$SRNA Form 10-K

Surna Inc. (“the Company”, “we”, or “our”) is a technology company that designs, manufactures, and distributes state-of-the-art systems for controlled environment agriculture (“CEA”). Our products offer growers improved process control while simultaneously reducing the energy and resources required to maximize crop yield. Currently, the Company’s revenues derive largely from supplying industrial-grade technology to state-regulated cannabis cultivation facilities with nominal revenue as well from other indoor agricultural producers including organic herb and vegetable producers. Ultimately, we plan to provide full-scale, energy efficient solutions for all aspects of a CEA facility.

We have a team of more than ten engineers with expertise in electrical, mechanical, optical, and thermodynamic engineering, as well as extensive cultivation experience. That team enables Surna to offer energy-efficient, turnkey solutions that include facility design, equipment manufacturing, and installation of our comprehensive line of lighting, cooling, and dehumidification systems that are optimized for indoor operations. Because of our specific expertise, our products are easily tailored and uniquely suited for state-regulated cannabis cultivation. Moreover, our technology is particularly valuable to state-regulated cannabis producers because growing cannabis is an extremely resource-intensive endeavor, and our technology can make a significant impact on the bottom line and long-term sustainability of such a facility. Furthermore, we anticipate that the already substantial demand for CEA products designed for cannabis will continue to grow as more states and countries begin to permit and regulate cannabis use and cultivation.

Products

Surna Chillers. Surna’s cornerstone technology and products are state-of-the-art liquid cooling systems that provide more efficient thermal cooling solutions that have a number of advantages over typical air conditioning products:

? Liquid-based cooling systems are more efficient. Our cooling systems and proprietary technologies rely on liquid, instead of air, as a medium for heat exchange, which is widely understood to increase efficiencies and versatility. Surna’s systems can reduce the costs associated with cooling facilities by anywhere from 10-75%, depending on the specific environment and the version of our system the client chooses.

? Closed-loop cooling systems reduce opportunities for contamination. Typical air conditioning systems provide a vector for contaminants to enter a grow room because they are vulnerable to pollutants from outside the building. Surna’s chillers use closed loop systems of cooled liquid, so there are fewer opportunities for outside contaminants to infiltrate a grow room. This allows our customers to focus on maintaining their plants and worry less about potential cross-pollination or contamination by molds, mildews, pests, and communicable plant diseases.

? Redundancy is essential. Due to the high value of indoor crops like cannabis, systems need to be designed with redundancy in mind in order to minimize the likelihood of crop loss due to system failure. Surna’s chillers are easily scalable and allow for redundant system design without significant cost.

Surna Reflectors. Surna has developed a new reflector that optimizes light-on-target reflectivity by using compound parabola morphology. Moreover, the premier reflector model incorporates Surna’s unique cooling capabilities for even greater efficiency gains. The liquid-cooled version of the reflector is designed to connect directly to Surna’s chillers or cooling towers so that the heat (an unfortunate byproduct of the necessary lighting) can be removed before it is transferred to a grow room, thereby reducing overall cooling needs and substantially reducing associated energy consumption. The company is currently releasing its liquid-cooled reflectors under a limited beta-test license. Two other models, the vented and forced-air reflectors, will also be available for use with any climate control system.

Because of the energy-intensive nature of indoor cannabis cultivation, even small improvements in the energy efficiency of any component can have a significant impact on a business’s bottom line. While typical reflectors achieve approximately 70% light-on-target reflectivity, Surna’s new reflector is expected to achieve close to 90% or better. Thus, Surna is optimistic the industry will quickly adopt its new reflector.

Hybridized Greenhouses. The Company is currently developing a hybrid structure to combine the advantages of a greenhouse with those of an indoor grow operation. Relying on natural sunlight, greenhouses offer much lower energy costs, but they often lack the environmental controls necessary to grow the best products, and they lack the security features necessitated by some state and international regulations. The Company anticipates that its hybrid facility will combine the best of both worlds at an economical price point for growers, and hopes to complete a proof-of-concept within the next twelve months.

Additional Targeted Products. We expect to expand our existing engineering department to include MEP (mechanical, electrical, and plumbing) services that will assist in engineering commercial scale indoor grow operations. By combining strategic acquisitions and in-house engineering, we aim to bring game-changing new technologies to the state regulated cannabis and indoor agriculture marketplace, which will contribute to our dramatic growth.

Furthermore, as part of our overall strategy to gain market share and create recurring revenue streams, we also plan to develop an integrated software platform that combines all of the indoor agriculture systems (lighting, temperature, humidity, environment, grow media, nutrients, etc.) into one user-friendly platform that will monitor the system in real-time to provide information to both the gardener and an automated oversight facility. The system is being designed to inform the gardener of irregularities relating to the agriculture in real time and provide a database of the system and its characteristics as compared and overlaid with the plant performance under various conditions.

Recent Developments

On October 16, 2014, we closed a private placement of convertible promissory notes to investors in the aggregate principle amount of $1,336,783. The notes
(i) are unsecured, (ii) bear interest at the rate of 10% per annum, and (iii) are due two years from the date of issuance. The convertible promissory notes are convertible at any time at the option of the investor into shares of the Company’s common stock that is determined by dividing the amount to be converted by the lesser of (i) $1.00 per share or (ii) eighty percent (80%) of the prior thirty day weighted average market price for the Company’s common stock. The Note holders are restricted to converting only ten percent of their position into common stock per month, for the initial six months following maturity. If the Note is held to maturity and not converted, the Note holder shall be paid an amount equal to the amount of the Note plus an additional amount equal to fifty percent (50%) of the Note (in lieu of the accrued annual interest).

Between October 31, 2014 and December 31, 2014, the Company sold 32.5 units consisting of an aggregate of (i) 8,125,000 shares of the Company’s common stock, (ii) $1,625,000 principal amount 10% convertible notes, and (iii) warrants for the purchase of an aggregate of 1,625,000 shares of the Company’s common stock. The Company paid an aggregate of $157,500 to its placement agent in commissions in connection with the sale of the units. All of the units were offered and sold only to accredited investors.

On January 5, 2015, we appointed Bryon Jorgenson as our Chief Operating Officer, effective January 12, 2015. Also on January 5, 2015, the Company entered into an employment agreement (the “Employment Agreement”) with Mr. Jorgenson. The Employment Agreement has a term of three years and provides for an annual base salary of $130,000, a one-time sign-on bonus of $15,000 and 1,200,000 stock options. Pursuant to the terms of the Employment Agreement, the Company will reimburse Mr. Jorgenson for his actual moving expenses up to a maximum of $20,000. The Employment Agreement contains a 1-year non-solicitation provision. Pursuant to the terms of the Employment Agreement, if Mr. Jorgenson’s employment is terminated upon a change of control, change of employment or without cause, the Company will pay Mr. Jorgenson six months’ severance.

On January 5, 2015, the Company and Mr. Jorgenson also entered into an executive officer confidentiality, non-competition and non-solicitation agreement (the “Confidentiality Agreement”). The Confidentiality Agreement provides that Mr. Jorgenson will have overall strategic and operational responsibility for all Company programs and will manage a group of departments. In addition, Mr. Jorgenson will be responsible for external relationship development and strategic plan implementation. The Confidentiality Agreement provides for a 12-month non-competition and non-solicitation period and a 5-year confidentiality period.

On January 8, 2015 we agreed to acquire 66% of the total membership interests in Agrisoft Development Group, LLC (“Agrisoft”) from its members Jim Willett and Forbeez Capital, LLC for an aggregate purchase price of $4,000,001. The purchase price will be paid 50% in our common stock and 50% will be in the form of a promissory note. The note will be a two-year note in the aggregate principal amount of $2,000,000, with interest accruing at 8% annually, payable in quarterly installments of $150,000, with the first $150,000 payment due 90 days following the closing date, and with a balloon payment due at maturity. On February 23, 2015 we amended our agreement to acquire an interest in Agrisoft whereby each of the parties to the agreement agreed that they may terminate the agreement at any time and if the sellers terminate, we may elect to have all loans we made to Agrisoft converted to equity. For purposes of determining the ownership interest we may acquire upon conversion of such loan, Agrisoft will be valued at $6,000,000. The closing for this transaction was extended to July 1, 2015.

Results of Operations

The following comparative analysis on results of operations was based primarily on the comparative audited financial statements, footnotes and related information for the periods identified below and should be read in conjunction with the financial statements and the notes to those statements that are included elsewhere in this report. Furthermore, our acquisition of Safari in March 2014 and Hydro in July 2014 reflect a fundamental shift in both the scale and focus of our operations. As such, a comparison from 2013 to 2014 will show extreme growth (~100%) in most categories.

                                                                 Year Ended
                                                                December 31,
                                                             2014            2013

 Revenue                                                 $  1,838,912     $       50
 Cost of revenue                                            1,534,918              -
 Gross margin                                                 303,994             50

 Operating Expenses
 Advertising and marketing                                    240,784              -
 Product development costs                                    319,430            100
 General and administrative expenses                        2,936,244        193,106
 Operating loss                                            (3,192,464 )     (193,156 )

 Other income (expense)
 Interest expense                                            (357,579 )            -
 Amortization of debt discount on convertible notes          (476,044 )            -
 Gain on derivative liability                               1,051,889              -
 Warrant expense on convertible notes                                              -

 Loss from continuing operations                           (2,974,198 )     (193,156 )

 Loss from discontinued operations                            (17,771 )            -

 Net loss                                                  (2,991,969 )     (193,156 )

 Comprehensive loss: Foreign currency translation loss              -         (6,946 )

 Comprehensive loss                                      $ (2,991,969 )   $ (200,102 )

Operating expenses in 2013 were largely for corporate, legal, and accounting expenses. Operating expenses for the year ended December 31, 2014 were $3,496,458 compared to $193,206 for the year ended December 31, 2013. The increase is attributable to increases in advertising and marketing expense of $240,784, product development costs of $319,430 and the increase for general and administrative expenses from $193,106 for the year ended December 31, 2013 to $2,936,244 for the year ended December 31, 2014, which includes $1,329,990 in consulting fees. Additionally the Company had other income of $218,266 for the year ended December 31, 2014 compared to $0 for the year ended December 31, 2013. The increase consists of interest expense of $(357,579), amortization of debt discount on convertible notes of $(476,044) and, gain on derivative liability of $1,051,889. The Company incurred a loss of $17,771 from discontinued operations in connection with the sale of Surna Media, Inc. and its affiliates. Overall, the Company has realized a net loss of $2,991,969 for the year ended December 31, 2014 compared to a net loss of $193,156 for the year ended December 31, 2013.

Liquidity and Capital resources

Liquidity is the ability of an enterprise to generate adequate amounts of cash to meet its needs for cash requirements. The following table is a summary of statement of cash flow:

                                                             Year Ended
                                                            December 31,
                                                          2014           2013

       Cash provided (used) in operating activities   $ (1,994,271 )   $  6,501
       Cash flows from investing activities               (235,995 )          -
       Cash flows from financing activities              2,919,477            -
       Effect of exchange rate changes on cash                   -       (6,946 )
       Net change in cash                             $    689,211     $   (445 )

Pursuant to the terms of our employment agreement with David W. Traylor, our Chief Business Officer, we are obligated to pay Mr. Traylor $110,400 per year.

Pursuant to the terms of our employment agreement with Bryon Jorgenson, our Chief Operating Officer, we are obligated to pay Mr. Jorgenson $130,000 per year.

Cash Requirements

Our ability to fund our growth and meet our obligations on a timely basis is dependent on our ability to match our available financial resources to our growth strategy which includes acquisitions for cash or a combination of cash and debt. The decisions we make with regard to acquisitions drive the level of capital required and the level of our financial obligations.

If we are unable to generate cash flow from operations and successfully raise sufficient additional capital through future debt and equity financings or strategic and collaborative ventures with potential partners, we would likely have to reduce the size and scope of our acquisitions. During the year ended 2014, the Company raised a total of $2,961,783 in connection with two private placements. Subsequent to year ended December 31, 2014 the Company has raised an additional $911,250 through March 21, 2015.

We have suffered recurring losses from operations. The continuation of our company is dependent upon our company attaining and maintaining profitable operations and raising additional capital as needed. In this regard, we have raised additional capital through equity offerings and loan transactions, and, in the short term, will seek to raise additional capital in such manners to fund our operations. Our officers and shareholders have not made any written or oral agreement to provide us additional financing. There can be no assurance that we will be able to continue to raise capital on terms and conditions that are deemed acceptable to us.

Inflation

In the opinion of management, inflation has not and will not have a material effect on our operations in the immediate future. Management will continue to monitor inflation and evaluate the possible future effects of inflation on our business and operations.

Off Balance Sheet Arrangements

Under Commission regulations, we are required to disclose our off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, such as changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. As of December 31, 2014, we have no off-balance sheet arrangements.

Going Concern

The Company’s independent registered public auditor’s report accompanying our December 31, 2014 and 2013 audited financial statements contains an explanatory paragraph expressing substantial doubt about our ability to continue as a going concern. The financial statements have been prepared “assuming that the Company will continue as a going concern.” Our ability to continue as a going concern is dependent on raising additional capital to fund our operations and ultimately on generating future profitable operations. There can be no assurance that we will be able to raise sufficient additional capital or eventually have positive cash flow from operations to address all of our cash flow needs. If we are not able to find alternative sources of cash or generate positive cash flow from operations, our business and shareholders will be materially and adversely affected.

Critical Accounting Policies

To aid in the understanding of our financial reporting, our most critical accounting policies are described in the notes accompanying our financial statements. These policies have the potential to have a more significant impact on our financial statements, either because of the significance of the financial statement item to which they relate, or because they require judgment and estimation due to the uncertainty involved in measuring, at a specific point in time, events which are continuous in nature.

Use of Estimates:

The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and that affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Reclassifications:

Effective June 30, 2014, the Company sold all of its interest in its wholly owned subsidiary Surna Media, along with Surna Media’s subsidiaries Surna HK and Flying Cloud. As a result, the assets and liabilities of Surna Media and its subsidiaries have been reclassified as assets held for sale on the December 31, 2013 balance sheet.

Certain reclassifications have been made to amounts in prior periods to conform with the current period presentation. All reclassifications have been applied consistently to the periods presented.

Financial Instruments:

The accounting standards regarding fair value of financial instruments and related fair value measurements define fair value, establish a three-level valuation hierarchy for disclosures of fair value measurement and enhance disclosure requirements for fair value measures.

The three levels are defined as follows:

? Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

? Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

? Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement.

Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The Company has determined that the convertible debt instruments outstanding as of the date of these financial statements include an exercise price “reset” adjustment that qualifies as derivative financial instruments under the provisions of ASC 815-40, Derivatives and Hedging – Contracts in an Entity’s Own Stock (“ASC 815-40”). See Note 8 for discussion of the impact the derivative financial instruments had on the Company’s consolidated financial statements and results of operations.

The fair value of these derivative notes was determined using a Black-Scholes-Merton option pricing model with any change in fair value during the period recorded in earnings as “Other income (expense) – Unrealized gain
(loss) on change in convertible derivative value.”

Significant Level 3 inputs used to calculate the fair value of the derivative notes include the stock price on the valuation date, expected volatility, risk-free interest rate and management’s assumptions regarding the likelihood of a repricing of these derivative notes pursuant to the anti-dilution provision. See Note 5 for further discussion.

The carrying amounts reported in the balance sheets for cash, accounts payable and accrued expenses approximate their fair market value based on the short-term maturity of these instruments.

The following table presents assets and liabilities that are measured and recognized at fair value as of December 31, 2014, on a recurring basis:

                                                                                  Gains
Description                       Level 1         Level 2         Level 3         (Losses)
Derivative liability on
warrants                       $         -     $         -     $   304,432     $          -
Derivative liability on
conversion feature                       -     $         -         847,438        1,051,889
Total                          $         -     $         -     $ 1,151,870       $1,051,889

Revenue Recognition:

The Company provides climate equipment, integrated solutions, and installation designed for the CEA industry through construction-type contracts. The term of these types of contracts is typically less than one year. Revenues related to these contracts are recognized upon shipment to the customer.

Accounts Receivable and Allowance for Doubtful Accounts:

Accounts receivable are recorded at invoiced amount and generally do not bear interest. An allowance for doubtful accounts is established, as necessary, based on past experience and other factors which, in management’s judgment, deserve current recognition in estimating bad debts. Such factors include growth and composition of accounts receivable, the relationship of the allowance for doubtful accounts to accounts receivable and current economic conditions. The determination of the collectability of amounts due from customer accounts requires the Company to make judgments regarding future events and trends. Allowances for doubtful accounts are determined based on assessing the Company’s portfolio on an individual customer and on an overall basis. This process consists of a review of historical collection experience, current aging status of the customer accounts, and the financial condition of Surna’s customers. Based on a review of these factors, the Company establishes or adjusts the allowance for specific customers and the accounts receivable portfolio as a whole. At December 31, 2014, an allowance of $10,000 for doubtful accounts was considered necessary as most accounts receivable were deemed collectible. At December 31, 2013 an allowance for doubtful accounts was not considered necessary as all accounts receivable were deemed collectible.

Concentration of Credit Risk:

Financial instruments that potentially subject Surna to concentration of credit risk consist of cash and accounts receivable. Under Section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, for the two-year period of January 1, 2013 through December 31, 2014, cash balances in noninterest-bearing transaction accounts at all FDIC-insured depository institutions are provided temporary unlimited deposit insurance coverage. At December 31, 2014, cash balances in interest-bearing accounts are $0.

The Company’s revenues earned from sale of products for the year ended December 31, 2014 included an aggregate of 11% of the Company’s total revenues from one customer. The Company purchased 75% of it cost of goods sold from four vendors during the year ended December 31, 2014. The Company believes that, in the event that its primary vendors are unable or unwilling to continue to sell their products, there are alternative vendors at comparable prices.

Comprehensive Income (Loss):

The Company adopted Accounting Standards Codification subtopic 220-10, Comprehensive Income (“ASC 220-10”) which establishes standards for the reporting and displaying of comprehensive income (loss) and its components. Comprehensive income (loss) is defined as the change in stockholders’ equity (deficit) of a business during a period from transactions and other events and circumstances from non-owners sources. It includes all changes in stockholders’ equity (deficit) during a period except those resulting from investments by owners and distributions to owners. ASC 220-10 requires other comprehensive income (loss) to include foreign currency translation adjustments and unrealized gains and losses on available for sale securities.

Research and Development

The Company accounts for research and development cost in accordance with Accounting Standards Codification subtopic 730-10, Research and Development (“ASC 730-10”). ASC 730-10 requires research and development costs to be charged to expenses as incurred. Accordingly, internal research and development costs are expensed as incurred. Third-party research and developments costs are expensed when the contracted work has been performed or as milestone results have been achieved. For the year ended December 31, 2014, we incurred approximately $319,430 for research and development expenses which are included in the consolidated statements of operations.

Fair Value Measurements

The carrying value of financial instruments, including cash and cash equivalents, accrued liabilities, and accounts payable approximate fair value because of the short maturity of these instruments. The carrying amount of amounts due to related party approximates fair value primarily because all amounts due to related parties are due on demand or have relatively short maturities and considered short term.

Income Taxes

The Company accounts for income taxes using the asset and liability approach for financial accounting and reporting for income taxes and recognizes and measures deferred tax assets based upon the likelihood of realization of tax benefits in future years. Under the asset and liability approach, deferred taxes are . . .