3.
            Capital Lease
Obligations





As of
December 31, 2009 the Company has $43,856 of capitalized lease obligations for
computer equipment, licensed software, and factory equipment due on various
dates through November 2010.  The interest rates range from 12% to 15%
per annum.  These lease obligations are collateralized by the related
assets with a net book value of $67,141 as of December 31, 2009. In addition,
the Company has recorded  a security deposit of $48,180, which will be
released upon the achievement of certain financial requirements.  The
leases also required $4,529 in prepaid rents.


4.
            Long Term Debt and Current Portion – Long Term
    Debt





First
National Loan





On May
19, 2008, the Company and Jack J. Walker, then one of the Company’s directors
and now the Company’s Chairman and CEO, acting as co-borrowers, entered into a
Business Loan Agreement with First National Bank (the “FNB Loan Agreement”) for
a loan to the Company in a principal amount of up to $1,000,000 (the “FNB
Loan”).  The Company agreed, among other things, that while the FNB
Loan Agreement is in effect, the Company will not (without FNB's prior written
consent): (i) incur or assume indebtedness, except for trade debt in the
ordinary course of business, capital leases in an amount not to exceed $500,000,
and capital expenditures of not more than $500,000 during any fiscal year; (ii)
sell, transfer, mortgage, assign, pledge, lease, grant a security interest in,
or encumber any of the Company’s assets (except as specifically allowed); or
(iii) sell with recourse any of the Company’s accounts, except to FNB. In
the event of a default under the FNB Loan, at FNB's option, all indebtedness
owed under the FNB Loan will become immediately due and payable.  The
FNB Loan had an initial maturity date of May 19, 2009.





On May
19, 2009, the Company, Mr. Walker, and FNB entered into a Change in Terms
Agreement (the “First Change in Terms Agreement”), extending the maturity of the
FNB Loan until July 19, 2009, and increasing the interest rate from the Wall
Street Journal Prime Rate plus 0.50% floating to the Wall Street Journal Prime
Rate plus 2.0% floating, with a floor interest rate of 5.50%.





On August
28, 2009, the Company, Mr. Walker, and FNB entered into a second Change in Terms
Agreement (the “Second Change in Terms Agreement”) extending the maturity of the
FNB Loan to November 30, 2009.  The Second Change in Terms Agreement
increased the interest rate to a fixed rate effective July 19, 2009, of 7% per
annum, and provided for principal payments of $100,000 and a loan origination
payment of $2,500 at closing of the Second Change in Terms Agreement and then
principal payments of $50,000, $50,000, and $100,000 on August 31, 2009,
September 30, 2009, and October 31, 2009, respectively.  The terms and
conditions of the Second Change in Terms Agreement were consented to by FCC, LLC
d/b/a First Capital (“FCC”), the Company’s senior lender, in accordance with the
Subordination and Intercreditor Agreement by and among FNB, FCC, and the Company
(the “Subordination Agreement”).  The Company is prohibited from
making principal payments against the FNB Loan, including scheduled principal
payments, unless and until such time as FCC provides its consent or such time as
the Company’s liquidity position exceeds certain thresholds defined in the
Subordination Agreement.


At
closing of the Second Change in Terms Agreement on August 31, 2009, the Company
made the scheduled $100,000 principal payment with the consent of
FCC.  Principal payments totaling $200,000 that were due during the
term of the Second Change in Terms Agreement were made by Mr. Walker to FNB
because FCC did not consent to the Company making such payments.  The
first $150,000 of payments made by Mr. Walker were recorded by the Company as an
offset to a $150,000 receivable due from Mr. Walker.  Effective as of
November 20, 2009, the Company executed a promissory note in favor of Mr. Walker
for the remaining $50,000.  The promissory note matured on February 1,
2010 and carries an interest rate of 20% per annum.  As of February 1,
2010, Mr. Walker agreed to extend the maturity date of this promissory note to
April 30, 2010.  No principal or interest payments have been made
against this promissory note to date.  As of December 31, 2009,
$51,123 was outstanding under the promissory note, including accrued
interest.


As of
February 16, 2010, Mr. Walker made an additional $208,439 principal and interest
payment to FNB, reducing the outstanding principal balance on the FNB Loan to
$500,000.  Effective as of the same date, the Company executed a
promissory note for $208,439 in favor of Mr. Walker having a maturity date of
April 30, 2010 and carrying an interest rate of 20% per annum.


10
 Table of Contents





As of the
date of this report, the Company, Mr. Walker and FNB are negotiating the terms
of an extension to the maturity date of the FNB Loan.  FNB has
informed the Company and Mr. Walker that it has approved an extension of the
loan’s maturity date to March 31, 2010 subject to the completion and acceptance
of appropriate documentation.  Under the terms of an intercreditor
subordination agreement between the Company, FNB, FCC, and Mr. Walker, the
Company is unable to make scheduled payments against the FNB Loan without the
consent of FCC.  Such consent has not been provided.  Under
the terms of the intercreditor subordination agreement, FNB is prohibited from
exercising any rights or remedies with respect to AeroGrow or any collateral
until such time as the FCC Revolving Credit Facility has been paid in
full.


As of
December 31, 2009, $704,219 in loans were outstanding under the FNB Loan,
including accrued interest.





WLLC
Loan Agreement





On May
22, 2008, the Company entered into a Loan Agreement (the “WLLC Loan Agreement”)
and associated Promissory Note with WLoans, LLC, a Colorado limited liability
company (“WLLC”), as lender, and Jack J. Walker.  The WLLC Loan
Agreement provided for a loan up to a maximum of $1,500,000 for business
purposes, at an annual interest rate of 12% (the “WLLC Loan”).  The
Company granted WLLC a security interest in all of the Company’s assets,
subordinate to the security interests in such assets granted to FCC and
FNB.  The WLLC Loan had an initial maturity date of April 1,
2009.  Mr. Walker is the manager of WLLC and owns a 73.3% membership
interest in WLLC, with the remaining membership interest owned by former
officers and former directors of the Company.


On May
19, 2009, Mr. Walker, WLLC, and the Company entered into a Loan Extension
Agreement (the “Loan Extension Agreement”) effective April 1, 2009, extending
the maturity date of the WLLC Loan until June 30, 2009.  The Company
paid WLLC $5,000 in consideration for the loan extension.  The balance
of principal due on the WLLC Loan as of May 19, 2009, was
$1,200,000.





On June
30, 2009, the principal outstanding under the WLLC Loan Agreement totaling
$1,200,000 was converted to 1,200 shares of Series A Convertible Preferred
Stock, and the WLLC Loan Agreement was terminated.





Revolving
Credit Facility





On June
23, 2008, the Company entered into a Loan and Security Agreement with FCC (the
“FCC Loan Agreement”) for a revolving credit facility up to a maximum amount of
$12,000,000 (the “Revolving Credit Facility”) to fund working capital
requirements.  The actual amount available for borrowing under the
Revolving Credit Facility is limited at any given time to the sum of a
percentage of eligible inventory and a percentage of eligible accounts
receivable, each as defined in the FCC Loan Agreement.





The
Revolving Credit Facility has an initial termination date of June 23, 2010, with
one-year renewals thereafter, unless prior written notice is provided by either
party.  Continued availability of the Revolving Credit Facility is
subject to the Company’s compliance with customary financial and reporting
covenants.  As collateral for the Revolving Credit Facility, the
Company granted FCC a first priority security interest over all of the Company’s
assets, including, but not limited to, accounts receivable, inventory, and
equipment.





As of
December 31, 2008, the Company was not in compliance with three covenants under
the FCC Loan Agreement.  Effective as of January 31, 2009, FCC and the
Company executed a forbearance agreement related to the FCC Loan Agreement (the
“Forbearance Agreement”).  Pursuant to the terms of the Forbearance
Agreement, FCC agreed to forbear its rights and remedies under the FCC Loan
Agreement and related documents with respect to any existing defaults under the
FCC Loan Agreement (the “Existing Defaults”) until the earlier of June 30, 2009,
or the date of occurrence of a default other than the Existing
Defaults.  The Forbearance Agreement also increased the Company’s
ability to borrow against inventory and accounts receivable during the term of
the Forbearance Agreement (the “Additional Borrowing Capacity”).  In
return for FCC providing the forbearance period and the Additional Borrowing
Capacity, the Company agreed to pay FCC a $25,000 forbearance fee (in five
monthly installments), an amendment fee equal to 1.5% per month on the average
utilization of the Additional Borrowing Capacity, and issue to FCC a minimum of
250,000 warrants to purchase common stock of the Company at a purchase price of
$1.00 per share.  Simultaneously with the execution of the Forbearance
Agreement, Mr. Walker provided a $1 million guarantee against certain
liabilities under the FCC Loan Agreement.  As compensation for
providing the guarantee, the Company issued to Mr. Walker 50,000 warrants to
purchase common stock of the Company at a purchase price of $1.00 per
share.





On June
1, 2009, the Company, FCC, and Jack J. Walker, as guarantor, executed a Second
Forbearance Agreement, effective as of April 29, 2009 (the “Second Forbearance
Agreement”), in which FCC agreed to forbear from exercising its rights and
remedies under the Loan Agreement until June 30, 2009, if no further defaults
occurred.  The Second Forbearance Agreement also increased the advance
rate against inventory until July 1, 2009, and eliminated the Company’s
obligation to pay the monthly forbearance and amendment fees and to provide cash
flow projections.  In return, AeroGrow agreed to pay FCC a fee of
$60,000.  In connection with the Second Forbearance Agreement, FCC
permitted AeroGrow to borrow up to $800,000 more than would otherwise be
permitted by the applicable borrowing base calculation under the Loan Agreement,
with such additional borrowing to be repaid by June 30, 2009.  FCC did
not charge AeroGrow a fee for the additional borrowing capacity.




11
 Table of Contents





As of
July 1, 2009, FCC, AeroGrow, and Jack J. Walker, as guarantor, executed an
amendment to the FCC Loan Agreement (the “Third FCC Amendment”).  The
Third FCC Amendment reduced the maximum amount of the Revolving Credit Facility
to $8 million, re-set the covenant levels beginning July 1, 2009, and waived
existing defaults.  In addition, the Third FCC Amendment re-set the
formulas for determining the borrowing base against which the Company can
borrow.  The Third FCC Amendment also changed the definition of Base
Rate to the greater of (a) the Prime Rate, or (b) LIBOR plus 3.25%, and
increased the interest rate to Base Rate plus 4.0%.  The Third FCC
Amendment provides for a $30,000 success fee to be paid by the Company to FCC on
April 30, 2010.  In addition, the Third FCC Amendment replaces a
minimum borrowing fee with a fee calculated as 0.50% per annum of the daily
average unused portion of the Revolving Credit Facility, payable monthly in
arrears.  Finally, the Third FCC Amendment increased the annual
facility fee to 1.0% of the maximum amount of the Revolving Credit Facility,
from 0.75%.  The Company paid Mr. Walker a $25,000 fee as compensation
for providing the guarantee associated with the Third FCC
Amendment.  The Third FCC Amendment did not change the original due
date of June 23, 2010, with one year renewals, thereafter, unless prior written
notice is provided by either party.





On
October 8, 2009, the Company and FCC executed a temporary amendment to the FCC
Loan Agreement, effective as of September 30, 2009, that delayed a reduction in
the advance rate against inventory from 80% to 70%, originally scheduled to take
effect on October 1, 2009, until November 15, 2009.





As of
September 30, 2009, the Company was not in compliance with the minimum fixed
charge coverage covenant under the revised FCC Loan Agreement.  On November
19, 2009, FCC and the Company executed a Waiver Agreement to the FCC Loan
Agreement (the “Waiver Agreement”).  The Waiver Agreement waived the
covenant violations as of September 30, 2009.  FCC charged the Company a
$10,000 waiver fee.





As of
December 31, 2009, the Company was not in compliance with the minimum fixed
charge coverage and minimum tangible net worth covenants under the revised FCC
Loan Agreement.  As of February 15, 2010, the Company, FCC, and Jack J.
Walker, as guarantor, executed a Forbearance Agreement and Fourth Amendment,
(the “Fourth Amendment”), in which FCC agreed to forbear from exercising its
rights and remedies with regard to the Company’s non-compliance with financial
covenants until April 30, 2010, if no other defaults occurred.  The
Fourth Amendment increased the advance rate against eligible inventory from 50%
to 60% until April 30, 2010, and reduced the maximum amount of the Revolving
Credit Facility to $2.25 million until March 19, 2010, and then to $2.0 million
thereafter.  In connection with the Fourth Amendment, FCC permitted
AeroGrow to borrow up to $600,000 more than would otherwise be permitted by the
applicable borrowing base calculation under the Loan Agreement, with such
additional borrowing to be repaid by April 30, 2010.  The Fourth
Amendment provided for a $500 per day forbearance fee, with such fee to be
payable on the earlier of April 30, 2010 or the date on which loans under the
Revolving Credit Facility are repaid in full.  Simultaneous with the
execution of the Fourth Amendment, Mr. Walker provided a $1.5 million guarantee
against certain liabilities under the FCC Loan Agreement.





As of
December 31, 2009, loans totaling $2,818,837 were outstanding, including accrued
interest, under the Revolving Credit Facility.  Also as of December
31, 2009, there was approximately $240,000 in additional borrowing capacity
available under the Revolving Credit Facility.  As of February 17,
2010, there was a
$1,538,792loan
balance outstanding under the Revolving Credit Facility, and an estimated
remaining availability of approximately $710,000.  However, the amount
available under the Revolving Credit Facility varies from day to day, depending
on the level of sales, accounts receivable collections, and inventory on-hand
levels.


Mainpower
Promissory Note





On June
30, 2009, the Company entered into a Letter Agreement (“Letter Agreement”) with
Main Power Electrical Factory, Ltd. (“MainPower”) and executed a Promissory
Note.  Pursuant to the terms of the Letter Agreement, MainPower agreed
to release the Company from $1,386,041 of existing accounts payable obligations
owed by the Company to MainPower in return for the Company executing the
Promissory Note for the same amount.  In addition, the Letter
Agreement included other provisions relating to the terms and conditions under
which AeroGrow must purchase AeroGarden products from MainPower.  The
Promissory Note has a final maturity of June 30, 2011, and carries an interest
rate of 8% per annum, with interest accrued and added to the principal amount of
the Promissory Note for the first year.  During the second year of the
Promissory Note, interest is due and payable quarterly.  Principal
payments of $150,000 are due and payable monthly beginning January 31, 2011,
with a final payment of all principal and accrued but unpaid interest due on
June 30, 2011.  As of December 31, 2009, the outstanding balance under
the Promissory Note totaled $1,442,502, including accrued interest.


Bridge
Financing





On August
28 through September 1, 2009, the Company entered into bridge financing
arrangements totaling $500,000 (the “Bridge Loans”) with six lenders (the
“Lenders”) as detailed in the table below.  The Bridge Loans are
unsecured, subordinated to loans made to the Company by FCC, and bear interest
at 15% per annum.  The Company issued 500,000 warrants to purchase
common shares of the Company to the Lenders.  Each of the warrants has
a five-year term and an exercise price of $0.25 per common share.




12
 Table of Contents




The
Bridge Loans were originally scheduled to mature on November 16, 2009; however,
no principal payments have been made by the Company to-date because FCC has not
provided the consent required under the terms of the intercreditor subordination
agreements executed by the Company, the Lenders, and FCC.  Interest
totaling $15,822 was paid to the Lenders during the three months ended December
31, 2009.  As of December 31, 2009, $509,247 was outstanding under the
Bridge Loans, including accrued interest.





Lender
            Current
      Relationship to the
      Company
            
            Bridge
      Loan Amount
            
            Date of Loan
            
            Warrants
      Issued to LenderLazarus
      Investment Partners LLLP
            Greater
      than 10% beneficial owner
            
            $
            250,000
            
            September
      1, 2009
            
            
            250,000Jack
      J. Walker
            Chairman
      and CEO, director, greater than 10% beneficial owner
            
            $
            100,000
            
            August
      28, 2009
            
            
            100,000Michael
      S. Barish
            Director,
      greater than 10% beneficial owner
            
            $
            75,000
            
            September
      1, 2009
            
            
            75,000Jervis
      B. Perkins
            Former
      Chief Executive Officer, current director, and greater than 10% beneficial
      owner
            
            $
            25,000
            
            August
      28, 2009
            
            
            25,000J.
      Michael Wolfe
            Chief
      Operating Officer and greater than 10% beneficial owner
            
            $
            25,000
            
            September
      1, 2009
            
            
            25,000H.
      Leigh Severance
            Greater
      than 10% beneficial owner
            
            $
            25,000
            
            September
      1, 2009
            
            
            25,000





Between
October 30 and November 9, 2009, the Company entered into additional bridge
financing arrangements totaling $580,000 (the “Additional Bridge Loans”) with
five lenders (the “Additional Lenders”) as detailed in the table
below.  The Additional Bridge Loans are unsecured, subordinated to
loans made to the Company by FCC, and mature on February 1, 2010, and bear
interest at 20% per annum.  The Company issued 580,000 warrants to
purchase common shares of the Company to the Additional Lenders.  Each
of the warrants has a five-year term and an exercise price of $0.25 per common
share.  One of the Additional Bridge Loans in the principal amount of
$180,000 is guaranteed by Jack J. Walker, the Company’s Chairman and
CEO.





The
Bridge Loans were originally scheduled to mature on February 1, 2010; however,
no principal payments have been made by the Company to-date because FCC has not
provided the consent required under the terms of the intercreditor subordination
agreements executed by the Company, the Lenders, and FCC.  No interest
had been paid to the Lenders as of December 31, 2009.  As of December
31, 2009, $597,973 was outstanding under the Bridge Loans, including accrued
interest.




Lender
            Current
      Relationship to the
      Company
            
            Bridge
      Loan Amount
            
            Date of Loan
            
            Warrants
      Issued to LenderLazarus
      Investment Partners LLLP
            Greater
      than 10% beneficial owner
            
            $
            200,000
            
            November
      9, 2009
            
            
            200,000Grad
      Wurn LLC
            None
            
            $
            180,000
            
            November
      1, 2009
            
            
            180,000Michael
      S. Barish
            Director,
      greater than 10% beneficial owner
            
            $
            100,000
            
            November
      4, 2009
            
            
            100,000Jervis
      B. Perkins
            Former
      Chief Executive Officer, current director, and greater than 10% beneficial
      owner
            
            $
            50,000
            
            October
      30, 2009
            
            
            50,000J.
      Michael Wolfe
            Chief
      Operating Officer and greater than 10% beneficial owner
            
            $
            50,000
            
            November
      5, 2009
            
            
            50,000





13
 Table of Contents




5.
            Equity Compensation
Plans





In
September 2009, the Company reset the exercise price of certain employee stock
options issued under the Company’s 2005 Equity Compensation Plan.  The
exercise price on options to purchase 1,193,973 shares was reset to $0.12 per
share, the closing price of the Company’s common stock on September 10, 2009
(the “Exchange”).  The vesting schedules were not impacted by the
reset.  The reset resulted in the recognition of a modification charge
of $48,639 in the quarter ended September 30, 2009 for vested shares and an
additional $8,394 will be recognized over the remaining vesting periods of the
reset options.  The options subject to the price reset were deemed to
be cancelled and reissued as of September 10, 2009.  In effect, the
price reset was treated as an exchange of outstanding options for newly granted
options.  Therefore, any discussion of the number of options granted
and cancelled/expired, in this Note 5 includes 1,193,973 options granted and
canceled in connection with the Exchange.


For the
three months ended December 31, 2009, the Company granted 25,000 options to
purchase the Company’s common stock at an exercise price of $0.14 per share
under the 2005 Plan.  For the three months ended December 31, 2008,
the Company granted 23,160 options to purchase the Company’s common stock at an
exercise price of $2.86 per shares under the 2005 Plan.





For the
nine months ended December 31, 2009, the Company granted 1,644,973 options to
purchase the Company’s common stock at exercise prices ranging from $0.07 to
$0.14 per share under the 2005 Plan.  For the nine months ended
December 31, 2008, the Company granted 634,070 options to purchase the Company’s
common stock at exercise prices ranging from $1.25 to $2.96 per share under the
2005 Plan.





During
the three months ended December 31, 2009, there were 286,118 options that either
were cancelled or expired and 0 shares of common stock issued upon exercise of
outstanding stock options under the 2005 plan equity compensation
plan.  During the three months ended December 31, 2008, there were
126,257 options to purchase common stock forfeited and 21,040 shares of common
stock were issued upon exercise of outstanding stock options under the Company’s
equity compensation plans.





During
the nine months ended December 31, 2009, there were 1,577,829 options that
either were cancelled or expired and 4,075 shares of common stock issued upon
exercise of outstanding stock options under the 2005 Plan.  During the
nine months ended December 31, 2008, 140,889 options to purchase common stock
were forfeited and 43,576 options were exercised.





As of
December 31, 2009, the Company had granted options for 982,746 shares of the
Company’s common stock that are unvested that will result in $145,551 of
compensation expense in future periods if fully vested.





Information
regarding all stock options outstanding under the 2005 Plan as of December 31,
2009 is as follows:





OPTIONS
      OUTSTANDING
            
            OPTIONS
      EXERCISABLEWeighted-
            
            
            
            
            
            
            
            
            
            
            Weighted-average
            
            
            Weighted-
            
            
            
            
            
            
            
            average
            
            
            Weighted-Remaining
            
            
            average
            
            
            Aggregate
            
            
            
            
            Remaining
            
            
            average
            
            
            AggregateExercise
            
            
            
            
            Contractual
            
            
            Exercise
            
            
            Intrinsic
            
            
            
            
            Contractual
            
            
            Exercise
            
            
            Intrinsicprice range
            
            Options
            
            
            Life (years)
            
            
            Price
            
            
            Value
            
            Options
            
            
            Life (years)
            
            
            Price
            
            
            ValueOver
      $0.00 to $0.50
            
            
            2,616,215
            
            
            
            3.57
            
            
            $
            0.14
            
            
            
            
            
            1,633,469
            
            
            
            3.15
            
            
            $
            0.14Over
      $0.50 to $2.50
            
            
            -
            
            
            
            -
            
            
            $
            -
            
            
            
            
            
            -
            
            
            
            -
            
            
            $
            -Over
      $2.50 to $5.00
            
            
            2,290
            
            
            
            3.25
            
            
            $
            2.96
            
            
            
            
            
            2,290
            
            
            
            3.25
            
            
            $
            2.96Over
      $5.00 to $5.50
            
            
            438,637
            
            
            
            1.23
            
            
            $
            5.00
            
            
            
            
            
            438,637
            
            
            
            1.23
            
            
            $
            5.00Over
      $5.50
            
            
            25,000
            
            
            
            2.22
            
            
            $
            5.90
            
            
            
            
            
            25,000
            
            
            
            2.22
            
            
            $
            8.733,082,142
            
            
            
            3.23
            
            
            $
            0.88
            
            $
            34,174
            
            
            2,099,396
            
            
            
            2.74
            
            
            $
            1.26
            
            $
            24,827





The
aggregate intrinsic value in the preceding table represents the difference
between the Company’s closing stock price and the exercise price of each
in-the-money option on the last trading day of the period presented, December
31, 2009.




14
 Table of Contents




6.
            Income Taxes





In
September 2006, the FASB issued ASC 740 (prior authoritative guidance: FASB
issued FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income
Taxes and SFAS No. 109, Accounting for Income Taxes).
ASC 740 clarifies the accounting for uncertainty in income taxes recognized in
an enterprise’s financial statements.  This interpretation defines the
minimum recognition threshold a tax position is required to meet before being
recognized in the financial statements. The Company adopted ASC 740 on April 1,
2007.  As a result of the implementation, the Company recognized no
material adjustment in the liability of unrecognized income tax
benefits.  At the adoption date of April 1, 2007, the Company had no
unrecognized tax benefits, all of which would affect the Company’s effective tax
rate if recognized.  It is possible that the Company’s unrecognized
tax benefit may change; however, the Company does not expect any such change to
be material.


Deferred
income taxes are recognized for the tax consequences in future years of
differences between the tax basis of assets and liabilities and their financial
reporting amounts at the end of each period, based on enacted laws and statutory
rates applicable to the periods in which the differences are expected to affect
taxable income.  Any liability for actual taxes to taxing authorities
is recorded as income tax liability. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period that
includes the enactment date.  A valuation allowance is established
against such assets where management is unable to conclude more likely than not
that such asset will be realized.  As of December 31, 2009 and March
31, 2009, the Company recognized a valuation allowance equal to 100% of the net
deferred tax asset balance.


7.
            Related Party
Transactions





See Note
4, Long Term Debt and Current Portion-Long Term Debt for further disclosure of
related party transactions.





8.
            Stockholders’ Equity





On June
30, 2009, the Company issued 6,836 shares of Series A Convertible Preferred
Stock (the “Series A Shares”) for aggregate consideration totaling
$6,250,341.  2,690 Series A Shares were issued in exchange for cash
invested into the Company totaling $2,690,000.  2,332 Series A Shares
were issued in exchange for the release of existing obligations of the Company
totaling $2,332,000.  1,642 Series A Shares were issued in exchange
for a combination of $950,000 in cash, 924,703 shares of the Company’s common
stock, and 462,352 warrants to purchase shares of the Company’s common
stock.  172 Series A Shares were issued in exchange for $172,000 in
short term notes receivable having maturities of 90 days or less.  In
addition, the Series A Shares were issued with a total of 3,414 warrants (the
“Warrants”) to purchase additional Series A Shares at an exercise price of
$1,250 per Series A Share.  The exercise period for the Warrants
expires five years from the date of issuance.  Between October 16,
2009 and October 21, 2009, the Company issued 750 shares of Series A Convertible
Preferred Stock (the “Additional Series A Shares”) in exchange for $599,979 in
cash and 24,000 shares of the Company’s common shares.  The Additional
Series A Shares were issued with a total of 750 warrants (the “Additional
Warrants”) to purchase Series A Shares at an exercise price of $1,250 per Series
A Share.  The exercise period for the Additional Warrants expires five
years from the date of issuance.





The
Series A Shares carry certain rights, preferences, and designations, including
the right to convert each Series A Share into 5,000 shares of the Company’s
common stock.  Each Series A Share has an original issue price of
$1,000.  The holders of the Series A Shares are entitled to receive
cumulative dividends in preference to any dividend on the Company’s common stock
at the rate of 8% of the original issue price per annum, and are entitled to
participate pro rata in any dividends paid on the Company’s common stock on as
as-if-converted basis.  In the event of a sale, liquidation, or other
winding up of the Company, the holders of the Series A Shares are entitled to
receive in preference to the holders of the Company’s common stock a per share
amount equal to the greater of (i) 1.5 times the original issue price, plus any
accrued but unpaid dividends or (ii) the amount that the holder of a Series A
Share would otherwise receive in such event on an as-converted to common stock
basis.  The holders of the Series A Shares will vote along with
holders of the Company’s common stock on an as-if-converted
basis.  Each Series A Share shall have a number of votes equal to the
number of shares of the Company’s common stock then issuable upon conversion of
such Series A Share.  In addition, the holders of the Series A Shares
are entitled to elect three members of the Company’s Board of Directors by an
affirmative vote or consent of the holders of at least a majority of the
outstanding Series A Shares, voting together as a single class.  The
Series A shares also carry certain other rights, including the right to block
certain actions of the Company unless such actions are approved by a vote of the
holders of the Series A Shares voting together as a single class, anti-dilution
provisions, and other rights and preferences commonly associated with preferred
shares.





The
issuance of the Series A Shares was conducted in reliance upon exemptions from
registration under the Securities Act of 1933, as amended (the “Securities
Act”), including, without limitation, those under Rule 506 of Regulation D (as
promulgated under the Securities Act).  The Series A Shares were
offered and sold only to investors who are “accredited investors,” as defined in
Rule 501 under the Securities Act.  The investors purchasing the
Series A Shares included AeroGrow directors, executive management, institutional
investors, trade partners of the Company, and high net worth
individuals.  Proceeds from the issuance of the Series A Shares will
be used for general corporate purposes, including but not limited to the payment
of fixed expenses, refinancing existing debt arrangements, and payments to
vendors of goods and services.




15
 Table of Contents





A summary
of the Company’s common stock warrant activity for the period from April 1,
2009, through December 31, 2009, is presented below:





Warrants
              Outstanding
            
            Weighted
                AverageExercise PriceOutstanding,
      April 1, 2009
            
            
            5,415,742
            
            $
            5.76Granted
            
            
            1,080,000
            
            $
            .25Exercised
            
            
            --
            
            $
            --Expired/Forfeited
            
            
            462,352
            
            $
            2.00Outstanding,
      December 31, 2009
            
            
            6,033,390
            
            $
            5.06




As
of December 31, 2009, the Company had the following outstanding warrants to
purchase its common stock:





Weighted
            
            
            WeightedWarrants
            
            
            Average
            
            
            AverageOutstanding
            
            
            Exercise Price
            
            
            Remaining Life1,080,000
            
            
            $
            0.25
            
            
            
            4.763,200
            
            
            $
            0.66
            
            
            
            0.70325,000
            
            
            $
            1.00
            
            
            
            4.13132,639
            
            
            $
            2.00
            
            
            
            1.5616,000
            
            
            $
            2.07
            
            
            
            3.50450,000
            
            
            $
            5.00
            
            
            
            0.70505,796
            
            
            $
            6.00
            
            
            
            1.241,937,299
            
            
            $
            6.25
            
            
            
            1.1650,000
            
            
            $
            6.96
            
            
            
            2.58746,956
            
            
            $
            7.50
            
            
            
            2.19720,000
            
            
            $
            8.00
            
            
            
            4.6866,500
            
            
            $
            8.25
            
            
            
            4.686,033,390
            
            
            $
            5.06
            
            
            
            2.55





A summary
of the Company’s preferred stock warrant activity for the period from April 1,
2009, through December 31, 2009, is presented below:





Warrants
      Outstanding
            
            Weighted
                AverageExercise PriceOutstanding,
      April 1, 2009
            
            
            --
            
            $
            --Granted
            
            
            4,164
            
            $
            1,250Exercised
            
            
            --
            
            $
            --Expired
            
            
            --
            
            $
            --Outstanding,
      December 31, 2009
            
            
            4,164
            
            $
            1,250




The
warrants granted expire five years from issuance.




16
 Table of Contents




9.
            Subsequent Event





On
January 14, 2010, the Board of Directors of the Company appointed Jack J. Walker
as Chief Executive Officer, in addition to his existing role as Chairman of the
Company’s Board of Directors.  The Board of Directors also appointed
J. Michael Wolfe as Chief Operating Officer, and John K. Thompson as Senior Vice
President of Sales and Marketing on that date.





Mr.
Walker replaced Jervis B. Perkins who had been the Company’s President and Chief
Executive Officer since March 2008, and who left the Company effective January
15, 2010.  Mr. Perkins’ departure reflected the strategic decision by
the Board of Directors to reduce the Company’s reliance on sales to retailers,
an area in which Mr. Perkins had specific expertise.  Mr. Perkins will
remain a director of the Company.  The
estimated expense associated with his separation that will be recorded in the
quarter ending March 31, 2010 is approximately $357,600.


On
January 14, 2010, AeroGrow eliminated the Vice President of Sales position,
reflecting the Company’s strategic decision to reduce its reliance on sales to
retailers.  As a result, Jeffrey M. Brainard, who was AeroGrow’s Vice
President of Sales since March 2006, and a Named Executive Officer, left the
Company, effective January 15, 2010.  The estimated expense associated
with Mr. Brainard’s separation that will be recorded in the quarter ending March
31, 2010 is approximately $176,600.


As of
February 15, 2010, the Company, FCC, and Jack J. Walker as guarantor, executed
an amendment to the Revolving Credit Facility, as more fully described in Note
4. Long Term Debt and Current Portion – Long Term Debt.




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





The
discussion contained herein is for the three and nine months ended December 31,
2009 and December 31, 2008. The following discussion should be read in
conjunction with the financial statements of AeroGrow International, Inc. (the
“Company,” “we,” or “our”) and the notes to the financial statements included
elsewhere in this Quarterly Report on Form 10-Q for the period ended December
31, 2009 (this “Quarterly Report”).  The following discussion contains
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended (the “Securities Act”), and Section 21E of the
Securities Exchange Act of 1934, as amended (the “Exchange Act”), including
statements that include words such as “anticipates,” “expects,” “intends,”
“plans,” “believes,” “may,” “will,” or similar expressions that are intended to
identify forward-looking statements.  In addition, any statements that
refer to expectations, projections, or other characterizations of future events
or circumstances, including any underlying assumptions, are forward-looking
statements.  Such statements include, but are not limited to,
statements regarding our intent, belief, or current expectations regarding our
strategies, plans, and objectives, our product release schedules, our ability to
design, develop, manufacture, and market products, the ability of our products
to achieve or maintain commercial acceptance, and our ability to obtain
financing necessary to fund our future operations.  Such statements
are not guarantees of future performance and are subject to risks,
uncertainties, and assumptions that are difficult to predict. Therefore, the
Company’s actual results could differ materially and adversely from those
expressed in any forward-looking statements as a result of various factors.
Factors that could cause or contribute to the differences are discussed in this
Item 2, Management’s Discussion and Analysis of Financial Condition and Results
of Operations and in Part II, Item 1A (“Risk Factors”). Except as required by
applicable law or regulation, the Company undertakes no obligation to revise or
update any forward-looking statements contained in this Quarterly Report. The
information contained in this Quarterly Report is not a complete description of
the Company’s business or the risks associated with an investment in the
Company’s common stock. Each reader should carefully review and consider the
various disclosures made by the Company in this Quarterly Report and in the
Company’s other filings with the SEC.


Overview





AeroGrow
International, Inc. was incorporated in the State of Nevada on March 25,
2002.  On January 12, 2006, the Company and Wentworth I, Inc., a
Delaware corporation (“Wentworth”), entered into an Agreement and Plan of Merger
(the “Merger Agreement”), which was consummated on February 24,
2006.  Under the Merger Agreement, Wentworth merged with and into the
Company, and the Company was the surviving corporation (the “Merger”). The
Merger, for accounting and financial reporting purposes, has been accounted for
as an acquisition of Wentworth by the Company.  As such, the Company
was the accounting acquirer in the Merger, and the historical financial
statements of the Company will be the financial statements for the Company
following the Merger.


The
Company’s principal business is developing, marketing, and distributing advanced
indoor aeroponic and hydroponic garden systems designed and priced to appeal to
the consumer gardening, cooking, and small indoor appliance markets
worldwide.  The Company’s principal activities from its formation
through March 2006 consisted of product research and development, market
research, business planning, and raising the capital necessary to fund these
activities.  In December 2005, the Company commenced pilot production
of its AeroGarden system and, in March 2006, began shipping these systems to
retail and catalogue customers.  Today the Company manufactures,
distributes, and markets over 11 different models of its AeroGarden systems in
multiple colors, as well as over 50 varieties of seed kits and a full line of
accessory products through multiple channels including retail, catalogue, and
direct-to-consumer sales in the United States as well as selected countries in
Europe and Asia, and in Australia.


17
 Table of Contents





Our
Critical Accounting Policies





Inventory


Inventories
are valued at the lower of cost, determined by the first-in, first-out method,
or market. Included in inventory costs where the Company is the manufacturer are
raw materials, labor, and manufacturing overhead. The Company records the raw
materials at delivered cost. Standard labor and manufacturing overhead costs are
applied to the finished goods based on normal production capacity as prescribed
under ASC 330 (prior authoritative guidance: Accounting Research Bulletin No.
43, Chapter 4, Inventory
Pricing).  A majority of the Company’s products are
manufactured overseas and are recorded at cost.





The
Company determines an inventory obsolescence reserve based on management’s
historical experience and establishes reserves against inventory according to
the age of the product. As of December 31, 2009 and March 31, 2009, the Company
had reserved $170,134 and $335,705 for inventory obsolescence,
respectively.





Accounts
Receivable and Allowance for Doubtful Accounts


The
Company sells its products to retailers and consumers.  Consumer
transactions are paid primarily by credit card. Retailer sales terms vary by
customer, but are generally net 30 days.  Accounts receivable are
reported at net realizable value and net of the allowance for doubtful
accounts.  The Company uses the allowance method to account for
uncollectible accounts receivable.  The Company also maintains a
credit insurance policy which insures against losses from most retailer
accounts. The Company's allowance estimate is based on a review of the current
status of trade accounts receivable, which resulted in an allowance of $211,824
and $1,423,508 at December 31, 2009 and March 31, 2009,
respectively.


Other
Receivables


In
conjunction with the Company’s processing of credit card transactions and for
its direct-to-consumer sales activities and as security with respect to the
Company’s performance for required credit card refunds and chargebacks, the
Company is required to maintain a cash reserve with Litle and Company, the
Company’s credit card processor.  This reserve is equal to 5% of the
credit card sales processed during the previous six months. As of December 31,
2009 and March 31, 2009, the balance in this reserve account was $164,905 and
$332,059, respectively.


Revenue
Recognition


The
Company recognizes revenue from product sales, net of estimated returns, when
persuasive evidence of a sale exists as determined by the following factors: a
product is shipped under an agreement with a customer; risk of loss and title
has passed to the customer; the fee is fixed or determinable; and collection of
the resulting receivable is reasonably assured.  Accordingly, the
Company did not record $3,201 and $430 of revenue as of December 31, 2009 and
December 31, 2008, respectively, related to the unpaid balance due for orders
shipped in conjunction with the Company’s direct-to-consumer sales, because the
consumer has 36 days to evaluate the product, and is required to pay only the
shipping and handling costs for such products before making the required
installment payments after the expiration of the 36-day trial period. The
Company also, as of December 31, 2009 and December 31, 2008, did not record
$1,139 and $131 of product costs associated with the foregoing revenue because
the customer is required to return the product and the Company is therefore able
to recover these costs through resale of the goods. The liability for sales
returns is estimated based upon historical experience of return
levels.


Additionally,
the Company did not record $459,869 and $475,112 of revenue as of December 31,
2009 and December 31, 2008, respectively, related to the wholesale sales value
of inventory held by its retail shopping channel customers as these sales are
contingent upon the shopping channels selling the goods.  Deferred
payments for these goods are charged to Customer Deposits.  The
Company also deferred, as of December 31, 2009 and December 31, 2008,
recognition of $307,798 and $196,395, respectively, of product and freight costs
associated with these sales, which have been included in inventory.


The
Company records estimated reductions to revenue for customer and distributor
programs and incentive offerings, including promotions, rebates, and other
volume-based incentives.  Certain incentive programs require the
Company to estimate based on industry experience the number of customers who
will actually redeem the incentive. At December 31, 2009 and December 31, 2008,
the Company had accrued $347,860 and $698,130, respectively, as its estimate for
the foregoing deductions and allowances.


Advertising
and Production Costs


The
Company expenses all production costs related to advertising, including, print,
television, and radio advertisements when the advertisement has been broadcast
or otherwise distributed.  The Company records media costs related to
its direct-to-consumer advertisements, inclusive of postage and printing costs
incurred in conjunction with mailings of direct-response catalogues, and related
direct-response advertising costs, in accordance with the ASC 340-20-25 (prior
authoritative guidance: Statement of Position (“SOP”) No. 93-7, Reporting on Advertising
Costs).  ASC 340-20-25 requires companies to report direct
response advertising costs as assets and amortize them over the estimated period
of the benefits, based on the proportion of current period revenue from the
advertisement to probable future revenue.  As of December 31, 2009 and
December 31, 2008, the Company had deferred $38,869 and $359,665, respectively,
related to such media costs. Advertising expenses for the three and nine months
ended December 31, 2009 were $1,221,286 and $1,870,455, respectively, and for
the three and nine months ended December 31, 2008 were $2,094,269 and
$3,911,012, respectively.




18
 Table of Contents





Warranty
and Return Reserves


The
Company records warranty liabilities at the time of sale for the estimated costs
that may be incurred under its basic warranty program.  The specific
warranty terms and conditions vary depending upon the product sold but generally
include technical support, repair parts, and labor for periods up to one
year.  Factors that affect the Company’s warranty liability include
the number of installed units currently under warranty, historical and
anticipated rates of warranty claims on those units, and cost per claim to
satisfy the Company’s warranty obligation.  Based upon the foregoing,
the Company has recorded as of December 31, 2009 and March 31, 2009 a provision
for potential future warranty costs of $61,621and $69,587,
respectively.


The
Company reserves for known and potential returns from customers and associated
refunds or credits related to such returns based upon historical
experience.  In certain cases, customers are provided an allowance to
cover returned goods, usually in the 1% to 2% range, that is deducted from
payments from such customers.  As of December 31, 2009 and March 31,
2009, the Company has recorded a reserve for customer returns of $147,282 and
$101,743, respectively.


Shipping
and Handling Costs


Shipping
and handling costs associated with inbound freight are recorded in cost of
revenue.  Shipping and handling costs associated with freight out to
customers are also included in cost of revenue. Shipping and handling charges to
customers are included in sales.


Equity
Compensation Plans


In
December 2004, the FASB issued ASC 710-10-55 (prior authoritative guidance: FASB
Statement 123(R), Share-Based
Payment). Subsequently, the SEC provided for a phased-in implementation
process for ASC 710-10-55, which required adoption of the new accounting
standard no later than January 1, 2006. ASC 710-10-55 requires accounting for
stock options using a fair-value-based method as described in such statement and
recognition of the resulting compensation expense in the Company’s financial
statements.  Prior to January 1, 2006, the Company accounted for
employee stock options using the intrinsic value method under Accounting
Principles Board No. 25, Accounting for Stock Issued to Employees and related
interpretations, which generally results in no employee stock option
expense.  We adopted ASC 710-10-55 on January 1, 2006, and did not
plan to restate financial statements for prior periods.  We plan to
continue to use the Black-Scholes option valuation model in estimating the fair
value of the stock option awards issued under ASC 710-10-55.


Results
of Operations





Three
Months Ended December 31, 2009 and December 31, 2008





Summary
Overview


For the
three months ended December 31, 2009, sales totaled $7,939,248, a 27.9% decrease
from the same period in the prior year.  The decline in sales
principally reflected a 35.1% reduction in sales to retailers, caused in part by
more conservative product, procurement, and inventory management strategies
being executed by major retail chains during the current year period, as well as
the continuing effects of the recession, which adversely affected the levels of
consumer spending on discretionary products.  In addition, we
experienced a decline in the number of retail storefronts carrying our products,
from more than 9,000 at December 31, 2008 to approximately 4,600 at December 31,
2009, reflecting a shift in stocking strategy by many retail chains to focus
inventory investment on more traditional consumer product
categories.  Our direct-to-consumer sales also declined, by 14.5% from
the prior year, reflecting a 41.7% reduction in the amount of revenue-generating
media spending during the period.  Overall, the effectiveness of our
media improved, however, as we generated $3.41 of revenue for every dollar of
revenue-generating media spent in the 2009 period, as compared to $2.32 of
revenue per media dollar in 2008.  The decline in revenue was
primarily reflected in sales of AeroGardens which declined by 34.8% from the
prior year.  Recurring revenue from seed kit and accessories declined
more modestly, by 2.1%, and increased as a percent of total revenue to 28.7% for
the three months ended December 31, 2009, up from 21.1% in the prior year
period.


Gross
margin for the three months ended December 31, 2009 was 39.2%, as compared to
31.4% for the year earlier period.  The increase reflected a shift in
revenue mix toward the higher margin direct-to-consumer channel, and toward
higher margin seed kit and accessory sales.  In addition, the increase
reflected a comparison to the prior year period in which we recognized
approximately $1.8 million in reserves for potential markdowns and returns by
our retailer customers.  These reserves reduced our net sales without
impacting our cost of revenue, thereby causing a decrease in our gross margin in
the prior year period.  Operating expenses other than cost of revenue
were reduced $3,893,965, or 52.3%, from the prior year reflecting cost saving
initiatives, reduction in media spending, and staffing reductions.




19
 Table of Contents




Our loss
from operations totaled $443,016 for the three months ended December 31, 2009,
as compared to a loss of $3,993,279 in the prior year period.  The
decreased loss principally reflected the impact of the higher gross margin,
combined with the significant decrease in operating expenses other than cost of
revenue.





Other
expense for the three months ended December 31, 2009 totaled $267,651 as
compared to other expense of $408,943 in the prior year, principally reflecting
a decrease in interest expense resulting from a lower average level of debt
outstanding in the current year period.





The net
loss for the three months ended December 31, 2009 was $710,667 as compared to a
net loss of $4,402,222 in the same period a year earlier.





The
following table sets forth, as a percentage of sales, our financial results for
the three months ended December 31, 2009 and the three months ended December 31,
2008:




Three
      Months Ended December 31,2009
            
            
            2008RevenueProduct
      sales - retail, net
            46.0
            %
            
            
            51.1
            %Product
      sales - direct to consumer, net
            52.4
            %
            
            
            44.2
            %Product
      sales – international
            1.6
            %
            
            
            4.7
            %Total
      sales
            100.0
            %
            
            
            100.0
            %Operating
      expensesCost
      of revenue
            60.9
            %
            
            
            68.6
            %Research
      and development
            4.0
            %
            
            
            6.4
            %Sales
      and marketing
            29.8
            %
            
            
            42.7
            %General
      and administrative
            10.9
            %
            
            
            18.5
            %Total
      operating expenses
            105.6
            %
            
            
            136.2
            %Profit/(loss)
      from operations
            -5.6
            %
            
            
            -36.2
            %





Revenue


For the
three months ended December 31, 2009, revenue totaled $7,939,248, a
year-over-year decrease of 27.9% or $3,071,637 from the three months ended
December 31, 2008.





Three
      Months Ended December 31,Product Revenue
            
            2009
            
            
            2008Retail, net
            
            $
            3,649,483
            
            
            $
            5,621,688Direct to consumer,
      net
            
            
            4,159,984
            
            
            
            4,867,808International
            
            
            129,781
            
            
            
            521,389Total
            
            $
            7,939,248
            
            
            $
            11,010,885








Sales to
retailer customers for the three months ended December 31, 2009, declined
$1,972,205 or 35.1%, from the same period a year earlier.  The decline
principally reflected more conservative product, procurement, and inventory
management strategies being executed by major retail chains during the current
year period and a comparison to a prior year period in which more retailer
customers stocked AeroGrow products.  As of December 31, 2009 our
products were carried in approximately 4,600 traditional “brick and mortar”
storefronts in the United States and Canada, as compared to more than 9,000 as
of December 31, 2008. Because of the impact of non-“brick and mortar” retailers,
which do not have storefronts, on our retail sales, we do not believe “sales per
store” is a meaningful metric for assessing our retail
business.  However, we did experience a decline in order rates from
our key customers during the three months ended December 31, 2009.




20
 Table of Contents




Direct-to-consumer
sales for the three months ended December 31, 2009 decreased $707,824 or 14.5%,
from the prior year period.  The decrease principally reflected an
approximate $930,000 reduction in the amount of television infomercials aired
relative to the same period in 2008, offset by a 16% increase in catalogues
mailed, and an increase in web marketing activity.  Overall, there was
an increase in the media effectiveness as sales per dollar of media spending
totaled $3.41 in the quarter ended December 31, 2009, as compared to $2.32 per
dollar of media spending in the prior year period.





International
sales for the three months ended December 31, 2009 were down $391,608 from the
same period in the prior fiscal year.  Inventory levels at our
international distributors remained sufficient to meet local demand for our
products, limiting re-orders from these customers in the 2009
period.





Our
products consist of AeroGardens and seed kits and accessories.  A
summary of the sales of these two product categories for the three months ended
December 31, 2009 and December 31, 2008 is as follows:





Three
      Months Ended December 31,2009
            
            
            2008Product RevenueAeroGardens
            
            $
            5,662,031
            
            
            $
            8,683,670Seed
      kits and accessories
            
            
            2,277,217
            
            
            
            2,327,215Total
            
            $
            7,939,248
            
            
            $
            11,010,885% of Total RevenueAeroGardens
            
            
            71.3
            %
            
            
            78.9
            %Seed
      kits and accessories
            
            
            28.7
            %
            
            
            21.1
            %Total
            
            
            100.0
            %
            
            
            100.0
            %





AeroGarden
sales declined $3,021,639 or 34.8%, from the year earlier period, reflecting the
overall decline in aggregate sales in each of our distribution
channels.  Sales of seed kits and accessories, which represent a
recurring revenue stream generated by the 936,942 AeroGardens sold to-date,
declined a more modest 2.1%.  For the three months ended December 31,
2009, sales of seed kits and accessories represented 28.7% of total revenue, up
from 21.1% in the prior year period.





Cost
of Revenue


Cost of
revenue for the three months ended December 31, 2009 totaled $4,830,387, a
decrease of 36.1% from the three months ended December 31, 2008.  Cost
of revenue includes product costs for purchased and manufactured products,
freight costs for inbound freight from manufacturers and outbound freight to
customers, costs related to warehousing and the shipping of products to
customers, credit card processing fees for direct sales, and duties and customs
applicable to products imported.  The dollar amount of cost of revenue
decreased primarily because of the decline in revenue discussed
above.  As a percent of total revenue, these costs represented 60.8%
of revenue as compared to 68.6% for the quarter ended December 31,
2008.  The decrease in costs as a percent of revenue reflects changes
in channel, customer, and product mix, particularly increases in the percent of
net revenue represented by higher margin direct-to-consumer and seed kit and
accessory sales.  In addition, the decrease reflects a comparison to
the prior year period in which approximately $1.8 million in reserves for
potential markdown and return allowances for retailer customers were recorded,
reducing net sales and causing an increase in the cost of revenue as a percent
of net sales.





Gross
Margin


Our gross
margin varies based upon the factors impacting net revenue and cost of revenue
as discussed above, as well as the mix of our revenue that comes from the
retail, direct-to-consumer, and international channels.  In a
direct-to-consumer sale, we recognize as revenue the full consumer purchase
price for the product as opposed to retail and international sales, where we
recognize as revenue the wholesale price for the product which we charge to the
retailer or international distributor.  Media costs associated with
direct sales are included in sales and marketing expenses.  For
international sales, margins are structured based on the distributor purchasing
products by letter of credit or cash in advance terms with the distributor
bearing all of the marketing and distribution costs within their
territory.  As a result, international sales have lower margins than
domestic retail sales.  The gross margin for the quarter ended
December 31, 2009 was ­­­­­­­39.2% as compared to
31.4% for the quarter ended December 31, 2008.





21
 Table of Contents




Sales
and Marketing


Sales and
marketing costs for the three months ended December 31, 2009 totaled
$­­­­­2,369,726, as compared to $4,704,912 for the three
months ended December 31, 2008, a decrease of 49.6% or
$2,335,186.  Sales and marketing costs include all costs associated
with the marketing, sales, operations, customer support, and sales order
processing for our products, and consist of the following:





Three
      Months Ended December 31,2009
            
            
            2008Advertising
            
            $
            1,221,286
            
            
            $
            2,094,269Personnel
            
            
            570,195
            
            
            
            974,178Sales
      commissions
            
            
            163,947
            
            
            
            205,455Trade
      Shows
            
            
            5,923
            
            
            
            489Other
            
            
            408,375
            
            
            
            1,430,521$
            2,369,726
            
            
            $
            4,704,912





Advertising
is principally made up of the costs of developing and airing our infomercials
and short-form television commercials, the costs of development, production,
printing, and postage for our catalogues, and mailing and web media costs for
search and affiliate web marketing programs.  Each of these are key
components of our integrated marketing strategy because they help build
awareness of, and consumer demand for, our products, for all our channels of
distribution, in addition to generating direct-to-consumer
sales.  Advertising expense totaled $1,221,286 for the quarter ended
December 31, 2009, a year-over-year decrease of 41.7%, or $872,983, principally
reflecting the approximately $930,000 reduction in television infomercial
activity noted above.





Sales and
marketing personnel costs include salaries, payroll taxes, employee benefits and
other payroll costs for our sales, operations, customer service, graphics and
marketing departments.  For the three months ended December 31, 2009,
personnel costs for sales and marketing were $570,195, down from $974,178 for
the three months ended December 31, 2008, a decrease of 41.5%.  The
decrease principally reflects staff reductions implemented in December 2008 and
in April 2009.





Sales
commissions, ranging from 2.5% to 7% of net cash collections from our retailer
customers are paid to sales representative organizations that assist us in
developing and maintaining our relationships with retailers.  The
$41,508 year-over-year decline in sales commissions primarily reflects the
decline in sales to retailers during the quarter ended December 31, 2009, as
discussed above.





General
and Administrative


General
and administrative costs for the three months ended December 31, 2009 totaled
$864,105 as compared to $2,037,797 for the three months ended December 31, 2008,
a decrease of 57.6%, or $1,173,692.  The decrease reflected declines
in most spending categories, as well as a comparison to the prior year period
which included approximately $383,000 of total expense relating to executive
severance agreements and non-cash compensation recognized upon shareholder
approval of previously vested options.





Research
and Development


Research
and development costs for the quarter ended December 31, 2009 totaled $318,046,
a decrease of 54.8% from the quarter ended December 31, 2008.  The
lower cost principally reflected lower headcount costs related to staffing
reductions.





Operating
Loss


Our loss
from operations for the three months ended December 31, 2009 was $443,016, as
compared to a loss of $3,993,279 for the three months ended December 31,
2008.





Other
Income and Expense


Other
income and expense for the quarter ended December 31, 2009 totaled to a net
expense of $267,651, as compared to net expense of $408,943 in the prior year
period.  The year-over-year change principally reflected a $150,018
decrease in interest expense, resulting from lower average amounts of
interest-bearing debt outstanding during the current year period.





Net
Loss


For the
three months ended December 31, 2009 totaled $710,667 as compared to a net loss
of $4,402,222 for the three months ended December 31, 2008.





Nine Months Ended December 31, 2009
and December31,
2008




22
 Table of Contents





Summary
Overview


For the
nine months ended December 31, 2009, sales decreased ­­­­55.0%
year-over year, from $31,585,896 to $14,204,890 principally reflecting a
$13,422,766, or 67.9%, decline in sales to retailer customers.  Sales
declined in each of our channels of distribution, reflecting the decline in
economic activity associated with the global recession, which adversely affected
the levels of consumer spending and retailer procurement relative to the prior
year period, a decline in the number of retail storefronts carrying our
products, and a reduction in our media and advertising spending.  We
elected to reduce this spending because of general economic conditions and a low
anticipated return on investment,  causing a reduction in
direct-to-consumer sales, but ultimately contributing to a reduced operating
loss during that time period.  In addition, cash constraints
experienced during the nine months ended December 31, 2009 contributed to the
decline in media spending.  Direct-to-consumer sales for the nine
month period totaled $7,545,368, down only 21.2% despite a 52.2% reduction in
revenue-generated media.  Sales of AeroGardens for the nine months
ended December 31, 2009 declined 61.6% year-over-year, principally reflecting
the decline in sales to retailers noted above, and a comparison to a period in
the prior year in which large stocking orders were shipped to
retailers.  Sales of seed kits and accessories, which represent
recurring revenue related to cumulative sales of AeroGardens, also declined by a
more modest 30.5% from the prior year period.  As a result, sales of
seed kits and accessories increased to 32.5% of total revenue from 21.0% in the
year earlier period.





Gross
margin for the nine months ended December 31, 2009 was 36.8%, as compared to
39.0% for the year earlier period.  The decline reflected changes in
channel, customer, and product mix, as well as the impact of fixed facility
costs in our Indianapolis, Indiana manufacturing and distribution facility that
became fully operational in October 2008, on a lower revenue base in the current
year period.  Operating expenses other than cost of revenue were
reduced $9,227,103, or 50.3%, from the prior year reflecting cost saving
initiatives, staffing reductions, and reduced spending on advertising and
promotion.




Our loss
from operations totaled $3,873,227 for the nine months ended December 31, 2009,
as compared to a loss of $6,020,046 in the prior year.  The lower loss
reflected the impact of cost savings initiatives and lower media spending which
offset the impact of lower sales and gross margin during the 2009
period.





Other
income for the nine months ended December 31, 2009 totaled $335,574 as compared
to a net expense of $781,155 in the prior year.  The year-over-year
change is reflected in the $138,980 decrease in interest expense resulting from
a lower average level of debt outstanding in the current year period and the
approximately $807,310 in gains recorded as a result of negotiated reductions in
account payable amounts owed to certain vendors.


The net
loss for the nine months ended December 31, 2009 was $3,537,653 as compared to a
net loss of $6,801,201 in the same period a year earlier. The lower loss
reflects the impact of cost savings initiatives, lower media spending, and the
gains recorded on the negotiated reductions in accounts payable which offset the
impact of lower sales and gross margin during the period.


The
following table sets forth, as a percentage of sales, our financial results for
the nine months ended December 31, 2009 and the nine months ended December 31,
2008:





Nine
      Months Ended
              December
      31,2009
            
            
            2008RevenueProduct
      sales - retail, net
            44.7
            %
            
            
            62.6
            %Product
      sales - direct to consumer, net
            53.1
            %
            
            
            30.3
            %Product
      sales – international, net
            2.2
            %
            
            
            7.1
            %Total
      sales
            100.0
            %
            
            
            100.0
            %Operating expensesCost
      of revenue
            63.2
            %
            
            
            61.0
            %Research
      and development
            4.3
            %
            
            
            5.9
            %Sales
      and marketing
            33.6
            %
            
            
            34.9
            %General
      and administrative
            26.2
            %
            
            
            17.3
            %Total
      operating expenses
            127.3
            %
            
            
            119.1
            %-27.3
            %
            
            
            -19.1
            %





23
 Table of Contents




Revenue


For the
nine months ended December 31, 2009 and December 31, 2008, revenue totaled
$14,204,890 and $31,585,896 respectively, a decrease year-over-year of 55.0% or
$17,381,006.





Nine
      Months Ended
              December
      31,Product Revenue
            
            2009
            
            
            2008Retail, net
            
            $
            6,349,527
            
            
            $
            19,772,293Direct to consumer,
      net
            
            
            7,545,368
            
            
            
            9,572,656International,
    net
            
            
            309,995
            
            
            
            2,240,947Total
            
            $
            14,204,890
            
            
            $
            31,585,896




The
year-over-year decrease in revenue principally reflected sales to retailer
customers, which declined by 67.9%, or $13,422,766.  This decline
resulted from a combination of factors, including a comparison to a prior year
period that included large stocking orders in anticipation of the 2008 holiday
shopping season.  In 2009, retailers generally took a more cautious
approach to inventory decisions, resulting in fewer and smaller orders than in
previous years.  In addition, the decline in sales to retailers
reflects a decline in the number of retail store doors carrying our products, to
an estimated 4,600 at December 31, 2009, from more than 9,000 a year
earlier.




Direct-to-consumer
sales also decreased 21.2% year-over-year, to $7,545,368.  The decline
principally reflected a reduction in the amount of revenue-generating media
spending during the 2009 period.  Specifically, infomercial spending
declined $1,364,838 year-over-year, and there was a 22.8% decrease in the number
of catalogues mailed, to 2,712,289.  In both cases the decline in
spending reflected management’s determination to more precisely target marketing
spending because of the reduced level of consumer spending in the economy
generally, cash constraints experienced during the nine months ended December
31, 2009, and analysis demonstrating that media spending in the April to June
time period had historically resulted in an inadequate return on
investment.  During the nine months ended December 31, 2009,
direct-to-consumer sales were down 21.2% relative to the prior year period,
despite a much larger ­52.2% reduction in the total amount of
revenue-generating media spending.




A summary
of the sales of AeroGardens and seed kits and accessories for the nine months
ended December 31, 2009 and December 31, 2008 is as follows:





Nine
      Months Ended
              December
      31,2009
            
            
            2008Product RevenueAeroGardens
            $
            9,589,778
            
            
            $
            24,945,346Seed
      kits and accessories
            
            4,615,112
            
            
            
            6,640,550Total
            $
            14,204,890
            
            
            $
            31,585,896% of Total RevenueAeroGardens
            
            67.5
            %
            
            
            79.0
            %Seed
      kits and accessories
            
            32.5
            %
            
            
            21.0
            %Total
            
            100.0
            %
            
            
            100.0
            %





AeroGarden
sales decreased $15,355,568, or 61.6%, year-over-year, principally reflecting
the decline in sales to retailer customers, and, to a lesser extent, the sales
declines in other channels of distribution.  Seed kit and accessories
sales also declined, $2,025,438 or 30.5%, and also primarily reflected the
comparison to the prior year period in which large stocking orders were shipped
to retailer customers.  Overall, sales of seed kits and accessories
increased as a percent of total revenue to 32.5% from 21.0% in the prior year
period.





Cost
of Revenue


Cost of
revenue for the nine months ended December 31, 2009 and December 31, 2008
totaled $8,970,748 and $19,271,470, respectively, a year-over-year decrease of
53.5%.  The decline principally resulted from the decrease in sales
during the period.  As a percent of total revenue, these costs totaled
63.2% for the nine months ended December 31, 2009, as compared to 61.0% in the
year earlier period.  The increase in costs as a percent of revenue
reflects changes in channel, customer, and product mix, as well as the impact of
higher fixed facility costs on a lower revenue base.  These latter
costs principally reflect the impact of our Indianapolis, Indiana manufacturing
and distribution center which was opened in July 2008 and became fully
operational in October 2008.  As a result, the gross margin for the
nine months ended December 31, 2009 was 36.8%, down from 39.0% for the same
period in 2008.





24
 Table of Contents





Sales
and Marketing


Sales and marketing
costs for the nine months ended December 31, 2009 totaled $4,777,624, as
compared to $11,030,524 for the nine months ended December 31, 2008, a decrease
of 56.7%.  The breakdown of sales and marketing costs for both time
periods is presented in the table below:





Nine
      Months Ended
              December
      31,2009
            
            
            2008Advertising
            
            $
            1,870,455
            
            
            $
            3,911,012Personnel
            
            
            1,803,272
            
            
            
            3,122,773Sales
      commissions
            
            
            304,054
            
            
            
            904,250Trade
      shows
            
            
            37,031
            
            
            
            182,197All
      other
            
            
            762,812
            
            
            
            2,910,292$
            4,777,624
            
            
            $
            11,030,524





Advertising
expense totaled $1,870,455 for the nine months ended December 31, 2009, a
decrease of 52.2% from the same period in 2008, principally reflecting
management’s determination to more precisely target marketing spending because
of the reduced level of consumer spending in the economy generally, cash
constraints experienced during the nine months ended December 31, 2009, and
analysis demonstrating that media spending in the April to June time period had
historically resulted in an inadequate return on investment.  Spending
on television infomercials declined $1,364,838, or 85.9%, relative to the prior
year period, while other forms of advertising, including catalogue mailings and
web marketing, decreased by $675,719, or 29.1%.




For the
nine months ended December 31, 2009, personnel costs for sales and marketing
totaled $1,803,272, a decrease of 42.3% from the same period in
2008.  The decrease principally reflected headcount reductions in
sales, marketing, and operations personnel, as well as a comparison to the prior
year period which included approximately $102,000 in severance related to the
departure of our former chief marketing officer.





Year-over-year,
sales commissions decreased 66.4% to $304,054, primarily reflecting the decrease
in sales to retailers during the nine months ended December 31, 2009, as
discussed above.





General
and Administrative


General
and administrative expenses for the nine months ended December 31, 2009 totaled
$3,719,147 as compared to $5,458,622 for the nine months ended December 31,
2008, a decrease of 31.9%.  The decrease reflected spending reductions
in all areas, and a comparison to the prior year period which included
approximately $362,000 in severance expense related to general headcount
reductions and the departure of our former chief executive officer, former chief
financial officer, and former vice president of human resources.




Research
and Development


Research
and development costs for the nine months ended December 31, 2009 totaled
$610,598 as compared to $1,845,326 for the nine months ended December 31, 2008,
a decrease of 66.9%.  The decrease reflected lower headcount costs
resulting from staffing reductions, and a significant reduction in design and
development costs related to new products that were introduced in the prior
fiscal year period, or that will be introduced in upcoming
periods.





Operating
Loss


Our loss
from operations for the nine months ended December 31, 2009 was $3,873,227 as
compared to an operating loss of $6,020,046 for the nine months ended December
31, 2008.





Other
Income and Expense


Other
income and expense for the nine months ended December 31, 2009 and December 31,
2008 totaled to net income of $335,574 and net expense of $781,155,
respectively.  The year-over-year change of $1,116,729 was driven by
approximately $807,000 of gains attributable to negotiated reductions in
accounts payable due to vendors and a decrease in interest expense of
approximately $140,000 during the nine months ended December 31,
2009.





Net
Loss


The net
loss for the nine months ended December 31, 2009 totaled $3,537,653, as compared
to the $6,801,201 loss reported for the same period in 2008.




25
 Table of Contents




Liquidity
and Capital Resources





After
adjusting the net loss for non-cash items, including depreciation, amortization,
bad debt allowances, issuances of common stock and options, and gains on the
forgiveness of accounts payable obligations, the net cash loss for the nine
months ended December 31, 2009 totaled $4,281,757 as compared to a $5,774,708
net cash loss in the prior period.





Changes
in current assets contributed cash of $4,155,462 during the nine months ended
December 31, 2009, principally from reductions in inventory totaling $3,191,163
and the collection of accounts receivable.  As of December 31, 2009,
the inventory balance was $5,158,972, representing approximately 195 days of
sales activity, and 123 days of sales activity, at the average daily rate of
product cost expensed during the 12 months and three months ended December 31,
2009, respectively.  Net accounts receivable totaled $2,768,121 as of
December 31, 2009, representing approximately 92 days of net retail sales
activity, and 48 days of net retail sales activity, at the average daily rate of
sales recognized during the 12 months and three months ended December 31, 2009,
respectively.





Current
operating liabilities decreased $1,872,185 during the nine months ended December
31, 2009.  The reduction included the impact of approximately
$2,618,000 in accounts payable and accrued liabilities that were converted to
either Series A Preferred shares or into long-term debt.  Accounts
payable as of December 31, 2009 totaled $3,874,286, representing approximately
52 days of daily expense activity, and 42 days of daily expense activity, at the
average daily rate of expenses incurred during the 12 months and three months
ended December 31, 2009, respectively.





Financing
activity, including the impact of the issuance of Series A Preferred shares and
the conversions of various short-term obligations to Series A Preferred shares
and long term debt, as well as new short-term loans, provided cash of $2,396,046
during the nine months ended December 31, 2009.





As of
December 31, 2009, we had a cash balance of $991,970, including $438,507 in cash
that is restricted as collateral for letters of credit and other corporate
obligations.  This compares to a cash balance of $771,029 as of March
31, 2009, of which $438,331 was restricted.





We rely
upon a variety of funding sources to meet our liquidity
requirements:





First
National Loan





On May
19, 2008, the Company and Jack J. Walker, then one of the Company’s directors
and now the Company’s Chairman and CEO, acting as co-borrowers, entered into a
Business Loan Agreement with First National Bank (the “FNB Loan Agreement”) for
a loan to the Company in a principal amount of up to $1,000,000 (the “FNB
Loan”).  The Company agreed, among other things, that while the FNB
Loan Agreement is in effect, the Company will not (without FNB's prior written
consent): (i) incur or assume indebtedness, except for trade debt in the
ordinary course of business, capital leases in an amount not to exceed $500,000,
and capital expenditures of not more than $500,000 during any fiscal year; (ii)
sell, transfer, mortgage, assign, pledge, lease, grant a security interest in,
or encumber any of the Company’s assets (except as specifically allowed); or
(iii) sell with recourse any of the Company’s accounts, except to FNB. In
the event of a default under the FNB Loan, at FNB's option, all indebtedness
owed under the FNB Loan will become immediately due and payable.  The
FNB Loan had an initial maturity date of May 19, 2009.





On May
19, 2009, the Company, Mr. Walker, and FNB entered into a Change in Terms
Agreement (the “First Change in Terms Agreement”), extending the maturity of the
FNB Loan until July 19, 2009, and increasing the interest rate from the Wall
Street Journal Prime Rate plus 0.50% floating to the Wall Street Journal Prime
Rate plus 2.0% floating, with a floor interest rate of 5.50%.





On August
28, 2009, the Company, Mr. Walker, and FNB entered into a second Change in Terms
Agreement (the “Second Change in Terms Agreement”) extending the maturity of the
FNB Loan to November 30, 2009.  The Second Change in Terms Agreement
increased the interest rate to a fixed rate effective July 19, 2009, of 7% per
annum, and provided for principal payments of $100,000 and a loan origination
payment of $2,500 at closing of the Second Change in Terms Agreement and then
principal payments of $50,000, $50,000, and $100,000 on August 31, 2009,
September 30, 2009, and October 31, 2009, respectively.  The terms and
conditions of the Second Change in Terms Agreement were consented to by FCC, LLC
d/b/a First Capital (“FCC”), the Company’s senior lender, in accordance with the
Subordination and Intercreditor Agreement by and among FNB, FCC, and the Company
(the “Subordination Agreement”).  The Company is prohibited from
making principal payments against the FNB Loan, including scheduled principal
payments, unless and until such time as FCC provides its consent or such time as
the Company’s liquidity position exceeds certain thresholds defined in the
Subordination Agreement.





At
closing of the Second Change in Terms Agreement on August 31, 2009, the Company
made the scheduled $100,000 principal payment with the consent of
FCC.  Principal payments totaling $200,000 that were due during the
term of the Second Change in Terms Agreement were made by Mr. Walker to FNB
because FCC did not consent to the Company making such payments.  The
first $150,000 of payments made by Mr. Walker were recorded by the Company as an
offset to a $150,000 receivable due from Mr. Walker.  Effective as of
November 20, 2009, the Company executed a promissory note in favor of Mr. Walker
for the remaining $50,000.  The promissory note matured on February 1,
2010 and carries an interest rate of 20% per annum.  As of February 1,
2010, Mr. Walker agreed to extend the maturity date of this promissory note to
April 30, 2010.  No principal or interest payments have been made
against this promissory note to date.  As of December 31, 2009,
$51,123 was outstanding under the promissory note, including accrued
interest.


26
 Table of Contents





As of
February 16, 2010, Mr. Walker made an additional $208,439 principal and interest
payment to FNB, reducing the outstanding principal balance on the FNB Loan to
$500,000.  Effective as of the same date, the Company executed a
promissory note for $208,439 in favor of Mr. Walker having a maturity date of
April 30, 2010 and carrying an interest rate of 20% per annum.


As of the
date of this report, the Company, Mr. Walker and FNB are negotiating the terms
of an extension to the maturity date of the FNB Loan.  FNB has
informed the Company and Mr. Walker that it has approved an extension of the
loan’s maturity date to March 31, 2010 subject to the completion and acceptance
of appropriate documentation.  Under the terms of an intercreditor
subordination agreement between the Company, FNB, FCC, and Mr. Walker, the
Company is unable to make scheduled payments against the FNB Loan without the
consent of FCC.  Such consent has not been provided.  Under
the terms of the intercreditor subordination agreement, FNB is prohibited from
exercising any rights or remedies with respect to AeroGrow or any collateral
until such time as the FCC Revolving Credit Facility has been paid in
full.


As of
December 31, 2009, $704,219 in loans were outstanding under the FNB Loan,
including accrued interest.





WLLC
Loan Agreement





On May
22, 2008, the Company entered into a Loan Agreement (the “WLLC Loan Agreement”)
and associated Promissory Note with WLoans, LLC, a Colorado limited liability
company (“WLLC”), as lender, and Jack J. Walker.  The WLLC Loan
Agreement provided for a loan up to a maximum of $1,500,000 for business
purposes, at an annual interest rate of 12% (the “WLLC Loan”).  The
Company granted WLLC a security interest in all of the Company’s assets,
subordinate to the security interests in such assets granted to FCC and
FNB.  The WLLC Loan had an initial maturity date of April 1,
2009.  Mr. Walker is the manager of WLLC and owns a 73.3% membership
interest in WLLC, with the remaining membership interest owned by former
officers and former directors of the Company.


On May
19, 2009, Mr. Walker, WLLC, and the Company entered into a Loan Extension
Agreement (the “Loan Extension Agreement”) effective April 1, 2009, extending
the maturity date of the WLLC Loan until June 30, 2009.  The Company
paid WLLC $5,000 in consideration for the loan extension.  The balance
of principal due on the WLLC Loan as of May 19, 2009, was
$1,200,000.





On June
30, 2009, the principal outstanding under the WLLC Loan Agreement totaling
$1,200,000 was converted to 1,200 shares of Series A Convertible Preferred
Stock, and the WLLC Loan Agreement was terminated.





Revolving
Credit Facility





On June
23, 2008, the Company entered into a Loan and Security Agreement with FCC (the
“FCC Loan Agreement”) for a revolving credit facility up to a maximum amount of
$12,000,000 (the “Revolving Credit Facility”) to fund working capital
requirements.  The actual amount available for borrowing under the
Revolving Credit Facility is limited at any given time to the sum of a
percentage of eligible inventory and a percentage of eligible accounts
receivable, each as defined in the FCC Loan Agreement.





The
Revolving Credit Facility has an initial termination date of June 23, 2010, with
one-year renewals thereafter, unless prior written notice is provided by either
party.  Continued availability of the Revolving Credit Facility is
subject to the Company’s compliance with customary financial and reporting
covenants.  As collateral for the Revolving Credit Facility, the
Company granted FCC a first priority security interest over all of the Company’s
assets, including, but not limited to, accounts receivable, inventory, and
equipment.





As of
December 31, 2008, the Company was not in compliance with three covenants under
the FCC Loan Agreement.  Effective as of January 31, 2009, FCC and the
Company executed a forbearance agreement related to the FCC Loan Agreement (the
“Forbearance Agreement”).  Pursuant to the terms of the Forbearance
Agreement, FCC agreed to forbear its rights and remedies under the FCC Loan
Agreement and related documents with respect to any existing defaults under the
FCC Loan Agreement (the “Existing Defaults”) until the earlier of June 30, 2009,
or the date of occurrence of a default other than the Existing
Defaults.  The Forbearance Agreement also increased the Company’s
ability to borrow against inventory and accounts receivable during the term of
the Forbearance Agreement (the “Additional Borrowing Capacity”).  In
return for FCC providing the forbearance period and the Additional Borrowing
Capacity, the Company agreed to pay FCC a $25,000 forbearance fee (in five
monthly installments), an amendment fee equal to 1.5% per month on the average
utilization of the Additional Borrowing Capacity, and issue to FCC a minimum of
250,000 warrants to purchase common stock of the Company at a purchase price of
$1.00 per share.  Simultaneously with the execution of the Forbearance
Agreement, Mr. Walker provided a $1 million guarantee against certain
liabilities under the FCC Loan Agreement.  As compensation for
providing the guarantee, the Company issued to Mr. Walker 50,000 warrants to
purchase common stock of the Company at a purchase price of $1.00 per
share.




27
 Table of Contents




On June
1, 2009, the Company, FCC, and Jack J. Walker, as guarantor, executed a Second
Forbearance Agreement, effective as of April 29, 2009 (the “Second Forbearance
Agreement”), in which FCC agreed to forbear from exercising its rights and
remedies under the Loan Agreement until June 30, 2009, if no further defaults
occurred.  The Second Forbearance Agreement also increased the advance
rate against inventory until July 1, 2009, and eliminated the Company’s
obligation to pay the monthly forbearance and amendment fees and to provide cash
flow projections.  In return, AeroGrow agreed to pay FCC a fee of
$60,000.  In connection with the Second Forbearance Agreement, FCC
permitted AeroGrow to borrow up to $800,000 more than would otherwise be
permitted by the applicable borrowing base calculation under the Loan Agreement,
with such additional borrowing to be repaid by June 30, 2009.  FCC did
not charge AeroGrow a fee for the additional borrowing capacity.





As of
July 1, 2009, FCC, AeroGrow, and Jack J. Walker, as guarantor, executed an
amendment to the FCC Loan Agreement (the “Third FCC Amendment”).  The
Third FCC Amendment reduced the maximum amount of the Revolving Credit Facility
to $8 million, re-set the covenant levels beginning July 1, 2009, and waived
existing defaults.  In addition, the Third FCC Amendment re-set the
formulas for determining the borrowing base against which the Company can
borrow.  The Third FCC Amendment also changed the definition of Base
Rate to the greater of (a) the Prime Rate, or (b) LIBOR plus 3.25%, and
increased the interest rate to Base Rate plus 4.0%.  The Third FCC
Amendment provides for a $30,000 success fee to be paid by the Company to FCC on
April 30, 2010.  In addition, the Third FCC Amendment replaces a
minimum borrowing fee with a fee calculated as 0.50% per annum of the daily
average unused portion of the Revolving Credit Facility, payable monthly in
arrears.  Finally, the Third FCC Amendment increased the annual
facility fee to 1.0% of the maximum amount of the Revolving Credit Facility,
from 0.75%.  The Company paid Mr. Walker a $25,000 fee as compensation
for providing the guarantee associated with the Third FCC
Amendment.  The Third FCC Amendment did not change the original due
date of June 23, 2010, with one year renewals, thereafter, unless prior written
notice is provided by either party.





On
October 8, 2009, the Company and FCC executed a temporary amendment to the FCC
Loan Agreement, effective as of September 30, 2009, that delayed a reduction in
the advance rate against inventory from 80% to 70%, originally scheduled to take
effect on October 1, 2009, until November 15, 2009.





As of
September 30, 2009, the Company was not in compliance with the minimum fixed
charge coverage covenant under the revised FCC Loan Agreement.  On November
19, 2009, FCC and the Company executed a Waiver Agreement to the FCC Loan
Agreement (the “Waiver Agreement”).  The Waiver Agreement waived the
covenant violations as of September 30, 2009.  FCC charged the Company a
$10,000 waiver fee.





As of
December 31, 2009, the Company was not in compliance with the minimum fixed
charge coverage and minimum tangible net worth covenants under the revised FCC
Loan Agreement.  As of February 15, 2010, the Company, FCC, and Jack J.
Walker, as guarantor, executed a Forbearance Agreement and Fourth Amendment,
(the “Fourth Amendment”), in which FCC agreed to forbear from exercising its
rights and remedies with regard to the Company’s non-compliance with financial
covenants until April 30, 2010, if no other defaults occurred.  The
Fourth Amendment increased the advance rate against eligible inventory from 50%
to 60% until April 30, 2010, and reduced the maximum amount of the Revolving
Credit Facility to $2.25 million until March 19, 2010, and then to $2.0 million
thereafter.  In connection with the Fourth Amendment, FCC permitted
AeroGrow to borrow up to $600,000 more than would otherwise be permitted by the
applicable borrowing base calculation under the Loan Agreement, with such
additional borrowing to be repaid by April 30, 2010.  The Fourth
Amendment provided for a $500 per day forbearance fee, with such fee to be
payable on the earlier of April 30, 2010 or the date on which loans under the
Revolving Credit Facility are repaid in full.  Simultaneous with the
execution of the Fourth Amendment, Mr. Walker provided a $1.5 million guarantee
against certain liabilities under the FCC Loan Agreement.





As of
December 31, 2009, loans totaling $2,818,837 were outstanding, including accrued
interest, under the Revolving Credit Facility.  Also as of December
31, 2009, there was approximately $240,000 in additional borrowing capacity
available under the Revolving Credit Facility.  As of February 17,
2010, there was a $1,538,792 loan balance outstanding under the Revolving Credit
Facility, and an estimated remaining availability of approximately
$710,000.  However, the amount available under the Revolving Credit
Facility varies from day to day, depending on the level of sales, accounts
receivable collections, and inventory on-hand levels.


Mainpower
Promissory Note





On June
30, 2009, the Company entered into a Letter Agreement (“Letter Agreement”) with
Main Power Electrical Factory, Ltd. (“MainPower”) and executed a Promissory
Note.  Pursuant to the terms of the Letter Agreement, MainPower agreed
to release the Company from $1,386,041 of existing accounts payable obligations
owed by the Company to MainPower in return for the Company executing the
Promissory Note for the same amount.  In addition, the Letter
Agreement included other provisions relating to the terms and conditions under
which AeroGrow must purchase AeroGarden products from MainPower.  The
Promissory Note has a final maturity of June 30, 2011, and carries an interest
rate of 8% per annum, with interest accrued and added to the principal amount of
the Promissory Note for the first year.  During the second year of the
Promissory Note, interest is due and payable quarterly.  Principal
payments of $150,000 are due and payable monthly beginning January 31, 2011,
with a final payment of all principal and accrued but unpaid interest due on
June 30, 2011.  As of December 31, 2009, the outstanding balance under
the Promissory Note totaled $1,442,502, including accrued interest.


28
 Table of Contents





Bridge
Financing





On August
28 through September 1, 2009, the Company entered into bridge financing
arrangements totaling $500,000 (the “Bridge Loans”) with six lenders (the
“Lenders”) as detailed in the table below.  The Bridge Loans are
unsecured, subordinated to loans made to the Company by FCC, and bear interest
at 15% per annum.  The Company issued 500,000 warrants to purchase
common shares of the Company to the Lenders.  Each of the warrants has
a five-year term and an exercise price of $0.25 per common share.





The
Bridge Loans were originally scheduled to mature on November 16, 2009; however,
no principal payments have been made by the Company to-date because FCC has not
provided the consent required under the terms of the intercreditor subordination
agreements executed by the Company, the Lenders, and FCC.  Interest
totaling $15,822 was paid to the Lenders during the three months ended December
31, 2009.  As of December 31, 2009, $509,247 was outstanding under the
Bridge Loans, including accrued interest.





Lender
            Current
      Relationship to the
      Company
            
            Bridge
      Loan Amount
            
            Date of Loan
            
            Warrants
      Issued to LenderLazarus
      Investment Partners LLLP
            Greater
      than 10% beneficial owner
            
            $
            250,000
            
            September
      1, 2009
            
            
            250,000Jack
      J. Walker
            Chairman
      and CEO, director, greater than 10% beneficial owner
            
            $
            100,000
            
            August
      28, 2009
            
            
            100,000Michael
      S. Barish
            Director,
      greater than 10% beneficial owner
            
            $
            75,000
            
            September
      1, 2009
            
            
            75,000Jervis
      B. Perkins
            Former
      Chief Executive Officer, current director, and greater than 10% beneficial
      owner
            
            $
            25,000
            
            August
      28, 2009
            
            
            25,000J.
      Michael Wolfe
            Chief
      Operating Officer and greater than 10% beneficial owner
            
            $
            25,000
            
            September
      1, 2009
            
            
            25,000H.
      Leigh Severance
            Greater
      than 10% beneficial owner
            
            $
            25,000
            
            September
      1, 2009
            
            
            25,000





Between
October 30 and November 9, 2009, the Company entered into additional bridge
financing arrangements totaling $580,000 (the “Additional Bridge Loans”) with
five lenders (the “Additional Lenders”) as detailed in the table
below.  The Additional Bridge Loans are unsecured, subordinated to
loans made to the Company by FCC, and mature on February 1, 2010, and bear
interest at 20% per annum.  The Company issued 580,000 warrants to
purchase common shares of the Company to the Additional Lenders.  Each
of the warrants has a five-year term and an exercise price of $0.25 per common
share.  One of the Additional Bridge Loans in the principal amount of
$180,000 is guaranteed by Jack J. Walker, the Company’s Chairman and
CEO.





The
Bridge Loans were originally scheduled to mature on February 1, 2010; however,
no principal payments have been made by the Company to-date because FCC has not
provided the consent required under the terms of the intercreditor subordination
agreements executed by the Company, the Lenders, and FCC.  No interest
had been paid to the Lenders as of December 31, 2009.  As of December
31, 2009, $597,973 was outstanding under the Bridge Loans, including accrued
interest.




29
 Table of Contents




Lender
            Current
      Relationship to the
      Company
            
            Bridge
      Loan Amount
            
            Date of Loan
            
            Warrants
      Issued to LenderLazarus
      Investment Partners LLLP
            Greater
      than 10% beneficial owner
            
            $
            200,000
            
            November
      9, 2009
            
            
            200,000Grad
      Wurn LLC
            None
            
            $
            180,000
            
            November
      1, 2009
            
            
            180,000Michael
      S. Barish
            Director,
      greater than 10% beneficial owner
            
            $
            100,000
            
            November
      4, 2009
            
            
            100,000Jervis
      B. Perkins
            Former
      Chief Executive Officer, current director, and greater than 10% beneficial
      owner
            
            $
            50,000
            
            October
      30, 2009
            
            
            50,000J.
      Michael Wolfe
            Chief
      Operating Officer and greater than 10% beneficial owner
            
            $
            50,000
            
            November
      5, 2009
            
            
            50,000








Series
A Convertible Preferred Stock





On June
30, 2009, the Company issued 6,836 shares of Series A Convertible Preferred
Stock (the “Series A Shares”) for aggregate consideration totaling
$6,250,341.  2,690 Series A Shares were issued in exchange for cash
invested into the Company totaling $2,690,000.  2,332 Series A Shares
were issued in exchange for the release of existing obligations of the Company
totaling $2,332,000.  1,642 Series A Shares were issued in exchange
for a combination of $950,000 in cash, 924,703 shares of the Company’s common
stock, and 462,352 warrants to purchase shares of the Company’s common
stock.  172 Series A Shares were issued in exchange for $172,000 in
short term notes receivable having maturities of 90 days or less.  In
addition, the Series A Shares were issued with a total of 3,414 warrants (the
“Warrants”) to purchase additional Series A Shares at an exercise price of
$1,250 per Series A Share.  The exercise period for the Warrants
expires five years from the date of issuance.





Between
October 16, 2009 and October 21, 2009, the Company issued 750 shares of Series A
Convertible Preferred Stock (the “Additional Series A Shares”) in exchange for
$599,979 in cash and 24,000 shares of the Company’s common
shares.  The Additional Series A Shares were issued with a total of
750 warrants (the “Additional Warrants”) to purchase Series A Shares at an
exercise price of $1,250 per Series A Share.  The exercise period for
the Additional Warrants expires five years from the date of
issuance.





The
Series A and Additional Series A Shares (the “Preferred Shares”) carry certain
rights, preferences, and designations, including the right to convert each
Preferred Share into 5,000 shares of the Company’s common stock.  Each
Preferred Share has an original issue price of $1,000.  The holders of
the Preferred Shares are entitled to receive cumulative dividends in preference
to any dividend on the Company’s common stock at the rate of 8% of the original
issue price per annum, and are entitled to participate pro rata in any dividends
paid on the Company’s common stock on as as-if-converted basis.  In
the event of a sale, liquidation, or other winding up of the Company, the
holders of the Preferred Shares are entitled to receive in preference to the
holders of the Company’s common stock a per share amount equal to the greater of
(i) 1.5 times the original issue price, plus any accrued but unpaid dividends or
(ii) the amount that the holder of a Preferred Share would otherwise receive in
such event on an as-converted to common stock basis.  The holders of
the Preferred Shares will vote along with holders of the Company’s common stock
on an as-if-converted basis.  Each Preferred Share shall have a number
of votes equal to the number of shares of the Company’s common stock then
issuable upon conversion of such Preferred Share.  In addition, the
holders of the Preferred Shares are entitled to elect three members of the
Company’s Board of Directors by an affirmative vote or consent of the holders of
at least a majority of the outstanding Preferred Shares, voting together as a
single class.  The Preferred shares also carry certain other rights,
including the right to block certain actions of the Company unless such actions
are approved by a vote of the holders of the Preferred Shares voting together as
a single class, anti-dilution provisions, and other rights and preferences
commonly associated with preferred shares.





The
issuance of the Preferred Shares was conducted in reliance upon exemptions from
registration under the Securities Act of 1933 (the “Securities Act”) including,
without limitation, those under Rule 506 of Regulation D (as promulgated under
the Securities Act).  The Preferred Shares were offered and sold only
to investors who are “accredited investors,” as defined in Rule 501 under the
Securities Act.





Cash
Requirements





The
Company generally requires cash to:





·
            fund
      our operations and working capital
requirements,


·
            develop
      and execute our product development and market introduction
      plans,


·
            execute
      our sales and marketing plans,


·
            fund
      research and development efforts,
and


·
            pay
      for debt obligations as they come
due.




30
 Table of Contents





We expect
to fund these and other cash requirements with cash provided by operations, our
Revolving Credit Facility, and other debt facilities, as well as with existing
cash.  At this time, based on a variety of assumptions including, but
not limited to, the level of customer and consumer demand, the impact of cost
reduction programs, and the state of the general economic environment in which
we operate, we believe we will need additional funding to successfully operate
our business over the near term.  As a result, we have engaged aninvestment
banker to assist us in exploring strategic alternatives to address our funding
requirements, with a goal of raising new long-term capital in a range of $5 to
$10 million.  We are currently seeking to secure the additional
funding; however, there can be no assurance that we will be able to raise
sufficient funds, or on a timely basis, to meet all our cash
requirements.





We cannot
predict with certainty the cash and other ongoing operational requirements for
our proposed plans as market conditions, competitive pressures, regulatory
requirements, and customer requirements can change rapidly.  If we are
unable to generate cash from operations at currently estimated levels, or if our
access to new borrowings under our debt agreements is constrained, or if we
cannot raise the additional funds we deem to be necessary, our ability to
operate at projected levels will be adversely impacted.  In such an
event, we will take such actions as we can to address any liquidity shortfall,
including but not limited to spending reductions, cash management actions, and
operational curtailments; however, there can be no assurance that such actions
will be sufficient to allow us to meet our cash requirements.





At this
time, we do not expect to enter into additional capital leases to finance major
purchases.  At present, we have no binding commitments with any third
parties to obtain any material amount of equity or debt financing other than the
financing arrangements described in this report.  The terms,
conditions, and timing of any future transactions have not been conclusively
determined.





Assessment
of Future Liquidity and Results of Operations





Liquidity.  To assess
our ability to fund ongoing operating requirements, we developed assumptions
regarding our business plan, projected operating cash flow, anticipated capital
expenditures, and availability under our various existing credit
facilities.  Critical sources of funding, and key assumptions and
areas of uncertainty include:





·
            our
      cash of $991,970 ($438,507 of which is restricted as collateral for
      letters of credit and other corporate obligations) as of December 31,
      2009,


·
            approximately
      $1.1million in short-term, unsecured bridge financing that are currently
      due.  Under the terms of an intercreditor subordination
      agreement between the Company, the bridge lenders, and FCC, we are
      currently unable to make scheduled payments against these loans, without
      the consent of FCC.  Such consent has not been
      provided.


·
            approximately
      $500,000 in short term debt to FNB that is currently due.  Under
      the terms of an intercreditor subordination agreement between the Company,
      FNB, FCC, and Jack J. Walker, we are currently unable to make scheduled
      payments against this loan without the consent of FCC.  Such
      consent has not been provided.  Under the terms of the
      intercreditor subordination agreement, FNB is prohibited from exercising
      any rights or remedies with respect to AeroGrow or any collateral until
      such time as the FCC Revolving Credit Facility has been paid in
      full.


·
            the
      continued availability of funding from the Revolving Credit Facility and
      our other existing credit facilities to supplement our
      internally-generated cash flow.  As of February 17, 2010, we had
      approximately $710,000 available under the Revolving Credit
      Facility.  The amount available under the revolving credit
      facility varies from day to day, depending on the level of sales, accounts
      receivable collections, and inventory on-hand
  levels,


·
            continued
      support of, and extensions of credit by, our suppliers and
      lenders,


·
            our
      anticipated sales to retail customers, international distributors, and
      consumers, including the fact that we have historically experienced
      increased sales during the holiday season (September through December) and
      lower sales volume from January through
August,


·
            the
      anticipated level of spending to support our planned initiatives,
      and


·
            our
      expectations regarding cash flow from
  operations.





The
Revolving Credit Facility is subject to covenants and limitations that require
us to maintain compliance with specified operating and financial
covenants.  Although our lender agreed to forbear its rights and
remedies with respect to our non-compliance with these covenants through April
31, 2010, there can be no assurance that we will regain compliance with these
covenants over time, or that our lender will waive or forbear its rights and
remedies with respect to any future violations, especially if our borrowings
increase or our operating results are not sufficient to cover our fixed
financing payments.


We
believe that we need to find additional sources of funding to support our
operating requirements and fund investments to grow our business for the
future.  Through our financial intermediary we are seeking additional
capital investments from potential investors to fund our
requirements.  However, there can be no assurance that we will be able
to raise additional capital in a sufficient amount or on a timely enough basis
to meet our operating requirements.  In the event we are unable to
raise new long-term capital, we estimate the Company’s existing sources of
liquidity may be sufficient to fund our operations, as currently structured, for
approximately the next three to four months.  If faced with an
inability to raise new long-term capital, we would attempt to restructure our
business to reduce the capital resources required to support our continued
operations.  However, there can be no assurances that such actions
would be undertaken on a sufficiently timely basis, or would ultimately be
successful in re-sizing the Company’s operational requirements to the available
resources.




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Results of Operations. 
There are several factors that could affect our future results of
operations.  These factors include, but are not limited to, the
following:





·
            sell-through
      of our products by our retailer customers to consumers, and the consequent
      impact on expected re-orders from our retailer
  customers,


·
            uncertainty
      regarding the impact of macroeconomic conditions on the retail market and
      on consumer spending,


·
            uncertainty
      regarding the impact of macroeconomic conditions, particularly with regard
      to the capital markets, and our access to sufficient capital to support
      our current and projected scale of
  operations,


·
            the
      effectiveness of our consumer-focused marketing efforts in generating both
      direct-to-consumer sales, and sales to consumers by our retailer
      customers,


·
            the
      seasonality of our business, in which we have historically experienced
      higher sales volume during the holiday season (October through December),
      and


·
            sufficient
      capacity to meet demand and a continued, uninterrupted supply of product
      from our third-party manufacturing suppliers in
  China.





The
factors noted above regarding results of operations could impact our expected
financial results, either positively or negatively.


Off-Balance
Sheet Arrangements





We have
certain current commitments under capital leases and have not entered into any
contracts for financial derivative such as futures, swaps, and
options.  We do not believe that these arrangements are material to
our current or future financial condition, results of operations, liquidity,
capital resources or capital expenditures.


Item 3. Quantitative and Qualitative
Disclosures About Market Risk





Interest
Rate Risk





Our
interest income is most sensitive to fluctuations in the general level of U.S.
interest rates. As such, changes in U.S. interest rates affect the interest
earned on our cash, cash equivalents, and short-term investments, and the value
of those investments.  Due to the short-term nature of our cash
equivalents and investments, we have concluded that a change in interest rates
does not pose a material market risk to us with respect to our interest income.
The interest payable to our lenders is determined in part based on variable
interest rates and, therefore, is affected by changes in market interest rates.
Interest rates on our capital leases are dependent on interest rates in effect
at the time the lease is drawn upon.  Total liabilities outstanding at
December 31, 2009 under our credit facilities and capital leases were
approximately $6 million.  Based on amounts borrowed as of
December 31, 2009, we would have a resulting decline in future annual earnings
and cash flows of approximately $60,000 for every one percentage point increase
in our lending rates.


Foreign
Currency Exchange Risk





We
transact business primarily in U.S. currency.  Although we purchase
our products in U.S. dollars, the prices charged by our Chinese factories are
predicated upon their cost for components, labor, and overhead. Therefore,
changes in the valuation of the U.S. dollar in relation to the Chinese currency
may cause our manufacturers to raise prices of our products, which could reduce
our profit margins.





In future
periods over the long term, we anticipate we will be exposed to fluctuations in
foreign currency exchange rates on accounts receivable from sales in these
foreign currencies and the net monetary assets and liabilities of the related
foreign subsidiary.





Item 4. Controls and
Procedures





(a)
Evaluation of Disclosure Controls and Procedures





Disclosure
controls and procedures are designed to ensure that information required to be
disclosed in the reports filed or submitted by the Company under the Exchange
Act, is recorded, processed, summarized, and reported, within the time periods
specified in the rules and forms of the SEC.  Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed in the reports filed under the
Exchange Act is accumulated and communicated to the Company’s management,
including its principal executive and financial officer, as appropriate, to
allow timely decisions regarding required disclosure.


32
 Table of Contents




The
Company carried out an evaluation, under the supervision and with the
participation of its management, including its principal executive officer and
principal financial officer, of the effectiveness of the design and operation of
the Company’s disclosure controls and procedures as of the end of the period
covered by this report. Based upon and as of the date of that evaluation, the
Company’s principal executive officer and financial officer concluded that the
Company’s disclosure controls and procedures are effective to ensure that
information required to be disclosed in the reports the Company files and
submits under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in the SEC’s rules and forms.





(b)
Changes in Internal Controls





There
were no changes in the Company’s internal controls or in other factors that
could have significantly affected those controls during the three months ended
December 31, 2009.




PART
II - OTHER INFORMATION





Item 1. Legal Proceedings





None





Item 1A. Risk Factors





Our
business, future performance and forward-looking statements are affected by
general industry and market conditions and growth rates, general U.S. and
non-U.S. economic and political conditions (including the global economy),
competition, interest rate and currency exchange rate fluctuations and other
events.  The following items are representative of the risks,
uncertainties and other conditions that may impact our business, future
performance and the forward-looking statements that we make in this report or
that we may make in the future.


Risks
Related to our Business, Products and Markets





We
will need additional capital to fund our future operations and we may not be
able to obtain the amount of capital required, particularly when the credit and
capital markets are unstable.





During
the nine months ended December 31, 2009, we issued an aggregate of $6,684,536 of
Series A Convertible Preferred stock and incurred $1,080,000 of bridge financing
to address our immediate short-term liquidity needs, fund prior operating losses
and provide capital to support business operations.  In addition,
during June 2009 we converted certain accounts payable totaling approximately
$1.4 million to long-term debt, amended our working capital financing agreement
and negotiated concessions with certain of our accounts payable creditors with
regard to payment timing and amounts due.   (See Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of
Operation – Liquidity and Capital Resources, and Note 4 – Long Term Debt and
Current Portion – Long Term Debt and Note 8 – Stockholders’ Equity in the
accompanying Financial Statements for additional details.)





We will
require additional capital to support our business and cover operational
expenses.  It is possible that none of our outstanding warrants and
options will be exercised and we will therefore not receive additional capital
from these sources.  We currently rely upon our senior secured
revolving credit facility to support our operations.  Because we are
not currently in compliance with certain debt covenants in our FCC Loan
Agreement and Revolving Credit Facility, it is possible that our access to
funding from this facility could be curtailed.  We are actively seeking
waivers and/or extensions to our forbearance agreement with FCC. We may need to
issue equity, debt, or securities convertible into equity, which are likely to
rank senior to our common stock and to dilute the current stock ownership in
AeroGrow.  If we are unable to raise additional capital, or cannot
raise capital on acceptable terms, we may not have sufficient capital to operate
our business as planned and would have to modify our business plan or curtail
some or all of our operations.





Because
we have a limited operating history, we may not be able to successfully manage
our business or achieve profitability.





We have a
limited operating history upon which to base an evaluation of our prospects and
the potential value of our common stock.  Since commencing operations
in 2002, we have not achieved profitability in any fiscal year.  We
are confronted with the risks inherent in an early stage company, including
difficulties and delays in connection with the production and sales of our
indoor garden systems, reliance on a small number of products and manufacturers,
operational difficulties, and difficulty in estimating future sales, production
requirements and costs, and administrative costs.  If we cannot
successfully manage our business, we may not be able to generate future profits
and may not be able to support our operations.  We are likely to incur
additional expenses and losses in the further implementation of our business
plan.  We may not be able to improve operations and therefore may
never become profitable.





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 Table of Contents




We
have incurred substantial losses since inception and may never achieve
profitability.





Since we
commenced operations in 2002, and through December 31, 2009, we incurred
substantial losses, including a net loss of $3,537,653 for the nine month period
ended December 31, 2009.  As of December 31, 2009, our losses have
resulted in an accumulated deficit of $53,479,251.  The future success
of our business will depend on our ability to profitably expand sales and
distribution of our AeroGarden indoor garden systems, seed kits and accessory
products to consumers, and develop new product extensions and
applications.





We are
subject to many of the risks common to developing enterprises, including
undercapitalization, cash shortages, limitations with respect to financial and
other resources, and insufficient revenue to be self-sustaining. There is no
assurance that we will ever attain profitability.





A
worsening of the United States economy could materially adversely affect our
business.





The
success of our business operations depends significantly on consumer confidence
and spending, which have deteriorated as a result of the worldwide economic
downturn.  This economic downturn and decrease in consumer spending
may adversely impact our revenue, ability to market our products, build customer
loyalty, or otherwise implement our business strategy.  If the current
economic situation persists, or deteriorates significantly, our business could
be negatively impacted.





Our
sales to retailer customers are highly concentrated in a small number of major
retail chains in the United States and Canada.  The loss of one or
more of these customers could have a material adverse impact on our
business.





In the
fiscal year ended March 31, 2009 and the nine month period ended December 31,
2009, approximately 61% and 45%, respectively, of our net sales were to retailer
customers.  Of these sales, approximately 30% represented sales to the
top three retailer customers.  The loss of one or more of these
customers, or a significant decline in orders from one or more of these
retailers could materially affect our sales of indoor garden systems, seed kits
and accessories, and therefore have a material adverse impact on our business
and our financial results.





We
have recently shifted the focus of our business strategy toward the
direct-to-consumer sales channels.  Failure to successfully develop our
position in these channels could have an adverse impact on our future results of
operations.


On
January 15, 2010, we announced a strategic shift to increase our focus on the
direct-to-consumer business channels.  We intend to dedicate a larger
proportion of our capital and human resources to develop these channels. 
Successfully growing these channels will require that we invest in
revenue-generating media to attract new customers, effectively target our
marketing messages to consumers, and develop ongoing relationships with
consumers through excellence in our fulfillment, shipping and customer service
operations.  There can be no assurance that we will be successful in
achieving these requirements, or that we can do so on a timely basis.  In
the event we do not succeed in developing the direct-to-consumer channels as we
intend, there could be a material adverse impact on our future results of
operations.


A
significant portion of our sales are to retailers, many of which have been
adversely impacted by the deterioration in economic conditions and the
consequent impact on consumer spending.





In the
fiscal year ended March 31, 2009 and the nine month period ended December 31,
2009, approximately 61% and 45%, respectively, of our net sales were to retailer
customers.  Our business plan anticipates continued sales through this
distribution channel.  Uncertainty about the current and future global
economic conditions may cause consumers and retailers to defer purchases,
attempt to return inventory, or cancel purchase orders for our products in
response to tighter credit, decreased cash availability and declining consumer
confidence.  In the event that certain retailers are adversely
impacted by the current economic downturn, re-structure their business
operations to reduce costs and capital investment, or choose to reduce the
breadth of their product offering, our sales could be adversely
affected.





Our
future depends on the success of our indoor garden systems, seed kits and
accessory products. We do not know if our indoor garden systems, seed kits and
accessory products will generate consumer acceptance on a broader
scale.





We have
introduced our indoor garden systems and seed kits as new products to consumer
markets unfamiliar with their use and benefits.  Although we believe
that we have penetrated only a small portion of the potential market for our
products, we cannot be certain that our products will generate widespread
consumer acceptance. If consumers do not purchase our products in sufficient
numbers, we will not be profitable.




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 Table of Contents





If
we are unable to recruit, train and retain key personnel necessary to operate
our business, our ability to successfully manage our business and develop and
market our products may be harmed.





To
maintain our business position, we will need to attract, retain, and motivate
highly skilled design, development, management, accounting, sales,
merchandising, marketing, and customer service personnel.  Competition
for many of these types of personnel can be intense, depending on general
economic conditions, alternative employment options, and job
location.  As a result, we may be unable to successfully attract or
retain qualified personnel. Additionally, any of our officers or employees can
terminate their employment with us at any time. The loss of any key employee, or
our inability to attract or retain other qualified employees, could harm our
business and results of operations.





As
a result of the economic downturn, decline in consumer spending and the
consequent impact on the sales of our products, we restructured our operations
and implemented a substantial workforce reduction.  These actions
could adversely impact the morale and performance of our remaining employees and
our ability to hire new personnel.





Our
business was adversely impacted by the deterioration in the global economy and
the consequent impact on our various channels of distribution.  We
restructured our business operations in order to re-size our overhead costs and
streamline our distribution, fulfillment, and manufacturing
operations.  This resulted in a substantial decrease in the number of
our full-time employees.  These restructuring actions and headcount
reductions could have unintended impacts on our remaining employees, could lead
to a decline in employee morale, and could lead to a loss of additional
personnel over and above the level desired  by the
Company.  In the event of such employee attrition, we may not be able
to replace the lost personnel on a timely basis, or with individuals having the
same level of skills.  In either case, our operations and our
financial performance could be adversely impacted.





Our
marketing strategies may not be successful, which would adversely affect our
future revenue and profitability.





Our
future revenue and profitability depend on the successful marketing of our
indoor garden systems.  We cannot give assurance that consumers will
continue to be interested in purchasing our products.  We use direct
consumer marketing, including television commercials, infomercials, catalogue,
magazine and newspaper advertising, and the Internet. In addition, we
collaborate with our retailer customers to market our products to
consumers.  If our marketing strategies fail to attract customers, our
product sales will not produce future revenue sufficient to meet our operating
expenses or fund our future operations.





Our
current or future manufacturers could fail to fulfill our orders for indoor
garden systems, which would disrupt our business, increase our costs, and could
potentially cause us to lose our market.





We
currently depend on three contract manufacturers in China to produce our indoor
garden systems.  These manufacturers could fail to produce the indoor
garden system to our specifications or in a workmanlike manner and may not
deliver the systems on a timely basis.  Our manufacturers must also
obtain inventories of the necessary parts and tools for
production.  We own the tools and dies used by our
manufacturers.  Our manufacturers operate in China and may be subject
to business risks that fall outside our control, including but not limited to,
political, currency, and regulatory risks, each of which may affect the
manufacturer’s ability to fulfill our orders for indoor garden systems. In
addition, weather or natural disasters in China could disrupt our supply of
product.  Any change in manufacturers could disrupt our ability to
fulfill orders for indoor garden systems. Any change in manufacturers could
disrupt our business due to delays in finding a new manufacturer, providing
specifications, and testing initial production.


Our
revenue and level of business activity are highly seasonal, requiring us to
staff our operations, incur overhead and marketing costs, purchase and
manufacture inventory, and incur other operating costs in advance of having firm
customer orders for our products.  A material variance in actual
orders relative to anticipated orders could have an adverse impact on our
business.





For the
fiscal year ended March 31, 2009, approximately 55% of our total net sales
occurred during the last four calendar months (September –
December).  During the nine months ended December 31, 2009,
approximately 56% of our total net sales occurred during the last three calendar
months.  We must estimate sales in advance of these peak months and
operate our business during the balance of the year in such a way as to insure
that we can meet the demand for our products during the peak
months.  This requires us to incur significant operating, marketing,
and overhead expenses, and to utilize cash and other capital resources to invest
in inventory in advance of having certainty as to the ultimate level of demand
for our product during the peak months.  Significant variations in
actual demand for our products during the peak months relative to our forecast
could result in our sales being limited by lack of product, our not achieving a
sufficient level of sales to cover expenses incurred throughout the balance of
the year, or in our having excess inventory to liquidate at potentially lower
margins.  In any of these cases, there could be a material adverse
impact on our financial performance.





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 Table of Contents





We
are highly reliant upon a single company-operated distribution and manufacturing
facility.  Any material disruption to the operation of this facility
could adversely affect our business.





In July
2008 we opened a company-operated distribution and fulfillment center in
Indianapolis, Indiana to supplement our existing third-party logistics
providers.  Since then, our facility in Indianapolis has become our
primary distribution and fulfillment center for the United States and Canada,
with the majority of our shipment volume expected to be handled through this
facility in our fiscal year ending March 31, 2010.  In February 2009
we re-located our seed kit manufacturing operations to the facility in
Indianapolis from its previous location in Longmont, Colorado.  We now
manufacture all of our seed kits in the Indianapolis facility.  Any
material disruption to the operation of this facility, whether caused by
internal or external factors, could have a material adverse impact on our
business and financial performance.





We
rely on third party providers in our manufacturing, warehouse, distribution,
order processing, and fulfillment operations. If these parties are unwilling to
continue providing services to us, or are unable to adequately perform such
services for us on a cost effective basis, our business could be materially
harmed.





We engage
third parties to perform many critical functions supporting our business
operations.  Any disruption in our relationship with any of our
vendors could cause significant disruption to our business and we may not be
able to locate another party that can provide comparable services in a timely
manner or on acceptable commercial terms.  In addition, no assurance
can be made that these relationships will be adequate to support our business as
we follow our business plan.





Our
intellectual property and proprietary rights give us only limited protection,
and can be expensive to defend.





Our
ability to produce and sell indoor garden systems exclusively depends in part on
securing patent protection for the components of our systems, maintaining
various trademarks, and protecting our operational trade secrets. To protect our
proprietary technology, we rely on a combination of patents pending (and if
granted, patents), trade secrets, and non-disclosure agreements, each of which
affords only limited protection. We own the rights to 17 United States and
international patent applications. However, these patent applications may not
result in issued patents and even issued patents may be challenged. We are
selling our indoor garden systems prior to receiving issued patents relating to
our patent applications.  All of our intellectual property rights may
be challenged, invalidated, or circumvented.  Claims for infringement
may be asserted or prosecuted against us in the future and we may not be able to
protect our patents, if any are obtained, and intellectual property rights
against others. Our former employees or consultants may violate their
non-disclosure agreements, leading to a loss of proprietary intellectual
property.  We could also incur substantial costs to assert our
intellectual property or proprietary rights against others.


We
may face significant competition, and if we are unable to compete effectively,
our sales may be adversely affected.





We
believe that our complete indoor garden systems offer significant benefits over
traditional hydroponic industry products.  There are companies in a
variety of related markets including but not limited to, consumer electronics,
commercial hydroponics, gardening wholesale, and soil-based gardening that are
larger, better funded, have more recognizable brand names, and have experience
in our channels of distribution.  These companies could potentially
decide to develop products to compete with our products. These companies could
use hydroponic technologies, and could achieve better consumer
acceptance.  The success of any competing products may adversely
impact us.





Increases
in energy prices, resulting from general economic conditions, or other factors,
may raise our cost of goods sold and adversely affect our business, results of
operations and financial condition.





Energy
costs, especially gasoline and fuel costs, are significant expenses in the
delivery of our products. Increased costs resulting from general economic
conditions, acts of nature, or other factors, may result in declining margins
and operating results if market conditions prevent us from passing these
increased costs on to our customers through timely price increases on our
products.





Our
current or future manufacturers are located in China and therefore our product
costs may be subject to fluctuations in the value of the dollar against the
Chinese currency.





Although
we purchase our AeroGarden products in U.S. dollars, the prices charged by our
factories are predicated upon their cost for components, labor and overhead.
Therefore, changes in the valuation of the U.S. dollar in relation to the
Chinese currency may cause our manufacturers to raise prices of our products
which could reduce our profit margins.





If
our indoor garden systems fail to perform properly, our business could suffer
with increased costs and reduced income.





We have
sold over 936,000 AeroGardens since our inception and have provided a limited
warranty with each garden sold.  In addition, our indoor garden
systems are “guaranteed to grow.”  We therefore may be required to
replace or repair products or refund the purchase price to
consumers.  Failure of our products to meet expectations could damage
our reputation, decrease sales, increase costs related to returns and repairs,
delay market acceptance of our products, result in unpaid accounts receivable,
and divert our resources to remedy the malfunctions.  The occurrence
of any of these events would have an adverse impact on our results of
operations.




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 Table of Contents





From
time to time, we may be subject to litigation that, if decided adversely to us,
could have a material adverse impact on our financial condition.





From time
to time, we are a party to various litigation matters, in most cases involving
ordinary and routine claims incidental to our business.  We cannot
estimate with certainty our ultimate legal and financial liability with respect
to any such pending litigation matters.  However, we believe, based on
our examination of such matters, that our ultimate liability, if any, will not
have a material adverse effect on our financial position, results of operations
or cash flows.





In
connection with the Linens ‘N Things (“LNT”) bankruptcy proceedings, a Complaint
to Avoid and Recover Preferential Transfers was filed by LNT in the United
States Bankruptcy Court for the District of Delaware on April 20, 2009 (the
“Complaint”).  The Complaint alleges that, pursuant to Sections 547
and 550 of the United States Bankruptcy Code, we are required to return to LNT
approximately $623,000 in “preferential” transfers allegedly made to AeroGrow
during the 90-day period preceding the filing of the LNT bankruptcy cases. The
Complaint also alleges that AeroGrow is required to pay to LNT approximately
$44,000 on account of credits allegedly earned but not redeemed by LNT prior to
the filing of the LNT bankruptcy cases.  We engaged outside counsel
and filed a response to the Complaint on May 8, 2009 disputing that we have any
obligation to either return the “preferential” transfers allegedly made, or to
pay the credits allegedly earned, to LNT.  As of December 31, 2009, an
estimate has been accrued in our balance sheet and consolidated statement of
operations in anticipation of the cost of defending, or settling, this
matter.  We believe we have a number of strong potential defenses to
all of the claims made in the Complaint and therefore do not expect that the
resolution of this matter will have a material adverse effect on
us.  However, we cannot at this time predict with certainty the
outcome of this matter.  If the Complaint were to be decided in a
manner adverse to us, which, if it were to occur, at a minimum is not expected
to occur during the fiscal year ended March 31, 2010, it could materially
adversely impact our results of operations for that period in which the
Complaint is finally decided.





Risks
Related to the Market for our Securities





The
market price of our shares may fluctuate greatly. Investors in AeroGrow bear the
risk that they will not recover their investment.





Effective
as of May 4, 2009, our common stock ceased to be listed on The Nasdaq Stock
Market and is now traded on the OTC Bulletin Board.  Currently,
trading in our common stock is limited, and the price per share is likely to be
influenced by the price at which and the amount of shares the selling security
holders are attempting to sell at any time.  This could have the
effect of limiting the trading price or lowering the market price to the selling
security holders’ offering prices.  Common stock such as ours is also
subject to the activities of persons engaged in short selling securities, which
generally has the effect of driving the price down. In addition, the common
stock of emerging growth companies is typically subject to high price and volume
volatility. Therefore, the price of our common stock has fluctuated, and may
continue to fluctuate, widely.  A full and stable trading market for
our common stock may never develop and, as a result, stockholders may not be
able to sell their shares at the time they elect, if at all.


There
may be substantial sales of our common stock by existing security holders which
could cause the price of our stock to fall.





Future
sales of substantial amounts of our common stock in the public market or the
perception that such sales might occur, could cause the market price of our
common stock to decline and could impair the value of an investment in our
common stock and our ability to raise equity capital in the
future.





Sales of
our common stock by security holders, or even the appearance that such holders
may make such sales, may limit the market for our common stock or depress any
trading market volume and price before other investors are able to sell the
common stock.  Moreover, a number of shareholders have held their
investment for a substantial period of time and may desire to sell their shares,
which could drive down the price of our common stock.





We can issue debt securities and
shares of preferred stock without stockholder approval, which could adversely
affect the rights of common stockholders.





Our
Articles of Incorporation allow our Board of Directors to approve the terms and
conditions of debt securities and preferred stock for issuance by the Company,
including but not limited to voting rights, conversion privileges and
liquidation preferences, without the approval of common
stockholders.  The rights of the holders of our common stock may be
adversely impacted as a result of the rights that could potentially be granted
to holders of debt securities or preferred stock that we may issue in the
future.  In addition, there could be an impact on the price of our
common stock because of the potential impact on the rights of common
shareholders resulting from future issuances of debt or preferred
stock.




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Our
outstanding warrants, options and additional future obligations to issue our
securities to various parties, may dilute the value of an investment in AeroGrow
and may adversely affect our ability to raise additional capital.





As of
December 31, 2009, we were committed to issue up to 9,115,532 additional shares
of common stock under the terms of outstanding warrants, options and other
arrangements as detailed in Note 5 – Equity Compensation Plans and Note 8 –
Stockholders’ Equity in the accompanying Financial Statements.





In
addition, during the nine months ended December 31, 2009 we issued an aggregate
of 7,586 shares of Series A Convertible Preferred stock giving the holders the
right to convert their preferred shares into a total of 37,930,000 common shares
of AeroGrow.  The preferred shareholders also received 4,164 warrants
to purchase additional preferred shares that could be converted into 20,820,000
shares of AeroGrow common stock.  Furthermore, during the nine months
ended December 31, 2009, we incurred $1,080,000 in bridge financing in which we
also issued warrants to purchase an additional 1,080,000 shares of AeroGrow
common stock.  See Management’s Discussion and Analysis of Financial
Condition – Liquidity and Capital Resources and Note 8 – Stockholders’ Equity in
the accompanying Financial Statements).





For the
length of time the warrants, options and preferred shares are outstanding, the
holders will have an opportunity to profit from a rise in the market price of
our common stock without assuming all the risks of common share ownership. This
may adversely affect the terms upon which we can obtain additional
capital.  The holders of such derivative securities would likely
exercise or convert them at a time when we would be able to obtain equity
capital on terms more favorable than the exercise or conversion prices provided
by the notes, warrants or options.


Further,
future sales of substantial amounts of these shares, or the perception that such
sales might occur, could cause the market price of our common stock to decline
and could impair the value of an investment in our common stock and our ability
to raise equity capital in the future.





During
the nine months ended December 31, 2009, we issued an aggregate of $6,684,536
Series A Convertible Preferred securities.  The terms and conditions
of these securities could significantly impact the price of our common shares,
and could adversely impact our ability to raise additional equity
capital.





The
holders of our Series A Convertible Preferred shares (the “Preferred
Shareholders”) have the right to convert each of their shares and warrants into
5,000 common shares of AeroGrow.  In addition, the Preferred
Shareholders have the right to vote their shares on an as-converted basis on all
matters voted on by common shareholders.  The Preferred Shareholders
also have the right to elect three Directors of AeroGrow, voting as a separate
class.  As a result of these rights, the Preferred Shareholders have
effective control over AeroGrow and its governance.  In addition, the
Preferred Shareholders possess certain rights that give them preferences
relative to common shareholders in the event of a sale or liquidation of the
Company.  It is possible that the Preferred Shareholders could take
actions that could adversely impact the value of investments in common shares of
the Company.  In addition, the control position of the Preferred
Shareholders, as well as other anti-dilution rights held by the Preferred
Shareholders, could adversely impact our ability to raise capital in the
future.  (For more detail on the Series A Convertible Preferred
securities, see Item 2. Management’s Discussion and Analysis of Financial
Condition – Liquidity and Capital Resources and Note 8 – Stockholders’ Equity in
the accompanying Financial Statements.)





If
an exemption from registration on which we have relied for any of our past
offerings of common stock or warrants are challenged legally, our principals may
have to spend time defending claims, and we would then risk paying expenses for
defense, rescission, and/or regulatory sanctions.





To raise
working capital, we offered common stock and warrants in private transactions
that we believed to be exempt from registration under the Securities Act and
state securities laws.  In 2004 we conducted a state-registered
offering in Colorado of common stock and warrants, intended to be exempt from
registration under the Securities Act as an intrastate
offering.  However, because we are incorporated in Nevada, the
offering did not satisfy all of the requirements for an intrastate
offering.  This could result in investors or regulators asserting that
the Colorado offering and/or private offerings subsequent to the Colorado
offering (if the private offerings were integrated with the Colorado offering)
violated the Securities Act. There can be no assurance that investors or
regulators will not be successful in asserting a claim that these transactions
should not be integrated. In the event that one or more investors seeks
rescission, with resulting return of investment funds and interest at a market
rate, or that state or federal regulators seeks sanctions against us or our
principals, we would spend time and financial resources to pay expenses for
defense, rescission awards, or regulatory sanctions. The use of funds would
reduce the capital available to operate our business. No assurance can be given
regarding the outcome of any such actions.


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Item 2. Unregistered Sales of Equity Securities and Use of
Proceeds





Information
regarding the sale of unregistered equity securities, including Series A
Convertible Preferred Stock and warrants to purchase common stock (collectively,
the “Unregistered Transactions”), during the quarter ended December 31, 2009 has
been previously disclosed in Current Reports on Form 8-K filed on October 22,
2009, November 5, 2009, and November 10, 2009.  Refer also to Note 8
“Stockholders’ Equity” to the Condensed Financial Statements.  The
Unregistered Transactions were conducted in reliance upon exemptions from
registration under  the Securities Act of 1933, as amended (the
“Securities Act”), including, without limitation, those under Rule 506 of
Regulation D (as promulgated under the Securities Act).  The Unregistered
Transactions were offered and sold only to investors who are “accredited
investors,” as defined in Rule 501 under the Securities Act.  Proceeds from
the Unregistered Transactions will be used for general corporate purposes,
including but not limited to the payment of fixed expenses, refinancing existing
debt arrangements, and payments to vendors of goods and services.





Item 3. Defaults Upon Senior Securities





None.





Item 4. Submission of Matters to a Vote of Security
Holders





None.





Item 5. Other Information





None.






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Item 6. Exhibits


3.1
              Articles
      of Incorporation of the Company (incorporated by reference to Exhibit 3.1
      of our Current Report on Form 8-K/A-2, filed November 16,
      2006).3.2
              Certificate
      of Amendment to Articles of Incorporation, dated June 25, 2002
      (incorporated by reference to Exhibit 3.2 of our Current Report on Form
      8-K/A-2, filed November 16, 2006).3.3
              Certificate
      of Amendment to Articles of Incorporation, dated November 3, 2002
      (incorporated by reference to Exhibit 3.3 of our Current Report on Form
      8-K/A-2, filed November 16, 2006).3.4
              Certificate
      of Change to Articles of Incorporation, dated January 31, 2005
      (incorporated by reference to Exhibit 3.4 of our Current Report on Form
      8-K/A-2, filed November 16, 2006).3.5
              Certificate
      of Amendment to Articles of Incorporation, dated July 27, 2005
      (incorporated by reference to Exhibit 3.5 of our Current Report on Form
      8-K/A-2, filed November 16, 2006).3.6
              Certificate
      of Amendment to Articles of Incorporation, dated February 24, 2006
      (incorporated by reference to Exhibit 3.6 of our Current Report on Form
      8-K/A-2, filed November 16, 2006).3.7
              Amended
      and Restated Bylaws (incorporated by reference to Exhibit 3.1 of our
      Current Report on Form 8-K, filed September 26,
  2008).3.8
              Amendment
      to Bylaws (incorporated by reference to Exhibit 3.9 of our Form 10-K for
      the fiscal year ended March 31, 2009, filed on July 6,
    2009).3.9
              Certificate
      of Designations of Series A Convertible Preferred Stock (incorporated by
      reference to Exhibit 3.7 of our Annual Report on Form 10-K for the fiscal
      year ended March 31, 2009, filed July 6, 2009).4.1
              Form
      of Common Stock Warrant (incorporated by reference to Exhibit 4.1 of our
      Current Report on Form 8-K, filed September 5, 2007).4.2
              Form
      of Series A Preferred Stock Warrant (incorporated by reference to Exhibit
      4.19 of our Annual Report on Form 10-K, filed July 6,
    2009).10.1*
              Temporary Amendment to the Loan and Security Agreement
      between FCC, LLC, d/b/a First Capital, the Company, and Jack J. Walker as
      Guarantor, effective as of September 30, 2009.10.2*
              Form of Promissory Note (Bridge Loan) between the
      Company and Lazarus Investment Partners LLLP, Michael S. Barish, Jervis B.
      Perkins and J. Michael Wolfe (dated October 30, 2009 through November 5,
      2009).10.3*
              Form of Promissory Note (Bridge Loan) between the
      Company and Grad Wurn LLC, dated November 1, 2009.10.4*
              Form of Subordination Agreement between the Company,
      FCC, LLC, d/b/a First Capital, and Lazarus Investment Partners LLLP,
      Michael S. Barish, Jervis B. Perkins, J. Michael Wolfe, and Grad Wurn LLC
      (dated October 30, 2009 through November 5, 2009).10.5*
              Forbearance Agreement and Fourth Amendment to the Loan
      and Security Agreement between FCC, LLC, d/b/a First Capital, the Company,
      and Jack J. Walker as Guarantor, effective as of February 15,
      2010.10.6*
              Waiver Agreement between FCC, LLC, d/b/a First Capital,
      the Company, and Jack J. Walker as Guarantor, effective as of November 19,
      2009.10.7*
              Pledge Agreement dated as of February 15, 2010 executed
      by Jack J. Walker in favor of FCC LLC, d/b/a First Capital supporting
      borrowings of the Company under the Loan and Security Agreement between
      FCC, LLC, d/b/a First Capital and the Company, as amended and
      revised.10.8
              Form
      of Stock Option Agreement relating to the 2005 Equity Compensation Plan
      (incorporated by reference to Exhibit 10.5 of our Current Report on Form
      8-K filed March 7, 2006).31.1*
              Certifications of the Chief Executive Officer Under
      Section 302 of the Sarbanes-Oxley Act.31.2*
              Certifications of the Chief Financial Officer Under
      Section 302 of the Sarbanes-Oxley Act.32.1*
              Certifications of the Chief Executive Officer Under
      Section 906 of the Sarbanes-Oxley Act.32.2*
              Certifications of the Chief Financial Officer Under
      Section 906 of the Sarbanes-Oxley Act.*
      Filed herewith.




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   SIGNATURES





In
accordance with the requirements of the Securities Exchange Act of 1934 the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.





AeroGrow
      International Inc.Date:  February
      17, 2010
            
            /s/Jack
      J.
      WalkerBy:
      Jack J. WalkerIts:
      Chief Executive Officer (Principal Executive Officer)Date:  February
      17, 2010
            
            /s/H.
      MacGregor
      ClarkeBy:
      H. MacGregor ClarkeIts:
      Chief Financial Officer (Principal Financial Officer)Date: : February
      17, 2010
            
            /s/Grey
      H.
      GibbsBy:
      Grey H. GibbsIts:
      Controller (Principal Accounting
Officer)











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