Funko, Inc. (FNKO) FY 2022 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion and analysis of our financial condition and results of operations together with our audited consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements based upon current plans, expectations and beliefs involving risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various important factors, including those set forth under “Risk Factors” included in this Annual Report on Form 10-K. Our results of operations for the year ended December 31, 2020, including a discussion of the year ended December 31, 2021 compared to the year ended December 31, 2020, can be found under "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2021.
Overview
Funko is a leading pop culture lifestyle brand. Our business is built on the principle that almost everyone is a fan of something and the evolution of pop culture is leading to increasing opportunities for fan loyalty. We create whimsical, fun and unique products that enable fans to express their affinity for their favorite “something”—whether it is a movie, TV show, video game, musician or sports team. We infuse our distinct designs and aesthetic sensibility into one of the industry’s largest portfolios of licensed content over a wide variety of product categories, including figures, plush, accessories, apparel, homewares, vinyl record, poster or digital NFT.
Given our diverse product offering, in 2022, we created three new branded categories to better align our product net sales results and execute against our operating objectives. The Core Collectible branded category includes Pop! Vinyl, and newer collectible brands such as Soda, Vinyl Gold and Popsies. The Loungefly branded category includes our softlines products. The Other branded category includes our Toy and Games brands and our Digital Brands. Net sales product revenue has been recast into these branded categories for the year ended December 31, 2021.
Key Performance Indicators
We consider the following metrics to be key performance indicators to evaluate our business, develop financial forecasts, and make strategic decisions.
| Year Ended December 31, | ||||||
|---|---|---|---|---|---|---|
| 2022 | 2021 | |||||
| (in thousands) | ||||||
| Net sales | $ | 1,322,706 | $ | 1,029,293 | ||
| Net (loss) income | $ | (5,240) | $ | 67,854 | ||
| EBITDA (1) | $ | 34,962 | $ | 133,277 | ||
| Adjusted EBITDA (1) | $ | 97,425 | $ | 149,931 |
(1)Earnings before interest, taxes, depreciation and amortization (“EBITDA”) and Adjusted EBITDA are financial measures not calculated in accordance with U.S. GAAP. For a reconciliation of EBITDA and Adjusted EBITDA to net (loss) income, the most closely comparable U.S. GAAP financial measure, see “Non-GAAP Financial Measures” in this item.
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Factors Affecting our Business
Growth in the Market for Pop Culture Consumer Products
Our operating results and prospects will be impacted by developments in the market for pop culture consumer products. Our business has benefited from pop culture trends including (1) technological innovation that has facilitated content consumption and engagement, (2) creation of more quality content, (3) greater cultural prevalence and acceptance of pop culture fandom and (4) increased engagement by fans with pop culture content beyond mere consumption driven by social media and demonstrated by fan-centric experiences, such as Comic-Con events around the world. These trends have contributed to significant growth in the demand for pop culture products like ours in recent years; however, consumer demand for pop culture products and pop culture trends can and does shift rapidly and without warning. To the extent we are unable to offer products that appeal to consumers, our operating results will be adversely affected. This is particularly true given the concentration of our sales of products under certain of our brands, particularly our Core Collectible branded products, which represented approximately 75% and 80% of our sales for the years ended December 31, 2022 and 2021, respectively, and which are sold across multiple product categories.
Relationships with Content Providers
We generate a majority of our net sales from products based on intellectual property we license from others. We have strong relationships with many established content providers and seek to establish licensing relationships with newer content providers. Our content provider relationships are highly diversified, allowing us to license a wide array of properties and thereby reduce our exposure to any individual property or license.
We believe there is a trend of content providers consolidating their relationships to do more business with fewer licensees. We believe our ability to help maximize the value and extend the relevance of our content providers’ properties has allowed us to benefit from this trend. Although we have a successful track record of renewing and extending the scope of licenses, our license agreements typically have short terms (between two and three years), are not automatically renewable and, in some cases, give the licensor the right to terminate the license agreement at will. In addition, the efforts of our senior management team have been integral to our relationships with our licensors. Inability to license newer pop culture properties, the termination or lack of renewal of one or more of our license agreements, or the renewal of a license agreement on less favorable terms, could adversely affect our business.
Retail Industry Dynamics; Relationships with Retail Customers
Historically, substantially all of our sales have been derived from our retail customers and distributors, upon which we rely to reach the consumers who are the ultimate purchasers of our products. Our top ten customers represented approximately 44% and 45% of our sales for the years ended December 31, 2022 and 2021, respectively. During the years ended December 31, 2022 and 2021, we saw shifts in our client mix as a direct result of the COVID-19 pandemic and the enhanced online presence of our top customers.
We depend on retailers to provide adequate and attractive space for our products and point of purchase displays in their stores. We continue to have dedicated shelf space for our products in a variety of aisles in mass-market retailer and specialty stores, with our growing diversified product offerings. In recent years, traditional retailers have been affected by a shift in consumer preferences towards other channels, particularly e-commerce.
Our customers do not make long-term commitments to us regarding purchase volumes and can therefore easily reduce their purchases of our products. Any reduction in purchases of our products by our retail customers and distributors, or the loss of any key retailer or distributor for any reason could adversely affect our business. In addition, our future growth depends upon our ability to successfully execute our business strategy. See Item 1A, “Risk Factors.”
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Content Mix
The timing and mix of products we sell in any given quarter or year will depend on various factors, including the timing and popularity of new releases by third-party content providers and our ability to license properties based on these releases. We have diversified our product offerings across property categories. We have visibility into the new release schedule of many our content providers and our expansive license portfolio allows us to dynamically manage new product creation. This insight allows us to adjust the mix of products based on classic evergreen properties and new releases, depending on the media release cycle. For example, in 2022 there was an increase in new originally scripted series and new movie theater releases, which we believe contributed to a higher percent of our sales attributable to current properties than compared to recent historical trends.
Our results of operations may also fluctuate significantly from quarter to quarter or year to year depending on the timing and popularity of new product releases and related content releases. Sales of a certain product or group of products tied to a particular property can dramatically increase our net sales in any given quarter or year. While we expect to see growth in the number of properties and products over time, we expect that the number of active properties and the sales per active property will fluctuate from quarter to quarter or year over year based on what is relevant in pop culture at that time and the types of properties we are producing. In addition, despite our efforts to diversify the properties on which we base our products, if the performance of one or more of these properties fail to meet expectations or are delayed in their release, our operating results could be adversely affected.
Inventory Management
Inventory consists primarily of figures, plush, apparel, homewares, accessories, games, vinyl records and other finished goods, and is accounted for using the first-in, first-out (“FIFO”) method. Inventory costs include direct product costs and freight costs. We order inventory based on assumptions of future demand and maintain reserves for excess and obsolete inventories to reflect the inventory balance at the lower of cost or net realizable value. This valuation requires us to make judgments, based on currently available information, about the likely method of disposition, such as through sales to customers, or liquidation, and expected recoverable value of each disposition category. We also monitor our warehouse operations for maximum throughput to minimize carrying costs and aging of on-hand inventory. We may from time to time, liquidate and/or dispose of inventory to increase warehouse operating efficiency. Subsequent to the year ended December 31, 2022, the Company approved an inventory reduction plan to improve U.S. warehouse operational efficiency. The products were determined to be stated at their net realizable value at December 31, 2022, but were subsequently approved for destruction, and the Company expects an incremental charge for the write-down of products identified to be recorded to cost of sales in the first half of 2023 to be in the range of $30.0 million to $36.0 million.
Taxation and Expenses
We are subject to U.S. federal, state and local income taxes with respect to our allocable share of any taxable income of FAH, LLC, and we are taxed at the prevailing corporate tax rates. In addition to tax expenses, we incur expenses related to our operations, as well as payments under the Tax Receivable Agreement. We have caused and intend to continue to cause FAH, LLC to make distributions in an amount sufficient to allow us to pay our tax obligations and operating expenses, including distributions to fund any ordinary course payments due under the Tax Receivable Agreement.
Components of our Results of Operations
Net Sales
We sell a broad array of licensed pop culture consumer products across a variety of categories, including figures, plush, accessories, apparel, games, homewares, vinyl records, posters and NFTs, primarily to retail customers and distributors. We also sell our products directly to consumers through our e-commerce operations, our retail stores and, to a lesser extent, at specialty licensing and comic book conventions and exhibitions.
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Revenue from the sale of our products is recognized when control of the goods is transferred to the customer, which is upon shipment or upon receipt of finished goods by the customer, depending on the contract terms. The majority of revenue is recognized upon shipment of products to the customer. We routinely enter into arrangements with our customers to provide sales incentives, support customer promotions, and provide allowances for returns and defective merchandise. The estimated costs of these programs reduce gross sales in the period the related sale is recognized. We evaluate the need for price increases along with other incentive arrangements and cost of product to help manage gross margins. In 2021, we instituted price increases for certain of our products and we expect to increase prices for certain of our other products in early 2023. Sales terms typically do not allow for a right of return except in relation to a manufacturing defect. Shipping costs billed to our customers are included in net sales, while shipping and handling costs, which include inbound freight costs and the cost to ship products to our customers, are included in cost of sales.
Cost of Sales
Cost of sales consists primarily of product costs, royalty expenses paid to our licensors and the cost to ship our products, including both inbound freight and outbound products to our customers. Our cost of sales excludes depreciation and amortization.
Our products are produced and assembled by third-party manufacturers primarily in Vietnam, China and Mexico. The use of third-party manufacturers enables us to avoid incurring fixed product costs, while maximizing flexibility, capacity and capability. As part of a continuing effort to reduce manufacturing costs and ensure speed to market, we have historically kept our production concentrated with a small number of manufacturers and factories even as we have grown and diversified.
Our product costs and gross margins will be impacted from period to period based on the product mix in any given period. Our Loungefly branded products tend to have a higher product cost and higher duties as a percentage of sales and therefore lower gross margins than our Core Collectible branded products.
Our royalty costs and gross margins will also be impacted from period to period based on our mix of licensed products sold, as well as a variety of other factors including reserves for minimum guarantees and ongoing and future royalty audits.
Our shipping costs, both inbound and outbound, will fluctuate from period to period based on customer mix due to varying shipping terms and other factors. In 2021, we experienced significant increases in shipping rates due to global capacity constraints and the lack of availability of shipping containers. In late 2022, ocean freight rates began to stabilize, however difficulties in our warehouse and distribution operations led us to incur a substantial amount of ground transportation and temporary storage costs.
We anticipate inflationary pressures throughout our supply chain in future periods, specific to shipping and, to a lesser extent, product costs.
Selling, General and Administrative Expenses
Selling, general and administrative expenses are primarily driven by wages, commissions and benefits, warehouse, fulfillment (internal and external), rent and facilities costs, infrastructure and technology costs, advertising and marketing expenses, including the costs to participate at specialty licensing and comic book conventions and exhibitions, as well as costs to develop promotional video and other online content created for advertising purposes. Credit card fees, insurance, legal expenses, other professional expenses and other miscellaneous operating costs are also included in selling, general and administrative expenses. Selling costs generally correlate to revenue timing and therefore experience similar moderate seasonal trends. We expect general and administrative costs to increase as our business evolves.
We have invested considerably in general and administrative costs to support the growth and anticipated growth of our business and anticipate continuing to do so in the future.
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Depreciation and Amortization
Depreciation expense is recognized on a straight-line basis over the estimated useful lives of our property and equipment. Amortization relates to definite-lived intangible assets that are expensed on a straight-line basis over the estimated useful lives. Our intangible assets, which are being amortized over a range of two to 20 years, are mainly comprised of trade names, customer relationships and intellectual property we recognized as part of the ACON Acquisition and, to a lesser extent, the 2017 acquisition of Underground Toys, the 2017 acquisition of Loungefly, the 2019 acquisition of Forrest-Pruzan and the 2022 acquisition of Mondo.
Interest Expense, Net
Interest expense, net includes the cost of our short-term borrowings and long-term debt, including the amortization of debt issuance costs and original issue discounts, net of any interest income earned.
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Results of Operations
Year Ended December 31, 2022 Compared to Year Ended December 31, 2021
The following table sets forth information comparing the components of net (loss) income for the years ended December 31, 2022 and 2021:
| Year Ended December 31, | Period over Period Change | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | Dollar | Percentage | |||||||||||
| (in thousands, except percentages) | ||||||||||||||
| Net sales | $ | 1,322,706 | $ | 1,029,293 | $ | 293,413 | 28.5 | % | ||||||
| Cost of sales (exclusive of depreciation and amortization shown separately below) | 888,685 | 648,302 | 240,383 | 37.1 | % | |||||||||
| Selling, general, and administrative expenses | 398,272 | 244,331 | 153,941 | 63.0 | % | |||||||||
| Depreciation and amortization | 47,669 | 41,195 | 6,474 | 15.7 | % | |||||||||
| Total operating expenses | 1,334,626 | 933,828 | 400,798 | 42.9 | % | |||||||||
| (Loss) income from operations | (11,920) | 95,465 | (107,385) | nm | ||||||||||
| Interest expense, net | 10,334 | 7,167 | 3,167 | 44.2 | % | |||||||||
| Loss on extinguishment of debt | — | 675 | (675) | nm | ||||||||||
| Other expense, net | 787 | 2,708 | (1,921) | (70.9) | % | |||||||||
| (Loss) income before income taxes | (23,041) | 84,915 | (107,956) | nm | ||||||||||
| Income tax (benefit) expense | (17,801) | 17,061 | (34,862) | nm | ||||||||||
| Net (loss) income | (5,240) | 67,854 | (73,094) | nm | ||||||||||
| Less: net income attributable to non-controlling interests | 2,795 | 23,954 | (21,159) | (88.3) | % | |||||||||
| Net (loss) income attributable to Funko, Inc. | $ | (8,035) | $ | 43,900 | $ | (51,935) | nm |
Net Sales
Net sales were $1.3 billion for the year ended December 31, 2022, an increase of 28.5% compared to $1.0 billion for the year ended December 31, 2021. The increase in net sales was primarily due to increased sales to our mass-market retailers, distributors and e-commerce site customers.
In the year ended December 31, 2022, the number of active properties decreased 3.0% to 926 from 955 in the year ended December 31, 2021, and average net sales per active property increased 32.5% to $1.4 million for the year ended December 31, 2022 from $1.1 million for the year ended December 31, 2021. While we expect to see growth in the number of active properties over time, we expect that the average sales per active property will fluctuate from year to year or quarter to quarter based on what is relevant in pop culture at that time and the types of properties we are producing against.
On a geographical basis, net sales in the United States increased 30.0% to $966.7 million in the year ended December 31, 2022 as compared to $743.8 million in the year ended December 31, 2021, net sales in Europe increased 22.3% to $262.6 million in the year ended December 31, 2022 from $214.7 million in the year ended December 31, 2021 and net sales in other international locations increased 32.0% to $93.4 million in the year ended December 31, 2022 from $70.7 million in the year ended December 31, 2021.
On a product category basis, net sales of Core Collectible branded products increased 21.6% to $998.4 million in the year ended December 31, 2022 as compared to $820.9 million in the year ended December 31, 2021. Net sales of Loungefly branded products increased 67.7% to $253.0 million in the year ended December 31, 2022 as compared to $150.8 million in the year ended December 31, 2021. Net sales of other products increased 23.9% to $71.3 million in the year ended December 31, 2022 as compared to $57.5 million the year ended December 31, 2021.
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Although this Management’s Discussion and Analysis generally does not present a discussion of the year ended December 31, 2021 compared to the year ended December 31, 2020, given our creation of three new branded categories in 2022, we are presenting a discussion of net sales by product category for the year ended December 31, 2021 compared to the year ended December 31, 2020, recast to reflect our new product categories, as follows:
On a product category basis, net sales of Core Collectible branded products increased 55.7% to $820.9 million in the year ended December 31, 2021 as compared to $527.2 million in the year ended December 31, 2020. Net sales of Loungefly branded products increased 157.6% to $150.8 million in the year ended December 31, 2021 as compared to $95.7 million in the year ended December 31, 2020. Net sales of other products increased 194.1% to $57.5 million in the year ended December 31, 2021 as compared to $29.6 million the year ended December 31, 2020.
Cost of Sales and Gross Margin (exclusive of depreciation and amortization)
Cost of sales (exclusive of depreciation and amortization) was $888.7 million for the year ended December 31, 2022, an increase of 37.1%, compared to $648.3 million for the year ended December 31, 2021. Cost of sales (exclusive of depreciation and amortization) increased primarily as a result of increases in shipping and freight costs outpacing net sales growth over the same time period. Product costs increased $114.0 million, shipping and freight costs increased $51.2 million and royalty expenses increased $51.8 million.
Gross margin (exclusive of depreciation and amortization), calculated as net sales less cost of sales as a percentage of sales, was 32.8% for the year ended December 31, 2022, compared to 37.0% for the year ended December 31, 2021. Gross margin (exclusive of depreciation and amortization) decreased 420 basis points for the year ended December 31, 2022 compared to the year ended December 31, 2021, due primarily to challenges with warehouse operations and increased freight and inventory storage costs. We expect the elevated warehouse, freight and inventory costs to continue at least through first half of 2023.
Selling, General, and Administrative Expenses
Selling, general, and administrative expenses were $398.3 million for the year ended December 31, 2022, an increase of 63.0%, compared to $244.3 million for the year ended December 31, 2021. The increase was driven primarily by a $68.6 million increase in personnel expenses, commissions and stock option expense, a $33.5 million increase in software expenses, primarily as a result of the abandonment of the enterprise resource planning cloud computing arrangement of $32.5 million, a $10.3 million increase in professional fees, primarily as a result of one-time warehouse consolidation, severance and relocation costs, a $9.6 million increase in advertising and marketing, a $9.5 million increase in administrative expenses, primarily as a result of increased bad debt reserves, and a $9.4 million increase in facilities and rent, primarily related to the new U.S. warehouse and distribution center.
Selling, general, and administrative expenses were 30.1% of sales for the year ended December 31, 2022, compared to 23.7% of sales for the year ended December 31, 2021, primarily due to the increase in general and administrative expenses outpacing net sales.
Depreciation and Amortization
Depreciation and amortization expense was $47.7 million for the year ended December 31, 2022, compared to $41.2 million for the year ended December 31, 2021, primarily driven by the type and timing of assets placed into service.
Interest Expense, Net
Interest expense, net was $10.3 million for the year ended December 31, 2022, an increase of 44.2%, compared to $7.2 million for the year ended December 31, 2021. The increase in interest expense, net was due to higher average balances of debt outstanding as well as higher interest rates during the year ended December 31, 2022.
Loss on debt extinguishment
As a result of the debt refinancing in September 2021, $0.7 million loss on debt extinguishment was recorded for the year ended December 31, 2021 as unamortized debt financing fees were written-off.
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Income Tax (Benefit) Expense
Income tax benefit was $17.8 million for the year ended December 31, 2022, compared to an income tax expense of $17.1 million for the year ended December 31, 2021. The increase in income tax benefit was primarily due to a decrease in income before income taxes of $108.0 million for the year ended December 31, 2022 as compared to the year ended December 31, 2021. The Company also realized a discrete benefit of $11.0 million from the release of a valuation allowance on the outside basis deferred tax asset during the year ended December 31, 2022.
Net (Loss) Income
Net loss was $5.2 million for the year ended December 31, 2022, compared to net income of $67.9 million for the year ended December 31, 2021. The decrease in net income was primarily the result of the increases in cost of goods sold and selling, general and administrative costs outpacing the increases in net sales for the year ended December 31, 2022 as compared to the year ended December 31, 2021, as discussed above.
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Non-GAAP Financial Measures
EBITDA, Adjusted EBITDA, Adjusted Net Income and Adjusted Earnings per Diluted Share (collectively the “Non-GAAP Financial Measures”) are supplemental measures of our performance that are not required by, or presented in accordance with, U.S. GAAP. The Non-GAAP Financial Measures are not measurements of our financial performance under U.S. GAAP and should not be considered as an alternative to net (loss) income, earnings per share or any other performance measure derived in accordance with U.S. GAAP. We define EBITDA as net (loss) income before interest expense, net, income tax expense (benefit), depreciation and amortization. We define Adjusted EBITDA as EBITDA further adjusted for non-cash charges related to equity-based compensation programs, acquisition transaction costs and other expenses, certain severance, relocation and related costs, loss on extinguishment of debt, foreign currency transaction gains and losses, Tax Receivable Agreement liability adjustments, and other unusual or one-time items. We define Adjusted Net (Loss) Income as net (loss) income attributable to Funko, Inc. adjusted for the reallocation of income attributable to non-controlling interests from the assumed exchange of all outstanding common units and options in FAH, LLC for newly issued-shares of Class A common stock of Funko, Inc. and further adjusted for the impact of certain non-cash charges and other items that we do not consider in our evaluation of ongoing operating performance. These items include, among other things, non-cash charges related to equity-based compensation programs, acquisition transaction costs and other expenses, certain severance, relocation and related costs, loss on extinguishment of debt, foreign currency transaction gains and losses, Tax Receivable Agreement liability adjustments, and the income tax expense (benefit) effect of these adjustments. We define Adjusted Earnings per Diluted Share as Adjusted Net (Loss) Income divided by the weighted-average shares of Class A common stock outstanding, assuming (1) the full exchange of all outstanding common units and options in FAH, LLC for newly issued-shares of Class A common stock of Funko, Inc. and (2) the dilutive effect of stock options and unvested common units, if any. We caution investors that amounts presented in accordance with our definitions of the Non-GAAP Financial Measures may not be comparable to similar measures disclosed by our competitors, because not all companies and analysts calculate the Non-GAAP Financial Measures in the same manner. We present the Non-GAAP Financial Measures because we consider them to be important supplemental measures of our performance and believe they are frequently used by securities analysts, investors, and other interested parties in the evaluation of companies in our industry. Management believes that investors’ understanding of our performance is enhanced by including these Non-GAAP Financial Measures as a reasonable basis for comparing our ongoing results of operations.
Management uses the Non-GAAP Financial Measures:
•as a measurement of operating performance because they assist us in comparing the operating performance of our business on a consistent basis, as they remove the impact of items not directly resulting from our core operations;
•for planning purposes, including the preparation of our internal annual operating budget and financial projections;
•as a consideration to assess incentive compensation for our employees;
•to evaluate the performance and effectiveness of our operational strategies; and
•to evaluate our capacity to expand our business.
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By providing these Non-GAAP Financial Measures, together with reconciliations, we believe we are enhancing investors’ understanding of our business and our results of operations, as well as assisting investors in evaluating how well we are executing our strategic initiatives. The Non-GAAP Financial Measures have limitations as analytical tools, and should not be considered in isolation, or as an alternative to, or a substitute for net (loss) income or other financial statement data presented in our consolidated financial statements included elsewhere in this Annual Report on Form 10-K as indicators of financial performance. Some of the limitations are:
•such measures do not reflect our cash expenditures, or future requirements for capital expenditures or contractual commitments;
•such measures do not reflect changes in, or cash requirements for, our working capital needs;
•such measures do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments on our debt;
•although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future and such measures do not reflect any cash requirements for such replacements; and
•other companies in our industry may calculate such measures differently than we do, limiting their usefulness as comparative measures.
Due to these limitations, Non-GAAP Financial Measures should not be considered as measures of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our U.S. GAAP results and using these non-GAAP measures only supplementally. As noted in the table below, the Non-GAAP Financial Measures include adjustments for non-cash charges related to equity-based compensation programs, acquisition transaction costs and other expenses, certain severance, relocation and related costs, loss on extinguishment of debt, foreign currency transaction gains and losses, Tax Receivable Agreement liability adjustments and other unusual or one-time items. It is reasonable to expect that these items will occur in future periods. However, we believe these adjustments are appropriate because the amounts recognized can vary significantly from period to period, do not directly relate to the ongoing operations of our business and complicate comparisons of our internal operating results and operating results of other companies over time. Each of the normal recurring adjustments and other adjustments described herein and in the reconciliation table below help management with a measure of our core operating performance over time by removing items that are not related to day-to-day operations.
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The following tables reconcile the Non-GAAP Financial Measures to the most directly comparable U.S. GAAP financial performance measure, which is net (loss) income, for the periods presented:
| Year Ended December 31, | ||||||
|---|---|---|---|---|---|---|
| 2022 | 2021 | |||||
| (in thousands, except per share data) | ||||||
| Net (loss) income attributable to Funko, Inc. | $ | (8,035) | $ | 43,900 | ||
| Reallocation of net income attributable to non-controlling interests from the assumed exchange of common units of FAH, LLC for Class A common stock (1) | 2,795 | 23,954 | ||||
| Equity-based compensation (2) | 16,591 | 12,994 | ||||
| Acquisition transaction costs and other expenses (3) | 2,850 | — | ||||
| Certain severance, relocation and related costs (4) | 9,775 | 277 | ||||
| Loss on extinguishment of debt (5) | — | 675 | ||||
| Foreign currency transaction (gain) loss (6) | (3,232) | 1,118 | ||||
| Tax receivable agreement liability adjustments (7) | 3,987 | 1,590 | ||||
| One-time cloud based computing arrangement abandonment (8) | 32,492 | — | ||||
| Income tax expense (9) | (27,657) | (8,331) | ||||
| Adjusted net income | $ | 29,566 | $ | 76,177 | ||
| Weighted-average shares of Class A common stock outstanding-basic | 44,555 | 38,392 | ||||
| Equity-based compensation awards and common units of FAH, LLC that are convertible into Class A common stock | 6,967 | 15,437 | ||||
| Adjusted weighted-average shares of Class A stock outstanding-diluted | 51,522 | 53,829 | ||||
| Adjusted earnings per diluted share | $ | 0.57 | $ | 1.42 |
| Year Ended December 31, | ||||||
|---|---|---|---|---|---|---|
| 2022 | 2021 | |||||
| (in thousands) | ||||||
| Net (loss) income | $ | (5,240) | $ | 67,854 | ||
| Interest expense, net | 10,334 | 7,167 | ||||
| Income tax (benefit) expense | (17,801) | 17,061 | ||||
| Depreciation and amortization | 47,669 | 41,195 | ||||
| EBITDA | $ | 34,962 | $ | 133,277 | ||
| Adjustments: | ||||||
| Equity-based compensation (2) | 16,591 | 12,994 | ||||
| Acquisition transaction costs and other expenses (3) | 2,850 | — | ||||
| Certain severance, relocation and related costs (4) | 9,775 | 277 | ||||
| Loss on extinguishment of debt (5) | — | 675 | ||||
| Foreign currency transaction (gain) loss (6) | (3,232) | 1,118 | ||||
| Tax receivable agreement liability adjustments (7) | 3,987 | 1,590 | ||||
| One-time cloud based computing arrangement abandonment (8) | 32,492 | — | ||||
| Adjusted EBITDA | $ | 97,425 | $ | 149,931 |
(1)Represents the reallocation of net income attributable to non-controlling interests from the assumed exchange of common units of FAH, LLC in periods in which income was attributable to non-controlling interests.
(2)Represents non-cash charges related to equity-based compensation programs, which vary from period to period depending on timing of awards.
(3)Represents acquisition-related costs related to investment banking and due diligence fees.
(4)Represents certain severance, relocation and related costs. For the year ended December 31, 2022, includes charges related to residual one-time relocation and severance costs for U.S. warehouse personnel in connection with the opening of a warehouse and distribution facility in Buckeye, Arizona. For the year ended December 31, 2021, includes charges related to one-time relocation costs for U.S. warehouse personnel in connection with the new opening of a warehouse and distribution facility in Buckeye, Arizona and residual severance payments related to the global workforce reduction implemented in response to the COVID-19 pandemic.
(5)Represents write-off of unamortized debt financing fees for the year ended December 31, 2021.
(6)Represents both unrealized and realized foreign currency losses (gains) on transactions other than in U.S. dollars.
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(7)Represents recognized adjustments to the tax receivable agreement liability.
(8)Represents abandoned cloud computing arrangement charge related to the enterprise resource planning project for the year ended December 31, 2022.
(9)Represents the income tax expense effect of the above adjustments. This adjustment uses an effective tax rate of 25% for the years ended December 31, 2022 and 2021. For the year ended December 31, 2022, this also includes the $11.0 million discrete benefit from the release of a valuation allowance on the outside basis deferred tax asset.
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Liquidity and Financial Condition
Introduction
Our primary requirements for liquidity and capital are working capital, inventory management, capital expenditures, debt service and general corporate needs.
On September 17, 2021, the Company entered into a new credit agreement (the “New Credit Agreement”) providing for a term loan facility in the amount of $180.0 million (the “New Term Loan Facility”) and a revolving credit facility of $100.0 million (the “New Revolving Credit Facility”) (together the “New Credit Facilities”). Proceeds from the New Credit Facilities were primarily used to repay the Company’s $235.0 million term loan facility (the "Former Term Loan Facility") and its $75.0 million revolving credit facility (the “Former Revolving Credit Facility” and together with the Former Term Loan Facility, the “Former Credit Facilities”). On July 29, 2022, the New Revolving Credit Facility was increased to $215.0 million and on February 28, 2023 the New Revolving Credit Facility was reduced to $180.0 million and thereafter will be reduced to $150.0 million on December 31, 2023. Currently, we are unable to draw on the New Revolving Credit Facility in amounts in excess of the amount outstanding under the New Revolving Credit Facility on the effective date of the Third Amendment until the end of the Waiver Period as defined herein. The New Credit Facilities are secured by substantially all assets of the borrowers under the New Credit Facilities and any of their existing or future material domestic subsidiaries, subject to customary exceptions.
On November 25, 2022, the Company entered into a $20.0 million equipment finance agreement ("Equipment Finance Loan"). The Equipment Finance Loan is secured by certain identified assets held within our Buckeye, Arizona warehouse.
We are a holding company with no material assets, and we do not conduct any business operations of our own. We have no independent means of generating revenue or cash flow, and our ability to pay dividends in the future, if any, is dependent upon the financial results and cash flows of FAH, LLC and its subsidiaries and distributions we receive from FAH, LLC. Under the terms of the New Credit Facilities, our subsidiaries are currently limited in their ability to pay cash dividends to the Company, subject to certain customary exceptions, including among others:
•the ability to pay, so long as there is no current or ongoing event of default, amounts required to be paid under the Tax Receivable Agreement, certain expenses associated with being a public company and reimbursement of expenses required by the FAH LLC Agreement or the Registration Rights Agreement; and
•the ability to make other distributions of up to $25.0 million during any period of four consecutive fiscal quarters as long as after giving pro forma effect to such distribution (i) no event of default then exists or would result therefrom and (ii) the Net Leverage Ratio (as defined in the New Credit Agreement) is not greater than a ratio that is 0.50:1.00 less than the Net Leverage Ratio set forth in the financial covenant for the applicable fiscal quarter, provided that we do not have the ability to make such distributions during the Waiver Period.
We expect these limitations to continue in the future under the terms of our New Credit Agreement and that they may continue under the terms of any future credit agreement or any future debt or preferred equity securities of ours or of our subsidiaries. These limitations are also more restrictive during the Waiver Period as described herein.
On July 15, 2022, we filed a preliminary shelf registration statement on Form S-3 with the SEC. The Form S-3 was declared effective by the SEC on July 26, 2022 and will remain effective until through July 25, 2025. The Form S-3 allows us to offer and sell from time-to-time up to $100.0 million of Class A common stock, preferred stock, debt securities, warrants, purchase contracts or units comprised of any combination of these securities for our own account and allows certain selling stockholders to offer and sell 17,318,008 shares of Class A common stock in one or more offerings.
The Form S-3 is intended to provide us flexibility to conduct registered sales of our securities, subject to market conditions and our future capital needs. The terms of any future offering under the shelf registration statement will be established at the time of such offering and will be described in a prospectus supplement filed with the SEC prior to the completion of any such offering.
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Liquidity and Capital Resources
The following table shows summary cash flow information for the years ended December 31, 2022 and 2021 (in thousands):
| Year Ended December 31, | ||||||
|---|---|---|---|---|---|---|
| 2022 | 2021 | |||||
| Net cash (used in) provided by operating activities | $ | (40,134) | $ | 87,362 | ||
| Net cash used in investing activities | (78,065) | (27,381) | ||||
| Net cash provided by (used in) financing activities | 54,639 | (28,628) | ||||
| Effect of exchange rates on cash and cash equivalents | (797) | (51) | ||||
| Net change in cash and cash equivalents | $ | (64,357) | $ | 31,302 |
Operating Activities. Our net cash (used in) provided by operating activities consists of net (loss) income adjusted for certain non-cash items, including depreciation and amortization, equity-based compensation, accretion of discount on long-term debt, as well as the effect of changes in working capital and other activities.
Net cash used in operating activities was $40.1 million for the year ended December 31, 2022, compared to net cash provided by operating activities of $87.4 million for the year ended December 31, 2021. Changes in net cash provided by operating activities resulted primarily from cash received from net sales and cash payments for product costs and royalty expenses paid to our licensors. Other drivers of the changes in net cash provided by operating activities include shipping and freight costs, selling, general and administrative expenses (including personnel expenses and commissions and rent and facilities costs) and interest payments made for our short-term borrowings and long-term debt. Our accounts receivable typically are short term and settle in approximately 30 to 90 days.
The decrease for the year ended December 31, 2022 compared to the year ended December 31, 2021 was primarily due to changes in working capital, which decreased net cash provided by operating activities by $51.8 million and were primarily due to decreases in accrued expenses and other liabilities, income taxes payable, increases in prepaid expenses and other assets, and a decrease in net income, excluding non-cash adjustments, driven primarily by a decrease in net income, of $86.4 million, $30.6 million, $11.0 million, and $75.7 million, respectively. These were partially offset by decreases in accounts receivable and inventory of $75.7 million and $25.0 million, respectively.
Investing Activities. Our net cash used in investing activities primarily relates to the purchase of property and equipment and acquisitions, net of cash acquired. For the year ended December 31, 2022, net cash used in investing activities was $78.1 million, which was used for the purchase of property and equipment, primarily related to tooling and molds used for the expansion of product lines and warehouse equipment for the U.S. consolidated warehouse and distribution center. In addition, we used $14.0 million in net cash for the acquisition of Mondo Collectibles LLC (f/k/a Mondo Tees Buyer, LLC) and $5.5 million in net cash to purchase the remaining membership interests in TokenWave, LLC.
For the year ended December 31, 2021, net cash used in investing activities was $27.4 million and was used for the purchase of property and equipment, primarily related to tooling and molds used for the expansion of product lines.
Financing Activities. Our financing activities primarily consist of proceeds from stock issuances, the issuance of long-term debt, net of debt issuance costs, the repayment of long-term debt, payments and borrowings under our line of credit facility, distributions to members and the payment of contingent consideration.
For the year ended December 31, 2022, net cash provided by financing activities was $54.6 million, primarily related to proceeds from net borrowings on the New Revolving Line of Credit of $70.0 million and proceeds of $20.0 million from the Equipment Finance Loan, offset by payments under the Tax Receivable Agreement of $7.7 million, distributions to the Continuing Equity Owners of $10.7 million, and net payments on the Term Loan Facility of $18.0 million.
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For the year ended December 31, 2021, net cash used in financing activities was $28.6 million, primarily related to payments under the Tax Receivable Agreement of $1.7 million, distributions to the Continuing Equity Owners of $9.3 million, and net payments on the Term Loan Facility of $18.4 million, partially offset by $3.8 million proceeds from the exercise of equity-based options.
Financial Condition
Notwithstanding our obligations under the Tax Receivable Agreement between Funko, Inc., FAH, LLC and each of the Continuing Equity Owners, we believe that our sources of liquidity and capital will be sufficient to finance our continued operations, growth strategy, our planned capital expenditures and the additional expenses we incur as a public company for at least the next 12 months.
However, we cannot assure you that our cash provided by operating activities, cash and cash equivalents or, after the end of the Waiver Period cash available under our Revolving Credit Facility will be sufficient to meet our future needs. In particular, though we were in compliance with the financial and other covenants under the New Credit Agreement as of December 31, 2022, subsequent to such date, our projections indicated that we would be unable to maintain compliance with such financial covenants as of March 31, 2023. As a result, on February 28, 2023, we entered into an amendment to the New Credit Agreement (the "Third Amendment") to, among other things, (i) modify the financial covenants under the New Credit Agreement for the period beginning on the date of the Third Amendment through the fiscal quarter ending December 31, 2023 (the “Waiver Period”), (ii) reduce the size of the New Revolving Credit Facility from $215.0 million to $180.0 million as of the date of the Third Amendment and thereafter to $150.0 million on December 31, 2023, which reduction shall be permanent after the Waiver Period, (iii) restrict the ability to draw on the New Revolving Credit Facility during the Waiver Period in excess of the amount outstanding on the date of the Third Amendment, (iv) increase the margin payable under the Credit Facilities during the Waiver Period to (a) 4.00% per annum with respect to any Term Benchmark Loan or RFR Loan (each as defined in the New Credit Agreement), and (b) 3.00% per annum with respect to any Canadian Prime Loan or ABR Loan (each as defined in the New Credit Agreement), (iv) allow that any calculation of Consolidated EBITDA (as defined in the New Credit Agreement) that includes the fiscal quarters during the Waiver Period may include certain agreed upon amounts for certain addbacks, (v) further limit our ability to make certain restricted payments, including the ability to pay dividends or make other distributions on equity interests, or redeem, repurchase or retire equity interests, incur additional indebtedness, incur additional liens, enter into sale and leaseback transactions or issue additional equity interests or securities convertible into or exchange for equity interests (other than the issuance of common stock) during the Waiver Period, (vi) require a minimum cash requirement of at least $10.0 million and (vii) require a mandatory prepayment of the New Revolving Credit Facility during the Waiver Period with any cash proceeds in excess of $25.0 million. Following the Waiver Period, beginning in the fiscal quarter ended March 31, 2024, the Third Amendment resets the maximum Net Leverage Ratio and the minimum Fixed Charge Coverage Ratio (each as defined in the New Credit Agreement) that must be maintained by the Credit Agreement Parties to 2.50:1.00 and 1.25:1.00, respectively, which were the ratios in effect under the New Credit Agreement prior to the Third Amendment. We cannot assure you that we will be able to maintain compliance with our financial covenants as amended after the Waiver Period, or that we will be able to further amend the New Credit Agreement should similar circumstances arise in the future.
If our operating results fail to improve or if we are otherwise unable to maintain compliance with the financial or other covenants under the New Credit Agreement, our lenders could, among other things, continue to refuse to permit any additional borrowings under the New Revolving Credit Facility, terminate all outstanding commitments thereunder and accelerate all outstanding borrowings and other obligations, which would require us to seek additional financing. Even in the absence of such event, if we are unable to generate sufficient cash flows from operations in the future, and if availability under our Revolving Credit Facility is not sufficient after the Waiver Period, we may have to obtain additional financing. If we obtain additional capital by issuing equity, the interests of our existing stockholders will be diluted. If we incur additional indebtedness, that indebtedness may contain significant financial and other covenants that may significantly restrict our operations. We cannot assure you that we could obtain refinancing or additional financing on favorable terms or at all, particularly during the Waiver Period.
As noted above, on September 17, 2021, we entered into the New Credit Facilities which, as amended, are secured by substantially all assets of the Borrowers and any of their existing or future material domestic subsidiaries, subject to customary exceptions.
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The New Term Loan Facility matures on September 17, 2026 (the “Maturity Date”) and amortizes in quarterly installments in aggregate amounts equal to 2.50% of the original principal amount of the New Term Loan Facility, with any outstanding balance due and payable on the Maturity Date. The first amortization payment commenced with the quarter ending on December 31, 2021. The New Revolving Credit Facility also terminates on the Maturity Date and loans thereunder may be borrowed, repaid, and reborrowed up to such date.
Subject to the interest rates during the Waiver Period as described above, loans under the New Credit Facilities will, at the Borrowers’ option, bear interest at either (i) Term SOFR, EURIBOR, HIBOR, CDOR, SONIA and/or the Central Bank Rate, as applicable, plus (x) 2.50% per annum and (y) solely in the case of Term SOFR based loans, 0.10% per annum or (ii) ABR or the Canadian prime rate, as applicable, plus 1.50% per annum, in each case of clauses (i) and (ii), subject to two 0.25% per annum step-downs based on the achievement of certain leverage ratios following July 29, 2022. Each of Term SOFR, EURIBOR, HIBOR, CDOR and Daily Simple SONIA rates are subject to a 0.00% floor. For loans based on ABR, the Central Bank Rate or the Canadian prime rate, interest payments are due quarterly. For loans based on SONIA, interest payments are due monthly. For loans based on Term SOFR, EURIBOR, HIBOR or CDOR, interest payments are due at the end of each applicable interest period.
The New Credit Agreement contains a number of covenants that, among other things and subject to certain exceptions, restrict our ability to:
•incur additional indebtedness;
•incur certain liens;
•consolidate, merge or sell or otherwise dispose of our assets;
•make investments, loans, advances, guarantees and acquisitions;
•pay dividends or make other distributions on equity interests, or redeem, repurchase or retire equity interests;
•enter into transactions with affiliates;
•enter into sale and leaseback transactions in respect to real property;
•enter into swap agreements;
•enter into agreements restricting our subsidiaries’ ability to pay dividends;
•issue or sell equity interests or securities convertible into or exchangeable for equity interests;
•redeem, repurchase or refinance other indebtedness; and
•amend or modify our governing documents.
These limitations are also more restrictive during the Waiver Period as described herein. In addition, the New Credit Agreement requires FAH, LLC and its subsidiaries to comply on a quarterly basis with a maximum Net Leverage Ratio and a minimum fixed charge coverage ratio (in each case, measured on a trailing four-quarter basis) other than during the Waiver Period. The maximum Net Leverage Ratio and the minimum fixed charge coverage ratio for the fiscal quarter ending December 31, 2022 are 2.50:1.00 and 1.25:1.00, respectively, and such ratios will apply again commencing after the Waiver Period for the fiscal quarter ended March 31, 2024.
As of December 31, 2022 and 2021, we were in compliance with all covenants with the New Credit Facilities. Subsequent to the Third Amendment, we expect to maintain compliance with our covenants for at least one year from the issuance of these financial statements based on our current expectations and forecasts. If economic conditions worsen, such as due to the COVID-19 pandemic or international conflict, and negatively impact the Company’s earnings and operating cash flows, this could impact our ability to regain compliance with our amended financial covenants and require the Company to seek additional amendments to our New Credit Agreement.
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The New Credit Agreement also contains certain customary representations and warranties and affirmative covenants, and certain reporting obligations. In addition, the lenders under the New Credit Facilities will be permitted to accelerate all outstanding borrowings and other obligations, terminate outstanding commitments and exercise other specified remedies upon the occurrence of certain events of default (subject to certain grace periods and exceptions), which include, among other things, payment defaults, breaches of representations and warranties, covenant defaults, certain cross-defaults and cross-accelerations to other indebtedness, certain events of bankruptcy and insolvency, certain material monetary judgments and changes of control. The New Credit Agreement defines “change of control” to include, among other things, any person or group other than ACON and its affiliates becoming the beneficial owner of more than 35% of the voting power of the equity interests of Funko, Inc.
As of December 31, 2022, we had $19.2 million of cash and cash equivalents and $111.8 million of working capital, compared with $83.6 million of cash and cash equivalents and $167.6 million of working capital as of December 31, 2021. Working capital is impacted by seasonal trends of our business and the timing of new product releases, as well as our current portion of long-term debt and draw downs on our line of credit. For further discussion of changes in our debt, see below, and Note 10, Debt of the notes to our consolidated financial statements.
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Future Sources and Uses of Liquidity
Sources
As noted above, historically, our primary sources of cash flows have been cash flows from operating activities and borrowings under our Credit Facilities. We expect these sources of liquidity to continue to be our primary sources of liquidity.
Credit Facilities. On September 17, 2021, the Company entered into the New Credit Facilities. For a discussion of our Credit Facilities, see Note 10, Debt of the notes to our consolidated financial statements.
Offerings of Registered Securities. On July 15, 2022, we filed a preliminary shelf registration statement on Form S-3 with the SEC. The Form S-3 was declared effective by the SEC on July 26, 2022 and will remain effective until through July 25, 2025. The Form S-3 allows us to offer and sell from time-to-time up to $100.0 million of Class A common stock, preferred stock, debt securities, warrants, purchase contracts or units comprised of any combination of these securities for our own account and allows certain selling stockholders to offer and sell 17,318,008 shares of Class A common stock in one or more offerings. The terms of any offering under the shelf registration statement will be established at the time of such offering and will be described in a prospectus supplement filed with the SEC prior to the completion of any such offering.
Uses
As noted above, our primary requirements for liquidity and capital are working capital, inventory management, capital expenditures, debt service and general corporate needs. For a description of the Company's future maturities of debt, see Note 10, Debt, and for a description of the Company's operating lease agreements, see Note 11, Leases. See Note 13 "Liabilities under Tax Receivable Agreement" in the Notes to Consolidated Financial Statements included in this Form 10-K for a discussion of our obligations under the Tax Receivable Agreement. See Note 14 "Commitments and Contingencies" in the Notes to Consolidated Financial Statements included in this Form 10-K for a discussion of other material contractual obligations.
Additional future liquidity needs may include tax distributions, the redemption right held by the Continuing Equity Owners that they may exercise from time to time (should we elect to exchange their common units for a cash payment), payments under the Tax Receivable Agreement and general cash requirements for operations and capital expenditures (including future warehouse management system (WMS), additional platforms to support our direct-to-consumer experience, and capital build out of new leased warehouse and office space). The Continuing Equity Owners may exercise their redemption right for as long as their common units remain outstanding. Although the actual timing and amount of any payments that may be made under the Tax Receivable Agreement will vary, we expect that the payments we will be required to make to the TRA Parties will be significant. Any payments made by us to the TRA Parties under the Tax Receivable Agreement will generally reduce the amount of overall cash flow that might have otherwise have been available to us or to FAH, LLC and, to the extent that we are unable to make payments under the Tax Receivable Agreement for any reason, the unpaid amounts generally will be deferred and will accrue interest until paid by us; provided however, that nonpayment for a specified period may constitute a material breach under the Tax Receivable Agreement and therefore may accelerate payments due under the Tax Receivable Agreement.
Seasonality
While our customers in the retail industry typically operate in highly seasonal businesses, we have historically experienced only moderate seasonality in our business. Historically, over 50% of our net sales are made in the third and fourth quarters, primarily in the period from August through November, as our customers build up their inventories in anticipation of the holiday season. Historically, the first quarter of the year has represented the lowest volume of shipment and sales in our business and in the retail and toy industries generally and it is also the least profitable quarter due to the various fixed costs of the business. However, the rapid growth we have experienced in recent years may have masked the full effects of seasonal factors on our business to date, and as such, seasonality may have a greater effect on our results of operations in future periods.
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Recent Accounting Pronouncements
See discussion of recently adopted and recently issued accounting pronouncements in Note 2, Significant Accounting Policies of the notes to our consolidated financial statements.
Critical Accounting Policies and Estimates
Discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and related disclosures of contingent assets and liabilities, revenue and expenses at the date of the consolidated financial statements. We base our estimates on historical experience and on various other assumptions in accordance with U.S. GAAP that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
Critical accounting policies and estimates are those that we consider the most important to the portrayal of our financial condition and operating results and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Our critical accounting policies and estimates include those related to revenue recognition and sales allowances, royalties, inventory, goodwill and intangible assets and income taxes. Changes to these policies and estimates could have a material adverse effect on our results of operations and financial condition.
Revenue Recognition and Sales Allowance. Revenue from the sale of our products is recognized when control of the goods is transferred to the customer, which is upon shipment or upon receipt of finished goods by the customer, depending on the contract terms. The majority of revenue is recognized upon shipment of products to the customer.
We routinely enter into arrangements with our customers to provide sales incentives, support customer promotions, and provide allowances for returns and defective merchandise. These sales adjustments require management to make estimates. In making these estimates, management considers all available information including the overall business environment, historical trends and information from customers, such as agreed upon customer contract terms as well as historical experience from the customer. The estimated costs of these programs reduce gross sales in the period the related sale is recognized. We adjust our estimates at least quarterly or when facts and circumstances used in the estimate process change; historically adjustments to these estimates have not been material.
We have elected to account for shipping and handling activities that occur after control of the related good transfers as fulfillment activities instead of assessing such activities as performance obligations. Accordingly, shipping and handling activities that are performed by us, whether before or after a customer has obtained control of the products, are considered fulfillment costs to satisfy our performance obligation to transfer the products and are recorded as incurred within cost of goods sold.
We have made an accounting policy election to exclude from revenue all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by the Company from a customer (for example, sales, use, value added, and certain excise taxes).
Royalties. We enter into agreements for rights to licensed trademarks, copyrights and likenesses for use in our products. These licensing agreements require the payment of royalty fees to the licensor based on a percentage of revenue. Many licensing agreements also require minimum royalty commitments. When royalty fees are paid in advance, we record these payments as a prepaid asset. If we determine that it is probable that the expected revenue will not be realized, a reserve is recorded against the prepaid asset for the non-recoverable portion. As of December 31, 2022, we recorded a prepaid asset of $13.0 million, net of a reserve of $0.8 million. As of December 31, 2021, we recorded a prepaid asset of $4.7 million, net of a reserve of $0.7 million.
We record a royalty liability as revenues are recognized based on the terms of the licensing agreement. In situations where a minimum commitment is not expected to be met based on expected revenues, we will accrue up to the minimum amount when it is reasonably certain that revenues generated will not meet the minimum commitment. Royalty and license expense is recorded within cost of sales on the consolidated statements of operations. Royalty expenses for the years ended December 31, 2022 and 2021, were $213.1 million and $161.6 million, respectively.
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Inventory. Inventory consists primarily of figures, plush and accessories and other finished goods, and is accounted for using the first-in, first-out, or FIFO, method. Inventory costs include direct product costs and freight costs. We maintain reserves for excess and obsolete inventories to reflect the inventory balance at the lower of cost or net realizable value. This valuation requires us to make judgments, based on currently available information, about the likely method of disposition, through sales to customers, or liquidation, and expected recoverable value of each disposition category. We estimate obsolescence based on assumptions regarding future demand.
Goodwill and Intangible Assets. Goodwill represents the excess of the purchase price over the net amount of identifiable assets acquired and liabilities assumed in a business combination measured at fair value. We evaluate goodwill for impairment annually on October 1 of each year and upon the occurrence of triggering events or substantive changes in circumstances that could indicate a potential impairment by assessing qualitative factors or performing a quantitative analysis in determining whether it is more likely than not that the fair value of the net assets is below their carrying amounts.
Intangible assets acquired in a business combination are recognized separately from goodwill and are initially recognized at their fair value at the acquisition date. Intangible assets acquired include intellectual property (product design), customer relationships, and trade names. These are definite-lived assets and are amortized on a straight-line basis over their estimated useful lives. Intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets might not be recoverable. Conditions that would necessitate an impairment assessment include a significant decline in the observable market value of an asset, a significant change in the extent or manner in which an asset is used, or any other significant adverse change that would indicate that the carrying amount of an asset or group of assets may not be recoverable.
Income Taxes. We apply the provisions of Accounting Standards Codification (“ASC”) Topic No. 740, “Income Taxes” (“ASC 740”). Under ASC 740, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. We record a valuation allowance against our deferred tax assets when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In evaluating our ability to recover our deferred tax assets, we consider all available positive and negative evidence, including our operating results, ongoing tax planning and forecasts of future taxable income on a jurisdiction-by-jurisdiction basis. If we determine we will not be able to fully utilize all or part of these deferred tax assets, we would record a valuation allowance through earnings in the period the determination was made, which would have an adverse effect on our results of operations and earnings. In accordance with ASC 740, we recognize, in our consolidated financial statements, the impact of our tax positions that are more likely than not to be sustained upon examination based on the technical merits of the positions. We recognize interest and penalties for uncertain tax positions in selling, general and administrative expenses.
We are subject to U.S. federal, state and local income taxes with respect to our allocable share of any taxable income of FAH, LLC and are taxed at the prevailing corporate tax rates. FAH, LLC is treated as a partnership for U.S. federal income tax purposes and, as such, generally is not subject to any entity‑level U.S. federal income tax. Instead, taxable income is allocated to holders of its common units, including us. As a result, we incur income taxes on our allocable share of any net taxable income of FAH, LLC. Pursuant to the Second Amended and Restated FAH, LLC Agreement, FAH, LLC will generally make pro rata tax distributions to holders of common units in an amount sufficient to fund all or part of their tax obligations with respect to the taxable income of FAH, LLC that is allocated to them.
Pursuant to the Tax Receivable Agreement, we are required to make cash payments to the TRA Parties equal to 85% of the tax benefits, if any, that we realize, or in some circumstances are deemed to realize, as a result of (1) any redemptions funded by us or exchanges (or deemed exchanges in certain circumstances) of common units for Class A common stock or cash, and (2) certain additional tax benefits attributable to payments under the Tax Receivable Agreement ("Tax Receivable Agreement Payments”). Amounts payable under the Tax Receivable Agreement are contingent upon, among other things, (i) generation of taxable income over the term of the Tax Receivable Agreement and (ii) changes in tax laws. If we do not generate sufficient taxable income in the aggregate over the term of the Tax Receivable Agreement to utilize the tax benefits, then we would not be required to make the related Tax Receivable Agreement Payments. Therefore, we only recognize a liability for Tax Receivable Agreement Payments if we determine that it is probable that we will generate sufficient future taxable income over the term of the Tax Receivable Agreement to utilize the related tax benefits. Estimating future taxable income is inherently uncertain and requires judgment. In projecting future taxable income, we consider our historical results and incorporate certain assumptions, including projected revenue growth, and operating margins, among others.
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Upon redemption or exchange of common units in FAH, LLC, we record a liability relating to the obligation if we believe that it is probable that we would have sufficient future taxable income to utilize the related tax benefits. If we determine in the future that we will not be able to fully utilize all or part of the related tax benefits, we would derecognize any portion of the liability related to the benefits not expected to be utilized.
Additionally, we will estimate the amount of Tax Receivable Agreement Payments expected to be paid within the next 12 months and classify this amount as current on our consolidated balance sheets. This determination is based on our estimate of taxable income for the next fiscal year. To the extent our estimate differs from actual results, we may be required to reclassify portions of our liabilities under the Tax Receivable Agreement between current and non-current.
During years ended December 31, 2022 and 2021, the Company acquired an aggregate of 6.5 million and 3.9 million common units of FAH, LLC, respectively, in connection with the redemption of common units, which resulted in an increase in the tax basis of our investment in FAH, LLC subject to the provisions of the Tax Receivable Agreement. As a result of these exchanges, during the years ended December 31, 2022 and 2021, the Company recognized an increase to its net deferred tax assets in the amount of $30.6 million and $17.2 million, respectively, and corresponding Tax Receivable Agreement liabilities of $30.0 million and $20.7 million, respectively, representing 85% of the tax benefits due to the Continuing Equity Owners. In addition, during the year ended December 31, 2022 and 2021, the Company recognized $4.0 million and $1.6 million, respectively of expenses in other expense, net on our consolidated statements of operations related to remeasurement adjustments of Tax Receivable Agreement liabilities.
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