Turtle Beach Corporation
Turtle Beach Corp (Form: 10-Q, Received: 08/09/2016 14:40:28)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark one)
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2016
or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to  

Commission File Number: 001-35465
 
TURTLE BEACH CORPORATION
(Exact name of registrant as specified in its charter)
 
Nevada
27-2767540
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
 
 
12220 Scripps Summit Drive, Suite 100
San Diego, California
92131
(Address of principal executive offices)
(Zip Code)
 
(914) 345-2255
(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 to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   ý Yes  ¨  No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  ý  Yes  ¨  No
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 ¨     Accelerated filer ¨     Non-accelerated filer ¨         Smaller reporting company ý
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  ¨  Yes  ý  No

The number of shares of the registrant's Common Stock, par value $0.001 per share, outstanding on July 31, 2016 was 49,229,502 .

 

INDEX


 
 
Page
PART I. FINANCIAL INFORMATION
 
 
 
 
Item 1.
Financial Statements (unaudited)

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
PART II. OTHER INFORMATION
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 6.
 
 
SIGNATURES


1


PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.
Turtle Beach Corporation
Condensed Consolidated Balance Sheets
(unaudited)

 
June 30,
2016

December 31, 2015
ASSETS
(in thousands, except par value and share amounts)
Current Assets:
 

 
 

Cash and cash equivalents
$
1,162

 
$
7,114

Accounts receivable, net
18,085

 
57,192

Inventories
27,898

 
26,146

Prepaid income taxes
260

 
260

Prepaid expenses and other current assets
5,698

 
4,191

Total Current Assets
53,103

 
94,903

Property and equipment, net
5,522

 
6,859

Goodwill

 
31,152

Intangible assets, net
35,237

 
37,956

Deferred income taxes
505

 

Other assets
1,505

 
1,590

Total Assets
$
95,872

 
$
172,460

LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 

Current Liabilities:
 
 
 

Revolving credit facilities
$
7,192

 
$
32,453

Term loan
4,814

 
4,814

Accounts payable
18,966

 
17,680

Other current liabilities
8,816

 
14,236

Total Current Liabilities
39,788

 
69,183

Term loan, long-term portion
9,711

 
12,174

Series B redeemable preferred stock
16,797

 
16,145

Deferred income taxes

 
4

Subordinated notes - related party
16,573

 
15,365

Other liabilities
2,832

 
2,937

Total Liabilities
85,701

 
115,808

Commitments and Contingencies
 
 
 
Stockholders' Equity
 

 
 

Common stock, $0.001 par value - 100,000,000 shares authorized; 49,229,502 and 42,529,502 shares issued and outstanding as of June 30, 2016 and December 31, 2015, respectively
49

 
43

Additional paid-in capital
144,860

 
136,693

Retained earnings (accumulated deficit)
(134,202
)
 
(79,618
)
Accumulated other comprehensive loss
(536
)
 
(466
)
Total Stockholders' Equity
10,171

 
56,652

Total Liabilities and Stockholders' Equity
$
95,872

 
$
172,460










See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

2



Turtle Beach Corporation
Condensed Consolidated Statements of Operations
(unaudited)

 
Three Months Ended 
 
Six Months Ended
 
June 30,
2016
 
June 30,
2015
 
June 30,
2016

June 30,
2015
 
(in thousands, except per-share data)
Net Revenue
$
29,362

 
$
22,612

 
$
53,390

 
$
42,301

Cost of Revenue
24,249

 
19,210

 
44,915

 
35,783

Gross Profit
5,113

 
3,402

 
8,475

 
6,518

Operating expenses:
 
 
 
 
 
 
 
Selling and marketing
7,121


6,961


12,721


14,707

Research and development
2,040


2,824


4,064


5,678

General and administrative
5,287


5,991


10,570


10,731

Goodwill Impairment
31,152




31,152



Restructuring charges

 
184

 
225

 
509

Total operating expenses
45,600


15,960


58,732


31,625

Operating loss
(40,487
)
 
(12,558
)
 
(50,257
)
 
(25,107
)
Interest expense
1,686

 
834

 
3,465


1,618

Other non-operating expense (income), net
704

 
(346
)
 
1,069


282

Loss before income tax benefit
(42,877
)
 
(13,046
)
 
(54,791
)
 
(27,007
)
Income tax benefit
(304
)
 
(3,148
)
 
(207
)
 
(6,516
)
Net loss
$
(42,573
)

$
(9,898
)

$
(54,584
)

$
(20,491
)
 
 
 
 
 
 
 
 
Net loss per share:
 
 
 
 
 
 
 
Basic
$
(0.86
)
 
$
(0.23
)
 
$
(1.14
)
 
$
(0.49
)
Diluted
$
(0.86
)
 
$
(0.23
)
 
$
(1.14
)
 
$
(0.49
)
Weighted average number of shares:
 
 
 
 
 
 
 
Basic
49,230

 
42,188

 
47,934

 
42,113

Diluted
49,230

 
42,188

 
47,934

 
42,113

 





















See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

3



Turtle Beach Corporation
Condensed Consolidated Statements of Comprehensive Income (Loss)
(unaudited)

 
Three Months Ended 
 
Six Months Ended
 
June 30, 2016
 
June 30, 2015
 
June 30, 2016
 
June 30, 2015
 
(in thousands)
Net loss
$
(42,573
)
 
$
(9,898
)
 
$
(54,584
)
 
$
(20,491
)
 
 
 
 
 
 
 
 
Other comprehensive income (loss):

 
 
 
 
 
 
 
Foreign currency translation adjustment
(49
)
 
357

 
(70
)
 
30

Other comprehensive income (loss)

(49
)
 
357

 
(70
)
 
30

Comprehensive loss
$
(42,622
)
 
$
(9,541
)
 
$
(54,654
)
 
$
(20,461
)









































See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

4



Turtle Beach Corporation
Condensed Consolidated Statements of Cash Flows
(unaudited)

 
Six Months Ended
 
June 30, 2016
 
June 30, 2015
 
(in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
 

 
 

Net loss
$
(54,584
)
 
$
(20,491
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 
 
 
Depreciation and amortization
2,471

 
3,076

Amortization of intangible assets
2,695

 
453

Amortization of debt financing costs
632

 
93

Stock-based compensation
2,205

 
3,395

Accrued interest on Series B redeemable preferred stock
651

 
599

Paid in kind interest
1,039

 
151

Deferred income taxes
(510
)
 
(6,691
)
Reversal of sales returns reserve
(5,689
)
 
(2,180
)
Provision for (reversal of) doubtful accounts
(27
)
 
2

Provision for obsolete inventory
1,596

 
742

Loss on disposal of property and equipment

 
38

Loss on impairment of assets
31,152

 

Changes in operating assets and liabilities:
 
 
 
Accounts receivable
44,823

 
47,552

Inventories
(3,348
)
 
338

Accounts payable
1,798

 
(13,555
)
Prepaid expenses and other assets
(1,183
)
 
(853
)
Income taxes payable
81

 
42

Other liabilities
(5,565
)
 
(4,544
)
Net cash provided by operating activities
18,237

 
8,167

CASH FLOWS FROM INVESTING ACTIVITIES
 
 
 
Purchase of property and equipment
(1,645
)
 
(2,483
)
Net cash used for investing activities
(1,645
)
 
(2,483
)
CASH FLOWS FROM FINANCING ACTIVITIES
 
 
 
Borrowings on revolving credit facilities
82,701

 
85,182

Repayment of revolving credit facilities
(107,962
)
 
(107,211
)
Repayment of capital leases
(19
)
 
(20
)
Repayment of term loan
(2,407
)
 
(641
)
Proceeds from sale of common stock, net of issuance costs
5,968

 

Proceeds from exercise of stock options

 
365

Debt financing costs
(761
)
 
(37
)
Proceeds from issuance of subordinated notes - related party

 
11,800

Net cash used for financing activities
(22,480
)
 
(10,562
)
Effect of exchange rate changes on cash and cash equivalents
(64
)
 
(10
)
Net decrease in cash and cash equivalents
(5,952
)
 
(4,888
)
Cash and cash equivalents - beginning of period
7,114

 
7,908

Cash and cash equivalents - end of period
$
1,162

 
$
3,020

 
 
 
 
SUPPLEMENTAL DISCLOSURE OF INFORMATION
 
 
 
Cash paid for interest
$
992

 
$
538

Cash paid for income taxes
$

 
$






See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

5



Turtle Beach Corporation
Condensed Consolidated Statement of Stockholders' Equity
(unaudited)

 
Common Stock
 
Additional Paid-In Capital
 
Retained Earnings (Accumulated Deficit)
 
Accumulated Other Comprehensive Income (Loss)
 
Total
 
Shares
Amount
 
 
 
 
 
(in thousands)

Balance at December 31, 2015
42,530

$
43

 
$
136,693

 
$
(79,618
)
 
$
(466
)
 
$
56,652

Net loss


 

 
(54,584
)
 

 
(54,584
)
Other comprehensive loss


 

 

 
(70
)
 
(70
)
Sale of common stock, net of issuance costs
6,700

6

 
5,962

 

 

 
5,968

Stock-based compensation


 
2,205

 

 

 
2,205

Balance at June 30, 2016
49,230

$
49

 
$
144,860

 
$
(134,202
)
 
$
(536
)
 
$
10,171








































See accompanying Notes to the Condensed Consolidated Financial Statements (unaudited)

6

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)


Note 1 . Background and Basis of Presentation
Organization
Turtle Beach Corporation (“Turtle Beach” or the “Company”), headquartered in San Diego, California and incorporated in the state of Nevada in 2010, is a premier audio technology company with expertise and experience in developing, commercializing and marketing innovative products across a range of large addressable markets under the Turtle Beach® and HyperSound® brands. Turtle Beach is a worldwide leading provider of feature-rich headset solutions for use across multiple platforms, including video game and entertainment consoles, handheld consoles, personal computers, tablets and mobile devices. HyperSound technology is an innovative patent-protected sound technology that delivers immersive, directional audio offering unique potential benefits in a variety of commercial settings and consumer devices, including improved clarity and comprehension for listeners with hearing loss with the HyperSound Clear™ 500P product.
VTB Holdings, Inc. (“VTBH”), the parent holding company of the historical business of the headset business, was incorporated in the state of Delaware in 2010 with operations principally located in Valhalla, New York. Voyetra Turtle Beach, Inc. (“VTB”) was incorporated in the state of Delaware in 1975.
In October 2012, VTB acquired Lygo International Limited (“Lygo”), a private limited company organized under the laws of England and Wales, which was subsequently renamed Turtle Beach Europe Limited (“TB Europe”).

Basis of Presentation
The accompanying interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and, in the opinion of management, reflect all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation of the financial position, results of operations, and cash flows for the periods presented. All intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures, normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), have been condensed or omitted pursuant to those rules and regulations. We believe that the disclosures made are adequate to make the information presented not misleading. The results of operations for the interim periods are not necessarily indicative of the results of operations for the entire fiscal year.

The December 31, 2015 Condensed Consolidated Balance Sheet has been derived from the Company's most recent audited financial statements included in its Annual Report on Form 10-K.

These financial statements should be read in conjunction with the annual financial statements and the notes thereto included in our Annual Report on Form 10-K filed with the SEC on March 30, 2016 (“Annual Report”) that contains information useful to understanding the Company's businesses and financial statement presentations.

Note 2 . Summary of Significant Accounting Policies
The preparation of consolidated annual and quarterly financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, the disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. The Company can give no assurance that actual results will not differ from those estimates.

There have been no material changes to the critical accounting policies and estimates from the information provided in Note 1 of the notes to our consolidated financial statements in our Annual Report.

Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09,  Revenue from Contracts with Customers , which requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. The new guidance also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and

7

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements - (Continued)
(unaudited)


changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. On July 9, 2015, the FASB agreed to a one-year deferral of the effective date to annual reporting periods beginning after December 15, 2017 and interim periods within those annual periods, but will permit public business entities to adopt the standard as of the original effective date (annual reporting periods beginning after December 15, 2016). The Company is currently evaluating the impact, if any, this new standard will have on its consolidated financial statements and has not yet determined the method of adoption.

In April 2015, the FASB issued ASU No. 2015-03, Interest—Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs , which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. ASU 2015-15 further clarified that debt issuance costs related to line-of-credit arrangements may continue to be presented as an asset and amortized ratably over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. The amendment is effective for annual reporting periods beginning after December 15, 2015 and interim periods within those annual periods with early adoption permitted. The Company adopted this guidance on a retrospective basis as required and as such reclassified $1.4 millio n of deferred financing fees from “Other Assets” to “Term Loan, long term portion” on the Condensed Consolidated Balance Sheet at December 31, 2015. Refer to Note 8 , “Credit Facilities and Long-Term Debt” for further information.

In February 2016, the FASB issued ASU No. 2016-02,  Leases , that introduces the recognition of a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term and, a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis for all leases (with the exception of short-term leases). The guidance will be effective for public companies for annual reporting periods beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted. The Company has not yet selected a transition method or determined the effect on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09, Compensation—Stock Compensation , which modifies current guidance related to the accounting for forfeitures, employer tax withholding on share-based compensation and the financial statement presentation of excess tax benefits or deficiencies. This amendment also clarifies the statement of cash flows presentation for certain components of share-based awards. The standard is effective for interim and annual reporting periods beginning after December 15, 2016, although early adoption is permitted. The Company is currently evaluating the impact, if any, this new standard will have on its consolidated financial statements.

Note 3 . Equity Offering and Private Placement
On February 2, 2016, the Company entered into an Underwriting Agreement (the “Underwriting Agreement”) with Oppenheimer & Co. Inc., as representative of the several other underwriters named therein, relating to an underwritten public offering (the “Offering”) of 5,000,000 shares of our common stock, at a price to the public of $1.00 per share (the “Offering Price”). Under the terms of the Underwriting Agreement, the Company also granted the underwriters a 30-day option to purchase up to an additional 750,000 shares of common stock at the Offering Price less the underwriting discount and estimated offering expenses payable by the Company, which was not exercised.

In addition, on February 1, 2016, the Company entered into a separate, concurrent, side-by-side private placement of 1,700,000 shares of its common stock at a price of $1.00 per share.

The Company received net proceeds from the Offering and a side by side private placement of approximately  $6.0 million  after deducting the underwriting discount and offering expenses of $0.7 million . The Company used all net proceeds from the Offering to pay down amounts outstanding under its working capital line of credit, which is consistent with past practice and required under the terms of our Credit Facility and Term Loan Due 2019.


8

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 4 . Fair Value Measurement
The Company follows a three-level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:

Level 1 — Quoted prices in active markets for identical assets or liabilities.
Level 2 — Observable inputs other than quoted prices included in Level 1, such as quoted prices for markets that are not active, or other inputs that are observable or can be corroborated by observable market data.
Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.
Financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and certain debt instruments. As of June 30, 2016 and December 31, 2015 , there were no outstanding financial assets and liabilities recorded at fair value on a recurring basis and the Company had not elected the fair value option for any financial assets and liabilities for which such an election would have been permitted.

The following is a summary of the carrying amounts and estimated fair values of our financial instruments at June 30, 2016 and December 31, 2015 :
 
June 30, 2016
 
December 31, 2015
 
Reported
 
Fair Value
 
Reported
 
Fair Value
 
 (in thousands)
Financial Assets and Liabilities:
 
 
 
 
 
 
 
Cash and cash equivalents
$
1,162

 
$
1,162

 
$
7,114

 
$
7,114

Credit Facility
7,192

 
7,192

 
32,453

 
32,453

Term Loans
15,972

 
15,811

 
18,379

 
18,179

Subordinated Debt
18,285

 
17,008

 
17,247

 
15,892


Cash equivalents are stated at amortized cost, which approximates fair value as of the consolidated balance sheet dates, due to the short period of time to maturity; and accounts receivable and accounts payable are stated at their carrying value, which approximates fair value due to the short time to the expected receipt or payment. The Credit Facility and Term Loan Due 2018 carrying value equals fair value as the stated interest rate approximates market rates currently available to the Company, which are considered Level 2 inputs. The fair values of our Term Loan Due 2019 and Subordinated Debt are based upon an estimated market value calculation that factors principal, time to maturity, interest rate and current cost of debt, which is considered a Level 3 input.

Note 5 . Allowance for Sales Returns
The following tables provide the changes in our sales return reserve, which is classified as a reduction of accounts receivable:

 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2016
 
2015
 
2016
 
2015
 
 (in thousands)
Balance, beginning of period
$
3,527

 
$
1,179

 
$
6,268

 
$
4,155

Reserve accrual
2,401

 
4,756

 
4,534

 
6,422

Recoveries and deductions, net
(5,349
)
 
(3,960
)
 
(10,223
)
 
(8,602
)
Balance, end of period

$
579

 
$
1,975

 
$
579

 
$
1,975


9

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements - (Continued)
(unaudited)


Note 6 . Composition of Certain Financial Statement Items
Inventories
Inventories consist of the following:
 
June 30, 2016

December 31, 2015
 
 (in thousands)
Raw materials
$
1,837

 
$
1,481

Finished goods
26,061

 
24,665

Total inventories
$
27,898

 
$
26,146

Property and Equipment, net
Property and equipment, net, consists of the following:
 
June 30, 2016

December 31, 2015
 
 (in thousands)
Machinery and equipment
$
1,357

 
$
1,238

Software and software development
422

 
1,022

Furniture and fixtures
270

 
284

Tooling
2,056

 
3,395

Leasehold improvements
1,250

 
1,255

Demonstration units and convention booths
6,900

 
16,531

Total property and equipment, gross
12,255

 
23,725

Less: accumulated depreciation and amortization
(6,733
)
 
(16,866
)
Total property and equipment, net
$
5,522

 
$
6,859

Note 7 . Goodwill and Other Intangible Assets
At acquisition, the Company estimates and records the fair value of purchased intangible assets. The fair values of these intangible assets are estimated based on our assessment. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill and certain other intangible assets having indefinite lives are not amortized to earnings, but instead are subject to periodic testing for impairment. Intangible assets determined to have definite lives are amortized over their remaining useful lives. 

We assess the impairment of long-lived assets, intangibles assets and goodwill whenever events or changes in circumstances indicate that full recoverability of net asset balances through future cash flows is in question. Goodwill and indefinite-lived intangible assets are assessed at least annually, but also whenever events or changes in circumstances indicate the carrying values may not be recoverable. Factors that could trigger an impairment review include: (a) significant underperformance relative to historical or projected future operating results; (b) significant changes in the manner of use of the acquired assets or the strategy for our overall business; (c) significant negative industry or economic trends; (d) significant decline in our stock price for a sustained period; and (e) a decline in our market capitalization below net book value.

Since the launch of the HyperSound Clear™ 500P product in October 2015 to a limited initial group of offices, the hearing health product has achieved a high sales conversion rate with customers that attend a demonstration at an audiologist's office. However, the audiologist channel has proven to require a significant amount of resources to fully pursue due to the substantial training efforts along with resistance to integrate the product into the office workflow. This has strained capital resources such that the business has experienced lower than forecasted sales volumes. As a result, the Company has begun the process to explore strategic options for the HyperSound business.

As a result of the shortfall versus plan, Management concluded that indicators of potential goodwill impairment were present and, performed an initial interim impairment assessment of whether it is more-likely-than-not that the carrying amount of the HyperSound

10

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

reporting unit is greater than its fair value. The initial impairment test utilized a market approach based primarily on market data and comparables provided by a third-party firm, including the synergistic benefit for a market participant with greater resources, and assumptions about industry conditions, growth rates and profitability as Management believes this represents the most likely use of the assets. This analysis indicated that the Company’s net book value exceeded its fair value and as a result, the Company recorded a  $31.2 million  goodwill impairment charge, which represents the entire goodwill amount for the HyperSound reporting unit.

Management believes that the estimate of goodwill impairment loss is reasonable and represents our best estimate of the goodwill impairment loss to be incurred. However, the Company is currently exploring a wide range of potential business model modifications such as new consumer/retail-oriented sales channels, business partnerships to license the technology or a disposition of all, or a portion of the HyperSound business. The completion of the strategic option exploration may result in significant changes to the estimates used and it is possible that a future impairment charge could result for a portion or all of the other intangible assets. This assessment will be updated in the September 30, 2016 Form 10-Q.

Acquired Intangible Assets
Acquired identifiable intangible assets, and related accumulated amortization, as of June 30, 2016 and December 31, 2015 consist of:
 
June 30, 2016
 
Gross Carrying Value
 
Accumulated Amortization
 
Net Book Value
 
 (in thousands)
Customer relationships
$
5,796

 
$
3,478

 
$
2,318

Non-compete agreements
147

 
147

 

In-process Research and Development
27,100

 
3,055

 
24,045

Developed technology
8,880

 
609

 
8,271

Trade names
170

 
84

 
86

Patent and trademarks
921

 
58

 
863

Foreign Currency
$
(933
)
 
$
(587
)
 
$
(346
)
Total Intangible Assets
$
42,081

 
$
6,844

 
$
35,237

 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2015
 
Gross Carrying Value
 
Accumulated Amortization
 
Net Book Value
 
 (in thousands)
Customer relationships
$
5,796

 
$
3,213

 
$
2,583

Non-compete agreements
177

 
177

 

In-process Research and Development
27,100

 
1,018

 
26,082

Developed technology
8,880

 
225

 
8,655

Trade names
170

 
67

 
103

Patent and trademarks
730

 
37

 
693

Foreign Currency
$
(463
)
 
$
(303
)
 
$
(160
)
Total Intangible Assets
$
42,390

 
$
4,434

 
$
37,956

In October 2012, VTB acquired Lygo International Limited, subsequently renamed TB Europe Ltd. The acquired intangible assets related to customer relationships that are being amortized over an estimated useful life of thirteen years with the amortization being included within sales and marketing expense.

In January 2014, the merger between VTBH and Turtle Beach (f/k/a Parametric Sound Corporation) was completed. The acquired intangible assets relating to developed technology, customer relationships and trade name are subject to amortization. Customer relationships and trade name are being amortized over an estimated useful life of two years and five years, respectively, with the amortization being included within sales and marketing expense. In October 2015, the purchased in-process technology for research projects, primarily related to directed audio solutions that beam sound to a specific listening

11

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

area without the ambient noise of traditional speakers, reached technological feasibility and was reclassified as an amortizable finite-lived asset and is being amortized over an estimated useful life of approximately eight years with the amortization being included within cost of revenue. During 2016, in connection with the Company's HyperSound business exploration of strategic options the estimated useful life of the developed technology was reassessed and as a result, the remaining balance will be amortized over an estimated economic useful life of approximately 5.5 years years with the amortization being included within cost of revenue.

Amortization expense related to definite lived intangible assets of  $1.5 million and $2.7 million  was recognized in the  three and six months ended June 30, 2016 , respectively, and $0.2 million and  $0.5 million  for the  three and six months ended June 30, 2015 , respectively.


As of June 30, 2016 , estimated annual amortization expense related to definite lived intangible assets in future periods is as follows:
 
 (in thousands)
2016
$
2,950

2017
6,349

2018
6,604

2019
6,134

2020
1,953

Thereafter
11,593

Total
$
35,583

Goodwill
Changes in the carrying values of goodwill for the  six months ended June 30, 2016 are as follows:
 
 (in thousands)
Balance as of January 1, 2016

$
31,152

 
 
Impairment Charge (HyperSound)

$
31,152

Balance as of June 30, 2016
$



12

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 8 . Credit Facilities and Long-Term Debt
 
June 30, 2016
 
December 31, 2015
 
 (in thousands)
Revolving credit facility, maturing March 2019
$
7,192

 
$
32,453

 
 
 
 
Term Loan Due 2018
4,487

 
5,769

Term Loan Due 2019
11,485

 
12,610

Less unamortized deferred financing fees
1,447

 
1,391

Total Term Loans
14,525

 
16,988

 
 
 
 
Subordinated notes
18,285

 
17,247

Less unamortized debt discount
1,712

 
1,882

Total Subordinated notes
16,573

 
15,365

Total outstanding debt
38,290

 
64,806

Less: current portion of revolving line of credit
(7,192
)
 
(32,453
)
Less: current portion of term loans
(4,814
)
 
(4,814
)
Total noncurrent portion of long-term debt
$
26,284

 
$
27,539

Total interest expense, inclusive of amortization of deferred financing costs, on long-term debt obligations was $1.2 million and $2.6 million for the  three and six months ended June 30, 2016 , respectively, and $0.5 million and $0.9 million for the  three and six months ended June 30, 2015 , respectively.
Amortization of deferred financing costs was $0.3 million and $0.6 million for the three and six months ended June 30, 2016 , respectively, and $0.0 million and $0.1 million for the  three and six months ended June 30, 2015 , respectively.
Revolving Credit Facility
On March 31, 2014, Turtle Beach and certain of its subsidiaries entered into a new asset-based revolving credit agreement (“Credit Facility”) with Bank of America, N.A. (“Bank of America”) , as Agent, Sole Lead Arranger and Sole Bookrunner, which replaced the then existing loan and security agreement. The Credit Facility, which expires on  March 31, 2019 , provides for a line of credit of up to $60 million inclusive of a sub-facility limit of $10 million for TB Europe, a wholly owned subsidiary of Turtle Beach. The Credit Facility may be used for working capital, the issuance of bank guarantees, letters of credit and other corporate purposes.
The maximum credit availability for loans and letters of credit under the Credit Facility is governed by a borrowing base determined by the application of specified percentages to certain eligible assets, primarily eligible trade accounts receivable and inventories, and is subject to discretionary reserves and revaluation adjustments.

Amounts outstanding under the Credit Facility bear interest at a rate equal to either a rate published by Bank of America or the LIBOR rate, plus in each case, an applicable margin, which is between 1.00% to 1.50% for U.S. base rate loans and between  2.00% to 2.50% for U.S. LIBOR loans and U.K. loans. As of June 30, 2016 , interest rates for outstanding borrowings were 5.00% for base rate loans and approximately 2.92% for LIBOR rate loans. In addition, Turtle Beach is required to pay a commitment fee on the unused revolving loan commitment at a rate ranging from  0.25%  to 0.50% , and letter of credit fees and agent fees.

If certain availability thresholds are not met, meaning that the Company does not have receivables and inventory which are eligible to borrow on under the Credit Facility in excess of amounts borrowed, the Credit Facility requi res the Company and its restricted subsidiaries to maintain a fixed charge coverage ratio. The fixed charge ratio is defined as the ratio, determined on a consolidated basis for the most recent four fiscal quarters, of (a) EBITDA minus capital expenditures, excluding those financed through other instruments, and cash taxes paid, and (b) Fixed Charges defined as the sum of cash interest expense plus scheduled principal payments. The current fixed charge coverage ratio of at least 1.15 to 1.00 on the last day of each month

13

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

while a Covenant Trigger Period (as defined in the Credit Facility) is in effect will become effective again after the Company has complied with such ratio for six consecutive months.
The Credit Facility also contains affirmative and negative covenants that, subject to certain exceptions, limit our ability to take certain actions, including our ability to incur debt, pay dividends and repurchase stock, make certain investments and other payments, enter into certain mergers and consolidations, engage in sale leaseback transactions and transactions with affiliates and encumber and dispose of assets. Obligations under the Credit Facility are secured by a security interest and lien upon substantially all of the Company's assets.
On November 2, 2015, the Company entered into a sixth amendment (the “Sixth Amendment”) to the Credit Facility pursuant to which Bank of America and the lenders amended certain provisions of the Credit Facility to, among other things, modify certain provisions to provide (i) that the Company will make certain periodic reports with respect to certain financial metrics and (ii) that the loan availability is decreased by an additional block.

On December 1, 2015, in connection with the sixth amendment, the Company amended the definition of EBITDA to exclude certain non-recurring expenses and replaced certain financial covenants by amended EBITDA levels each month beginning with the month ended December 31, 2015 through (and including) the month ending March 31, 2017 (with revised financial covenants to be agreed upon based on new financial projections after such date) on both an overall and segment-by-segment basis.

On February 1, 2016, the Company further amended certain provisions of the Credit Facility to, among other things, provide that, on or prior to February 5, 2016, the Company receive net proceeds of not less than $6.0 million of additional equity capital or additional third lien debt financing and apply such proceeds against the outstanding principal balance of the working capital line of credit, amend the definition of EBITDA to exclude certain non-recurring expenses and replace certain financial covenants by amended EBITDA levels. The Company satisfied its paydown obligation with the proceeds from the Offering and private placement. Refer to Note 3 , “Equity Offering and Private Placement,” for further details.
On June 17, 2016, the Company amended certain provisions of the Credit Facility to, among other things, temporarily reduce the existing loan availability blocks, maintain certain cash flow levels with respect to its HyperSound division during each rolling four week period through the period ending October 28, 2016 and make certain periodic reports with respect to certain financial metrics.
As of June 30, 2016 , the Company was in compliance with all the amended financial covenants, and excess borrowing availability was approximately $4.9 million , net of the outstanding Term Loan Due 2018 (as defined below) that is considered to be an additional outstanding amount under the Credit Facility.
Term Loans
Term Loan Due 2018

On December 29, 2014, the Company amended the Credit Facility (the “December Amendment”) to permit the repayment of $7.7 million of then existing subordinated debt and accrued interest with the proceeds of an additional loan (the “Term Loan Due 2018”). The Term Loan Due 2018 resulted in modified financial covenants while it is outstanding, will bear interest at a rate of LIBOR for the applicable interest period plus 5% and will be repaid in equal monthly installments beginning on April 1, 2015 and ending on April 1, 2018. Amounts so repaid are recognized by lowering the balance of the term loan tranche and increasing the lower interest rate base revolver amount, with no net impact on borrowing availability.

Term Loan Due 2019

On July 22, 2015, the Company and its subsidiaries, entered into a term loan, guaranty and security agreement (the “Term Loan Due 2019”) with Crystal Financial LLC, as agent, sole lead arranger and sole bookrunner, Crystal Financial SPV LLC and the other persons party thereto (“Crystal”), which provides for an aggregate term loan commitment of $15 million that bears interest at a rate per annum equal to the 90-day LIBOR rate plus 10.25% . Under the terms of the Term Loan Due 2019, the Company is required to make payments of interest in arrears on the first day of each month beginning August 1, 2015 and will repay the principal in monthly payments beginning January 1, 2016, with a final payment on June 28, 2019 , the maturity date.


14

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

The Term Loan Due 2019 is secured by a security interest in substantially all of the Company and each of its subsidiaries' working capital assets and is subject to the first-priority lien of Bank of America, as agent, under the Credit Facility, other than with respect to equipment, fixtures, real property interests, intellectual property, intercompany property, intercompany indebtedness, equity interest in their subsidiaries, and certain other assets specified in an inter-creditor agreement between Bank of America and Crystal.

The Company and its subsidiaries are required to comply with various customary covenants including, (i) maintaining minimum EBITDA and Headset EBITDA (each as defined in the Term Loan Due 2019) in each trailing twelve month period beginning August 31, 2015, (ii) maintaining a Consolidated Leverage Ratio (as defined in the Term Loan Due 2019) to be measured on the last day of each month while the term loans are outstanding of no more than 5.75 :1 beginning December 31, 2015 with periodic step-downs to 3.00 :1 on January 31, 2017, (iii) not making capital expenditures in excess of $11 million in the year ending December 31, 2015 and in excess of $7 million in each of the years ending December 31, 2016, 2017, 2018 and 2019, (iv) restrictions on the Company’s and its subsidiaries ability to prepay its subordinated notes, pay dividends, incur debt, create or suffer liens and engage in certain fundamental transactions and (v) an obligation to provide certain financial and other information. The agreement permits certain equity holders of the Company to contribute funds to the Company to cure certain financial covenant defaults. In connection with certain amendments, the testing of the consolidated leverage ratio covenants has been suspended through April 2017.

The Term Loan Due 2019 contains customary representations, mandatory prepayment events and events of default, including defaults triggered by the failure to make payments when due, breaches of covenants and representations, material impairment in the perfection of Crystal’s security interest in the collateral and events related to bankruptcy and insolvency of the Company and its subsidiaries. Upon an event of default, Crystal may declare all outstanding obligations immediately due and payable (along with a prepayment fee), a default rate of an additional 2.0% may be applied to amounts outstanding and may take other actions including collecting or taking such other action with respect to the collateral pledged in connection with the term loan.

On February 1, 2016, the Company entered into a third amendment (the “Term Loan Amendment”) to the Term Loan Due 2019 to, among other things, amend the definition of EBITDA to exclude certain non-recurring expenses and replace certain financial covenants by amended EBITDA levels each month beginning with the month ended December 31, 2015 and on a trailing twelve-month period basis beginning with the period ending October 31, 2016, through the termination date on both an overall and segment-by-segment basis.

As of June 30, 2016 , the Company was in compliance with all the amended financial covenants.

Subordination Agreement
On November 16, 2015, as a condition precedent to the Company's lenders permitting the Company to enter into certain subordinated notes, the Company entered into a subordination agreement with and between Bank of America and Crystal, pursuant to which the parties agreed that the Company's obligations under any such notes would be subordinate in right of payment to the payment in full of all the Company’s obligations under the Credit Facility and Term Loan Due 2019.
Subordinated Notes - Related Party
O n April 23, 2015, the Company issued a $5.0 million subordinated note (the “April Note”) to SG VTB Holdings, LLC, the Company’s largest stockholder (“SG VTB”). The April Note was issued with an interest rate of (i) 10% per annum for the first year and (ii) 20% per annum for all periods thereafter, with interest accruing and being added to the principal amount of the note quarterly.
On May 13, 2015, the Company issued subordinated notes (the “May Notes”) with an aggregate principal amount of $3.8 million to SG VTB, and a trust affiliated with Ronald Doornink, the Chairman of the Company's board of directors (the “Board”). The May Notes were issued with an interest rate of 10%  per annum until the maturity date of the May Notes (which was August 13, 2015 but could be extended up to two additional 90 day periods upon the written agreement of the Company and the noteholder), with interest accruing and being added to the principal amount of the May Notes quarterly. Following the maturity date, the interest rate would have increased to 20%  per annum.

On June 17, 2015, the Company issued a subordinated note (the “June Note”) with an aggregate principal amount of $3.0 million to SG VTB. The June Note was issued at an interest rate of 10%  per annum until the maturity date of the June Note (which was September 17, 2015 but could be extended up to two additional 90 day periods upon the written agreement of the

15

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Company and the noteholder), with interest accruing and being added to the principal amount of the June Note quarterly. Following the maturity date, the interest rate would have increased to 20%  per annum. In addition, the Company had the option to request that SG VTB make, in SG VTB’s sole discretion, additional advances from time to time up to an aggregate principal amount of $15.0 million . Prior to the amendment (see below), following an additional advance of $6.0 million on July 8, 2015, $9.0 million was outstanding under the June Note.

Concurrently with the completion of the Term Loan Due 2019, the Company amended and restated each of its outstanding subordinated notes (the “Amended Notes”). The obligations of the Company under the Amended Notes are subordinate and junior to the prior payment of amounts due under the Credit Facility and Term Loan Due 2019. In addition, the stated maturity date of the Amended Notes was extended to September 29, 2019 , subject to acceleration in certain circumstances, such as a change of control of the Company. The Amended Notes bear interest at a rate per annum equal to LIBOR plus 10.5% and shall be paid-in-kind by adding the amount to the principal amount due. Further, as consideration for the concessions in the Amended Notes, the Company issued warrants to purchase 1.7 million of the Company’s common stock at an exercise price of $2.54 per share.

On November 16, 2015, the Company issued a $2.5 million subordinated note (the “November Note”) to SG VTB, the proceeds of which, as set forth in the amendment to the Term Loan Due 2019, were applied against the outstanding balance of the Term Loan Due 2019. The November Note will bear interest at a rate of 15%  per annum until its maturity date, which is September 29, 2019 , and is subordinated to all senior debt of the Company.

In consideration of the credit extended under the November Note, VTB and VTBH entered into a Third Lien Continuing Guaranty, (as amended, the “Third Lien Guaranty”), under which they guarantee and promise to pay to Stripes, any and all obligations of the Company under the November Note. To secure our obligations under the November Note and the Third Lien Guaranty, the Company entered into a Third Lien Security Agreement, dated as of November 16, 2015, pursuant to which Stripes was granted a security interest upon all property of the VTB and VTBH until the payment in full of the Subordinated Note or the release of the guarantee or collateral, as applicable. Concurrent with entering into the November Note and Third Lien Guaranty, the Company also issued to SG VTB a warrant to purchase 1.4 million shares of the Company’s common stock at an exercise price of $2.00 per share.

SG VTB is an affiliate of Stripes Group LLC (“Stripes”), a private equity firm focused on internet, software, healthcare IT and branded consumer products businesses. Kenneth A. Fox, one of our directors, is the managing general partner of Stripes and the sole manager of SG VTB and Ronald Doornink, our Chairman of the Board, is an operating partner of Stripes.

Note 9 . Income Taxes

In order to determine the quarterly provision for income taxes, we use an estimated annual effective tax rate (“ETR”), which is based on expected annual income and statutory tax rates in the various jurisdictions. However, to the extent that application of the estimated annual effective tax rate is not representative of the quarterly portion of actual tax expense expected to be recorded for the year, we determine the quarterly provision for income taxes based on actual year-to-date income (loss). Certain significant or unusual items are separately recognized as discrete items in the quarter during which they occur and can be a source of variability in the effective tax rates from quarter to quarter.

As a result of cumulative losses in recent years primarily due to incremental costs associated with the console transition, acquisition costs and initial investments in the HyperSound business, the Company concluded that a full valuation allowance is required on its U.S. net deferred tax assets. There is no valuation allowance on our foreign net deferred tax assets.

The following table presents our income tax expense (benefit) and effective income tax rate: 

 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2016
 
2015
 
2016
 
2015
 
 (in thousands)
Income tax benefit
$
(304
)
 
$
(3,148
)
 
$
(207
)
 
$
(6,516
)
Effective income tax rate
0.7
%
 
24.1
%
 
0.4
%
 
24.1
%

16

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)


Income tax benefit for the three and six months ended June 30, 2016 was $0.3 million at an effective tax rate of 0.7% and $0.2 million at an effective tax rate of 0.4% , respectively. The effective tax rate was primarily impacted by the full valuation allowance on domestic earnings, foreign entity tax benefits and certain state tax expense.

Income tax benefit for the three and six months ended June 30, 2015 was $3.1 million at an effective tax rate of 24.1% and $6.5 million at an effective tax rate of 24.1% , respectively. The effective tax rate was impacted by differences in book and tax treatment of transaction costs, interest on the Series B Redeemable Preferred Stock and foreign entity taxable loss.

At  December 31, 2015 , the Company had  $44.6 million  of net operating loss carryforwards and $20.6 million  of state net operating loss carryforwards, which will begin to expire in 2029. An ownership change occurred on January 15, 2014 as a result of the Merger, and $12.7 million of federal net operating losses included in the above are pre-change losses subject to Section 382. Based on the estimated Section 382 limitation and the net operating loss carryforward period, the Company believes that the pre-ownership change net operating losses can be fully utilized in future years if there is sufficient taxable income in such carryforward period.

The Company is subject to income taxes domestically and in various foreign jurisdictions. Significant judgment is required in evaluating uncertain tax positions and determining its provision for income taxes.

The Company recognizes only those tax positions that meet the more-likely-than-not recognition threshold, and establishes tax reserves for uncertain tax positions that do not meet this threshold. Interest and penalties associated with income tax matters are included in the provision for income taxes in the condensed consolidated statement of operations. As of June 30, 2016 , the Company had uncertain tax positions of $2.3 million , inclusive of $0.8 million of interest and penalties.

The Company files U.S., state and foreign income tax returns in jurisdictions with various statutes of limitations. The federal tax years open under the statute of limitations are 2012 through 2014, and the state tax years open under the statute of limitations are 2011 through 2014.

Note 10 . Stock-Based Compensation
Total estimated stock-based compensation expense for employees and non-employees, related to all of the Company's stock-based awards, was comprised as follows:


Three Months Ended

Six Months Ended

June 30,

June 30,

2016

2015

2016

2015

 (in thousands)
Cost of revenue
$
125

 
$
324

 
$
246

 
$
542

Selling and marketing
(11
)
 
75

 
10

 
219

Research and development
142

 
265

 
286

 
470

General and administrative
822

 
1,406

 
1,663

 
2,164

Total stock-based compensation
$
1,078

 
$
2,070

 
$
2,205

 
$
3,395


The following table presents the stock activity and the total number of shares available for grant as of June 30, 2016 :
 
(in thousands)
Balance at December 31, 2015
3,258

Options granted
(1,726
)
Restricted Stock granted
(129
)
Forfeited/Expired shares added back
621

Balance at June 30, 2016
2,024


17

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Stock Option Activity
 
Options Outstanding
 
Number of Shares Underlying Outstanding Options
 
Weighted-Average Exercise Price
 
Weighted-Average Remaining Contractual Term
 
Aggregate Intrinsic Value
 
 
 
 
 
 (In years)
 
 
Outstanding at December 31, 2015
5,613,384

 
2.19
 
7.89
 
628,833

Granted
1,725,932

 
1.14
 
 
 
 
Exercised

 
 
 
 
 
Forfeited
(620,529
)
 
2.63
 
 
 
 
Outstanding at June 30, 2016
6,718,787

 
1.88
 
7.86
 
365

Vested and expected to vest at June 30, 2016
6,480,977

 
1.94
 
7.81
 
295

Exercisable at June 30, 2016
2,943,489

 
2.21
 
6.39
 

Stock options are time-based and the majority are exercisable within 10 years of the date of grant, but only to the extent they have vested. The options generally vest as specified in the option agreements subject, in some instances, to acceleration in certain circumstances. In the event participants in the 2013 Plan cease to be employed or engaged by the Company, then all of the options would be forfeited if they are not exercised within 90 days. Forfeitures on option grants are estimated at 10% for non-executives and 0% for executives based on evaluation of historical and expected future turnover. Stock-based compensation expense was recorded net of estimated forfeitures, such that expense was recorded only for those stock-based awards expected to vest. The Company reviews this assumption periodically and will adjust it if it is not representative of future forfeiture data and trends within employee types (executive vs. non-executive).
Aggregate intrinsic value represents the difference between the estimated fair value of the underlying common stock and the exercise price of outstanding, in-the-money options. There were no option exercises during the six months ended June 30, 2016 .
The Company uses the Black-Scholes option-pricing model to estimate the fair value of options granted as of the grant date. The following are assumptions for the six months ended June 30, 2016 .
Expected term (in years)
6.1
Risk-free interest rate
1.1% - 1.9%
Expected volatility
40.7% - 42.2%
Dividend rate
0%
Each of these inputs is subjective and generally requires significant judgment to determine.
The weighted average grant date fair value of options granted during the six months ended June 30, 2016 was $0.48 . The total estimated fair value of employee options vested during the six months ended June 30, 2016 was $1.4 million . As of June 30, 2016 , total unrecognized compensation cost related to non-vested stock options granted to employees was $5.1 million , which is expected to be recognized over a remaining weighted average vesting period of 3.0 years .

18

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Restricted Stock Activity
 
Shares
 
Weighted Average Grant Date Fair Value Per Share
Nonvested restricted stock at December 31, 2015
71,898

 
$
3.48

Granted
129,309

 
1.16

Vested
(65,502
)
 
2.29

Nonvested restricted stock at June 30, 2016
135,705

 
1.84

As of June 30, 2016 , total unrecognized compensation cost related to the nonvested restricted stock awards granted was $0.2 million , which is expected to be recognized over a remaining weighted average vesting period of 1.8 years .

Stock Warrants
In connection with and as consideration for the concessions in the Amended Notes, the Company issued to SG VTB and a trust affiliated with Ronald Doornink warrants to purchase 1.7 million shares of the Company’s common stock at an exercise price of $2.54 per share. The warrants are exercisable for a period of five years beginning on the date of issuance, July 22, 2015. The exercise price and the number of shares of Common Stock purchasable are subject to adjustment and do not carry any voting rights or other rights as a stockholder of the Company prior to exercise. The shares issuable upon exercise are also subject to the “demand” and “piggyback” registration rights set forth in the in the Company’s Stockholder Agreement, dated August 5, 2013, as amended July 10, 2014.

In connection with the November Note, the Company issued a warrant to purchase 1.4 million shares of the Company’s common stock at an exercise price of $2.00 per share to SG VTB. The exercise price and the number of shares are subject to standard anti-dilution adjustments and do not carry any voting rights as a stockholder of the Company prior to exercise. The warrant is exercisable for a period of ten years beginning on the date of issuance and does not entitle the holder to any voting rights or other rights as a stockholder of the Company prior to exercise.

The warrants meet the requirements for classification within equity as warrants entitle the holder to purchase a stated amount of shares of common stock at a fixed exercise price that are not puttable (either the warrant or the shares) to the Company or redeemable for cash.


Series B Redeemable Preferred Stock
In September 2010, VTBH issued 1,000,000 shares of its Series B Redeemable Preferred Stock with a fair value of $12.4 million . The Series B Redeemable Preferred Stock is required to be redeemed on the earlier of September 28, 2030, or the occurrence of a liquidation event at its original issue price of $12.425371 per share plus any accrued but unpaid dividends. The redemption value was $16.8 million and $16.1 million as of June 30, 2016 and December 31, 2014, respectively.
On February 18, 2015, the holder of the Series B Redeemable Preferred Stock, filed a complaint in Delaware Chancery Court alleging breach of contract against VTBH. According to the complaint, the Merger purportedly triggered a contractual obligation for VTBH to redeem the stock. Refer to Note 13 , “Commitments and Contingencies” for further information.
Phantom Equity Activity

In November 2011, VTBH adopted a 2011 Phantom Equity Appreciation Plan (the “Appreciation Plan”) that covers certain employees, consultants, and directors of VTBH (“Participants”) who are entitled to phantom units, as applicable, pursuant to the provisions of their respective award agreements. The Appreciation Plan is shareholder-approved, which permits the granting of phantom units to VTBH’s Participants of up to 1,500,000 units. These units are not exercisable or convertible into shares of common stock but give the holder a right to receive a cash bonus equal to the appreciation in value between the exercise price and value of common stock at the time of a change in control event as defined in the plan.


19

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

As of June 30, 2016 and December 31, 2015, 714,347 phantom units at a weighted-average exercise price of $0.93 have been granted and are outstanding. Because these phantom units are not exercisable or convertible into common shares, said amounts and exercise prices were not subject to the exchange ratio provided by the Merger agreement. As of June 30, 2016 , compensation expense related to the Appreciation Plan units remained unrecognized because as of those dates a change in control, as defined in the plan, had not occurred and is not probable to occur. In July 2015, the Appreciation Plan was terminated as to new grants, but vested and unvested phantom units will continue.

Note 11 . Net Loss Per Share

The following table sets forth the computation of basic and diluted net loss per share of common stock attributable to common stockholders:
 
Three Months Ended

Six Months Ended
 
June 30,

June 30,
 
2016

2015

2016

2015
 
 (in thousands, except per-share data)
Net Loss
$
(42,573
)
 
$
(9,898
)
 
$
(54,584
)
 
$
(20,491
)
 
 
 
 
 
 
 
 
Weighted average common shares outstanding — Basic
49,230

 
42,188

 
47,934

 
42,113

Plus incremental shares from assumed conversions:
 
 
 
 
 
 
 
Dilutive effect of stock options

 

 

 

Weighted average common shares outstanding — Diluted
49,230

 
42,188

 
47,934

 
42,113

Net loss per share:
 
 
 
 
 
 
 
Basic
$
(0.86
)
 
$
(0.23
)
 
$
(1.14
)
 
$
(0.49
)
Diluted
$
(0.86
)
 
$
(0.23
)
 
$
(1.14
)
 
$
(0.49
)

Incremental shares from stock options, restricted stock awards and warrants are computed using the treasury stock method. The weighted average shares listed below were not included in the computation of diluted earnings per share because to do so would have been anti-dilutive for the periods presented or were otherwise excluded under the treasury stock method. The treasury stock method calculates dilution assuming the exercise of all in-the-money options, warrants and vesting of restricted stock, reduced by the repurchase of shares with the proceeds from the assumed exercises, unrecognized compensation expense for outstanding awards and the estimated tax benefit of the assumed exercises.
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Stock options
6,638

 
6,440

 
6,101

 
6,527

Warrants
3,068

 
31

 
3,074

 
31

Unvested restricted stock awards
137

 
66

 
105

 
36

Total
9,843

 
6,537

 
9,280

 
6,594



20

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Note 12 . Segment and Geographic Information

The following tables show our net revenues, operating income and total assets by our reporting segments:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2015
 
2014
 
2016
 
2015
Net Revenues
 (in thousands)
Headset
$
29,142

 
$
22,525

 
$
52,889

 
$
42,123

HyperSound
220

 
87

 
501

 
178

Total
$
29,362

 
$
22,612

 
$
53,390

 
$
42,301

 
 
 
 
 
 
 
 
Operating Loss
 
 
 
 
 
 
 
Headset
$
(4,401
)
 
$
(9,249
)
 
$
(9,681
)
 
$
(18,488
)
HyperSound
(36,086
)
 
(3,309
)
 
(40,576
)
 
(6,619
)
Total
$
(40,487
)
 
$
(12,558
)
 
$
(50,257
)
 
$
(25,107
)
Interest Expense
$
1,686

 
$
834

 
$
3,465

 
$
1,618

Other non-operating expense (income), net
$
704

 
$
(346
)
 
$
1,069

 
$
282

Loss before income tax benefit
$
(42,877
)
 
$
(13,046
)
 
$
(54,791
)
 
$
(27,007
)

 
June 30,
2016
 
December 31,
2015
Total Assets
 (in thousands)
Headset
$
52,372

 
$
96,444

HyperSound
77,751

 
111,490

Eliminations
$
(34,251
)
 
$
(35,474
)
Total
$
95,872

 
$
172,460


The following table represents total net revenues based on where customers are physically located:
 
Three Months Ended

Six Months Ended
 
June 30,

June 30,
 
2016

2015

2016

2015
 
 (in thousands)
North America
$
22,725

 
$
16,880

 
$
41,616

 
$
31,039

United Kingdom
3,344

 
2,159

 
5,931

 
4,533

Europe
1,985

 
1,902

 
3,458

 
3,270

International
1,308

 
1,671

 
2,385

 
3,459

Total net revenues
$
29,362

 
$
22,612

 
$
53,390

 
$
42,301


Note 13 . Commitments and Contingencies
Litigation
The Company is subject to various legal proceedings and claims that arise in the ordinary course of its business. Although the amount of any liability that could arise with respect to these actions cannot be determined with certainty, in the Company’s opinion, any such liability will not have a material adverse effect on its consolidated financial position, consolidated results of operations or liquidity.


21

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Shareholders Class Action: On August 5, 2013, VTBH and the Company (f/k/a Parametric) announced that they had entered into the Merger Agreement pursuant to which VTBH would acquire an approximately 80% ownership interest and existing shareholders would maintain an approximately 20% ownership interest in the combined company. Following the announcement, several shareholders filed class action lawsuits in California and Nevada seeking to enjoin the Merger. The plaintiffs in each case alleged that members of the Company’s Board of Directors breached their fiduciary duties to the shareholders by agreeing to a Merger that allegedly undervalued the Company. VTBH and the Company were named as defendants in these lawsuits under the theory that they had aided and abetted the Company's Board of Directors in allegedly violating their fiduciary duties. The plaintiffs in both cases sought a preliminary injunction seeking to enjoin closing of the Merger, which, by agreement, was heard by the Nevada court with the California plaintiffs invited to participate. On December 26, 2013, the court in the Nevada cases denied the plaintiffs’ motion for a preliminary injunction. Following the closing of the Merger, the Nevada plaintiffs filed a second amended complaint, which made essentially the same allegations and sought monetary damages as well as an order rescinding the Merger. The California plaintiffs dismissed their action without prejudice, and sought to intervene in the Nevada action, which was granted. Subsequent to the intervention, the plaintiffs filed a third amended complaint, which made essentially the same allegations as prior complaints and sought monetary damages. On June 20, 2014, VTBH and the Company moved to dismiss the action, but that motion was denied on August 28, 2014. That denial is currently under review by the Nevada Supreme Court, which held a hearing on the Company's petition for review on September 1, 2015. After the hearing, the Nevada Supreme Court requested supplemental briefing, which the parties completed on October 13, 2015. The Nevada Supreme Court also invited the Business Law Section of the Nevada State Bar to submit an amicus brief by December 3, 2015 and briefing was completed on that date. The Company believes that the plaintiffs’ claims against it are without merit.

Dr. John Bonanno Complaint: On February 18, 2015, Dr. John Bonanno, a minority shareholder of VTBH, filed a complaint in Delaware Chancery Court alleging breach of contract against VTBH. According to the complaint, the Merger purportedly triggered a contractual obligation for VTBH to redeem Dr. Bonanno's stock. Dr. Bonanno requests a declaratory judgment stating that he is entitled to damages including a redemption of his stock for the redemption value of $15.1 million (equal to the original issue price of his stock plus accrued dividends) as well as other costs and expenses. On February 8, 2016, the Delaware Chancery Court granted VTBH's motion to dismiss for improper venue, and Dr. Bonnano's complaint was dismissed without prejudice. VTBH maintains that the Merger did not trigger any obligation to redeem Mr. Bonanno's stock.

The Company will continue to vigorously defend itself in the foregoing matters. However, litigation and investigations are inherently uncertain. Accordingly, the Company cannot predict the outcome of these matters. The Company has not recorded any accrual at  June 30, 2016  for contingent losses associated with these matters based on its belief that losses, while possible, are not probable. Further, any possible range of loss cannot be reasonably estimated at this time. The unfavorable resolution of these matters could have a material adverse effect on the Company’s business, results of operations, financial condition or cash flows. The Company is engaged in other legal actions not described above arising in the ordinary course of its business and, while there can be no assurance, believes that the ultimate outcome of these other legal actions will not have a material adverse effect on its business, results of operations, financial condition or cash flows.

Warranties

We warrant our products against certain manufacturing and other defects. These product warranties are provided for specific periods of time depending on the nature of the product. Warranties are generally fulfilled by replacing defective products with new products. The following table provides the changes in our product warranties, which are included in accrued liabilities:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2016
 
2015
 
2016
 
2015
 
 (in thousands)
Warranty, beginning of period
$
660

 
$
380

 
$
580

 
$
493

Warranty costs accrued
216

 
213

 
455

 
213

Settlements of warranty claims
(174
)
 
(150
)
 
(333
)
 
(263
)
Warranty, end of period

$
702

 
$
443

 
$
702

 
$
443

XO FOUR Stealth Product Recall: I n August 2015, the Company received a limited number of reports from consumers and retailers that certain EAR FORCE ® XO FOUR Stealth headsets appeared to have a white substance or spots on the ear pads.

22

Turtle Beach Corporation
Notes to Condensed Consolidated Financial Statements
(unaudited)

Upon receiving the reports, the Company promptly stopped shipping any units of the XO FOUR Stealth headsets and notified our retail customers to stop sales pending the results of the Company’s investigation. An outside laboratory engaged by the Company identified the substance as mold. In cooperation with the U.S. Consumer Product Safety Commission (“CPSC”), the Company is voluntarily recalling certain units of the headsets. As of June 30, 2016 and the date of this report, the Company has not received notice of any law suits against the Company in connection with the recall and is working with the contract manufacturer to collect reimbursement for certain related costs.
On February 3, 2016, the Company notified CPSC promptly upon discovery that a vendor had mistakenly shipped certain recalled headsets to fill online orders. The Company has attempted to notify directly each of the affected purchasers to instruct them to participate in the recall.


23



Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our operations should be read together with our unaudited condensed consolidated financial statements and the related notes included in Part I of this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and the related notes included in our Annual Report on Form 10-K filed with the Securities Exchange Commission on March 30, 2016 (the "Annual Report.")
This Report on Form 10-Q contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements in this Report are indicated by words such as “anticipates,” “expects,” “believes,” “intends,” “plans,” “estimates,” “projects,” “strategies” and similar expressions. Caution should be taken not to place undue reliance on any such forward-looking statements because they involve risks, uncertainties and other factors that could cause actual results to differ materially from those expressed or implied in, or reasonably inferred from, such statements. Forward-looking statements are based on the beliefs, as well as assumptions made by, and information currently available to, the Company's management and are made only as of the date hereof. The Company undertakes no obligation to update or revise the forward-looking statements, whether as a result of new information, future events or otherwise. In addition, forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from the Company's historical experience and its present expectations or projections.

Business Overview
Turtle Beach Corporation (herein referred to as the “Company,” “we,” “us,” or “our”), headquartered in San Diego, California and incorporated in the state of Nevada in 2010, is a premier audio technology company with expertise and experience in developing, commercializing and marketing innovative products across a range of large addressable markets operating under two reportable segments, Turtle Beach® (“Headset“) and HyperSound®.
Turtle Beach is a worldwide leading provider of feature-rich headset solutions for use across multiple platforms, including video game and entertainment consoles, handheld consoles, personal computers, tablets and mobile devices.
HyperSound technology is an innovative patent-protected sound technology that delivers immersive, directional audio offering unique potential benefits in a variety of commercial settings and consumer devices. The recent launch of the HyperSound Clear™ 500P product has transitioned the business to the hearing healthcare market, where we believe a large percentage of people with hearing loss could use the product to improve their listening experiences from sources such as TV, CD/DVD players and stereo systems.
The Company's stock is traded on NASDAQ Global Market under the symbol HEAR.
Business Trends
Headset
Sales in the gaming accessories market, which includes headsets and other peripherals such as gamepads, specialty controllers, adapters, batteries, memory and interactive gaming toys are heavily dependent on the global video game console industry. In 2013, the gaming industry experienced a cyclical event as Microsoft and Sony each announced new consoles for the first time in eight years, and the consumer response to the Xbox One and PlayStation®4 (the “new generation” or “new-gen” consoles) has been overwhelmingly positive, creating a growing installed base of gamers and a market for new-gen headsets. In 2015, we completed the transitioned of our headset portfolio to new-gen product and in 2016, anticipate that Xbox 360 and Playstation®3 (the “old generation” or “old-gen” consoles) will take a final, large drop as the market completes the transition to new-gen compatible headsets.



24



Cumulative New Generation Console Sales (in millions)

Source: DFC Intelligence Forecasts: Worldwide Console Forecast, May 2015.

According to Intelligence: Worldwide Console Forecast  reports by DFC Intelligence Forecasts, or “DFC,” over 60% of cumulative new generation console sales are still to come, including over 30 million consoles expected to be sold worldwide in 2016. Further, DFC estimates that cumulative new generation consoles will exceed $65 billion by 2018. Turtle Beach continues to be the category leader as noted by NPD Group's Retail Tracking Service U.S. retail data with an overall US market revenue share of 42% for 2015, and 44% of the overall U.S. market revenue share in the 2015 holiday season following the full release of the new-gen headset portfolio.
HyperSound
Hearing Health Care. Gradual hearing loss can affect individuals of all ages, varying from mild to profound and is a growing, widespread issue. In the United States, there are nearly 50 million people with some degree of hearing loss significant enough to require a hearing aid. 
Source: World Health Organization, 2013.
HyperSound technology offers a fundamentally new way to deliver sound, and our research indicates that it improves the home listening experience. We believe that a large percentage of people with hearing loss may be able to use HyperSound Clear 500P to improve their listening experiences from sources such as TV, CD/DVD players and stereo systems.


25



Seasonality

Our gaming headset business is seasonal with a significant portion of sales and profits typically occurring around the holiday period. Historically, more than 50% of headset business revenues are generated during the period from September through December as new headsets are introduced and consumers engage in holiday shopping.
Key Performance Indicators and Non-GAAP Measures

Management routinely reviews key performance indicators including revenue, operating income and margins, earnings per share, among others. In addition, we believe certain other measures provide useful information to management and investors about us and our financial condition and results of operations for the following reasons: (i) it is one of the measures used by our board of directors and management team to evaluate our operating performance; (ii) it is one of the measures used by our management team to make day-to-day operating decisions; (iii) the adjustments made are often viewed as either non-recurring or not reflective of ongoing financial performance or have no cash impact on operations; and (iv) it is used by securities analysts, investors and other interested parties as a common operating performance measure to compare results across companies in our industry by backing out potential differences caused by variations in capital structures (affecting relative interest expense), and the age and book value of facilities and equipment (affecting relative depreciation and amortization expense). These metrics, however, are not measures of financial performance under accounting principles generally accepted in the United States of America (“GAAP”) and, given the limitations of these metrics as analytical tools, should not be considered a substitute for gross profit, gross margins, net income (loss) or other consolidated income statement data as determined in accordance with GAAP. We consider the following non-GAAP measure, which may not be comparable to similarly titled measures reported by other companies, to be key performance indicators:

Adjusted EBITDA is defined as net income (loss) before interest, taxes, depreciation and amortization, stock-based compensation (non-cash) and, certain special items that we believe are not representative of core operations.
Cash Margins is defined as gross margin excluding depreciation and amortization, and stock-based compensation.
Adjusted EBITDA (and a reconciliation to Net loss , the nearest GAAP financial measure) for the three and six months ended June 30, 2016 and 2015 are as follows:
 
 
Three Months Ended
 
Six Months Ended
 
 
June 30,

June 30,
 
 
2016

2015

2016

2015
 
 
(in thousands)
Net loss
 
$
(42,573
)
 
$
(9,898
)
 
$
(54,584
)
 
$
(20,491
)
Interest expense
 
1,686

 
834

 
3,465

 
1,618

Depreciation and amortization
 
2,677

 
1,722

 
5,166

 
3,529

Stock-based compensation
 
1,078

 
2,070

 
2,205

 
3,395

Income tax benefit
 
(304
)
 
(3,148
)
 
(207
)
 
(6,516
)
Restructuring charges
 

 
184

 
225

 
509

Impairment charge
 
31,152

 

 
31,152

 

Adjusted EBITDA
 
$
(6,284
)
 
$
(8,236
)
 
$
(12,578
)
 
$
(17,956
)
Comparison of the Three Months Ended June 30, 2016 to the Three Months Ended June 30, 2015

For the three months ended June 30, 2016 , Adjusted EBITDA on a consolidated basis was $(6.3) million , including investments of $3.3 million in the HyperSound business compared to $(8.2) million , including investments of $3.1 million in the HyperSound business during the three months ended June 30, 2015 . Headset adjusted EBITDA totaled approximately $(3.0) million in the three months ended June 30, 2016 compared to $(5.2) million in the prior year period.


26



Adjusted EBITDA increased for the three months ended June 30, 2016 as compared to the prior year period, including the negative impact of $0.7 million related to foreign currency, as consumer demand for our new-gen headset portfolio and effective promotions helped drive higher North American sales volumes and margin improvement.
Comparison of the Six Months Ended June 30, 2016 to the Six Months Ended June 30, 2015

For the six months ended June 30, 2016 , Adjusted EBITDA on a consolidated basis was $(12.6) million , including investments of $6.4 million in the HyperSound business compared to $(18.0) million , including investments of $6.2 million in the HyperSound business during the six months ended June 30, 2015 . Headset adjusted EBITDA totaled approximately $(6.2) million in the six months ended June 30, 2016 compared to $(11.8) million in the prior year period.

Adjusted EBITDA increased for the six months ended June 30, 2016 as compared to the prior year period, including the negative impact of $1.1 million related to foreign currency, as a result of continued new-gen domestic and international headset market share gains, product mix driven margin improvement and operating cost initiatives.
Results of Operations
The following table sets forth the Company’s statement of operations for the periods presented:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Net Revenue
$
29,362

 
$
22,612

 
$
53,390

 
$
42,301

Cost of Revenue
24,249

 
19,210

 
44,915

 
35,783

Gross Profit
5,113

 
3,402

 
8,475

 
6,518

Operating expenses
45,600

 
15,960

 
58,732

 
31,625

Operating loss
(40,487
)
 
(12,558
)
 
(50,257
)
 
(25,107
)
Interest expense
1,686

 
834

 
3,465

 
1,618

Other non-operating expense (income), net
704

 
(346
)
 
1,069

 
282

Loss before income tax benefit
(42,877
)
 
(13,046
)
 
(54,791
)
 
(27,007
)
Income tax benefit
(304
)
 
(3,148
)
 
(207
)
 
(6,516
)
Net loss
$
(42,573
)
 
$
(9,898
)
 
$
(54,584
)
 
$
(20,491
)

Net Revenue and Gross Profit
Headset Segment

The following table summarizes net revenue and gross profit for the periods presented:
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2016
 
2015
 
2016

2015
 
 (in thousands)
Net Revenue
$
29,142

 
$
22,525

 
$
52,889

 
$
42,123

Gross Profit
7,143

 
3,626

 
11,877

 
6,958

Gross Margin
24.5
%
 
16.1
%
 
22.5
%
 
16.5
%
Cash Margin  (1)
25.5
%
 
18.1
%
 
23.6
%
 
18.2
%
(1) Excludes non-cash charges of $0.3 million and $0.4 million , respectively, for the three months ended June 30, 2016 and 2015 , and $0.6 million and $0.7 million , respectively, for the six months ended June 30, 2016 and 2015 .


27



Comparison of the Three Months Ended June 30, 2016 to the Three Months Ended June 30, 2015

Net revenues for the three months ended June 30, 2016 increased $6.6 million , or 29.4% , as compared to the three months ended June 30, 2015 , as consumer sell-through of new-gen headsets portfolio led by our Recon  Series entry-level headsets and multi-platform compatible Ear Force PX24 continued to drive growth both domestically and in Europe.

Gross profit as a percentage of net revenues for the three months ended June 30, 2016 was 24.5% compared to 16.1% for the three months ended June 30, 2015. The current year period benefited from increased sales of high margin new-gen headsets and operational efficiencies related to our contract manufacturer transition, as well as high promotional credits in the prior year period to clear old-gen and licensed headset inventory.

Comparison of the Six Months Ended June 30, 2016 to the Six Months Ended June 30, 2015

Net revenues for the six months ended June 30, 2016 increased $10.8 million or 25.6% , as compared to six months ended June 30, 2015 , with robust North American and European retailer sales and less promotional activity in the current year period due to strong consumer response to both our new-gen Xbox and Playstation compatible headsets.

Gross profit as a percentage of net revenues for the six months ended June 30, 2016 was 22.5% versus 16.5% in the comparable period primarily due to a product mix shift to new-gen headsets and channel mix to domestic customers partially offset by $1.6 million of additional reserves on certain old-gen and refurbished inventory.
HyperSound Segment
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2016
 
2015
 
2016
 
2015
 
 (in thousands)
Net Revenue
220

 
87

 
501

 
178

Gross Profit
$
(2,030
)
 
$
(224
)
 
$
(3,402
)
 
$
(440
)
Gross Margin
(922.7
)%
 
(257.5
)%
 
(679.0
)%
 
(247.2
)%


Net revenues for the six months ended June 30, 2016 were $0.5 million and reflect the initial sales of the HyperSound Clear 500P product that launched in November 2015. The slower than anticipated ramp in sales volumes has resulted from the extensive training and resources necessary to build market awareness in the hearing healthcare channel.

As a result of certain start-up costs related to the HyperSound Clear 500P product, including the incremental amortization expense related to technological feasibility of the purchased in-process research and development intangible asset, gross profit as a percentage of net revenue was negative for the periods.

Operating Expenses
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2016
 
2015
 
2016
 
2015
 
(in thousands)
Selling and marketing
$
7,121

 
$
6,961

 
$
12,721

 
$
14,707

Research and development
2,040

 
2,824

 
4,064

 
5,678

General and administrative
5,287

 
5,991

 
10,570

 
10,731

Goodwill Impairment
31,152

 

 
31,152

 

Restructuring charges

 
184

 
225

 
509

Total operating expenses
$
45,600

 
$
15,960

 
$
58,732

 
$
31,625


28



Selling and Marketing
Selling and marketing expenses for the three months ended June 30, 2016 totaled $7.1 million , or 24.3% as a percentage of net revenues, compared to $7.0 million , or 30.8% as a percentage of net revenues, for the three months ended June 30, 2015 . The increase was primarily due to increased marketing spend related to our recent eSports sponsorships and certain media events to support product launches, including the HyperSound business May market test initiatives.
Selling and marketing expenses for the six months ended June 30, 2016 totaled $12.7 million , or 23.8% as a percentage of net revenues, compared to $14.7 million , or 34.8% as a percentage of net revenues, for the six months ended June 30, 2015 . The decrease was primarily due to headcount reduction and lower depreciation as certain of our major retail customers have shifted away from independent in-store displays.
Research and Development
As a result of the completion of new-gen headset portfolio transition and the launch of the HyperSound Clear 500P product, research and development expenses decreased for the three and six months ended   June 30, 2016  versus the comparable prior year period.

General and Administrative
General and administrative expenses for the three months ended June 30, 2016 totaled $5.3 million , or 18.0% as a percentage of net revenues, compared to $6.0 million , or 26.5% as a percentage of net revenues, for the three months ended June 30, 2015 . The decrease was primarily due to lower legal expenses and non-cash stock compensation compared to the prior year period that included charges related to the legacy option exchange.
General and administrative expenses for the six months ended June 30, 2016 totaled $10.6 million , or 19.8% as a percentage of net revenues, compared to $10.7 million , or 25.4% as a percentage of net revenues, for the six months ended June 30, 2015 . The decrease was primarily due to headcount reduction and lower legal fees offset, in part, by an increase in professional service charges.
Goodwill Impairment
As a result of our impairment test, we recorded a  $31.2 million  goodwill impairment charge in connection with the decline in implied fair value of the HyperSound reporting unit. There were no such charges in the three or six months ended June 30, 2015 .

Restructuring Charges
During 2014, we began to focus on company-wide overhead and operating expense cost reduction activities, such as closing excess facilities and reducing redundancies. In connection with our efforts to improve our operating efficiency and reduce costs, we consolidated certain operational functions in 2016 and completed the closure of certain production operations at one of our contract manufacturing operations in China in 2015.

Interest Expense
For the three and six months ended June 30, 2016 , interest expense increased as compared to June 30, 2015 due to additional expense related to the Term Loan Due 2019 and the Subordinated Notes.
Income Taxes
Income tax benefit for the three and six months ended June 30, 2016 was $0.3 million at an effective tax rate of 0.7% and $0.2 million at an effective tax rate of 0.4% , respectively. The effective tax rate was primarily impacted by the full valuation allowance on domestic earnings, foreign entity tax benefits and certain state tax expense.

Income tax benefit for the three and six months ended June 30, 2015 was $3.1 million at an effective tax rate of 24.1% and $6.5 million at an effective tax rate of 24.1% . The effective tax rate was impacted by differences in book and tax treatment of transaction costs, interest on the Series B Redeemable Preferred Stock and foreign entity taxable loss.


29



Liquidity and Capital Resources
Our primary source of working capital is cash flow from operations. We have funded operations and acquisitions in recent periods with operating cash flows, and proceeds from debt and equity financings.

The following table summarizes our sources and uses of cash:

 
Six Months Ended
 
June 30,
 
2016
 
2015
 
(in thousands)
Cash and cash equivalents at beginning of period
$
7,114

 
$
7,908

Net cash provided by operating activities
18,237

 
8,167

Net cash used for investing activities
(1,645
)
 
(2,483
)
Net cash used for financing activities
(22,480
)
 
(10,562
)
Effect of foreign exchange on cash
(64
)
 
(10
)
Cash and cash equivalents at end of period
$
1,162

 
$
3,020

Operating activities
Cash used for operating activities for the six months ended   June 30, 2016 was $18.2 million , an increase of $10.1 million as compared to $8.2 million for the  six months ended June 30, 2015 . The increase is primarily the result of the benefit of higher sales and margins excluding non-cash amortization expense and working capital improvements, primarily lower year-over-year payments of accounts payable as compared to inventory build-up requirements ahead of our contract manufacture transition in the prior year.

Investing activities
Cash used for investing activities was $1.6 million during the  six months ended June 30, 2016 compared to $2.5 million in the prior period on lower capital expenditures as domestic retailer customers continue to transition their advertising display models.
Financing activities
Net cash used for financing activities was $22.5 million during the  six months ended June 30, 2016 compared to $10.6 million during the  six months ended June 30, 2015 . Financing activities during the six months ended June 30, 2016 included net payments on our revolving credit facilities of $25.3 million with cash from operations and the issuance of common stock. Financing activities during the six months ended June 30, 2015 included net payments on our revolving credit facilities of $22.0 million with cash from operations and the issuance of $11.8 million of subordinated notes.
Management assessment of liquidity
Management believes that our current cash and cash equivalents, the amounts available under our revolving credit facility, the impact of the proceeds from our recent term loans and subordinated notes, and equity raise and cash flows derived from operations will be sufficient to meet anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements.
We believe the combination of our revolving credit facility, long-term debt and cash flow generated by our gaming headset business and reduced costs related to the HyperSound business will provide the necessary liquidity to fund our annual working capital needs.

Foreign cash balances at  June 30, 2016  and December 31, 2015 were  $0.2 million and $0.2 million , respectively.


30



Revolving Credit Facility
On March 31, 2014, Turtle Beach and certain of its subsidiaries entered into a new asset-based revolving credit agreement (“Credit Facility”) with Bank of America, N.A. (“ Bank of America ”) , as Agent, Sole Lead Arranger and Sole Bookrunner, which replaced the then existing loan and security agreement. The Credit Facility, which expires on  March 31, 2019 , provides for a line of credit of up to $60 million inclusive of a sub-facility limit of $10 million for TB Europe, a wholly owned subsidiary of Turtle Beach. The Credit Facility may be used for working capital, the issuance of bank guarantees, letters of credit and other corporate purposes.
The maximum credit availability for loans and letters of credit under the Credit Facility is governed by a borrowing base determined by the application of specified percentages to certain eligible assets, primarily eligible trade accounts receivable and inventories, and is subject to discretionary reserves and revaluation adjustments.

Amounts outstanding under the Credit Facility bear interest at a rate equal to either a rate published by Bank of America or the LIBOR rate, plus in each case, an applicable margin, which is between 1.00% to 1.50% for U.S. base rate loans and between  2.00% to 2.50% for U.S. LIBOR loans and U.K. loans. As of June 30, 2016 , interest rates for outstanding borrowings were 5.00% for base rate loans and approximately 2.92% for LIBOR rate loans. In addition, Turtle Beach is required to pay a commitment fee on the unused revolving loan commitment at a rate ranging from  0.25%  to 0.50% , and letter of credit fees and agent fees.

If certain availability thresholds are not met, meaning that the Company does not have receivables and inventory which are eligible to borrow on under the Credit Facility in excess of amounts borrowed, the Credit Facility requi res the Company and its restricted subsidiaries to maintain a fixed charge coverage ratio. The fixed charge ratio is defined as the ratio, determined on a consolidated basis for the most recent four fiscal quarters, of (a) EBITDA minus capital expenditures, excluding those financed through other instruments, and cash taxes paid, and (b) Fixed Charges defined as the sum of cash interest expense plus scheduled principal payments. The current fixed charge coverage ratio of at least 1.15 to 1.00 on the last day of each month while a Covenant Trigger Period (as defined in the Credit Facility) is in effect will become effective again after the Company has complied with such ratio for six consecutive months.
The Credit Facility also contains affirmative and negative covenants that, subject to certain exceptions, limit our ability to take certain actions, including our ability to incur debt, pay dividends and repurchase stock, make certain investments and other payments, enter into certain mergers and consolidations, engage in sale leaseback transactions and transactions with affiliates and encumber and dispose of assets. Obligations under the Credit Facility are secured by a security interest and lien upon substantially all of the Company's assets.
On November 2, 2015, the Company entered into a sixth amendment (the “Sixth Amendment”) to the Credit Facility pursuant to which Bank of America and the lenders amended certain provisions of the Credit Facility to, among other things, that modify certain provisions to provide (i) that the Company will make certain periodic reports with respect to certain financial metrics and (ii) that the loan availability is decreased by an additional block.

On December 1, 2015, in connection with the sixth amendment, the Company amended the definition of EBITDA to exclude certain non-recurring expenses and replaced certain financial covenants by amended EBITDA levels each month beginning with the month ended December 31, 2015 through (and including) the month ending March 31, 2017 (with revised financial covenants to be agreed upon based on new financial projections after such date) on both an overall and segment-by-segment basis.

On February 1, 2016, the Company further amended certain provisions of the Credit Facility to, among other things, provide that, on or prior to February 5, 2016, the Company receive net proceeds of not less than $6.0 million of additional equity capital or additional third lien debt financing and apply such proceeds against the outstanding principal balance of the working capital line of credit, amend the definition of EBITDA to exclude certain non-recurring expenses and replace certain financial covenants by amended EBITDA levels. The Company satisfied its paydown obligation with the proceeds from the recent offering and private placement. Refer to Note 3 , “Equity Offering and Private Placement,” for further details.
On June 17, 2016, the Company amended certain provisions of the Credit Facility to, among other things, temporarily reduce the existing loan availability blocks, maintain certain cash flow levels with respect to its HyperSound division during each rolling four week period through the period ending October 28, 2016 and make certain periodic reports with respect to certain financial metrics.

31



As of June 30, 2016 , the Company was in compliance with all the amended financial covenants, and excess borrowing availability was approximately $4.9 million , net of the outstanding Term Loan Due 2018 (as defined below) that is considered to be an additional outstanding amount under the Credit Facility.
Term Loan Due 2018

On December 29, 2014, the Company amended the Credit Facility (the “December Amendment”) to permit the repayment of $7.7 million of then existing subordinated debt and accrued interest with the proceeds of an additional loan (the “Term Loan Due 2018”). The Term Loan Due 2018 resulted in modified financial covenants while it is outstanding, will bear interest at a rate of LIBOR for the applicable interest period plus 5% and will be repaid in equal monthly installments beginning on April 1, 2015 and ending on April 1, 2018. Amounts so repaid are recognized by lowering the balance of the term loan tranche and increasing the lower interest rate base revolver amount, with no net impact on borrowing availability.

Term Loan Due 2019

On July 22, 2015, the Company and its subsidiaries, entered into a term loan, guaranty and security agreement (the “Term Loan Due 2019”) with Crystal Financial LLC, as agent, sole lead arranger and sole bookrunner, Crystal Financial SPV LLC and the other persons party thereto (“Crystal”), which provides for an aggregate term loan commitment of $15 million that bears interest at a rate per annum equal to the 90-day LIBOR rate plus 10.25% . Under the terms of the Term Loan Due 2019, the Company is required to make payments of interest in arrears on the first day of each month beginning August 1, 2015 and will repay the principal in monthly payments beginning January 1, 2016, with a final payment on June 28, 2019 , the maturity date.

The Term Loan Due 2019 is secured by a security interest in substantially all of the Company and each of its subsidiaries' working capital assets and is subject to the first-priority lien of Bank of America, as agent, under the Credit Facility, other than with respect to equipment, fixtures, real property interests, intellectual property, intercompany property, intercompany indebtedness, equity interest in their subsidiaries, and certain other assets specified in an inter-creditor agreement between Bank of America and Crystal.

The Company and its subsidiaries are required to comply with various customary covenants including, (i) maintaining minimum EBITDA and Headset EBITDA (each as defined in the Term Loan Due 2019) in each trailing twelve month period beginning August 31, 2015, (ii) maintaining a Consolidated Leverage Ratio (as defined in the Term Loan Due 2019) to be measured on the last day of each month while the term loans are outstanding of no more than 5.75 :1 beginning December 31, 2015 with periodic step-downs to 3.00 :1 on January 31, 2017, (iii) not making capital expenditures in excess of $11 million in the year ending December 31, 2015 and in excess of $7 million in each of the years ending December 31, 2016, 2017, 2018 and 2019, (iv) restrictions on the Company’s and its subsidiaries ability to prepay its subordinated notes, pay dividends, incur debt, create or suffer liens and engage in certain fundamental transactions and (v) an obligation to provide certain financial and other information. The agreement permits certain equity holders of the Company to contribute funds to the Company to cure certain financial covenant defaults. In connection with certain amendments, the testing of the consolidated leverage ratio covenants has been suspended through April 2017.

The Term Loan Due 2019 contains customary representations, mandatory prepayment events and events of default, including defaults triggered by the failure to make payments when due, breaches of covenants and representations, material impairment in the perfection of Crystal’s security interest in the collateral and events related to bankruptcy and insolvency of the Company and its subsidiaries. Upon an event of default, Crystal may declare all outstanding obligations immediately due and payable (along with a prepayment fee), a default rate of an additional 2.0% may be applied to amounts outstanding and may take other actions including collecting or taking such other action with respect to the collateral pledged in connection with the term loan.

On February 1, 2016, the Company entered into a third amendment (the “Term Loan Amendment”) to the Term Loan Due 2019 to, among other things, amend the definition of EBITDA to exclude certain non-recurring expenses and replace certain financial covenants by amended EBITDA levels each month beginning with the month ended December 31, 2015 and on a trailing twelve-month period basis beginning with the period ending October 31, 2016, through the termination date on both an overall and segment-by-segment basis.


32



Subordinated Notes - Related Party
O n April 23, 2015, the Company issued a $5.0 million subordinated note (the “April Note”) to SG VTB Holdings, LLC, the Company’s largest stockholder (“SG VTB”). The April Note was issued with an interest rate of (i) 10% per annum for the first year and (ii) 20% per annum for all periods thereafter, with interest accruing and being added to the principal amount of the note quarterly.
On May 13, 2015, the Company issued subordinated notes (the “May Notes”) with an aggregate principal amount of $3.8 million to SG VTB, and a trust affiliated with Ronald Doornink, the Chairman of the Company's board of directors (the “Board”). The May Notes were issued with an interest rate of 10%  per annum until the maturity date of the May Notes (which was August 13, 2015 but could be extended up to two additional 90 day periods upon the written agreement of the Company and the noteholder), with interest accruing and being added to the principal amount of the May Notes quarterly. Following the maturity date, the interest rate would have increased to 20%  per annum.

On June 17, 2015, the Company issued a subordinated note (the “June Note”) with an aggregate principal amount of $3.0 million to SG VTB. The June Note was issued at an interest rate of 10%  per annum until the maturity date of the June Note (which was September 17, 2015 but could be extended up to two additional 90 day periods upon the written agreement of the Company and the noteholder), with interest accruing and being added to the principal amount of the June Note quarterly. Following the maturity date, the interest rate would have increased to 20%  per annum. In addition, the Company had the option to request that SG VTB make, in SG VTB’s sole discretion, additional advances from time to time up to an aggregate principal amount of $15.0 million . Prior to the amendment (see below), following an additional advance of $6.0 million on July 8, 2015, $9.0 million was outstanding under the June Note.

Concurrently with the completion of the Term Loan Due 2019, the Company amended and restated each of its outstanding subordinated notes (the “Amended Notes”). The obligations of the Company under the Amended Notes are subordinate and junior to the prior payment of amounts due under the Credit Facility and Term Loan Due 2019. In addition, the stated maturity date of the Amended Notes was extended to September 29, 2019 , subject to acceleration in certain circumstances, such as a change of control of the Company. The Amended Notes bear interest at a rate per annum equal to LIBOR plus 10.5% and shall be paid-in-kind by adding the amount to the principal amount due.

On November 16, 2015, the Company issued a $2.5 million subordinated note (the “November Note”) to SG VTB, the proceeds of which, as set forth in the amendment to the Term Loan Due 2019, were applied against the outstanding balance of the Term Loan Due 2019. The November Note will bear interest at a rate of 15%  per annum until its maturity date, which is September 29, 2019 , and is subordinated to all senior debt of the Company.

SG VTB is an affiliate of Stripes Group LLC (“Stripes”), a private equity firm focused on internet, software, healthcare IT and branded consumer products businesses. Kenneth A. Fox, one of our directors, is the managing general partner of Stripes and the sole manager of SG VTB and Ronald Doornink, our Chairman of the Board, is an operating partner of Stripes.

Series B redeemable preferred stock
In September 2010, VTBH issued 1,000,000 shares of its Series B Redeemable Preferred Stock with a fair value of $12.4 million. We are required to redeem the Series B Redeemable Preferred Stock on the earlier to occur of September 28, 2030 or the occurrence of a liquidation event at its original issue price of $12.425371 per share plus any accrued but unpaid dividends. The redemption value was $16.8 million and $16.1 million as of June 30, 2016 and December 31, 2015 , respectively.
Stock Warrants
In connection with and as consideration for the concessions in the Amended Notes, the Company issued to SG VTB and a trust affiliated with Ronald Doornink warrants to purchase 1.7 million shares of the Company’s common stock at an exercise price of $2.54 per share. The warrants are exercisable for a period of five years beginning on the date of issuance, July 22, 2015. The exercise price and the number of shares of Common Stock purchasable are subject to adjustment and do not carry any voting rights or other rights as a stockholder of the Company prior to exercise. The shares issuable upon exercise are also subject to the “demand” and “piggyback” registration rights set forth in the in the Company’s Stockholder Agreement, dated August 5, 2013, as amended July 10, 2014.


33



In connection with the November Note, the Company issued a warrant to purchase 1.4 million shares of the Company’s common stock at an exercise price of $2.00 per share to SG VTB. The exercise price and the number of shares are subject to standard anti-dilution adjustments and do not carry any voting rights as a stockholder of the Company prior to exercise. The warrant is exercisable for a period of ten years beginning on the date of issuance and does not entitle the holder to any voting rights or other rights as a stockholder of the Company prior to exercise.

Critical Accounting Estimates
Our discussion and analysis of our results of operations and capital resources are based on our condensed consolidated financial statements, which have been prepared in conformity with GAAP. The preparation of these condensed consolidated financial statements requires management to make estimates and assumptions that affect the rep