**U.S.Securities and Exchange Commission**

**Washington,D.C. 20549**

** **

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** **

**Form 10-QSB**

** **

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** **

**(Mark One)**

 

**ý****                                ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the quarterly period ended March 31, 2006**

 

**o****                                ****TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

 

**For the transition period from                         to                         **

 

**Commission file no. 0-24921**

 

**Power3Medical Products, Inc.**

(Exact name of smallbusiness issuer as specified in its charter)

 

| **New York**                     | ** ** | **65-0565144**      |
|----------------------------------|------------|---------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer    |
| incorporation or  organization)  |       | Identification No.) |

 

**3400 Research Forest Drive, Suite B2-3**

**Woodlands, Texas 77381**

(Address of principalexecutive offices)

 

**(281) 466-1600**

(Issuer’s telephonenumber)

 

Check whether the issuer (1) filed allreports required to be filed by Section 13 or 15(d) of the Exchange Actduring the past 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  o  No  ý

 

Indicate by check mark whetherthe registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes o  No ý

 

As of March 31, 2006, there were 69,600,348 shares of voting common stock of theregistrant issued and outstanding.

 

Transitional Small Business Disclosure Format(check one): Yes  o  No  ý

 

 

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**INDEX**

 
| PART  I. FINANCIAL INFORMATION                                          |   |
|-------------------------------------------------------------------------|--------|
|                                                                    |   |
| Item 1. Financial Statements                                       |   |
|                                                                    |   |
| Condensed Balance Sheet (unaudited)                                     |   |
|                                                                    |   |
| Condensed Statements of Operations (unaudited)                          |   |
|                                                                    |   |
| Condensed Statement of Cash Flows  (unaudited)                          |   |
|                                                                    |   |
| Notes to Condensed Financial Statements  (unaudited)                    |   |
|                                                                    |   |
| Item 1. Organization, Principal Activities  and Basis of Presentation   |   |
|                                                                    |   |
| Item 2. Management’s  Discussion and Analysis or Plan of Operation |   |
|                                                                    |   |
| Item 3. Controls  and Procedures                                        |   |
|                                                                    |   |
| Part II. OTHER INFORMATION                                              |   |
|                                                                    |   |
| Item 1. Legal Proceedings                                               |   |
|                                                                    |   |
| Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds    |   |
|                                                                    |   |
| Item 3. Defaults  upon Senior Securities                                |   |
|                                                                    |   |
| Item 4.  Submission of Matters to a Vote of Security Holders            |   |
|                                                                    |   |
| Item 5. Other Information                                               |   |
|                                                                    |   |
| Item 6. Exhibits                                                        |   |
|                                                                    |   |
| SIGNATURES                                                              |   |

 

2

----

 

**I. FINANCIAL INFORMATION**

 

**Item 1.Financial Statements**

** **

**POWER3 MEDICAL PRODUCTS, INC.**

**(A Development Stage Enterprise)**

**CONDENSED BALANCE SHEET AS OF March 31, 2006**

**(unaudited)**

** **
| **ASSETS**                                                                                             |   |        |       |
|--------------------------------------------------------------------------------------------------------|--------|-------------|------------|
| CURRENT ASSETS                                                                                         |   |        |       |
| Cash and cash equivalents                                                                              |   | $           | 163,191    |   |
| All Other Current Assets                                                                               |   | 36,149      |       |
| Total Current Assets                                                                                   |   | 199,340     |       |
| FIXED ASSETS                                                                                           |   |        |       |
| Furniture, Fixtures and Equipment  (Net of accumulated depreciation of $72,004)                        |   | 63,930      |       |
| Intellectual Property                                                                                  |   | 179,786     |       |
| Total Fixed Assets                                                                                     |   | 243,716     |       |
| OTHER ASSETS                                                                                           |   |        |       |
| Goodwill                                                                                               |   | 13,371,776  |       |
| Deferred Finance Costs                                                                                 |   | 284,715     |       |
| Deposits                                                                                               |   | 25,900      |       |
| Total Other Assets                                                                                     |   | 13,682,391  |       |
|                                                                                                   |   |        |       |
| **TOTAL ASSETS**                                                                                       |   | $           | 14,125,447 |   |
|                                                                                                   |   |        |       |
| **LIABILITIES AND STOCKHOLDER’S EQUITY**                                                          |   |        |       |
| CURRENT LIABILITIES                                                                                    |   |        |       |
| Accounts Payable                                                                                       |   | $           | 998,007    |   |
| Notes Payable-in default                                                                               |   | 2,089,131   |       |
| Convertible  Debentures-in default                                                                     |   | 107,280     |       |
| Other Current Liabilities                                                                              |   | 945,663     |       |
| Derivative  Liabilities                                                                                |   | 1,975,089   |       |
|                                                                                                   |   |        |       |
| TOTAL LIABILITIES                                                                                      |   | $           | 6,115,170  |   |
|                                                                                                   |   |        |       |
| STOCKHOLDER’S EQUITY                                                                              |   |        |       |
| Common Stock-$0.001 par value:150,000,000  shares authorized; 69,600,348 shares issued and outstanding |   | 69,900      |       |
| Additional Paid-In Capital                                                                             |   | 58,375,402  |       |
| Deferred Compensation Expense                                                                          |   | (1,717,766  | )          |
| Deficit accumulated before entering  development stage                                                 |   | (11,681,500 | )          |
| Deficit  accumulated during development stage                                                          |   | (37,035,759 | )          |
| Total Stockholder’s Equity                                                                        |   | 8,010,277   |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS EQUITY**                                                          |   | $           | 14,125,447 |   |

 

See notes to the condensed financial statements.

 

3

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**POWER3 MEDICAL PRODUCTS, INC.**

**(A Development Stage Enterprise)**

**BALANCE SHEETS**

**AS OF DECEMBER 31, 2005**

 
| ** **                                                                                             | ** ** | **2005**    | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-------------|------------|
| **ASSETS**                                                                                             |       |        |       |
|                                                                                                   |       |        |       |
| **CURRENT ASSETS**                                                                                     |       |        |       |
| Cash and cash equivalents                                                                              |       | $           | 1,399      |   |
| Accounts receivable                                                                                    |       |        |       |
| Prepaid expenses and other current assets                                                              |       | 21,092      |       |
| Total current assets                                                                                   |       | 22,491      |       |
|                                                                                                   |       |        |       |
| **OTHER ASSETS**                                                                                       |       |        |       |
| Goodwill                                                                                               |       | 13,371,776  |       |
| Deferred finance costs, net                                                                            |       | 290,027     |       |
| Intangible  assets, net                                                                                |       | 179,786     |       |
| Furniture, fixtures and equipment, net                                                                 |       | 70,751      |       |
| Deposits                                                                                               |       | 25,900      |       |
|                                                                                                   |       |        |       |
| **TOTAL ASSETS**                                                                                       |       | $           | 13,960,730 |   |
|                                                                                                   |       |        |       |
| **LIABILITIES  AND STOCKHOLDER’S EQUITY**                                                         |       |        |       |
| **CURRENT LIABILITIES**                                                                                |       |        |       |
| Accounts payable and accrued liabilities                                                               |       | $           | 1,003,331  |   |
| Notes payable—in default                                                                          |       | 1,285,739   |       |
| Convertible debentures—in default                                                                 |       | 75,279      |       |
| Other current liabilities                                                                              |       | 916,857     |       |
| Derivative liabilities                                                                                 |       | 1,454,936   |       |
| Total current liabilities                                                                              |       | 4,736,142   |       |
|                                                                                                   |       |        |       |
| **STOCKHOLDERS’ EQUITY**                                                                          |       |        |       |
| Common Stock-$0.001 par value:150,000,000  shares authorized; 65,215,121 shares issued and outstanding |       | 65,215      |       |
| Additional paid-in capital                                                                             |       | 57,773,506  |       |
| Deferred compensation                                                                                  |       | (4,802,621  | )          |
| Loss accumulated before entering  development stage                                                    |       | (11,681,500 | )          |
| Loss accumulated during the development  stage                                                         |       | (32,130,011 | )          |
| Total stockholders’ equity                                                                        |       | 9,224,588   |       |
|                                                                                                   |       |        |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                    |       | $           | 13,960,730 |   |

 

4

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**POWER3 MEDICAL PRODUCTS, INC.**

**(A Development Stage Enterprise)**

**STATEMENTS OF OPERATIONS**

**(unaudited)**

 
| ** **                                          | ** ** | **For the three month  period ended March 31,  2006** | ** ** | **For the three  month period  ended March 31,  2005** | ** ** | **Development Stage from  May 18, 2004  to  March 31, 2006** | ** **  |
|-----------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|-------------|
| ** **                                          | ** ** | ** **                                                                          | ** ** | **(as restated)**                                                          | ** ** | ** **                                                                                      | ** **  |
| **REVENUES:**                                       |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| Sales                                               |       | $                                                                                   |       |                                                                            |       |                                                                                            |        |
| Other revenue                                       |       |                                                                                |       |                                                                            |       | 4,000                                                                                           |        |
| Total revenue                                       |       | $                                                                                   |       |                                                                            |       | 4,000                                                                                           |        |
|                                                |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| **COST OF GOODS SOLD:**                             |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| Production costs                                    |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| Total cost of goods sold                            |       | $                                                                                   |       |                                                                            |       |                                                                                            |        |
|                                                |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| **GROSS PROFIT**                                    |       |                                                                                |       |                                                                            |       | 4,000                                                                                           |        |
|                                                |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| **OPERATING EXPENSES:**                             |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| Stock based compensation                            |       | $                                                                                   | 3,084,855  |                                                                            | 3,356,775  |                                                                                            | 22,959,712  |   |
| Employee compensation and benefits                  |       | 451,788                                                                             |       | 309,959                                                                         |       | 2,536,160                                                                                       |        |
| Professional and consulting fees                    |       | 187,924                                                                             |       | 182,766                                                                         |       | 8,267,767                                                                                       |        |
| Occupancy and equipment                             |       | 39,345                                                                              |       | 56,744                                                                          |       | 342,324                                                                                         |        |
| Travel and entertainment                            |       | 15,391                                                                              |       | 22,006                                                                          |       | 171,016                                                                                         |        |
| Other selling, general and administrative  expenses |       | 28,684                                                                              |       | 142,194                                                                         |       | 634,290                                                                                         |        |
| Total operating expenses                            |       | (3,807,987                                                                          | )          | (4,070,444                                                                      | )          | (34,911,269                                                                                     | )           |
|                                                |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| **LOSS FROM OPERATIONS**                            | ** ** | $                                                                                   | (3,807,987 | )                                                                               | (4,070,444 | )                                                                                               | (34,907,269 | ) |
|                                                |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| **OTHER INCOME AND (EXPENSE):**                     |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| Derivative income (expense)                         |       | $                                                                                   | (520,154   | )                                                                               | 718,846    |                                                                                            | 3,070,078   |   |
| Interest income                                     |       |                                                                                |       | 225                                                                             |       | 1,474                                                                                           |        |
| Other income (expense)                              |       |                                                                                |       |                                                                            |       | (715,077                                                                                        | )           |
| Interest expense                                    |       | (577,607                                                                            | )          | (19,506                                                                         | )          | (1,103,991                                                                                      | )           |
| Total other income(expense)                         |       | $                                                                                   | (1,097,761 | )                                                                               | 699,565    |                                                                                            | 1,252,484   |   |
|                                                |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| **NET LOSS**                                        |       | $                                                                                   | (4,905,748 | )                                                                               | $          | (3,370,879                                                                                      | )           | (33,654,785 | ) |
|                                                |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| **NET LOSS PER SHARE**                              |       | $                                                                                   | (0.07      | )                                                                               | $          | (0.05                                                                                           | )           | $ | (0.52 | ) |
|                                                |       |                                                                                |       |                                                                            |       |                                                                                            |        |
| Weighted average number of shares  outstanding      |       | 67,759,930                                                                          |       | 65,345,121                                                                      |       | 64,827,754                                                                                      |        |
|                                                     |            |                                                                                     |            |                                                                                 |            |                                                                                                 |             |  |  |  |

 

5

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**POWER 3 MEDICAL PRODUCTS, INC**

**(A Development Stage Enterprise)**

**CONDENSED STATEMENTS OF CASH FLOWS**

**(unaudited)**

 
| ** **                                                                  | ** ** | ** **                  | ** ** | ** **                  | ** ** | **Development**                   | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------------|------------|
| ** **                                                                  | ** ** | **For the Three** | ** ** | **For the Three** | ** ** | **Stage Results**            | ** ** |
| ** **                                                                  | ** ** | **Months Ended**       | ** ** | **Months Ended**       | ** ** | **May 18, 2004 -** | ** ** |
| ** **                                                                  | ** ** | **March 31 2006** | ** ** | **March 31 2005** | ** ** | **March 31, 2006**      | ** ** |
| ** **                                                                  | ** ** | **(as restated)**      | ** ** |
| Operating Activities:                                                       |       |                        |       |                        |       |                              |       |
| Net Loss                                                                    |       | (4,905,748                  | )          | (3,370,879                  | )          | (33,654,785                       | )          |
| Adjustment to reconcile net loss to net  cash used in operating activities: |       |                        |       |                        |       |                              |       |
| Stock based services and compensation                                       |       | 3,442,507                   |       | 3,356,775                   |       | 30,786,612                        |       |
| Stock issued to retire preferred stock and  debt                            |       |                        |       |                        |       | 4,236                             |       |
| Derivative (income) expense                                                 |       | 520,154                     |       | (718,846                    | )          | (3,070,078                        | )          |
| Depreciation and amortization                                               |       | 6,820                       |       | 15,564                      |       | 72,002                            |       |
| Amortization of debt discount and finance  costs                            |       | 212,440                     |       | 14,199                      |       | 334,614                           |       |
| Other                                                                       |       |                        |       |                        |       | (34,935                           | )          |
| Decrease(increase) in deposits                                              |       |                        |       |                        |       | (25,900                           | )          |
| Decrease(increase) in prepaids                                              |       | (15,057                     | )          |                        |       | (36,149                           | )          |
| Increase (decrease) in Deferred finance  costs                              |       |                        |       | (300                        | )          | 290,027                           |       |
| Increase(decrease) in accounts payable and  accrued liabilities and other   |       | 23,482                      |       | 249,884                     |       | 1,707,810                         |       |
|                                                                        |       |                        |       |                        |       |                              |       |
| Net cash used in Operating Activities                                       |       | (715,402                    | )          | (453,603                    | )          | (3,626,546                        | )          |
|                                                                        |       |                        |       |                        |       |                              |       |
| INVESTING ACTIVITIES                                                        |       |                        |       |                        |       |                              |       |
| Capital expenditures, net                                                   |       |                        |       | (2,822                      | )          | (135,933                          | )          |
| Increase (decrease) in other assets                                         |       |                        |       | (1,980                      | )          | (179,786                          | )          |
| Net cash used in Investing Activities                                       |       |                        |       | (4,802                      | )          | (315,719                          | )          |
|                                                                        |       |                        |       |                        |       |                              |       |
| FINANCING ACTIVITIES                                                        |       |                        |       |                        |       |                              |       |
| Proceeds from CD, warrants and investment  rights                           |       |                        |       | 338,000                     |       | 1,197,041                         |       |
| Adjustment related to derivatives                                           |       | 198,865                     |       |                        |       | 198,865                           |       |
| Proceeds from borrowings under notes  payable (net)                         |       | 429,400                     |       |                        |       | 1,810,208                         |       |
| Proceeds from sale of common stock, net                                     |       | 248,929                     |       |                        |       | 896,746                           |       |
|                                                                        |       |                        |       |                        |       |                              |       |
| Net cash provided by financing activities                                   |       | 877,194                     |       | 338,000                     |       | 4,102,860                         |       |
|                                                                        |       |                        |       |                        |       |                              |       |
| Net increase (decrease) in cash and cash  equivalents                       |       | 161,792                     |       | (120,405                    | )          | 160,595                           |       |
|                                                                        |       |                        |       |                        |       |                              |       |
| Cash and cash equivalents, beginning of  period                             |       | 1,399                       |       | 158,301                     |       | 2,596                             |       |
|                                                                        |       |                        |       |                        |       |                              |       |
| Cash and cash equivalents, end of period                                    |       | 163,191                     |       | 37,896                      |       | 163,191                           |       |

 

6

----

 
| ** **                                                                    | ** ** | **For the Three  months ended  March 31, 2006** | ** ** | **For the Three  months ended  March 31, 2005** | ** ** | **Cumulative  during  Development  Stage  May 18, 2004 to  March 31, 2006** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
|                                                                          |       |                                                                     |       |                                                                     |       |                                                                                            |       |
| Cash paid for:                                                                |       |                                                                     |       |                                                                     |       |                                                                                            |       |
| Interest                                                                      |       | 0                                                                        |       | 0                                                                        |       | 0                                                                                               |       |
| Income taxes                                                                  |       | 0                                                                        |       | 0                                                                        |       | 0                                                                                               |       |
|                                                                          |       |                                                                     |       |                                                                     |       |                                                                                            |       |
| Non-cash transactions:                                                        |       |                                                                     |       |                                                                     |       |                                                                                            |       |
| Conversion of convertible notes payable and  accrued interest to common stock |       |                                                                     |       |                                                                     |       |                                                                                            |       |
| Conversion of accrued payroll to preferred  stock                             |       |                                                                     |       |                                                                     |       |                                                                                            |       |
| Conversion of stockholder advances to notes  payable                          |       |                                                                     |       |                                                                     |       | —                                                                                          |       |
| Conversion of notes payable to equity                                         |       | —                                                                   |       |                                                                     |       |                                                                                            |       |
| Conversion of preferred stock to common  stock                                |       |                                                                     |       |                                                                     |       |                                                                                            |       |
| Conversion of other liabilities to  stockholder advances                      |       |                                                                     |       |                                                                     |       |                                                                                            |       |
| Issuance of warrants in connection with  services                             |       | 90,000                                                                   |       |                                                                     |       |                                                                                            |       |
| Issuance of warrants in connection with  convertible debentures               |       | —                                                                   |       |                                                                     |       |                                                                                            |       |

 

Seenotes to the condensed financial statements.

 

7

----

 

**POWER 3 MEDICAL PRODUCTS, INC**

**(A Development Stage Enterprise)**

 

**NOTES TO CONDENSED FINANCIAL STATEMENTS**

**(unaudited)**

 

***Note 1. ORGANIZATION, PRINCIPAL ACTIVITIESAND BASIS OF PRESENTATION***

 

Power3 Medical Products, Inc. (the “Company” or “Power3“) was incorporated in the State of Florida on May 15, 1992 and merged into aNew York Corporation in 1994, under the name Sheffield Acres, Inc.. Power3 andits wholly owned subsidiaries, C5 Health, Inc. (C5), which was officiallydissolved in the State of Delaware and the State of Florida effective December31, 2003 and Power3 Medical, Inc., a Nevada Corporation, now known asTenthgate, Inc., were engaged in product development, sales, distribution andservices for the healthcare industry. On September 12, 2003, Surgical SafetyProducts, Inc. amended its Certificate of Incorporation to (a) declare a 1:50reverse split of its common stock; (b) increase its authorized capital to150,000,000 shares of common stock and 50,000,000 shares of preferred stock;and (c) change its name to Power3 Medical Products, Inc. All references to thenumber of shares in the accompanying financial statements and notes theretohave been adjusted to reflect the stock split as if it occurred on January 1,2004.

 

Prior to May 17, 2004, the Company had one directsubsidiary, Tenthgate, Inc. (“Tenthgate”), a Nevada corporation formerly knownas Power3 Medical, Inc. Prior to this date, Tenthgate was accounted for, byPower3, as a wholly-owned subsidiary, operating as a “development stage company”,under the cost method. As part of the transaction which involved theacquisition of substantially all the assets and certain liabilities fromAdvanced BioChem, now known as Industrial Enterprises of America, it was agreedthat Power3 would distribute the shares of its subsidiary, Tenthgate, to itsthen existing shareholders. To fulfill this obligation, the shares of Tenthgatewere transferred to a trustee for distribution to the shareholders of Power3 asof May 17, 2004. Tenthgate was spun off because the management of Power3, inplace prior to May 17, 2004, desired to continue to own and eventually operatethis subsidiary. At the time of the spinoff, Tenthgate was granted the rightsto market a product line that had previously been marketed by Power3, but whichthe company had decided to abandon. Tenthgate had not been an operatingcompany, and their management has apparently abandoned any plans to market theproduct as evidenced by their SEC filings, specifically their amended 10-QSBfiled for the quarterly period ending January 31, 2005, wherein theyspecifically state that they are a “development stage company.”  The prior operations of the company which arereflected in the financial statements as occurring prior to reentering the developmentstage were the operations the Company had decided to abandon and which weretransferred to the prior shareholders under the control of prior management. Anyactivities since May 17, 2004, are not consolidated from Power3 because Power3does not now own or control the operations or activities of Tenthgate, nor aretheir activities associated with Power3 in any manner whatsoever.

 

In2003, the Company was an operating company, marketing devices to aid surgicalprocedures. Prior to May 18, 2004, the products had received only minor marketacceptance and sales had slowed to the point that Power3 was searching forother products and markets to increase its presence in the healthcare industry.In early 2004, Power3 became aware of a biotech company that appeared to have aset of assets and intellectual properties that it required to more effectivelypursue its business model. That company, named Advanced BioChem, doing businessas ProteEx, now known as Industrial Enterprises of America, providedcontract-for-fee lab services analyzing protein biomarkers. At the conclusionof negotiations with Advanced BioChem, Power3 entered into an Asset PurchaseAgreement dated May 18, 2004, whereby it purchased substantially all the assetsand intellectual properties of Advanced BioChem, and assumed certainliabilities, as scheduled in the agreement, from Advanced BioChem. After thetransaction, certain employees from Advanced BioChem became employees of Power3and were later issued employment agreements by Power3. As consideration in theAsset Purchase Agreement, Power3 issued 15,000,000 shares of common stock toAdvanced BioChem.

 

8

----

 

Power3Medical Products, Inc. did not continue the business activity of AdvancedBioChem and never conducted any contract-for-fee lab service work. Subsequentto the asset purchase, the business model of Power3 was significantly changed,the Company entered into the development stage and began to commercialize theintellectual property it acquired in the transaction, with its focus in theearly detection, monitoring and targeting of diseases through the analysis ofproteins. Power3’s new developmental stage objective, and activity, is todevelop its intellectual properties by focusing on disease diagnosis, proteinand biomarker identification and early detection indicators in the areas ofcancers, neurodegenerative and neuromuscular diseases, as well as otherscientific areas of interest associated with protein biomarkers.

 

***Note 2.******SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES***

 

TheCompany’s financial statements provide for (i) the classification of warrantsas liabilities, at fair value, (ii) the classification of embedded conversionand other features embedded in the convertible debentures and investment rightsas liabilities at fair value and (iii) the amortization of discounts thatresulted in the host instruments using the effective interest method. Thisrevised accounting is required because, under current accounting standards,financial instruments, such as warrants and embedded conversion features thatare indexed to a Company’s common stock, are classified as liabilities wheneither (a) the holder possesses rights to net-cash settlement or (b) physicalor net-share settlement is not within the control of the Company. In suchinstances, net-cash settlement is assumed for financial accounting andreporting, even when the terms of the underlying contracts do not provide fornet-cash settlement. Such financial instruments are initially recorded at fairvalue and subsequently adjusted to fair value at the close of each reportingperiod. This accounting will be utilized in the accounting for theseinstruments until the Company reaquires the ability to share settle theinstruments or physically settles the instruments through other means. Also seeNote 8.

 

FinancialInstruments and Concentrations of Credit Risk 

 

TheCompany’s financial instruments consist of cash and cash equivalents, accountsreceivable, accounts payable, accrued expenses, notes payable, derivativefinancial instruments, other current liabilities, and convertible debentures.Management believes the carrying values of cash and cash equivalents, accountspayable, accounts payable and accrued expenses, notes payable, and othercurrent liabilities approximate their fair values due to their short-termnature. The convertible debentures have a face value and carrying value of$107,280 and $1,400,000, respectively and the Trinity notes payable have a facevalue and carrying value of $302,750 and $311,000, respectively

 

TheCompany generally does not use derivative financial instruments to hedgeexposures to cash-flow risks or market-risks that may affect the fair values ofits financial instruments. However, certain other financial instruments, suchas warrants and embedded conversion features that are indexed to the Company’scommon stock, are classified as liabilities when either (a) the holderpossesses rights to net-cash settlement or (b) physical or net-share settlementis not within the control of the Company. In such instances, net-cashsettlement is assumed for financial accounting and reporting, even when theterms of the underlying contracts do not provide for net-cash settlement. Suchfinancial instruments are initially recorded at fair value and subsequentlyadjusted to fair value at the close of each reporting period.

 

Thecaption Derivative Financial Instruments consists of (i) the fair valuesassociated with derivative features embedded in the Convertible Debentures and(ii) the fair values of the detachable warrants and additional investmentrights that were issued in connection with the debenture financingarrangements. (See Note 8. Financing Arrangements)

 

Financialinstruments that potentially subject the Company to significant concentrationsof credit risk consist primarily of cash and cash equivalents. The Companyoccasionally maintains cash and cash equivalents balances in excess offederally insured limits. The Company has not experienced any losses in suchaccounts.

 

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Principlesof Consolidation and Investments

 

During2003, the Company accounted for its investment in its subsidiary, Tenthgate,Inc. under the cost method. As described in Note 1, the Company’s formersubsidiary, known as Tenthgate, Inc., is not consolidated for periods after May17, 2004, because the Company, in May of 2004, distributed its common stockownership in Tenthgate to a trustee for distribution to the shareholders ofrecord as of May 17, 2004. Power3 does not now own or control Tenthgate, Inc.’sactivities or operations in any manner whatsoever. Since Tenthgate, Inc. wasspun off in May, 2004, as described in Item I, it is not consolidated forperiods subsequent to that transaction..

 

Useof Estimates

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make certain estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements. Thereported amounts of revenues and expenses during the reporting period may beaffected by the estimates and assumptions management is required to make. Estimatesthat are critical to the accompanying financial statements include assessingthe impact of contingencies and the amortization periods for the debt issuancecosts and debt discount on the convertible debentures (see Note 7) as well asestimating depreciation and amortization periods of tangible and intangibleassets, and long-lived impairments, among others. The markets for the Company’sproducts are characterized by intense competition, evolving standards and pricecompetition, all of which could impact the future realizability of the Company’sassets. Estimates and assumptions are reviewed periodically and the effects ofrevisions are reflected in the financial statements in the period they aredetermined to be necessary.

 

Furniture,Fixtures and Lab Equipment

 

Furniture,fixtures and lab equipment are stated at cost. Major additions are capitalized,while minor additions and maintenance and repairs, which do not extend theuseful life of an asset, are expensed as incurred. Depreciation andamortization are provided using the straight-line method over the assets’estimated useful lives. At March 31, 2006, certain lab equipment having a netbook value of approximately $37,500 serves as security for certain liabilities.

 

Debt Discounts and Deferred Finance Costs 

 

Debt discounts and deferred finance costs are beingamortized through periodic charges to interest expense over the maximum term ofthe convertible debentures of three years using the effective interest method.Amortization of debt discounts amounted to $207,128 for the quarter ended March31, 2006.

 

Long-Lived Assets 

 

Statement ofFinancial Accounting Standards (SFAS) 142 “Accounting for Intangible Assets”provides that goodwill is not subject to periodic amortization, but isevaluated at least annually for impairments. The goodwill acquired by theCompany at the time of the May 18, 2004 transaction was evaluated at March 31,2006, and for the years ended December 31, 2005 and 2004. Goodwill wasdetermined to not be impaired because the fair value of the reporting unit,based on the market capitalization of the Company, exceeded the carrying valueof the reporting unit, based on assets minus liabilities, at year end in 2004and 2005 and at March 31, 2006.

 

Net Loss Per Share 

 

Net loss per share is computed in accordancewith SFAS No. 128 “Earnings per Share” (“SFAS No. 128”) and SEC StaffAccounting Bulletin No. 98 (“SAB 98”). Under the provisions of SFAS No. 128 andSAB 98, basic net loss per share is computed by dividing the net loss availableto common stockholders for the period by the weighted average number of commonshares outstanding during the period. Diluted net loss per share is computed bydividing the net loss, adjusted for using the “if-converted method” for

 

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convertible securities, for the period by theweighted average number of common and common equivalent shares (using the “treasury-stock”method) outstanding during the period. In periods in which common stockequivalents would be anti-dilutive, such shares are ignored in the loss pershare calculations because they would have an anti-dilutive effect.

 

Reclassification of Liabilities

 

Based on the Event of Default, resulting fromthe Company’s failure to get an SB-2 effective for the shares involved withconversion of the debentures and warrant shares, that occurred on April 25,2005 for the convertible debentures issued in October, 2004 and January, 2005,Power3 has reclassified the convertible debentures as a Current Liability,rather than as a Long Term Liability as they were previously shown in ourfinancial statements in both the original 10-KSB filed for 2004 and will do soin amended quarterly reports for June 30, 2005 and September 30, 2005.

 

In addition, since the Event of Default occurredon April 25, 2005, Power3 now recognizes the Mandatory Prepayment Amount, as aCurrent Liability, as described in the debenture agreements as due in case anEvent of Default occurs.

 

Stock – Based Compensation 

 

TheCompany accounts for equity instruments awarded to employees for services basedon the fair value of common stock issued and the intrinsic value of stockoptions and warrants. The accompany accounts for all equity instruments issuedto those other than employees based on the fair value of the considerationreceived or the fair value of the equity instruments, whichever is morereliably measurable. Fair value is measured based on the closing market priceof the common stock on the effective date of the agreement or Board resolution,using the Black Scholes valuation model.

 

Duringthe 1st quarter of 2006, the Company amortized $3,025,493 tostock-based compensation for employees who had been issued stock in May, 2004;$59,362 for warrants issued in 2004 and 2005; and $179,635 for stock issued toconsultants and others for services.

 

Income Taxes 

 

TheCompany computes income taxes using the asset and liability method inaccordance with Financial Accounting Standards Statement No. 109 “Accountingfor Income Taxes” (“SFAS 109”). Under SFAS 109, deferred taxes are recognizedfor the tax consequences of temporary differences by applying enacted statutoryrates applicable to future years to differences between the financial statementcarrying amounts and the tax basis of existing assets and liabilities. Also,the effect on deferred taxes of a change in tax rates is recognized in incomein the period that included the enactment date. There were no significanttemporary differences at March 31, 2006.

 

Research and Development 

 

Research and development costs, whichapproximated $14,907 for the quarter ended March 31, 2006, were expensed asincurred.

 

Cash Equivalents

 

For purposes of thestatements of cash flows, the Company considers all highly liquid debtinstruments purchased with a maturity of three months or less to be cashequivalents.

 

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RevenueRecognition

 

In2004, the Company shipped its product directly from the outsource manufacturerto the customer without taking ownership or possession of its products. Allshipments were FOB destination with freight allowed and payment terms were net30 days after shipment. Accordingly, revenue was recognized upon delivery.

 

TheCompany’s revenue recognition policy is consistent with the criteria set forthin Staff Accounting Bulletin 104-Revenue Recognition in Financial Statements(SAB 104) for determining when revenue is realized or realizable and earned. Inaccordance with the requirements of SAB 104 the Company recognizes revenue when(1) Persuasive evidence of an arrangement exists; (2) Delivery has occurred;(3) the Seller’s price is fixed or determinable; and (4) collectibility isreasonably assured.

 

AdvertisingCosts

 

Advertisingcosts are expenses as incurred. Advertising expenses were $-0- for each of theyears ended December 31, 2005 and December 31, 2004. No advertising expenseswere incurred during the quarter ended March 31, 2006.

 

***Note 3. GOING CONCERN***

 

TheCompany’s financial statements are presented on a going concern basis, whichcontemplates the realization of assets and satisfaction of liabilities in thenormal course of business. The Company is in the development stage and hasprimarily been involved in research and development and capital raisingactivities; as such the Company has incurred significant losses from operationsduring 2004 and 2005.

 

Asa result, the Company has an immediate need for capital to continue itsoperations, and it will need to raise significant additional funds to implementits business plan. This cash will have to come from equity sales and/orborrowings as management has projected that the Company will need significantadditional capital for development and other ongoing operational activitiesbefore it will have any anticipated revenue generating products. The actualamount of funds that the Company will need will be determined by many factors,some of which are beyond the Company’s control. These factors include:

 

•                  The extent to which the Company enters intolicensing arrangements, collaborations or joint ventures;

•                  The progress and results of research andproduct development;

•                  The costs and timing of obtaining new patentrights;

•                  The extent to which the Company requires orlicenses other technologies; and

•                  Regulatory changes and competition andtechnological developments in the market.

 

Acurrent possibility available to the Company is to raise the remaining funds of$1,600,000 potentially available to them pursuant to the Securities PurchaseAgreement dated October 28, 2004 (the “Agreement”). These funds will beimmediately reduced by the payment of certain delinquent payables ofapproximately $1,597,500 of certain bridge financing received in 2005 and 2006.The Company is in immediate need for capital to continue its operations and assuch its ability to continue as a going concern is subject to its ability togenerate a profit or obtain necessary funding from outside sources. Managementbelieves that even though the Company currently has limited cash resources andliquidity, assuming exercise of the warrants and additional investment rightsspecified in the Agreement, that the net funds available from the final closingunder such Agreement will allow the Company to continue operations throughJune, 2006. In the event the final closing and sale of $1,600,000 in aggregateprincipal amount of debentures occurs, but the warrants and additionalinvestment rights are not exercised, the Company anticipates that it will needto raise additional capital prior to June, 2006 to meet its operating costs.However, the Company is currently in default under the conditions set forth inthe Agreement as well as the debentures and registration rights agreement andconsequently, there is no assurance that the Company will be successful incompleting the sale and issuance of the remaining $1,600,000 aggregateprincipal amount of debentures and/or the additional investments rightspursuant to the Agreement. If the Company is unsuccessful in the closing of thesale and issuance of the $1,600,000

 

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aggregateprincipal amount of debentures at the final closing, the Company will berequired to obtain alternative financing, sell or license some of itstechnology, and/or curtail or cease its operations. Any such funding maysignificantly further dilute existing shareholders or may limit the Company’srights to its technology. Moreover, the increase in the number of sharesavailable in the public marketplace may reduce the market price for the Company’scommon stock, and consequently, the price investors may receive at the time ofsale. The financial statements do not include any adjustments to reflect thepossible future effects on the recoverability and classification of assets orthe amounts and classification of liabilities that may result from the possibleinability of the Company to continue as a going concern.

 

***Note 4. LOSS PER SHARE***

 

AtDecember 31, 2005, common stock options were excluded from the fully dilutedloss per share calculations because the effects would be anti-dilutive:

 

•                  2,500,000 warrants, and additional investmentrights having a value of $2,500,000, which were issued to certain accreditedinvestors on October 28, 2004 under the Agreement. In addition, pursuant to theAgreement, the investors purchased certain convertible debentures that ifexercised, will result in the issuance of an indeterminate number of shares ofcommon stock.

 

•                  333,333 warrants which were issued to certainaccredited investors on January 26, 2005 under the Amended Agreement. Inaddition, pursuant to the Agreement, the investors purchased certainconvertible debentures that if exercised, will result in the issuance of anindeterminate number of shares of common stock

 

•                  580,000 shares of warrants which were issuedto members of the Company’s Scientific Advisory Board and various otherconsultants in 2004 (including 100,000 to the agent that placed the convertibledebentures discussed above). The warrants, which expire three to five yearsfrom the dates of the respective grants and were issued at no cost to suchpersonnel, may be converted to a like number of shares of the Company’s commonstock at any time prior to their expiration(s). As a result, during the periodMay 18, 2004 (date of acquisition) to December 31, 2005, the Company hasrecorded $284,447 of stock based compensation as a result of the issuance ofthese warrants.

 

•                  2,000,000 shares of warrants were issued inNovember and December of 2005 to Trinity Finance Investments associated withtwo Notes, 1,000,000 warrants each, for invested funds. The warrants whichexpire in 7-8 years may be converted to a like number of shares at any timeprior to their expiration date. As a result the Company recorded $6,429 ofstock-based compensation as a result of the issuance of these warrants during2005.

 

Inaddition, at December 31, 2005, loss per share excludes 34,222,222 shares thatare indexed to convertible debentures and investment rights. These instrumentswould also have an anti-dilutive effect on loss per share.

 

***Note 5*****.*INCOME TAXES***

 

TheCompany recognized losses for both financial and tax reporting purposes duringeach of the periods in the accompanying statements of operations. Accordingly,no provisions for income taxes and/or deferred income taxes payable have beenprovided for in the accompanying financial statements.

 

Basedon the Company’s 2004 tax return, the Company has net operating losscarryforwards for income tax purposes of approximately $12,957,858 arisingprimarily from stock based expenses that are considered to be permanent differences.These net operating loss carryforwards expire at various times through theperiod ended December 31, 2022 however because the Company has experiencedchanges in control and has incurred significant operating losses, utilizationof the income tax loss carryforwards are

 

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notassured. As a result, the non-current deferred income tax asset arising fromthese net operating loss carryforwards is not recorded in the accompanyingbalance sheet because the Company established a valuation allowance to fullyreserve such assets as their realization did not meet the required assetrecognition standard established by SFAS 109. The tax return for 2005 has notbeen finalized at the time of this report, however it is expected thatadditional net operating loss carryforwards will result from the Company’s 2005operations.

 

***Note 6*****.*RELATED PARTY TRANSACTIONS***

 

On January 20, 2006, the Company received an OfficerAdvance in the amount of $40,000 from Steven B. Rash, Chief Executive Officerof the Company. This advance is in the form of a short-term Note Payable to theOfficer, is payable on July 20, 2006 and bears interest at a rate of 6% perannum until paid.

 

During February, 2006, the Chief Scientific Officeradvanced the Company $89,400 as short-term Officer Advances in order to enablethe Company to meet certain payment obligations. These advances were in theamounts of $5,000, $5,000, $20,000, $20,000, $20,000 and $19,400. On February28, 2006, the Company executed a 180-day Note Payable in the amount of $39,400with the Officer, payable on August 27, 2006, with interest at 6% per annumuntil paid. In addition, on March 1, 2006, the Company executed a 180-day NotePayable in the amount of $50,000 with the Officer, payable on or beforeSeptember 1, 2006.

 

***Note 7.**OTHER COMMITMENTS AND CONTINGENCIES***

 

OperatingLease for Office and Laboratory Space

 

InAugust 2004, the Company entered into a new lease which expires on August 31,2009, has an initial term of sixty-three months, and requires base monthlyminimum lease payments ranging from approximately $6,000 to $9,600 (plusutilities and operating expenses) over the lease term. The lease contains aprovision which allows the Company to extend the lease for two additional termsof sixty months. Rent expense (for the office lease) was $20,016 for thequarter ended March 31, 2006.

 

OtherLeases

 

InJune, 2004, the Company entered into a new lease for a telephone system whichexpires in June, 2009, has an initial term of 60 months and requires basemonthly minimum lease payments in the amount of $184.51 per month over thelease term. The Company paid $554 on this lease during the quarter ended March31, 2006.

 

InOctober, 2004, the Company entered into a new lease for computers which expiresin September, 2006, has an initial term of 24 months and requires base monthlyminimum lease payments in the amount of $344 per month over the lease term. TheCompany paid $1,032 on this lease during the quarter ended March 31, 2006.

 

Futurelease commitments are as follows:

 
| 2006 |   | $ | 96,129  |   |
|------|--------|---|---------|--------|
| 2007 |   | $ | 106,420 |   |
| 2008 |   | $ | 114,800 |   |
| 2009 |   | $ | 39,434  |   |

 

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EmploymentAgreements 

 

TheCompany is obligated under amended and restated employment agreements with itsChief Executive Officer, Chief Scientific Officer and Chief Financial Officer. Thesignificant terms of the agreements are as follows:

 

ChiefExecutive Officer – The amended and restated employment agreement is effectiveas of May 18, 2004 and has an initial term of five years, subject to eachparty’s termination rights. The agreement provides for a base salary of$250,000 per year and the opportunity to receive cash bonuses based onperformance upon the discretion of the board of directors. The agreement alsoincludes participation in employee benefit plans offered to employees, as wellas a grant of 13,250,000 shares of restricted common stock and 1,500,000 sharesof restricted Series B preferred stock (the Series B preferred shares have notyet been issued). Either party may terminate the Chief Executive Officer’semployment under the contract, either with or without cause upon giving theother party at least thirty days notice. If the Company terminates the chiefexecutive officer’s employment at any time during the initial term withoutcause, he will be entitled to receive compensation provided under the agreementfor the remaining initial term of employment. In addition, in the event of achange in control as defined in the agreement, the Company may waive, in wholeor in part, any and all remaining restrictions on the restricted shares ofcommon stock and Series B preferred stock granted to him.

 

ChiefScientific Officer – The amended and restated employment agreement is effectiveas of May 18, 2004 and has an initial term of five years, subject to eachparty’s termination rights. The agreement provides for a current base salary of$125,000 through December 18, 2004 and $100,000 thereafter and the opportunityto receive cash bonuses based on performance upon the discretion of the boardof directors. The agreement also includes participation in employee benefitplans offered to employees, as well as a grant of 13,250,000 shares ofrestricted common stock and 1,500,000 shares of restricted Series B preferredstock (the Series B preferred shares have not yet been issued). Either partymay terminate the chief scientific officer’s employment under the contract,either with or without cause upon giving the other party at least thirty daysnotice. If the Company terminates the Chief Scientific Officer’s employment atany time during the initial term without cause, he will be entitled to receivecompensation provided under the agreement for the remaining initial term ofemployment. In addition, in the event of a change in control as defined in theagreement, the Company may waive, in whole or in part, any and all remainingrestrictions on the restricted shares of common stock and Series Bpreferred stock granted to him.

 

ChiefFinancial Officer – The employment agreement is effective as of September 1,2005 and has an initial term of three years, subject to each party’stermination rights. The agreement provides for a base salary of $100,000 peryear and the opportunity to receive cash bonuses based on performance upon thediscretion of our board of directors. The agreement also includes participationin employee benefit plans offered by us to our employees, as well as a grant of140,000 shares of restricted common stock. Either party may terminate the ChiefFinancial Officer’s employment under the contract, either with or without causeupon giving the other party at least thirty days notice. If the Companyterminates the chief financial officer’s employment at any time during theinitial term without cause, he will be entitled to receive compensationprovided under the agreement for the remaining initial term of employment. Inaddition, in the event of a change in control as defined in the agreement, theCompany may waive, in whole or in part, any and all remaining restrictions onthe restricted shares of common stock granted to him.

 

OtherCommon Stock Grants

 

Inaddition to the above common stock grants, during 2004, the Company granted1,445,000 shares of its common stock to various other employees. Because all ofthe shares were granted at no cost to the employees, and because the sharesgenerally vest over a period of two years, the total value of the grants, toall employees, was recorded as $25,451,500 of deferred compensation expenseupon the date of the grant (which amount was determined based on the totalnumber of shares granted times the trading values of the shares on the datesthe stock grants were made). This amount is being amortized to stock basedcompensation expense over the vesting period.

 

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Asmentioned above, the Company has agreed to issue a total of 3,000,000 shares ofSeries B Preferred Stock to two of its officers. However, for various reasons,including certain restrictions required by the indebtedness (which preclude theshares from being issued for at least 90 days after the effective date of theregistration statement that has been filed to cover the resale of the shares ofcommon stock that will be issued upon the conversion or exercise of thesecurities issued by the Company for such indebtedness), the shares have notyet been issued. The Company intends to issue such shares of the Series BPreferred Stock at such time as it is permitted.

 

Futurerequired payments for base compensation under all of the employment agreementsdiscussed above are approximately as follows:

 
| **Periods Ending  December 31,** | ** ** | **Amounts** | ** ** |
|--------------------------------------------|------------|-------------|------------|
|                                       |       |        |       |
| 2006                                       |       | 470,000     |       |
| 2007                                       |       | 410,000     |       |
| 2008                                       |       | 350,000     |       |
| 2009                                       |       | 131,250     |       |
|                                       |       |        |       |
| Total                                      |       | $           | 1,361,250  |   |
|                                            |            |             |            |  |

 

Other Contingencies

 

Inthe normal course of business, the Company is involved in certain litigation,including one matter in which the plaintiff is seeking $1,522,000 in damages. Managementbelieves the claim is without merit, and intends to vigorously contest suchclaim. This matter is currently in ongoing negotiations between the parties andtheir attorneys and accordingly its ultimate resolution cannot be determined atthis time. As such, no effect has been given to any loss that might result fromthe outcome of this litigation in the accompanying financial statements.

 

Inaddition, an equipment vendor filed a complaint against Advanced BioChem (whichrelated to equipment acquired by Power3 in the May 18, 2004 transaction) inApril of 2002 in a California court alleging breach of contract and seekingdamages. Advanced BioChem reached a settlement agreement in April of 2003 underwhich Advanced BioChem agreed to pay the vendor $40,000 in installments throughAugust of 2003. At December 31, 2003, Advanced BioChem had a balance remainingof $20,000. In April 2005 the equipment vendor filed a lawsuit against AdvancedBioChem and certain former officers of Advanced BioChem, and against Power3, inorder to enforce its claim for the remaining balance which is past due and maybe assumed by the Company as part of the settlement of the dispute withAdvanced BioChem as to liabilities assumed in the May 18, 2004 transaction.

 

InJune, 2005, Charles Caudle et al filed a lawsuit in Harris County, TX againstAdvanced BioChem, Power3 and the officers and directors of both companies. Power3has filed an answer denying all claims in the lawsuit. The Company believesthat the Plaintiff’s claims are without merit, however the Company cannot beassured it will prevail or if the outcome of the action will adversely affectthe Company’s financial position or operations. Settlement negotiations betweenthe parties are ongoing, however no resolution has been achieved thus far.

 

InMay, 2005, Quinn Capital Consulting, Inc. filed suit against Power3 and it’sChief Executive Officer, claiming breach of contract regarding payment forservices claimed to have been provided to Power3, with payment to have beenmade by issue of 500,000 shares of Power3’s common stock to Quinn Capital. Power3believes that it is not liable for the issuance of such shares to Quinn Capitalfor the services

 

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performed,however we cannot be assured we will prevail or if the outcome of this actionwill affect our financial position or operations.

 

InSeptember, 2005, Focus Partners LLC filed suit against David Zazoff and Power3alledging that Power3 breached its agreement with Focus Partners in that itfailed to issue stock to the Plaintiff according to the terms of theiragreement, that the stock in question was issued to Zazoff and that Zazofflater sold the stock in question for $480,000. Negotiations between the partiesare ongoing, however no resolution has been achieved so far.

 

TheCompany is involved in several other debt collection lawsuits totalingapproximately $38,600 plus court costs and interest. Since none of thesematters has come to court, or is expected to within a short amount of time, theCompany cannot be certain how any of these four matters will be resolved. The originaldebt amounts are recorded in accounts payable on the balance sheet of theCompany.

 

*Subpoenafrom the SEC, Division of Enforcement*

 

OnJune 27, 2005, the Company received a subpoena for documents regarding the SEC’sDivision of Enforcement investigation In The Matter of Maui General Store, Inc.It is the Company’s understanding that the Maui General Store matter relates toa promotional scheme by certain individuals to promote the stock and stockprice of certain entities during 2004. The Company provided all documents inits possession pursuant to the subpoena and complied fully with the subpoena onJuly 11, 2005. In February, 2006, Steven B. Rash and Dr. Ira Goldknopf appearedbefore a Grand Jury in Washington, D.C., as witnesses, for the SEC Division ofEnforcement. The Company has received no further correspondence from theEnforcement Division of the SEC. The Company has not been notified that it is asubject of this investigation.

 

***Note 8.FINANCING ARRANGEMENTS*****:**

 

**Securities Purchase Agreement—ConvertibleDebentures**

 

TheCompany entered into a Securities Purchase Agreement, dated October 28, 2004(the “Agreement”) with certain accredited investors (the “Purchasers”).Pursuant to the Agreement, the Purchasers agreed to purchase convertibledebentures due three (3) years from the date of issuance in the aggregateprincipal amount of $3,000,000. The Agreement also provides for the issuance tothe Purchasers, at no additional cost to the purchasers, warrants to purchaseshares of the Company’s common stock and additional investment rights topurchase additional convertible debentures. In connection with the Agreement,the Company also entered into a Registration Rights Agreement with thePurchasers that requires the Company to (i) file a registration statement withthe SEC registering the resale of the shares of common stock issuable uponconversion of the debentures and the exercise of the warrants, (ii) achieveeffectiveness within a stated period and (iii) maintain effectiveness of theregistration statement. Failure to meet these requirements will require theCompany to incur liquidating damages amounting to 2.0% for each month.

 

OnOctober 28, 2004, the Company issued the Purchasers the first $1,000,000 inaggregate principal amount of such debentures at the initial closing under theAgreement. Effective January 26, 2005, the Company issued and sold, to asub-group of the original investors, a second tranche of $400,000 aggregateprincipal amount of debentures. Subject to the conditions set forth in theAgreement, all purchasers are required to purchase the remaining $1,600,000 inaggregate principal amount of such debentures at the final closing, which is tooccur on or before the fifth trading day after the effective date of theregistration statement. The Company is currently in default under the Agreementand the previously issued debentures and related registration rights agreement,and therefore the conditions of the Agreement will not be satisfied orotherwise met on a timely basis. Consequently, there are no assurances that thePurchasers will purchase all or any portion of the remaining $1,600,000aggregate principal amount of debentures. The $1,000,000 aggregate principalamount of debentures issued in the initial closing and the

 

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$400,000aggregate principal amount of debentures issued on January 19, 2005 are due andpayable in accordance with their original terms in full three years after thedate of issuance and do not bear interest. The debentures which may be issuedat the final closing will be due and payable in full three (3) years after thedate of their issuance, and will also not bear interest. At any time from theclosing date until the maturity date of the debentures, the Purchasers have theright to convert the debentures, in whole or in part, into common stock of theCompany at the then effective conversion price, which varies relative to theCompany’s trading stock price, as follows: $0.90 per share, provided however ifthe lesser of (i) 75% of the average of the 5 consecutive Closing Pricesimmediately prior to the Effective Date, as defined in the Securities PurchaseAgreement, and (ii) the Closing Price on the Effective Date (the lesser of (i)and (ii) being referred to as the “Effective Date Price”) is less than theConversion Price, the Conversion Price shall be reduced to equal the EffectiveDate Price.

 

The debentures also affordthe Purchasers anti-dilution protection should, at any time while thedebentures are outstanding, the Company offer, sell or grant any option topurchase or offer, sell or grant any right to reprice its securities, orotherwise dispose of or issue any common stock or common stock equivalents,entitle any person to acquire shares of common stock at an effective price pershare less than the then effective Conversion Price, as calculated by theformula described above; then, in such instance, the Conversion Price for theconvertible debenture shares shall be reduced to the lower price. In case ofany such adjustment in the effective Conversion Price for the convertibledebenture shares, this could significantly dilute existing investors.

 

Under the Agreement, thePurchasers also received warrants to purchase an aggregate of up to 2,500,000shares of common stock and additional investment rights to purchase up to anadditional $2,500,000 principal amount of convertible debentures. The warrantsare exercisable at a price of $1.44 per share, subject to adjustment, includingunder anti-dilution protection similar to that described above.

 

Theadditional investment rights are exercisable at a price equal to the principalamount of the debentures to be purchased, for (1) a period of nine monthsfollowing the effective date of the registration statement to be filed pursuantto the Registration Rights Agreement, or (2) a period of 18 months from thedate of issuance of the additional investment rights, whichever is shorter. Therights debentures will have the same terms as the debentures described above,except that the conversion price will be equal to $1.08.

 

Thedebentures contain covenants that limit the Company’s ability to, among otherthings: incur or guarantee additional indebtedness; incur or create liens;amend the Company’s certificate of incorporation, bylaws or other charterdocuments so as to adversely affect any rights of the holders of thedebentures; and repay or repurchase more than a de minimus number of shares ofcommon stock other than as permitted in the debentures and other documentsexecuted with the purchasers.

 

Theconvertible debentures contain consequences in case of default. Events ofdefault which could subject the Company to penalties and liabilities asspecified in the Agreement include:

 

•                  Any default in the payment of the principalamount of the debentures or the liquidated damages;

 

•                  Any untrue or incorrect representation orwarranty in the Transaction document or any other report, financial statementor certificate made to Holder(s);

 

•                  Any case or action of bankruptcy orinsolvency commenced by the Company, against the Company or adjudicated by acourt against the Company for the benefit of creditors;

 

•                  Any default in its obligations under amortgage or debt in excess of $150,000;

 

•                  Any cease in the eligibility of the Company’sstock to be quoted on a Trading Market;

 

•                  Any Change in Control or sale or disposal of33% or more of the assets of the Company;

 

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•                  Any lapse in the effectiveness of theRegistration Statement covering the shares related to the debenture conversionoption, the warrants or the additional investment rights as described andtransacted in the Securities Purchase Agreement and accompanying documents;

 

•                  Any failure to deliver certificates withinthe specified time; and

 

•                  Any failure, by the Company, to pay in fullthe amount of cash due pursuant to a Buy-In or failure to pay any amounts owedon account on account of an Event of Default within 10 days of the date due.

 

Uponthe occurrence of an event of default, each debenture may become immediatelydue and payable, either automatically or by declaration of the holder of suchdebenture. The aggregate amount payable upon an acceleration by reason of anevent of default shall be equal to the greater of 130% of the principal amountof the debentures to be prepaid or the principal amount of the debentures to beprepaid, divided by the conversion price on the date specified in thedebenture, multiplied by the closing price on the date set forth in thedebenture.

 

Otherprovisions included in the Securities Purchase Agreement include the following:

 

•                  The debenture may be exchanged for an equalaggregate principal amount of debentures in different authorized denominations;

 

•                  The debenture is convertible into commonstock, at the option of the Holder, at any time after the effective date of thedebenture, any time after an event of default and from time to time subject tolimitations on conversion specified in the Agreement;

 

•                  Conversions can be made in smaller incrementsand from time to time. If smaller amounts of the debentures are converted, theHolder will not be required to physically surrender the debentures;

 

•                  The Company has one business day afterreceipt of conversion notice to object to any such request to convert;

 

•                  The Holder shall not have the right toconvert any portion of his debenture if such conversion would enable him to ownin excess of 4.99% of the outstanding common stock of the Company;

 

•                  No later than 3 trading days after anyconversion date, the Company will deliver a certificate representing theconverted shares, free of any legends and trading restrictions for the numberof shares converted;

 

•                  If the Company fails to deliver saidcertificates, liquidated damages of $1,000 per day will be paid;

 

•                  The Company will reserve and keep availableauthorized and unissued registered shares available to be issued uponconversion;

 

•                  Holder will not be responsible for anytransfer taxes relative to issuance of shares;

 

•                  If the Company pays a stock dividend or otherdistribution on its shares, or splits or subdivides its shares or issue byreclassification or any such change in its common shares outstanding, then thenumber of shares available to Holder shall be adjusted proportionally;

 

19

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•                  If the Company shall offer, sell, grant anyoption or otherwise distribute shares to holders of common stock, the number ofshares available to Holder shall be adjusted proportionally;

 

•                  If the Company is involved in any merger oracquisition, the conversion price of the stock shall be adjusted to reflect theeffects of such previous adjustment;

 

•                  During the term of the debentures, theCompany is not permitted to do certain things unless approved by the holders of2/3 majority of the debentures such as create any indebtedness senior to theCompany’s debenture obligations, amend its certificate of incorporation or buyback any amount of its common stock;

 

•                  If the Company offers, sells or grants stockat an effective per share price less than the then Conversion Price, then theConversion Price shall be reduced to equal the effective conversion, exchangeor purchase price for such common stock or common stock equivalents;

 

•                  If the Company offers, sells or grantssecurities that have a price less than the otherwise calculated ConversionPrice, then the current exercise price of the warrants is thereby adjusted tobe the lower of the offered or sold price or the otherwise calculatedConversion Price;

 

•                  If there is an Event of Default, all amountsbecome due in the form of a Mandatory Prepayment Amount (discussed as follows),with maximum interest and penalty payments; and

 

•                  Miscellaneous other provisions such as noticein writing, governing law, waiver and severability.

 

As mentioned above, the Company is in default underthe provisions of the Agreement, Registration Rights Agreement and previouslyissued debentures. The events of default principally relate to the Company’sinability to have its registration statement declared effective within the timeperiod required by the agreements. Although the Company intends to seek waiversor forbearance agreements from the holders of its debentures, there is noassurance that the Company will receive such concessions. As such, the indebtednesshas been classified as a current liability in the accompanying balance sheet. Ifthe Company is unable to obtain such concessions, the aggregate amount payableunder the outstanding debentures due to the acceleration thereof by reason ofthe default is equal to the “Mandatory Prepayment Amount” as specified in thedebentures. The Mandatory Prepayment Amount equals the sum of (i) the greaterof:  (a) 130% of the principal amount ofthe debentures to be prepaid, or (b) the principal amount of the debentures tobe prepaid, divided by the conversion price on (x) the date the payment isdemanded or otherwise due, or (y) the date the payment is paid in full,whichever is less, multiplied by the closing price of the Company’s commonstock on (x) the date the payment is demanded or otherwise due, or(y) the date the payment is paid in full, whichever is greater, and(ii) all other amounts, costs, expenses and liquidated damages due inrespect of the debentures.

 

The Company is in default on the Convertible Debentureswith regard to the deadline for having the registration statement be effective,the withdrawal of the Company’s stock from trading on the OTCBB and severalother default clauses. Besides the provisions for the Mandatory Prepaymentprovisions which become effective if the Company is in default on thesedebentures and the liquidated damages resulting from the registration statementnot being effective, as discussed immediately above, the Company is alsosubject to partial liquidated damages for not being able to deliver sharecertificates, if such were demanded in a conversion action by a debentureholder. These partial liquidated damages amount to $10 per trading day, foreach $1,000 of principal amount being converted, increasing to $20 per tradingday after 5 trading days from when such damages begin to accrue, until theshare certificates are delivered by the Company.

 

The Company has received notice from one of thePurchasers informing the Company that it is in default under the debentures anddemanding payment of the Mandatory Prepayment Amount, together with theliquidated damages, to which it is entitled pursuant to the agreement. TheCompany has filed an SB-2 to

 

20

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register the shares of stock associated with theconvertible debenture agreements and is endeavoring to have it declaredeffective as soon as practicable. The Company is in discussion with itsdebenture holders regarding a resolution of this matter.

 

Inconnection with such financing, the Company issued, a warrant to purchase100,000 shares of common stock at an exercise price of $3.00 to its placementagent, Westor Online and Kogan and Associates. If any investor exercises theiradditional investment rights and purchases additional debentures, the placementagent will be entitled to receive additional warrants to purchase up to anumber of shares of common stock equal to ten percent (10%) of the exerciseprice paid upon exercise of the additional investment rights divided by ninety percent(90%) of the market price as of the initial closing. The Company accounted forthe warrants as deferred financing costs and is amortizing the fair valuesthereof through periodic charges to interest expense using the effectivemethod.

 

ConvertibleDebentures, Warrants and Additional Investment Rights:

 

Thecarrying values of the Company’s convertible debentures amounted to $14,251 and$75,279, at December 31, 2004 and 2005, respectively. As of March 31, 2006, thecarrying values were increased to $107,280. Convertible debentures consist offace value $1,000,000 and $1,400,000, as of December 31, 2004 and 2005,respectively, non-interest bearing convertible debentures due in two traunches:$1,000,000 on October 28, 2007 and $400,000 due on January 26, 2008. Theconvertible debentures arose from the aforementioned financing, where theproceeds were allocated among the components of the financing arrangement, asfollows:

 
| ** **                   | ** ** | **Traunch 1**             | ** ** | **Traunch 2**             | ** ** | ** ** | ** ** |
|------------------------------|------------|--------------------------------|------------|--------------------------------|------------|------------|------------|
| **Instrument:**              | ** ** | **October 28, 2004** | ** ** | **January 26, 2005** | ** ** | **Total**  | ** ** |
| Convertible debentures (1)   |       | $                              | —     |                           | $          | —     |       | $ | — |   |
| Common stock warrants (2)    |       | 3,070,750                      |       | 135,000                        |       | 3,205,750  |       |
| Embedded conversion feature  |       | 882,556                        |       | 266,592                        |       | 1,149,148  |       |
| Additional investment rights |       | 606,867                        |       | 225,415                        |       | 832,282    |       |
| Derivative loss              |       | (3,560,173                     | )          | (227,006                       | )          | (3,787,179 | )          |
| Total gross proceeds (3)     |       | $                              | 1,000,000  |                           | $          | 400,000    |       | $ | 1,400,000 |   |

 

----

(1)     The discount to the face value of theconvertible debentures that resulted from the allocation is being amortizedthrough periodic charges to interest expense using the effective method.Amortization of the discount amounted to $14,251 and $61,028 during the yearsended December 31, 2004 and 2005, respectively.

 

(2)     The Company issued additional warrants topurchase 333,333 share of common stock in connection with Traunch 2, which wasnot contemplated in the initial financing agreement. Current accountingstandards require that these warrants be allocated between the debt (andrecorded as deferred financing costs) and the derivative instruments (and allocateddirectly to derivative expense). Since the initial allocation of proceeds didnot result in any initial value allocated to the debt, the fair value of thesewarrants was charged to derivative expense, as reflected in the table.

 

(3)     Direct financing costs associated with theofferings amounted to $140,959 and $62,000 for Traunch 1 and Traunch 2,respectively. Deferred financing costs are being amortized through periodiccharges to interest expense using the effective method. Amortization of thedeferred financing costs amounted to $5,312 for the quarter ended March 31,2006.

 

Derivativefinancial instruments arising from the financing are initially recorded andcontinuously carried at fair values. The following tabular presentationreflects the components of derivative financial instruments on the Company’sbalance sheet at December 31, 2004 and 2005:

 

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| **(Assets) Liabilities:**   | ** ** | **2004** | ** ** | **2005** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|
| Common stock warrants            |       | $        | 1,227,250  |     | $          | 57,250 |   |
| Embedded conversion feature      |       | 464,941  |       | 632,000  |       |
| Additional investment rights     |       | 423,137  |       | 537,778  |       |
| Other derivative instruments (1) |       | 762,591  |       | 229,124  |       |
|                             |       | $        | 2,877,919  |     | $          | 1,454,936 |   |

 

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(1)   The fair values of certain other derivativefinancial instruments (warrants and convertible preferred stock) that existedat the time of the initial Debenture Financing were reclassed from stockholders’equity to liabilities when, in connection with the Debenture Financing, theCompany no longer controlled its ability to share-settle these instruments.These derivative financial instruments had a fair value of $5,835,443 onOctober 28, 2004, when the Company no longer controlled its ability toshare-settle the instruments. Prior to December 31, 2004, the Company settledthe preferred stock with the issuance of common stock. As a result, thederivative liability associated with the preferred stock was adjusted to fairvalue immediately before the settlement and reclassed to common equity. Theremaining instruments will be reclassified to stockholders’ equity when theCompany reacquires the ability to share-settle the instruments.

 

Thefollowing tabular presentation reflects the number of common shares into whichthe aforementioned derivative financial instruments are indexed at December 31,2004 and 2005:

 
| **Shares of common stock** | ** ** | **2004**  | ** ** | **2005**   | ** ** |
|-------------------------------------------|------------|-----------|------------|------------|------------|
| Common stock warrants                     |       | 2,500,000 |       | 2,833,333  |       |
| Embedded conversion feature (1)           |       | 2,039,216 |       | 18,666,666 |       |
| Additional investment rights (1)          |       | 1,699,346 |       | 15,555,555 |       |
| Other derivative instruments (2)          |       | 1,480,000 |       | 3,480,000  |       |
|                                      |       | 7,718,562 |       | 40,535,556 |       |

 

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(1)   The terms of the embedded conversion featuresin the debentures and additional investment rights provide for variableconversion rates that are indexed to the Company’s trading common stock price. Asa result, the number of indexed shares is subject to continuous fluctuation.The substantial increase in the number of shares from December 31, 2004 toDecember 31, 2005 is indicative of a significant decline in the Company’strading common stock prices.

 

(2)   During November and December 2005, theCompany issued the Trinity notes payable that had detachable warrants for thepurchase of 2,000,000 shares of common stock. These warrants constitute theincremental increase in other derivative instruments. Because share settlementof these warrants is not within the control of the Company, the warrants wereclassified as derivative financial instruments at their initial fair value. SeeTrinity Notes Payable, below.

 

Derivativeincome (expense) for the years ended December 31, 2004 and 2005 associated withadjustments recorded to reflect the aforementioned derivatives at fair value(in addition to the initial allocation, above) amounted to $5,130,521 and$2,246,890, respectively.

 

Fairvalue considerations for derivative financial instruments:

 

Freestandingderivative financial instruments, consisting of warrants that arose from thedebenture financing, are valued using the Black-Scholes-Merton valuationmethodology because that model embodies all of the relevant assumptions thataddress the features underlying these instruments. Significant assumptionsincluded in this model are as follows:

 

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| ** **           | ** ** | **Traunch 1** | ** ** | **Traunch 2** | ** ** |
|----------------------|------------|--------------------|------------|--------------------|------------|
| **Instrument**       | ** ** | **Warrants**       | ** ** | **Warrants**       | ** ** |
| Exercise prices      |       | $                  | 1.44       |               | $          | 1.44 |   |
| Initial term (years) |       | 5.0                |       | 5.0                |       |
| Volatility           |       | 84.90              | %          | 84.90              | %          |
| Risk-free rate       |       | 3.34               | %          | 3.73               | %          |
|                      |            |                    |            |                    |            |  |  |

 

Embeddedderivative financial instruments, arising from the debentures and theadditional investment rights, consist of multiple individual features that wereembedded in the convertible debentures. The Company evaluated all significantfeatures of the hybrid instruments and, where required under current accountingstandards, bifurcated features for separate report classification. These featureswere, as attributable to each convertible debenture and additional investmentright, aggregated into one compound derivative financial instrument forfinancial reporting purposes. The compound embedded derivative instruments arevalued using the Flexible Monte Carlo methodology because that model embodiescertain relevant assumptions (including, but not limited to, interest raterisk, credit risk, and conversion/redemption privileges) that are necessary tovalue these complex derivatives.

 

Assumptionsincluded exercise estimates/behaviors and the following other significantestimates:

 
| ** **                                 | ** ** | **Traunch 1** | ** ** | **Traunch 2** | ** ** |
|--------------------------------------------|------------|--------------------|------------|--------------------|------------|
| **Instrument**                             | ** ** | **Features**       | ** ** | **Features**       | ** ** |
| Conversion prices                          |       | $0.10—$0.90   |       | $0.10—$1.08   |       |
| Remaining terms (years)                    |       | 1.6—4.5       |       | 1.8—4.5       |       |
| Equivalent volatility                      |       | 78.17%—81.53% |       | 78.17%—81.53% |       |
| Equivalent interest-risk adjusted rate     |       | 5.18%—5.43%   |       | 5.20%—5.24%   |       |
| Equivalent credit-risk adjusted yield rate |       | 23.1%—45.7%   |       | 12.8%—14.2%   |       |

 

Equivalentamounts reflect the net results of multiple modeling simulations that the MonteCarlo Simulation methodology applies to underlying assumptions.

 

Otherderivative financial instruments consist of warrants and Series A Preferredstock that were issued prior to and subsequent to the debenture financing andwere reclassified from stockholders’ equity or initially accounted asliabilities, at fair values, since share-settlement was not within the Company’scontrol after the debenture financing. The other warrants are valued using theBlack-Scholes-Merton valuation methodology because that model embodies all ofthe relevant assumptions that address the features underlying thoseinstruments. The preferred stock was determined by management to containsimple, non-complex conversion features and was, therefore, also valued usingBlack-Scholes-Merton methodology. Significant assumptions included in thismodel are as follows:

 
| **Instrument**       | ** ** | **Other Warrants** | ** ** | **Preferred Stock** | ** ** |
|----------------------|------------|-------------------------|------------|--------------------------|------------|
| Exercise prices (1)  |       | $0.14—$3.00        |       | $                        | 1.00       |   |
| Initial term (years) |       | 5.0—8.0            |       | 5.0                      |       |
| Volatility           |       | 84.90%—171.12%     |       | 84.90                    | %          |
| Risk-free rate       |       | 3.34%—3.73%        |       | 3.34                     | %          |
|                      |            |                         |            |                          |            |  |

 

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(1)          The weighted average exercise price of the other 3,480,000 common stockwarrants is $0.61. As previously discussed, the preferred stock was convertedto common stock before the close of the 2004 year end.

 

TrinityNotes Payable

 

DuringNovember and December 2005, the Company issued $300,000 face value, 11% notespayable and detachable warrants to purchase 2,000,000 shares of common stock toTrinity Financing Investments Corporation. Principal and interest on the notesare payable $150,000 in March and $150,000 in April 2006. The warrants haveeight-year terms and strike prices of $0.25 for 1,000,000 shares and $0.14 for1,000,000 shares.

 

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Theproceeds from the Trinity financing were allocated first to the warrants, basedupon their fair values, with the balance of $103,100 allocated to the notes.The allocation of proceeds to the fair value to the warrants was performedbecause, as discussed in the previous section, share settlement is not withinmanagement’s control. Such amount was initially classified as a derivativeliability. The resulting note discount is being amortized through periodiccharges to interest expense using the effective method. Amortization of notediscount amounted to $207,900 during the period from issuance of the notes toDecember 31, 2005.

 

TheCompany did not make its required debt service payments in March and April2006. As a result of this default, the Company is required to accrue interestat a composite rate of 21%.

 

***Note 9. OTHERSIGNIFICANT EQUITY TRANSACTIONS***

 

On January 3, 2006, Power3executed an agreement with Stonemill Consulting Company (“Stonemill”) whereinthe Company engaged Stonemill to find and bring in investor capital from thirdparty investors. The Company agreed to provide Stonemill with 121,428 shares ofcommon stock of Power3 as commission for locating investors to purchase commonstock of Power3. The Company issued 50,000 shares of common stock to Stonemillas S-8 stock issued under its 2004 Stock Compensation Plan. In February, 2006,the Company issued an additional 71,428 shares to Stonemill for services.

 

On January, 5, 2006,Power3 executed an agreement with Glocap Advisors LLC (“Glocap”) wherein theCompany engaged Glocap to act as financial advisors and provide the Companywith financial advice and strategic consulting services. The Company agreed toprovide Glocap with a retainer equal to $30,000 in free-trading common stock ofthe Company upon the signing of the engagement letter. In confirmation of thisagreement, Power3 issued 226,415 shares of common stock to Glocap, as S-8shares issued under its 2004 Stock Compensation Plan.

 

On February 9, 2006,Power3 executed an agreement with The Kaminer Group wherein the Company engagedThe Kaminer Group to create and implement programs designed to generateinterest from strategic partners and investors. As compensation for theseservices, the Company agreed to a monthly retainer fee of $3,000 in cash andthe Kaminer Group will receive the equivalent of $2,000 in options per month topurchase Power3 common shares at the average daily closing market price forshares during the previous month.

 

Stock Option Plans

 

The Company has various stock option and warrantplans outstanding. Options granted under the 1998 stock option plans areexercisable only after the respective vesting period, which is determined bythe Company’s stock option committee. Options expire seven years from the dateof grant. Under the 1999 stock option plan, options granted to employees vestedratably over three years as determined by the Company’s stock option committeefor options granted to officers, directors, and consultants. Options expire tenyears from the date of grant. A total of 6,360 options remained in effect forwarrants granted in 2000. The fair value of these warrants was estimated at thedate of grant using a Black-Scholes option pricing model with the followingassumptions for warrants granted in 2000: risk-free interest rate of 6.03%;dividend yield of 0%; volatility factorof the expected market price of the Company’s common stock of $.34; and aweighted-average expected life of the options of 2.7 years.

 

InMarch 2003, the Company’s board of directors approved a 2003 Stock CompensationPlan. On September 25, 2003, the Company fileda Post-Effective Amendment No. 1, to it’s previously filed Form S-8Registration Statement for the 2003 Stock Compensation Plan, to deregister the2003 Stock Compensation Plan as well as the 8,000,000 shares of Power3’s commonstock previously registered in the previous S-8 filed and the warrants that hadbeen previously issued were cancelled by mutual consent.

 

24

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In January 2004, the Company’s Board ofDirectors approved the 2004 Directors, Officers and Consultants Stock Option,Stock Warrant, and Stock Award Plan (the 2004 Plan). Pursuant to the 2004 Plan,initially 10,000,000 shares of common stock, warrants, options, preferred stockor any combination thereof may be optioned. After the grant of any option,warrant or share of preferred stock, the number of shares that may be optionedunder the 2004 Plan will be increased. The number of shares of such increaseshall be an amount such that immediately following such increase, the totalnumber of shares issuable under this plan and reserved for issuance uponexercise of options, warrants, or conversion of shares of preferred stock willequal 15% of the total number of issued and outstanding shares of the Company’scommon stock. The Company has issued 38,926,466 shares of common stock and580,000 warrants under the 2004 Plan. Based upon the automatic increaseprovisions above, the number of shares available for issue under the Plan is 9,929,269,based upon 15% of the outstanding shares as of December 31, 2005.

 

Proforma information regarding net income and earnings per share is required bySFAS 123, and has been determined as if the Company had accounted for all ofits options and warrants (the “Warrants”) under the fair value method of that Statement. The fair value for theWarrants was estimated at the date of grant using a Black-Scholes optionpricing model with the following assumptions for Warrants granted in 2000:risk-free interest rate of 6.03%; dividend yield of 0%; volatility factor ofthe expected market price of the Company’s common stock of .34; and aweighted-average expected life of the options of 2.7 years. The followingassumptions were used for Warrants granted in 2004: Risk-free interest rate of5.0%; dividend yield of 0%; volatility factor of the expected market price ofthe Company’s common stock of 1.86 and a weighted-average expected life of theoptions of -0- years (as all were immediately vested). The following assumptionswere used for Warrants granted in 2005: Risk-free interest rate of 5.5%; dividend yield of 0%, volatility factorof the expected market price of the Company’s common stock of 1.86 and aweighted-average expected life of the 2005 options for 7 years. TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded Warrants that have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becausethe Company’s Warrants have characteristics significantly different from thoseof traded Warrants, and because changes in the subjective input assumptions canmaterially affect the fair value estimate, in management’s opinion, theexisting models do not necessarily provide a reliable single measure of thefair value of its stock options.

 

Allof the Company’s warrants were recorded at their fair values; accordingly stockbased compensation actually recorded and stock based compensation that would berecorded using a fair value based method are identical. For purposes of proforma disclosures, the estimated fair value of the options is charged toexpense over the options’ vesting period.

 

25

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Asummary of the Company’s warrant activity and related information for the yearsended December 31, 2005 and 2004 is as follows:

 
| ** **                         | ** ** | **2005**     | ** ** | **2004**     | ** ** |
|------------------------------------|------------|--------------|------------|--------------|------------|
| ** **                         | ** ** | ** **   | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                         | ** ** | ** **   | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                         | ** ** | ** **   | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                         | ** ** | **Warrants** | ** ** | **Price**    | ** ** | **Warrants** | ** ** | **Price** | ** ** |
|                               |       |         |       |         |       |   |   |   |   |
| Outstanding at beginning of year   |       | 3,086,360    |       | 1.46         |       | 6,360 |   | 12.50 |   |
|                               |       |         |       |         |       |   |   |   |   |
| Cancelled                          |       | —       |       | —       |       | — |   | — |   |
|                               |       |         |       |         |       |   |   |   |   |
| Granted                            |       | 2,333,333    |       | .32          |       | 3,080,000 |   | 1.44 |   |
|                               |       |         |       |         |       |   |   |   |   |
| Exercised                          |       | —       |       | —       |       | — |   | — |   |
|                               |       |         |       |         |       |   |   |   |   |
| Outstanding at end of year         |       | 5,419,693    |       | .97          |       | 3,086,360 |   | 1.46 |   |
|                               |       |         |       |         |       |   |   |   |   |
| Exercisable at the end of the year |       | 5,419,693    |       | .97          |       | 3,086,360 |   | 1.46 |   |

 

Thefollowing table summarizes information about the Company’s Warrants outstandingat December 31, 2005...

 
| ** **          | ** ** | ** **              | ** ** | ** **                                                | ** ** | **Weighted**        | ** ** |
|---------------------|------------|-------------------------|------------|-----------------------------------------------------------|------------|---------------------|------------|
| ** **          | ** ** | ** **              | ** ** | **Weighted Average**                                 | ** ** | **Average**         | ** ** |
| **Exercise  Price** | ** ** | **Number  Outstanding** | ** ** | **Remaining Contractual  Life (in years)** | ** ** | **Exercise  Price** | ** ** |
| $                   | .14        |                    | 1,000,000  |                                                      | 8.0        |                | $          | .14 |   |
| $                   | .25        |                    | 1,000,000  |                                                      | 7.0        |                | $          | .25 |   |
| $                   | .98        |                    | 300,000    |                                                      | 2.0        |                | $          | .98 |   |
| $                   | 1.00       |                    | 100,000    |                                                      | 1.5        |                | $          | 1.00 |   |
| $                   | 1.08       |                    | 333,333    |                                                      | 2.0        |                | $          | 1.08 |   |
| $                   | 1.43       |                    | 50,000     |                                                      | 1.8        |                | $          | 1.43 |   |
| $                   | 1.44       |                    | 2,500,000  |                                                      | 1.9        |                | $          | 1.44 |   |
| $                   | 2.77       |                    | 30,000     |                                                      | 2.0        |                | $          | 2.77 |   |
| $                   | 3.00       |                    | 100,000    |                                                      | 1.9        |                | $          | 3.00 |   |
| $                   | 6.50       |                    | 5,460      |                                                      | 5.0        |                | $          | 6.50 |   |
| $                   | 50.00      |                    | 900        |                                                      | 2.0        |                | $          | 50.00 |   |
|                |       |                    |       |                                                      |       |                |       |
|                |       | 5,419,693               |       |                                                      |       | $                   | .97        |   |

 

InFebruary, 2006, Power3 executed an agreement to issue warrants allowing theholder, The Kaminer Group, to purchase the equivalent of $2,000 per month incommon stock, based upon the average daily closing market price for the stockduring the previous month.

 

26

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***Note***** *10. RECENT PRONOUNCEMENTS***

 

*FIN 46 – Consolidation ofVariable Interest Entities*

 

InJanuary 2003, the FASB issued FIN 46, (revised in December 2003 as FIN46R) “Consolidationof Variable Interest Entities,” which clarifies the application of AccountingResearch Bulletin (“ARB”) 51, Consolidated Financial Statements, to certainentities (called variable interest entities) in which equity investors do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. The disclosurerequirements of this Interpretation are effective for all financial statementsissued after January 31, 2003. The consolidation requirements apply to allvariable interest entities created after January 31, 2003. In addition, publiccompanies must apply the consolidation requirements to variable interestentities that existed prior to February 1, 2003 and remain in existence as ofthe beginning of annual or interim periods beginning after June 15, 2003. Theadoption of FIN 46R had no impact on the financial statements of the Company asthe Company has no variable interests in variable interest entities.

 

*SFAS 150 - Accounting for Certain‘Financial Instruments with Characteristics of Both Liabilities and Equity*

 

In May 2003, SFAS No. 150 “Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity,” wasissued to establish new standards for how an entity classifies and measurescertain financial instruments with characteristics of both liabilities and equity.It requires that an entity classify a financial instrument that is within itsscope as a liability (or an asset in some circumstances). Many of theseinstruments were previously classified as equity. This statement was effectivewhen issued for financial instruments entered into or modified after May 31,2003, and otherwise is effective for calendar year public companies for thethird quarter of 2003. The adoption of SFAS 150 had no impact on the financialstatements of the Company.

 

*SFAS 132 - Employers’ Disclosuresabout Pensions and Other Postretirement Benefits*

 

In December 2003, FASB Statement No. 132 (revised)was issued which prescribes the required employers’ disclosures about pensionplans and other postretirement benefit plans; but it does not change themeasurement or recognition of those plans. The Statement retains and revisesthe disclosure requirements contained in the original Statement 132. It alsorequires additional disclosures about the assets, obligations, cash flows, andnet periodic benefit cost of defined benefit pension plans and otherpostretirement benefit plans. The Statement generally is effective for fiscalyears ending after December 15, 2003. Since the Company does not have any typesof pension plans or other postretirement benefits, the adoption of thisStatement did not have an effect on the Company’s financial statements.

 

*SFAS 123(R) ‘Share-Based Payments’*

 

In December 2004, the Financial AccountingStandards Board issued Statement Number 123 (“FAS 123 (R)”), Share-BasedPayments. FAS 123 (R) requires all entities to recognize compensation expensein an amount equal to the fair value of shared-based payments such as stockoptions granted to employees. The Company will be required to apply FAS 123 (R)on a modified prospective method. Under this method, the Company is required torecord compensation expense (as previous awards continue to vest) for theunvested portion of previously granted awards that remain outstanding at thedate of adoption. In addition, the Company may elect to adopt FAS 123 (R) byrestating previously issued financial statements, basing the amounts on theexpense previously calculated and reported in the pro forma disclosures thathad been required by FAS 123. FAS 123 (R) is effective for the first reportingperiod beginning after June 15, 2005. The Company does not believe theimpact of adopting this Statement will be material as there are no unvestedoptions and warrants at December 31, 2005.

 

*SFAS 153 - Exchanges of Non-monetary Assetsan Amendment of APB Opinion No. 29*

 

In December 2004, FASB Statement No. 153 wasissued amending APB Opinion No. 29 to eliminate the exception allowingnon-monetary exchanges of similar productive assets to be measured based on thecarrying value of the assets exchanged as opposed to at their fair values. Thisexception was replaced

 

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with a general exception for exchanges ofnon-monetary assets that do not have commercial substance. A non-monetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange. The provisions ofthis statement are effective for non-monetary asset exchanges occurring infiscal periods beginning after the June 15, 2005. The adoption of thisstatement did not have a material impact on the Company’s financial statements.

 

*FIN- 45Guarantor’s Accounting and Disclosure Requirements for Guarantees, IncludingIndirect Guarantees of Indebtedness of Others*

 

InNovember 2002, the FASB issued FASB Interpretation (“FIN”) 45 “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others,” which elaborates on the disclosures tobe made by a guarantor in its interim and annual financial statements about itsobligations under certain guarantees that it has issued. It also clarifies thata guarantor is required to recognize, at the inception of the guarantee, aliability for the fair value of the obligation undertaken in issuing theguarantee. The initial recognition and initial measurement provisions of thisInterpretation are applied prospectively to guarantees issued or modified afterDecember 31, 2002. The adoption of these recognition provisions will result inrecording liabilities associated with certain guarantees provided by us. Thedisclosure requirements of this Interpretation are effective for financialstatements of interim or annual periods ending after December 15, 2002. FIN 45has no impact on the Company’s financial statements

 

*FASB154 Accounting Changes and Error Corrections.*

 

SFASNo. 154 replaces APB Opinion No. 20, Accounting Changes and SFAS No. 3,Reporting Accounting Changes in Internal Financial Statements, and changes therequirements for the accounting for and reporting of a change in accountingprinciple.SFAS No. 154 requires retrospective application of changes in accountingprinciple to prior periods’ financial statements unless it is impracticable todetermine either the period-specific effects or the cumulative effect of thechange. SFAS No. 154 is effective for accounting changes and corrections oferrors made in fiscal years beginning after December 15, 2005. We adopted SFASNo. 154 on January 1, 2006. Any impact on our results of operations andearnings per share have been recognized where appropriate.

 

***Item 2. MANAGEMENT’S DISCUSSION AND ANALYSISOR PLAN OF OPERATION***

 

Forward Looking Statements

 

This report contains certain forward-looking statements of theintentions, hopes, beliefs, expectations, strategies, and predictions of theCompany or its management with respect to future activities or other futureevents or conditions within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934, asamended. These statements are usually identified by the use of words such as “believes,”“will,” “anticipates,” “estimates,” “expects,” “projects,” “plans,” “intends,” “should,”“could,” or similar expressions. These statements are based on certainassumptions and analyses made by the Company in light of its experience and itsperception of historical trends, current conditions, expected futuredevelopments and other factors it believes are appropriate. Investors arecautioned that all forward-looking statements involve risks and uncertainties,including, without limitation:

 

•                  TheCompany’s history of operating losses;

 

•                  TheCompany’s need and ability to raise significant capital and obtain adequatefinancing for its development efforts;

 

•                  TheCompany’s ability to successfully develop and complete validation studies forits products;

 

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•                  TheCompany’s dependence upon and the uncertainties associated with obtaining andenforcing patents and intellectual property rights important to its business;

 

•                  Theuncertainties associated with the lengthy regulatory approval process,including uncertainties associated with the United States Food and DrugAdministration (“FDA”) decisions and timing of product development or approval;

 

•                  Developmentby competitors of new or competitive products or services;

 

•                  TheCompany’s ability to retain management, implement its business strategy,assimilate and integrate any acquisitions;

 

•                  TheCompany’s lack of operating experience and present commercial productioncapabilities; and

 

•                  Theincreasing emphasis on controlling healthcare costs and potential legislationor regulation of healthcare pricing.

 

Although the Companybelieves that the assumptions underlying the forward-looking statementscontained in this report are reasonable, any of the assumptions could beinaccurate, and, therefore, there can be no assurance that the forward-lookingstatements included in this report will prove to be accurate. In light of thesignificant uncertainties inherent in the forward-looking statements includedin this report, the inclusion of such information should not be regarded as arepresentation by the Company or any other person that the objectives and plansof the Company will be achieved. Except for its ongoing obligation to disclosematerial information as required by the federal securities laws, the Companyundertakes no obligation to release publicly any revisions to anyforward-looking statements to reflect events or circumstances after the date ofthis report or to reflect the occurrence of unanticipated events. Accordingly,the reader should not rely on forward-looking statements, because they aresubject to known and unknown risks, uncertainties, and other factors that maycause our actual results to differ materially from those contemplated by theforward-looking statements.

 

Overview

 

The Company is an earlystage development company engaged in the early detection, monitoring, andtargeting of diseases through the analysis of proteins. The Company’s businessobjective is to commercialize its intellectual property by focusing on diseasediagnosis, protein and biomarkers identification and drug resistance in theareas of cancers, neurodegenerative and neuromuscular diseases. The Company hasestablished a scientific advisory board to assist in the research anddevelopment of its products. The members of the scientific advisory board arerecognized leaders in their chosen fields, and the Company is working with themin the development of effective early diagnosis and drug targets for earlytreatment of cancers, neurodegenerative and neuromuscular diseases.

 

Priorto the Company’s acquisition of the assets of Advanced BioChem, Inc. onMay 18, 2004, the Company was primarily engaged in the production anddistribution of surgical safety devices through the operations of itssubsidiary, Power3 Medical, Inc. On May 18, 2004, the Company completed itsacquisition of the assets of Advanced BioChem. The Company acquired all assetsand intellectual properties of Advanced BioChem and assumed certain liabilitiesin exchange for the issuance of 15,000,000 shares of the Company’s commonstock. Subsequent to the Advanced BioChem transaction, the Company establishedthe new business direction described above. After the acquisition of the assetsand certain liabilities of Advanced BioChem, the Company transformed into anadvanced proteomics company applying existing proprietary methodologies tocommercialize the intellectual property it acquired in the Advanced BioChemtransaction and subsequently developed new proprietary methodologies related tothe discovery and identification of protein biomarkers associated with diseases.The Company currently has no products for sale nor does it provide any servicefor hire. The Company is focused on research and development activities andinitiating the “proof of concept” of its technologies.

 

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The Company is in the developmental stage. As such, it has not begungenerating revenue from the sales of products or services, nor has it producedsuch for sale at this time. The Company is dependent on debt and equity capitalfor its activities. Our ongoing operations consist of research and developmentoperations and activities directed toward commercializing the intellectualproperty of the Company at this time. The Company has been in its currentdevelopmental stage since its acquisition of its current set of intellectualproperties on May 18, 2004.

 

The Company has incurredsignificant losses since inception. The Company anticipates that it willcontinue to incur substantial operating losses as it progresses in its researchand development activities as well as the commercialization of its technologies.The Company does not expect to produce revenues from operations in the nearterm and expects that its revenues will be limited to research grants,collaboration agreements, and other strategic alliances which the Company isable to obtain. The Company has an immediate need for capital to continue itscurrent operations

 

*ScientificDevelopments*

 

The members of theCompany’s scientific team have developed a method for the differentialdiagnosis of neurodegenerative diseases utilizing blood serum, which wasco-developed with neurologist, Dr. Stan Appel, Chair of Neurology and his teamat The Methodist Hospital Neurological Research Institute in Houston. Under thetrade name of NuroProTM, the Company is continuing development of a suite offour tests to differentiate individuals with no known neurological disordersfrom those with Alzheimer’s disease, Parkinson’s disease, ALS, and otherdisorders that have similar clinical symptoms as these diseases. The Company isalso continuing to do research in the area of early breast cancer detection,based on the identification and study of protein biomarkers in blood serum.

 

***Product Candidates***

** **

The Company plans to target the protein-baseddiagnostic and drug targeting markets utilizing the Company’s portfolio ofproprietary biomarker disease footprints. In the area of neurodegenerativedisease, the Company has completed clinical validation studies involving over650 patient samples and is utilizing biostatistics to monitor appropriatebiomarkers for diagnostic sensitivity, specificity, positive predictive value,and negative predictive value. By testing patient body fluids and tissues, suchas serum, nipple aspirate fluid, and bone marrow, the Company has discoveredunique snapshots of protein patterns in diseases including:

 

•                  cancers such asbreast, leukemia, prostate, bladder, stomach, and esophageal;and

 

•                  neurodegenerativediseases such as Alzheimer’s, ALS, and Parkinson’s disease.

 

The Company’s discovery platform uses both proprietarymethodologies owned by or licensed to the Company and accepted technologies todiscover biomarkers in clinical samples. Following sample preparation, a 2D Gelsystem is used for the separation of protein. The gels are stained, imaged andanalyzed with unprecedented sensitivity for differences in the diseased vs.normal samples. The significance of these differences is evaluated relative tothe status of the health of the individual. The proteins of interest areremoved from the gel matrix and analyzed on a mass spectrometer. Thisinformation is then cross-referenced on a worldwide database to identify theprotein of origin. This process requires a great deal of proteomics experienceand expertise to make the end-data interpretable. In addition, all of theprocedures are scaleable. The Company’s biomarker discovery platform deliverssignificant discoveries that are capable of detecting up to 20 times as manyproteins in nipple aspirate fluids as Mud Pit or SELDI TOF (competingtechnologies); exhibiting reproducible and reliable identification; and displayingbroad dynamic range and linearity of disease protein footprints.

 

The Company has successfully identified more than 400proteins, protein fragments and isoforms that are differentially expressed inresponse to disease by employing proprietary technologies gained from over 50years of combined experience in protein biochemistry.

 

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Power3 is transitioning from a company focused only onresearch and development to one that is demonstrating “proof of concept” of itstechnology as it enters the commercialization stage for its technology,products and services. The Company is engaged in the process of developing aportfolio of products including the biomarkers and blood serum tests (for earlydetection of breast cancer), NuroProTM biomarkers and blood serum tests (forneurodegenerative diseases including Alzheimer’s, Parkinson’s and ALS diseases)and biomarkers, tests and drug targets for drug resistance tochemotherapeutics.

 

**License and SponsoredResearch**

** **

Advanced Bio/Chem entered into a license agreementwith the Board of Regents of The University of Texas System, an agency of theState of Texas, on behalf of The University of Texas M.D. Anderson CancerCenter in September 2003, which the Company acquired in its transaction withAdvanced Bio/Chem. The license agreement gives the Company an exclusive,worldwide, royalty-bearing license to certain patent rights and technologyrights for proteomic methods of diagnosis and monitoring of breast cancer usingnipple aspirate fluids. On February 17, 2006, Power3 received notice from UTM.D. Anderson Cancer Center confirming that the license agreements betweenPower3 and UT M.D. Anderson Cancer Center were terminated under Section 13.3 ofthe license agreement for breach of certain payment obligations as outlined inthe License Agreement. The letter further described maintenance fees, licensedocumentation fees and patent costs due to UT M.D. Anderson in the amounts of$46,945.62, prior to the termination date. In addition, the letter stated thatPower3 was obligated to grant UT M.D. Anderson a non-exclusive royalty-bearinglicense to improvements made by Power3 and asked the Company to immediatelydisclose these improvements so that UT M.D. Anderson could consider whether itwished to license them.

 

Effective June 28, 2004, Power3 entered into anexclusive license agreement with the Baylor College of Medicine which grants tothe Company an exclusive, worldwide, sublicensable license for serum proteomicsmethods under certain patent rights for all biomarkers for both diagnostic andtherapeutic use in neurodegenerative disease. Under the terms of the agreement,Power3 paid Baylor an initial license fee and it has the obligation to payfuture royalties and additional licensing fees upon the achievement of certainmilestones. The Company is obligated under the license agreement to indemnifyBaylor, its faculty members, scientists, researchers, employees, officers,trustees and agents against claims arising from the design, process,manufacture or use of any of the patent rights or licensed products that aredeveloped through the use of the license from Baylor. Subject to customarytermination provisions, the term of the agreement is established on acountry-by-country basis and expires on the date of expiration of the lastpatent rights to expire in that country or the tenth anniversary of the firstcommercial sale of licensed products in countries where no patents exist insuch country. After such expiration the Company will have a perpetual paid infull license in such country.

 

On August 1, 2004, Power3 entered into an exclusivelicense agreement with M.D. Anderson which grants the Company an exclusive,worldwide, sublicensable license to patents and technologies for earlydetection screening tests, identified protein biomarkers and drug targets forcancer patient’s resistance to drug therapy. The licensed technology wasdeveloped through joint collaboration between the Company’s scientific team andM.D. Anderson. Under the terms of the agreement, the Company paid M.D. Andersonan initial license fee and the Company has the obligation to pay furtherroyalties and additional licensing fees upon the achievement of certainmilestones. The license agreement imposes upon the Company an obligation toindemnify the Board of Regents, The University of Texas System, M.D. Anderson,the regents, officers, employees, students, and agents against claims arisingon account of any injury or death or damage to property caused by the exerciseof the rights granted under the license agreement to the Company, its officersand affiliates. The term of the license agreement is based on the date ofexpiration of the last patent rights to expire or, in the case of licensedtechnology rights, for a term of fifteen (15) years. However, in addition tocustomary termination provisions, M.D. Anderson has the right to terminate thelicense in any country if the Company fails, within ninety (90) days afterreceiving written notification from M.D. Anderson, to provide satisfactoryevidence that it has commercialized or is attempting to commercialize thelicensed invention in such country.

 

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On August 31, 2004 the Company entered into a researchagreement with Baylor College of Medicine for the purpose of discoveringbiomarkers in serum and plasma that are of particular utility in the diagnosisand drug targeting for metabolic syndrome and associated disorders includingdiabetes, cardiovascular disease, hypertension and stroke. Under the terms ofthe agreement, Baylor College of Medicine will provide the Company samplematerials for use in diagnosis in drug targeting metabolic syndrome andassociated diseases including diabetes, cardiovascular disease, hypertensionand stroke. With respect to any inventions developed pursuant to the agreement,the party who develops such invention will retain sole and exclusive rights tosuch invention. The other party will have the right to an exclusive license forthe invention, which has been developed. Inventions developed jointly by theparties will be jointly owned. Power3 does not have any obligations for thepayment of fees or royalties pursuant to this agreement. The agreement has aterm ending June 30, 2007 and may be renewed for successive one-year periods.

 

On March 21, 2005, the Company entered into acollaborative research agreement with New Horizons Diagnostic for thedevelopment of antibody based diagnostic tests for neurodegenerative diseaseutilizing the Company’s identified biomarkers. The research agreement is basedon groups of biomarkers whose profiles are relatively sensitive and specific indistinguishing patients with ALS, Alzheimer’s disease and Parkinson’s diseasefrom each other, as well as from normal patients and patients with otherneuromuscular and neurological disorders. The purpose of the agreement is totailor monoclonal and polyclonal antibodies to the biomarkers, which will beincorporated into immunoassays. Once the assays are available, they will bedeveloped to validate diagnostic tests specifically designed to detect anddiscriminate among the neurodegenerative diseases. The research agreementprovides that the parties will develop an agreed upon schedule and budget forthe work contemplated thereunder within sixty (60) days of the effective date. Theagreement provides that in the event the parties are able to achieve specifiedgoals relating to the development of a diagnostic kit as contemplated by theresearch agreement, New Horizons would be compensated in any one of thefollowing manners with respect to such diagnostic kit:  (i) a contract to manufacture at least onekey component of such diagnostic kit; (ii) royalties on the sale of suchdiagnostic kit; (iii) the opportunity to form a joint venture with the Companyfor the commercialization of such diagnostic kit; or (iv) a reasonablepercentage of any cash consideration that the Company receives from a thirdparty for such diagnostic kit. Although the form and amounts of anyconsideration to be paid have not been agreed upon, the parties have agreed tobe reasonable in negotiating such consideration.

 

OnMay 24, 2005, the Company entered into a Collaboration Agreement with BioSiteIncorporated. The Agreement provides that the Company and Biosite will engagein a collaborative research program in which Biosite will attempt to developantibodies and diagnostic assays for selected target biomolecules proposed bythe Company. The Company and Biosite will then assess the diagnostic andtherapeutic potential of these antibodies and diagnostic assays for breastcancer and neurological diseases. If the antibodies and diagnostic assays arefound to have diagnostic and/or therapeutic potential, Biosite will develop andcommercialize Biosite Products for the detection and/or treatment of breastcancer and/or neurological diseases. Biosite will make milestone payments tothe Company, as well as pay royalties on the sale of any Biosite Productscontaining antibodies to any selected target biomolecule claimed in a patentapplication or an issued patent.

 

Morespecifically, the Agreement provides that the Company shall propose targetbiomolecules for the collaborative research program; Biosite and the Companyshall mutually select certain target biomolecules for immunization (“ProgramTarget”); and Biosite shall use commercially reasonable efforts to developmonoclonal and omniclonal antibodies to the selected target biomolecules thatmeet the specification set out by the parties (“Program Antibodies”). Upon Biosite’swritten request subsequent to the delivery of Program Antibodies to theCompany, the Company will provide Biosite with blood-based clinical samplesuseful in the assessment of the Program Antibodies.

 

Biositewill use commercially reasonable efforts to generate an ELISA-based assay foreach Program Target for which Biosite has generated Program Antibodies. IfBiosite successfully develops an

 

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ELISA-basedassay for any such Program Target, Biosite shall analyze each of the clinicalsamples provided by Power3 with such assay and shall provide the resulting datato Power3.

 

Underthe terms of the Agreement, Power3 grants to Biosite a worldwide,royalty-bearing license under the Power3 patent rights for the targetbiomolecules and Power3 know-how rights to develop, make, have made, use, offerfor sale, sell and import Biosite Products for use in the detection, prognosis,diagnosis or monitoring of any breast cancer-related disease. This license isexclusive with the right to grant sublicenses for the assay of less than orequal to 100 patient samples per hour. This license is semi-exclusive, with theright for each party to grant one sublicense, for the assay of 100 or morepatient samples per hour.

 

Underthe terms of the Agreement, Power3 grants to Biosite a non-exclusive,worldwide, royalty-bearing license under the Power3 patent rights for thetarget biomolecules and Power3 know-how rights to develop, make, have made,use, offer for sale, sell and import Biosite Products for use in the detection,prognosis, diagnosis or monitoring of any neurological-related disease. Thislicense includes the right for Biosite to grant one sublicense for each ProgramTarget, provided that the grant of such sublicense will replace Biosite’s ownrights under the license.

 

Inconsideration for the collection and transfer of samples, Biosite shall payspecified fees to Power3 based on a minimum number of samples delivered toBiosite and per unit fees for samples delivered in excess of the minimum.

 

Biositeshall pay the Company milestone payments based on certain specified events asfollows:

 

• upon the earlier of (a) the First CommercialSale by Biosite of a Biosite Product, or the effective date of the firstwritten agreement between Biosite and a Third Party sublicensee for asublicense,

 

• upon demonstration, as determined in Biosite’ssole and reasonable discretion, that a panel of antibodies (including one ormore antibodies to a Program Target) is suitable for development of acommercial product,

 

• upon the first submission by Biosite of thefirst 510(k) (premarket notification) or PMA (pre-market approval application)to the FDA for the first Biosite Product; and

 

• upon the first FDA approval of the first 510kor PMA submitted by Biosite for the first Biosite Product.

 

Commencingat the end of the first full calendar year following the date of FirstCommercial Sale for the first Biosite product, and at the end of eachsubsequent calendar year during the term of this Agreement, Biosite shall paythe Company specified annual minimum royalties. During the applicable RoyaltyTerm for a Biosite Product, on a country-by-country basis, Biosite shall paythe Company royalties, with respect to each Biosite Product equal to a specifiedpercentage of Net Sales of each Biosite product in that country. In addition tothe specified royalty payments, to the extent that Biosite reaches certainspecified sales targets, then Biosite shall be obligated to make additionalpayment to the Company. The Agreement expires upon the expiration of the lastto expire applicable Power3 patent right. The agreement may be terminated forcause, by either party or upon written notice by either party following thetwenty four month anniversary date of the Agreement, or by Biosite if it isunable to develop and deliver Program antibodies to the to the Program Targets.

 

OnOctober 13, 2005, Power3 executed a Research Agreement with Pfizer, Inc. tofurther evaluate the Company’s NuroProTM test capabilities and to test blind andunblended samples, provided by Pfizer, under controlled conditions. The Companyis completing the analysis of the results with the blinded samples inpreparation to present them to Pfizer.

 

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OnDecember 28, 2005, the Company submitted 6 breast cancer blood serum biomarkersto Biosite, for consideration under the agreement. The development ofantibodies was begun by Biosite for the first of this series.

 

**Breast Cancer ScreeningTest**

** **

An important factor in surviving cancer is earlydetection and treatment. According to the American Cancer Society SurveillanceResearch, when breast cancer is confined to the breast, the five-year survivalrate is close to 100%. Breast cancer is the second leading cause of cancerdeaths in women, with over $7 billion spent on breast cancer diagnosis annually.Due to the limitations of the current diagnostic techniques of mammograms andself-examination, diagnosis of cancer is often missed or inconclusive. TheCompany’s proteomic discovery platform covered by pending patent applicationsand trade secrets for identifying proteins which signal pre-mammography stagesof breast cancer has led to what the Company believes to be one of the firsttests of its type that may detect breast cancer earlier than current technologyallows. These discoveries establish the basis of a very sensitive,non-invasive, early detection breast cancer-screening test.

 

The Company has decided to focus development effortsfor its early-detection tests for breast cancer on blood serum. The Company hassuccessfully used blood serum as the platform for its NuroProTMneurodegenerative tests and believes that blood serum as a single platform isthe best medium for the development and commercialization of proteomicsdiagnostic tests.

 

The Company’s Breast CancerNAFTestTM analyzes fluids from the breast called nipple aspirates fluid (NAF).Initial success yielded the identification of groups of breast cancer proteinsin the aspirates. The procedure utilizes a breast pump to obtain a drop offluid from the nipple. The aspirate is analyzed to identify specific breastcancer protein footprints.

 

During the past year, Power3has conducted clinical validation studies of its breast nipple aspirate fluidbreast cancer test a three clinical sites: Mercy Woman’s Center in Oklahoma City, the NYU Medical Center in NewYork City and Obstetrics and Gynecological Associates at The Woman’s Hospitalin Houston. The use of breast duct fluid samples for this purpose is thesubject of an issued patent and patent pending license from MD Anderson CancerCenter.

 

Concurrently, Power3conducted its own biomarker discovery program using blood serum samplescollected from the same clinical validation sites, in collaboration with Dr.Alan Hollingsworth at the Mercy Woman’s Center.

 

The blood serum biomarkersand tests for early-detection of breast cancer discovered by comparing bloodserum samples, distinguish between women with breast cancer, women with benignbreast disease, and normal women with high sensitivity and specificity. TheCompany believes that there are many advantages to a simple blood test overother samples taken from patients, not the least of which is the readyacceptance by patients to having blood drawn. This, along with numerouscomplaints from patients about the discomfort of the procedure, as well as thelow success rate in getting nipple aspirate samples (less than 50%) and theexperience that even when samples were successfully drawn, they were often notrepresentative enough for accurate testing, has led the Company to decide thatnipple aspirate testing is not commercially viable.

 

Since the Company haselected to not pursue nipple aspirate testing for commercialization, thelicense agreement with MD Anderson has not been renewed by the Company. The bloodserum biomarkers and tests, discovered directly using blood serum, are coveredunder intellectual property solely owned by the Company.

 

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**NeurodegenerativeScreening Test**

** **

Early detection of neurodegenerative disease generallyresults in better patient outcomes. Three diseases of particular interest areAlzheimer’s disease, Parkinson’s disease and ALS. The Alzheimer’s Associationreports that Alzheimer’s disease is the most common form of dementia affectingover 4 million Americans. People as young as 30 years old can contract thedisease and one in ten people age 65 and over have Alzheimer’s disease. Inaddition, the American Parkinson’s Disease Association reports that more than1.5 million people in the U.S. have Parkinson’s disease, affecting about 1 in100 Americans over the age of 60. On a smaller scale, the ALS Associationreports that an average of approximately 30,000 Americans are afflicted withALS, with 5,000 new cases diagnosed annually.

 

The members of the Company’s scientific team havedeveloped a method for the differential diagnosis of neurodegenerative diseasesutilizing blood serum, which was co-developed with neurologist, Dr. Stan Appel,now Chair of Neurology and Co-Director of Methodist Neurological Institute inHouston. With this test, which involves monitoring the concentration ofdifferentially expressed proteins, the Company has identified groups of uniquemarkers that appear to distinguish normal patients from those with motor neuron,cognitive, and other neurological disorders.

 

The Company is continuing its ongoing clinicalvalidation program in collaboration with the Methodist Neurological Institute. Theinitial phase was completed in July 2004 and the latest phase was completed inMarch, 2006. During this time period, the Company’s database has increased from183 to over 650 unique samples classified either as normal or being clinicallydiagnosed with ALS, Alzheimer’s, Parkinson’s, and other related neurologicaldisorders. During this time, the number of differentially expressed proteinsused in the discriminant analysis has increased from 9 to 47. The ability todifferentiate diseases from each other and from normal and disease controls hasimproved using the proprietary PD3TM process, including PolyiterativeTMbiostatistical analysis on the larger database and the expanded set ofbiomarkers. Currently, select panels of biomarkers are being employed indevelopment of the NuroProTM blood serum-based tests for four diseasediagnostics including neurological diseases of motor control such as Parkinson’sdisease, ALS and their like disorders; ALS specific tests for ALS vs. ALS-likedisorders; Alzheimer’s disease specific tests; and a Parkinson’sdisease-specific test. Pre-IDE applications for the first two have been filedwith the U.S. Food and Drug Administration.

 

**Drug Resistance toChemotherapeutic Agents**

** **

By the time a patient’s development of resistance tochemotherapeutic agents is detected, it is often too late to revise treatmentor otherwise save the patient. In 2002, the Company completed an initial “proofof concept,” which addresses drug resistance to a major chemotherapy agent. Determiningthat a cancer patient is sensitive or detecting a development of resistanceduring the early stages of treatment may eliminate toxic effects from thetreatment drugs, and the need for trial-and-error treatment regimens. Thesefindings may ultimately provide the pharmaceutical industry with the technologyto screen patients, on a molecular level, prior to clinical trials and designnew drugs to overcome resistance.

 

**Strategic PartnersInitiative**

** **

In January of 2006, the Company retained GloCapAdvisors, LLC, as exclusive advisor for strategic alternatives. As the Companycontinues to seek synergistic strategic partners to license and develop itsgrowing portfolio of protein biomarkers and tests, it believes Glocap Advisorsassistance, business introductions and advice will increase the Company’s exposurein target markets, provide important strategic relationships and identifyappropriate strategic partners, instrumental and essential for overallsuccessful execution of the Company’s business plan. The Company’s businessplan includes the development of these strategic partnerships which itanticipates will assist in the Company’s evolution over the next several yearsincluding the commercialization of its proprietary technologies.

 

The Company recognizes that the licensing of itsproprietary technologies to industry leaders is one of the most expedientapproaches to develop the Company’s technology into important diagnostic

 

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tools for the detectionof diseases. The Company believes this focused positioning of its products andservices will enable the Company to capture clinical and public awareness ofits proprietary technologies, and apply a major portion of that technology tothe early detection and screening markets.

 

**Results of Operations**

** **

*Three Months Ended March 31, 2006 as Compared to Three Months Ended March 31, 2005*

 

Revenues for the three months ending March 31, 2006 were $-0- and $-0-for the same period in 2005. Due to the Company’s focus on disease diagnosis,protein and biomarkers identification, and research on drug resistance in theareas of cancer, neurodegenerative and neuromuscular diseases, it is unlikelythat the Company will receive any revenues from commercial operations in theimmediate future.

 

Total operating expenses were $3,807,987 during the three months endedMarch 31, 2006 as compared to $4,070,444 for the three months ended March 31,2005, a decrease of $262,457. The decrease in operating expenses was primarilyattributable to a decrease of $271,920 in stock based compensation expense andto the amortized costs of the warrants issued to consultants and to theconvertible debenture holders. Other income and expenses, including gain orloss from derivatives, were ($1,097,761) in the first three months of 2006 ascompared to $699,565 during the first three months of 2005.

 

Interest expense thus far in 2006 has amounted to $577,607 as comparedto $19,506 during the same three month period of 2005. The increase in interestexpense is primarily attributable to the recognition of the original issuediscount on notes payable, the additional interest due on the notes payable thecompany has taken on and the amortization of the debt discounts and deferredfinance costs.

 

The above matters result in our Net Loss being $1,534,869 greater in2006 than during the first three months of 2005.

 

Liquidity and Capital Resources

 

The Company has financed its operations since the date of the AdvancedBioChem transaction primarily through the net proceeds generated from the saleof common stock, the issuance of convertible debentures and the issuance ofnotes payable as bridge loans. From the date of the Advanced BioChemtransaction through March 31, 2006, the Company has raised approximately$3,026,978 in debt capital. As described in “Recent Financing” below, theCompany may sell an additional $1,600,000 in aggregate principal amount ofconvertible debentures following the effectiveness of the RegistrationStatement on Form SB-2 filed by the Company for the resale of certainshares of the Company’s stock by the purchasers of the Company’s convertibledebentures. The Company is in default under the terms of the SecuritiesPurchase Agreement, the previously issued debentures and related registrationrights agreement and there can be no assurance that the existing investors willpurchase all or any portion of the additional $1,600,000 aggregate principalamount of debentures. If additional debentures are issued and sold by theCompany, the Company will use a portion of the proceeds from the sale and issuanceof such debentures to pay the $451,000 principal balance owing under thepromissory notes dated April and September, 2005, the $446,500 principalbalance owing under the promissory note dated June 17, 2005, amended inSeptember, 2005 and the Officer Advances.

 

The Company’s liquidity and capital needsrelate primarily to working capital, development and other general corporaterequirements. The Company has not received any cash from operations. TheCompany has an immediate need for capital to continue its current operations. Inaddition to seeking additional capital, the Company will seek revenues fromresearch grants, collaboration agreements, and other strategic alliances.

 

In the event the sale and issuance of the$1,600,000 aggregate principal amount of debentures occurs and the investorsexercise their warrants and additional investment rights, the Companyanticipates it will have adequate cash to meet its funding requirements throughthe fourth quarter of 2006. The foregoing

 

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projections are based upon the Company’sexisting obligations. If the Company’s obligations are increased, the Companywill require additional funding sooner than is currently anticipated.

 

Net cash used in operating activities approximated ($715,402) for thethree months ended March 31, 2006, compared to ($445,963) for the three monthsended March 31, 2005. The increase in net cash used in operating activitiesduring 2006 was primarily due to a larger loss from operations, losses onderivatives and an increase in accounts payable, as compared to the first threemonths of 2005.

 

Net cash provided by financing activities approximated $877,194 for thefirst three months of 2006 as compared to $338,000 for the three months endedMarch 31, 2005, based primarily on new bridge loans taken out during the firstquarter of 2006.

 

As of March 31, 2006, the Company’s principal source of liquidity wasapproximately $163,191 in cash.

 

*Recent Financing*

 

On January 20, 2006, Power3 executed a promissorynote in the principal amount of $40,000 payable to Steven B. Rash, ChiefExecutive Officer, of the Company. Under the terms of the note, the principalamount of Forty thousand dollars ($40,000), (the “Principal”) shall be due andpayable on or before July 19, 2006 (the “Maturity Date”.)  Should the principal not be repaid as of July19, 2006, interest of 6% per year on any unpaid principal amount will be earnedby the note holder until such time as all of the principal amount is repaid. Thisnote may be repaid at any time prior to July 19, 2006, without interest orpenalty.

 

During February, 2006, Dr. Ira Goldknopf, theChief Scientific Officer of the Company, advanced the Company a total of$39,400 in a series of five different infusions as Officer Advances. On March2, 2006, the Company executed a promissory note in the principal amount of$89,400 payable to Dr. Goldknopf, the “note holder”. This note is due andpayable on September 1, 2006 and may be repaid at any time prior to September1, 2006, by the Company, without penalty. Should the principal not be repaid asof September 1, 2006, interest of 6% per year on any unpaid principal amountwill be earned by the note holder, until such time as the entire principalamount has been repaid.

 

On March 1, 2006, Power3 executed apromissory note in the principal amount of $50,000 payable to Dr. IraGoldknopf, the Chief Scientific Officer of the Company (the “payee”.)  Under the terms of the note, the principalamount of $50,000 shall be due and payable on or before September 1, 2006 (the “maturitydate”.)  Should the principal not berepaid as of September 1, 2006, interest of 6% per year on any unpaid principalamount will be earned the payee until such time as all of the principal amounthas been repaid. The note may be repaid at any time prior to September 1, 2006,without interest or penalty.

 

Previously, in March, 2006, the Company executed a promissory note inthe principal amount of $80,000 payable to Steven B. Rash, Chief ExecutiveOfficer of Power3. This note was cancelled on March 31, 2006, by mutual consentof the Company and Mr. Rash and no monies were ever received by the Companyfrom Mr. Rash for this note.

 

On March 29, 2006, the Company executed a promissory note with JohnFife (the “note holder”) in the principal amount of $400,000 (the “Principal”.)  The note is due and payable on the earlier ofJune 28, 2006 or the fifth day following the effective date of the Company’sregistration statement on Form SB-2 becoming effective. In case of default, allamounts due on the note shall bear interest at the rate of 18% per annum fromthe date such interest is due through and including the date of payment. Thenote is secured by a stock pledge agreement from the Chief Executive Officerand the Chief Scientific Officer of Power3, as a pledge of their personalshares of common stock of Power3.

 

37

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*Plan of Operation and Cash Requirements*

 

The Company currently does not have operating revenues from productsales or the performance of services and it continues to experience netoperating losses. The Company is actively pursuing third party licensingagreements, collaboration agreements and similar business arrangements in orderto establish a revenue base utilizing its capabilities in disease diagnosisbased on protein and biomarker identification, and drug resistance in the areasof cancers, neurodegenerative and neuromuscular diseases. The Company hasundertaken clinical validation studies to demonstrate the diagnosticcapabilities of its technologies. However, there can be no assurances thatrevenue-generating agreements will be in place in the next twelve months.

 

Absent a source of revenues, the Company will require funding in orderto carry out its business plan until such time as it is able to generatesustained revenues. The Company’s current cash requirements are approximately$300,000 per month and the Company anticipates that it will requireapproximately $3,600,000 for the twelve months ended March 31, 2007, tocontinue its development activities, undertake and perform clinical validationstudies, continue its marketing efforts and maintain its administrativeinfrastructure, broken down as follows:

 

Estimated ExpendituresRequiredDuring Next Twelve Months

 
| General and Administrative                    |   | $      | 2,750,000 |   |
|-----------------------------------------------|--------|--------|-----------|--------|
| Patent filings and intellectual property      |   | $      | 200,000   |   |
| Capital Expenditures and research  agreements |   | $      | 650,000   |   |
|                                          |   |   |      |   |
| Total                                         |   | $      | 3,600,000 |   |

 

The foregoing is based upon the Company’scurrent estimated cash requirements. The resolution of the Company’s currentdispute with Advanced BioChem regarding the liabilities assumed by the Companyin the parties’ transaction may result in an increase in the Company’sliabilities and cash requirements. The Company has no significant capitalexpenditure requirements and does not plan to increase its monthly expenditurerate absent an increase in revenues or additional funding.

 

Asnoted previously, the Company entered into a securities purchase agreement andan amendment to the securities purchase agreement pursuant to which certaininvestors agreed to purchase, subject to the satisfaction of certainconditions, convertible debentures in the aggregate principal amount of$3,000,000. Assuming the completion of the remaining closing and sale andissuance of the remaining $1,600,000 in aggregate principal amount of theconvertible debentures, the Company estimates that, after repayment of thebridge loans immediately following the sale and issuance of such debentures, theCompany will still require additional cash to allow it to meet its currentfunding requirements through the second quarter of 2006. In the event the saleand issuance of such debentures occurs and the investors exercise theirwarrants and additional investment rights, the Company anticipates it will haveadequate cash to meet its current funding requirements through the end of 2006.

 

The Company will continue to requireadditional debt or equity financing for its operations, which may not bereadily available. The Company’s ability to continue as a going concern issubject to its ability to generate a profit or obtain necessary funding fromoutside sources.

 

*Off-Balance Sheet Arrangements*

 

At March 31, 2006, with the exception of the lease for its operating facility,and employment agreements entered with its three principal officers, theCompany did not have any significant off balance sheet commitments.

 

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*Critical Accounting Policies*

 

The Company accounts for equity instruments issued to employees forservices based on the intrinsic value of the equity instruments issued. Equityinstruments issued to non-employees that are fully vested and non-forfeitableare measured at fair value at the issuance date and expensed in the period overwhich the benefit is expected to be received.

 

The Company has adopted Statement of Financial Accounting Standards No.148 “Accounting for Stock-Based Compensation - Transition and Disclosure” (SFASNo. 148). This statement amends FASB statement No. 123, “Accounting for StockBased Compensation”. It provides alternative methods of transition for anentity that voluntarily changes to the fair value based method of accountingfor employee stock based compensation. It also amends the disclosure provisionof FASB statement No. 123 to require prominent disclosure about the effects onreported net income of an entity’s accounting policy decisions with respect tostock-based employee compensation. As permitted by SFAS No. 123 and amended bySFAS No. 148, the Company continues to apply the intrinsic value method underAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees,” to account for its stock-based employee compensationarrangements.

 

In December 2004, the Financial Accounting Standards Board issuedStatement Number 123 (“FAS 123 (R)”), Share-Based Payments. FAS 123 (R)requires all entities to recognize compensation expense in an amount equal tothe fair value of share-based payments such as stock options granted toemployees. The Company will be required to apply FAS 123 (R) on amodified prospective method. Under this method, the Company will be required torecord compensation expense (as previous awards continue to vest) for theunvested portion of previously granted awards that remain outstanding at thedate of adoption. In addition, the Company may elect to adoptFAS 123 (R) by restating previously issued financial statements,basing the amounts on the expense previously calculated and reported in the proforma disclosures that had been required by FAS 123, FAS 123 (R)is effective for the first reporting period beginning after June 15, 2005.The Company has not yet determined the impact that FAS 123 (R) willhave on its financial statements; however, it does not believe the impact ofadopting this Statement will be material as there are no unvested options andwarrants at September 30, 2005.

 

***Item 3. CONTROLS ANDPROCEDURES***

 

*DisclosureControls and Procedures*

* *

Under the supervision and with the participation ofthe Company’s management, including its Chief Executive Officer and ChiefFinancial Officer, the Company conducted an evaluation of its disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of theExchange Act). Based on this evaluation and for the reasons set forth below,the Chief Executive Officer and Chief Financial Officer concluded that theCompany’s disclosure controls and procedures were ineffective as of December31, 2005, the end of the period covered by this annual report.

 

As reported in the Company’s Quarterly Reports on Form10-QSB for the quarterly periods ended September 30, 2004 and March 31, 2005,the Company identified certain deficiencies which caused management to concludethat the Company’s disclosure controls were ineffective as of September 30,2004. The Company has undertaken steps and implemented actions as disclosed inits previous Form 10-QSB’s in an effort to resolve these deficiencies. Whilethe actions identified in the previously filed Form 10-QSB’s and the actionsidentified below have addressed many of these deficiencies, the Companycontinued to have deficiencies with respect to its disclosure controls andprocedures at December 31, 2005 including the following:

 

•                  Althoughthe Company has hired accounting personnel as reported in its previous Form 10-QSB,the Company’s limited financing and available capital have restricted theCompany’s ability to fully implement its procedures for the improvement of itsinternal control over financial reporting and to engage outside professionalsand advisors to the extent the Company has desired to

 

39

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support the Company’saccounting personnel in the preparation and/or audit of financial statementsand reports to be filed with the SEC.

 

The Company continues to believe that the deficienciesare attributable to many factors including issues relating to the quality ofthe Company’s disclosure controls and procedures at the time of the AdvancedBio/Chem transaction and the transition following the transaction. Managementis committed to a sound disclosure control and internal control environment andis continuing its efforts to improve the Company’s infrastructure, personnel,processes and controls to help ensure that the Company is able to produceaccurate financial statements on a timely basis.

 

In addition, during the past year, Power3 facedstaffing issues relative to its cash flow situation. The Company has retainedoutside consultants, on an interim basis, to provide accounting and legalexpertise directed toward improving its reporting and control procedures. TheCompany has implemented additional controls over its daily operations and hasdrafted various Internal Controls memoranda.

 

Limitations onEffectiveness of Controls

 

Internal control over financial reporting cannotprovide absolute assurance of achieving financial reporting objectives becauseof its inherent limitations. Internal control over financial reporting is aprocess that involves human diligence and compliance and is subject to lapsesin judgement and breakdowns resulting from human failures. Internal controlover financial reporting also can be circumvented by collusion or impropermanagement override. Because of such limitations, there is a risk that materialmisstatements may not be prevented or detected on a timely basis by internalcontrol over financial reporting. However, these inherent limitations are knownfeatures of the financial reporting process. Therefore, it is possible todesign into the process, safeguards to reduce, though not eliminate, this risk.

 

*Changesin Internal Control Over Financial Reporting*

* *

As previously disclosed in the Company’s QuarterlyReport on Form 10-QSB for the quarterly period ending September 30, 2004, theCompany implemented several actions during the third quarter of 2004 in aneffort to improve its internal control over financial reporting. During thefourth quarter of 2004, the Company continued the implementation of morerigorous policies with respect to its disclosure and financial reporting reviewprocess including improvements of its infrastructure and processes to improveits internal control over financial reporting. The Company also is continuingits implementation of procedures to improve its review and processing ofnon-accounting documentation and contracts.

 

During 2005, the Company changed its auditing firm andimplemented additional internal controls over documents and accounting that aredesigned to improve its reporting. The Company’s auditors have identified theabove issues as material weaknesses and the Company is consulting with itsauditors to remediate these issues.

 

Other than the changes described above, there were nochanges in the Company’s internal control over financial reporting thatoccurred during the Company’s fiscal quarter ended March 31, 2006 that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal controls over financial reporting.

 

# **PARTII. OTHER INFORMATION**

# ** **

## ***Legal Proceedings***

## ** **

In November 2004, Chapman Spira & Carson, LLC (“Chapman Spira”),an investment banking firm, filed a lawsuit in the Supreme Court of the Stateof New York for the County of New York against Advanced BioChem (thePredecessor), Power3 and Steven Rash. The suit alleges that Advanced BioChemand Power3 are liable to Chapman Spira for damages allegedly resulting from thebreach of a

 

40

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letter agreement between Chapman Spira and Advanced BioChem relating tothe performance of strategic and investment banking services. Chapman Spira isseeking damages in the amount of $1,522,000 plus interest. The Company hasfiled an answer in the lawsuit. The Company disputes the allegations in thecomplaint and is vigorously defending this matter.

 

This action was commenced in April, 2005, by an equipment vendor andconcerns equipment which the Company acquired in its May 18, 2004 transactionwith Advanced BioChem, now known as Industrial Enterprises of America. AdvancedBioChem reached a settlement agreement with the equipment vendor in April of2003 under which Advanced BioChem would pay the equipment vendor $40,000 ininstallments through August, 2003. As of December 31, 2003, Advanced BioChemhad a balance remaining of $20,000. In April, 2005, the equipment vendor fileda lawsuit against Advanced BioChem, certain former officers of Advanced BioChemand against Power3 in order to enforce its claim for the remaining balancewhich is past due. The Company has filed an answer, disputing the allegationsin the complaint and is vigorously defending this matter.

 

On May 17, 2005, the LawOffices of Jerry Scheff, Spencer and Associates and Proteomic Research Servicesfiled suit against the Company seeking recovery of amounts billed to Power3 forservices and legal fees invoiced in November, 2004. In February, 2006, asettlement was reached between all parties and all legal actions between theparties have been fully resolved.

 

In June, 2005, CharlesCaudle and others filed a lawsuit in Harris County, Texas, against AdvancedBioChem, Power3 and the officers and directors of both companies. The suitalleges that Advanced BioChem, Power3 and the officers and directors of Power3,are liable to plaintiffs for unspecified damages. The Company, and its officersand directors, has filed an answer denying all claims in the lawsuit. TheCompany disputes the allegations in the complaint and is vigorously defendingthis matter.

 

Plaintiff,Quinn Capital Consulting, Inc. commenced this action against Power3 andSteven B. Rash on May 19, 2005, alleging the breach of a consulting agreementand seeking 500,000 shares of the Company’s common stock. Plaintiff claims thatpursuant to the agreement, the Company was required to issue Plaintiff 500,000shares of the Company’s common stock. The Company disputes the allegations inthe complaint, has filed an answer and is vigorously defending this matter.

 

InJanuary of 2005, Plaintiff Kamy Behzadi, a previous employee of AdvancedBioChem and Power3, filed suit against Advanced BioChem and Power3. Plaintiffwas seeking 1,000,000 common shares of Power3 pursuant to an EmploymentAgreement with the Company. In May, 2005, Power3 filed a action against Behzadiregarding his employment with the Company. On March 22, 2006, both lawsuitswere settled and all actions between the parties have been fully resolved,pending compliance with the settlement agreement.

 

On October 28, 2005,Centigrade Services, Inc. commenced this action against Power3 to collect anoutstanding debt of $2,117.09 plus court costs. The Company has settled thismatter and no further actions are expected on this issue.

 

**On August 3, 2005, Focus Partners LLC filed suit against David Zazoff andPower3, seeking damages in the amount of $480,000 allegedly arising from theCompany’s failure to pay consideration, in the form of Company’s stock, toPlaintiff, pursuant to an alleged consulting agreement entered into and betweenPlaintiff and the Company. Plaintiff alleges that the Company improperly paidsuch consideration to Zazoff, a former employee of Plaintiff. The Companyanswered the complaint on December 27, 2005. It denies the material allegationsof the complaint and asserts that it has paid all consideration due and owingPlaintiff pursuant to the alleged consulting agreement. The Company has alsoasserted counterclaims against Plaintiff and cross-claims against Zazoffarising from, among other things, fraudulent acts of Plaintiff and Zazoffcommitted during the parties’ relationship. The parties are**

 

41

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**presently engaged in discovery. The Company intends to vigorously defendthis matter and prosecute its counterclaims and cross-claims.**

** **

**On August 30, 2005, Carlotta Lansford, a previous consultant for AdvancedBioChem, now known as Industrial Enterprises of America, commenced an actionagainst Advanced BioChem and Power3. Plaintiff is seeking $3,295 in unpaidconsulting and accounting fees. The Company believes this lawsuit will besettled prior to the court date, however no resolution has been achieved thusfar. The Company disputes the allegations in this matter and is vigorouslydefending this matter. The debt is recorded in accounts payable by Power3.**

** **

**On February 15, 2006, Bowne of Dallas LP commenced this action againstPower3 seeking payment for services allegedly rendered by Plaintiff to Power3. Plaintiffseeks damages in the amount of $17,315.03. The Company believes this lawsuitwill be settled prior to the court date, however no resolution has beenachieved thus far. The Company disputes the allegations in the complaint and isvigorously defending this matter. The debt is recorded in accounts payable byPower3.**

** **

**On October 28, 2005, Power3 received Notice of a Petition to EnforceForeign Judgement citation filed against the Company by KForce regarding anemployment fee adjudicated in December, 2003 in the state of Florida againstthe Company, in the amount of $15,872.77, together with $4,735.02 in interest. Power3does not agree with the Foreign Judgement and is attempting to resolve theissue prior to enforcement. No resolution has been achieved on this issue atthis time, however the Company is endeavoring to resolve the petition. Thisdebt is recorded and outstanding in accounts payable by the Company. In thisaction, Plaintiff seeks the enforcement of a foreign judgement entered inDecember, 2003, in the State of Florida, in the amount of $15,872,77, withinterest thereon, for non-payment of fees for services rendered by Plaintiff. TheCompany disputes the allegations in the complaint and is vigorously defendingthis matter.**

** **

**Item 2. Unregistered Sale of EquitySecurities and use of Proceeds**

 

During the 1st quarter of 2006, Power3 sold shares of itscommon stock under its 2004 Stock Compensation Plan as follows:

 

•                  On January 6,2006, Power3 sold 500,000 shares of common stock to Congregation Beth Josephfor working capital

 

•                  On February 3,2006, Power3 sold 400,000 shares of common stock to four private individuals forworking capital

 

•                  On February 3,2006, Power3 sold 500,000 shares of common stock to Congregation Beth Josephfor working capital

 

•                  On February 3,2006, Power3 sold 214,286 shares of common stock to Congregation Beth Shmielfor working capital

 

•                  On March 8,2006, Power3 sold 800,000 shares of common stock to 6 private individuals forworking capital

 

**Item 3. Defaults Upon Senior Securities**

 

The Company is in default under the provisions of its October, 2004Securities Purchase Agreement, and accompanying registration rights agreementand debentures. The default stems from the Company’s inability to obtaineffectiveness of the registration statement on Form SB-2, as amended (File No.333-122227) filed pursuant to the registration rights agreement.

 

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Although the Company intends to seek waivers or forbearance agreementsfrom the holders of its debentures, there is no assurance that the Company willreceive such concessions. If the Company is unable to obtain such concessions,the aggregate amount payable under the outstanding debentures due to theacceleration thereof by reason of the default is equal to the “MandatoryPrepayment Amount” as specified in the debentures. The Mandatory PrepaymentAmount equals the sum of (i) the greater of:  (a) 130% of the principal amount of thedebentures to be prepaid, or (b) the principal amount of the debentures tobe prepaid, divided by the conversion price on (x) the date the payment isdemanded or otherwise due, or (y) the date the payment is paid in full,whichever is less, multiplied by the closing price of the Company’s commonstock on (x) the date the payment is demanded or otherwise due, or(y) the date the payment is paid in full, whichever is greater, and(ii) all other amounts, costs, expenses and liquidated damages due inrespect of the debentures.

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders**

 

No matters were submitted to the security holders for a vote during thequarter ended March 31, 2006.

 

**Item5. Other Information**

 

None.

 

**Item6. Exhibits**

 

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| **EXHIBIT NO.** | ** ** | **DESCRIPTION**                                                                                                                                                                                                                                                                                                                |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **           | ** ** | ** **                                                                                                                                                                                                                                                                                                                     |
| 10.1                 |       | Promissory Note, dated September 5, 2005, executed by Power3 and  Cordillera Fund, in the amount of $200,000 (incorporated by reference to Exhibit  10.3 to the Company’s Form 8-K filed on September 9, 2005                                                                                                             |
| 10.2                 |       | Promissory Note, dated September 6, 2005, executed by Power3 and Dr.  Ira Goldknopf in the amount of $80,000 (incorporated by reference to Exhibit  10.2 to the Company’s Form 8-K filed on September 9, 2005                                                                                                             |
| 10.3                 |       | Promissory Note (Amended version), dated August 29, 2005, executed by  Power3 and John Fife in the amended amount of $446,500 (incorporated by  reference to Exhibit 10.1 to the Company’s Form 8-K filed on September 9,  2005                                                                                           |
| 10.4                 |       | Collaborative Research Agreement, dated October 13, 2005 by and  between Power3 and Pfizer Inc. with Pfizer Inc.(incorporated by reference to  the Company’s Form 8-K filed on October 19, 2005.)                                                                                                                         |
| 10.5                 |       | Employment Agreement with John Burton dated September 15, 2005  (incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K filed on  September 21, 2005                                                                                                                                                         |
| 10.6                 |       | Exclusive License Agreement dated effective June 28, 2005, by and  between Power3 and Baylor College of Medicine (incorporated by reference to  Exhibit 10.1 to the Company’s Form 10-QSB for the quarter ended September 30,  2004                                                                                       |
| 10.7                 |       | Patent and Technology License Agreement dated August 1, 2004, by and  between Power3 and The University of Texas System, on behalf of The  University of Texas M.D. Anderson Cancer Center (incorporated by reference to  Exhibit 10.2 to the Company’s Form 10-QSB for the quarter ended September 30,  2004             |
| 10.8                 |       | Patent and Technology License Agreement dated September 1, 2003 by  and between The University of Texas System, on behalf of The University of  Texas M.D. Anderson Cancer Center and Advanced BioChem (incorporated by  reference to Exhibit 10.3 to the Company’s Form 10-QSB for the quarter ended  September 30, 2004 |
| 10.9                 |       | Securities Purchase Agreement dated October 28, 2004 among the  Company and each purchaser identified therein (incorporated by reference to  Exhibit 10.1 to the Company’s Form 8-K filed on November 3, 2004                                                                                                             |
| 10.10                |       | Amendment to Securities Purchase Agreement dated January 19, 2005,  between the Company and each purchaser identified therein (incorporated by  reference to Exhibit 10.8 of the Company’s Registration Statement on   Form SB-2 (File No. 122227)                                                                        |
| 10.11                |       | Power3’s Registration Statement (incorporated by reference to the  SB-2 (File No. 122227) as filed on January 21, 2005                                                                                                                                                                                                    |
| 10.12                |       | Amended and Restated Employment Agreement for Steven B. Rash  (incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K filed  January 5, 2005                                                                                                                                                                 |
| 10.13                |       | Amended and Restated Employment Agreement for Ira L. Goldknopf, PhD  (incorporated by reference to   Exhibit 10.2 to the Company’s Form 8-K filed on January 5, 2005)                                                                                                                                                     |
| 10.14                |       | Collaborative Research Agreement dated March 21, 2005, by and between  New Horizons Diagnostics and Power3 (incorporated by reference to Exhibit  10.1 to the Company’s Form 8-K filed on March 28, 2005                                                                                                                  |
| 10.15                |       | Collaborative Research and Licensing Agreement dated May 17, 2005, by  and between BioSite Incorporated and Power3 (incorporated by reference to  Exhibit 10.13 to the Company’s Form 10-KSB filed on September 9, 2005                                                                                                   |

 

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| 10.16  |   | Promissory Note dated November 3, 2005 between Power3 and Trinity  financing in the amount of $150,000 (incorporated by reference to Exhibit  10.1 to the Company’s Form 8K filed on November 8, 2005). |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17  |   | Promissory Note executed on December 12, 2005 between Power3 and  Trinity Financing (incorporated by reference to Exhibit 10.1 to the Company’s  Form 8K filed December 12, 2005).                      |
| 10.18* |   | Promissory Note dated March 1, 2006 between Power3 and Steven B. Rash  in the amount of $50,000.                                                                                                             |
| 10.19* |   | Promissory Note dated March 2, 2006 between Power3 and Dr. Ira  Goldknopf in the amount of $89,400.                                                                                                          |
| 10.20* |   | Promissory Note, dated March 28, 2006, executed by Power3 and John  Fife in the amount of $400,000.                                                                                                          |
| 10.21* |   | Stock Pledge Agreement for Fife Promissory Note, dated March 28,  2006.                                                                                                                                      |
| 10.22* |   | Agreement between Power3 and Glocap executed on January 5, 2006.                                                                                                                                             |
| 10.23* |   | Agreement between Power3 and The Kaminer Group executed on February  9, 2006.                                                                                                                                |
|   |   |
| 31.1*  |   | Certification                                                                                                                                                                                                |
| 31.2*  |   | Certification                                                                                                                                                                                                |
| 32.1** |   | Certification Pursuant to Section 906                                                                                                                                                                        |
| 32.2** |   | Certification Pursuant to Section 906                                                                                                                                                                        |
|        |        |                                                                                                                                                                                                              |  |

 

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  *Filed with this report.**Furnished with this report.

 

(1)  Filed with this report

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|               | Power3 Medical Products, Inc. (Registrant) |
|--------------------|--------------------------------------------|
|               |                                       |   |
|               |                                       |   |
| Date: May 15, 2006 |                                       | By: | /s/ Steven B. Rash |   |
|               |                                       | Steven B. Rash |
|               |                                       | Chairman and Chief Executive Officer |

 

Pursuant tothe requirements of the Exchange Act, this report has been signed by thefollowing persons in the capacities and on the dates indicated.

 
| **Signature**      | ** ** | **Title**               | ** **              | **Date** |
|--------------------|------------|-------------------------|-------------------------|----------|
|               |       |                    |                    |     |
| /s/ Steven B. Rash |       |                    | Chairman and            |     | May 15, 2006 |
| Steven B. Rash     |       | Chief Executive Officer |                    |     |
|               |       |                    |                    |     |
| /s/ John P. Burton |       |                    | Chief Financial Officer |     | May 15, 2006 |
| John P. Burton     |       |                    |                    |     |

 

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