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 September 30,
    2009ORo
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACTFor
      the transition period from  ______________ to
      ______________





Commission File No. 000-50888





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 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, or a non-accelerated filer.





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 October 31,
2009:  12,398,249




Table of Contents




AeroGrow
International, Inc.


TAB LE OF CONTENTS


FORM
10-Q REPORT


September
30, 2009





PART
      I   Financial InformationItem
      1.
            Condensed Financial
      Statements
            1Condensed Balance Sheets as of
      September 30, 2009 (Unaudited) and March 31,
    2009
            1Condensed
      Statements of Operations for the Three and Six Months Ended September 30,
      2009 and September 30, 2008 (Unaudited)
            2Condensed
      Statements of Cash Flows for the Six Months Ended September 30, 2009 and
      September 30, 2008 (Unaudited)
            3Notes to
      the Condensed Financial Statements
    (Unaudited)
            4Item
      2.
            Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
            15Item
      3.
            Quantitative and
      Qualitative Disclosures about Market Risk
            27Item
      4T.
            Controls and
      Procedures
            28PART
      II  Other InformationItem
      1.
            Legal
      Proceedings
            29Item
      1A.
            Risk
      Factors
            29Item
      2.
            Unregistered Sales
      of Equity Securities and Use of Proceeds
            29Item
      3.
            Defaults Upon
      Senior Securities
            29Item
      4.
            Submission of
      Matters to Vote of Security Holders
            29Item
      5.
            Other
      Information
            29Item
      6.
            Exhibits
            30Signatures
            31











i
 Table of Contents





Item
1.Condensed
Financial Statements





AEROGROW
INTERNATIONAL, INC.


CONDENSED BALANCE SHEETS


(Unaudited)





September
      30,
            
            
            March
      31,2009
            
            
            2009ASSETSCurrent
      assetsCash
            
            $
            46,891
            
            
            $
            332,698Restricted
      cash
            
            
            438,441
            
            
            
            438,331Accounts
      receivable, net of allowance for doubtful accounts of
              $636,161
      and $1,423,508 at September 30, 2009 and March 31,2009,
      respectively
            
            
            2,444,181
            
            
            
            2,278,052Other
      receivable
            
            
            39,461
            
            
            
            332,059Inventory
            
            
            7,753,816
            
            
            
            8,350,135Prepaid
      expenses and other
            
            
            506,356
            
            
            
            565,454Total
      current assets
            
            
            11,229,146
            
            
            
            12,296,729Property
      and equipment, net of accumulated depreciation of $2,109,660 and
      $1,675,148 at
              September
      30, 2009 and March 31, 2009, respectively
            
            
            1,336,464
            
            
            
            1,768,369Other
      assetsIntangible
      assets, net of $4,990 and $3,515 of accumulated
              amortization
      at September 30, 2009 and March 31, 2009,respectively
            
            
            257,145
            
            
            
            231,590Deposits
            
            
            190,776
            
            
            
            110,776Deferred
      debt issuance costs, net of accumulated amortization
              of
      $345,173 and $243,937 at September 30, 2009 and March 31,2009,  respectively
            
            
            162,990
            
            
            
            201,726Total
      other assets
            
            
            610,911
            
            
            
            544,092Total
      Assets
            
            $
            13,176,521
            
            
            $
            14,609,190LIABILITIES
      AND STOCKHOLDERS' EQUITY (DEFICIT)Current
      liabilitiesCurrent
      portion  - long term debt
            
            $
            5,996,083
            
            
            $
            1,099,060Accounts
      payable
            
            
            4,452,184
            
            
            
            8,338,559Accrued
      expenses
            
            
            1,474,916
            
            
            
            2,318,670Customer
      deposits
            
            
            459,869
            
            
            
            246,728Deferred
      rent
            
            
            49,028
            
            
            
            57,283Total
      current liabilities
            
            
            12,432,080
            
            
            
            12,060,300Long
      term debt, net of current portion
            
            
            1,405,113
            
            
            
            5,547,144Long
      term debt-related party
            
            
            -
            
            
            
            1,233,371Stockholders'
      equity (deficit)Preferred
      stock, $.001 par value, 20,000,000 shares authorized,
              6,836
      and -0- shares issued and outstanding at September 30,2009
              and
      March 31, 2009 respectively
            
            
            7
            
            
            
            --Common
      stock, $.001 par value, 75,000,000 shares authorized,
              12,422,249
      and 13,342,877 shares issued and outstanding atSeptember
      30,
              2009
      and March 31, 2009,  respectively
            
            
            12,422
            
            
            
            13,343Additional
      paid-in capital
            
            
            52,095,483
            
            
            
            45,696,630Accumulated
      (deficit)
            
            
            (52,768,584
            )
            
            
            (49,941,598
            )Total
      Stockholders' Equity (Deficit)
            
            
            (660,672
            )
            
            
            (4,231,625
            )Total
      Liabilities and Stockholders' Equity (Deficit)
            
            $
            13,176,521
            
            
            $
            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
              
              Six
      Months endedSeptember
      30,
              
              
              September
      30,2009
              
              
              2008
              
              
              2009
              
              
              2008RevenueProduct
      sales
              
              $
              3,285,949
              
              
              $
              13,854,930
              
              
              $
              6,265,642
              
              
              $
              20,575,011Operating
      expensesCost
      of revenue
              
              
              2,270,556
              
              
              
              8,026,325
              
              
              
              4,140,361
              
              
              
              11,713,148Research
      and development
              
              
              173,354
              
              
              
              416,778
              
              
              
              742,552
              
              
              
              1,142,193Sales
      and marketing
              
              
              1,248,102
              
              
              
              2,875,729
              
              
              
              2,407,898
              
              
              
              6,325,612General
      and administrative
              
              
              1,353,782
              
              
              
              1,902,113
              
              
              
              2,405,042
              
              
              
              3,420,825Total
      operating expenses
              
              
              5,045,794
              
              
              
              13,220,945
              
              
              
              9,695,853
              
              
              
              22,601,778Profit
      (loss) from operations
              
              
              (1,759,845
              )
              
              
              633,985
              
              
              
              (3,430,211
              )
              
              
              (2,026,767
              )Other
      (income) expense, netInterest
      (income)
              
              
              (61
              )
              
              
              (454
              )
              
              
              (141
              )
              
              
              (1,504
              )Interest
      expense
              
              
              185,756
              
              
              
              216,069
              
              
              
              384,754
              
              
              
              373,716Other
      (income)
              
              
              (180,286
              )
              
              
              -
              
              
              
              (987,838
              )
              
              
              -Total
      other (income) expense, net
              
              
              5,409
              
              
              
              215,615
              
              
              
              (603,225
              )
              
              
              372,212Net
      income (loss)
              
              $
              (1,765,254
              )
              
              $
              418,370
              
              
              $
              (2,826,986
              )
              
              $
              (2,398,979
              )Net
      income (loss) per share, basic
              
              $
              (0.14
              )
              
              $
              0.03
              
              
              $
              (0.22
              )
              
              $
              (0.20
              )Net
      income (loss) per share, diluted
              
              $
              (0.14
              )
              
              $
              0.03
              
              
              $
              (0.22
              )
              
              $
              (0.20
              )Weighted
      average number of common shares outstanding used to calculated basic net
      income per share
              12,422,249
              
              
              
              12,121,858
              
              
              
              12,729,125
              
              
              
              12,108,177Effect
      of dilutive securities:Equity
      based compensation
              
              
              -
              
              
              
              254,698
              
              
              
              -
              
              
              
              -Weighted
      average number of common shares outstanding used to calculated diluted net
      income per share
              
              
              12,422,249
              
              
              
              12,376,556
              
              
              
              12,729,125
              
              
              
              12,108,177




See
accompanying notes to the condensed financial statements.




2
 Table of Contents





AEROG
ROW INTERNATIONAL, INC.


CONDENSED STATEMENTS OF CASH FLOWS


(Unaudited)





Six months ended September
    30,2009
            
            
            2008Cash
      flows from operating activities:Net
      (loss)
            
            $
            (2,826,986
            )
            
            $
            (2,398,979
            )Adjustments
      to reconcile net (loss) to cash (used) by operations:Issuance
      of common stock and options under equity compensation
plans
            
            
            338,919
            
            
            
            17,317Issuance
      of warrants related to debt
            
            
            15,000
            
            
            
            --Depreciation
      and amortization expense
            
            
            435,987
            
            
            
            431,563Allowance
      for bad debt
            
            
            (787,347
            )
            
            
            94,276Amortization
      of debt issuance costs
            
            
            101,236
            
            
            
            85,070Gain
      on forgiveness of accounts payable
            
            
            (807,310
            )
            
            
            --Change
      in assets and liabilities:(Increase)
      decrease in accounts receivable
            
            
            621,218
            
            
            
            (9,908,600
            )Decrease
      in other receivable
            
            
            292,598
            
            
            
            220,913(Increase)
      decrease in inventory
            
            
            596,319
            
            
            
            (5,704,257
            )(Increase)
      decrease in other current assets
            
            
            59,098
            
            
            
            (312,461
            )(Increase)
      in deposits
            
            
            (80,000
            )
            
            
            -Increase
      (decrease) in accounts payable
            
            
            (650,025
            )
            
            
            7,722,452Increase
      (decrease) in accrued expenses
            
            
            (843,754
            )
            
            
            972,894Increase
      in accrued interest
            
            
            19,589
            
            
            
            --(Decrease)
      in accrued interest-related party
            
            
            (30,652
            )
            
            
            --Increase
      (decrease) in customer deposits
            
            
            213,141
            
            
            
            (43,039
            )(Decrease)
      in deferred rent
            
            
            (8,255
            )
            
            
            (20,512
            )Net
      cash (used) by operating activities
            
            
            (3,341,224
            )
            
            
            (8,843,363
            )Cash
      flows from investing activities:(Increase)
      in restricted cash
            
            
            (110
            )
            
            
            (344,737
            )Purchases
      of equipment
            
            
            (2,607
            )
            
            
            (584,082
            )Patent
      expenses
            
            
            (27,030
            )
            
            
            (171,797
            )Net
      cash (used) by investing activities
            
            
            (29,747
            )
            
            
            (1,100,616
            )Cash
      flows from financing activities:(Increase)
      in prepaid debt issuance costs
            
            
            (62,500
            )
            
            
            (373,528
            )(Decrease)
      in amount due to factor
            
            
            --
            
            
            
            (1,480,150
            )Proceeds
      from long term debt borrowings
            
            
            5,623,317
            
            
            
            10,664,200Proceeds
      from long term debt borrowings-related party
            
            
            225,000
            
            
            
            --Repayments
      of long term debt borrowings
            
            
            (6,435,093
            )
            
            
            --Proceeds
      from exercise and issuance of warrants
            
            
            --
            
            
            
            25,000Proceeds
      from the exercise of stock options
            
            
            20
            
            
            
            25,343Proceeds
      from the issuance of preferred stock
            
            
            3,801,000
            
            
            
            --Principal
      payments on capital leases
            
            
            (66,580
            )
            
            
            (62,217
            )Net
      cash provided by financing activities
            
            
            3,085,164
            
            
            
            8,798,648Net
      increase (decrease) in cash
            
            
            (285,807
            )
            
            
            (1,145,331
            )Cash,
      beginning of period
            
            
            332,698
            
            
            
            1,559,792Cash,
      end of period
            
            $
            46,891
            
            
            $
            414,461





Supplemental
      disclosure of non-cash investing and financing activities:Interest
      paid
            
            $
            293,765
            
            
            $
            426,681Income
      taxes paid
            
            $
            --
            
            
            $
            --Proceeds
      from capital lease
            
            $
            --
            
            
            $
            311,015Conversion
      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
            
            $
            50,000
            
            
            $
            --Modification
      of accrued expenses to equity
            
            $
            89,000
            
            
            $
            --Modification
      of accounts payable to long term debt
            
            $
            1,386,040
            
            
            $
            --





See
accompanying notes to the condensed financial statements.




3
 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 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 September 30, 2009, the
results of operations for the three and six months ended September 30, 2009 and
2008, and the cash flows for the six months ended September 30, 2009 and 2008.
The results of operations for the three and six months ended September 30, 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 six months ended September 30, 2009 of $2,826,986.  Sources of
funding to meet prospective cash requirements include cash flows from
operations, $599,979 in cash proceeds from the issuance of Series A Convertible
Preferred shares in October 2009, and borrowings under the Company’s revolving
credit facility and other debt arrangements.  In addition, the Company
is currently seeking to raise additional funds 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,
there can be no assurance that the Company can execute its operating plan or
meet all of its cash requirements over the next 12 months.  The
Company’s operating plan is predicated on a variety of assumptions including,
but not limited to, the level of customer and consumer demand, the impact of
cost reduction programs, access to sufficient funding, 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
operating plan.
 
 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.
 
 4
 Table of Contents
 
 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 literature:  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 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.
 
 Financial
instruments consist of cash and cash equivalents, accounts receivable, debt, and
accounts payable. The carrying values of all financial instruments approximate
their fair value.
 
 Customers:
 The
Company maintains a credit insurance policy on many of its trade accounts
receivables. For the three months ended September 30, 2009, the Company had two
customers who represented 26.2% and 12.3% of the Company’s net product
sales.  For the three months ended September 30, 2008, the Company had
three customers who represented 17.5% and 11.4% and 10.3% of the Company’s net
product sales.  For the six months ended September 30, 2009, the
Company had two customers who represented 13.3% and 10.8% of net product
sales.  For the six months ended September 30, 2008, the Company had
one customer who represented 13.7% of net product sales.
 
 Suppliers:
 For the
three months ended September 30, 2009, the Company purchased inventories and
other inventory-related items from three suppliers totaling $1,037,865,
$303,764, and $196,457, representing 45.7%, 13.4%, and 8.7% of cost of
sales.  For the three months ended September 30, 2008, the Company
purchased inventories and other inventory-related items from three suppliers
totaling $5,068,874, $2,119,490, and $2,052,164, representing 27.0%, 18.6%, and
7.2% of cost of sales.  For the six months ended September 30, 2009, the
Company purchased inventories and other inventory-related items from three
suppliers totaling $1,058,191, $526,545, and $330,641, representing 25.6%,
12.7%, and 8.0% of cost of sales.  For the six months ended September
30, 2008, the Company purchased inventories and other inventory related items
from three suppliers totaling $6,065,355, $2,738,592 and $2,386,644 representing
51.8%, 23.4%, and 20.4% of cost of sales.  Although the Company
believes alternate sources of manufacturing could be obtained, loss of any of
these suppliers could have an adverse impact on operations.
 
 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.
 
 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 September
30, 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 literature: 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 to
sell 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:


5
 Table of Contents




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
September 30, 2009 and March 31, 2009, the Company did not have any financial
assets or liabilities that were measured at 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 $636,161 and $1,423,508 at
September 30, 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
September 30, 2009 and March 31, 2009, the balance in this reserve account was
$139,461 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.




September
      30,
            
            
            March
      31,2009
            
            
            2009Finished
      goods
            
            $
            6,267,398
            
            
            $
            6,799,996Raw
      materials
            
            
            1,486,418
            
            
            
            1,550,139$
            7,753,816
            
            
            $
            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 September 30, 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: that is, 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 $190 and
$5,409 of revenue as of September 30, 2009 and September 30, 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 September
30, 2009 and September 30, 2008, did not record $66 and $1,637, 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 liability for sales returns
is estimated based upon historical experience of return levels.


Additionally,
the Company did not record $459,869 and $189,161 of revenue as of September 30,
2009 and September 30, 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 September 30, 2009 and September 30, 2008, recognition of
$307,798 and $91,000, respectively, of product and freight costs associated with
these sales, which have been included in inventory.


6
 Table of Contents




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 September 30, 2009 and September 30, 2008, the
Company had accrued $370,468 and $858,898, 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 literature: 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 September 30, 2009
and September 30, 2008, the Company had deferred $49,698 and $481,526,
respectively, related to such media costs.  Advertising expenses for the
three and six months ended September 30, 2009 were $196,587 and $649,169,
respectively, and for the three and six months ended September 30, 2008 were
$330,859 and $1,816,743, 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 as of September 30, 2009 and March 31, 2009 a provision
for potential future warranty costs of $61,812 and $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,
usually in the 1% to 2% range, to cover returned goods from which this allowance
is deducted from payments from such customers.  As of September 30,
2009 and March 31, 2009, the Company has recorded a reserve for customer returns
of $65,493 and $101,743, respectively.


New Accounting
Pronouncements




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.
 
 In May
2009, the FASB issued ASC 855, Subsequent Events(formerly
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 November 19, 2009, which is
the date the financial statements were issued.


7
 Table of Contents




In April
2009, the FASB issued ASC 825-10-65, Financial Instruments (formerly 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 (formerly 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 (formerly 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 June
2009, the FASB issued ASC 105, Generally Accepted Accounting Principles
(formerly 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 March
2008, the FASB issued ASC 815-10-50 (prior authoritative literature: 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 (formerly 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 (formerly 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.


In
February 2007, the FASB issued ASC 825-10 (formerly 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
September 30, 2009 the Company has capitalized lease obligations for computer
equipment, licensed software, and factory equipment due on various dates through
November 2010 of $62,794.  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 $134,503 as of September 30, 2009.  In
addition, recorded in deposits is a security deposit of $48,180, which will be
released upon the Company achieving certain financial
requirements.  The leases also required $21,465 in prepaid
rents.


8
 Table of Contents




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





First
National Loan





On May
19, 2008, the Company and Jack J. Walker, one of the Company’s directors, acting
as co-borrowers, entered into a Business Loan Agreement with First National Bank
(the “Business Loan Agreement”) for a loan to the Company in the principal
amount of $1,000,000 (the “First National Loan”).  The Company has
agreed, among other things, that while the Business Loan Agreement is in effect,
the Company will not (without First National Bank'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 First
National Bank. In the event of a default under the First National Loan, at First
National Bank's option, all indebtedness owed under the First National Loan will
become immediately due and payable.





Pursuant
to the Business Loan Agreement, the Company and Mr. Walker provided First
National Bank with a promissory note for a principal amount of up to $1,000,000
(the “First National Note”).  The First National Note provided for
monthly payments of interest only, with the balance of principal and all accrued
but unpaid interest due and payable on 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 First National
Loan until July 19, 2009, and increasing the interest rate from the Wall Street
Journal Prime Rate plus .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
First National 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 First National 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, the Company made the scheduled
$100,000 principal payment with the consent of FCC.  The principal
payments due on August 31, 2009 and September 30, 2009 were made by Mr. Walker
to FNB (on September 22, 2009 and October 20, 2009, respectively) because FCC
did not consent to the Company making such payments.  These payments
by Mr. Walker were recorded by the Company as offsets to a $150,000 receivable
due from Mr. Walker.  As of September 30, 2009, $854,732 in loans were
outstanding under the First National 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 provides for a loan up to a maximum of $1,500,000 for business
purposes, at an annual interest rate of 12% (the “WLLC Loan”). Mr. Walker is the
manager of WLLC and owns a 73.3% membership interest in WLLC, with the remaining
membership interest owned by other officers and directors of the
Company.  As a condition of the WLLC Loan, the Company paid WLLC a
non-refundable commitment fee of $37,500.  Further, in consideration
of WLLC holding available funds equal to the principal amount not yet disbursed,
the Company must pay a non-refundable fee of 1% of the retained funds as a
holding fee, payable quarterly.  If not paid sooner, the WLLC Loan, if
drawn upon, was due and payable on April 1, 2009.  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 First National Bank (each
as described herein).  Further, in the event we receive any equity
financing, all obligations due under the WLLC Loan Agreement became immediately
due and payable.  In the event of any default under the WLLC Loan
Agreement, WLLC may, at its option, declare all amounts owed immediately due and
payable, foreclose on the security interest granted, and increase the annual
rate of interest to 18%.


The WLLC
Loan Agreement also set forth the terms and conditions under which Mr. Walker
agreed to act as co-borrower on the First National Loan. In consideration for
Mr. Walker's agreement to act as co-borrower, the Company agreed to: (i) pay Mr.
Walker a service fee of $50,000; (ii) allow Mr. Walker to purchase the First
National Loan in the event of the Company’s default under the First National
Loan and to repay Mr. Walker any amounts expended by Mr. Walker on the First
National Loan, together with interest at an annual rate of 18%; and (iii)
terminate and release Mr. Walker from any obligation under the First National
Loan on the one-year anniversary of the execution date of the First National
Loan Agreement.





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.  The parties agreed that the Company is not entitled to
any further disbursements under the WLLC Loan.  In the event the
Company receives any equity financing, all obligations due under the WLLC Loan
become immediately due and payable.





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





9
 Table of Contents





Revolving
Credit Facility





On June
23, 2008, the Company entered into a Loan and Security Agreement with FCC, LLC,
d/b/a First Capital (“FCC”) (the “FCC Loan Agreement”) for a revolving credit
facility up to a maximum amount of $12,000,000 (the “Revolving Credit
Facility”).  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.  Mr. Walker
provided a guarantee against certain contingent liabilities related to the FCC
Loan Agreement.  In return for this guarantee, the Company paid Mr.
Walker a fee of $7,500.





The
Revolving Credit Facility has an initial two-year term, 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.  The purpose of the Revolving Credit Facility is to provide
additional working capital.  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
June 30, 2008, the Company was not in compliance with two covenants under the
FCC Loan Agreement.  As of July 31, 2008, FCC and AeroGrow executed an
amendment to the FCC Loan Agreement (the “First FCC Amendment”).  The
First FCC Amendment re-set the covenant levels for June 30, 2008, and future
periods, thus waving the non-compliance as of June 30, 2008, under the old
covenants, temporarily reduced certain restrictions on the Company’s ability to
borrow against inventory, and increased the interest rate from Base Rate (as
such term is defined in the agreement) plus 2% to the current rate of Base Rate
plus 3.5%.  After the First FCC Amendment, the Company was in
compliance with the revised covenants as of June 30, 2008.





As of
September 30, 2008, the Company was not in compliance with two covenants under
the revised FCC Loan Agreement.  On October 24, 2008, FCC and the
Company executed a second amendment to the FCC Loan Agreement (the “Second FCC
Amendment”).  The Second FCC Amendment waived the covenant violations
as of September 30, 2008.  In addition, the Second FCC Amendment
changed the definition of Base Rate to be the higher of the prime rate or
one-month LIBOR + 2.75%, and adjusted the interest calculation under the FCC
Loan Agreement such that the interest rate resets monthly, rather than
daily.





As of
October 27, 2008, FCC and the Company executed a temporary amendment to the FCC
Loan Agreement that temporarily reduced certain restrictions on the Company’s
ability to borrow against inventory, and increased the advance rate against
inventory.





On
January 16, 2009, the Company and FCC executed a temporary amendment to the FCC
Loan Agreement that temporarily reduced certain restrictions on the Company’s
ability to borrow against inventory, and increased the advance rate against
inventory as of January 1, 2009.





As of
December 31, 2008, the Company was not in compliance with three covenants under
the revised 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 increases, 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.





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 amendments have not changed 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 (the “Waiver
Agreement”).  The Waiver Agreement waived the covenant violation as of
September 30, 2009.  FCC charged the Company a $10,000 waiver
fee.


10
 Table of Contents





As of
September 30, 2009, loans totaling $4,582,474 were outstanding, including
accrued interest, and the Revolving Credit Facility was fully
drawn.  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.  As of November 5, 2009,
there was an estimated remaining availability of approximately
$600,000.





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.


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, mature on November 16, 2009, and bear interest at 15% per annum with
interest payments due when the principal amounts are repaid.  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.





Lender
            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,
      director, greater than 10% beneficial owner
            $100,000
            August
      28, 2009
            100,000Michael
      S. Barish
            Director,
      greater than 5% beneficial owner
            $75,000
            September
      1, 2009
            75,000Jervis
      B. Perkins
            Chief
      Executive Officer, director, and greater than 10% beneficial
      owner
            $25,000
            August
      28, 2009
            25,000J.
      Michael Wolfe
            Employee
      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, mature on February
1, 2010, and bear interest at 20% per annum with interest payments due when the
principal amounts are repaid.  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.




Lender
            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 5% beneficial owner
            $100,000
            November
      4, 2009
            100,000Jervis
      B. Perkins
            Chief
      Executive Officer, director, and greater than 10% beneficial
      owner
            $50,000
            October
      30, 2009
            50,000J.
      Michael Wolfe
            Employee
      and greater than 10% beneficial owner
            $50,000
            November
      5, 2009
            50,000




11
 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 vesting schedules were not impacted by the
reset.  The reset resulted in the recognition of a modification charge
of $48,639 in the quarter for vested shares and an additional $8,394 will be
recognized over the remaining vesting periods of the reset
options.  The number of options granted and cancelled/expired includes
options granted and canceled in connection with the Exchange.





For the
three months ended September 30, 2009, the Company granted 1,619,973 options to
purchase the Company’s common stock at an exercise price ranging from $0.12 to
$0.13 per share under the 2005 Equity Compensation plan (“2005
Plan”).  For the three months ended September 30, 2008, the Company
granted 343,487 options to purchase the Company’s common stock at exercise
prices ranging from $1.25 to $2.07 per shares under the 2005 Plan.





For the
six months ended September 30, 2009, the Company granted 1,619,973 options to
purchase the Company’s common stock at exercise prices ranging from $0.12 to
$0.13 per share under the 2005 Plan.  For the six months ended
September 30, 2008, the Company granted 610,910 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 September 30, 2009, there were 1,237,898 options that
either were cancelled or expired and 0 shares issued upon exercise of
outstanding stock options under the 2005 plan equity compensation
plan.  During the three months ended September 30, 2008, there were
8,565 options to purchase common stock expired and 8,866 shares issued upon
exercise of outstanding stock options under the Company’s equity compensation
plans.





During
the six months ended September 30, 2009, there were 1,291,711 options that
either were cancelled or expired and 4,075 shares issued upon exercise of
outstanding stock options under the 2005 Plan.  During the six months
ended September 30, 2008 there were 14,632 options that either were cancelled or
expired and 22,536 shares exercised.





As of
September 30, 2009, the Company had granted options for 1,176,855 shares of the
Company’s common stock that are unvested that will result in $232,116 of
compensation expense in future periods if fully vested.





Information
regarding all stock options outstanding under the 2005 Plan as of September 30,
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
            
            
            2,652,773
            
            
            
            3.83
            
            
            $
            0.14
            
            
            
            
            1,475,918
            
            
            
            3.30
            
            
            $
            0.14Over
      $0.50 to $2.50
            
            
            6,670
            
            
            
            0.83
            
            
            $
            1.44
            
            
            
            
            6,670
            
            
            
            0.83
            
            
            $
            1.44Over
      $2.50 to $5.00
            
            
            21,057
            
            
            
            3.50
            
            
            $
            2.96
            
            
            
            
            21,057
            
            
            
            3.50
            
            
            $
            2.96Over
      $5.00 to $5.50
            
            
            625,760
            
            
            
            1.48
            
            
            $
            5.00
            
            
            
            
            625,760
            
            
            
            1.48
            
            
            $
            5.00Over
      $5.50
            
            
            37,000
            
            
            
            2.47
            
            
            $
            5.90
            
            
            
            
            37,000
            
            
            
            2.47
            
            
            $
            5.903,343,260
            
            
            
            3.36
            
            
            $
            1.14
            
            $
            3,940
            
            
            2,166,405
            
            
            
            2.75
            
            
            $
            1.67
            
            $
            985





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 (September
30, 2009).




12
 Table of Contents




6.
            Income
      Taxes




In
September 2006, the ASC 740 (formerly 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 September 30, 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 with our Chairman.





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.  As
of September 30, 2009, $100,000 remains outstanding and is reflected as an
offset to additional paid-in-capital on the balance sheet.





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.  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.  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 Regulation D 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.





13
 Table of Contents





A summary
of the Company’s common stock warrant activity for the period from April 1,
2009, through September 30, 2009, is presented below:




WeightedWarrants
            
            
            AverageOutstanding
            
            
            Exercise
      PriceOutstanding,
      March 31, 2009
            
            
            5,415,742
            
            
            $
            5.76Granted
            
            
            500,000
            
            
            $
            .25Exercised
            
            
            --
            
            
            $
            --Expired/Forfeited
            
            
            462,352
            
            
            $
            2.00Outstanding,
      September 30, 2009
            
            
            5,453,390
            
            
            $
            5.57





As of
September 30, 2009, the Company had the following outstanding warrants to
purchase its common stock:





Weighted
            
            
            WeightedWarrants
            
            
            Average
            
            
            AverageOutstanding
            
            
            Exercise Price
            
            
            Remaining Life500,000
            
            
            $
            0.25
            
            
            
            4.923,200
            
            
            $
            0.66
            
            
            
            0.95325,000
            
            
            $
            1.00
            
            
            
            4.38132,639
            
            
            $
            2.00
            
            
            
            1.8116,000
            
            
            $2.07
            
            
            
            3.75450,000
            
            
            $
            5.00
            
            
            
            0.95505,796
            
            
            $
            6.00
            
            
            
            1.471,937,299
            
            
            $
            6.25
            
            
            
            1.4150,000
            
            
            $
            6.96
            
            
            
            2.84746,956
            
            
            $
            7.50
            
            
            
            2.44720,000
            
            
            $
            8.00
            
            
            
            4.9366,500
            
            
            $
            8.25
            
            
            
            4.935,453,390
            
            
            $
            5.57
            
            
            
            2.55





A summary
of the Company’s preferred stock warrant activity for the period from April 1,
2009, through September 30, 2009, is presented below:





WeightedWarrants
            
            
            AverageOutstanding
            
            
            Exercise
      PriceOutstanding,
      March 31, 2009
            
            
            --
            
            
            $
            --Granted
            
            
            3,414
            
            
            $
            1,250Exercised
            
            
            --
            
            
            $
            --Expired
            
            
            --
            
            
            $
            --Outstanding,
      September 30, 2009
            
            
            3,414
            
            
            $
            1,250




The
warrants were granted on June 30, 2009 which expire five years from
issuance.





9.
            SubsequentEvent





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.





14
 Table of Contents





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





The
discussion contained herein is for the three and six months ended September 30,
2009 and September 30, 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 September
30, 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, our intentions with respect
to strategic acquisitions, the ability of our products to achieve or maintain
commercial acceptance, and our ability to obtain financing for our
obligations.  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 “Risk Factors” and elsewhere in the Company’s
annual report on Form 10-K for the period ended March 31, 2009, and filed on
July 6, 2009 with the Securities and Exchange Commission (the “SEC”). 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 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.


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 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 September 30, 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 $636,161 and $1,423,508 at September 30, 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
September 30, 2009 and March 31, 2009, the balance in this reserve account was
$139,461 and $332,059, respectively.




15
 Table of Contents





Revenue
Recognition
 The
Company recognizes revenue from product sales, net of estimated returns, when
persuasive evidence of a sale exists: that is, 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 $190 and $5,409 of
revenue as of September 30, 2009 and September 30, 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 September 30, 2009
and September 30, 2008, did not record $66 and $1,637 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 $189,161 of revenue as of September 30,
2009 and September 30, 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 September 30, 2009 and September 30, 2008, recognition of
$307,758 and $91,000, 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 September 30, 2009 and September 30,
2008, the Company had accrued $370,468 and $858,898, 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 literature: 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 September 30, 2009
and September 30, 2008, the Company had deferred $49,698 and $481,526,
respectively, related to such media costs.  Advertising expenses for
the three and six months ended September 30, 2009 were $196,587 and 649,169,
respectively, and for the three and six months ended September 30, 2008 were
$330,859 and $1,816,743, 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 as of September 30, 2009 and March 31, 2009 a provision for
potential future warranty costs of $61,812 and $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,
usually in the 1% to 2% range, to cover returned goods from which this allowance
is deducted from payments from such customers.  As of September 30,
2009 and March 31, 2009, the Company has recorded a reserve for customer returns
of $65,493 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 literature:
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.




16
 Table of Contents
 
 Results
of Operations





Three
Months Ended September 30, 2009 and September 30, 2008





Summary
Overview





For the
three months ended September 30, 2009, our sales totaled $3,285,949, a 76.3%
decrease from the same period in the prior year.  The decline in sales
reflected an 84.1% reduction in sales to retailers, caused in part by 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.  In addition, our sales to
retailers relative to the prior year period declined because of a comparison to
the 2008 period during which retailers took large stocking orders in
anticipation of the holiday shopping season.  In 2009, retailers are
delaying orders until later in the year, and ordering inventories on a
just-in-time, replenishment basis, rather than placing large stocking
orders.  In addition, we experienced a decline in the number of retail
storefronts carrying our products, from approximately 9,000 at September 30,
2008 to approximately 3,600 at September 30, 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
were up slightly from the prior year, despite a 25.9% reduction in the amount of
revenue-generating media spending during the period.  The increase in
sales was driven by strong direct-to-consumer sales of seed kits and
accessories, reflecting continued strength in the recurring revenue portion of
our direct-to-consumer business as the cumulative number of AeroGardens sold
continued to increase, to 852,092 as of September 30, 2009.  As a
percent of total revenue, seed kits and accessories represented 28.7% for the
three months ended September 30, 2009, up from 18.6% in the prior year
period.





The gross
margin for the three months ended September 30, 2009 was 30.9% as compared to
42.1% 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 September 2008, on a lower revenue base in the
current year period.  Operating expenses other than cost of revenue
were reduced $2,419,382, or 46.6%, from the prior year reflecting cost saving
initiatives and staffing reductions.




The loss
from operations totaled $1,759,845 for the three months ended September 30,
2009, as compared to an operating profit of $633,985 in the prior year
period.  The increased loss principally reflected the impact of the
decline in revenue and the lower gross margin, which, in combination, more than
offset the significant decrease in operating expenses other than cost of
revenue.





Other
expense for the three months ended September 30, 2009 totaled $5,409 as compared
to other expense of $215,615 in the prior year, principally reflecting the
impact of $180,286 in gains that were recognized during the three months ended
September 30, 2009 to reflect discounts negotiated on certain accounts payable
balances, partially offset by higher interest expense.





The net
loss for the three months ended September 30, 2009 was $1,765,254 as compared to
a net profit of $418,370 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 September 30, 2009 and the three months ended September
30, 2008:




Three
      Months Ended September 30,2009
            
            
            2008RevenueProduct
      sales - retail, net
            55.8
            %
            
            
            83.0
            %Product
      sales - direct to consumer, net
            41.8
            %
            
            
            9.9
            %Product
      sales – international
            2.4
            %
            
            
            7.1
            %Total
      sales
            100.0
            %
            
            
            100.0
            %Operating
      expensesCost
      of revenue
            69.1
            %
            
            
            57.9
            %Research
      and development
            5.3
            %
            
            
            3.0
            %Sales
      and marketing
            38.0
            %
            
            
            20.8
            %General
      and administrative
            41.2
            %
            
            
            13.7
            %Total
      operating expenses
            153.6
            %
            
            
            95.4
            %Profit/(loss)
      from operations
            (53.6)
            %
            
            
            4.6
            %





For the
three months ended September 30, 2009, revenue totaled $3,285,949, a
year-over-year decrease of 76.3% or $10,568,981 from the three months ended
September 30, 2008.





Three
      Months Ended September 30,Product Revenue
            
            2009
            
            
            2008Retail, net
            
            $
            1,831,781
            
            
            $
            11,508,030Direct to consumer,
      net
            
            
            1,375,141
            
            
            
            1,365,438International
            
            
            79,027
            
            
            
            981,462Total
            
            $
            3,285,949
            
            
            $
            13,854,930




17
 Table of Contents





Sales to
retailer customers for the three months ended September 30, 2009, declined 84.1%
from the same period a year earlier.  The decline reflected a number
of factors, most notably a comparison to a prior year period in which most
retailer customers took large stocking orders in anticipation of the 2008
holiday season.  In the current year period, in response to
uncertainty regarding the state of the economy in the United States, retailers
are aggressively managing inventory levels and are, in general, taking a
“just-in-time” approach to procurement.  As a result, we did not
receive large stocking orders during the current year period.  In
addition, our products are being stocked in fewer retailers in 2009 than in
2008, also reflecting more conservative product and procurement strategies being
executed by major retail chains.





Direct to
consumer sales for the three months ended September 30, 2009 rose slightly from
the prior year, by 0.7%, or $9,703.  The increase came despite a 25.9%
reduction in media spending.





International
sales for the three months ended September 30, 2009 were down $902,435 from the
same period in the prior fiscal year.  The decline principally
reflected a comparison to the impact of stocking orders shipped in the year
earlier period.  In addition, because of the decline in consumer
spending worldwide, 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
September 30, 2009 and September 30, 2008 is as follows:





Three
      Months Ended September 30,2009
            
            
            2008Product RevenueAeroGardens
            
            $
            2,343,439
            
            
            $
            11,278,260Seed
      kits and accessories
            
            
            942,510
            
            
            
            2,576,670Total
            
            $
            3,285,949
            
            
            $
            13,854,930% of Total RevenueAeroGardens
            
            
            71.3
            %
            
            
            81.4
            %Seed
      kits and accessories
            
            
            28.7
            %
            
            
            18.6
            %Total
            
            
            100.0
            %
            
            
            100.0
            %





Sales of
AeroGardens were adversely impacted by the year-over-year declines in sales to
retailers and into international markets.  AeroGarden sales declined
79.2% from the year earlier period, principally reflecting the comparison to
large stocking shipments to retailers in the prior year period.  Sales
of seed kits and accessories declined 63.4%, also reflecting the impact of a
comparison to large stocking shipments to retailers a year
earlier.  For the three months ended September 30, 2009, sales of seed
kits and accessories represented 28.7% of total revenue, up from 18.6% in the
prior year period.


Cost of
revenue for the three months ended September 30, 2009 totaled $2,270,556, a
decrease of 71.7% from the three months ended September 30,
2008.  Cost of revenue include 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.  As a percent of total
revenue, these costs represented 69.1% of revenue as compared to 57.9% for the
quarter ended September 30, 2008.  The increase in costs as a percent
of revenue reflects changes in channel, customer, and product mix, as well as
the impact of 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.  The dollar amount of cost of
revenue decreased primarily because of the decline in revenue discussed
above.





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 costs.  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,
hence they are lower than margins from domestic retail sales.  The
gross margin for the quarter ended September 30, 2009 was 30.9% as compared to
42.1% for the quarter ended September 30, 2008.





18
 Table of Contents





Sales and
marketing costs for the three months ended September 30, 2009 totaled
$1,248,102, as compared to $2,875,729 for the three months ended September 30,
2008, a decrease of 56.6% or $1,627,627.  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 September 30,2009
            
            
            2008Advertising
            
            $
            196,587
            
            
            $
            330,859Personnel
            
            
            619,970
            
            
            
            1,030,626Sales
      commissions
            
            
            89,534
            
            
            
            556,914Trade
      Shows
            
            
            37,698
            
            
            
            68,489Other
            
            
            304,313
            
            
            
            888,841$
            1,248,102
            
            
            $
            2,875,729





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 $196,587 for the quarter ended
September 30, 2009, a decrease of 40.6%, or $134,272.





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 September 30, 2009,
personnel costs for sales and marketing were $619,970 down from $1,030,626 for
the three months ended September 30, 2008, a decrease of 39.8%.  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
year-over-year decline in sales commissions primarily reflects the decline in
sales to retailers during the quarter ended September 30, 2009, as discussed
above.





General
and administrative costs for the three months ended September 30, 2009 totaled
$1,353,782 as compared to $1,902,113 for the three months ended September 30,
2008, a decrease of 28.8%, or $548,331.  The decrease reflected
declines in most spending categories, including travel, office expenses, legal
and accounting fees, and general governance costs.





Research
and development costs for the quarter ended September 30, 2009 totaled $173,354,
a decrease of 58.4% from the quarter ended September 30, 2008.  The
lower cost principally reflected lower headcount costs related to staffing
reductions, as well as general reductions in spending.





Our loss
from operations for the three months ended September 30, 2009 was $1,759,845, as
compared to a profit of $633,985 for the three months ended September 30,
2008.





Other
income and expense for the quarter ended September 30, 2009 totaled to a net
expense of $5,409, as compared to net expense of $215,615 in the prior year
period.  The year-over-year change reflected the offsetting impacts of
a $30,313 increase in interest expense, and $180,286 in gains recorded as a
result of negotiated reductions in accounts payable amounts owed to certain
vendors.





The net
loss for the three months ended September 30, 2009 totaled $1,765,254 as
compared to net income of $418,370 for the three months ended September 30,
2008.





Six
Months Ended September 30, 2009 and September 30, 2008





Summary
Overview





For the
six months ended September 30, 2009, sales decreased 69.5% year-over year, from
$20,575,011 to $6,265,642.  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 the level of our
media and advertising spending.  We elected to reduce this spending
because of the general economic conditions and a low anticipated return on
investment, particularly in our direct-to-consumer business in the first three
months of the fiscal year, causing a reduction in direct-to-consumer sales, but
ultimately contributing to a reduced operating loss during that time
period.  Sales of AeroGardens for the six months ended September 30,
2009 declined 75.8% 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 45.8% from the prior year
period.  As a result, sales of seed kits and accessories increased to
37.3% of total revenue from 21.0% in the year earlier period.





19
 Table of Contents





The gross
margin for the six months ended September 30, 2009 was 33.9% as compared to
43.1% 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 $5,333,138, or 49.0%, from the prior year reflecting cost saving
initiatives, staffing reductions, and reduced spending on advertising and
promotion.




The loss
from operations totaled $3,430,211 for the six months ended September 30, 2009,
as compared to $2,026,767 in the prior year.  The increased loss
reflected the impact of the decline in revenue and gross margin, partially
offset by the decrease in operating expenses other than cost of
revenue.





Other
income for the six months ended September 30, 2009 totaled $603,225 as compared
to other expense of $372,212 in the prior year, principally reflecting the
impact of $987,838 in gains that were recognized during the six months ended
September 30, 2009 to reflect discounts negotiated on certain accounts payable
balances, partially offset by higher interest expense resulting from a higher
average level of debt outstanding.





The net
loss for the six months ended September 30, 2009 was $2,826,986 as compared to a
$2,398,978 net loss in the same period a year earlier.





The
following table sets forth, as a percentage of sales, our financial results for
the six months ended September 30, 2009 and the six months ended September 30,
2008:








Six
      Months Ended
              September
      30,2009
            
            
            2008RevenueProduct
      sales - retail, net
            43.1
            %
            
            
            68.8
            %Product
      sales - direct to consumer, net
            54.0
            %
            
            
            22.9
            %Product
      sales – international, net
            2.9
            %
            
            
            8.3
            %Total
      sales
            100.00
            %
            
            
            100.00
            %Operating expensesCost
      of revenue
            66.1
            %
            
            
            56.9
            %Research
      and development
            4.7
            %
            
            
            5.6
            %Sales
      and marketing
            38.4
            %
            
            
            30.7
            %General
      and administrative
            45.6
            %
            
            
            16.6
            %Total
      operating expenses
            154.8
            %
            
            
            109.8
            %Profit/(loss)
      from operations
            (54.8)
            %
            
            
            (9.8)
            %








Six
      Months Ended
              September
      30,Product Revenue
            
            2009
            
            
            2008Retail, net
            
            $
            2,700,044
            
            
            $
            14,150,605Direct to consumer,
      net
            
            
            3,385,384
            
            
            
            4,704,848International,
    net
            
            
            180,214
            
            
            
            1,719,558Total
            
            $
            6,265,642
            
            
            $
            20,575,011








20
 Table of Contents





For the
six months ended September 30, 2009 and September 30, 2008, revenue totaled
$6,265,642 and $20,575,011 respectively, a decrease year-over-year of 69.5% or
$14,309,369.





The
year-over-year decrease in revenue principally reflects sales to retailer
customers, which declined by 80.9%, or $11,450,561.  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 are generally taking a more
cautious approach to inventory decisions, resulting in later orders than has
historically been the case.  In addition, the decline in sales to
retailers reflects a decline in the number of retailers carrying our products,
to an estimated 3,600 at September 30, 2009, from an estimated 9,000 a year
earlier.




Direct-to-consumer
sales also decreased year-over-year, by 28.0%, to $3,385,384.  The
decline principally reflected a reduction in the amount of media spending during
the first fiscal quarter ended June 30, 2009 for both catalogue mailings and
infomercials.  During the three months ended June 30, 2009, we mailed
approximately 414,000 catalogues as compared to approximately 1,443,000
catalogues in the year earlier period.  Spending on infomercials was
similarly reduced, by approximately $480,000 from the same period in
2008.  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 three months ended June 30, 2009, and because of analysis
demonstrating that media spending in the April to June time period has
historically resulted in an inadequate return on investment.  During
the three months ended September 30, 2009, direct-to-consumer sales were
essentially flat with the prior year period, despite a 25.9% reduction in the
amount of media spending.




A summary
of the sales of AeroGardens and seed kits and accessories for the six months
ended September 30, 2009 and September 30, 2008 is as follows:








Six
      Months Ended
              September
      30,2009
            
            
            2008Product RevenueAeroGardens
            $
            3,927,747
            
            
            $
            16,261,676Seed
      kits and accessories
            
            2,337,895
            
            
            
            4,313,335Total
            $
            6,265,642
            
            
            $
            20,575,011% of Total RevenueAeroGardens
            
            62.7
            %
            
            
            79.0
            %Seed
      kits and accessories
            
            37.3
            %
            
            
            21.0
            %Total
            
            100.0
            %
            
            
            100.0
            %





AeroGarden
sales decreased 75.8% year-over-year, principally reflecting the decline in
sales to retailer customers.  Seed kits and accessories sales
declined, by 45.8%, and also reflected the decline in sales to retailers and the
comparison to the prior year period in which large stocking orders were shipped
in the three months ended September 30, 2008.





Cost of
revenue for the six months ended September 30, 2009 and September 30, 2008
totaled $4,140,361 and $11,713,148, respectively, a year-over-year decrease of
64.7%.  The decline principally resulted from the decrease in sales
during the period.  As a percent of total revenue, these costs totaled
66.1% for the six months ended September 30, 2009, as compared to 56.9% 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.  As a result,
the gross margin for the six months ended September 30, 2009 was 33.9%, down
from 43.1 % for the same period in 2008.





Sales and
marketing costs for the six months ended September 30, 2009 totaled $2,407,898,
as compared to $6,325,612 for the six months ended September 30, 2008, a
decrease of 61.9%.  The breakdown of sales and marketing costs for
both time periods is presented in the table below:





Six
      Months Ended
              September
      30,2009
            
            
            2008Advertising
            
            $
            649,169
            
            
            $
            1,816,743Personnel
            
            
            1,233,078
            
            
            
            2,148,595Sales
      commissions
            
            
            140,107
            
            
            
            698,795Trade
      shows
            
            
            31,108
            
            
            
            181,708All
      other
            
            
            354,436
            
            
            
            1,479,771$
            2,407,898
            
            
            $
            6,325,612




21
 Table of Contents





Advertising
expense totaled $649,169 for the six months ended September 30, 2009, a decrease
of 64.3% 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 three months ended June 30, 2009, and because of analysis
demonstrating that media spending in the April to June time period has
historically resulted in an inadequate return on investment.




For the
six months ended September 30, 2009, personnel costs for sales and marketing
totaled $1,233,078, a decrease of 42.6% from the same period in
2008.  The decrease principally reflected headcount reduction in
sales, marketing, and operations personnel.





Year-over-year,
sales commissions decreased 80.0% to $140,107, primarily reflecting the decrease
in sales to retailers during the six months ended September 30, 2009, as
discussed above.





General
and administrative costs for the six months ended September 30, 2009 totaled
$2,855,042 as compared to $3,420,825 for the six months ended September 30,
2008, a decrease of 16.5%.  The decrease reflected spending reductions
in all areas, including outside services, general corporate governance and
administration, and office and related expenses.




Research
and development costs for the six months ended September 30, 2009 totaled
$292,552 against $1,142,193 for the six months ended September 30, 2008, a
decrease of 74.4%.  The lower cost reflected lower headcount costs
related to staffing reductions, and a comparison to the prior year period that
included 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.





Our loss
from operations for the six months ended September 30, 2009 was $3,430,211 as
compared to an operating loss of $2,026,767 for the six months ended September
30, 2008.





Other
income and expense for the six months ended September 30, 2009 and September 30,
2008 totaled to net income of $603,225 and net expense of $372,212,
respectively.  The year-over-year change reflected the offsetting
impacts of an increase in interest expense principally caused by a higher
average level of debt outstanding, and $987,838 in gains recorded as a result of
negotiated reductions in accounts payable amounts owed to certain
vendors.





The net
loss for the six months ended September 30, 2009 totaled $2,826,986, as compared
to the $2,398,979 loss reported for the same period in 2008.





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 six
months ended September 30, 2009 totaled $3,530,501 as compared to a $1,770,753
net cash loss in the prior year.





Changes
in current assets contributed cash of $1,569,233 during the six months ended
September 30, 2009, principally from the collection of accounts receivable and
reductions in inventory.  We source the majority of our inventory from
Chinese manufacturers and therefore face production and delivery lead times that
average 60 to 90 days.  In order to be prepared to meet anticipated
fall and holiday demand for our products, we contracted to purchase inventory in
the quarter ended September 30, 2008.  As consumer demand declined in
response to the global credit crisis in October and November, we reduced our
orders for product from China to the extent possible, but because of the long
procurement lead times we face, we were unable to effectively manage inventory
levels to the new lower demand expectations.  While we curtailed
purchases of additional inventory during calendar year 2009, there was still a
high level of on-hand inventory as of September 30, 2009 totaling $7,753,816,
and representing approximately 235 days of sales activity, and 434 days of sales
activity, at the average daily rate of product cost expensed during the 12
months and three months ended September 30, 2009, respectively.  Net
accounts receivable totaled $2,444,181 as of September 30, 2009, representing
approximately 78 days of net retail sales activity, and 59 days of net retail
sales activity, at the average daily rate of sales experienced during the 12
months and one month ended September 30, 2009, respectively.





Current
operating liabilities decreased $1,299,956 during the six months ended September
30, 2009.  The reduction included the impact of approximately
$3,718,000 in accounts payable and accrued liabilities that were converted to
either Series A Preferred shares or into long-term debt.  Accounts
payable as of September 30, 2009 totaled $4,452,184, representing approximately
48 days of daily expense activity, and 79 days of daily expense activity, at the
average daily rate of expenses experienced during the 12 months and three months
ended September 30, 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 $3,085,164
during the six months ended September 30, 2009.





As of
September 30, 2009, we had a cash balance of $485,332, including $438,441 in
cash that is restricted as collateral for letters of credit and other corporate
obligations.  This compares to $771,029 as of March 31, 2009, of which
$438,331 was restricted as to use.





22
 Table of Contents





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, one of the Company’s directors, acting
as co-borrowers, entered into a Business Loan Agreement with First National Bank
(the “Business Loan Agreement”) for a loan to the Company in the principal
amount of $1,000,000 (the “First National Loan”).  The Company has
agreed, among other things, that while the Business Loan Agreement is in effect,
the Company will not (without First National Bank'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 First
National Bank.  In the event of a default under the First National
Loan, at First National Bank's option, all indebtedness owed under the First
National Loan will become immediately due and payable.


Pursuant
to the Business Loan Agreement, the Company and Mr. Walker provided First
National Bank with a promissory note for a principal amount of up to $1,000,000
(the “First National Note”).  The First National Note provided for
monthly payments of interest only, with the balance of principal and all accrued
but unpaid interest due and payable on 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 First National
Loan until July 19, 2009, and increasing the interest rate from the Wall Street
Journal Prime Rate plus .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
First National 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 First National 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, the Company made the scheduled
$100,000 principal payment with the consent of FCC.  The principal
payments due on August 31, 2009 and September 30, 2009 were made by Mr. Walker
to FNB (on September 22, 2009 and October 20, 2009, respectively) because FCC
did not consent to the Company making such payments.  These payments
by Mr. Walker were recorded by the Company as offsets to a $150,000 receivable
due from Mr. Walker.  As of September 30, 2009, $854,732 in loans were
outstanding under the First National 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 provides for a loan up to a maximum of $1,500,000 for business
purposes, at an annual interest rate of 12% (the “WLLC Loan”). Mr. Walker is the
manager of WLLC and owns a 73.3% membership interest in WLLC, with the remaining
membership interest owned by other officers and directors of the
Company.  As a condition of the WLLC Loan, the Company paid WLLC a
non-refundable commitment fee of $37,500. Further, in consideration of WLLC
holding available funds equal to the principal amount not yet disbursed, the
Company must pay a non-refundable fee of 1% of the retained funds as a holding
fee, payable quarterly.  If not paid sooner, the WLLC Loan, if drawn
upon, was due and payable on April 1, 2009.  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 First National Bank (each as
described herein).  Further, in the event we receive any equity
financing, all obligations due under the WLLC Loan Agreement became immediately
due and payable.  In the event of any default under the WLLC Loan
Agreement, WLLC may, at its option, declare all amounts owed immediately due and
payable, foreclose on the security interest granted, and increase the annual
rate of interest to 18%.




The WLLC
Loan Agreement also set forth the terms and conditions under which Mr. Walker
agreed to act as co-borrower on the First National Loan.  In
consideration for Mr. Walker's agreement to act as co-borrower, the Company
agreed to: (i) pay Mr. Walker a service fee of $50,000; (ii) allow Mr. Walker to
purchase the First National Loan in the event of the Company’s default under the
First National Loan and to repay Mr. Walker any amounts expended by Mr. Walker
on the First National Loan, together with interest at an annual rate of 18%; and
(iii) terminate and release Mr. Walker from any obligation under the First
National Loan on the one-year anniversary of the execution date of the First
National Loan Agreement.


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.  The parties agreed that the Company is not entitled to
any further disbursements under the WLLC Loan.  In the event the
Company receives any equity financing, all obligations due under the WLLC Loan
become immediately due and payable.





On June
30, 2009, principal totaling $1,200,000 outstanding under the WLLC Loan
Agreement 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, LLC,
d/b/a First Capital (“FCC”) (the “FCC Loan Agreement”) for a revolving credit
facility up to a maximum amount of $12,000,000 (the “Revolving Credit
Facility”).  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.  Mr. Walker
provided a guarantee against certain contingent liabilities related to the FCC
Loan Agreement.  In return for this guarantee, the Company paid Mr.
Walker a fee of $7,500.





23
 Table of Contents





The
Revolving Credit Facility has an initial two-year term, 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.  The purpose of the Revolving Credit Facility is to provide
additional working capital.  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
June 30, 2008, the Company was not in compliance with two covenants under the
FCC Loan Agreement.  As of July 31, 2008, FCC and AeroGrow executed an
amendment to the FCC Loan Agreement (the “First FCC Amendment”).  The
First FCC Amendment re-set the covenant levels for June 30, 2008, and future
periods, thus waving the non-compliance as of June 30, 2008, under the old
covenants, temporarily reduced certain restrictions on the Company’s ability to
borrow against inventory, and increased the interest rate from Base Rate (as
such term is defined in the agreement) plus 2% to the current rate of Base Rate
plus 3.5%.  After the First FCC Amendment, the Company was in
compliance with the revised covenants as of June 30, 2008.





As of
September 30, 2008, the Company was not in compliance with two covenants under
the revised FCC Loan Agreement.  On October 24, 2008, FCC and the
Company executed a second amendment to the FCC Loan Agreement (the “Second FCC
Amendment”).  The Second FCC Amendment waived the covenant violations
as of September 30, 2008.  In addition, the Second FCC Amendment
changed the definition of Base Rate to be the higher of the prime rate or
one-month LIBOR + 2.75%, and adjusted the interest calculation under the FCC
Loan Agreement such that the interest rate resets monthly, rather than
daily.





As of
October 27, 2008, FCC and the Company executed a temporary amendment to the FCC
Loan Agreement that temporarily reduced certain restrictions on the Company’s
ability to borrow against inventory, and increased the advance rate against
inventory.





On
January 16, 2009, the Company and FCC executed a temporary amendment to the FCC
Loan Agreement that temporarily reduced certain restrictions on the Company’s
ability to borrow against inventory, and increased the advance rate against
inventory as of January 1, 2009.





As of
December 31, 2008, the Company was not in compliance with three covenants under
the revised 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 increases, 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.





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 amendments have not changed 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 (the “Waiver
Agreement”).  The Waiver Agreement waived the covenant violation as of
September 30, 2009.  FCC charged the Company a $10,000 waiver
fee.


As of
September 30, 2009, loans totaling $4,582,474 were outstanding, including
accrued interest, and the Revolving Credit Facility was fully
drawn.  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.  As of November 5, 2009,
there was an estimated remaining availability of approximately
$600,000.




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 Table of Contents




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.


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, mature on November 16, 2009, and bear interest at 15% per annum with
interest payments due when the principal amounts are repaid.  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.





Lender
            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,
      director, greater than 10% beneficial owner
            $100,000
            August
      28, 2009
            100,000Michael
      S. Barish
            Director,
      greater than 5% beneficial owner
            $75,000
            September
      1, 2009
            75,000Jervis
      B. Perkins
            Chief
      Executive Officer, director, and greater than 10% beneficial
      owner
            $25,000
            August
      28, 2009
            25,000J.
      Michael Wolfe
            Employee
      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, mature on February
1, 2009, and bear interest at 20% per annum with interest payments due when the
principal amounts are repaid.  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.





Lender
            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 5% beneficial owner
            $100,000
            November
      4, 2009
            100,000Jervis
      B. Perkins
            Chief
      Executive Officer, director, and greater than 10% beneficial
      owner
            $50,000
            October
      30, 2009
            50,000J.
      Michael Wolfe
            Employee
      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.





25
 Table of Contents





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 including, without limitation, those under
Regulation D 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





Over the
course of the next 12 months, we will require 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, and


·
            fund
      research and development efforts.





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.  We will also utilize funding provided by the issuances of
Series A Convertible Preferred Stock.  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, our business plan projects that we
will likely require additional funding in order to meet our cash requirements
for the next 12 months.  We are currently seeking to raise 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
execute our operational plans could 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 and cash management actions;
however, there can be no assurance that such actions will be sufficient to allow
us to fully execute our operating plan or meet our cash requirements over the
next 12 months.





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





26
 Table of Contents





Liquidity.  To assess
our ability to fund ongoing operating requirements over the next 12 months, 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 include:





·
            our
      cash of $485,332 (including $438,441 of restricted cash) as of September
      30, 2009,


·
            $1
      million in concessions we negotiated with certain of our unsecured
      creditors, as well as deferred payment schedules we agreed with a number
      of these, and other, unsecured
creditors,


·
            approximately
      $1.1MM in short-term, unsecured bridge
  financing,


·
            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 November 5, 2009, we had
      approximately $764,000 in unrestricted cash on hand and remaining
      availability 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,


·
            our
      anticipated sales to retail customers, international distributors, and
      consumers,


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


·
            our
      expectations regarding cash flow from
  operations.





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, on 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, and


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





Based on
the qualifications and contingencies presented above regarding liquidity, we
believe we can execute our operating plans.  However, the factors
noted above regarding results of operations could impact our expected financial
results, either positively or negatively.  As a result, we cannot be
certain that third-party financial forecasts will prove to be
accurate.





Off-Balance
Sheet Arrangements





We have
certain current commitments under capital leases and have not entered into any
contacts 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.
Quantitativeand Qualitative Disclosures About Market
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 September 30, 2009 under our credit facilities and
capital leases were approximately $7.5 million.  Based on amounts
borrowed as of September 30, 2009, we would have a resulting decline in future
annual earnings and cash flows of approximately $75,000 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.


27
 Table of Contents





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 4T.
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.


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
September 30, 2009.





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PART
II - OTHER INFORMATION





Item 1.Legal Proceedings





None.





Item 1A. RiskFactors





During
the three months ended September 30, 2009, there have not been any material
changes in risk factors previously disclosed.





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





Between
October 16, 2009 and October 21, 2009, the Company issued 750 shares of Series A
Convertible Preferred Stock in exchange for $599,979 in cash and 24,000 shares
of the Company’s common shares pursuant to agreements by and between the Company
and Alpha Capital Anstalt, Optimal Joy Limited, Joint Glory International
Limited, and New Finance Asset Limited.





The
Additional Series A Shares carry certain rights, preferences, and designations,
including the right to convert each Additional Series A Share into 5,000 shares
of the Company’s common stock.  Each Additional Series A Share has an
original issue price of $1,000.  In addition, the Additional Series A
Shares were issued with a total of 750 warrants (the “Warrants”) to purchase
additional Additional Series A Shares at an exercise price of $1,250 per
Additional Series A Share.  The exercise period for the Warrants
expires five years from the date of issuance.  The holders of the
Additional 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 Additional 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 Additional
Series A Share would otherwise receive in such event on an as-converted to
common stock basis.  The holders of the Additional Series A Shares
will vote along with holders of the Company’s common stock on an as-if-converted
basis.  Each Additional 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 Additional Series A Share.





In
addition, the holders of the Additional Series A Shares, along with other
existing holders of Series A Convertible Preferred Stock, 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 Additional Series A Shares was conducted in reliance upon
exemptions from registration under the Securities Act including, without
limitation, those under Regulation D promulgated under the Securities
Act.  The Additional Series A Shares were offered and sold only to
investors who are “accredited investors,” as defined in Rule 501 under the
Securities Act.





Proceeds
from the issuance of the Additional Series A Shares will be used for general
corporate purposes including but not limited to the payment of fixed expenses
and payments to vendors of goods and services.




Item 3. DefaultsUpon Senior Securities





None.





Item 4. Submissionof Matters to a Vote of Security
Holders





None.





Item 5. OtherInformation





None.




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 Table of Contents





Item6. 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 November 3, 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 January 31, 2005
      (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 July 27, 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 February 24, 2006
      (incorporated by reference to Exhibit 3.5 of our Current Report on Form
      8-K/A-2, filed November 16, 2006)3.6
            Amended
      Bylaws of the Company (incorporated by reference to Exhibit 3.6 of our
      Current Report on Form 8-K/A-2, filed November 16,
2006)3.7
            Certificate
      of Designations of Series A Convertible Preferred Stock (incorporated by
      reference to Item 15 of Form 10-K for the fiscal year ended March 31,
      2009, filed on July 6, 2009)3.8
            Amendment
      to Bylaws of the Registrant (incorporated by reference to Item 15 of our
      Form 10-K for the fiscal year ended March 31, 2009, filed on July 6,
      2009)10.1*
            Change in Terms Agreement, effective July 19, 2009,
      among First National Bank, Jack. J. Walker, and the
      Company10.2*
            Temporary Amendment to the Loan and Security Agreement
      between the Company and FCC, LLC, d/b/a First Capital, effective as of
      September 30, 2009.10.3*
            Waiver Agreement between the Company and FCC, LLC, d/b/a
      First Capital, dated November 19, 2009.10.4*
            Promissory Note in favor of Lazarus Investment Partners
      LLLP, dated as of September 1, 2009.10.5*
            Subordination and Assignment Agreements effective
      September 1, 2009 among FCC, LLC, d/b/a First Capital, Lazarus Investment
      Partners LLLP, and the Company.10.6*
            Promissory Note in favor of Jack J. Walker, dated August
      28, 2009.10.7*
            Subordination and Assignment Agreements effective August
      28, 2009 among FCC, LLC, d/b/a First Capital, Jack J. Walker, and the
      Company.10.8*
            Promissory Note in favor of Michael S. Barish, effective
      September 1, 2009.10.9*
            Promissory Note in favor of Jervis B. Perkins, effective
      August 28, 2009.10.10*
            Subordination and Assignment Agreements effective
      August 28, 2009 among FCC, LLC, d/b/a First Capital, Jervis B. Perkins,
      and the Company.10.11*
            Promissory Note in favor of J. Michael Wolfe, September
      1, 2009.10.12*
            Subordination and Assignment Agreements effective
      September 1, 2009 among FCC, LLC, d/b/a First Capital, J. Michael Wolfe,
      and the Company.10.13*
            Promissory Note in favor of H. Leigh Severance,
      effective September 1, 2009.10.14*
            Subordination and Assignment Agreements effective
      September 1, 2009 among FCC, LLC, d/b/a First Capital, H. Leigh Severance,
      and the Company.31.1*
            Certifications of the Chief Executive Officer Under
      Section 302 of the Sarbanes-Oxley Act31.2*
            Certifications of the Chief Financial Officer Under
      Section 302 of the Sarbanes-Oxley Act32.1*
            Certifications of the Chief Executive Officer Under
      Section 906 of the Sarbanes-Oxley Act32.2*
            Certifications of the Chief Financial Officer Under
      Section 906 of the Sarbanes-Oxley
Act





*
            Filed
      Herewith






30
 Table of Contents


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:  November
      19, 2009
            
            /s/Jervis
      B. PerkinsBy:
      Jervis B. PerkinsIts:
      Chief Executive Officer (Principal Executive Officer) and
      DirectorDate:  November
      19, 2009
            
            /s/H.
      MacGregor ClarkeBy:
      H. MacGregor ClarkeIts:
      Chief Financial Officer (Principal Financial Officer)Date: : November
      19, 2009
            
            /s/Grey
      H. GibbsBy:
      Grey H. GibbsIts:
      Controller (Principal Accounting
Officer)











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