Honest Company, Inc. (HNST) FY 2022 MD&A

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 consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This discussion, particularly information with respect to our future results of operations or financial condition, business strategy and plans, and objectives of management for future operations, includes forward-looking statements that involve risks and uncertainties as described under the heading “Special Note Regarding Forward-Looking Statements” in this Annual Report on Form 10-K. You should review the disclosure under the heading “Risk Factors” in this Annual Report on Form 10-K for a discussion of important factors that could cause our actual results to differ materially from those anticipated in these forward-looking statements. Unless the context otherwise requires, all references in this Annual Report on Form 10-K to “we,” “us,” “our,” “our company,” "the Company" and “Honest” refer to The Honest Company, Inc. and its consolidated subsidiaries.

A discussion regarding our financial condition and results of operations for the year ended December 31, 2022 compared to the year ended December 31, 2021 is presented below. A discussion regarding our financial condition and results of operations for the year ended December 31, 2021 compared to the year ended December 31, 2020 can be found in Item 7. “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 filed with the Securities and Exchange Commission (“SEC”) on March 28, 2022.

Overview

The Honest Company, Inc. (“Honest” and, together with its consolidated subsidiaries, the “Company,” “we,” “us” and “our”) is a digitally-native consumer products company born in the Gen Z era to make purpose-driven consumer products designed for all people. Our commitment to our core values, continual innovation and engaging our community has differentiated and elevated our brand and our products. Since our launch in 2012, we have been dedicated to developing clean, sustainable, effective and thoughtfully-designed products. By doing so with transparency, we have cultivated deep trust around what matters most to our consumers: their health, their families and their homes. We are an omnichannel brand, ensuring our products are available wherever our consumers shop. Our differentiated platform positions us for continued growth through our trusted brand, award-winning multi-category product offerings, deep digital-first connection with consumers and omnichannel accessibility.

Our integrated multi-category product architecture is intentionally designed to serve our consumers every day, at every age and through every life stage, no matter where they are on their journey. Our three product categories are Diapers and Wipes, Skin and Personal Care, and Household and Wellness, which represented 64%, 28%, and 8%, respectively, of our revenue for the year ended December 31, 2022, compared to 63%, 32%, and 5%, respectively, of our revenue for the year ended December 31, 2021. At the center of our product ecosystem are our diapers, which are a strategic consumer acquisition tool that acts as an entry point for our portfolio, as new parents often go on to purchase products from our other categories for their everyday family needs. Our integrated multi-category product architecture is designed to drive loyalty, increase our consumer wallet share and generate attractive consumer lifetime value.

We believe that our consumers are modern, aspirational, conscious and style-forward and that they seek out high quality, effective and thoughtfully-designed products. We believe that they are passionate about living a conscious life and are enthusiastic ambassadors for brands they trust. As purpose-driven consumers, they transcend any one demographic, spanning gender, age, geography, ethnicity and household income. Honest consumers are often young, mobile-centric and digitally-inclined. We build relationships with these consumers through a disruptive digital marketing strategy that engages them with “snackable” digital content (short-form, easily digestible content), immerses them in our brand values, and inspires them to join the Honest community. Our direct connection with our community enables us to understand what consumers’ needs are and inspires our product innovation pipeline, generating a significant competitive advantage over more traditional consumer packaged goods, or CPG, peers.

Our omnichannel approach seeks to meet consumers wherever they want to shop, balancing deep consumer connection with broad convenience and accessibility. Since our launch, we have built a well-integrated omnichannel presence by expanding our product availability across both Digital and Retail channels, including the launch of strategic partnerships with Target, Amazon and Walmart in 2014, 2017 and 2022, respectively. For the year ended December 31, 2022, we generated 45% and 55% of our revenue from our Digital and Retail channels, respectively, compared to 49% and 51%, respectively, for the year ended December 31, 2021. We maintain direct relationships with our consumers via our flagship digital platform, Honest.com, which allows us to influence brand experience and better understand consumer preferences and behavior. We increase accessibility of our products to more consumers through both the third-party pureplay ecommerce sites that, with Honest.com, comprise our Digital channel, and our Retail channel, which includes leading retailers and their websites. As of December 31, 2022, our products can be found in approximately 50,000 retail locations across the United States, Canada and Europe. Our integrated omnichannel presence provides meaningful benefits to our consumers which we believe is not easily replicated by our

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competitors. This distinctive business model has allowed us to efficiently scale our business while remaining agnostic as to the channel where consumers purchase our products.

Initial Public Offering

On May 7, 2021, we completed our IPO of 25,807,000 shares of our common stock at a stock price of $16.00 per share, resulting in aggregate net proceeds to us of approximately $91.0 million, after deducting the underwriting discount and commissions of $6.7 million and offering expenses of $5.5 million. We sold 6,451,613 shares and certain existing stockholders sold an aggregate of 19,355,387 shares. We granted the underwriters an option for a period of 30 days to purchase up to an additional 3,871,050 shares of common stock from the selling stockholders at $16.00 per share less the underwriting discounts and commissions. In May 2021, the underwriters fully exercised the option to purchase these additional shares from the selling stockholders. We did not receive any proceeds from the sale of shares of our common stock by the selling stockholders.

Key Factors Affecting Our Performance

We believe that the growth of our business and our future success are dependent on many factors. While each of these factors presents significant opportunities for us, they also pose important challenges that we must successfully address to enable us to sustain the growth of our business and improve our operations while staying true to our mission, including those discussed below and in the section of this Annual Report on Form 10-K titled “Item 1A. Risk Factors.”

Ability to Grow Our Brand Awareness

Our brand is integral to the growth of our business and is essential to our ability to engage and stay connected with the growing clean products consumer. Honest is still unknown to many consumers, with unaided brand awareness of 29% among diaper buyers according to our consumer research conducted in January 2022. In order to increase share of wallet of existing conscious consumers and to attract new consumers, our brand has to maintain its trustworthiness and authenticity. Our ability to attract new consumers will depend, among other things, on our ability to successfully produce products that are free of defects and communicate the value of those products as clean, sustainable and effective, the efficacy of our marketing efforts and the offerings of our competitors. Beyond preserving the integrity of our brand, our performance will depend on our ability to augment our reach and increase the number of consumers aware of Honest and our product portfolio. Given higher costs of digital marketing and increased retail distribution, we have and expect to continue to shift the focus of our marketing spend towards supporting retail marketing programs and to make changes in our domestic and global marketing initiatives to increase brand awareness. We believe our brand strength will enable us to continue to expand across categories and channels, allowing us to deepen relationships with consumers and expand our access to global markets. Our performance depends significantly on factors that may affect the level and pattern of consumer spending in the product categories in which we operate.

Continued Innovation

Research, development and innovation are core elements underpinning our growth strategy. Through our in-house research and development laboratories, we are able to access the latest advancements in clean ingredients and continue to innovate in the clean conscious space. Based in Los Angeles, California, our research and development team, including chemists, in-house toxicologists and an eco-toxicologist, develops innovative clean products based on the latest green technology. At Honest, product innovation never stops. The improvement of existing products and the introduction of new products have been, and continue to be, integral to our growth. We have made significant investments in our product development capabilities and plan to continue to do so in the future. We believe our rigorous approach to product innovation has helped redefine and grow the clean and natural product categories in which we operate. Our continued focus on research and development will be central to attracting and retaining consumers in the future. Our ability to successfully develop, market and sell new products will depend on a variety of factors, including our continued investment in innovation, integrated business planning processes and capabilities.

We use connectivity to our community of consumers to provide valuable insights that power innovation across categories. We use innovation to support our growth objectives across our portfolio, as highlighted in the three core pillars of our Innovation Framework: that we bring product innovation that 1) feeds and nurtures our core values, 2) expands within our existing product categories, and 3) grows into new potential product categories adjacent to existing categories that fit with our value proposition to the consumer.

We continue to innovate in each of our product categories in areas such as breakthrough new product formulations, innovative packaging, costovation (defined below) and marketing strategy, with a focus on driving “big bets” across potential product adjacencies where we have: 1) ability to build on our premium positioning, 2) ability to lead and win in a category, and 3) the opportunity to expand into more places within an existing Honest home while positioning ourselves as a premium brand. We are also focused on building a portfolio of products in complementary categories through our Innovation Strategy and the investment in our Digital Strategy. We are building an Honest community with the goal of creating a more holistic clean,

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conscious home for consumers and customers alike. We strive for continuous improvement in our existing products’ safety, sustainability, efficacy and design profile while achieving better performance often at lower cost, which we refer to as costovation.

Continued Product Category Growth

Our product mix is a driver of our financial performance given our focus on accretive product launches and innovation to increase product margins. Even though our growth strategy aims to boost sales across all product categories, we intend to prioritize growth in Skin and Personal Care given its attractive margin characteristics and leverage our brand equity and consumer insights to extend into new adjacent product categories. Since we launched our Innovation Strategy, we have enhanced our product portfolio by strategically discontinuing certain products and making calculated extensions within our three product categories. These product changes have contributed new revenue and brought higher margin products into our portfolio.

Continued Execution of Omnichannel Strategy

The continued execution of our omnichannel strategy impacts our financial performance. We intend to continue leveraging our marketing strategy to drive increased consumer traffic to our flagship digital platform, Honest.com, as it is a valuable tool for creating direct connections with our consumers, influencing brand experience and understanding consumer preference and behavior. Our partnerships with leading third-party retail platforms and national retailers have broadened our consumer reach, raised our brand awareness and enhanced our margins through operating leverage. We will continue to pursue partnerships with a wide variety of retailers, including online retailers, club retailers, grocery stores, drugstores and specialty retailers. Our ability to execute this strategy will depend on a number of factors, such as competitive dynamics and retailers’ satisfaction with the sales and profitability of our products, channel shifts of their customers, and their own supply chain, order timing, and inventory needs, which may fluctuate from period to period.

Operational and Marketing Efficiency

To grow our business, we intend to continue to improve our operational and marketing efficiency, which includes attracting new consumers, increasing community engagement and improving fulfillment and distribution operations. We invest significant resources in marketing and content generation, use a variety of brand and performance marketing channels and work continuously to improve brand exposure at our retail customers to acquire new consumers. It is important to maintain reasonable costs for these marketing efforts relative to the revenue we expect to derive from our consumers. We leverage our proprietary Honest Omni-Analytics to generate valuable consumer insights that guide our omnichannel strategy and inform our marketing spend optimization. Our future success depends in part on our ability to effectively attract consumers on a cost-efficient basis and achieve efficiencies in our operations.

Our paid advertising includes search engine marketing, display, paid social media and product placement and traditional advertising, such as direct mail, television, radio and magazine advertising. Paid advertising costs significantly increased industry-wide in 2021 and 2022, which negatively impacted our ability to cost-effectively drive traffic to Honest.com and contributed to the decline in Digital revenue in 2021 and 2022 as a result of our reduced digital media spending in the face of such higher advertising costs. We drive a significant amount of traffic to our website via search engines and, therefore, rely heavily on search engines. These elevated advertising costs have in 2022 impacted and may in the future impact marketing efficiencies, costs and revenue in our Digital channel.

Overall Macro Trends

We have strategically positioned ourselves to benefit from several macro trends related to changes in consumer behavior. We believe consumers’ increasing interest in purpose-designed products has contributed to higher demand for our products. At the same time, changes in macro-level consumer spending trends, including as a result of the COVID-19 pandemic or broader macroeconomic conditions, such as inflation, have resulted and could in the future result in fluctuations in our operating results. The COVID-19 pandemic in particular has caused general business disruption worldwide since January 2020. The full extent to which the COVID-19 pandemic and these broader macroeconomic conditions will directly or indirectly impact our cash flow, business, financial condition, results of operations and prospects will depend on future developments that are uncertain.

Business Operations

As a result of the COVID-19 pandemic, our headquarters were temporarily closed but have since reopened in a hybrid capacity. During the pandemic we implemented travel restrictions and social distancing measures, including replacing many in-person meetings with virtual interactions, as well as other precautions for the safety of our employees, many of which we have continued. These actions represented a significant change in how we operate our business, but we believe that we successfully

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navigated this transition. We will continue to take actions as may be required or recommended by government or health authorities or as we determine are in the best interests of our employees and business partners in light of the pandemic.

The operations of our retail customers, manufacturers and suppliers have also been impacted by the COVID-19 pandemic. While the duration and extent of the COVID-19 pandemic depends on future developments that cannot be accurately predicted at this time, it has already had an adverse effect on the global economy and the ultimate societal and economic impact of the COVID-19 pandemic remains unknown. In particular, the conditions caused by this pandemic may negatively impact collections of accounts receivable and reduce expected spending from new consumers, all of which could adversely affect our business, financial condition, results of operations and prospects in the future, and has led to tighter inventory management by retailers, which has negatively impacted our revenue and fulfillment operations, and may continue in the future. Prolonged unfavorable economic conditions, including as a result of COVID-19 or similar outbreaks, and any resulting recession or slowed economic growth, have had and may continue to have an adverse effect on our sales and profitability.

Supply Chain Disruptions

We experienced impacts on our inventory availability and delivery capacity during the COVID-19 outbreak. The out-of-stock inventory due to supply chain disruptions was significant on several key items, particularly in our Skin and Personal Care and Diapers and Wipes product categories. In the fourth quarter of 2021, we experienced lower than expected inventory receipts due largely to global supply chain delays, including a delay in receiving shipments from overseas, which we also experienced in the second quarter of 2022. For example, due to new COVID-19 lockdown restrictions in China in the second quarter of 2022, many of the ports shut down which has negatively impacted and may in the future negatively impact our ability to timely receive shipments of our products. To the extent that additional prevention and mitigation measures are implemented in the future, or there is uncertainty about the effectiveness of these or any other measures to contain the spread of COVID-19, there has been and continues to be an adverse impact on global economic conditions and consumer confidence and spending, which has adversely affected our supply chain as well as the demand for our products and has impacted our revenue and ability to service our customer orders. During 2022, we took measures to bolster key aspects of our supply chain, such as increasing inventory levels to support retail distribution growth and longer lead times.

In addition, as a result of the COVID-19 pandemic and other macroeconomic trends, we and our distribution partners have experienced disruptions to the operations of our fulfillment centers, including a nationwide truck driver shortage during the fourth quarter of 2021. For example, an international freight forwarder partner experienced a cybersecurity attack during the first quarter of 2022 resulting in a delay in the shipment and launch of our Beauty Restage products in Europe. Also, in the third quarter of 2022, some of our digital and retail customers began to reduce inventory on hand and have changed fulfillment schedules, which has negatively impacted our fulfillment operations and our revenue and is expected to continue to do so in the future.

We continue to work with our existing manufacturing, logistics and other supply chain partners to ensure our ability to service our consumers and retail and third-party ecommerce customers. We have experienced and anticipate continued increases in commodity prices, labor costs, input costs and transportation costs. For example, some of our contracts with third-party manufacturers have clauses that trigger good faith renegotiation of purchase costs in the case of significant raw material cost escalation. In the fourth quarter of 2021, we were informed by two third-party manufacturers in our Diapers and Wipes and Skin and Personal Care categories, respectively, that those hurdles had been met. In addition, in the third quarter of 2022, we received requests from the same two third-party manufacturers to renegotiate purchase costs due to continued increases in raw material costs. As a result, we negotiated and agreed to higher purchase prices which has negatively impacted our cost of revenue during the year ended December 31, 2022 and will continue to have a negative impact on our results of operations. Due to continued elevated input costs such as fluff pulp, we experienced further escalation of purchase costs and cost of revenue in the fourth quarter of 2022 and anticipate the same in 2023. Additionally, one of our fulfillment partners passed on increased service and inflation related costs to us, including warehouse labor cost, which negatively impacted our cost of revenue. If we are not successful negotiating future renewals, our business, financial condition, results of operations and prospects could be adversely affected.

Moreover, the demand for sustainable packaging and ingredients is outpacing the supply and increasing the cost of these raw materials. For example, there is a supplier shortage or significant demand for and cost impacts to various raw materials used in manufacturing and distributing our products, including post-consumer recycled plastic resin, post-consumer recycled cardboard shipping cartons for our Honest.com shipments, surfactants, fluff pulp and other diaper raw materials.

We implemented price increases that took effect in the first half of 2022 and in December 2022 and plan to take additional price increases in 2023 and in the future as needed to offset current and future input cost inflation and to pursue productivity initiatives to offset inflation. However, we may not be able to increase our prices or productivity sufficiently enough

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to offset these costs. We continue to experience significant increasing input cost levels that have and could continue to hamper our ability to drive margin expansion. Customer demand for our products may change based on price increases.

Consumer Preferences

We believe that during 2020, COVID-19 drove a demand shift towards our Digital channel as consumers shifted to online shopping amid the pandemic. Given our digitally-native brand and strong digital penetration, we believe we benefited from this trend. Additionally, in 2020 we benefited from increasing consumer and customer demand for sanitization and disinfecting products, which drove revenue growth in our Household and Wellness product category. In 2021 and 2022, we saw a significant decline in consumer demand for sanitization and disinfecting products as consumers returned to pre-COVID routines. In addition, retailers continue to manage heavy inventories of these products in stores and warehouse facilities.

In 2021, we began to see increased consumer willingness to return to in-store shopping as the economy reopened and more of the population became vaccinated, driving revenue growth within our Retail channel, specifically within our Diapers and Wipes and Skin and Personal Care product categories. During the year ended December 31, 2022, the Retail channel revenue continued to increase compared to our Digital channel due to this trend as well as expanded and new distribution, marketing efforts and strong retail consumption across product categories.

Inventory

Inventory is reflected at net realizable value which includes a reserve for excess inventory. We estimate reserve requirements based on current and forecasted demand, including the ability to liquidate excess inventory and estimated liquidation value. Given the significant decline in consumer demand for sanitizing and disinfecting products, we recorded an inventory write-down, inclusive of overhead costs and tariffs, of $4.3 million and $5.6 million, during the year ended December 31, 2022 and 2021, respectively, relating to certain sanitization and disinfecting products as the amount of inventory was significantly in excess of existing and projected demand, and we may record inventory write-downs in the future. Included in these inventory write-downs is $1.0 million and $0.7 million of Company earmarked donations of excess sanitization products during the year ended December 31, 2022 and 2021, respectively, which is included in selling, general and administrative expense on the consolidated statements of comprehensive loss. The amount of excess sanitization products donated in future periods may differ from those earmarked for donations. Depending on future consumer behavior in relation to changes in the COVID-19 pandemic, the macroeconomic environment or otherwise and related aging of inventory, among other factors, we may incur additional inventory write-downs, customer returns or incur additional donation expense or disposal costs as we reduce excess inventory.

Due to increasing supply chain lead times, new retail distribution and expectation of supplier price increases that took effect in early 2023, we have increased our inventory levels to ensure in-stock position to service customers and consumers. In addition, inflation in input costs, including higher product costs, inbound shipping and warehouse labor, has resulted in a higher dollar value of inventory. As a result of these factors, during the year ended December 31, 2022, inventory has increased by $40.0 million compared to the year ended December 31, 2021, which mainly represents an increase in quantities on-hand, as well as higher cost per unit due to input cost inflation and higher capitalized costs associated with in-bound freight and warehouse costs.

Inflation Reduction Act of 2022

On August 16, 2022, President Biden signed into law the Inflation Reduction Act of 2022 (the “Act”), which contains provisions that became effective on January 1, 2023, including a 15% corporate minimum tax and a 1% excise tax on stock buybacks. While we are still evaluating the impact of the Act, we do not currently expect any material changes on our consolidated financial position, results of operations and cash flows.

Components of Results of Operations

Revenue

We generate revenue through the sale of our products through Digital and Retail channels in the following product categories: Diapers and Wipes, Skin and Personal Care, and Household and Wellness. The Digital channel includes direct sales to the consumer through our website and sales to third-party ecommerce customers, who resell our products through their own online platforms. The Retail channel includes sales to traditional brick and mortar retailers and their respective websites, who may also resell our products through their own online platforms. Our revenue is recognized net of allowances for returns, discounts, credits and any taxes collected from consumers.

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In 2019, we entered into a license agreement with Butterblu, LLC, or Butterblu, pursuant to which we licensed certain of our trademarks to Butterblu for the manufacture and distribution of certain baby apparel products in exchange for royalties. Butterblu operates and maintains our baby apparel offerings independently through the honestbabyclothing.com website. For the year ended December 31, 2022 and 2021, we collected $1.0 million and $0.9 million, respectively, in royalty revenue related to this license agreement. For the year ended December 31, 2020, we did not collect any royalty revenue under this agreement due in part because we granted Butterblu temporary payment relief. In August 2022, we terminated the license agreement in advance of its expiration date and entered into a supplier services agreement with Butterblu, pursuant to which Butterblu provides certain design, manufacturing, sales and marketing services to us. As part of the supplier services agreement, we acquired all of Butterblu's existing inventory of Honest baby apparel products for $5.5 million, and have agreed to purchase and own inventory for the term of the supplier service agreement which is until December 31, 2026, unless terminated sooner. We entered into this supplier services agreement to create growth opportunities and synergies between our portfolio of products. Butterblu continues to operate and maintain our baby apparel offerings independently through the honestbabyclothing.com website under our supplier services agreement. Honest Baby Clothing® sales are now reflected as revenue in our consolidated statements of operations. For the year ended December 31, 2022, we recognized $10.0 million in revenue, excluding royalty revenue, which was included in our Household and Wellness product category, and $7.7 million of associated cost of revenue.

Cost of Revenue

Cost of revenue includes the purchase price of merchandise sold to customers, inbound and outbound shipping and handling costs, freight and duties, shipping and packaging supplies, credit card processing fees and warehouse fulfillment costs incurred in operating and staffing warehouses, including rent. Cost of revenue also includes depreciation and amortization for warehouse fulfillment facilities and equipment, allocated overhead and direct and indirect labor for warehouse personnel.

Gross Profit and Gross Margin

Gross profit represents revenue less cost of revenue. Gross margin is gross profit expressed as a percentage of revenue. Our gross margin may in the future fluctuate from period to period based on a number of factors, including the mix of products we sell, the channel through which we sell our products, the innovation initiatives we undertake in each product category, the promotional environment in the marketplace, manufacturing costs, commodity prices and transportation rates, among other factors.

Operating Expenses

Our operating expenses consist of selling, general and administrative, marketing and research and development expenses.

Selling, General and Administrative

Selling, general and administrative expenses consist primarily of personnel costs, principally for our selling and administrative functions. These include personnel-related expenses, including salaries, bonuses, benefits and stock-based compensation expense. Selling, general and administrative expenses also include technology expenses, professional fees, facility costs, including insurance, utilities and rent relating to our headquarters, third-party product development and marketing costs, depreciation and amortization and overhead costs. We expect our general and administrative expenses to increase in absolute dollars as we continue to grow our business and organizational capabilities. Since our IPO, we have also incurred additional costs for employees and third-party professional fees related to operating as a public company and costs to comply with the rules and regulations applicable to companies listed on a national securities exchange, costs related to compliance and reporting obligations, and increased expenses for insurance, investor relations and professional services.

Marketing

Marketing expenses include costs related to our branding initiatives, retail customer marketing activities, point of purchase displays, targeted online advertising through sponsored search, display advertising, email and influencer marketing campaigns, market research, content production and other public relations and promotional initiatives. Given higher costs in digital marketing and increased retail distribution, we have shifted the focus of our marketing spend towards supporting retail marketing programs and top of funnel marketing activities. We will continue to invest in marketing initiatives in our product categories and hero products with key retailers, as well as expand brand awareness, introduce new product innovation across multiple product categories and implement new marketing strategies in the United States. As we launch new products, we expect to make marketing investments to build brand awareness, drive trial and set the foundation for future revenue growth.

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Research and Development

Research and development expenses consist primarily of personnel-related expenses for our research and development team. Research and development expenses also include costs incurred for the development of new products, improvement in the quality of existing products and the development and implementation of new technologies to enhance the quality and value of products. This includes the expense related to claims and clinical trials as well as formulation and packaging testing. Research and development expenses also include allocated depreciation and amortization and overhead costs. We expect research and development expenses to increase in absolute dollars as we invest in the enhancement of our product offerings through innovation and the introduction of new adjacent product categories.

IPO-Related Expenses

After the closing of the IPO, we paid $9.5 million in bonuses to certain employees, including members of management, excluding in each case payroll taxes and expenses. The bonus was recognized in selling, general and administrative and research and development expense. In addition, upon the effective date of the registration statement for our IPO in May 2021, we recognized stock-based compensation expense in selling, general and administrative and research and development expenses of $3.1 million related to certain performance and market-based stock options and $0.2 million related to certain restricted stock units that vested upon this liquidity event.

Interest and Other Income (Expense), Net

Interest income consists primarily of interest income earned on our short-term investments and our cash and cash equivalents balances. Prior to the adoption of Financial Accounting Standards Board Accounting Standard Update No 2016-02, Leases (ASC 842) on January 1, 2022, interest expense consisted primarily of the portion of rent payments recognized as imputed interest expense under build-to-suit accounting associated with our leasing arrangements.

Other income (expense), net consists of our foreign currency exchange gains, losses relating to transactions denominated in currencies other than the U.S. dollar and contingent gains. We expect our foreign currency gains and losses to continue to fluctuate in the future due to changes in both the volume of foreign currency transactions and foreign currency exchange rates.

Income Tax Provision

We are subject to federal and state income taxes in the United States. Our annual estimated tax rate differed from the U.S. federal statutory rate of 21% primarily as a result of a valuation allowance against deferred tax assets, stock-based compensation, state taxes, nondeductible executive compensation and other permanent differences. We maintain a full valuation allowance for our federal and state deferred tax assets, including net operating loss carryforwards, as we have concluded that it is not more likely than not that the deferred tax assets will be realized.

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Results of Operations

The following table sets forth our consolidated statements of operations data for each of the periods indicated:

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(1)    Includes stock-based compensation expense as follows:

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The following table sets forth our consolidated statements of operations data expressed as a percentage of revenue*:

* Amounts may not sum due to rounding.

Comparison of the Year Ended December 31, 2022 and 2021

Revenue

Revenue was $313.7 million for the year ended December 31, 2022, as compared to $318.6 million for the year ended December 31, 2021. The decrease of $5.0 million, or 1.6%, was primarily due to a $12.4 million decrease in revenue from Skin and Personal Care products and a $0.5 million decrease in revenue from Diapers and Wipes, offset by a $7.9 million increase in revenue from Household and Wellness products. The revenue decrease from Skin and Personal Care was primarily driven by a decrease of $8.5 million in revenue related to a rotational program with a key club retailer that occurred during the year ended December 31, 2021 and did not occur during the year ended December 31, 2022 and a $4.7 million in liquidation sales in advance of our Beauty Restage to clear out legacy inventory, partially offset by higher consumption, price increases and distribution gains. The revenue decrease in Diapers and Wipes was primarily driven by a decrease in diaper revenue due to lower traffic, lower bundle subscribers and decreased revenue in our Digital channel as the price of digital marketing escalated and impacted our ability to cost-effectively drive traffic to our Honest.com and digital customers and led us to shift our advertising budget toward our Retail channel, partially offset by an increase in our wipes revenue, price increases in both Diapers and Wipes and distribution gains. The revenue increase in Household and Wellness was primarily driven by $10.0 million in revenue from Honest Baby

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Clothing as a result of our transition from a license agreement to a supplier services agreement with Butterblu, partially offset by a $2.3 million decrease in sanitization and disinfecting products revenue.

We estimate that pricing increases taken in the first half of 2022 contributed $10.3 million to revenue for the year ended December 31, 2022.

Revenue increased in our Retail channel for the year ended December 31, 2022, compared to the year ended December 31, 2021, primarily due to an increase in revenue across product categories related to new retail distribution gains and strong consumption growth at existing and new retail customers, partially offset by two rotational programs (sanitization and disinfecting and baby and personal care) with a key club customer during the year ended December 31, 2021, that did not occur during the year ended December 31, 2022. The decrease in revenue in our Digital channel for the year ended December 31, 2022, compared to the year ended December 31, 2021, was primarily due to higher digital marketing costs which impacted the ability to cost-effectively drive traffic to Honest.com and our digital customers, as well as a key digital customer that reduced its weeks of supply of inventory and experienced lower diaper and wipes bundle subscribers.

Cost of Revenue and Gross Profit

Cost of revenue was $221.3 million for the year ended December 31, 2022, as compared to $209.5 million for the year ended December 31, 2021. The increase of $11.9 million, or 5.7%, was primarily due to higher fulfillment costs, especially in transportation, freight and warehouse labor costs, higher product costs, driven by increased product costs for our diapers and personal care products, higher revenue from Honest Baby Clothing, as well as rent expense related to our warehouse facility due to the derecognition of our built-to-suit lease as a result of the adoption of ASC 842 (previously recognized in interest expense). Cost of revenue as a percentage of revenue increased by 483 basis points primarily due to higher input costs, along with higher trade promotion levels as compared to the year ended December 31, 2021, partially offset by pricing increases implemented in the first half of 2022 and cost reduction projects.

Gross profit was $92.3 million for the year ended December 31, 2022, as compared to $109.2 million for the year ended December 31, 2021. The decrease of $16.9 million, or 15.4%, was primarily due to the decrease in revenue in our Skin and Personal Care product category, higher input costs, including higher fluff pulp costs and higher raw material prices from manufacturers, and higher fulfillment costs, higher levels of promotional spending and fixed cost deleverage, partially offset by the increase in revenue in our Household and Wellness product category, pricing increases implemented in the first half of 2022 and cost savings.

Operating Expenses

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $87.3 million for the year ended December 31, 2022, as compared to $84.1 million for the year ended December 31, 2021. The increase of $3.3 million, or 3.9%, was primarily due to $5.8 million in CEO transition expenses, a $3.9 million increase in legal fees, a $2.0 million increase in service fees related to the Honest Baby Clothing servicing agreement, a $1.3 million in advanced shipping vendor violation charges related to implementation of our new order management system and a $1.1 million increase in donation expense, partially offset by non-recurring IPO related expenses for the year ended December 31, 2021 that did not occur during the year ended December 31, 2022. The IPO-related expenses during the year ended December 31, 2021 included $9.1 million in bonus payments made to certain employees, including members of management, excluding payroll taxes and expenses, $1.9 million in stock-based compensation expense related to the vesting of performance based awards and $1.0 million in accounting expenses related to the IPO during the year ended December 31, 2021.

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Marketing Expenses

Marketing expenses were $47.8 million for the year ended December 31, 2022, as compared to $54.3 million for the year ended December 31, 2021. The decrease of $6.5 million, or 11.9%, was primarily due to a strategic shift in digital marketing spend in the face of higher advertising costs to our Retail channel reflecting lower marketing spend of $4.8 million at Honest.com and $2.5 million with a key digital customer, offset by an increase in marketing expenses in our Retail channel.

Research and Development Expenses

Research and development expenses were $7.0 million for the year ended December 31, 2022, as compared to $7.7 million for the year ended December 31, 2021. The decrease of $0.7 million, or 8.9%, was primarily related to a $0.5 million decrease in stock-based compensation expense.

Interest and Other Income (Expense), Net

Interest and other income, net were $0.9 million for the year ended December 31, 2022, as compared to interest and other expense, net of $1.8 million for the year ended December 31, 2021. The increase of $2.6 million, or 149.0%, was primarily due to a decrease in interest expense related to the derecognition of our built-to-suit lease as a result of the adoption of ASC 842, as well as an increase in interest earned on investments. Under the new lease accounting, all lease expenses related to the built-to-suit lease are included in cost of revenue. Additionally, during the year ended December 31, 2022, $0.7 million of other income was related to the recognition of taxes and interest to be refunded from the Nevada Department of Taxation legal settlement. Refer to Note 11, “Commitments and Contingencies,” to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information on the legal settlement.

Liquidity and Capital Resources

We have incurred net losses and net cash outflows from operating activities since our inception. Prior to our IPO, our available liquidity and operations were financed primarily through the sale of redeemable convertible preferred stock, equity securities and to a lesser extent, debt financing. Upon the closing of our IPO, we received net proceeds of approximately $91.0 million, after deducting underwriting discounts and commissions of $6.7 million and offering expenses of $5.5 million. As of December 31, 2022, we had $9.5 million of cash and cash equivalents and $5.7 million of short-term investments. Although we are dependent on our ability to generate sufficient cash flow from operations or raise capital to achieve our business objectives, we believe our existing cash, cash equivalents and short-term investments will be sufficient to meet our short-term and long-term working capital and capital expenditure needs, given our plan to generate positive cash flow from reducing our inventory and the availability under our 2023 Credit Facility. Refer to 17, "Subsequent Events" included in the consolidated financial statements for more information on the 2023 Credit Facility. Future capital requirements will depend on many factors, including our rate of revenue growth, gross margin and the level of expenditures in all areas of the Company. To the extent that existing capital resources and sales growth are not sufficient to fund future activities, we will need to raise capital through additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all. Failure to raise additional capital, if and when needed, could have a material adverse effect on our financial position, results of operations, and cash flows.

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2021 Credit Facility

In April 2021, we entered into a first lien credit agreement (the “2021 Credit Facility”), with JPMorgan Chase Bank, N.A., as administrative agent and lender, and the other lenders party thereto, which provided for a $35.0 million revolving credit facility that matures on April 30, 2026. The 2021 Credit Facility included a subfacility that provided for the issuance of letters of credit in an amount of up to $10.0 million at any time outstanding, which reduced the amount available under the 2021 Credit Facility.

As of December 31, 2022, there were outstanding standby letters of credit of $4.8 million related to lease obligations with $30.2 million available to be drawn upon. The 2021 Credit Facility was subject to customary fees for loan facilities of this type, including a commitment fee based on the average daily undrawn portion of the revolving credit facility. We recognized the commitment fee as incurred in interest and other income (expense), net in the consolidated statements of comprehensive loss. For the year ended December 31, 2022 and 2021, the commitment fee incurred was immaterial. The interest rate applicable to the 2021 Credit Facility was, at our option, either (a) the LIBOR (or a replacement rate established in accordance with the terms of the 2021 Credit Facility) (subject to a 0.00% LIBOR floor), plus a margin of 1.50% or (b) the CB floating rate minus a margin of 0.50%. The CB floating rate is the higher of (a) the Wall Street Journal prime rate and (b)(i) 2.50% plus (ii) the adjusted LIBOR rate for a one-month interest period.

As of December 31, 2022, there was no outstanding balance under the 2021 Credit Facility we were in compliance with the covenants under this facility.

In January 2023, upon entry into the 2023 Credit Facility, the Company’s 2021 Credit Facility was terminated. Refer to Note 8, "Credit Facilities" and 17, "Subsequent Events" included in the consolidated financial statements for more information on the termination of the 2021 Credit Facility.

2023 Credit Facility

In January 2023, we entered into a first lien credit agreement (the “2023 Credit Facility”), with JPMorgan Chase Bank, N.A., as administrative agent and lender, and the other lenders party thereto, which provides for a $35.0 million revolving credit facility that matures on April 30, 2026. The 2023 Credit Facility includes a subfacility that provides for the issuance of letters of credit in an amount of up to $15.0 million at any time outstanding, which reduced the amount available under the 2021 Credit Facility. Availability of the 2023 Credit Facility will be based upon a borrowing base formula and periodic borrowing base certifications valuing certain of the Company’s accounts receivable and inventory as reduced by an availability block and certain reserves, if any. The 2023 Credit Facility includes an uncommitted accordion feature that allows for increases in the revolving commitment to as much as an additional $35.0 million, for up to $70.0 million in potential revolving commitment. The 2023 Credit Facility is subject to customary fees for loan facilities of this type, including a commitment fee based on the average daily undrawn portion of the 2023 Credit Facility.

The interest rate applicable to the 2023 Credit Facility will be, at the Company’s option, either (a) the Adjusted Term SOFR rate (subject to a 0.00% floor), plus a margin ranging from 1.50% to 2.25% or (b) the CB floating rate, (i) plus a margin of 0.25% or (ii) minus a margin ranging from 0.25% to 0.50%. The margin will be based upon the Company’s fixed charge coverage ratio. The CB floating rate is the highest of (a) the Wall Street Journal prime rate and (b) 2.50%.

The 2023 Credit Facility will terminate and borrowings thereunder, if any, will be due in full on April 30, 2026. Debt under the 2023 Credit Facility will be guaranteed by substantially all of the Company’s material domestic subsidiaries and will be secured by substantially all of the Company’s and such subsidiaries’ assets.

The Company is subject to certain affirmative and negative covenants including the requirement that it maintains a minimum total fixed charge coverage ratio during the periods set forth in the 2023 Credit Facility and also includes customary events of default. The 2023 Credit Facility contains covenants that restrict, among other things, the Company's ability to sell assets, make investments and acquisitions, grant liens, change the Company’s lines of business, pay dividends and make certain other restricted payments. Failure to do so, unless waived by the lenders under the 2023 Credit Facility pursuant to its terms, as amended, would result in an event of default under the 2023 Credit Facility.

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Cash Flows

The following table summarizes our cash flows for the periods presented:

Operating Activities

Our largest source of operating cash is from the sales of our products through Digital and Retail channels to our consumers and customers. Our primary uses of cash from operating activities are for cost of revenue expenses, selling, general and administrative expenses, marketing expenses and research and development expenses. We have generated negative cash flows from operating activities and have supplemented working capital requirements through net proceeds from the sale and maturity of short-term investments.

Net cash used in operating activities of $76.3 million for the year ended December 31, 2022 was primarily due to net loss of $49.0 million, non-cash adjustments of $24.2 million and a net decrease in cash related to changes in operating assets and liabilities of $51.4 million. Non-cash adjustments primarily consisted of stock-based compensation of $15.1 million, amortization of operating ROU assets of $6.2 million and depreciation and amortization of $2.8 million. Changes in cash flows related to operating assets and liabilities primarily consisted of a $40.0 million increase in inventory reflecting cost inflation (inclusive of the purchase of $5.5 million of Honest Baby Clothing inventory from Butterblu), an increase in weeks of supply due to longer lead times, as well as in advance of new distribution and an additional investment in advance of supplier price increases that took effect in early 2023, a $10.6 million increase in accounts receivable due to growth in Retail channel revenue, a $4.4 million increase in prepaid expenses and other assets due to timing of payments, offset by a $10.4 million use of cash due to the timing of payments associated with our accounts payable, accrued expenses and a $7.0 million use of cash due to operating lease obligations.

Net cash used in operating activities of $38.2 million for the year ended December 31, 2021 was primarily due to net loss of $38.7 million, non-cash adjustments of $21.3 million and a net decrease in cash related to changes in operating assets and liabilities of $20.8 million. Non-cash adjustments primarily consisted of stock-based compensation of $16.8 million and depreciation and amortization of $4.1 million. Changes in cash flows related to operating assets and liabilities primarily consisted of a $9.0 million increase in accounts receivable due to higher revenue from retail customers, $6.7 million use of cash due to the timing of payments associated with our accounts payable and operating leasing obligations, a $6.1 million increase in prepaid expenses and other assets due to timing of payments, as well as the non-monetary sale of our legacy beauty inventory for future marketing and transportation credits and a $1.0 million decrease in inventory due to timing of inventory purchases.

Investing Activities

Our primary source of investing cash is the sale and maturity of short-term investments and our primary use of investing cash is the purchase of short-term investments and property and equipment.

Net cash provided by investing activities of $35.0 million for the year ended December 31, 2022 was due to purchases of short-term investments of $12.8 million, offset by proceeds from the maturities of short-term investments of $49.4 million.

Net cash used in investing activities of $8.6 million for the year ended December 31, 2021 was due to purchases of short-term investments of $65.3 million, offset by proceeds from the sales and maturities of short-term investments of $27.4 million and $29.5 million, respectively.

Financing Activities

Our financing activities primarily consisted of proceeds from sales of securities, payment of offering costs, proceeds from stock option award exercises and principal payments of financing lease obligations.

Net cash provided by financing activities of $38.4 thousand for the year ended December 31, 2022 primarily consisted of proceeds from stock option exercises and the 2021 ESPP, partially offset by principal payments of financing lease obligations.

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Net cash provided by financing activities of $60.4 million for the year ended December 31, 2021 primarily consisted of proceeds from our IPO of $96.5 million, net of underwriting discounts and commissions and proceeds from the exercise of stock options of $5.7 million, offset by dividend payments of $35.0 million and payments of offering costs in connection with our IPO of $5.5 million.

Dividends

In April 2021, our board of directors declared a cash dividend of $35.0 million to the holders of record of our common stock and our redeemable convertible preferred stock as of May 3, 2021, which we paid on June 29, 2021 (the “2021 Dividend”). Other than the 2021 Dividend, we have not declared or paid cash dividends on our capital stock, and we do not anticipate declaring or paying any cash dividends other than the 2021 Dividend in the foreseeable future. Any future determination regarding the declaration and payment of dividends, if any, will be at the discretion of our board of directors and will depend on then-existing conditions, including our financial condition, operating results, contractual restrictions (including any restrictions in our then-existing debt arrangements), capital requirements, business prospects and other factors our board of directors may deem relevant. The 2023 Credit Facility contains restrictions on our ability to pay dividends. Refer to Note 17, "Subsequent Events" included in these consolidated financial statements for more information on the 2023 Credit Facility.

Non-GAAP Financial Measure

We prepare and present our consolidated financial statements in accordance with GAAP. However, management believes that adjusted EBITDA, a non-GAAP financial measure, provides investors with additional useful information in evaluating our performance.

We calculate adjusted EBITDA as net income (loss), adjusted to exclude: (1) interest and other (income) expense, net; (2) income tax provision; (3) depreciation and amortization; (4) stock-based compensation expense, including payroll tax; (5) the IPO bonus in the second quarter of 2021, including associated payroll taxes and expenses, and third-party costs associated with our IPO in 2021; (6) litigation and settlement fees associated with certain non-ordinary course securities litigation claims; and (7) CEO transition expenses.

Adjusted EBITDA is a financial measure that is not required by, or presented in accordance with GAAP. We believe that adjusted EBITDA, when taken together with our financial results presented in accordance with GAAP, provides meaningful supplemental information regarding our operating performance and facilitates internal comparisons of our historical operating performance on a more consistent basis by excluding certain items that may not be indicative of our business, results of operations or outlook. In particular, we believe that the use of adjusted EBITDA is helpful to our investors as it is a measure used by management in assessing the health of our business, determining incentive compensation and evaluating our operating performance, as well as for internal planning and forecasting purposes.

Adjusted EBITDA is presented for supplemental informational purposes only, has limitations as an analytical tool and should not be considered in isolation or as a substitute for financial information presented in accordance with GAAP. Some of the limitations of adjusted EBITDA include that (1) it does not reflect capital commitments to be paid in the future; (2) although depreciation and amortization are non-cash charges, the underlying assets may need to be replaced and adjusted EBITDA does not reflect these capital expenditures; (3) it does not consider the impact of stock-based compensation expense; (4) it does not reflect other non-operating expenses, including interest expense; (5) it does not include the IPO bonus, including associated payroll taxes and expenses, or third-party costs associated with the preparation of the IPO; (6) it does not reflect tax payments that may represent a reduction in cash available to us; and (7) does not include certain non-ordinary cash expenses that we do not believe are representative of our business on a steady-state basis, such as CEO transition expenses. In addition, our use of adjusted EBITDA may not be comparable to similarly titled measures of other companies because they may not calculate adjusted EBITDA in the same manner, limiting its usefulness as a comparative measure. Because of these limitations, when evaluating our performance, you should consider adjusted EBITDA alongside other financial measures, including our net income (loss) and other results stated in accordance with GAAP.

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The following table presents a reconciliation of net income (loss), the most directly comparable financial measure stated in accordance with GAAP, to adjusted EBITDA, for each of the periods presented:

____________

(1)    Includes IPO-related costs, including IPO bonus and transaction-related third-party expenses, which are generally incremental costs incurred associated with the preparation of the IPO.

(2)     Includes consulting fee, severance, and legal fees related to our former CEO, as well as recruiting fees, among other related costs.

Material Cash Requirements

We lease warehouse and office facilities under operating and finance lease agreements. We have unconditional purchase commitments for software service subscriptions, advertising services and certain other services. See Note 11, “Commitments and Contingencies,” to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K for more information on our short-term and long-term leases and purchase obligations.

Recent Accounting Pronouncements

Refer to Note 2, "Summary of Significant Accounting Policies," to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a discussion of recently issued accounting pronouncements not yet adopted and recently adopted accounting pronouncements.

Critical Accounting Policies and Estimates

We believe that the following accounting policies involve a high degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of our operations. See Note 2, "Summary of Significant Accounting Policies," to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a description of our other significant accounting policies. The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and judgments that affect the amounts reported in those financial statements and accompanying notes. Although we believe that the estimates we use are reasonable, due to the inherent uncertainty involved in making those estimates, actual results reported in future periods could differ from those estimates.

Revenue Recognition

We generate revenue through the sale of our products through Digital and Retail channels in the following product categories: Diapers and Wipes, Skin and Personal Care and Household and Wellness. The Digital channel includes direct to the consumer sales through our website and sales to third-party ecommerce customers, who resell our products through their own online platforms. The Retail channel includes sales to traditional brick and mortar retailers, who may also resell our products through their own online platforms. Our revenue is recognized net of allowances for returns, discounts, credits and any taxes collected from customers.

We account for revenue contracts with customers by applying the following steps in accordance with Accounting Standard Codification, or ASC, 606, Revenue from Contracts with Customers:

•Identification of the contract, or contracts, with a customer

•Identification of the performance obligations in the contract

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•Determination of the transaction price

•Allocation of the transaction price to the performance obligations in the contract

•Recognition of revenue when, or as, we satisfy a performance obligation

We elected an accounting policy to record all shipping and handling costs as fulfillment costs. We accrue the cost of shipping and handling and recognize revenue and costs at the point in time that control of the goods transfers to the customer.

Direct-to-Consumer

For direct sales to the consumer through our website, our performance obligation consists of the sale of finished goods to the consumer. Consumers may purchase products at any time or enter into subscription arrangements. Consumers place orders online in accordance with our standard terms and conditions and authorize payment when the order is placed. Credit cards are charged at the time of shipment. For subscription arrangements, consumers sign up to receive products on a periodic basis. Subscriptions are cancellable at any time without penalty, and no amounts are collected from the consumer until products are shipped. Revenue is recognized when transfer of control to the consumer takes place, which is when the product is delivered to the carrier. Sales taxes collected from consumers are accounted for on a net basis and are excluded from revenue.

Consumers may purchase gift cards, which are recorded as deferred revenue at the time of purchase. We recognize revenue when these gift cards are redeemed for products and the revenue recognition criteria as described above have been met.

Retail and Third-Party Ecommerce

For retail and third-party ecommerce sales, our performance obligation consists of the sale of finished goods to retailers and third-party ecommerce customers. Revenue is recognized when control of the promised goods is transferred to those customers at time of shipment or delivery, depending on the contract terms. After the completion of the performance obligation, we have the right to consideration as outlined in the contract. Payment terms vary among the retail and third-party ecommerce customers although terms generally include a requirement of payment within 30 to 45 days of product shipment.

Sales Returns and Allowances

For direct-to-consumer, retail and third-party ecommerce sales, we record estimated sales returns in the same period that the related revenue is recorded. We use the expected value method to estimate returns, taking into consideration assumptions of demand based on historical data and historical returns rates. When estimating returns, we also consider future business initiatives and relevant anticipated future events. Estimated sales returns and ultimate losses may vary from actual results, which could be material to the consolidated financial statements. The estimated sales returns allowance is recorded as a reduction in revenue.

For direct-to-consumer, retail and third-party ecommerce sales, we offer credits in the form of discounts, which are recorded as reductions in revenue and are allocated to products on a relative basis based on their respective standalone selling price.

For retail and third-party ecommerce sales, we routinely commit to one-time or ongoing sales incentive programs that may require us to estimate and accrue the expected costs of such programs, including trade promotion activities and contractual allowances. We record these programs as a reduction to revenue unless we receive a distinct benefit in exchange for credits claimed by the customer and can reasonably estimate the fair value of the benefit received, in which case we record the programs as marketing expense. We recognize a liability or a reduction to accounts receivable, and reduce revenue based on the estimated amount of credits that will be claimed by customers. An allowance is recorded as a reduction to accounts receivable if the customer can deduct the program amount from the outstanding invoice.

Estimates for these sales incentive programs are developed using the most likely amount and are included in the transaction price to the extent that a significant reversal of revenue would not result once the uncertainty is resolved. In developing our estimate, we use historical analysis and contractual rates in determining the accruals for these activities. Also, we consider the susceptibility of the incentive to outside influences, the length of time until the uncertainty is resolved, and our experience with similar contracts. Judgment is required to determine the timing and amount of recognition of sales incentive program accruals which we estimate based on past practice with similar arrangements.

Inventories

Inventories consists of finished goods and are stated at the lower of cost or estimated net realizable value. Cost is computed based on weighted-average historical costs. We allocate certain overhead costs to the carrying value of our finished goods. The carrying value of inventories is reduced for any excess and obsolete inventory. Excess and obsolete inventory

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reductions are determined based on assumptions about future demand and sales prices, estimates of the impact of competition, and the age of inventory. If actual conditions are less favorable than those previously estimated by management, additional inventory write-downs could be required.

Stock-Based Compensation

We recognize stock-based compensation expense for employees and non-employees based on the grant-date fair value of stock awards over the applicable service period. For awards that vest based on continued service, stock-based compensation cost is recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the awards. For awards with performance vesting conditions, stock-based compensation cost is recognized on a graded vesting basis over the requisite service period when it is probable the performance condition will be achieved.

The determination of stock-based compensation cost is inherently uncertain and subjective and involves the application of valuation models and assumptions requiring the use of judgment. If factors change and different assumptions are used, stock-based compensation expense and net losses could be significantly different.

Income Taxes

Income taxes are accounted for using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statement and tax basis of assets and liabilities and are measured using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates or tax law on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.

A valuation allowance is provided on deferred tax assets when it is determined that it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

We recognize the tax benefit from uncertain tax positions only if it is more likely than not that the tax positions will be sustained on examination by the tax authorities, based on the technical merits of the position. The tax benefit is measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. We recognize interest and penalties related to income tax matters in income tax expense.

Emerging Growth Company Status

In April 2012, the JOBS Act was enacted. Section 107(b) of the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to take advantage of the extended transition period to comply with new or revised accounting standards and to adopt certain of the reduced disclosure requirements available to emerging growth companies. As a result of the accounting standards election, we are not subject to the same implementation timing for new or revised accounting standards as other public companies that are not emerging growth companies which may make comparison of our financials to those of other public companies more difficult.