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 1934
 
For the quarterly period ended  September 30, 2010
 
OR
 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
 
For the transition period from  ______________ to ______________
  
Commission File No.  001-33531
 
AEROGROW INTERNATIONAL, INC.
(Exact Name of Registrant as specified in its charter)
 
NEVADA
46-0510685
(State or other jurisdiction
of incorporation or organization)
(IRS Employer
Identification 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 o No o

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

Large accelerated filer   o
Accelerated filer    o
 
Non-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 November 8, 2010:  12,650,605
 
 
 

 
AeroGrow International, Inc.
TABLE OF CONTENTS
FORM 10-Q REPORT
September 30, 2010
 
     
     
PART I   Financial Information
 
     
Item 1.
3
 
3
 
4
 
5
 
7
     
Item 2.
20
Item 3.
38
Item 4.
39
     
PART II  Other Information
 
     
Item 1.
40
Item 1A.  
40
Item 2.
40
Item 3.
41
Item 4.
41
Item 5.
41
Item 6.
42
43
 
 
 


Item 1. Condensed Financial Statements
  AERO GROW INTERNATIONAL, INC.
CONDENSED BALANCE SHEETS
 
   
September 30, 2010
   
March 31, 2010
 
ASSETS
 
(Unaudited)
   
(Derived from Audited Statements)
 
Current assets
           
Cash
  $ 629,178     $ 249,582  
Restricted cash
    87,904       443,862  
Accounts receivable, net of allowance for doubtful accounts of
     $85,416 and $87,207 at September 30, 2010 and March 31, 2010, respectively
    360,411       478,113  
Other receivables
    104,108       259,831  
Inventory
    4,245,458       3,493,732  
Prepaid expenses and other
    552,994       338,095  
            Total current assets
  $ 5,980,053     $ 5,263,215  
Property and equipment, net of accumulated depreciation of
      $2,875,420 and $2,486,377 at September 30, 2010 and March 31,  2010, respectively
    672,731       1,002,530  
Other assets
               
Intangible assets, net of $16,468 and $6,854 of accumulated
     amortization at September 30, 2010 and March 31, 2010,  respectively
    270,053       275,599  
Deposits
    217,840       240,145  
Deferred debt issuance costs, net of accumulated amortization
     of $244,316 and $486,791 at September 30, 2010 and March 31, 2010,  respectively
    1,867,280       62,291  
            Total other assets
  $ 2,355,173     $ 578,035  
Total Assets
  $ 9,007,957     $ 6,843,780  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
               
Current liabilities
               
Current portion – long term debt – related party
  $ 143,743     $ 911,275  
Current portion – long term debt
    1,914,636       3,053,984  
Accounts payable
    1,974,605       3,354,703  
Accrued expenses
    2,006,646       1,449,977  
Customer deposits
    13,223       339,041  
Deferred rent
    32,519       40,773  
            Total current liabilities
  $ 6,085,372     $ 9,149,753  
Long term debt
    1,407,070       1,020,957  
Long term debt – related party
    136,926       -  
Stockholders' equity
               
Preferred stock, $.001 par value, 20,000,000 shares authorized and
     7,586 shares issued and outstanding at September 30,  2010 and March 31, 2010
    8       8  
Common stock, $.001 par value, 500,000,000 shares authorized,
     12,650,605 and 12,398,249 shares issued and outstanding at
     September 30, 2010 and March 31, 2010, respectively
    12,650       12,398  
Additional paid-in capital
    61,497,338       52,933,467  
Accumulated (deficit)
    (60,131,407 )     (56,272,803 )
Total Stockholders' Equity (Deficit)
  $ 1,378,589     $ (3,326,930 )
Total Liabilities and Stockholders' Equity (Deficit)
  $ 9,007,957     $ 6,843,780  

See accompanying notes to the condensed financial statements.

 
3

 
AEROGROW INTERNATIONAL, INC.
CONDENSED STATEMENTS OF OPERATIONS
(Unaudited)

   
Three Months ended
September 30,
   
Six Months ended
September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Revenue
                       
Product sales
  $ 1,379,617     $ 3,285,949     $ 3,197,636     $ 6,265,642  
                                 
Operating expenses
                               
Cost of revenue
    1,038,812       2,270,556       2,360,515       4,140,361  
Research and development
    52,745       173,354       89,760       292,552  
Sales and marketing
    593,309       1,248,102       1,410,287       2,407,898  
General and administrative
    812,300       1,299,598       1,708,483       2,753,806  
Total operating expenses
  $ 2,497,166     $ 4,991,610     $ 5,569,045     $ 9,594,617  
                                 
Profit (loss) from operations
    (1,117,549 )     (1,705,661 )     (2,371,409 )     (3,328,975 )
                                 
Other (income) expense, net
                               
Interest (income)
    (1,900 )     (61 )     (8,530 )     (141 )
Interest expense
    933,400       239,940       1,451,500       485,990  
Interest expense – related party
    94,490       -       155,749       -  
Other (income)
    (13,986 )     (180,286 )     (111,525 )     (987,838 )
Total other (income) expense, net
    1,012,004       59,593       1,487,194       (501,989 )
                                 
Net income (loss)
  $ (2,129,553 )   $ (1,765,254 )   $ (3,858,603 )   $ (2,826,986 )
                                 
Net income (loss) per share, basic
  $ (0.17 )   $ (0.14 )   $ (0.31 )   $ (0.22 )
                                 
Net income (loss) per share, diluted
  $ (0.17 )   $ (0.14 )   $ (0.31 )   $ (0.22 )
                                 
Weighted average number of common shares
     outstanding used to calculated basic net
     income (loss) per share
    12,566,486       12,422,249       12,566,486       12,729,125  
                                 
Effect of dilutive securities:
                               
    Equity based compensation
    -       -       -       -  
Weighted average number of common shares
    outstanding used to calculated diluted net
    income per share
    12,566,486       12,422,249       12,566,486       12,729,125  
 
See accompanying notes to the condensed financial statements.
 
 
AEROGROW INTERNATIONAL, INC.
CONDEN SED STATEMENTS OF CASH FLOWS
(Unaudited)

   
Six months ended September 30,
 
   
2010
   
2009
 
Cash flows from operating activities:
           
Net (loss)
  $ (3,858,603 )   $ (2,826,986 )
Adjustments to reconcile net (loss) to cash (used) by operations:
               
Issuance of common stock and options under equity compensation plans
    39,887       338,919  
Issuance of common stock not under equity compensation plans
    24, 983       --  
Issuance of warrants related to debt
    --       15,000  
Depreciation and amortization expense
    398,656       435,987  
Allowance for bad debt
    (1,781 )     (787,347 )
Amortization of debt issuance costs
    306,254       101,236  
    Gain on forgiveness of accounts payable
    --       (807,310 )
    Amortization of convertible debentures, beneficial conversion feature
    362,633       --  
    Amortization of convertible debentures, beneficial conversion feature -
             related party
    51,399       --  
    Interest expense from warrants issued with convertible debentures
    343,570       --  
    Interest expense from warrants issued with convertible debentures –
             related party
    49,527       --  
Change in assets and liabilities:
               
Decrease in accounts receivable
    119,482       621,218  
Decrease in other receivable
    155,723       292,598  
(Increase) decrease in inventory
    (751,726 )     596,319  
(Increase) decrease in other current assets
    (214,899 )     59,098  
(Increase) decrease in deposits
    22,306       (80,000 )
(Decrease) in accounts payable
    (1,330,096 )     (650,025 )
Increase (decrease) in accrued expenses
    556,669       (843,754 )
Increase in accrued interest
    155,958       19,589  
Increase (decrease) in accrued interest-related party
    15,754       (30,652 )
Increase (decrease) in customer deposits
    (325,818 )     213,141  
(Decrease) in deferred rent
    (8,254 )     (8,255 )
Net cash (used) by operating activities
  $ (3,888,376 )   $ (3,341,224 )
Cash flows from investing activities:
               
(Increase) decrease in restricted cash
    355,958       (110 )
Purchases of equipment
    (59,243 )     (2,607 )
Patent expenses
    (4,069 )     (27,030 )
Net cash provided (used) by investing activities
  $ 292,646     $ (29,747 )
Cash flows from financing activities:
               
(Increase) in prepaid debt issuance costs
    (593,626 )     (62,500 )
Proceeds from long term debt borrowings
    2,060,425       5,623,317  
Proceeds from long term debt borrowings-related party
    --       225,000  
Repayments of long term debt borrowings
    (2,123,950 )     (6,435,093 )
Repayments of long term debt borrowings-related party
    (1,127,989 )     --  
Proceeds from the issuance of convertible debt
    5,485,000       --  
Proceeds from the issuance of convertible debt-related party
    300,000       --  
Proceeds from the exercise of stock options
    252       20  
Proceeds from the issuance of preferred stock
    --       3,801,000  
Principal payments on capital leases
    (24,786 )     (66,580 )
Net cash provided by financing activities
  $ 3,975,326     $ 3,085,164  
Net increase (decrease) in cash
    379,596       (285,807 )
Cash, beginning of period
    249,582       332,698  
Cash, end of period
  $ 629,178     $ 46,891  
 
See supplemental disclosures below and the accompanying notes to the condensed financial statements.
 
 
   
Six Months Ended September 30,
 
   
2010
   
2009
 
Interest paid
  $ 137,303     $ 293,765  
    Income taxes paid
  $ -     $ -  
                 
Supplemental disclosure of non-cash investing and financing activities:
               
     Conversion of related party debt to equity
  $ -     $ 1,200,000  
     Conversion of accounts payable to equity
  $ -     $ 1,043,000  
     Increase of notes  receivable for equity
  $ -     $ 139,000  
     Increase of notes receivable, related party for equity
  $ -     $ 762,000  
     Decrease of notes receivable, related party for equity as debt payment
  $ -     $ 50,000  
     Modification of accrued expenses to equity
  $ -     $ 89,000  
     Modification of accounts payable to long term debt
  $ -     $ 1,386,040  
     Modification of debt to convertible debt
  $ 475,000     $ -  
     Modification of related party debt to related party convertible debt
  $ 656,406     $ -  
     Modification of accrued interest to convertible debt
  $ 33,757     $ -  
     Modification of related party accrued interest to related party
             convertible debt
  $ 19,847     $ -  
     Modification of accounts payable to convertible debt
  $ 50,000     $ -  
     Conversion of convertible note to common stock
  $ 25,236     $ -  
     Warrants issued to placement agent as a cost of debt issuance
  $ 1,518,600     $ -  
 
 
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.  We are in the business of developing, marketing, and distributing advanced indoor aeroponic and hydroponic garden systems. After several years of initial research and product development, we began sales activities in March 2006. Since that time we have expanded all aspects of our operations in order to take advantage of what we believe to be an attractive market opportunity.  We currently offer more than 15 different indoor garden models, more than 50 seed kits, and various gardening and kitchen accessories.  Although our business is focused on the United States and Canada, our products are available in nine other countries.

During the fiscal year ended March 31, 2010 (“Fiscal 2010”), and continuing through September 30, 2010, we have scaled back our operations as a result of the general economic downturn and the resulting decline in consumer confidence and spending.  We also determined that broad distribution through retail channels was not appropriate for a company at our stage of development because of relatively low profit margins, high capital requirements, and the operational requirements of our retailer customers.  As of September 30, 2010, our products were offered in approximately 850 storefronts in North America, as compared to approximately 3,600 stores as of September 30, 2009.  Although we expect to further reduce the number of retailer storefronts carrying our products during the fiscal year ending March 31, 2011, we plan to maintain relationships with retailers, both traditional and non-traditional, that have historically proven to be good business partners for AeroGrow.  In this regard, we plan to continue selling through our largest retailer customers, including three customers that comprised approximately 59% of our retailer sales during Fiscal 2010.

In Fiscal 2010 we re-focused our efforts towards building our direct-to-consumer business, which carries higher margin opportunity. To position our business for the future, we have increased the depth and breadth of our direct sales distribution channels to include a direct mail catalogue business with approximately 3.7 million catalogues mailed in Fiscal 2010, web sales, infomercials, and 60 and 120 second television commercials.  Our products are also sold through television home shopping channels and by online retailers.  In Fiscal 2010, approximately 57.5% of our total sales were to direct customers.

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, 2010, as filed with the SEC on June 25, 2010.

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, 2010, the results of operations for the three and six months ended September 30, 2010 and 2009, and the cash flows for the six months ended September 30, 2010 and 2009. The results of operations for the three and six months ended September 30, 2010, 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, 2010, 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, 2010 of $3,858,603.  Sources of funding to meet prospective cash requirements include the Company’s existing cash balances, cash flow from operations, and borrowings under the Company’s debt arrangements.
 

During Fiscal 2010 we began the process of re-capitalizing the Company by issuing approximately $6.7 million in convertible preferred shares.  In addition, we negotiated deferred payment arrangements with certain vendors, negotiated reduced balances with certain vendors, and reduced the amount of our interest-bearing debt and our accounts payable obligations.  Nonetheless, we continued to face cash and liquidity constraints during Fiscal 2010 that were, at times, severe, and that had a material impact on our ability to operate our business.  In May, June and September 2010, we issued an aggregate of $7.02 million in convertible secured subordinated debt to supplement our internal cash sources and to address our liquidity constraints.

Because of the seasonality of our business and our working capital requirements, our liquidity position is at its low point during the summer and fall months.  To address the seasonality of our liquidity requirements for the current fiscal year, we recently closed on $1.5 million in 9-month convertible notes secured by a portion of our prospective credit card receipts.  With these facilities in place, we believe we have sufficient liquidity to support our operations through the balance of our current fiscal year.  Subsequent to that time period, in order to continue to meet our liquidity requirements we will need to secure additional capital, either in the form of seasonal working capital borrowings, or longer-term debt or equity capital, or reduce our scale of operations.  There can be no assurance that the Company will have access to sufficient capital, from our existing financing sources or from other sources, to enable us to meet our short-term cash requirements.  In the event the Company takes actions to reduce its scale of operations, there can be no assurance that such actions will be sufficient, or on a timely basis, to allow the Company to meet its liquidity requirements.

The Company’s liquidity projections are predicated on a variety of assumptions including, but not limited to:  the timing and seasonality of working capital needs, revenue and expenses, cash flow from operations, access to sufficient funding, the levels of customer and consumer demand, the impact of cost reduction programs, and the state of the general economic environment in which the Company operates.  In the event these assumptions prove to be inaccurate, there could be material adverse changes to the Company’s liquidity position, and there can be no assurance given that the Company would be able to successfully support its operations in such circumstances.

Significant Accounting Policies
 
Use of estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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 regard to return reserves, inventory obsolescence and the allowance for bad debts will occur in the near term.

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

Reclassifications
Certain prior year 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.  The amount on deposit with a financial institution exceeded the $250,000 federally insured limit as of September 30, 2010.  However, management believes that the financial institution is financially sound and the risk of loss is minimal.

Customers:
The Company maintains a credit insurance policy on many of its trade accounts receivables. For the three months ended September 30, 2010, the Company had one customer, Canadian Tire Corporation, who represented 16.3% of the Company’s net product sales.  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 six months ended September 30, 2010, the Company had one customer, Canadian Tire Corporation, who represented 8.4% of 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.

Suppliers:
For the three months ended September 30, 2010, the Company purchased inventories and other inventory-related items from three suppliers totaling $237,067, $174,834, and $131,411, representing 22.8%, 16.8% and 12.7% of cost of sales, respectively.  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, respectively.  For the six months ended September 30, 2010, the Company purchased inventories and other inventory-related items from three suppliers totaling $341,310, $272,869, and $200,973, representing 14.5%, 11.6%, and 8.5% of cost of sales, respectively.  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, respectively.  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.

Accounts Receivable:
As of September 30, 2010, the Company had one customer, Canadian Tire Corporation who represented 60% of outstanding accounts receivable.  Management believes all receivable from this customer are collectible.  As of September 30, 2010, the Company also had two customers who represented 9%, and 7% of outstanding accounts receivables.  As of March 31, 2010, the Company had two customers who represented 23% and 20% of outstanding accounts receivables.

Fair Value of Financial Instruments
ASC 820-10-55 (prior authoritative guidance: FSP 157-2/Statement 157, Fair Value Measurements) defines fair value as the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (also referred to as an exit price).  ASC 820-10-55 also establishes a three-level fair value hierarchy for classifying financial instruments that is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable.  The three levels of the ASC 820-10-55 fair value hierarchy are described below:

 
Level 1:
Quoted prices (unadjusted) in active markets for identical assets or liabilities.
 
Level 2:
Observable market-based inputs, other than quoted prices in active markets for identical assets or liabilities.
 
Level 3:
Unobservable inputs.
 
As of September 30, 2010 and March 31, 2010, the carrying amounts of cash and cash equivalents, accounts receivable, and accounts payable approximated fair value because of the relatively short maturities of these instruments.  The carrying amount of debt approximated fair value as of September 30, 2010 and March 31, 2010, based upon the terms and conditions currently available to the Company in comparison to the terms and conditions of the existing debt.

 
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 generally range from net 30 days to net 60 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 $85,416 and $87,207 at September 30, 2010 and March 31, 2010, respectively.

Other Receivables
In conjunction with the Company’s processing of credit card transactions for its direct-to-consumer sales activities and as security with respect to the Company’s performance for required credit card refunds and charge backs, 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, 2010 and March 31, 2010, the balance in this reserve account was $104,108 and $259,831, respectively.

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 ASC 340-20-25 (prior authoritative guidance: Statement of Position, “No. SOP 93-7” Reporting on Advertising Costs ). In accordance with ASC 340-20-25, direct response advertising costs incurred are reported as assets and are amortized 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, 2010 and September 30, 2009, the Company had deferred $4,556 and $49,698, respectively, related to such media costs. Advertising expenses for the three and six months ended September 30, 2010 were $123,437 and $350,502, respectively, and for the three and six months ended and September 30, 2009 were $196,587 and $649,169, 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,
 
   
2010
   
2010
 
Finished goods
 
$
3,373,482
   
$
2,515,451
 
Raw materials
   
871,976
     
978,281
 
   
$
4,245,458
   
$
3,493,732
 

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, 2010 and March 31, 2010, the Company had reserved $81,451 and $670,134, 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.

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, 2010 and September 30, 2009, the Company had accrued $72,970 and $370,468 respectively, as its estimate for the foregoing deductions and allowances.

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, 2010 and March 31, 2010 a provision for potential future warranty costs of $57,408 and $55,842, 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 a fixed 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, 2010 and March 31, 2010, the Company has recorded a reserve for customer returns of $18,687 and $47,398, respectively.

3.  
Capital Lease Obligations

As of September 30, 2010, the Company had capitalized lease obligations for factory equipment due November 2010 of $6,672 at 12% interest per annum.  This lease obligation is collateralized by related assets with a net book value of $44,194 as of September 30, 2010. 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 $4,529 in prepaid rents.

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

First National Loan

On May 19, 2008, the Company and Jack J. Walker, then one of the Company’s directors and now the Company’s Chairman and CEO, acting as co-borrowers, entered into a Business Loan Agreement with First National Bank for a loan to the Company in a principal amount of up to $1,000,000 (the “FNB Loan”).  The FNB Loan had an initial maturity date of May 19, 2009, which was extended by various agreements between the Company and FNB.

Principal payments totaling $408,439 were made by Mr. Walker against the FNB Loan during the loan term.  The first $150,000 of payments made by Mr. Walker was recorded by the Company as an offset to a $150,000 receivable due from Mr. Walker.  The remaining $258,439 was recorded by the Company as promissory notes due to Mr. Walker, which carried an interest rate of 20% per annum.  On May 7, 2010, the Company paid $50,000 in principal and $4,603 in interest to Mr. Walker.  On June 24, 2010, Mr. Walker converted $206,406 of principal and accrued interest on the promissory notes into three year convertible promissory notes (the “Subordinated Secured Convertible Notes”) issued by the Company, as further described below under the caption “Subordinated Secured Convertible Notes.”  On June 28, 2010, the Company paid $17,109 in remaining principal and interest to Mr. Walker.
 

On May 24, 2010, the Company paid the remaining balance on the FNB Loan of $511,647, including accrued interest, and the FNB Loan 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”) for a revolving credit facility (the “Revolving Credit Facility”) to fund working capital requirements.  The Revolving Credit Facility had an initial termination date of June 23, 2010.  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.  From time to time, Jack J. Walker, then one of the Company’s directors and now the Company’s Chairman and CEO, provided guarantees of up to a maximum of $1.5 million of the Company’s obligations under the Revolving Credit Facility.  Through the term of the Revolving Credit Facility, the Company, FCC and Mr. Walker, as guarantor, entered into various agreements to amend the terms of the Revolving Credit Facility.

On May 3, 2010, the Company, FCC, and Jack J. Walker, as guarantor, executed a Forbearance Agreement and Fifth Amendment (the “Fifth Amendment”) effective as of April 30, 2010.  Under the Fifth Amendment, FCC agreed to forbear from exercising its rights and remedies with regard to the Company’s non-compliance with financial covenants until May 21, 2010, if no other defaults occur.  The Fifth Amendment enabled the Company to borrow up to $600,000 more than would otherwise be permitted by the applicable borrowing base calculation under the Revolving Credit Facility until the earlier of (i) the Company closing on a sale of subordinated secured convertible promissory notes, or (ii) the termination date of the forbearance period.  In addition, the Fifth Amendment set the maximum borrowing under the Revolving Credit Facility at $2,000,000 until such time as the Company closed on a sale of subordinated secured convertible promissory notes, at which time the maximum borrowing amount was required to be reduced to $1,000,000.  The Fifth Amendment provided for a continuation of the $500 per day forbearance fee set forth in the Fourth Amendment, with such fees related to both the Fourth Amendment and Fifth Amendment to be payable on the earlier of (i) May 21, 2010 or (ii) the date on which loans under the Revolving Credit Facility were repaid in full.

On May 24, 2010, the Company paid $673,600 to FCC to repay, in full, amounts due under the Revolving Credit Facility, and the Revolving Credit Facility was terminated.

During Fiscal 2011, Mr. Walker was paid a fee of $25,000 for guaranteeing the Company’s obligations under the Revolving Credit Facility.
 
Main Power Promissory Note

On June 30, 2009, the Company entered into a Letter Agreement (“Letter Agreement”) with Main Power Electrical Factory, Ltd. (“Main Power”) and executed a Promissory Note.  Pursuant to the terms of the Letter Agreement, Main Power agreed to release the Company from $1,386,041 of existing accounts payable obligations owed by the Company to Main Power 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 Main Power.  The Promissory Note has a final maturity of June 30, 2011, and carries an interest rate of 8% per annum, with interest accrued and added to the principal amount of the Promissory Note for the first year.  During the second year of the Promissory Note, interest is due and payable quarterly.  Principal payments of $150,000 are due and payable monthly beginning January 31, 2011, with a final payment of all principal and accrued but unpaid interest due on June 30, 2011.  As of September 30, 2010, the outstanding balance under the Promissory Note totaled $1,510,425, including accrued interest.

Bridge Financing

On August 28 through September 1, 2009, the Company entered into bridge financing arrangements totaling $500,000 (the “Bridge Loans”) with six lenders who were directors or officers, or who had greater than a 10% beneficial ownership in the Company.  The Bridge Loans were unsecured, subordinated to loans made to the Company by FCC, and accrued interest at 15% per annum.  The Company issued 500,000 warrants to purchase common shares of the Company to the Lenders.  Each of the warrants has a five-year term and an exercise price of $0.25 per common share.
 

On May 6, 2010, $430,466 of the Bridge Loans, inclusive of accrued interest, was converted into the Subordinated Secured Convertible Notes issued by the Company, as further described below.  In addition, on May 6, 2010, $25,000 of the Bridge Loans was extended to a new maturity date of February 1, 2011.  On June 24, 2010, an additional $43,594 of the Bridge Loans, inclusive of accrued interest, was converted into the Subordinated Secured Convertible Notes issued by the Company, as described below under the caption “Subordinated Secured Convertible Notes.  As of September 30, 2010, $55,610 in Bridge Loans were outstanding, including accrued interest.

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.  Directors, officers, and shareholders with greater than a 10% beneficial ownership in the Company extended $400,000 of the Additional Bridge Loans.  The remaining $180,000 in Additional Bridge Loans was guaranteed by Jack J. Walker, then one of the Company’s directors and now the Company’s Chairman and CEO.  The Additional Bridge Loans were unsecured, subordinated to loans made to the Company by FCC, and accrued interest at 20% per annum.  The Company issued 580,000 warrants to purchase common shares of the Company to the Additional Lenders.  Each of the warrants has a five-year term and an exercise price of $0.25 per common share.

On May 6, 2010, $504,534 of the Additional Bridge Loans, inclusive of accrued interest, was converted into the Subordinated Secured Convertible Notes issued by the Company, as described below under the caption “Subordinated Secured Convertible Notes.”   Of this amount, $379,534 was converted by directors, officers, and shareholders with greater than a 10% beneficial ownership in the Company.  In addition, on May 6, 2010, $50,000 of the Additional Bridge Loans was extended to a new maturity date of February 1, 2011.  On June 1, 2010, a payment of principal and interest totaling $74,390 was made against the Additional Bridge Loans.   As of September 30, 2010, $64,164 in Additional Bridge Loans were outstanding, including accrued interest.

First Western Trust Credit Facilities

On May 21, 2010, the Company and First Western Trust Bank (“FWTB”) executed a business loan agreement and related promissory note (the “FWTB Line of Credit”).  The FWTB Line of Credit provides for loans by FWTB to the Company of up to a maximum of $2 million at any given time, subject to the Company maintaining an equivalent amount of cash on deposit in a restricted account at FWTB.  Loans under the FWTB Line of Credit bear interest at a fixed rate of 2.0% per annum.  In addition, the Company paid FWTB an origination fee of $2,500.  The terms and conditions of the FWTB Line of Credit include limitations on the Company incurring additional debt and paying dividends on the Company’s stock without the consent of FWTB.  In the event of a default under the FWTB Line of Credit, FWTB has the option to declare any loans outstanding immediately due and payable.  During the quarter ended September 30, 2010 there were no borrowing under the FWTB line of credit.  As of September 30, 3010 there were no loans outstanding under the FWTB Line of Credit.  On October 22, 2010 the FWTB Line of Credit was terminated.

On May 21, 2010, the Company, FWTB and Jack J. Walker, the Company’s Chairman and CEO, as guarantor, executed a business loan agreement and related promissory note (the “FWTB Term Loan”) for a four-year loan in an initial principal amount of $1 million.  The FWTB Term Loan is secured by a lien on the Company’s assets.  In addition, Mr. Walker provided a guaranty of all Company obligations relating to the FWTB Term Loan.  The Company paid Mr. Walker $50,000 as compensation for guaranteeing the FWTB Term Loan.  The FWTB Term Loan bears interest at a fixed rate of 7.25% per annum and the Company paid a $12,500 origination fee to FWTB.  The Company will make equal monthly payments of principal/interest over the four-year term of the FWTB Term Loan, which has a final maturity date of May 21, 2014.  The terms and conditions of the FWTB Term Loan include limitations on the Company incurring additional debt and paying dividends on the Company’s stock without the consent of FWTB.  In the event of a default under the FWTB Term Loan, FWTB has the option to declare the loan immediately due and payable.  As of September 30, 2010, there was $928,768 outstanding under the FWTB Term Loan, including accrued interest.
 

Subordinated Secured Convertible Notes

Beginning in March 2010, the Company began a private offering of units comprising an aggregate of up to $8.4 million of 8% Senior Secured Convertible Notes and warrants to purchase 84,000,000 shares of the Company’s common stock (the “Warrants”).  The Company intends to use the proceeds from the private offering to invest in advertising and marketing programs to support its direct-to-consumer business, provide general working capital, pay commissions and expenses related to the private offering, and repay certain outstanding obligations.  The issuance of the Units (as defined below) the Additional Units (as defined below), and the Final Units (as defined below) was conducted in reliance upon exemptions from registration requirements under the Securities Act, including, without limitation, those under Rule 506 of Regulation D (as promulgated under the Securities Act).  The Units, Additional Units, and Final Units were offered and sold only to investors who are “accredited investors,” as defined in Rule 501 of Regulation D under the Securities Act.  Because the units have not been registered under the Securities Act, investors will not be able to sell their Subordinated Secured Convertible Notes (or the shares of the Company’s common stock issuable upon conversion of the Subordinated Secured Convertible Notes or conversion of the Warrants) in the United States absent an effective registration statement or an applicable exemption from registration.

On May 6, 2010, the Company closed on the private sale of units (the “Units”) comprising an aggregate of $4,200,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 42,000,000 Warrants.  The Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Units sold comprised $3,265,000 in cash and $935,000 from the conversion of existing obligations of the Company into the Subordinated Secured Convertible Notes.

On June 24, 2010, the Company closed on the private sale of additional units (the “Additional Units”) comprising an aggregate of $2,600,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 26,000,000 Warrants.  The Additional Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  The Company also received a commitment to purchase an additional $200,000 face value of Subordinated Secured Convertible Notes under the same terms and conditions as the Additional Units.  Consideration for the Additional Units sold comprised $2,300,000 in cash and $300,000 from the conversion of existing obligations of the Company into the Subordinated Secured Convertible Notes.

On September 17, 2010, the Company closed on the private sale of units (the “Final Units”) comprising an aggregate of $220,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 2,200,000 Warrants.  The Final Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Final Units comprised $220,000 in cash.

On September 17, 2010, the Company and GVC Capital LLC, the Company’s placement agent, terminated the private offering.

The Subordinated Secured Convertible Notes bear interest at 8% per year, payable quarterly in cash, additional Subordinated Secured Convertible Notes, or in registered common stock of the Company, at the option of the Company, and mature on May 6, 2013.  The Subordinated Secured Convertible Notes can be converted into shares of the Company's common stock at any time, initially at a conversion price of $0.10 per share (the “Conversion Price”). The Subordinated Secured Convertible Notes will automatically convert into shares of the Company’s common stock in the event (i) there is an effective registration statement registering the resale under the Securities Act of 1933 (“Securities Act”) of the underlying stock (“Conversion Shares”) or the Conversion Shares are eligible to be resold without restriction or limitation under Rule 144 under the Securities Act, and (ii)  the closing bid price of the Company’s common stock as quoted on the OTC Bulletin Board or other principal trading market is at least $0.25 per share for 20 out of 30 consecutive trading days with an average daily trading volume of at least one million shares.  The Subordinated Secured Convertible Notes are secured by a subordinated lien on all assets of the Company.

Each Warrant entitles the holder to purchase one share of the Company's common stock at a price of $0.20 per share, and contains customary anti-dilution rights (for stock splits, stock dividends and sales of substantially all the Company’s assets) and piggyback registration rights.  The Warrants expire May 6, 2015.
 

In accordance with applicable accounting guidance, the Company recorded a $6,980,400 debt discount on the Subordinated Secured Convertible Notes because the combined value of the Warrants and the beneficial conversion feature (resulting because the market price of the Company’s shares on the date of issuance was greater than the Conversion Price of the Subordinated Secured Convertible Notes) exceeded the amount of Subordinated Secured Convertible Notes issued.  The amortization of the $6,980,400 debt discount will be reported as additional interest expense and increases in long-term debt over the three-year term of the Subordinated Secured Convertible Notes. 

During the quarter ended June 30, 2010, $25,000 of the Subordinated Secured Convertible Notes was converted into common stock.  The remaining unamortized debt discount of $24,018 related to the amount converted was charged to interest expense during the quarter.  Amortization of the debt discount on the Subordinated Secured Convertible Notes amounted to $582,198 and $807,129 for the three and six months ended September 30, 2010, respectively.  As of September 30, 2010, the remaining unamortized discount on the Subordinated Secured Convertible Notes was $6,149,253.

The Company paid $509,119 in placement agent fees and expenses in connection with the issuance of the Subordinated Secured Convertible Notes.  This amount was recognized as deferred financing costs on the Company’s balance sheet.  These costs will be amortized to expense over the three-year term of the Subordinated Secured Convertible Notes.  In addition, the Company granted warrants to purchase the Company’s common stock to the placement agent for its Subordinated Secured Convertible Notes (the “Placement Agent Warrants”).  The Company granted 7,020,000 Placement Agent Warrants with an exercise price of $0.10 per common share and 7,020,000 Placement Agent Warrants with an exercise price of $0.20 per common share.  The Placement Agent Warrants have a five year term expiring May 6, 2015 and contain a cashless exercise provision.  The value of the Placement Agent Warrants has been recognized as $1,518,600 in deferred financing cost on the Company’s balance sheet, which will be amortized to expense over the three-year term of the Subordinated Convertible Notes.  For the three and six months ended September 30, 2010, the amortized deferred financing costs relating to the Subordinated Convertible Notes totaled $170,671 and $233,128.

5.  
Equity Compensation Plans

For the three months ended September 30, 2010, the Company granted zero options to purchase the Company’s common stock under the Company’s 2005 Equity Compensation Plan (the “2005 Plan”).  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 Plan.

For the six months ended September 30, 2010, the Company granted 200,000 options to purchase the Company’s common stock at an exercise price of $0.14 per share 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.

During the three months ended September 30, 2010, there were 2,594 options that either were cancelled or expired and zero shares of common stock issued upon exercise of outstanding stock options 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 zero shares issued upon exercise of outstanding stock options under the 2005 Plan.

During the six months ended September 30, 2010 there were 96,830 options that either were cancelled or expired and zero shares exercised. 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.

As of September 30, 2010, the Company had granted options for 367,851 shares of the Company’s common stock that are unvested that will result in $29,929 of compensation expense in future periods if fully vested. 
 

Information regarding all stock options outstanding under the 2005 Plan as of September 30, 2010 is as follows:

   
OPTIONS OUTSTANDING
 
OPTIONS EXERCISABLE
         
Weighted-
                 
Weighted-
         
         
average
   
Weighted-
           
average
   
Weighted-
   
         
Remaining
   
average
 
Aggregate
       
Remaining
   
average
 
Aggregate
Exercise
       
Contractual
   
Exercise
 
Intrinsic
       
Contractual
   
Exercise
 
Intrinsic
price range
 
Options
   
Life (years)
   
Price
 
Value
 
Options
   
Life (years)
   
Price
 
Value
Over $0.00 to $0.50
    2,824,869       3.01     $ 0.15         2,457,018       2.84     $ 0.15    
Over $0.50 to $2.50
    -       -     $ -         -       -     $ -    
Over $2.50 to $5.00
    -       -     $ -         -       -     $ -    
Over $5.00 to $5.50
    421,763       0.51     $ 5.00         421,763       0.51     $ 5.00    
Over $5.50
    25,000       1.47     $ 5.90         25,000       1.47     $ 5.90    
      3,271,632       2.67     $ 0.82  
 $     1,330
    2,903,781       2.49     $ 0.90  
   43,455

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, which was September 30, 2010.

On July 28, 2010, the Company filed a definitive Information Statement pursuant to Section 14(c) of the Securities Exchange Act of 1934 (the “Information Statement”).  Among other items, the Information Statement provided notice to shareholders that the holders of 54.6% of its outstanding voting stock had approved an amendment to the 2005 Plan to authorize the issuance of an additional 10,000,000 shares under the 2005 Plan.  This action became effective on August 25, 2010, 20 days after the initial mailing of the Information Statement to the Company’s stockholders. 

6.  
Income Taxes

In September 2006, the FASB issued ASC 740 (prior authoritative guidance: FASB issued FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes and SFAS No. 109, Accounting for Income Taxes ). ASC 740 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements.  This interpretation defines the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. The Company adopted ASC 740 on April 1, 2007. As a result of the implementation, the Company recognized no material adjustment in the liability of unrecognized income tax benefits. At the adoption date, the Company had no unrecognized tax benefits, which would affect the Company’s effective tax rate. It is possible that the Company’s unrecognized tax benefit could 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, 2010 and March 31, 2010, 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 disclosure of related party transactions.

8.  
Stockholders’ Equity

As noted above in Note 4 “Long Term Debt and Current Portion – Long Term Debt”, on May 6, 2010, the Company closed on the private sale of Units comprising an aggregate of $4,200,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 42,000,000 Warrants.  The Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Units sold comprised $3,265,000 in cash and $935,000 from the conversion of existing obligations of the Company into the Subordinated Secured Convertible Notes.

As noted above in Note 4 “Long Term Debt and Current Portion – Long term Debt”, on June 24, 2010, the Company closed on the private sale of Additional Units comprising an aggregate of $2,600,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 26,000,000 Warrants.  The Additional Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Additional Units sold comprised $2,300,000 in cash and $300,000 from the conversion of existing obligations of the Company into the Subordinated Secured Convertible Notes.

As noted above in Note 4 “Long Term Debt and Current Portion-Long term Debt”, on September 17, 2010, the Company closed on the private sale of Final Units comprising an aggregate of $220,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 2,200,000 Warrants.  The Final Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Final Units sold comprised $220,000.

Each Warrant issued as part of the Units, Additional Units, or Final Units entitles the holder to purchase one share of the Company's common stock at a price of $0.20 per share, and contains customary anti-dilution rights (for stock splits, stock dividends and sales of substantially all the Company’s assets) and piggyback registration rights.  The Warrants expire May 6, 2015.

The Company granted warrants to purchase the Company’s common stock to the placement agent for its Subordinated Secured Convertible Notes (the “Placement Agent Warrants”).  The Company granted 7,020,000 Placement Agent Warrants with an exercise price of $0.10 per common share and 7,020,000 Placement Agent Warrants with an exercise price of $0.20 per common share.  The Placement Agent Warrants have a five year term expiring May 6, 2015 and contain a cashless exercise provision.  The value of the Placement Agent Warrants has been recognized as $1,518,600 in deferred financing cost on the Company’s balance sheet, which will be amortized to expense over the three-year term of the Subordinated Convertible Notes.  For the three and six months ended September 30, 2010, the amortized deferred financing costs relating to the Subordinated Convertible Notes totaled $170,671 and $233,128.

A summary of the Company’s warrant activity for the period from April 1, 2010 through September 30, 2010 is presented below:

         
Weighted
       
   
Warrants
   
Average
   
Aggregate
 
   
Outstanding
   
Exercise Price
   
Intrinsic Value
 
Outstanding, April 1, 2010
    6,273,390     $ 4.88       -  
Granted
    84,240,000       0.19          
Exercised
    -       -          
Expired
    -       -          
Outstanding, September 30, 2010
    90,513,390     $ 0.52     $ 0.00  

 
As of September 30, 2010, the Company had the following outstanding warrants to purchase its common stock:

     
Weighted Average
 
Warrants Outstanding
   
Exercise Price
   
Remaining Life (Yrs)
 
  7,020,000     $ 0.10       4.66  
  77,220,000     $ 0.20       4.66  
  1,320,000     $ 0.25       4.06  
  3,200     $ 0.66       0.05  
  325,000     $ 1.00       3.38  
  132,639     $ 2.00       0.82  
  16,000     $ 2.07       2.75  
  450,000     $ 5.00       0.05  
  505,796     $ 6.00       0.55  
  1,937,299     $ 6.25       0.41  
  50,000     $ 6.96       1.84  
  746,956     $ 7.50       1.45  
  720,000     $ 8.00       3.93  
  66,500     $ 8.25       3.93  
  90,513,390     $ 0.52       4.47  

A summary of the Company’s preferred stock warrant activity for the period from April 1, 2010, through September 30, 2010, is presented below:
 
       
Weighted
 
       
Average
 
 
Warrants Outstanding
   
Exercise Price
 
Outstanding, April 1, 2010
    4,164     $ 1,250  
Granted
    --     $ --  
Exercised
    --     $ --  
Expired
    --     $ --  
Outstanding, September 30, 2010
    4,164     $ 1,250  
 
The warrants granted expire five years from issuance.
 

9.  
Subsequent Events
 
Credit Card Receipts-Backed Notes

On October 28, 2010 and November 5, 2010, the Company closed on the private sale of $1.5 million in 15% secured convertible promissory notes backed by a portion of the Company’s prospective credit card receipts, (the “Credit Card Notes”) and 5,000,000 warrants to purchase the Company’s common stock (the “Credit Card Warrants”) (collectively, the “Credit Card Offering”). Consideration for the Credit Card Offering comprised $1.5 million in cash.  Net cash proceeds to the Company after deducting a 2% sales commission (1% on company-referred investors) paid to GVC Capital LLC, the Company’s placement agent, totaled $1,474,500.  In addition, the Company will pay a 3% deferred sales commission (2% on company-referred investors) to the placement agent concurrently with the repayment of principal of the Credit Card Notes.

The Company intends to use the proceeds from the Credit Card Offering to invest in advertising and marketing programs to support its direct-to-consumer business, provide general working capital, pay commissions and expenses related to the private offering, and repay certain outstanding obligations.  The issuance of the Credit Card Offering was conducted in reliance upon exemptions from registration requirements under the Securities Act of 1933 (the “Securities Act”), including, without limitation, those under Rule 506 of Regulation D (as promulgated under the Securities Act).  The Credit Card Offering was offered and sold only to six (6) investors who are, or the Company reasonably believed are, “accredited investors,” as defined in Rule 501(a) of Regulation D under the Securities Act.  Because the Credit Card Offering has not been registered under the Securities Act, the securities sold in the Offering, including the Credit Card Notes, Credit Card Warrants and shares of common stock underlying the Credit Card Notes and Warrants are “restricted securities” within the meaning of Rule 144 under the Securities Act, and investors will not be able to sell their Credit Card Notes (or the shares of the Company’s common stock issuable upon conversion of the Credit Card Notes or exercise of the Credit Card Warrants) in the United States absent an effective registration statement or an applicable exemption from registration.

The Credit Card Notes bear interest at 15% per annum, have a final maturity of July 28, 2011, and can be converted at any time into common shares of the Company at a conversion price of $0.18 per share.  20% of the Company’s daily credit card receipts will be held in escrow with First Western Trust Bank under an Escrow and Account Control Agreement to fund bi-weekly payments of principal and interest to the investors in the Credit Card Offering.

Each Credit Card Warrant entitles the holder to purchase one share of the Company's common stock at a price of $0.20 per share, and contains customary anti-dilution rights (for stock splits, stock dividends and sales of substantially all the Company’s assets) and piggyback registration rights.  The Warrants expire October 28, 2015.

The obligation of the Company to repay the Notes is severally guaranteed by Jack J. Walker, the Company’s Chairman and CEO (up to $500,000), J. Michael Wolfe, Chief Operating Officer (up to $200,000) and H. MacGregor Clarke, Chief Financial Officer (up to $100,000).  The guarantors have executed a Contribution Agreement between and among themselves to enforce the limited several guaranties; and the Company has executed an Indemnity Agreement to hold harmless the guarantors from any future liability under the guaranties.

For nominal consideration, the Company sold a total of 1,333,333 warrants to purchase the Company’s common stock to the placement agent.  833,333 of the placement agent warrants have an exercise price of $0.18 per share of common stock.  500,000 of the placement agent warrants have an exercise price of $0.20 per share of common stock.  The placement agent warrants have a five-year term and contain a cashless exercise provision.

On November 5, 2010 the Company and the placement agent terminated the private offering.
 
Revised Vendor Payment Agreement
 
On November 5, 2010, the Company entered into a revised payment agreement with a vendor.  The vendor had previously discounted the amount owed by $105,591 in order to accelerate payment terms.  Because the Company fell behind in the agreed accelerated payments, the vendor is now requiring the original amount due to be paid in full.  This is an event that provided evidence about a condition that did not exist at the date of the balance sheet but arose subsequent to that date.  The $105,591 will be accounted for as an adjustment to other (income) and expense in the quarter ending December 31, 2010. 
 
 
  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, 2010 and September 30, 2009.  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, 2010 (this “Quarterly Report”). The following discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including statements that include words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “may,” “will,” or similar expressions that are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements include, but are not limited to, statements regarding our intent, belief, or current expectations regarding our strategies, plans, and objectives, our product release schedules, our ability to design, develop, manufacture, and market products, the ability of our products to achieve or maintain commercial acceptance, and our ability to obtain financing necessary to fund our future operations. Such statements are not guarantees of future performance and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, the Company’s actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Factors that could cause or contribute to the differences are discussed in this Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Item 1A. “Risk Factors” of our Annual Report on Form 10-K for the year ended March 31, 2010.  Except as required by applicable law or regulation, we undertake 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 our business or the risks associated with an investment in our common stock. Each reader should carefully review and consider the various disclosures made by the Company in this Quarterly Report and in our other filings with the SEC.

Overview

AeroGrow International, Inc. (the “Company”) was incorporated in the State of Nevada on March 25, 2002.  We are in the business of developing, marketing, and distributing advanced indoor aeroponic and hydroponic garden systems. After several years of initial research and product development, we began sales activities in March 2006. Since that time we have expanded all aspects of our operations in order to take advantage of what we believe to be an attractive market opportunity.  We currently offer more than 15 different indoor garden models, more than 50 seed kits, and various gardening and kitchen accessories.  Although our business is focused on the United States and Canada, our products are available in nine other countries.

During the fiscal year ended March 31, 2010 (“Fiscal 2010”), and continuing through September 30, 2010, we scaled back our operations as a result of the general economic downturn and the resulting decline in consumer confidence and spending.  We also determined that broad distribution through retail channels was not appropriate for a company at our stage of development because of relatively low profit margins, high capital requirements, and the operational requirements of our retailer customers.  As of September 30, 2010, our products were offered in approximately 850 storefronts in North America, as compared to approximately 3,600 stores as of September 30, 2009.  Although we expect to further reduce the number of retailer storefronts carrying our products during the fiscal year ending March 31, 2011, we plan to maintain relationships with retailers, both traditional and non-traditional, that have historically proven to be good business partners for AeroGrow.  In this regard, we plan to continue selling through our largest retailer customers, including three customers that comprised approximately 59% of our retailer sales during Fiscal 2010.

In Fiscal 2010, we re-focused our efforts towards building our direct-to-consumer business, which carries higher margin opportunity. To position our business for the future, we have increased the depth and breadth of our direct sales distribution channels to include a direct mail catalogue business with approximately 3.7 million catalogues mailed in Fiscal 2010, web sales, infomercials, and 60 and 120 second television commercials.  Our products are also sold through television home shopping channels and by online retailers.  In Fiscal 2010, approximately 57.5% of our total sales were to direct customers.
 
 
Results of Operations

Three Months Ended September 30, 2010 and September 30, 2009

Summary Overview
For the three months ended September 30, 2010, sales totaled $1,379,617, a $1,906,332, or 58.0% decrease from the same period in the prior year.  $1,544,408, or 81.0%, of the overall decline in revenue resulted from an 84.3% reduction in sales to retailers, a result of our strategic decision to reduce our exposure to the retail channel because of its low margins and high capital requirements.  Our direct-to-consumer sales also declined, by 22.1% from the prior year, reflecting the combined impact of a 37.2% reduction in the amount of revenue-generating media spending, the impact of inventory stock outs during the period which were caused by cash constraints earlier in the fiscal year and long lead times on products procured from China, and lower average pricing on sales of our products resulting from our shift to an “everyday low pricing” sales model.  Despite these issues, the effectiveness of our direct-to-consumer advertising continued to improve, and increased 24.0% year-over-year as we generated $8.68 of direct-to-consumer revenue for every dollar of revenue-generating media spent in the 2010 period, as compared to $7.00 of direct-to-consumer revenue per media dollar in 2009.  The strategic shift away from sales to retailers, combined with the impact of inventory stock outs, was reflected in lower sales of AeroGardens, which declined by 78.2% from the prior year.  Recurring revenue from seed kit and accessories declined slightly, by 7.8%, as these sales were not as affected as AeroGardens by the reduced retail presence or by the inventory stocking issues.  Seed kit and accessory sales represented 63.0% percent of total revenue for the three months ended September 30, 2010, up from 28.7% in the prior year period.

Gross margin for the three months ended September 30, 2010 was 24.7%, as compared to 30.9% for the year earlier period.  The decrease in percentage margin reflected a variety of factors during the current year period, including lower average pricing on sales of our products, operational inefficiencies caused by cash and inventory constraints, and fixed manufacturing and distribution facility costs spread over a lower revenue base.  Operating expenses other than cost of revenue decreased $1,262,700, or 46.4%, from the prior year reflecting cost saving initiatives, reductions in media spending, and staffing reductions.
 
Our loss from operations totaled $1,117,549 for the three months ended September 30, 2010, as compared to a loss of $1,705,661 in the prior year period.  The decreased loss reflected the significant decrease in operating expenses other than cost of revenue, partially offset by the impact of lower sales and gross margin.

Other income and expense for the three months ended September 30, 2010 totaled to a net other expense of $1,012,004, as compared to net other expense of $59,593 in the prior year period.  The net other expense in the current year period included $760,900  in non-cash expense related to the combined effect of the amortization of deferred financing costs (principally the value of warrants granted to a placement agent) and a debt discount, on convertible notes we issued during the current fiscal year.  These notes were considered to have been issued at a discount because they had a conversion price lower than the market price of our stock at the time of issuance, and because the notes were issued with warrants to purchase our common stock. The resulting discount is being amortized to expense over the three-year life of the notes, as are the related financing costs.  The prior year net other expense amount included $180,286 in gains related to accounts payable balance reduction agreements negotiated with certain vendors.

The year-over-year increase in other expense more than offset the reduction in the operating loss, and, as a result, the net loss for the three months ended September 30, 2010 increased to $2,129,553 from a net loss of $1,765,254 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, 2010 and the three months ended September 30, 2009:

 
Three Months Ended September 30,
 
 
      2010
   
2009
 
Revenue
         
Product sales – retail, net
20.8
%
   
55.8
%
Product sales – direct to consumer, net
77.7
%
   
41.8
%
Product sales – international
1.5
%
   
2.4
%
    Total sales
100.0
%
   
100.0
%
             
Operating expenses
           
Cost of revenue
75.3
%
   
69.1
%
Research and development
3.8
%
   
5.3
%
Sales and marketing
43.0
%
   
38.0
%
General and administrative
58.9
%
   
41.2
%
     Total operating expenses
181.0
%
   
151.9
%
Profit/(loss) from operations
-81.0
 %
   
-51.9
 %

Revenue
For the three months ended September 30, 2010, revenue totaled $1,379,617 a year-over-year decrease of 58.0% or $1,906,332 from the three months ended September 30, 2009.

   
Three Months Ended September 30,
 
Product Revenue
 
2010
   
2009
 
Retail, net
  $ 287,373     $ 1,831,781  
Direct to consumer, net
    1,071,606       1,375,141  
International
    20,638       79,027  
Total
  $ 1,379,617     $ 3,285,949  

Sales to retailer customers for the three months ended September 30, 2010 totaled $287,373, down $1,544,408 or 84.3%, from the same period a year earlier.  The decline principally reflected our strategic decision to reduce our exposure to the retail channel because of the low margins and high capital requirements associated with sales into this channel.  As a result of this decision we discontinued our relationships with a number of retailers that had previously carried our products.  As of September 30, 2010, our products were carried in approximately 850 traditional “brick and mortar” storefronts in the United States and Canada, as compared to approximately 3,600 as of September 30, 2009.  Because of the impact of non-“brick and mortar” retailers, including online retailers and television shopping channels which do not have storefronts, on our retail sales, we do not believe “sales per store” is a meaningful metric for assessing our retail business.
 

Direct-to-consumer sales for the three months ended September 30, 2010 totaled $1,071,606, down $303,535 or 22.1%, from the prior year period.  The decrease reflected a combination of factors, including a 37.2% year-over-year reduction in the amount of revenue-generating media spent during the period and lower average pricing on the sales of our products that resulted from our shift to an “everyday low pricing” sales model.  In addition, cash constraints experienced during the first half of the fiscal year combined with long lead times on China-sourced product, impacted available inventory during the quarter ended September 30, 2010, resulting in stock-outs that had a significant negative impact on revenue during the current year period, and contributed to the year-over-year decline in revenue.  Despite the reduction in media spending, lower average pricing, and the inventory issues, there was a 24.0% increase in media effectiveness as direct-to-consumer sales per dollar of advertising expense totaled $8.68 in the quarter ended September 30, 2010, as compared to $7.00 per dollar of advertising expense in the prior year period.

International sales for the three months ended September 30, 2010 totaled $20,638, down $58,389 from the same period in the prior fiscal year.  During the current year period sales to international distributors were constrained by a lack of available inventory, and a dispute with a third party warehouse in Europe that impacted our ability to fulfill orders from customers in Western Europe.

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, 2010 and September 30, 2009 is as follows:

   
Three Months Ended September 30,
 
   
2010
   
2009
 
Product Revenue
           
AeroGardens
 
$
510,458
   
$
2,343,439
 
Seed kits and accessories
   
869,159
     
942,510
 
Total
 
$
1,379,617
   
$
3,285,949
 
% of Total Revenue
               
AeroGardens
   
37.0
%
   
71.3
%
Seed kits and accessories
   
63.0
%
   
28.7
%
Total
   
100.0
%
   
100.0
%

AeroGarden sales declined $1,832,981 or 78.2%, from the year earlier period, principally reflecting the impact of our decision to reduce sales into the retail channel.  In addition, inventory stock-out issues constrained our direct-to-consumer sales of AeroGardens during the current year quarter.  Sales of seed kits and accessories, which represent a recurring revenue stream that is generated by the 971,305 AeroGardens we have sold to-date, declined $73,351, or 7.8%.  Our sales of seed kits and accessories occur primarily in the direct-to-consumer channel, given the decline in our retail presence, and were not as adversely affected as AeroGarden sales by inventory stocking issues.  For the three months ended September 30, 2010, sales of seed kits and accessories represented 63.0% of total revenue, as compared to 28.7% in the prior year period.
 

Cost of Revenue
Cost of revenue for the three months ended September 30, 2010 totaled $1,038,812, a decrease of $1,231,744, or 54.2%, from the three months ended September 30, 2009.  Cost of revenue includes product costs for purchased and manufactured products, freight costs for inbound freight from manufacturers and outbound freight to customers, costs related to warehousing and the shipping of products to customers, credit card processing fees for direct sales, and duties and customs applicable to products imported.  The dollar amount of cost of revenue decreased primarily because of the decline in revenue discussed above.  As a percent of total revenue, these costs represented 75.3% of revenue as compared to 69.1% for the quarter ended September 30, 2009.  The increase in costs as a percent of revenue reflected the impact of lower average selling prices for our products in the current year, as well as changes in channel, customer, and product mix.  Finally, the increase reflected inefficiencies in our manufacturing and fulfillment operations necessitated by cash and inventory constraints we faced during the current year period, as well as the impact of fixed facility costs at our Indianapolis manufacturing and distribution facility on a lower revenue base.

Gross Margin
Our gross margin varies based upon the factors impacting net revenue and cost of revenue as discussed above, as well as the mix of our revenue that comes from the retail, direct-to-consumer, and international channels.  In a direct-to-consumer sale, we recognize as revenue the full consumer purchase price for the product; in retail and international sales, by comparison, we recognize as revenue the wholesale price for the product which we charge to the retailer or international distributor.  Media costs associated with direct sales are included in sales and marketing expenses.  For international sales, margins are structured based on the distributor purchasing products by letter of credit or cash in advance terms with the distributor bearing all of the marketing and distribution costs within their territory.  As a result, international sales generally have lower margins than domestic retail sales.  The gross margin for the quarter ended September 30, 2010 was 24.7% as compared to 30.9% for the quarter ended September 30, 2009.
 
Sales and Marketing
Sales and marketing costs for the three months ended September 30, 2010 totaled $593,309, as compared to $1,248,102 for the three months ended September 30, 2009, a decrease of 52.5% or $654,793.  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,
 
   
2010
   
2009
 
Advertising
  $ 123,437     $ 196,587  
Personnel
    311,147       619,970  
Sales commissions
    13,993       89,534  
Trade Shows
    -       37,698  
Other
    144,732       304,313  
    $ 593,309     $ 1,248,102  

Advertising expense is principally comprised 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 $123,437 for the quarter ended September 30, 2010, a year-over-year decrease of 37.2%, or $73,150, principally reflecting a 58.4% reduction in the number of catalogues mailed.
 

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, 2010, personnel costs for sales and marketing were $311,147, down from $619,970 for the three months ended September 30, 2009, a decrease of 49.8%.  The decrease principally reflects staff reductions undertaken throughout the prior fiscal year.

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.  These commissions totaled $13,393 during the quarter ended September 30, 2010, down 84.4% from the prior year.  The year-over-year decline in sales commissions resulted from the combined effects of the decline in sales to retailers during the quarter ended September 30, 2010, as discussed above, and the termination of our agreements with the majority of our sales representative organizations, reflecting our strategic decision to de-emphasize the retail channel.

Trade show expense and other marketing expense decreased year-over-year because of our reduced activity in the retail channel, and lower inventory storage fees during the three months ended September 30, 2010 for use of third party warehouses.

General and Administrative
General and administrative costs for the three months ended September 30, 2010 totaled $812,300, as compared to $1,299,598 for the three months ended September 30, 2009, a decrease of 37.5%, or $487,298.  The decrease reflected a $304,394 reduction in personnel costs, primarily resulting from a year-over-year decline in management headcount.  Also, there were reductions across a variety of expense categories, including legal costs which declined $60,723 because of prior year legal fees related to our issuance of preferred stock and other financing-related legal costs.
 
Research and Development
Research and development costs for the quarter ended September 30, 2010 totaled $52,745, a decrease of 69.6% from the quarter ended September 30, 2009.  The lower cost principally reflected lower headcount related to staffing reductions and a reduction in new product development activities.

Operating Loss
Our loss from operations for the three months ended September 30, 2010 was $1,117,549, as compared to a loss of $1,705,661 for the three months ended September 30, 2009.  The lower loss resulted from reductions in non-cost of sales operating expenses, partially offset by the impact of lower revenue and gross margin.

Other Income and Expense
Other income and expense for the quarter ended September 30, 2010 totaled to a net other expense of $1,012,004, as compared to net other expense of $59,593 in the prior year period, which included $180,286 in gains related to negotiated discounts on accounts payable obligations.  The net other expense in the current year period included $760,900 in non-cash expense related to: (i) the amortization of deferred financing costs, and (ii) the amortization of a calculated debt discount.  Each of these charges related to convertible notes issued during the current fiscal year.  These notes were considered to have been issued at a discount because they had a conversion price lower than the market price of our stock at the time of issuance, and because the notes were issued with warrants to purchase our common stock. The resulting discount will be amortized to expense over the three-year life of the notes, as will the related financing costs.
 

Net Loss
For the three months ended September 30, 2010 the net loss totaled $2,129,553 as compared to a net loss of $1,765,254 for the three months ended September 30, 2009.  The year-over-year increase in the net loss reflects the reduced operating loss, which was more than offset by the impact of the non-cash interest expense related to the convertible notes issued during the current fiscal year.
 
Six Months Ended September 30, 2010 and September 30, 2009

Summary Overview

For the six months ended September 30, 2010, sales totaled $3,197,636 which was 49.0% lower than in the prior year period.  The reduction in sales primarily reflected our strategic decision, taken in early 2010, to reduce our sales to retailers because of the relatively low margin and high capital requirements associated with servicing this channel.  As a consequence, sales to retailers declined 82.3% year-over-year, and represented 72.4% of our total sales decline.  Sales into the direct-to-consumer channel also declined, by 22.7%, as a consequence of a 46.0% year-over-year reduction in the amount of advertising expense, lower average selling prices for our products, as well as the impact of inventory shortages we experienced during the current year period.  Each of these factors reflected cash constraints we faced, particularly in the first quarter of Fiscal 2011.

The gross margin for the six months ended September 30, 2010 was 26.2% as compared to 33.9% for the year earlier period.  The decline in margin reflected a number of factors, including lower average selling prices during the current year period resulting from our shift to an “everyday low pricing” sales model, inefficiencies in our operations related to cash and inventory shortages, and the impact of fixed costs in our manufacturing and fulfillment facility on a lower revenue base.  Operating expenses other than cost of revenue were reduced $2,245,726, or 41.2%, from the prior year reflecting cost saving initiatives, staffing reductions, and reduced spending on advertising and promotion.
 
The loss from operations totaled $2,371,409 for the six months ended September 30, 2010, as compared to $3,328,975 in the prior year.  The decreased loss reflected the significant reduction in operating expenses other than cost of revenue, which was partially offset by the impact of the decline in revenue and gross margin.

Other expense for the six months ended September 30, 2010 totaled $1,487,194 as compared to other income of $501,989 in the prior year.  The current year expense included the impact of $1,138,384 in non-cash interest expense related to the amortization of debt discount and deferred financing costs related to our issuance of $7,020,000 in convertible notes in Fiscal 2011.  The prior year income amount included $987,838 in gains that were recognized to reflect discounts negotiated on certain accounts payable balances.

The net loss for the six months ended September 30, 2010 was $3,858,603 as compared to a $2,826,986 net loss in the same period a year earlier.  The net loss increased year-over-year as the $957,566 reduction in the operating loss was more than offset by the impact of more than $1.1 million in non-cash financing charges and the comparison to the prior year that included the almost $1 million in gains related to the negotiated accounts payable discounts.
 
 
The following table sets forth, as a percentage of sales, our financial results for the six months ended September 30, 2010 and the six months ended September 30, 2009:
 
 
Six Months Ended
September 30,
 
 
2010
   
2009
 
Revenue
         
Product sales - retail, net
15.0
%
   
43.1
%
Product sales - direct to consumer, net
81.9
%
   
54.0
%
Product sales – international, net
3.1
%
   
2.9
%
    Total sales
100.00
%
   
100.00
%
             
Operating expenses
           
Cost of revenue
73.9
%
   
66.0
%
Research and development
2.8
%
   
4.7
%
Sales and marketing
44.1
%
   
38.4
%
General and administrative
53.4
%
   
44.0
%
     Total operating expenses
174.2
%
   
153.1
%
             
Profit/(loss) from operations
(74.2)
%
   
(53.1)
%

Revenue
For the six months ended September 30, 2010 and September 30, 2009, revenue totaled $3,197,636 and $6,265,642 respectively, a year-over-year decrease of 49.0% or $3,068,006.


   
Six Months Ended
September 30,
 
Product Revenue
 
2010
   
2009
 
Retail, net
  $ 478,951     $ 2,700,044  
Direct to consumer, net
    2,618,541       3,385,384  
International, net
    100,144       180,214  
Total
  $ 3,197,636     $ 6,265,642  


The year-over-year decrease in revenue principally reflected sales to retailer customers, which declined by 82.3%, or $2,221,093, representing 72.4% of the total sales decline.  The decline in sales to retailers was caused by our strategic decision in early 2010 to reduce our exposure to the retail channel because of the relatively low margins and high capital requirements of servicing this channel.  As a result, the number of retailers carrying our products was reduced, to an estimated 850 at September 30, 2010, from an estimated 3,600 a year earlier.
 
Direct-to-consumer sales also decreased year-over-year, by 22.7%, to $2,618,541.  The decline reflected a 46.0% year-over-year reduction in the amount of revenue-generating media spent, lower average selling prices for our products resulting from our shift to an “everyday low pricing” sales model, and inventory stock-out issues resulting from our cash constraints early in the fiscal year, which caused delays in procuring long lead time products, particularly AeroGardens, from Chinese manufacturers.  Despite these issues, overall there was a 43.3% increase in media effectiveness as direct-to-consumer sales per dollar of advertising expense totaled $7.47 for the six months ended September 30, 2010, as compared to $5.21 in the prior year period. 

A summary of the sales of AeroGardens and seed kits and accessories for the six months ended September 30, 2010 and September 30, 2009 is as follows:

 
Six Months Ended
September 30,
 
 
2010
   
2009
 
Product Revenue
         
AeroGardens
$
1,619,450
   
$
3,927,747
 
Seed kits and accessories
 
1,578,186
     
2,337,895
 
Total
$
3,197,636
   
$
6,265,642
 
% of Total Revenue
             
AeroGardens
 
50.6
%
   
62.7
%
Seed kits and accessories
 
49.4
%
   
37.3
%
Total
 
100.0
%
   
100.0
%

AeroGarden sales decreased $2,308,297, or 58.8% year-over-year, principally reflecting the decline in sales to retailer customers, as well as the decline in revenue-generating media spending.  Seed kit and accessory sales also declined, by $759,709, or 32.5%.

Cost of Revenue
Cost of revenue for the six months ended September 30, 2010 totaled $2,360,510, a year-over-year decrease of $1,779,846, or 43.0%.  The decline principally resulted from the decrease in sales during the period.  As a percent of total revenue, these costs totaled 73.8% for the six months ended September 30, 2010, as compared to 66.1% in the year earlier period.  The increase in costs as a percent of revenue primarily reflects the impact of lower average selling prices for our products during the current year period, inefficiencies in our operations caused by cash and inventory shortages, and the impact of higher fixed facility costs on a lower revenue base.
 

Gross Margin
The lower pricing, inefficiencies in our operations and fixed cost de-leveraging caused our gross margin for the six months ended September 30, 2010 to decline to 26.2%, from 33.9 % for the prior year period.

Sales and Marketing
Sales and marketing costs for the six months ended September 30, 2010 totaled $1,410,286, as compared to $2,407,898 for the six months ended September 30, 2009, a decrease of $997,612, or 41.4%.  The breakdown of sales and marketing costs for both time periods is presented in the table below:

   
Six Months Ended
September 30,
 
   
2010
   
2009
 
Advertising
  $ 350,502     $ 649,169  
Personnel
    696,431       1,233,078  
Sales commissions
    19,401       140,107  
Trade shows
    -       31,108  
All other
    343,952       354,436  
    $ 1,410,286     $ 2,407,898  

Advertising expense totaled $350,502 for the six months ended September 30, 2010, a decrease of 46.0% from the same period a year earlier, principally reflecting a 56.2% decline in the number of catalogues mailed.  Cash constraints, particularly in the first quarter of the fiscal year, impacted the amount of advertising we were able to spend during the current year period.
 
For the six months ended September 30, 2010, personnel costs for sales and marketing totaled $696,431, a year-over-year decrease of $536,647, or 43.5%.  The decrease principally reflected headcount reduction in sales, marketing, and operations personnel.

Sales commissions decreased by $120,706, or 86.2%, to $19,401, reflecting our strategic shift away from the retail channel and the consequent decline in sales to retailers during the six months ended September 30, 2010, as discussed above.

General and Administrative
General and administrative costs for the six months ended September 30, 2010 totaled $1,708,483 as compared to $2,753,806 for the six months ended September 30, 2009, a decrease of 38.0%.  The decrease reflected the impact of lower headcount, as well as spending reductions in all areas, including legal expense, and administration, and facility and office-related expenses.
 
 
Research and Development
Research and development costs for the six months ended September 30, 2010 totaled $89,760 as compared to $292,552 for the six months ended September 30, 2009, a decrease of 69.3%.  The reduced cost principally reflected lower employee expense resulting from staffing reductions.

Operating Loss
The loss from operations for the six months ended September 30, 2010 totaled $2,371,409, and was $957,566 lower than the operating loss of $3,328,975 for the six months ended September 30, 2009, as the reductions in operating expenses other than cost of sales more than offset the impact of lower revenue and gross margin during the current year period.

Other Income and Expense
Other expense for the six months ended September 30, 2010 totaled $1,487,194, as compared to other income of $501,989 for the six months ended September 30, 2009.  The net other expense in the current year period included $1,138,384 in non-cash expense related to: (i) the amortization of deferred financing costs, and (ii) the amortization of a calculated debt discount.  Each of these charges related to convertible notes issued during the current fiscal year.  These notes were considered to have been issued at a discount because they had a conversion price lower than the market price of our stock at the time of issuance, and because the notes were issued with warrants to purchase our common stock. The resulting discount will be amortized to expense over the three-year life of the notes, as will the related financing costs.  The prior year income amount included the impact of $987,838  in gains recorded as a result of negotiated reductions in accounts payable amounts owed to certain vendors.

Net Loss
The net loss for the six months ended September 30, 2010 increased to $3,858,603 from $2,826,986 in the prior year, because the $957,566 reduction in the operating loss was offset by the impact of the more than $1.1 million in non-cash interest expense charges related to the convertible note issue in the current year, and the comparison to the prior year that included almost $1 million in gains related to the negotiated discounts on accounts payable obligations.
 
Liquidity and Capital Resources

After adjusting the net loss for non-cash items and changes in assets and liabilities, the net cash used by operating activities totaled $3,888,376 for the six months ended September 30, 2010 as compared to $3,341,224 in the prior year.

Non-cash items, comprising depreciation, amortization, bad debt allowances, issuances of common stock and options, change in allowances for bad debt, and interest expense from warrants issued with convertible debentures, totaled to a net cash gain of $1,575,130 for the six months ended September 30, 2010.

Changes in current assets contributed a net cash usage of $669,113 during the six months ended September 30, 2010, principally from an increase in inventory.  As of September 30, 2010, the inventory balance was $4,245,458, representing approximately 154 days of sales activity, and 368 days of sales activity, at the average daily rate of product cost expensed during the twelve months and three months ended September 30, 2010, respectively.  The days in inventory calculation based on the three months of sales activity is greatly impacted by the seasonality of our sales, which are at the lowest seasonal level during the summer months.  Net accounts receivable totaled $360,411 as of September 30, 2010, representing approximately 28 days of net retail sales activity, and 113 days of net retail sales activity, at the average daily rate of sales recognized during the twelve months and three months ended September 30, 2010, respectively.  The days of receivables calculation based on the three months of sales activity is impacted by the timing of sales to retailers which, in the three months ended September 30, 2010, were concentrated in the last several weeks of the period.
 

Current operating liabilities decreased $935,787 during the six months ended September 30, 2010, principally because of reductions in accounts payable totaling $1,330,096.  Accounts payable as of September 30, 2010 totaled $1,974,605, representing approximately 37 days of daily expense activity, and 71 days of daily expense activity, at the average daily rate of expenses incurred during the twelve months and three months ended September 30, 2010, respectively.

Financing activity, including the issuance of convertible debt, the impact of the conversions of various short-term obligations to convertible debt, as well as the net reduction in other debt obligations, provided net cash of $3,975,326 during the six months ended September 30, 2010, as compared to $3,085,164 in the prior year.

As of September 30, 2010, we had a cash balance of $717,082, of which $87,904 was restricted as collateral for our corporate credit card program.  This compares to a cash balance of $693,444 as of March 31, 2010, of which $443,862 was restricted as collateral for the credit card program and letter of credit obligations.

We use, or have used, a variety of debt funding sources to meet our liquidity requirements:

First National Loan

On May 19, 2008, the Company and Jack J. Walker, then one of the Company’s directors and now the Company’s Chairman and CEO, acting as co-borrowers, entered into a Business Loan Agreement with First National Bank for a loan to the Company in a principal amount of up to $1,000,000 (the “FNB Loan”).  The FNB Loan had an initial maturity date of May 19, 2009, which was extended by various agreements between the Company and FNB.

Principal payments totaling $408,439 were made by Mr. Walker against the FNB Loan during the loan term.  The first $150,000 of payments made by Mr. Walker was recorded by the Company as an offset to a $150,000 receivable due from Mr. Walker.  The remaining $258,439 was recorded by the Company as promissory notes due to Mr. Walker, which carried an interest rate of 20% per annum.  On May 7, 2010, the Company paid $50,000 in principal and $4,603 in interest to Mr. Walker.  On June 24, 2010, Mr. Walker converted $206,406 of principal and accrued interest on the promissory notes into three year convertible promissory notes (the “Subordinated Secured Convertible Notes”) issued by the Company, as further described below under the caption “Subordinated Secured Convertible Notes.”  On June 28, 2010, the Company paid $17,109 in remaining principal and interest to Mr. Walker.

On May 24, 2010, the Company paid the remaining balance on the FNB Loan of $511,647, including accrued interest, and the FNB Loan 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”) for a revolving credit facility (the “Revolving Credit Facility”) to fund working capital requirements.  The Revolving Credit Facility had an initial termination date of June 23, 2010.  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.  From time to time, Jack J. Walker, then one of the Company’s directors and now the Company’s Chairman and CEO, provided guarantees of up to a maximum of $1.5 million of the Company’s obligations under the Revolving Credit Facility.  Through the term of the Revolving Credit Facility, the Company, FCC and Mr. Walker, as guarantor, entered into various agreements to amend the terms of the Revolving Credit Facility.
 

On May 3, 2010, the Company, FCC, and Jack J. Walker, as guarantor, executed a Forbearance Agreement and Fifth Amendment (the “Fifth Amendment”) effective as of April 30, 2010.  Under the Fifth Amendment, FCC agreed to forbear from exercising its rights and remedies with regard to the Company’s non-compliance with financial covenants until May 21, 2010, if no other defaults occur.  The Fifth Amendment enabled the Company to borrow up to $600,000 more than would otherwise be permitted by the applicable borrowing base calculation under the Revolving Credit Facility until the earlier of (i) the Company closing on a sale of subordinated secured convertible promissory notes, or (ii) the termination date of the forbearance period.  In addition, the Fifth Amendment set the maximum borrowing under the Revolving Credit Facility at $2,000,000 until such time as the Company closed on a sale of subordinated secured convertible promissory notes, at which time the maximum borrowing amount was required to be reduced to $1,000,000.  The Fifth Amendment provided for a continuation of the $500 per day forbearance fee set forth in the Fourth Amendment, with such fees related to both the Fourth Amendment and Fifth Amendment to be payable on the earlier of (i) May 21, 2010 or (ii) the date on which loans under the Revolving Credit Facility were repaid in full.

On May 24, 2010, the Company paid $673,600 to FCC to repay, in full, amounts due under the Revolving Credit Facility, and the Revolving Credit Facility was terminated.

During Fiscal 2011, Mr. Walker was paid a fee of $25,000 for guaranteeing the Company’s obligations under the Revolving Credit Facility.

Main Power Promissory Note

On June 30, 2009, the Company entered into a Letter Agreement (“Letter Agreement”) with Main Power Electrical Factory, Ltd. (“Main Power”) and executed a Promissory Note.  Pursuant to the terms of the Letter Agreement, Main Power agreed to release the Company from $1,386,041 of existing accounts payable obligations owed by the Company to Main Power 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 Main Power.  The Promissory Note has a final maturity of June 30, 2011, and carries an interest rate of 8% per annum, with interest accrued and added to the principal amount of the Promissory Note for the first year.  During the second year of the Promissory Note, interest is due and payable quarterly.  Principal payments of $150,000 are due and payable monthly beginning January 31, 2011, with a final payment of all principal and accrued but unpaid interest due on June 30, 2011.  As of September 30, 2010, the outstanding balance under the Promissory Note totaled $1,510,425, including accrued interest.

Bridge Financing

On August 28 through September 1, 2009, the Company entered into bridge financing arrangements totaling $500,000 (the “Bridge Loans”) with six lenders who were directors or officers, or who had greater than a 10% beneficial ownership in the Company.  The Bridge Loans were unsecured, subordinated to loans made to the Company by FCC, and accrued interest at 15% per annum.  The Company issued 500,000 warrants to purchase common shares of the Company to the Lenders.  Each of the warrants has a five-year term and an exercise price of $0.25 per common share.

On May 6, 2010, $430,466 of the Bridge Loans, inclusive of accrued interest, was converted into the Subordinated Secured Convertible Notes issued by the Company, as further described below.  In addition, on May 6, 2010, $25,000 of the Bridge Loans was extended to a new maturity date of February 1, 2011.  On June 24, 2010, an additional $43,594 of the Bridge Loans, inclusive of accrued interest, was converted into the Subordinated Secured Convertible Notes issued by the Company, as described below under the caption “Subordinated Secured Convertible Notes.  As of September 30, 2010, $55,610 in Bridge Loans were outstanding, including accrued interest.

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.  Directors, officers, and shareholders with greater than a 10% beneficial ownership in the Company extended $400,000 of the Additional Bridge Loans.  The remaining $180,000 in Additional Bridge Loans was guaranteed by Jack J. Walker, then one of the Company’s directors and now the Company’s Chairman and CEO.  The Additional Bridge Loans were unsecured, subordinated to loans made to the Company by FCC, and accrued interest at 20% per annum.  The Company issued 580,000 warrants to purchase common shares of the Company to the Additional Lenders.  Each of the warrants has a five-year term and an exercise price of $0.25 per common share.
 

On May 6, 2010, $504,534 of the Additional Bridge Loans, inclusive of accrued interest, was converted into the Subordinated Secured Convertible Notes issued by the Company, as described below under the caption “Subordinated Secured Convertible Notes.”  Of this amount, $379,534 was converted by directors, officers, and shareholders with greater than a 10% beneficial ownership in the Company.  In addition, on May 6, 2010, $50,000 of the Additional Bridge Loans was extended to a new maturity date of February 1, 2011.  On June 1, 2010, a payment of principal and interest totaling $74,390 was made against the Additional Bridge Loans.  As of September 30, 2010, $64,164 in Additional Bridge Loans were outstanding, including accrued interest.

First Western Trust Credit Facilities

On May 21, 2010, the Company and First Western Trust Bank (“FWTB”) executed a business loan agreement and related promissory note (the “FWTB Line of Credit”).  The FWTB Line of Credit provides for loans by FWTB to the Company of up to a maximum of $2 million at any given time, subject to the Company maintaining an equivalent amount of cash on deposit in a restricted account at FWTB.  Loans under the FWTB Line of Credit bear interest at a fixed rate of 2.0% per annum.  In addition, the Company paid FWTB an origination fee of $2,500.  The terms and conditions of the FWTB Line of Credit include limitations on the Company incurring additional debt and paying dividends on the Company’s stock without the consent of FWTB.  In the event of a default under the FWTB Line of Credit, FWTB has the option to declare any loans outstanding immediately due and payable.  During the quarter ended September 30, 2010 there were no borrowing under the FWTB line of credit.  As of September 30, 3010 there were no loans outstanding under the FWTB Line of Credit.  On October 22, 2010 the FWTB Line of Credit was terminated.

On May 21, 2010, the Company, FWTB and Jack J. Walker, the Company’s Chairman and CEO, as guarantor, executed a business loan agreement and related promissory note (the “FWTB Term Loan”) for a four-year loan in an initial principal amount of $1 million.  The FWTB Term Loan is secured by a lien on the Company’s assets.  In addition, Mr. Walker provided a guaranty of all Company obligations relating to the FWTB Term Loan.  The Company paid Mr. Walker $50,000 as compensation for guaranteeing the FWTB Term Loan.  The FWTB Term Loan bears interest at a fixed rate of 7.25% per annum and the Company paid a $12,500 origination fee to FWTB.  The Company will make equal monthly payments of principal/interest over the four-year term of the FWTB Term Loan, which has a final maturity date of May 21, 2014.  The terms and conditions of the FWTB Term Loan include limitations on the Company incurring additional debt and paying dividends on the Company’s stock without the consent of FWTB.  In the event of a default under the FWTB Term Loan, FWTB has the option to declare the loan immediately due and payable.  As of September 30, 2010, there was $928,768 outstanding under the FWTB Term Loan, including accrued interest.

Subordinated Secured Convertible Notes

Beginning in March 2010, the Company began a private offering of units comprising an aggregate of up to $8.4 million of 8% Senior Secured Convertible Notes and warrants to purchase 84,000,000 shares of the Company’s common stock (the “Warrants”).  The Company intends to use the proceeds from the private offering to invest in advertising and marketing programs to support its direct-to-consumer business, provide general working capital, pay commissions and expenses related to the private offering, and repay certain outstanding obligations.  The issuance of the Units (as defined below), the Additional Units (as defined below), and the Final Units (as defined below) was conducted in reliance upon exemptions from registration requirements under the Securities Act, including, without limitation, those under Rule 506 of Regulation D (as promulgated under the Securities Act).  The Units, Additional Units, and Final Units were offered and sold only to investors who are “accredited investors,” as defined in Rule 501 of Regulation D under the Securities Act.  Because the units have not been registered under the Securities Act, investors will not be able to sell their Subordinated Secured Convertible Notes (or the shares of the Company’s common stock issuable upon conversion of the Subordinated Secured Convertible Notes or conversion of the Warrants) in the United States absent an effective registration statement or an applicable exemption from registration.
 

On May 6, 2010, the Company closed on the private sale of units (the “Units”) comprising an aggregate of $4,200,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 42,000,000 Warrants.  The Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Units sold comprised $3,265,000 in cash and $935,000 from the conversion of existing obligations of the Company into the Subordinated Secured Convertible Notes.

On June 24, 2010, the Company closed on the private sale of additional units (the “Additional Units”) comprising an aggregate of $2,600,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 26,000,000 Warrants.  The Additional Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  The Company also received a commitment to purchase an additional $200,000 face value of Subordinated Secured Convertible Notes under the same terms and conditions as the Additional Units.  Consideration for the Additional Units sold comprised $2,300,000 in cash and $300,000 from the conversion of existing obligations of the Company into the Subordinated Secured Convertible Notes.

On September 17, 2010, the Company closed on the private sale of units (the “Final Units”) comprising an aggregate of $220,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 2,200,000 Warrants.  The Final Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Final Units comprised $220,000 in cash.

On September 17, 2010, the Company and GVC Capital LLC, the Company’s placement agent, terminated the private offering.

The Subordinated Secured Convertible Notes bear interest at 8% per year, payable quarterly in cash, additional Subordinated Secured Convertible Notes, or in registered common stock of the Company, at the option of the Company, and mature on May 6, 2013.  The Subordinated Secured Convertible Notes can be converted into shares of the Company's common stock at any time, initially at a conversion price of $0.10 per share (the “Conversion Price”). The Subordinated Secured Convertible Notes will automatically convert into shares of the Company’s common stock in the event (i) there is an effective registration statement registering the resale under the Securities Act of 1933 (“Securities Act”) of the underlying stock (“Conversion Shares”) or the Conversion Shares are eligible to be resold without restriction or limitation under Rule 144 under the Securities Act, and (ii)  the closing bid price of the Company’s common stock as quoted on the OTC Bulletin Board or other principal trading market is at least $0.25 per share for 20 out of 30 consecutive trading days with an average daily trading volume of at least one million shares.  The Subordinated Secured Convertible Notes are secured by a subordinated lien on all assets of the Company.

Each Warrant entitles the holder to purchase one share of the Company's common stock at a price of $0.20 per share, and contains customary anti-dilution rights (for stock splits, stock dividends and sales of substantially all the Company’s assets) and piggyback registration rights.  The Warrants expire May 6, 2015.

In accordance with applicable accounting guidance, the Company recorded a $6,980,400 debt discount on the Subordinated Secured Convertible Notes because the combined value of the Warrants and the beneficial conversion feature (resulting because the market price of the Company’s shares on the date of issuance was greater than the Conversion Price of the Subordinated Secured Convertible Notes) exceeded the amount of Subordinated Secured Convertible Notes issued.  The amortization of the $6,980,400 debt discount will be reported as additional interest expense and increases in long-term debt over the three-year term of the Subordinated Secured Convertible Notes. 

During the quarter ended June 30, 2010, $25,000 of the Subordinated Secured Convertible Notes was converted into common stock.  The remaining unamortized debt discount of $24,018 related to the amount converted was charged to interest expense during that quarter.  Amortization of the debt discount on the Subordinated Secured Convertible Notes amounted to $582,198 and $807,129 for the three and six months ended September 30, 2010, respectively.  As of September 30, 2010, the remaining unamortized discount on the Subordinated Secured Convertible Notes was $6,149,253.
 

The Company paid $509,119 in placement agent fees and expenses in connection with the issuance of the Subordinated Secured Convertible Notes.  This amount was recognized as deferred financing costs on the Company’s balance sheet.  These costs will be amortized to expense over the three-year term of the Subordinated Secured Convertible Notes.  In addition, the Company granted warrants to purchase the Company’s common stock to the placement agent for its Subordinated Secured Convertible Notes (the “Placement Agent Warrants”).  The Company granted 7,020,000 Placement Agent Warrants with an exercise price of $0.10 per common share and 7,020,000 Placement Agent Warrants with an exercise price of $0.20 per common share.  The Placement Agent Warrants have a five year term expiring May 6, 2015 and contain a cashless exercise provision.  The value of the Placement Agent Warrants has been recognized as $1,518,600 in deferred financing cost on the Company’s balance sheet, which will be amortized to expense over the three-year term of the Subordinated Convertible Notes.  For the three and six months ended September 30, 2010, the amortized deferred financing costs relating to the Subordinated Convertible Notes totaled $170,671 and $233,128.

Credit Card Receipts-Backed Notes

On October 28, 2010 and November 5, 2010, the Company closed on the private sale of $1.5 million in 15% secured convertible promissory notes backed by a portion of the Company’s prospective credit card receipts, (the “Credit Card Notes”) and 5,000,000 warrants to purchase the Company’s common stock (the “Credit Card Warrants”) (collectively, the “Credit Card Offering”). Consideration for the Credit Card Offering comprised $1.5 million in cash.  Net cash proceeds to the Company after deducting a 2% sales commission (1% on company-referred investors) paid to GVC Capital LLC, the Company’s placement agent, totaled $1,474,500.  In addition, the Company will pay a 3% deferred sales commission (2% on company-referred investors) to the placement agent concurrently with the repayment of principal of the Credit Card Notes.

The Company intends to use the proceeds from the Credit Card Offering to invest in advertising and marketing programs to support its direct-to-consumer business, provide general working capital, pay commissions and expenses related to the private offering, and repay certain outstanding obligations.  The issuance of the Credit Card Offering was conducted in reliance upon exemptions from registration requirements under the Securities Act of 1933 (the “Securities Act”), including, without limitation, those under Rule 506 of Regulation D (as promulgated under the Securities Act).  The Credit Card Offering was offered and sold only to six (6) investors who are, or the Company reasonably believed are, “accredited investors,” as defined in Rule 501(a) of Regulation D under the Securities Act.  Because the Credit Card Offering has not been registered under the Securities Act, the securities sold in the Offering, including the Credit Card Notes, Credit Card Warrants and shares of common stock underlying the Credit Card Notes and Warrants are “restricted securities” within the meaning of Rule 144 under the Securities Act, and investors will not be able to sell their Credit Card Notes (or the shares of the Company’s common stock issuable upon conversion of the Credit Card Notes or exercise of the Credit Card Warrants) in the United States absent an effective registration statement or an applicable exemption from registration.

The Credit Card Notes bear interest at 15% per annum, have a final maturity of July 28, 2011, and can be converted at any time into common shares of the Company at a conversion price of $0.18 per share.  20% of the Company’s daily credit card receipts will be held in escrow with First Western Trust Bank under an Escrow and Account Control Agreement to fund bi-weekly payments of principal and interest to the investors in the Credit Card Offering.

Each Credit Card Warrant entitles the holder to purchase one share of the Company's common stock at a price of $0.20 per share, and contains customary anti-dilution rights (for stock splits, stock dividends and sales of substantially all the Company’s assets) and piggyback registration rights.  The Warrants expire October 28, 2015.

The obligation of the Company to repay the Notes is severally guaranteed by Jack J. Walker, the Company’s Chairman and CEO (up to $500,000), J. Michael Wolfe, Chief Operating Officer (up to $200,000) and H. MacGregor Clarke, Chief Financial Officer (up to $100,000).  The guarantors have executed a Contribution Agreement between and among themselves to enforce the limited several guaranties; and the Company has executed an Indemnity Agreement to hold harmless the guarantors from any future liability under the guaranties.

For nominal consideration, the Company sold a total of 1,333,333 warrants to purchase the Company’s common stock to the placement agent.  833,333 of the placement agent warrants have an exercise price of $0.18 per share of common stock.  500,000 of the placement agent warrants have an exercise price of $0.20 per share of common stock.  The placement agent warrants have a five-year term and contain a cashless exercise provision.
 

On November 5, 2010 the Company and the placement agent terminated the private offering.
 
Cash Requirements

The Company generally requires cash to:

·
fund our operations and working capital requirements,
·
develop and execute our product development and market introduction plans,
·
execute our sales and marketing plans,
·
fund research and development efforts, and
·
pay for debt obligations as they come due.
 
We expect to fund these and other cash requirements with cash provided by operations, the debt facilities described above, and with existing cash.  In addition, we are attempting to secure a new source of short-term funding to support our seasonal working capital requirements for our next fiscal year, and we may raise new long-term debt or equity capital depending on market conditions.  At this time, based on a variety of assumptions including, but not limited to, our anticipated operating cash flow, the level of customer and consumer demand, our access to funding, the impact of cost reduction programs, and the state of the general economic environment in which we operate, we believe we have sufficient liquidity to support our operations through the balance of our current fiscal year.  Subsequent to that time period, in order to continue to meet our liquidity requirements we will need to secure additional capital, either in the form of seasonal working capital borrowings, or longer-term debt or equity capital, or reduce our scale of operations.  There can be no assurance that the Company will have access to sufficient capital, from our existing financing sources or from other sources, to enable us to meet our short-term cash requirements.  In the event the Company takes actions to reduce its scale of operations, there can be no assurance that such actions will be sufficient, or on a timely basis, to allow the Company to meet its liquidity requirements.

We cannot predict with certainty the cash requirements for our operations as market conditions, competitive pressures, regulatory requirements, credit and capital markets, and customer requirements can change rapidly. If the assumptions regarding these and other factors do not prove to be accurate in all material respects, there could be a material adverse impact on our operations and liquidity position, and on our ability to support the operating requirements of our business.

At this time, we do not expect to enter into additional capital leases to finance major purchases.  In addition, we do not currently have any binding commitments with third parties to obtain any material amount of equity or debt financing other than the financing arrangements described in this report.
 

Assessment of Future Liquidity and Results of Operations

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

·
our cash of $717,082 ($87,904 of which was restricted as collateral for letters of credit and other corporate obligations) as of September 30, 2010,
·
our cash of $909,461 ($91,573 of which is restricted as collateral for letters of credit and other corporate obligations) as of November 8, 2010,
·
continued support of, and extensions of credit by, our suppliers and lenders,
·
our historical pattern of increased sales between September and March, and lower sales volume from April through August,
·
the level of spending necessary to support our planned initiatives, and
·
our sales to consumers, retailers, and international distributors, and the resulting cash flow from operations, which will depend in great measure on the success of our direct-to-consumer initiatives.

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:

·
the effectiveness of our consumer-focused marketing efforts in generating both direct-to-consumer sales, and sales to consumers by our retailer customers,
·
uncertainty regarding the impact of macroeconomic conditions on consumer spending,
·
uncertainty regarding the capital markets and on our access to sufficient capital to support our current and projected scale of operations,
·
the seasonality of our business, in which we have historically experienced higher sales volume during the fall and winter months (September through March), and
·
a timely, uninterrupted supply of product from our third-party manufacturing suppliers in China.

During Fiscal 2010, we took a number of actions to address our liquidity issues.  Specifically, we re-focused our efforts on building our direct-to-consumer business, which we believe carries higher margin opportunities than our retailer business.  We also reduced the number of retailers that carry our products in order to focus on those retailers that have proven to be the best and most profitable business partners.  We issued approximately $6.7 million of convertible preferred stock to re-capitalize the Company, restructured the amounts and payment timing of certain of our accounts payable, and reduced the amount of interest-bearing debt outstanding.  Furthermore, during Fiscal 2011, we have issued $7,020,000 in Subordinated Secured Convertible Notes and $1.5 million in Credit Card Notes (as described above).
 

Based on the assumptions and contingencies presented above, and on the sources of capital described above, we believe we have sufficient liquidity to support our operations through the balance of our current fiscal year.  Subsequent to that time period, in order to continue to meet our liquidity requirements we will need to secure additional capital, either in the form of seasonal working capital borrowings, or longer-term debt or equity capital, or reduce our scale of operations.  There can be no assurance that the Company will have access to sufficient capital, from our existing financing sources or from other sources, to enable us to meet our short-term cash requirements.  In the event the Company takes actions to reduce its scale of operations, there can be no assurance that such actions will be sufficient, or on a timely basis, to allow the Company to meet its liquidity requirements.

Off-Balance Sheet Arrangements

We have certain current commitments under capital leases and have not entered into any contracts for financial derivative such as futures, swaps, and options. We do not believe that these arrangements are material to our current or future financial condition, results of operations, liquidity, capital resources or capital expenditures.
 
  Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Risk
 
Our interest income is most sensitive to fluctuations in the general level of U.S. interest rates. As such, changes in U.S. interest rates affect the interest earned on our cash, cash equivalents, and short-term investments, and the value of those investments. Due to the short-term nature of our cash equivalents and investments, we have concluded that a change in interest rates does not pose a material market risk to us with respect to our interest income. Our debt carries fixed interest rates and therefore changes in the general level of market interest rates will not impact our interest expense during the terms of our existing debt arrangements.

Foreign Currency Exchange Risk

We transact business in primarily in U.S. currency.  Although we purchase our products in U.S. dollars, the prices charged by our China factories are predicated upon their cost for components, labor and overhead. Therefore, changes in the valuation of the U.S. dollar in relation to the Chinese currency may cause our manufacturers to raise prices of our products which could reduce our profit margins.
  
In future periods, it is possible that we could be exposed to fluctuations in foreign currency exchange rates on accounts receivable from sales and net monetary assets denominated in foreign currencies and liabilities.  To date, however, virtually all of our transactions have been denominated in U.S. dollars.
 
 
Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

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

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, 2010.
 
 
PART II - OTHER INFORMATION

Item 1. Legal Proceedings
None

Item 1A. Risk Factors
Our operations and financial results are subject to various risks and uncertainties that could adversely affect our business, results of operations, financial condition, future results, and the trading price of our common stock. In addition to the other information set forth in this Quarterly Report, you should carefully consider the factors described in “Part I. Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended March 31, 2010, which could materially affect our business, results of operations, financial condition, future results, and the trading price of our common stock.

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

Subordinated Secured Convertible Notes

Beginning in March 2010, the Company began a private offering of units comprising an aggregate of up to $8.4 million of 8% Subordinated Secured Convertible Notes and warrants to purchase 84,000,000 shares of the Company’s common stock (the “Warrants”).  The Company expects the private offering to remain open through September 30, 2010.  The Company intends to use the proceeds from the private offering to invest in advertising and marketing programs to support its direct-to-consumer business, provide general working capital, pay commissions and expenses related to the private offering, and repay certain outstanding obligations.  The issuance of the Units (as defined below), the Additional Units (as defined below), and the Final Units (as defined below) was conducted in reliance upon exemptions from registration requirements under the Securities Act, including, without limitation, those under Rule 506 of Regulation D (as promulgated under the Securities Act).  The Units, Additional Units, and Final Units were offered and sold only to investors who are “accredited investors,” as defined in Rule 501 of Regulation D under the Securities Act.  Because the units have not been registered under the Securities Act, investors will not be able to sell their Subordinated Secured Convertible Notes (or the shares of the Company’s common stock issuable upon conversion of the Subordinated Secured Convertible Notes or conversion of the Warrants) in the United States absent an effective registration statement or an applicable exemption from registration.

On May 6, 2010, the Company closed on the private sale of units (the “Units”) comprising an aggregate of $4,200,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 42,000,000 Warrants.  The Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Units sold comprised $3,265,000 in cash and $935,000 from the conversion of existing obligations of the Company into the Subordinated Secured Convertible Notes.

On June 24, 2010, the Company closed on the private sale of units (the “Additional Units”) comprising an aggregate of $2,600,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 26,000,000 Warrants.  The Company also received a commitment to purchase an additional $200,000 face value of Subordinated Secured Convertible Notes under the same terms and conditions as the Additional Units.  The Additional Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Additional Units sold comprised $2,300,000 in cash and $300,000 from the conversion of existing obligations of the Company into the Notes.

On September 17, 2010, the Company closed on the private sale of units (the “Final Units”) comprising an aggregate of $220,000 in 8% Subordinated Secured Convertible Notes and an aggregate of 2,200,000 Warrants.  The Final Units were sold at a price equal to the face value of the Subordinated Secured Convertible Notes.  Consideration for the Final Units comprised $220,000 in cash.
 

On September 17, 2010, the Company and GVC Capital LLC, the Company’s placement agent, terminated the private offering.

The Subordinated Secured Convertible Notes bear interest at 8% per year, payable quarterly in cash, additional Subordinated Secured Convertible Notes, or in registered common stock of the Company, at the option of the Company, and mature on May 6, 2013.  The Subordinated Secured Convertible Notes can be converted into shares of the Company's common stock at any time, initially at a conversion price of $0.10 per share. The Subordinated Secured Convertible Notes will automatically convert into shares of the Company’s common stock in the event (i) there is an effective registration statement registering the resale under the Securities Act of 1933 (“Securities Act”) of the underlying stock (“Conversion Shares”) or the Conversion Shares are eligible to be resold without restriction or limitation under Rule 144 under the Securities Act, and (ii) the closing bid price of the Company’s common stock as quoted on the OTC Bulletin Board or other principal trading market is at least $0.25 per share for 20 out of 30 consecutive trading days with an average daily trading volume of at least one million shares.  The Subordinated Secured Convertible Notes are secured by a subordinated lien on all assets of the Company.

Each Warrant entitles the holder to purchase one share of the Company's common stock at a price of $0.20 per share, and contains customary anti-dilution rights (for stock splits, stock dividends and sales of substantially all the Company’s assets) and piggyback registration rights.  The Warrants expire May 6, 2015.

In addition, the Company granted warrants to purchase the Company’s common stock to the placement agent for its Subordinated Secured Convertible Notes (the “Placement Agent Warrants”).  The Company granted 7,020,000 Placement Agent Warrants with an exercise price of $0.10 per common share and 7,020,000 Placement Agent Warrants with an exercise price of $0.20 per common share.  The Placement Agent Warrants have a five year term and contain a cashless exercise provision.
 
Item 3. Defaults Upon Senior Securities

None.

Item 4. Reserved

Not applicable.

Item 5. Other Information

Refer to the disclosure under the caption “Credit Card Receipts – Backed Notes” in Part I. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Quarterly Report of Form 10-Q.
 
 
Item 6. Exhibits
 
Exhibit
Number
 
 
Description
     
3.1
 
Articles of Incorporation of the Company (incorporated by reference to Exhibit 3.1 of our Current Report on Form 8-K/A-2, filed November 16, 2006).
3.2
 
Certificate of Amendment to Articles of Incorporation, dated June 25, 2002 (incorporated by reference to Exhibit 3.2 of our Current Report on Form 8-K/A-2, filed November 16, 2006).
3.3
 
Certificate of Amendment to Articles of Incorporation, dated November 3, 2002 (incorporated by reference to Exhibit 3.3 of our Current Report on Form 8-K/A-2, filed November 16, 2006).
3.4
 
Certificate of Change to Articles of Incorporation, dated January 31, 2005 (incorporated by reference to Exhibit 3.4 of our Current Report on Form 8-K/A-2, filed November 16, 2006).
3.5
 
Certificate of Amendment to Articles of Incorporation, dated July 27, 2005 (incorporated by reference to Exhibit 3.5 of our Current Report on Form 8-K/A-2, filed November 16, 2006).
3.6
 
Certificate of Amendment to Articles of Incorporation, dated February 24, 2006 (incorporated by reference to Exhibit 3.6 of our Current Report on Form 8-K/A-2, filed November 16, 2006).
3.7
 
Certificate of Amendment to Articles of Incorporation, certified May 3, 2010 (incorporated by reference to Exhibit 3.7 of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2010, filed August 12, 2010).
3.8
 
Amended and Restated Bylaws (incorporated by reference to Exhibit 3.1 of our Current Report on Form 8-K, filed September 26, 2008).
3.9
 
Amendment to Bylaws (incorporated by reference to Exhibit 3.9 of our Form 10-K for the fiscal year ended March 31, 2009, filed on July 6, 2009).
3.10
 
Certificate of Designations of Series A Convertible Preferred Stock (incorporated by reference to Exhibit 3.7 of our Annual Report on Form 10-K for the fiscal year ended March 31, 2009, filed July 6, 2009).
3.11
 
Certificate of Amendment to Series A Convertible Preferred Stock Certificate of Designations, certified June 21, 2010 (incorporated by reference to Exhibit 3.11 of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2010, filed August 12, 2010).
10.1
 
Form of 15% Secured Convertible Promissory Note or “Credit Card Note” (incorporated by reference to Exhibit 4.1 of our Current Report on Form 8-K, filed October 28, 2010).
10.2
 
Form of Credit Card Warrant (incorporated by reference to Exhibit 4.2 of our Current Report on Form 8-K, filed October 28, 2010).
10.3
 
Guaranty Agreement by Jack J. Walker, J. Michael Wolfe and H. MacGregor Clarke, dated October 21, 2010 (incorporated by reference to Exhibit 10.1 of our Current Report on Form 8-K, filed October 28, 2010).
10.4
 
Contribution Agreement by Jack J. Walker, J. Michael Wolfe and H. MacGregor Clarke, dated October 25, 2010 (incorporated by reference to Exhibit 10.2 of our Current Report on Form 8-K, filed October 28, 2010).
10.5
 
Indemnity Agreement by Jack J. Walker, J. Michael Wolfe and H. MacGregor Clarke, dated October 25, 2010 (incorporated by reference to Exhibit 10.3 of our Current Report on Form 8-K, filed October 28, 2010).
10.6
 
Escrow and Account Control Agreement dated October 21, 2010 (incorporated by reference to Exhibit 10.4 of our Current Report on Form 8-K, filed October 28, 2010).
10.9
 
2005 Equity Compensation Plan, as amended and restated (incorporated by reference to Appendix A of our Definitive Information Statement on Schedule 14C, filed July 28, 2010).
10.10*
 
31.1*
 
31.2*
 
32.1*
 
32.2*
 

*
Filed Herewith
 
 
SIGN ATURES

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 10, 2010
 
/s/Jack J. Walker                            
 
By: Jack J. Walker
 
Its: Chairman and Chief Executive Officer
 (Principal Executive Officer) and Director
     
     
     
Date:  November 10, 2010
 
/s/H. MacGregor Clarke                
 
By: H. MacGregor Clarke
 
Its: Chief Financial Officer (Principal Financial Officer)
     
   
     
Date: : November 10, 2010
 
/s/Grey H. Gibbs                            
 
By: Grey H. Gibbs
 
Its: Controller (Principal Accounting Officer)
 
Exhibit 10.10
INDEMNIFICATION AGREEMENT
 
This Indemnification Agreement ("Agreement") is made as of this ___ day of _____ 20__, by and between AeroGrow International, Inc., a Nevada corporation (the "Company"), and the undersigned ____________________________ ("Indemnitee").
 
WHEREAS, the Company and Indemnitee recognize the difficulty in obtaining directors' and officers' liability insurance that fully and adequately covers directors and officers for their acts and omissions on behalf of the Company and its subsidiaries;
 
WHEREAS, the Company and Indemnitee further recognize the substantial increase in corporate litigation in general, subjecting officers and directors to expensive litigation risks at the same time as the availability and coverage of liability insurance has been severely limited;
 
WHEREAS, Indemnitee does not regard the current protection available as adequate under the present circumstances, and Indemnitee and other officers and directors of the Company may not be willing to continue to serve as officers and directors without additional protection; and
 
WHEREAS, the Company desires to attract and retain the services of highly qualified individuals, such as Indemnitee, to serve as officers and directors of the Company and to indemnify its officers and directors so as to provide them with the maximum protection permitted by law.
 
NOW, THEREFORE, the Company and Indemnitee hereby agree as follows:
 
1. INDEMNIFICATION.

(a) THIRD PARTY PROCEEDINGS. The Company shall indemnify Indemnitee if Indemnitee is or was a party or is threatened to be made a party to any threatened, pending or completed action or proceeding, whether civil, criminal, administrative or investigative (other than an action by or in the right of the Company) by reason of the fact that Indemnitee is or was a director, officer, employee or agent of the Company or a Subsidiary (as hereinafter defined), by reason of any action or inaction on the part of Indemnitee while a director, officer, employee or agent or by reason of the fact that Indemnitee is or was serving at the request of the Company as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including reasonable attorneys' fees), judgments, fines and amounts paid in settlement (if such settlement is approved in advance by the Company, which approval shall not be unreasonably withheld) actually and reasonably incurred by Indemnitee in connection with such action or proceeding unless the Company shall establish, in accordance with the procedures described in subsection 2(c) of this Agreement, that Indemnitee did not act in good faith and in a manner Indemnitee reasonably believed to be in the best interests of the Company, and, with respect to any criminal action or proceeding, had no reasonable cause to believe Indemnitee's conduct was unlawful. The termination of any action or proceeding by judgment, order, settlement, conviction, or upon a plea of NOLO CONTENDERE or its equivalent, shall not, of itself, create a presumption (i) that Indemnitee did not act in good faith and in a manner which Indemnitee reasonably believed to be in the best interests of the Company, or (ii) with respect to any criminal action or proceeding, that Indemnitee had reasonable cause to believe that Indemnitee's conduct was unlawful.

(b) PROCEEDINGS BY OR IN THE RIGHT OF THE COMPANY. The Company shall indemnify Indemnitee if Indemnitee was or is a party or is threatened to be made a party to any threatened, pending or completed action or proceeding by or in the right of the Company or any Subsidiary of the Company to procure a judgment in its favor by reason of the fact that Indemnitee is or was a director, officer, employee or agent of the Company, or any Subsidiary of the Company, by reason of any action or inaction on the part of Indemnitee while a director, officer, employee or agent or by reason of the fact that Indemnitee is or was serving at the request of the Company as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including reasonable attorneys' fees) and, to the fullest extent permitted by law, amounts paid in settlement, in each case to the extent actually and reasonably incurred by Indemnitee in connection with the defense or settlement of such action or proceeding unless the Company shall establish, in accordance with the procedures described in subsection 2(c) of this Agreement, that Indemnitee did not act in good faith and in a manner Indemnitee reasonably believed to be in the best interests of the Company and its shareholders, except that no indemnification shall be made in respect of any claim, issue or matter as to which Indemnitee shall have been adjudged to be liable to the Company in the performance of Indemnitee's duty to the Company or any Subsidiary of the Company unless and only to the extent that the court in which such action or proceeding is or was pending shall determine upon application that, in view of all the circumstances of the case, Indemnitee is fairly and reasonably entitled to indemnity for expenses or amounts paid in settlement and then only to the extent that the court shall determine.
 
 
 

 
 
2. EXPENSES; INDEMNIFICATION PROCEDURE.

(a) ADVANCEMENT OF EXPENSES. The Company shall advance all reasonable expenses incurred by Indemnitee in connection with the investigation, defense, settlement or appeal of any civil or criminal action or proceeding referenced in subsection 1(a) or 1(b) of this Agreement (but not amounts actually paid in settlement of any such action or proceeding). Indemnitee hereby undertakes to repay such amounts advanced only if, and to the extent that, it shall ultimately be determined that Indemnitee is not entitled to be indemnified by the Company as authorized hereby. The advances to be made hereunder shall be paid by the Company to Indemnitee within twenty (20) days following delivery of a written request therefor by Indemnitee to the Company.

(b) NOTICE/COOPERATION BY INDEMNITEE. Indemnitee shall, as a condition precedent to his right to be indemnified or be advanced expenses under this Agreement, give the Company notice in writing as soon as practicable of any claim made against Indemnitee for which indemnification will or could be sought under this Agreement. Notice to the Company shall be directed to the Chief Executive Officer of the Company at the address shown on the signature page of this Agreement (or such other address as the Company shall designate in writing to Indemnitee). In addition, Indemnitee shall give the Company such information and cooperation as it may reasonably require and as shall be within Indemnitee's power.

(c) PROCEDURE. Any indemnification provided for in Section 1 of this Agreement shall be made no later than forty-five (45) days after the resolution (by judgment, settlement, dismissal or otherwise) of the claim to which indemnification is sought. If a claim under this Agreement, under any statute, or under any provision of the Company's Articles of Incorporation or By-laws providing for indemnification, is not paid in full by the Company within such period, Indemnitee may, but need not, at any time thereafter bring an action against the Company to recover the unpaid amount of the claim and, subject to Section 14 of this Agreement, Indemnitee shall also be entitled to be paid for the expenses (including reasonable attorneys' fees) of bringing such action. It shall be a defense to any such action (other than an action brought to enforce a claim for expenses incurred in connection with any action or proceeding in advance of its final disposition) that Indemnitee has not met the standards of conduct which make it permissible under applicable law for the Company to indemnify Indemnitee for the amount claimed, but the burden of proving such defense shall be on the Company, and Indemnitee shall be entitled to receive interim payments of expenses pursuant to subsection 2(a) of this Agreement unless and until such defense may be finally adjudicated by court order or judgment from which no further right of appeal exists. It is the parties' intention that if the Company contests Indemnitee's right to indemnification, the question of Indemnitee's right to indemnification shall be for the court to decide, and neither the failure of the Company (including its Board of Directors, any committee or subgroup of the Board of Directors, independent legal counsel, or its shareholders) to have made a determination that indemnification of Indemnitee is proper in the circumstances because Indemnitee has met the applicable standard of conduct required by applicable law, nor an actual determination by the Company (including its Board of Directors, any committee or subgroup of the Board of Directors, independent legal counsel, or its shareholders) that Indemnitee has not met such applicable standard of conduct, shall create a presumption that Indemnitee has or has not met the applicable standard of conduct.
 
(d) NOTICE TO INSURERS. If, at the time of the receipt of a notice of a claim pursuant to subsection 2(b) of this Agreement, the Company has director and officer liability insurance in effect, the Company shall give prompt notice of the commencement of such proceeding to the insurers in accordance with the procedures set forth in the respective policies. The Company shall thereafter take all necessary or desirable action to cause such insurers to pay, on behalf of the Indemnitee, all amounts payable as a result of such proceeding in accordance with the terms of such policies.

(e) RELATIONSHIP TO OTHER SOURCES. Indemnitee shall not be required to exercise any rights against any other parties (for example, under any insurance policy purchased by the Company, Indemnitee or any other person or entity) before Indemnitee enforces this Agreement. However, to the extent the Company actually indemnifies Indemnitee or advances expenses, the Company shall be entitled to enforce any such rights which Indemnitee may have against third parties. Indemnitee shall assist the Company in enforcing those rights if the Company pays Indemnitee's reasonable costs and expenses of doing so.
 
 
 

 

(f) SELECTION OF COUNSEL. In the event the Company shall be obligated under subsection 2(a) of this Agreement to pay the expenses of any proceeding against Indemnitee, the Company, if appropriate, shall be entitled to assume the defense of such proceeding, with counsel approved by Indemnitee, which approval shall not be unreasonably withheld, upon the delivery to Indemnitee of written notice of its election so to do. After delivery of such notice, approval of such counsel by Indemnitee and the retention of such counsel by the Company, the Company will not be liable to Indemnitee under this Agreement for any fees of counsel subsequently incurred by Indemnitee with respect to the same proceeding, provided that (i) Indemnitee shall have the right to employ his counsel in any such proceeding at Indemnitee's expense; and (ii) if (A) the employment of counsel by Indemnitee has been previously authorized by the Company, (B) Indemnitee shall have reasonably concluded that there may be a conflict of interest between the Company and Indemnitee in the conduct of any such defense or (C) the Company shall not, in fact, have employed counsel to assume the defense of such proceeding, then the reasonable fees and expenses of Indemnitee's counsel shall be at the expense of the Company.

3. ADDITIONAL INDEMNIFICATION RIGHTS; NONEXCLUSIVITY.

(a) SCOPE. Notwithstanding any other provision of this Agreement, the Company hereby agrees to indemnify the Indemnitee to the fullest extent permitted by law, notwithstanding that such indemnification is not specifically authorized by the other provisions of this Agreement, the Company's Articles of Incorporation, the Company's By-Laws or by statute. In the event of any change, after the date of this Agreement, in any applicable law, statute or rule which expands the right of a Nevada corporation to indemnify a member of its or a Subsidiary's board of directors or an officer, such changes shall be, IPSO FACTO, within the purview of Indemnitee's rights and the Company's obligations, under this Agreement. In the event of any change in any applicable law, statute or rule which narrows the right of a Nevada corporation to indemnify a member of its or a Subsidiary's Board of Directors or an officer, such changes, to the extent not otherwise required by such law, statute or rule to be applied to this Agreement shall have no effect on this Agreement or the parties' rights and obligations hereunder.

(b) NONEXCLUSIVITY. The indemnification provided by this Agreement shall not be deemed exclusive of any rights to which Indemnitee may be entitled under the Company's Articles of Incorporation, its By-Laws, any agreement, any vote of shareholders or disinterested directors, the General Corporation Law of the State of Nevada, or otherwise, both as to action in Indemnitee's official capacity and as to action or inaction in another capacity while holding such office. The indemnification provided under this Agreement shall continue as to Indemnitee for any action taken or not taken while serving in an indemnified capacity even though he may have ceased to serve in such capacity at the time of any action or other covered proceeding is commenced.

4. PARTIAL INDEMNIFICATION. If Indemnitee is entitled under any provision of this Agreement to indemnification by the Company for some or a portion of the expenses, judgments, fines or penalties actually or reasonably incurred by him in the investigation, defense, appeal or settlement of any civil or criminal action or proceeding, but not, however, for the total amount thereof, the Company shall nevertheless indemnify Indemnitee for the portion of such expenses, judgments, fines or penalties to which Indemnitee is entitled.

5. MUTUAL ACKNOWLEDGMENT. Both the Company and Indemnitee acknowledge that in certain instances, Federal law or applicable public policy may prohibit the Company from indemnifying its directors and officers under this Agreement or otherwise. Indemnitee understands and acknowledges that the Company has undertaken or may be required in the future to undertake with the Securities and Exchange Commission to submit the question of indemnification to a court in certain circumstances for a determination of the Company's right under public policy to indemnify Indemnitee.
 
 
 

 

6. DIRECTORS' AND OFFICERS' LIABILITY INSURANCE. The Company shall, from time to time, make the good faith determination whether or not it is practicable for the Company to obtain and maintain a policy or policies of insurance with reputable insurance companies providing the officers and directors of the Company with coverage for losses from wrongful acts, or to ensure the Company's performance of its indemnification obligations under this Agreement. Among other considerations, the Company will weigh the costs of obtaining such insurance coverage against the protection afforded by such coverage. In all policies of directors' and officers' liability insurance, Indemnitee shall be named as an insured in such a manner as to provide Indemnitee the same rights and benefits as are accorded to the most favorably insured of the Company's directors, if Indemnitee is a director; or of the Company's officers, if Indemnitee is not a director of the Company but is an officer. Notwithstanding the foregoing, the Company shall have no obligation to obtain or maintain such insurance if the Company determines in good faith that such insurance is not reasonably available, if the premium costs for such insurance are disproportionate to the amount of coverage provided, if the coverage provided by such insurance is limited by exclusions so as to provide an insufficient benefit, or if Indemnitee is covered by similar insurance maintained by a Subsidiary or parent of the Company.

7. SEVERABILITY. Nothing in this Agreement is intended to require or shall be construed as requiring the Company to do or fail to do any act in violation of applicable law. The Company's inability, pursuant to court order, to perform its obligations under this Agreement shall not constitute a breach of this Agreement. The provisions of this Agreement shall be severable as provided in this Section 7. If this Agreement or any portion hereof shall be invalidated on any ground by any court of competent jurisdiction, then the Company shall nevertheless indemnify Indemnitee to the full extent permitted by any applicable portion of this Agreement that shall not have been invalidated, and the balance of this Agreement not so invalidated shall be enforceable in accordance with its terms.

8. EXCEPTIONS. Any other provision herein to the contrary notwithstanding, the Company shall not be obligated pursuant to the terms of this Agreement:

(a) EXCLUDED ACTS. To indemnify Indemnitee for any acts or omissions or transactions from which a director, officer, employee or agent may not be relieved of liability under applicable law.

(b) CLAIMS INITIATED BY INDEMNITEE. To indemnify or advance expenses to Indemnitee with respect to proceedings or claims initiated or brought voluntarily by Indemnitee and not by way of defense, except with respect to proceedings brought to establish or enforce a right to indemnification under this Agreement or any other statute or law or otherwise as required under Section 317 of the Nevada General Corporation Law, but such indemnification or advancement of expenses may be provided by the Company in specific cases if the Board of Directors has approved the initiation or bringing of such suit; or
 
(c) LACK OF GOOD FAITH. To indemnify Indemnitee for any expenses incurred by the Indemnitee with respect to any proceeding instituted by Indemnitee to enforce or interpret this Agreement, if a court of competent jurisdiction determines that the material assertions made by the Indemnitee in such proceeding was not made in good faith or was frivolous; or

(d) INSURED CLAIMS. To indemnify Indemnitee for expenses or liabilities of any type whatsoever (including, but not limited to, judgments, fines, ERISA excise taxes or penalties, and amounts paid in settlement) which have been paid directly to Indemnitee by an insurance carrier under a policy of directors' and officers' liability insurance maintained by the Company; or

(e) CLAIMS UNDER SECTION 16(b). To indemnify Indemnitee for expenses and the payment of profits arising from the purchase and sale by Indemnitee of securities in violation of Section 16(b) of the Securities Exchange Act of 1934, as amended, or any similar successor statute.
 
 
 

 

9. EFFECTIVENESS OF AGREEMENT; TERM.

(a) This Agreement shall be effective as of the date set forth on the first page and shall apply to ats or omissions of Indemnitee which occurred prior to such date if Indemnitee was an officer, director, employee or other agent of the Company or any Subsidiary, or was serving at the request of the Company or any Subsidiary as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, at the time such act or omission occurred.

(b) The Company's obligations under this Agreement shall continuously, irrevocably and perpetually cover Indemnitee's covered acts and omissions which occur during the period ending two years after the date of this Agreement. Thereafter, such coverage shall extend to Indemnitee's acts and omissions which occur during succeeding 12-month periods, and shall continue until the end of the 12­month extension period during which the Company gives Indemnitee written notice of termination of the continuity of such coverage; provided, however that (a) such notice of termination shall only be effective if it is received by Indemnitee at least six months prior to the end of the 12-month extension period which is intended by the Company to be the final 12-month extension period, and (b) such coverage shall continue until the end of such final 12-month extension period. In any event, the Company's obligations under this Agreement shall continue perpetually with regard to covered acts and omissions occuring during the period covered by this Agreement (including all of the 12-month extension periods as set forth above), notwithstanding the giving of any such notice of termination or any other circumstance whatsoever.
 
10. CONSTRUCTION OF CERTAIN PHRASES.

(a) For purposes of this Agreement, the term "Company" shall include, in addition to the resulting corporation, any constituent corporation (including any constituent of a constituent) absorbed in a consolidation or merger which, if its separate existence had continued, would have had power and authority to indemnify its directors, officers, employees or agents, so that if Indemnitee is or was a director, officer, employee or agent of such constituent corporation, or is or was serving at the request of such constituent corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, Indemnitee shall stand in the same position under the provisions of this Agreement with respect to the resulting or surviving corporation as Indemnitee would have with respect to such constituent corporation if its separate existence had continued.
 
(b) For purposes of this Agreement, the term "Subsidiary" shall include a corporation, company or other entity
 
(i) 50% or more of whose outstanding shares or securities (representing the right to vote for the election of directors or other managing authority) are, or
 
(ii) which does not have outstanding shares or securities (as may be the case in a partnership, joint venture or unincorporated association), but 50% or more of whose ownership interest representing the right to make decisions for such other entity is, now or hereafter, owned or controlled, directly or indirectly, by the Company, or one or more Subsidiaries.
 
(c) For purposes of this Agreement, references to "other enterprises" shall include employee benefit plans; references to "fines" shall include any excise taxes assessed on Indemnitee with respect to an employee benefit plan; and references to "serving at the request of the Company" shall include any service as a director, officer, employee or agent of the Company which imposes duties on, or involves services by, such director, officer, employee or agent with respect to an employee benefit plan, its participants, or beneficiaries.
 
 
 

 
 
11. COUNTERPARTS. This Agreement may be executed in one or more counterparts, each of which shall constitute an original.
 
12. SUCCESSORS AND ASSIGNS. This Agreement shall be binding upon the Company and its successors and assigns, and shall inure to the benefit of Indemnitee and Indemnitee's estate, heirs, legal representatives and assigns.

13. ATTORNEYS' FEES. In the event that any action is instituted by Indemnitee under this Agreement to enforce or interpret any of the terms hereof, Indemnitee shall be entitled to be paid all court costs and expenses, including reasonable attorneys' fees, incurred by Indemnitee with respect to such action, unless as a part of such action, the court of competent jurisdiction determines that the material assertions made by Indemnitee as a basis for such action were not made in good faith or were frivolous. In the event of an action instituted by or in the name of the Company under this Agreement or to enforce or interpret any of the terms of this Agreement, Indemnitee shall be entitled to be paid all court costs and expenses, including reasonable attorneys' fees, incurred by Indemnitee in defense of such action (including with respect to Indemnitee's counterclaims and cross-claims made in such action), unless as a part of such action the court determines that Indemnitee's material defenses to such action were made in bad faith or were frivolous.

14. NOTICE. All notices, requests, demands and other communications under this Agreement shall be in writing and shall be deemed duly given (i) if delivered by hand and receipted for by the party addressee, on the date of such receipt, (ii) if mailed by domestic certified or registered mail with postage prepaid, on the fifth business day after the date postmarked, or (iii) if sent by confirmed telex or facsimile, on the date sent. Notices shall be addressed as follows:
 
(a) if to the Company:
 
AeroGrow International, Inc. 6075 Longbow Drive -Suite 200 Boulder, CO 80301
Phone: 303-444-7755
Fax: 303-444-0406
Email: info@aerogrow.com
 
(b) if to Indemnitee, to the address of Indemnitee set forth under Indemnitee's signature below;
or to such other address or attention of such other person as any party shall advise the other parties in writing.
 
15. CONSENT TO JURISDICTION; CHOICE OF VENUE. The Company and Indemnitee each hereby irrevocably consents to the jurisdiction of the courts of the State of Nevada and the federal courts within the State for all purposes in connection with any action or proceeding which arises out of or relates to this Agreement and agree that any action instituted under this Agreement shall be brought only in the United States District Court for District of Nevada and any Nevada State court within that District.
 
 
 

 
 
16. CHOICE OF LAW. THIS AGREEMENT SHALL BE GOVERNED BY AND ITS PROVISIONS CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF NEVADA AS APPLIED TO CONTRACTS BETWEEN NEVADA RESIDENTS ENTERED INTO AND TO BE PERFORMED ENTIRELY WITHIN NEVADA.
 
IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first above written.

AeroGrow International, Inc.
 
 
 
Authorized Signer
 
 
AGREED TO AND ACCEPTED:
 
INDEMNITEE:
 
 
Authorized Signer
 
 
 
 
 
 
 
 
EXHIBIT 31. 1
CERTIFICATIONS OF THE CHIEF EXECUTIVE OFFICER
UNDER SECTION 302 OF THE SARBANES-OXLEY ACT

I, Jack J. Walker certify that:

1. I have reviewed this report on Form 10-Q for the period ended September 30, 2010 of AeroGrow International Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have:

     (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

     (b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

     (c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the issuer’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

     (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

     (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
 
 
     
Date:  November 10, 2010
By:
/s/ Jack J. Walker                        
 
 
Jack J. Walker
 
 
Chairman and Chief Executive Officer
(Principal Executive Officer)
 

 
 
  EXHIBIT 31.2
CERTIFICATIONS OF THE CHIEF FINANCIAL OFFICER
UNDER SECTION 302 OF THE SARBANES-OXLEY ACT

I, H. MacGregor Clarke, certify that:

1. I have reviewed this report on Form 10-Q for the period ended September 30, 2010 of AeroGrow International Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have:

     (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

     (b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

     (c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the issuer’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

     (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

     (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.
 
     
Date:  November 10, 2010
By:
/s/ H. MacGregor Clarke                  
 
H. MacGregor Clarke
 
Chief Financial Officer
(Principal Financial Officer)
 
 
EXHIBIT 32.1
 
CERTIFICATIONS OF THE CHIEF EXECUTIVE OFFICER
UNDER SECTION 906 OF THE SARBANES-OXLEY ACT


In connection with the Quarterly Report of AeroGrow International Inc. (the “Company”) on Form 10-Q for the period ended September 30, 2010 (the “Report”), as filed with the Securities and Exchange Commission, I, Jack J. Walker, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of and for the period covered by this Report.

     
Date: November 10, 2010
By:
/s/ Jack J. Walker                 
 
Jack J. Walker
 
Chairman and Chief Executive Officer
(Principal Executive Officer)

 
 
EXHIBIT 32.2
 
CERTIFICATIONS OF THE CHIEF FINANCIAL OFFICER
UNDER SECTION 906 OF THE SARBANES-OXLEY ACT
 
 
In connection with the Quarterly Report of AeroGrow International Inc. (the “Company”) on Form 10-Q for the period ended September 30, 2010 (the “Report”), as filed with the Securities and Exchange Commission, I, H. MacGregor Clarke, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:
 
 (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
 
 (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company as of and for the period covered by this Report.

     
Date:  November 10, 2010
By:
/s/ H. MacGregor Clarke                      
 
H. MacGregor Clarke
 
Chief Financial Officer
(Principal Financial Officer)