**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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| **x**      | **Quarterly  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934 for the quarterly period ended March 31, 2009**                                                                            |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                            |
| **or**     |
| ** ** |                                                                                                                                                                                                                                  |
| **o**      | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934 (For the transition period from          to         ).** |

 

**Commission File Number: 000-31973**

 

**Beacon Power Corporation**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                    | ** ** | **04-3372365**      |
|---------------------------------|------------|---------------------|
| (State or other jurisdiction of |       | (I.R.S. Employer    |
| incorporation or organization)  |       | Identification No.) |

 

| **65 Middlesex Road**                    |       |       |
|------------------------------------------|------------|------------|
| **Tyngsboro, Massachusetts**             | ** ** | **01879**  |
| (Address of principal executive offices) |       | (Zip code) |

 

**(978) 694-9121**

(Registrant’s telephone number, including area code)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15 (d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  x Yes o No

 

Indicateby check mark whether the registrant has submitted electronically and posted onit corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or such shorter period that theregistrant was required to submit and post such files).  Yes o Noo

 

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

 

| Large accelerated filer  o |   | Accelerated filer  x   |
|---------------------------------|--------|-----------------------------|
|                            |   |                        |
| Non-accelerated filer  o   |   | Smaller Reporting Company o |

 

Indicateby check mark whether the registrant is a shell company (as defined in rule 12b-2of the Exchange Act.)  o Yes x No

 

Thenumber of shares of the Registrant’s common stock, par value $.01 per share,outstanding as of May 7, 2009 was 114,574,433.

 

 

 

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**BEACON POWER CORPORATION ANDSUBSIDIARIES**

**(A Development Stage Company)**

**Table of Contents**

 
| ** **                         | **Page**                                                                                                                                                                                              |
|------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                         | ** **                                                                                                                                                                                            |
| PART I. Financial Information |                                                                                                                                                                                                  |
|                               |                                                                                                                                                                                                  |
|                               | Item 1.                                                                                                                                                                                               | Financial Statements |   |
|                               |                                                                                                                                                                                                  |
|                               | Consolidated Balance Sheets at  March 31, 2009 (unaudited) and December 31, 2008 (audited).                                                                                                 | 1 |
|                               |                                                                                                                                                                                                  |
|                               | Unaudited Consolidated  Statements of Operations for the three months ended March 31, 2009 and  2008, and for the period from May 8, 1997 (date of inception) through  March 31, 2009. | 2 |
|                               |                                                                                                                                                                                                  |
|                               | Unaudited Consolidated  Statements of Cash Flows for the three months ended March 31, 2009 and  2008 and for the period from May 8, 1997 (date of inception) through  March 31, 2009.  | 3 |
|                               |                                                                                                                                                                                                  |
|                               | Notes to  Unaudited Consolidated Financial Statements.                                                                                                                                                | 5 |
|                               |                                                                                                                                                                                                  |
|                               | Item 2.                                                                                                                                                                                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations. | 18 |
|                               |                                                                                                                                                                                                  |
|                               | Item 3.                                                                                                                                                                                               | Quantitative  and Qualitative Disclosures about Market Risk. | 34 |
|                               |                                                                                                                                                                                                  |
|                               | Item 4.                                                                                                                                                                                               | Controls and  Procedures. | 34 |
|                               |                                                                                                                                                                                                  |
| PART II.Other  Information    |                                                                                                                                                                                                  |
|                               |                                                                                                                                                                                                  |
|                               | Item 1.                                                                                                                                                                                               | Legal Proceedings. | 34 |
|                               |                                                                                                                                                                                                  |
|                               | Item 1A.                                                                                                                                                                                              | Risk Factors. | 35 |
|                               |                                                                                                                                                                                                  |
|                               | Item 2.                                                                                                                                                                                               | Unregistered  Sales of Equity Securities and Use of Proceeds. | 35 |
|                               |                                                                                                                                                                                                  |
|                               | Item 3.                                                                                                                                                                                               | Defaults  Upon Senior Securities. | 35 |
|                               |                                                                                                                                                                                                  |
|                               | Item 4.                                                                                                                                                                                               | Submission  of Matters to a Vote of Security Holders. | 35 |
|                               |                                                                                                                                                                                                  |
|                               | Item 5.                                                                                                                                                                                               | Other Information. | 35 |
|                               |                                                                                                                                                                                                  |
|                               | Item 6.                                                                                                                                                                                               | Exhibits. | 36 |
|                               |                                                                                                                                                                                                  |
| Signatures                         | 38                                                                                                                                                                                                    |

 

ii

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**PART 1 — FINANCIAL INFORMATION**

**Item 1. Financial Statements**

**BEACON POWER CORPORATION ANDSUBSIDIARIES (A Development Stage Company)**

**Consolidated Balance Sheets**

 
| ** **                                                                                                                                                               | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                               | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| ** **                                                                                                                                                               | ** ** | **(unaudited)**    | ** ** | **(audited)**         | ** ** |
| **Assets**                                                                                                                                                               |       |               |       |                  |       |
| Current assets:                                                                                                                                                          |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                |       | $                  | 5,323,098  |                  | $          | 14,357,475 |   |
| Accounts receivable, net                                                                                                                                                 |       | 19,931             |       | 11,840                |       |
| Unbilled costs on contracts in progress                                                                                                                                  |       | 58,690             |       | 16,804                |       |
| Prepaid expenses and other current assets                                                                                                                                |       | 1,122,155          |       | 976,762               |       |
| Total current assets                                                                                                                                                     |       | 6,523,874          |       | 15,362,881            |       |
| Property and equipment, net                                                                                                                                              |       | 23,661,104         |       | 23,027,909            |       |
| Restricted cash                                                                                                                                                          |       | 205,041            |       | 205,020               |       |
| Total assets                                                                                                                                                             |       | $                  | 30,390,019 |                  | $          | 38,595,810 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                            |       |               |       |                  |       |
| Current liabilities:                                                                                                                                                     |       |               |       |                  |       |
| Accounts payable                                                                                                                                                         |       | $                  | 812,332    |                  | $          | 3,825,520 |   |
| Accrued compensation and benefits                                                                                                                                        |       | 1,013,374          |       | 1,410,038             |       |
| Other accrued expenses                                                                                                                                                   |       | 1,842,296          |       | 3,253,407             |       |
| Advance billings on contracts                                                                                                                                            |       | 13,858             |       | 10,811                |       |
| Accrued contract loss                                                                                                                                                    |       | 257,362            |       | 132,526               |       |
| Deferred rent - current                                                                                                                                                  |       | 119,245            |       | 112,808               |       |
| Current portion of long term debt                                                                                                                                        |       | 282,732            |       | 117,023               |       |
| Total current liabilities                                                                                                                                                |       | 4,341,199          |       | 8,862,133             |       |
| Long term liabilities:                                                                                                                                                   |       |               |       |                  |       |
| Deferred rent - long term                                                                                                                                                |       | 852,046            |       | 885,076               |       |
| Long term debt, net of unamortized discount of $207,872                                                                                                                  |       | 3,081,389          |       | 3,237,061             |       |
| Total long term liabilities                                                                                                                                              |       | 3,933,435          |       | 4,122,137             |       |
| Commitments and contingencies (Note 5)                                                                                                                                   |       |               |       |                  |       |
| Stockholders’ equity:                                                                                                                                               |       |               |       |                  |       |
| Preferred Stock, $.01 par value; 10,000,000 shares authorized; no  shares issued or outstanding                                                                          |       | —             |       | —                |       |
|                                                                                                                                                                     |       |               |       |                  |       |
| Common stock, $.01 par value; 200,000,000 shares authorized;  112,999,802 and 107,433,190 shares issued at March 31, 2009 and  December 31, 2008, respectively |       | 1,129,998          |       | 1,074,332             |       |
| Additional paid-in-capital                                                                                                                                               |       | 214,133,352        |       | 212,145,254           |       |
| Deficit accumulated during the development stage                                                                                                                         |       | (192,435,126       | )          | (186,895,207          | )          |
| Treasury stock, 421,692 shares at cost                                                                                                                                   |       | (712,839           | )          | (712,839              | )          |
| Total stockholders’ equity                                                                                                                                          |       | 22,115,385         |       | 25,611,540            |       |
| Total liabilities and stockholders’ equity                                                                                                                          |       | $                  | 30,390,019 |                  | $          | 38,595,810 |   |

 

See notes tounaudited consolidated financial statements.

 

1

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**BEACONPOWER CORPORATION AND SUBSIDIARIES**

**(A Development Stage Company)**

**Consolidated Statements of Operations (Unaudited)**

 
| ** **                                 | ** ** | ** **                             | ** ** | ** **                  | ** ** | **Cumulative  from**     | ** ** |
|--------------------------------------------|------------|----------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                                 | ** ** | ** **                             | ** ** | ** **                  | ** ** | **May 8,  1997**    | ** ** |
| ** **                                 | ** ** | ** **                             | ** ** | ** **                  | ** ** | **(date  of inception)** | ** ** |
| ** **                                 | ** ** | **Three  months ended March 31,** | ** ** | **through  March 31,** | ** ** |
| ** **                                 | ** ** | **2009**                               | ** ** | **2008**                    | ** ** | **2009**                 | ** ** |
| Revenue                                    |       | $                                      | 110,935    |                        | $          | 20,203                   |       | $ | 4,899,613 |   |
| Cost of goods sold                         |       | 172,033                                |       | 57                          |       | 5,351,297                |       |
| Gross profit                               |       | (61,098                                | )          | 20,146                      |       | (451,684                 | )          |
| Operating expenses:                        |       |                                   |       |                        |       |                     |       |
| Operations and maintenance                 |       | 777,137                                |       | —                      |       | 777,137                  |       |
| Research and development                   |       | 2,191,054                              |       | 3,032,342                   |       | 86,007,916               |       |
| Selling, general and administrative        |       | 1,897,462                              |       | 2,175,661                   |       | 59,946,068               |       |
| Loss on contract commitments               |       | 132,500                                |       | —                      |       | 2,936,562                |       |
| Depreciation and amortization              |       | 423,888                                |       | 279,741                     |       | 6,179,510                |       |
| Restructuring charges                      |       | —                                 |       | —                      |       | 2,159,280                |       |
| Loss on impairment of assets               |       | —                                 |       | —                      |       | 4,663,916                |       |
| Total operating expenses                   |       | 5,422,041                              |       | 5,487,744                   |       | 162,670,389              |       |
| Loss from operations                       |       | (5,483,139                             | )          | (5,467,598                  | )          | (163,122,073             | )          |
| Other income (expense):                    |       |                                   |       |                        |       |                     |       |
| Interest income                            |       | 10,521                                 |       | 180,394                     |       | 5,586,008                |       |
| Interest expense                           |       | (67,301                                | )          | —                      |       | (1,232,456               | )          |
| Gain on sale of investment                 |       | —                                 |       | —                      |       | 3,562,582                |       |
| Other income (expense)                     |       | —                                 |       | (132                        | )          | (222,993                 | )          |
| Total other income (expense), net          |       | (56,780                                | )          | 180,262                     |       | 7,693,141                |       |
| Net loss                                   |       | (5,539,919                             | )          | (5,287,336                  | )          | (155,428,932             | )          |
| Preferred stock dividends                  |       | —                                 |       | —                      |       | (36,825,680              | )          |
| Accretion of convertible preferred stock   |       | —                                 |       | —                      |       | (113,014                 | )          |
| Loss to common shareholders                |       | $                                      | (5,539,919 | )                           | $          | (5,287,336               | )          | $ | (192,367,626 | ) |
| Loss per share, basic and diluted          |       | $                                      | (0.05      | )                           | $          | (0.06                    | )          |   |   |
| Weighted-average common shares outstanding |       | 109,003,196                            |       | 88,668,383                  |       |                     |       |

 

See notes to unaudited consolidated financial statements.

 

2

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**BEACON POWER CORPORATION AND SUBSIDIARIES(A Development Stage Company)**

**Consolidated Statements of Cash Flows(Unaudited)**

 
| ** **                                                                   | ** ** | ** **                             | ** ** | ** **         | ** ** | **Cumulative  from**     | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------|------------|--------------------------|------------|
| ** **                                                                   | ** ** | ** **                             | ** ** | ** **         | ** ** | **May 8,  1997**    | ** ** |
| ** **                                                                   | ** ** | ** **                             | ** ** | ** **         | ** ** | **(date  of inception)** | ** ** |
| ** **                                                                   | ** ** | ** **                             | ** ** | ** **         | ** ** | **through**              | ** ** |
| ** **                                                                   | ** ** | **Three  months ended March 31,** | ** ** | **March 31,** | ** ** |
| ** **                                                                   | ** ** | **2009**                               | ** ** | **2008**           | ** ** | **2009**                 | ** ** |
| Cash flows from operating activities:                                        |       |                                   |       |               |       |                     |       |
| Net loss                                                                     |       | $                                      | (5,539,919 | )                  | $          | (5,287,336               | )          | $ | (155,428,932 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                                   |       |               |       |                     |       |
| Depreciation and amortization                                                |       | 423,889                                |       | 279,741            |       | 6,179,513                |       |
| Loss (gain) on sale of fixed assets                                          |       | —                                 |       | 132                |       | 193,078                  |       |
| Impairment of assets, net                                                    |       | —                                 |       | —             |       | 4,551,147                |       |
| Interest expense relating to issuance of warrants                            |       | 10,037                                 |       | —             |       | 391,076                  |       |
| Non-cash charge for change in option terms                                   |       | —                                 |       | —             |       | 346,591                  |       |
| Non-cash charge for settlement of lawsuit                                    |       | —                                 |       | —             |       | 821,160                  |       |
| Amortization of deferred consulting expense, net                             |       | —                                 |       | —             |       | 1,160,784                |       |
| Amortization of deferred stock compensation                                  |       | —                                 |       | —             |       | 3,699,721                |       |
| Options and warrants issued for consulting services                          |       | —                                 |       | —             |       | 1,585,654                |       |
| Services and interest expense paid in preferred stock                        |       | —                                 |       | —             |       | 11,485                   |       |
| Gain on sale of investments                                                  |       | —                                 |       | —             |       | (3,562,582               | )          |
| Stock-based compensation                                                     |       | 279,012                                |       | 751,310            |       | 4,246,380                |       |
| Deferred rent                                                                |       | (26,593                                | )          | 65,972             |       | (458,710                 | )          |
| Cash received from landlord for build-out credit                             |       | —                                 |       | 1,430,000          |       | 1,430,000                |       |
| Changes in operating assets and liabilities:                                 |       |                                   |       |               |       |                     |       |
| Accounts receivable                                                          |       | (8,091                                 | )          | 352,873            |       | (19,931                  | )          |
| Unbilled costs on government contracts                                       |       | (41,886                                | )          | 56                 |       | (58,690                  | )          |
| Prepaid expenses and other current assets                                    |       | 51,893                                 |       | (652,680           | )          | (1,024,530               | )          |
| Accounts payable                                                             |       | (3,013,188                             | )          | 376,759            |       | 812,332                  |       |
| Accrued compensation and benefits                                            |       | (396,664                               | )          | (220,852           | )          | 1,013,374                |       |
| Advance billings on contracts                                                |       | 3,047                                  |       | (56                | )          | 13,858                   |       |
| Accrued interest                                                             |       | —                                 |       | —             |       | 275,560                  |       |
| Accrued loss on contract commitments                                         |       | 124,836                                |       | (498               | )          | 257,362                  |       |
| Other accrued expenses and current liabilities                               |       | (1,411,111                             | )          | (58,313            | )          | 1,850,966                |       |
| Net cash used in operating activities                                        |       | (9,544,738                             | )          | (2,962,892         | )          | (131,713,334             | )          |
| Cash flows from investing activities:                                        |       |                                   |       |               |       |                     |       |
| Purchase of investments                                                      |       | —                                 |       | —             |       | (1,190,352               | )          |
| Sale of investments                                                          |       | —                                 |       | —             |       | 4,752,934                |       |
| Restricted cash                                                              |       | (21                                    | )          | 174,346            |       | (205,041                 | )          |
| Increase in other assets                                                     |       | —                                 |       | —             |       | (412,072                 | )          |
| Purchases and manufacture of property and equipment                          |       | (1,053,935                             | )          | (2,609,586         | )          | (33,915,536              | )          |
| Sale of property and equipment                                               |       | —                                 |       | —             |       | 202,674                  |       |
| Net cash used in investing activities                                        |       | (1,053,956                             | )          | (2,435,240         | )          | (30,767,393              | )          |
| Cash flows from financing activities:                                        |       |                                   |       |               |       |                     |       |
| Initial public stock offering, net of expenses                               |       | —                                 |       | —             |       | 49,341,537               |       |
| Stock offerings, net of expenses                                             |       | 1,764,852                              |       | 18,357             |       | 72,687,520               |       |
| Payment of dividends                                                         |       | —                                 |       | —             |       | (1,159,373               | )          |
|                                                                              |            |                                        |            |                    |            |                          |            |  |  |  |

 

3

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| ** **                                          | ** ** | ** **                             | ** ** | ** **         | ** ** | **Cumulative  from**     | ** ** |
|-----------------------------------------------------|------------|----------------------------------------|------------|--------------------|------------|--------------------------|------------|
| ** **                                          | ** ** | ** **                             | ** ** | ** **         | ** ** | **May 8,  1997**    | ** ** |
| ** **                                          | ** ** | ** **                             | ** ** | ** **         | ** ** | **(date  of inception)** | ** ** |
| ** **                                          | ** ** | ** **                             | ** ** | ** **         | ** ** | **through**              | ** ** |
| ** **                                          | ** ** | **Three  months ended March 31,** | ** ** | **March 31,** | ** ** |
| ** **                                          | ** ** | **2009**                               | ** ** | **2008**           | ** ** | **2009**                 | ** ** |
| Shares issued under employee stock purchase plan    |       | —                                 |       | —             |       | 275,821                  |       |
| Exercise of employee stock options                  |       | (100                                   | )          | —             |       | 2,303,991                |       |
| Issuance of debt                                    |       | —                                 |       | —             |       | 3,571,993                |       |
| Warrants issued in relation to lease                |       | —                                 |       | —             |       | 716,614                  |       |
| Cash paid for financing costs                       |       | (200,435                               | )          | —             |       | (203,583                 | )          |
| Issuance of preferred stock                         |       | —                                 |       | —             |       | 32,868,028               |       |
| Repayment of subscription receivable                |       | —                                 |       | —             |       | 5,000,000                |       |
| Proceeds from capital leases                        |       | —                                 |       | —             |       | 495,851                  |       |
| Repayment of capital leases                         |       | —                                 |       | —             |       | (1,031,395               | )          |
| Repurchase company stock                            |       | —                                 |       | —             |       | (613,179                 | )          |
| Proceeds from notes payable issued to investors     |       | —                                 |       | —             |       | 3,550,000                |       |
| Net cash provided by (used in) financing activities |       | 1,564,317                              |       | 18,357             |       | 167,803,825              |       |
| (Decrease) increase in cash and cash equivalents    |       | (9,034,377                             | )          | (5,379,775         | )          | 5,323,098                |       |
| Cash and cash equivalents, beginning of period      |       | 14,357,475                             |       | 30,417,095         |       | —                   |       |
| Cash and cash equivalents, end of period            |       | $                                      | 5,323,098  |               | $          | 25,037,320               |       | $ | 5,323,098 |   |
| Supplemental disclosure of cash flow information:   |       |                                   |       |               |       |                     |       |
| Cash paid for interest                              |       | $                                      | 58,045     |               | $          | —                   |       | $ | 605,465 |   |
| Cash paid for taxes                                 |       | $                                      | —     |               | $          | —                   |       | $ | 32,750 |   |
| Assets acquired through capital lease               |       | $                                      | —     |               | $          | —                   |       | $ | 535,445 |   |
| Warrants issued in relation to loan (non-cash)      |       | $                                      | —     |               | $          | —                   |       | $ | 227,946 |   |

 

See notes tounaudited consolidated financial statements.

 

4

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**BEACON POWER CORPORATION ANDSUBSIDIARIES (A Development Stage Company)**

**Notes to Unaudited ConsolidatedFinancial Statements**

 

**Note1.  Nature of Business and Operations**

 

*Natureof Business*

 

Beacon PowerCorporation (the “Company”, “Beacon”, “we”, “our”, or “us”) (a developmentstage company) was incorporated on May 8, 1997.  Since our inception,we have been primarily engaged in the development of flywheel devices forstoring and transmitting kinetic energy.  We have experienced net lossessince our inception and, as of March 31, 2009, had an accumulated deficitof approximately $192.4 million.  Weexpect to generate revenues in the future from the commercialization of ourflywheel energy storage systems to supply frequency regulation services to theelectricity grid. Because we have not yet generated a significant amountof revenue from our principal operations, we are accounted for as a developmentstage company under the Financial Accounting Standards Board’s Statement ofFinancial Accounting Standards (SFAS) No. 7.

 

In February 2009,we entered into a Stock Purchase Agreement with an investor, Seaside 88, LP (“Seaside”).Under the terms of this agreement, Seaside will invest one million dollars on amonthly basis for at least 6 months, and up to18 months, through the purchaseof our common stock. (See Note 7 for additional information.) Since our initialpublic offering in November of 2000, we have raised approximately $73.6million through the sale of common stock and warrants, including the sale ofstock to Seaside during February, March and April, 2009.

 

*Operations*

 

The focus of ourresearch and development has been to establish commercially-viableflywheel-based energy storage technologies that can provide highly reliableenergy solutions for the worldwide electricity grid at competitive costs. Webelieve that as we expand our production capabilities we can become a providerof frequency regulation services to grid operators on a global basis. Inaddition we believe that as the commercialization of our technologiescontinues, we will develop other cost-effective applications for our flywheelsystems that will provide additional revenue opportunities.

 

Our market focusis on the geographic regions of the domestic grid that provide open bid marketsfor regulation services. These regions and their Independent System Operator(ISO) or Regional Transmission Operator (RTO) designations are: New England(ISO New England or ISO-NE); California (California ISO or CAISO); New York(New York ISO or NYISO); Mid-Atlantic (PJM Interconnection); Midwest ISO (MISO)and Texas (ERCOT). Because ERCOT is not regulated by the Federal EnergyRegulatory Commission (FERC), we are not able to encourage beneficial market rule changesthere by leveraging FERC Order 890, which was intended to promote greatercompetition in electricity markets, in part by allowing non-generativeresources such as ours the ability to bid and sell into frequency regulationmarkets and be compensated on equal terms with traditional generationresources. As a result, we are focusing on the other open bid markets first andwill begin to work on entry into ERCOT once we are operating in the othermarkets.

 

Our business planis to be a merchant provider of frequency regulation service into all of theopen bid energy markets. To execute our business plan and continue as a goingconcern will require substantial additional outlays of capital to buildregulation facilities and support operations at our Tyngsboro facility.  We do not expect to become profitable or cashflow positive until at least 2011. Based on our current cash usage rates andadditional expenditures expected in support of our business plan, and includingthe approximately $2.7 million of net proceeds we have raised through April 2009from the sale of stock to Seaside, we have sufficient cash to fund operationsinto the third quarter of 2009. If we exercise our option to extend the Seasidestock purchase agreement, we would have sufficient cash to fund our operationsinto 2010.  In order to build and deploy our flywheel systems, and increase ourrevenues, we will need substantial funding. To execute our business plan for2009 and 2010 for the installation of frequency regulation capacity and workingcapital, in addition to the funds from the sale of stock to Seaside, we willneed to raise $30 million during 2009 and a similar amount in 2010 through theissuance of equity securities orthrough other financing alternatives.

 

5

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**Note2.  Basis of Presentation and Summary of Significant Accounting Policies**

** **

**Basis ofPresentation**

 

The accompanyingunaudited consolidated financial statements have been prepared using accountingprinciples generally accepted in the United States of America except thatcertain information and footnote disclosures normally included in consolidatedfinancial statements prepared in accordance with generally accepted accountingprinciples have been condensed or omitted in this Form 10-Q.  Wesuggest that the consolidated financial statements presented herein be read inconjunction with our consolidated financial statements and notes theretoincluded in our Annual Report on Form 10-K for the year ended December 31,2008.  In our management’s opinion, all adjustments consisting of normalrecurring accruals considered necessary for a fair presentation have beenincluded in the accompanying unaudited financial statements.  Operatingresults for the three months ended March 31, 2009 are not necessarilyindicative of the results that may be expected for the full year ending December 31,2009.

* *

*GoingConcern*

 

The accompanyingconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business.  As shown in ourconsolidated financial statements, we have had minimal revenues and incurredlosses of approximately $192.4 million since our inception, including lossesduring the three months ending March 31, 2009 of approximately $5.5million.  We have approximately $5.3 million of cash and cash equivalentson hand at March 31, 2009, and have raised an additional $0.9 million incash subsequent to the end of the quarter through the sale of stock to Seasidein April 2009.  In addition to the funds we expect to receive fromthe sale of stock to Seaside, there is an additional $1.4 million which can bedrawn on the Mass Development loan, should we choose to do so, to offsetqualified expenditures for equipment for our manufacturing facility. Since ouroperating cash requirements far exceed any cash generated from operations, wemay be unable to continue as a going concern.  The consolidated financialstatements contained herein do not include any adjustments relating to the recoverabilityand classification of liabilities that might be necessary should we be unableto continue as a going concern.

 

Werecognize that our continuation as a going concern is dependent upon ourability to generate sufficient cash flow to allow us to satisfy our obligationson a timely basis.  The generation of sufficient cash flow is dependent inthe short-term on our ability to obtain additional equity and debt financing,and in the long-term, on the successful commercialization of our Smart EnergyMatrixTM and our ability to provide frequency regulation services to theelectricity grid. We believe that the successful achievement of theseinitiatives should provide us with sufficient resources to meet our long-termcash requirements.  In addition we arealso considering a number of other strategic financing alternatives and haveincurred substantial costs in these efforts; however, no assurance can be madewith respect to the success of these efforts or the viability of our company.

 

*Consolidation*

 

The accompanyingconsolidated financial statements include the accounts of Beacon PowerCorporation and our subsidiary, Beacon Power Securities Corporation. In September 2008,we established two wholly-owned subsidiaries, Tyngsboro Regulation Services LLCand Tyngsboro Holding LLC.  As of March 31,2009, both entities were inactive.  All significant inter-company accountsand transactions have been eliminated in consolidation.

 

*Lossper Share — Basic and Diluted*

 

Basic and dilutedlosses per share have been computed using the weighted-average number of sharesof common stock outstanding during each period. Warrants, options and othersecurities exercisable for common shares are used in the calculation offully-diluted EPS only if their conversion to common shares would decreaseincome or increase loss per share from continuing operations.  Since thethree month periods ended March 31, 2009 and 2008 reflect losses,including the potential conversion of warrants and options in the diluted EPScalculation would decrease loss per share. Accordingly, they are consideredanti-dilutive and are not included in the calculation of earnings per share.

 

6

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**Summaryof Significant Accounting Policies**

* *

*Use ofEstimates*

 

The preparation ofconsolidated financial statements in accordance with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe consolidated financial statements and the reported amounts of revenues andexpenses during the reporting period.  Actual results could differ fromthose estimates.

 

*LeaseObligation and Deferred Rent*

 

During July 2007,we signed a seven-year operating lease with escalating payments on a 103,000square foot facility in Tyngsboro, Massachusetts. As part of this leaseagreement, we issued to the landlord 150,000 shares of our common stock and awarrant exercisable for 500,000 shares of our common stock in return for lowercash payments under the lease. (See Note 5: Commitments andContingencies.)  Additionally, thelandlord has reimbursed us for certain leasehold improvements we have made. Inaccordance with SFAS No. 13, “*Accounting for Leases,*”these reimbursements have been credited to “Deferred rent”, and we haverecorded rent expense on a straight line basis. The current portion of thedeferred rent is included in current liabilities, and the remainder is shown onthe balance sheet as “Deferred rent — long term.”

* *

*Property and Equipment*

 

Propertyand equipment in service is stated at cost and depreciated using thestraight-line method over the estimated useful lives of the assets. Propertyand equipment are defined as tangible items with unit costs exceeding ourcapitalization threshold that are used in the operation of the business, arenot intended for resale and which have a useful life of one year or more. Thecost of fixed assets is defined as the purchase price of the item, as well asall of the costs necessary to bring it to the condition and location necessaryfor its intended use.  These costsinclude labor, overhead, capitalized interest and, if applicable, exit costs.Exit costs for which we are obligated are accounted for in accordance with SFASNo. 143, “*Accounting for Asset Retirement Obligations.*”No overhead is generally applied for internally-constructed projects notdirectly related to our core business (e.g., leasehold improvements.) Repairand maintenance costs are expensed as incurred. Materials used in our development efforts are considered research anddevelopment materials, and are expensed as incurred in accordance with SFAS No. 2“*Accounting for Research and Development Costs*.”

 

Capitalassets are classified as “Construction in Progress” (CIP) when initiallyacquired, and reclassified to the appropriate asset account when placed inservice, with the exception of land, which is capitalized upon purchase.Depreciation expense is not recorded on assets not yet placed into service.

 

Materialspurchased to build flywheels, power electronics and other components used inour frequency regulation installations are classified as CIP, along with therelated labor and overhead costs. Some components of the Smart Energy MatrixTM, such as the flywheels and power electronics, areconsidered “fungible” in that they can be moved and redeployed at a differentlocation.  Non-fungible costs are costswhich would not be recovered if we redeployed the matrix or portionsthereof.  In some cases, we may elect todeploy a Smart Energy MatrixTM system at a location for the purpose ofdemonstrating our technology or gaining experience operating in that particularmarket.  In these instances, the costs ofthe fungible components are capitalized, and the remaining costs, which mayinclude such costs as site preparation, interconnection costs and estimatedexit costs, are expensed.

 

*Stock-BasedCompensation*

 

We account forstock-based compensation in accordance with the Financial Accounting StandardsBoard’s SFAS No. 123R (“SFAS 123R”), “*Share-Based Payment*”.Under the fair value recognition provision of SFAS 123R, stock-basedcompensation cost is measured at the grant date based on the fair value of theaward and is recognized as an expense as it is earned over the requisiteservice period, which is the vesting period.

* *

*Restructuring and Asset Impairment Charges*

 

Inaccordance with SFAS No. 144, “*Accounting for theImpairment or Disposal of Long-Lived Assets*,” long-lived assets tobe held and used are reviewed to determine whether any events or changes incircumstances indicate that the carrying value of 

 

7

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theasset may not be recoverable.  Theconditions considered include whether or not the asset is in service, hasbecome obsolete, or whether external market circumstances indicate that thecarrying amount may not be recoverable. We recognize a loss for the difference between the estimated fair valueof the asset and the carrying amount or the cost to repair the asset. The fairvalue of the asset is measured using either available market prices orestimated discounted cash flows.

 

In certain instances, wemay determine that it is in the best interest of the Company to move andre-deploy all or part of a Smart Energy MatrixTM System installed at a givenlocation.  When such a determination hasbeen made, we will determine which costs are associated with the movable(fungible) components, and which costs are non-fungible. We will record aperiod expense for the net book value associated with the non-fungiblecomponents.

 

No asset impairmentcharges were considered necessary for the three months ended March 31,2009 or 2008.

 

*RevenueRecognition*

 

Although we have soldphotovoltaic inverters and recorded revenues for flywheel development andfrequency regulation service from the ISO-NE Pilot program, our operations havenot yet reached a level that would qualify us to emerge from the developmentstage.  Therefore we continue to beaccounted for as a development stage company under SFAS No. 7, “*Accounting and Reporting by Development Stage Enterprises*.”

 

·                  *Frequency Regulation Revenue*

 

Revenuefrom frequency regulation is recognized when it has been earned and is realizedor realizable. Revenue from services is earned either as the services areperformed or when they are complete and is considered realizable once thecustomer has committed to pay for the services and the customer’s ability topay is not in doubt.  Frequencyregulation revenue is calculated on an hourly basis, as services are provided,based on formulas specific to the tariffs in effect at the applicable ISO atbid award rates that are published by the ISO. Frequency regulation service revenue is calculated using the applicablerates and formulas as services are provided.

 

·                  *Inverter Sales*

 

Generally,revenue on inverter and related product sales is recognized on transfer oftitle, typically when products are shipped and all related costs areestimable.  For sales to distributors, wemake an adjustment to defer revenue until the products are subsequently sold bydistributors to their customers.

 

·                  *Research and Development ContractRevenue Recognized on the Percentage-of-Completion Method*

 

We recognize contractrevenue using the percentage-of-completion method. We use labor hours as thebasis for the percentage of completion calculation, which is measuredprincipally by the percentage of labor hours incurred to date for each contractto the estimated total labor hours for each contract at completion. Changes tototal estimated contract costs or losses, if any, are recognized in the periodin which they are determined. Changes in project performance andconditions, estimated profitability, and final contract settlements may resultin future revisions to contract costs and revenue.  Revenues recognized in excess of amountsbilled are classified as current assets, and included in “Unbilled costs oncontracts in process” in our balance sheets.  Amounts billed to clients inexcess of revenues recognized to date are classified as current liabilitiesunder “Advance billings on contracts.”  Changes in project performance andconditions, estimated profitability, and final contract settlements may resultin future revisions to construction contract costs and revenue.

 

Some of our research anddevelopment contracts are subject to cost review by government agencies. Ourreported results from these contracts could change adversely as a result ofthese reviews.

 

Each quarter we perform an estimate-to-completeanalysis, and any changes to our original estimates are recognized in theperiod in which they are determined.  Inthe second quarter of 2008, we recorded a contract loss of approximately$87,000, which represents our expected “cost share” portion of the Tehachapicontract. During the first quarter of 2009, we recorded an additional contractloss on the Tehachapi contract of approximately $132,500, which represents thedifference between our overhead applied based on a “full production” rate, andthe contract bid rate.  Our contract lossreserves are as follows:

 

8

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| ** **             | ** ** | **Three  months ended March 31,** | ** ** |
|------------------------|------------|----------------------------------------|------------|
| ** **             | ** ** | **2009**                               | ** ** | **2008** | ** ** |
| Beginning balance      |       | $                                      | 132,526    |   | $ | 67,419 |   |
| Charges for the period |       | 132,500                                |       | — |   |
| Reductions             |       | (7,664                                 | )          | (498 | ) |
| Ending balance         |       | $                                      | 257,362    |   | $ | 66,921 |   |

 

*Costof Goods Sold*

 

Wevalue our products at the lower of cost or market.  Costs in excess of this measurement areexpensed in the period in which they are incurred.

 

Forfrequency regulation revenue, cost of goods sold represents the cost ofenergy.  In the future, we expect ourenergy costs to be for the nominal energy losses associated with operating ourflywheel systems.  However, during thequarter ended March 31, 2009, our energy costs for the ISO-NE pilot programwere substantially higher as we were billed at retail for all of the energystored on our flywheels, rather than for our net energy usage. See furtherdiscussion in Management Discussion and Analysis.

 

Governmentcontracts are calculated on a percentage of completion basis. In the event thatexpected costs exceed total contract revenue, the excess costs are charged tocontract loss.

 

Weprovide a five-year limited product warranty for our Smart Power M-seriesinverter product line and accrue for estimated future warranty costs in theperiod in which the revenue is recognized*.*  In 2004, we established a reserve for ourSmart Power M-series inventory as a result of lower than anticipated salesvolumes.  During 2009 and 2008 wecontinue to have very limited sales from our inventory of inverter products,which we are no (small) longer manufacturing. The costs related to these sales are not fully reflected in the cost ofgoods sold as a result of the inventory having been reserved in a prioryear.  Therefore, our cost of goods solddoes not fully reflect the costs associated with these revenues.

 

**Note3.  Accounts Receivable**

 

Our accountsreceivable include amounts due from customers and are reported net of a reservefor uncollectible accounts as follows:

 
| ** **                 | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| Accounts receivable, trade |       | $                  | 19,931     |                  | $          | 11,840 |   |
| Reserve                    |       | —             |       | —                |       |
| Accounts receivable, net   |       | $                  | 19,931     |                  | $          | 11,840 |   |

 

Some of ourresearch and development contracts contain holdback provisions that allow ourcustomers to withhold 10% from each invoice payment. At March 31, 2009 andDecember 31, 2008, we had approximately $6,000 of holdbacks in ouraccounts receivable balance.  These holdbacks are payable once work hasbeen satisfactorily completed and the final reports have been delivered andapproved.

 

9

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**Note4.  Property and Equipment**

 

Details of ourproperty and equipment follow:

 
| ** **                                     | ** ** | **Estimated** | ** ** | **As of:**         | ** ** |
|------------------------------------------------|------------|---------------|------------|--------------------|------------|
| ** **                                     | ** ** | **Useful**    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                     | ** ** | **Lives**     | ** ** | **2009**           | ** ** | **2008** | ** ** |
| Construction in Progress                       |       | Varied        |       | $                  | 12,355,273 |   | $ | 11,629,918 |   |
| Land                                           |       |          |       | 192,487            |       | 192,487 |   |
| Smart Energy 25 flywheels                      |       | 20  years     |       | 2,009,419          |       | 2,009,419 |   |
| Machinery and equipment                        |       | 5  - 10 years |       | 2,644,338          |       | 2,600,410 |   |
| Service vehicles                               |       | 5  years      |       | 16,763             |       | 16,763 |   |
| Furniture and fixtures                         |       | 7  years      |       | 702,264            |       | 634,294 |   |
| Office equipment and software                  |       | 3  years      |       | 1,028,037          |       | 1,028,037 |   |
| Leasehold improvements                         |       | Lease  term   |       | 7,788,926          |       | 7,572,244 |   |
| Equipment under capital lease obligations      |       | Lease  term   |       | 700,517            |       | 700,517 |   |
| Total                                          |       |          |       | $                  | 27,438,024 |   | $ | 26,384,089 |   |
| Less accumulated depreciation and amortization |       |          |       | (3,776,920         | )          | (3,356,180 | ) |
| Property and equipment, net                    |       |          |       | $                  | 23,661,104 |   | $ | 23,027,909 |   |

 

InNovember 2008, we deployed 1 MW of capacity under the ISO-NE AlternativeEnergy Storage Technology Pilot Program (Pilot Program) with a system installedinside our Tyngsboro facility. The Smart Energy 25 flywheels shown aboverepresent the cost of the flywheels and electronic control modules in use forthis pilot program.

 

InJuly 2008, we exercised our option to purchase land in Stephentown, NY,for the construction of a frequency regulation system, the cost of which isreflected as “Land” in the schedule shown above.  On February 23, 2009, we announced thatwe had signed a contract with American Electric Power (AEP), and one of itsoperating subsidiaries, Columbus Southern Power Company to build a 1 MW SmartEnergy MatrixTM regulation facility at an AEP site in Groveport, Ohio.

 

Thecomponents of “Construction in progress”, which represents costs related toassets that have not yet been placed into service and for which no depreciationexpense has been taken, were as follows:

 
| ** **                              | ** ** | **As of:**         | ** ** |
|-----------------------------------------|------------|--------------------|------------|
| ** **                              | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                              | ** ** | **2009**           | ** ** | **2008** | ** ** |
| Materials to build production flywheels |       | $                  | 5,243,590  |   | $ | 6,553,828 |   |
| Smart Energy 25 flywheels               |       | 4,298,098          |       | 2,199,164 |   |
| Smart Energy MatrixTM in progress   |       | 2,437,689          |       | 2,296,608 |   |
| Machinery and equipment                 |       | 294,803            |       | 302,267 |   |
| Leasehold improvements                  |       | 81,093             |       | 278,051 |   |
| Construction in progress                |       | $                  | 12,355,273 |   | $ | 11,629,918 |   |

 

As of March 31, 2009 and December 31,2008, approximately $12,000,000 and $11,000,000,respectively, of the total shown as CIP represents completed flywheels,materials to build flywheels and other costs related to the Smart EnergyMatrixTM installations under construction at our Tyngsboro and Stephentown sites. The Smart Energy MatrixTM installationcosts included in CIP at March 31, 2009 and December 31, 2008 includeapproximately $2,000,000 and $1,900,000, respectively, for fungible componentswe expect to deploy at either our site in Stephentown, New York or inGroveport, Ohio, and approximately $435,000 and $385,000, respectively, in sitecosts related to Stephentown.  Theremaining costs in CIP related to various machinery, equipment, tooling,software and computer equipment which were not in service as of the periodsreported.

 

10

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**Note5.  Commitments and Contingencies**

 

The followingtable summarizes our purchase obligations and the aggregate maturities andpayments due for our contractual obligations for the five years following March 31,2009:

 
| ** **             | ** ** | **Description  of Commitment** | ** ** |
|------------------------|------------|--------------------------------|------------|
| ** **             | ** ** | **Operating  leases**          | ** ** | **Purchase  Obligations** | ** ** | **Total** | ** ** |
| Period ending:         |       |                           |       |   |   |   |   |
| March 31, 2009    |       | $                              | —     |   | $ | 4,517,197 |   | $ | 4,517,197 |   |
| December 31, 2009 |       | 527,875                        |       |   |   | 527,875 |   |
| December 31, 2010 |       | 727,437                        |       |   |   | 727,437 |   |
| December 31, 2011 |       | 753,188                        |       |   |   | 753,188 |   |
| December 31, 2012 |       | 778,937                        |       |   |   | 778,937 |   |
| December 31, 2013 |       | 804,689                        |       |   |   | 804,689 |   |
| Thereafter             |       | 618,000                        |       |   |   | 618,000 |   |
| Total Commitments      |       | $                              | 4,210,126  |   | $ | 4,517,197 |   | $ | 8,727,323 |   |

 

At March 31,2009, we had firm purchase commitments with our suppliers to acquire componentsfor our commercial flywheel units, begin the build-out of the Smart EnergyMatrixTM in Stephentown, and satisfy contractual obligations for our researchand development programs in the amount of approximately $4.5 million. Inaddition, we have a commitment of approximately $2.2 million to purchase a keycomponent from a supplier who has not yet been able to meet our technicalspecifications. We do have another supplier for this component. However, sinceour objective is to have at least two suppliers for all key components, we areworking closely with the supplier to resolve this from a technical perspective.If not, however, the contract will be cancelled due to the supplier’s inabilityto perform.

 

In July 2007, wesigned a seven-year lease on our current corporate headquarters, and relocatedall of our operations to this facility in January 2008.  This facility significantly expands ourmanufacturing capacity and provides sufficient space to continue our researchand development activities. Our facility is located at 65 Middlesex Road,Tyngsboro, Massachusetts.  The103,000-square-foot facility, which has manufacturing capacity that will allowproduction of more than 1,000 flywheels per year, has been renovated andbuilt-out to our specifications.

 

We provided ourlandlord with an irrevocable letter of credit securing our performance underthe lease with a balance at September 30, 2008 of $200,000, which isreduced periodically over the lease term.  This letter of credit issecured by a cash deposit, which is included in restricted cash in theaccompanying consolidated balance sheets. In addition to our rent payments, we are responsible for real estatetaxes and all operating expenses of the Tyngsboro facility.  Rent expense was approximately $147,000 and$144,000 during the three months ended March 31 2009 and 2008,respectively.

 

Additional capitalexpenditures will be required in the future to optimize the plant for maximumcapacity.  The amount and timing of theseexpenditures are dependent on requirements of equipment needed to meetproduction schedules as well as having sufficient funding.

* *

*LegalProceedings*

 

We may from timeto time be subject to legal proceedings, often likely to involve routinelitigation incidental to our business.  The outcome of any legal proceedingis not within our complete control, may often be difficult to predict and maybe resolved over a very long period of time.  Estimating probable lossesassociated with any legal proceedings or other loss contingency is very complexand requires the analysis of many factors, including assumptions aboutpotential actions by third parties.  A loss contingency is recorded as aliability in the consolidated financial statements when it is both (i) probableand known that a liability has been incurred and (ii) the amount of theloss is reasonably estimable.  If the reasonable estimate of the loss is arange and no amount within the range is a better estimate, the minimum amountof the range is recorded as a liability.  If a loss contingency is not probableor not reasonably estimable, a liability is not recorded in the consolidatedfinancial statements.

 

11

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**Note6.  Long-Term Debt**

 

Long-term debt was asfollows. which approximates fair value:

 
| ** **                                           | ** ** | **As of:**         | ** ** |
|------------------------------------------------------|------------|--------------------|------------|
| ** **                                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                           | ** ** | **2009**           | ** ** | **2008** | ** ** |
| 6.5% Note Payable to MassDev, due November 2015 |       | $                  | 3,571,993  |   | $ | 3,571,993 |   |
| Less unamortized discount (warrants)                 |       | (207,872           | )          | (217,909 | ) |
| Total                                                |       | 3,364,121          |       | 3,354,084 |   |
| Less current portion of long term debt               |       | (282,732           | )          | (117,023 | ) |
| Net long-term debt                                   |       | $                  | 3,081,389  |   | $ | 3,237,061 |   |

 

On June 30, 2008, weentered into an agreement with Massachusetts Development Finance Agency (“MassDev”)pursuant to which MassDev has agreed to lend to the Company up to $5 million.This loan derives from a funding collaboration between the Emerging TechnologyFund of MassDev and the Massachusetts Technology Collaborative’s BusinessExpansion Initiative. The loan proceeds were used to help fund the expansion ofour production facility.

 

The MassDev loan isevidenced by a promissory note under which we may make one or more requests foradvances of up to an aggregate of $5 million for the purchase of equipment andinstallation of certain building improvements at our Tyngsboro, Massachusettsfacility. We have one year following the date of the initial advance to draw onthe loan, should we choose to do so. The initial advance on the loan was madein October 2008 for approximately $3.6 million. The note will mature 84months after the initial advance and bears a fixed annual interest rate of6.5%.

 

Payments to MassDev beganin November 2008. The payments will be of interest only during the firsttwelve months and thereafter, the balance of the principal outstanding underthe note shall be amortized in equal monthly installments of principal andinterest over the remaining term of the note.

 

Based on the amountcurrently outstanding, principal payments required under the loan over the nextfive years, excluding discount due to warrants, are as follows:

 
| ** **             | ** ** | **Amount** | ** ** |
|------------------------|------------|------------|------------|
| Period ending:         |       |       |       |
| December 31, 2009 |       | $          | 118,749    |   |
| December 31, 2010 |       | 494,718    |       |
| December 31, 2011 |       | 527,851    |       |
| December 31, 2012 |       | 563,202    |       |
| December 31, 2013 |       | 600,920    |       |
| Thereafter             |       | 1,266,553  |       |
| Total Payments         |       | $          | 3,571,993  |   |

 

Pursuant to the note, weentered into a security agreement which grants to MassDev an exclusive firstpriority security interest in all equipment and tenant improvements funded withthe proceeds of the loan with an approximate carrying value of $5,861,000 and$6,135,000 at March 31, 2009 and December 31, 2008, respectively. Wealso entered into a collateral assignment of lease agreement as additionalsecurity for the repayment of borrowings. This agreement grants MassDev all rights, title and interest in and to ourlease for the Tyngsboro facility in the event that we default on ourobligations.

 

As partial considerationfor the loan, on June 30, 2008, we issued MassDev two warrants. Eachwarrant provides for the purchase of 85,979 shares of our common stock at anexercise price of $1.89 per share, subject to any adjustments as set forth inthe warrants. The warrants are exercisable for seven years commencing on June 30,2008. MassDev assigned one of the warrants to the Massachusetts Technology ParkCorporation (“MTPC”), as part of MTPC’s participation under the MassachusettsTechnology Collaborative’s Business Expansion Initiative.  The Black-Scholes fair value of the warrantsis shown as a discount against the loan, and is being amortized over the lifeof the loan using the effective interest method at an imputed interest rate of1.124%.  The 

 

12

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amortization of thisdiscount resulted in approximately $10,000 charged to interest expense duringthe first quarter of 2009.  The effectiveinterest rate of the loan, including the cost of the warrants and otherdeferred loan costs, is approximately 8.4%.

 

Additional capitalexpenditures will be required in the future to optimize the plant for maximummanufacturing capacity.  The amount andtiming of these expenditures are dependent on requirements for equipment neededto meet production schedules as well as having sufficient funding.

 

**Note7.  Sale of Stock**

 

OnFebruary 20, 2009, we entered into a common stock purchase agreement withSeaside, valued at up to $18 million. The agreement requires Seaside to buy $1 million of common stock from usonce each month for up to 18 months, beginning on February 20, 2009, andon the 20th day of each month thereafter (orthe next closest business day.)  Theagreement is structured in three six-month tranches, or segments, each coveringmonthly closings of $1 million each, for up to $6 million total.  We are committed to only the first six-monthtranche, but we have the option, exercisable at our sole discretion, to extendthe agreement for up to two additional six-month periods (each for up to $6million), for a total of up to $18 million over the three tranches.  We have paid Seaside $100,000 for the rightto exercise the first optional extension (although we have not actuallyexercised that extension), and would pay an additional $50,000 if we wish toexercise the second such extension. Additionally, at our sole discretion, we can freeze the monthlytransactions for up to six months by paying a fee to Seaside of $100,000.  At each monthly closing, the number of sharesof common stock to be issued will be determined by applying a 20% discount tothe volume weighted average trading price during the five trading days precedingthe closing.  If in any month the five-dayweighted average trading price of our common stock is below $0.25, then theclosing for that month will not occur and will not be made up.  Shareholder approval will be required beforewe can issue shares that would constitute more than 19.9% of the total sharesoutstanding on February 20, 2009.

 

On February 20,2009, we sold 2,656,184 shares of Common Stock to Seaside at a purchase priceof $0.37648 per share (calculated based upon volume weighted average marketprice of $0.4706 per share over a period of 5 days prior to the sale toSeaside). On March 20, 2009 we sold Seaside an additional2,896,200 shares of Common Stock for a purchase price of $0.34528 pershare (calculated based upon volume weighted average market price of $0.4316per share over a period of 5 days prior to the sale to Seaside). The totaldollar value of the Common Stock sold to Seaside through March 2009(calculated using the closing market price on the dates of sale) was$2,167,830. On April 20, 2009, Seaside purchased additional stock underthis agreement, as discussed in Note 10, “Subsequent Events.” Because the stock was sold at a price below$1.85 per share, certain warrants issued in November 2005 were adjustedaccording to the terms of those warrants, as discussed in Note 8 below.

 

**Note8.  Stock Warrants**

 

We haveoutstanding various series of warrants to purchase our common stock. Holders ofthe warrants are not entitled to receive dividends, vote, receive notice of anymeetings of stockholders or otherwise have any right as stockholders withrespect to their warrant shares. The following schedule shows warrantsoutstanding as of March 31, 2009:

 
| **Description**                                        | ** ** | **Grant  Date** | ** ** | **Expiration  Date** | ** ** | **Strike  Price** | ** ** | **Issued  and  Outstanding** | ** ** |
|--------------------------------------------------------|------------|-----------------|------------|----------------------|------------|-------------------|------------|------------------------------|------------|
| May 24, 2005 Financing                            |       | 5/24/2005       |       | 5/25/2010            |       | $                 | 1.008      |                         | 800,000    |   |
| November 8, 2005 Financing (Investors)            |       | 11/8/2005       |       | 5/9/2011             |       | $                 | 1.66       |                         | 4,089,227  |   |
| February 15, 2007 Shelf Issue                     |       | 2/15/2007       |       | 2/15/2012            |       | $                 | 1.33       |                         | 6,261,786  |   |
| GFI Tyngsboro Lease                                    |       | 7/23/2007       |       | 7/22/2014            |       | $                 | 1.77       |                         | 500,000    |   |
| September 10, 2007 Shelf Issue (Investors)        |       | 9/10/2007       |       | 3/11/2013            |       | $                 | 1.99       |                         | 6,122,449  |   |
| September 10, 2007 Shelf Issue (Placement Agents) |       | 9/10/2007       |       | 3/11/2013            |       | $                 | 1.99       |                         | 153,061    |   |
| October 31, 2007 Shelf Issue                      |       | 10/31/2007      |       | 5/1/2013             |       | $                 | 2.97       |                         | 5,431,805  |   |
| June 30, 2007 Massachusetts Development Loan      |       | 6/30/2008       |       | 6/30/2015            |       | $                 | 1.89       |                         | 171,958    |   |
| October 15, 2008 Shelf Issue                      |       | 10/15/2008      |       | 4/16/2014            |       | $                 | 1.20       |                         | 8,700,000  |   |
| December 24, 2008 Shelf Issue                     |       | 12/24/2008      |       | 6/25/2014            |       | $                 | 0.74       |                         | 8,966,000  |   |
| Total warrants outstanding                             |       |            |       |                 |       |              |       | 41,196,286                   |       |

 

13

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The followingshows changes to the warrants outstanding from December 31, 2008 through March 31,2009:

 
| ** **                                                         | ** ** | **# Warrants** | ** ** |
|--------------------------------------------------------------------|------------|----------------|------------|
| Warrants outstanding as of December 31, 2008:                 |       | 46,932,939     |       |
| 1/21/2009 Quercus Trust surrender of warrants issued 10/31/2007    |       | (5,884,455     | )          |
| Warrant Ratchet 11/8/2005 warrant due to pricing (Seaside 2/20/09) |       | 72,542         |       |
| Warrant Ratchet 11/8/2005 warrant due to pricing (Seaside 3/20/09) |       | 75,260         |       |
| Warrants outstanding as of March 31, 2009:                    |       | 41,196,286     |       |

 

Warrants withactivity during the three months ended March 31, 2009 are described below:

 

*October 2007Shelf Warrants*

 

In October 2007,we sold 11,911,852 units of the Company at a purchase price of $2.10 perunit.  Each unit consisted of one shareof our common stock, par value $0.01 per share, and a warrant to purchase 0.95shares of common stock at an exercise price of $2.97 per share, for a total of11,316,260 warrants, of which 5,431,805 are outstanding as of March 31,2009. The warrants became exercisable six months and one day after theirissuance, and expire May 1, 2013. The units were issued pursuant to aprospectus supplement filed with the Securities and Exchange Commission inconnection with an effective registration statement.  On January 29, 2009, Quercus Trustsurrendered their 5,884,455 warrants.

* *

*November 2005Financing Warrants*

 

As part of afinancing transaction in November 2005, we issued warrants to purchase anaggregate of 2,960,527 shares of our common stock to ten “accredited investors.”In addition, 450,000 warrants were issued to the placement agents.  The per-share exercise price for the warrantshares was $2.21. Each investor warrant is exercisable at any time until May 9,2011.  The placement agent warrantsexpired on November 8, 2008.  Theterms of the investor warrants include anti-dilution provisions which requireus to adjust the exercise price and the number of shares of our common stock tobe issued upon exercise of the warrants under certain circumstances, whichinclude:

 

·                  Subdivisions, stock dividends or combinations of ourcommon stock

·                  Reclassifications, exchanges, substitutions, orin-kind distributions that result in a change in the number and/or class of thesecurities issuable upon exercise of the warrants

·                  Reorganizations, mergers and similar transactions; and

·                  Issuance of additional shares of our common stock, orsecurities convertible into our common stock, at a price per share lower thanthe closing stock price on the date of this transaction, which was $1.85.

 

Based on thewarrants’ anti-dilution provisions, the exercise price of these warrants wasadjusted as shown below.  Warrants issuedto the placement agent were not subject to adjustment.

 
| ** **                                   | ** ** | **# Warrants** | ** ** | **Exercise  Price** | ** ** |
|----------------------------------------------|------------|----------------|------------|---------------------|------------|
| Original Warrant                             |       | 2,960,527      |       | $                   | 2.21       |   |
| Adjustment based on anti-dilution provision: |       |           |       |                |       |
| Financing February 2007                 |       | 327,294        |       | $                   | 1.99       |   |
| Financing October 2008                  |       | 248,808        |       | $                   | 1.85       |   |
| Financing December 2008                 |       | 404,796        |       | $                   | 1.66       |   |
| Seaside 2/20/09 purchase                     |       | 72,542         |       | $                   | 1.63       |   |
| Seaside 3/20/09 purchase                     |       | 75,260         |       | $                   | 1.60       |   |
| Adjusted Warrant:                            |       | 4,089,227      |       | $                   | 1.60       |   |

 

14

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**Note9.  Stock Based Compensation**

 

**Descriptionof Plans**

 

*StockOption Plan*

 

Our Third Amendedand Restated 1998 Stock Incentive Plan allows for the granting of stock optionsto purchase up to 23,000,000 shares of our common stock.  Options may begranted to our employees, officers, directors, consultants and advisors. Underthe terms of the option plan, incentive stock options (“ISOs”) are to begranted at the fair market value of our common stock at the date of grant, andnonqualified stock options (“NSOs”) are to be granted at a price determined bythe Board of Directors.  In general, the Board has authorized vestingperiods of one to three years and terms of varying length but in no case longerthan 10 years.  Our stock option program is a long-term retention programthat is intended to attract, retain and provide incentives for talentedemployees, officers and directors, and to align stockholder and employeeinterests.  We consider our option program critical to our operation andproductivity; essentially all of our employees participate.  At March 31,2009, we had 18,425,284 shares reserved for issuance under this plan, of which12,685,963 relate to outstanding options and RSUs.

 

*EmployeeStock Purchase Plan*

 

Our Employee StockPurchase Plan (the “ESPP”) allows substantially all of our employees topurchase shares of our common stock at a discount through payrolldeductions.  Participating employees may purchase our common stock at apurchase price equal to 85% of the lower of the fair market value of the commonstock at the beginning of an offering period or on the exercise date. Employees may designate up to 10% of their base compensation for the purchaseof common stock under this plan.  The ESPP provides for the purchase of upto 2,000,000 shares of our common stock.  At March 31, 2009, we had1,718,943 shares reserved for issuance under this plan.

 

*RestrictedStock Unit Arrangements*

 

Our Third Amendedand Restated 1998 Stock Incentive Plan permits the grant of restricted stockunits (“RSUs”) to our employees, officers, directors and other serviceproviders.  We use RSUs to (i) alignour employees’ interests with those of the Company, (ii) motivate ouremployees to achieve key product development milestones and thus createstockholder value, (iii) retain key employees by providing equity to suchemployees and (iv) conserve cash, by paying bonuses in the form of RSUs,rather than in cash, but with the number of such RSUs calculated on adiscounted basis to compensate for the reduced liquidity as compared tocash.  With respect to the RSUs that are granted in lieu of cash bonuses,the number of RSUs granted are based on performance, and are automatically convertedinto shares of common stock in four equal tranches in the fiscal year followingthe year of performance. Certain other RSUs are granted to our officers as aform of equity incentive, are not tied to performance, and vest over athree-year period in equal quarterly installments.  There are also otherperformance-based restricted stock units (PSUs) granted to our officers thatcliff-vest upon the achievement of certain earnings-based milestones and uponthe Company achieving a level of revenue such that it is no longer treated as adevelopment stage company for accounting purposes, both such vesting eventssubject to the recipient officer being employed by us during the period endingwith the milestones. The unvested portion of any RSU or PSU grant is subject toforfeiture upon the holder’s resignation or termination for cause.  As of March 31, 2009 and December 31,2008, certain RSUs granted under the officer employment agreements were vestedbut stock was not issued because the trading window was closed to insiders asof the respective vesting dates.

 

Restricted stockunit activity as of December 31, 2008 and for the three months ended March 31,2009 is as follows:

 
| ** **                                          | ** ** | **Three  months  ended March 31,** | ** ** | **Year  ended  December 31,** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------|------------|------------------------------------|------------|
| ** **                                          | ** ** | **2009**                                | ** ** | **2008**                           | ** ** |
| ** **                                          | ** ** | **(number  of shares)**                 | ** ** |
| Shares issued related to vested RSUs:               |       |                                    |       |                               |       |
| Current year grant based upon prior year bonus plan |       | —                                  |       | —                             |       |
| Based on prior year grants                          |       | 14,228                                  |       | 38,084                             |       |
| Based upon current year executive officer agreement |       | —                                  |       | 14,094                             |       |
|                                                |       |                                    |       |                               |       |
| Vested RSUs not yet converted to stock              |       | 10,708                                  |       | 14,228                             |       |
|                                                |       |                                    |       |                               |       |
| RSU’s granted but not vested:                  |       |                                    |       |                               |       |
| Related to 2007 executive officer agreement         |       | 18,058                                  |       | 24,068                             |       |
| Related to 2008 executive officer agreement         |       | 32,904                                  |       | 37,602                             |       |
| Related to performance-based executive plan*        |       | 1,265,823                               |       | 1,265,823                          |       |

 

----

*    Vesting of the performance-based RSUs(PSUs) is subject to the achievement of performance requirements. Based on ourbusiness plan as of December 2008, which slows the deployment of frequencyregulation installations due primarily to the tightening of credit markets, ourexecutive management does not believe that it is probable that the award willbe earned.  Accordingly, the cumulativecompensation expense recorded as of December 31, 2008, was reversed duringthat period, and no compensation expense was recorded for these PSUs for thethree months ended March 31, 2009.

 

15

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**StockOption Plan Schedules**

 

Stock optionactivity for the first three months of 2009 was as follows:

 
| ** **                          | ** ** | ** **     |   | **Weighted-** |   | **Weighted-** |    |
|-------------------------------------|------------|----------------|--------|---------------|--------|---------------|---------|
| ** **                          |       |           |   | **Average**   |   | **Average**   |    |
| ** **                          |       | **Number  of** |   | **Exercise**  |   | **Fair**      |    |
| ** **                          | ** ** | **Shares**     |   | **Price**     |   | **Value**     |    |
| Outstanding, December 31, 2008 |       | 11,338,470     |   | $             | 1.18   |          |    |   |
| Granted                             |       | 20,000         |   | $             | 0.89   |          | Note  1 |   |
| Exercised                           |       | —         |   | $             | — |          |    |   |
| Canceled, forfeited or expired      |       | —         |   | $             | — |          |    |   |
| Outstanding, March 31, 2009    |       | 11,358,470     |   | $             | 1.18   |          |    |   |

 

Note 1:  Options granted during the first quarter of2009 were to a consultant.  Half of theseoptions will vest on May 5, 2009, and the remainder will vest on November 5,2009, subject to the consultant’s continued service to the Company.  In accordance with EITF 96-18, “*Accounting for equity instruments that are issued to other thanemployees for acquiring, or in conjunction with selling, goods or services*,”the measurement dates for these options has been determined to be the vestingdates.  As neither of the vesting dateshad occurred as of March 31, 2009, the weighted fair value of this grantcould not be determined.

 

The following tablesummarizes information about stock options outstanding at March 31, 2009:

 
| ** **    | ** ** | ** **      | ** ** | **Weighted-**     | ** ** | ** **    | ** ** | ** **      | ** ** | **Vested**    | ** ** |
|---------------|------------|-----------------|------------|-------------------|------------|---------------|------------|-----------------|------------|---------------|------------|
| ** **    | ** ** | ** **      | ** ** | **Average**       | ** ** | **Weighted-** | ** ** | ** **      | ** ** | **Weighted-** | ** ** |
| ** **    | ** ** | **Number**      | ** ** | **Remaining**     | ** ** | **Average**   | ** ** | **Vested**      | ** ** | **Average**   | ** ** |
| **Exercise**  | ** ** | **of  Options** | ** ** | **Contractual**   | ** ** | **Exercise**  | ** ** | **Number**      | ** ** | **Exercise**  | ** ** |
| **Price**     | ** ** | **Outstanding** | ** ** | **Life  (Years)** | ** ** | **Price**     | ** ** | **of  Options** | ** ** | **Price**     | ** ** |
| $0.26 - $0.74 |       | 3,553,233       |       | 5.74              |       | $             | 0.69       |            | 3,271,658  |          | $          | 0.70 |   |
| $0.80 - $1.46 |       | 5,812,517       |       | 7.11              |       | $             | 1.06       |            | 3,699,290  |          | $          | 0.99 |   |
| $1.51 - $2.19 |       | 1,535,470       |       | 6.49              |       | $             | 1.82       |            | 1,453,128  |          | $          | 1.82 |   |
| $2.50 - $3.10 |       | 130,000         |       | 1.10              |       | $             | 2.64       |            | 130,000    |          | $          | 2.64 |   |
| $4.10 - $5.27 |       | 222,250         |       | 1.91              |       | $             | 4.40       |            | 222,250    |          | $          | 4.40 |   |
| $6.00 - $9.31 |       | 105,000         |       | 1.56              |       | $             | 6.40       |            | 105,000    |          | $          | 6.40 |   |
| Total         |       | 11,358,470      |       |              |       |          |       | 8,881,326       |       |          |       |

 

16

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**StockCompensation**

 

We account for ourstock compensation in accordance with SFAS 123R. We use the Black-Scholesoption pricing model to determine the fair value of stock options and employeestock purchase plan shares. The valuations determined using this model areaffected by our stock price as well as assumptions we make regarding a number ofcomplex and subjective variables, including our stock price volatility,expected life of the option, risk-free interest rate and expected dividends, ifany.

 

We estimate thevolatility of our common stock by using historical volatility.  Weestimate the expected term of the option grant, and determine a risk-freeinterest rate based on U.S. Treasury issues with remaining terms similar to theexpected term of the stock or options. We do not anticipate paying any cashdividends in the foreseeable future and therefore use an expected dividendyield of zero in our valuation model. We are required to estimate forfeituresat the time of grant and revise those estimates in subsequent periods. Allstock-based payment awards are amortized as they are earned over the requisiteservice periods of the awards, which are generally the vesting periods.

 

Restricted stockunits (RSUs) are valued at the stock price at date of grant, and expensedratably over the performance period or vesting period, as appropriate. The number of PSUs for which stock compensation expense is calculated is basedupon management’s assessment of the likelihood of achieving the performancetargets.

 

As noted above,the only option grants made during the three months ended March 31, 2009were to a consultant, and the measurement date for those options had notoccurred as of March 31, 2009. Accordingly, no grants were valued during this three month period. Theassumptions used to value stock option grants for the three months ended March 31,2008 are as follows:

 
| ** **                                                                               | ** ** | **Three  months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                               | ** ** | **2008**                                     | ** ** |
| Risk-free interest rate                                                                  |       | 2.15%  - 2.89%                               |       |
| Expected life of option                                                                  |       | 3.5  years                                   |       |
| Expected dividend payment rate, as a percentage of the stock price on  the date of grant |       | 0%                                           |       |
| Assumed volatility                                                                       |       | 87%  - 98%                                   |       |
| Expected forfeitures                                                                     |       | 10%                                          |       |

 

Stock-basedcompensation expense recognized on our consolidated statement of operations forthe three months ended March 31, 2009 and 2008 are as follows:

 
| ** **                                    | ** ** | **Three  months ended March 31,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                    | ** ** | **2009**                               | ** ** | **2008** | ** ** |
| Operations and maintenance                    |       | $                                      | 34,497     |   | $ | — |   |
| Research and development                      |       | 107,693                                |       | 362,909 |   |
| Selling, general and administrative           |       | 136,822                                |       | 388,401 |   |
| Total stock compensation expense              |       | $                                      | 279,012    |   | $ | 751,310 |   |
|                                          |       |                                   |       |   |   |
| Components of stock compensation expense:     |       |                                   |       |   |   |
| Compensation expense related to RSUs          |       | $                                      | 8,054      |   | $ | 162,147 |   |
| Compensation expense related to stock options |       | 270,958                                |       | 589,163 |   |
| Total stock compensation expense              |       | $                                      | 279,012    |   | $ | 751,310 |   |

 

As of March 31,2009, there was approximately $644,000 of unrecognized compensation cost,adjusted for estimated forfeitures, related to unvested stock-based paymentsgranted to our employees and directors. Total unrecognized compensation costwill be adjusted for future changes in estimated forfeitures and recognizedover the remaining vesting periods of the stock option grants.

 

17

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**Note10.  Subsequent Event**

 

On April 20, 2009 wesold Seaside 1,912,777 shares of Common Stock for a purchase price of$0.5228 per share (calculated based upon a 20% discount to the volume weightedaverage market price of $0.6535 per share over a period of 5 days prior tothe sale to Seaside). Between February 2009 through April 2009,Seaside has purchased a total of 7,465,161 shares, at a total dollar value of$3,411,135, calculated using the closing market price on the dates of sale.

 

Because the stock was sold at a price below $1.85 per share, certainwarrants issued in November 2005 were adjusted according to the terms ofthose warrants.  The April 20, 2009stock sale to Seaside resulted in an increase in the number of sharesexercisable for the November 2005 warrants of 51,764, and an adjusted exercise price as of April 20,2009 of $1.58.

 

**Item 2. Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

**NoteRegarding Forward Looking Statements**

 

This QuarterlyReport on Form 10-Q contains forward-looking statements concerning, amongother things, our expected future revenues, operations and expenditures, andestimates of the potential markets for our products and services.  Suchstatements made may fall within the meaning of the Private SecuritiesLitigation Reform Act of 1995, as amended.  All such forward-lookingstatements are necessarily only estimates of future results and the actualresults we achieve may differ materially from these projections due to a numberof factors as discussed in the section entitled “Risk Factors” of this Form 10-Q.New risks can arise and it is not possible for management to predict all suchrisks, nor can management assess the impact of all such risks on our businessor the extent to which any factor, or combination of factors, may cause actualresults to differ materially from those contained in any forward-lookingstatement.  Given these risks and uncertainties, investors should notplace undue reliance on forward-looking statements as a prediction of actualresults.  All forward-looking statements speak only as of the date of thisQuarterly Report on Form 10-Q.  We undertake no obligation to reviseor update publicly any forward-looking statement in order to reflect any eventor circumstance that may arise after the date of this Quarterly Report on Form 10-Q,other than as required by law.

 

**CriticalAccounting Policies and Estimates**

 

The preparation offinancial statements requires management to make estimates and judgments thatmay significantly affect the reported amounts of assets, liabilities, revenues,expenses and related disclosures. On an ongoing basis, management evaluates ourestimates and assumptions including, but not limited to, those related torevenue recognition, asset impairments, inventory valuation, warranty reservesand other assets and liabilities.  Management bases its estimates onhistorical experience and various other assumptions that it believes to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources.  Actual results may differ fromthese estimates under different assumptions or conditions.

 

*Loss onResearch and Development Contract Commitments*

 

We establishreserves for anticipated losses on contract commitments if, based on our costestimates to complete the commitment, we determine that the cost to completethe contract will exceed the total expected contract revenue.  Most of our contracts have been granted on acost-share basis, for which the expected cost-share is recorded as a contractloss. The U.S. Naval Sea Systems Command (NAVSEA) contract, however, has beengranted on a cost-plus-fixed-fee basis. Each quarter, we perform an evaluation of expected costs to complete ourin-progress contracts and adjust the contract loss reserve accordingly.

 

During the quarterended March 31, 2009, we increased the loss reserve for the Tehachapicontract by approximately $133,000 to reflect the difference between theoverhead rate used when we bid on the contract, and our current “full-capacity”rate.  Our current manufacturing capacityis 600 flywheels per year, and current overhead rates are based on ourforecasted costs at this capacity. Because we are not yet operating at this capacity, use of this rateresults in a significant portion of our costs being expensed as periodcosts.  However, we bid on the Tehachapicontract mid-2007, prior to our move to the Tyngsboro facility.  At the time, we had anticipated expanding ourmanufacturing capacity to 1,000 units per year, and had calculated the overheadrate used in our bid based on that capacity. Our engineering and manufacturing overhead rates are based upon directlabor hours, and thus are sensitive to changes in capacity or headcount. Costestimates for our contracts are also subject to change based upon the number ofhours required to complete the project as well as the cost of direct materials,contract-related travel and outside services such as consultants.

 

18

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Our contractshistorically have been completed over multiple fiscal periods, and a reservefor contract losses is recorded at the point when we estimate that such a lossmay occur.  Although the allocation ofoverhead to a fixed-price contract does not impact the Company’s total costs orloss from operations, it may result in such costs being recognized in anearlier period than when the costs are actually incurred. Moreover, since ourcurrent production levels are significantly lower than those used in our “full-capacity”overhead rate, our forecasted costs are based upon subjective estimates andmanagement judgment, and actual results may differ significantly.  However, the two fixed price contracts thatwe are currently working on are relatively small, and the impact of ourestimates and assumptions relative to these contracts are not expected to havea material impact on our financial condition or operating performance.

 

*FixedAssets*

 

Propertyand equipment in service is stated at cost and depreciated using thestraight-line method over the estimated useful lives of the assets. Propertyand equipment are defined as tangible items with unit costs exceeding ourcapitalization threshold that are used in the operation of the business, arenot intended for resale and which have a useful life of one year or more. Thecost of fixed assets is defined as the purchase price of the item, as well asall of the costs necessary to bring it to the condition and location necessaryfor its intended use.  These costsinclude material, labor, overhead, capitalized interest and, if applicable,exit costs. Exit costs for which we are obligated are accounted for inaccordance with SFAS No. 143, “*Accounting for AssetRetirement Obligations*.” No overhead is generally applied forinternally-constructed projects not directly related to our core business(e.g., leasehold improvements.) Repair and maintenance costs are expensed asincurred.  Materials used in ourdevelopment efforts are considered research and development materials, and areexpensed as incurred in accordance with SFAS No. 2 “*Accountingfor Research and Development Costs*.”

 

Capitalassets are classified as “Construction in Progress” when initially acquired,and reclassified to the appropriate asset account when placed into service,with the exception of land, which is capitalized upon purchase. Depreciationexpense is not recorded on assets not yet placed into service.

 

Materialspurchased to build flywheels, power electronics and other components used inour frequency regulation installations are classified as CIP, along with therelated labor and overhead costs. Some components of the Smart Energy MatrixTM,such as the flywheels and power electronics, are considered “fungible” in thatthey can be moved and redeployed at a different location.  Non-fungible costs are costs which would notbe recovered if we redeployed the matrix or portions thereof.  In some cases, we may elect to deploy a SmartEnergy MatrixTM system at a location for the purpose of demonstrating ourtechnology or gaining experience operating in that particular market.  In these instances, the costs of the fungiblecomponents are capitalized, and the remaining costs, which may include suchcosts as site preparation, interconnection costs, capitalized interest andestimated exit costs are expensed.

 

*Impairmentof Long-Lived Assets*

 

In accordance withSFAS No. 144 “*Accounting for theImpairment or Disposal of Long-Lived Assets*” long-lived assets wehold and use are reviewed to determine whether any events or changes incircumstances indicate that the carrying value of the asset may not berecoverable.  The conditions to beconsidered include whether or not the asset is in service, has become obsolete,is damaged, or whether external market circumstances indicate that the carryingamount may not be recoverable.  Whenappropriate we recognize a loss for the difference between the estimated fair valueof the asset and the carrying amount. The fair value of the asset is measured using either available marketprices or estimated discounted cash flows.

 

In certain instances, wemay determine that it is in the best interest of the Company to re-deploy allor part of a Smart Energy MatrixTM system installed at a given location.  When such a determination has been made, wewill determine which costs are associated with the movable (fungible)components, and which costs are non-fungible. We will record a period expensefor the net book value not associated with the fungible components.

 

As of March 31,2009, in order to determine whether or not the current inventory of flywheelsand related equipment on hand is impaired, we reviewed the current status ofthe 20 MW system, and noted the following:

 

·      The first 20MW installation, expected to be inStephentown, NY, is expected to cost more than $60 million, which includessubstantial administrative costs related to the Department of Energy duediligence and review process.

 

19

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·      The second 20MW installation is expectedto cost approximately 25% less than the first 20MW plant.  Cost reductions for the second plant areexpected to occur due to potential volume supplier agreements and our ownconstruction experience.

 

·      The location for the first 20MWinstallation will be in NYISO.  This isthe most attractive market for regulation services in that they offer thehighest historical frequency regulation clearing prices and will provide uswith an optimum signal that is ideal for our resource.  We are currently planning to deploy ourflywheels in New York.

 

·      We performed cash flow testing based upona variety of scenarios, using historical 12-month average day-ahead andreal-time clearing prices for regulation in the NYISO.  Our analysis included the potential impact ofvarious “worst case” scenarios based upon potential negative factors,individually and in combination, such a reduction in the frequency regulationclearing price of up to 20%, increases in energy costs of up to 20%, higherconstruction costs of up to 30% or certain changes in energy signals.

 

·      Our forecast and models indicate that wecan expect positive cash flows from a 20 MW frequency regulation installationin New York, and that consequently, as of March 31, 2009 no impairmentreserve is required for our current supply of flywheels and related fungibleSmart Energy MatrixTM materials.

 

**Overview**

 

Wedesign, develop, configure and are taking steps to commercialize advancedproducts and services to support more reliable and cost-effective electricitygrid operation. The focus of our research and development has been to establishcommercially viable flywheel-based energy storage technologies that can providehighly reliable energy solutions for the worldwide electricity grid atcompetitive costs. Initially, we expect to generate revenues from the commercializationof our flywheel energy storage systems to supply frequency regulation servicesto the electricity grid in North America. We believe that, as we expand ourproduction capabilities, we can become a provider of frequency regulationservices to grid operators on a global basis. In addition we believe that asthe commercialization of our technologies continues, we will develop othercost-effective applications for our flywheel systems that will provideadditional revenue opportunities.

 

Ourmarket focus is on the geographic regions of the domestic grid that provideopen bid markets for regulation services. These regions and their IndependentSystem Operator (ISO) or Regional Transmission Organization (RTO) designationsare: New England (ISO New England or ISO-NE); California (California ISO orCAISO); New York (New York ISO or NYISO); Mid-Atlantic (PJM Interconnect);Midwest ISO (MISO) and Texas (ERCOT). Because ERCOT is not regulated by FERC, we are not able to encouragebeneficial market rule changes in ERCOT by leveraging Federal EnergyRegulatory Committee (FERC) Order 890, which was intended to promote greatercompetition in electricity markets, in part by allowing non-generativeresources such as ours the ability to bid and sell into frequency regulationmarkets.  As a result, we are focusing onthe other open bid markets first and will begin to work on entry into ERCOTonce we are operating in the other markets.

 

Theseregional ISOs/RTOs or grid operators purchase frequency regulation servicesfrom independent providers in open bid markets that they manage and maintain.We are seeking to become one such provider. We believe our technology willoffer grid operators the benefits of greater reliability; faster response time;cleaner operation, including zero direct emissions of carbon dioxide (CO2), nitrogen oxide, sulfur dioxide and mercury; and lowermaintenance costs compared to conventional power generation facilities thatalso provide frequency regulation services. We believe that we will have lower operating costs and faster responsetime than the majority of other entities that provide frequency regulationservices, which we believe will allow us to have sufficient margins to make thecompany economically viable.

 

Underthe open-bid market like that operated by NYISO, grid operators forecast theneed for frequency regulation as a percentage of expected power demand, andapproved suppliers submit bids for these services. Bids are stacked from lowestto highest prices until the cumulative amount of bids is sufficient to meet thecalculated need. The price submitted by the highest selected bidder determinesthe price paid to every bidder that has been scheduled to provide service,although each ISO may calculate payments based on formulas that yield differentrevenue results even with equivalent frequency regulation clearing prices.

 

OurSmart Energy MatrixTM recycles excess energy when generated power exceeds loadand delivers it when load increases. We believe that our low operating costscoupled with a useful life of 20 years will allow us to participate in theseopen markets with a very favorable profit margin. Also, our systems respond upto 100 times faster than fossil fuel generators providing 

 

20

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frequencyregulation.  Certain ISOs have or areconsidering tariff changes that would provide payment mechanisms to compensateresources, such as ours, for faster regulation response.  If such performance-based tariffs areapproved, we believe that there is potential for us to receive greater revenuesfor providing regulation services.

 

To participate in this regulatory-drivenopen-bid market, we expect to build, own and operate a number of frequencyregulation installations known as Smart Energy MatrixTM systems designed toprovide reliable and sustainable frequency regulation services for utilitygrids. Our primary business model is a sale-of-services model, similar to thatof independent power producers who also build, own and operate their own powerplants. Under this model, we will be bidding our services into multipleopen-bid markets for regulation on a daily basis. Additionally, we may:

 

·      Participate in pilot programs todemonstrate our technology, such as the ISO-NE Alternative Energy Storage PilotProgram, under rules that may provide alternative bidding and paymentplans than those provided by the permanent market rules

·      Sell Smart Energy MatrixTM systems on anequipment-sale basis in both the US and overseas markets

·      Become fractional owners of some plantsas a means of accelerating cash flow during the early years of our commercialdeployment

·      Enter into bi-lateral contracts withutilities that currently self-provide or purchase regulation services tosatisfy their obligations to pay for or self-provide regulation services intheir respective ISOs.

 

Our Smart Energy 25 flywheels consist of theflywheels and the associated power electronics. A Smart Energy MatrixTM is anarray of ten Smart Energy 25 flywheels that can provide 1 MW of energy storage.A frequency regulation installation includes one or more Smart EnergyMatricesTM, along with ancillary equipment and site work. A typical full-scaleinstallation would have a capacity of 20 MW. The components of a frequencyregulation installation are divided into three categories:

 

·      Non-fungible location-based costs whichwould not be economically viable for redeployment

·      Fungible location-based costs which wouldbe economically viable for redeployment

·      Fungible flywheel and power electronicscosts which would be economically viable for redeployment.

 

On November 18,2008, we connected our first 1 MW Smart Energy MatrixTM to the electric grid inTyngsboro, Massachusetts. The 1 MW system was installed under the ISO NewEngland Alternative Technologies Pilot Program, which allows us to generaterevenue for regulation services while we, and ISO-NE, explore ways to optimizethe beneficial impact of the technology and while ISO-NE develops permanentmarket rules that will govern the application of the technology. The pilotprogram and its revenue component will continue until such rules are inplace. This process is expected to take approximately 18 months from the November 2008start. The pilot program was approved by FERC as part of ISO New England’s compliancewith FERC Order No. 890, which is intended to promote greater competitionin electricity markets, strengthen the reliability of the grid, and allowso-called “non-generation” resources (which include our flywheel technology),to participate in frequency regulation markets on a non-discriminatory basis.

 

As part of the process ofmodifying its market rules, ISO New England is working with us to optimizeperformance by adjusting the control signal sent from the ISO to our SmartEnergy MatrixTM to help maximize regulation effectiveness for the grid whileproviding fair and equitable regulation service payments to us and other energystorage-based providers of frequency regulation service. In contrast to, say,NYISO’s single part payment model for regulation, ISO New England has athree-part payment model:

 

1.     Payment for the resource’s MWs of capacity that arescheduled to perform regulation called “Time-On-Regulation”.

2.     Payment based on the amount a resource is signaled tochange its output called “Regulation Service” or “Mileage”.  Faster response resources receive highermileage payments.

3.     Opportunity cost payments to compensate generators forlost revenue as a consequence of providing frequency regulation rather thanconventional power generation.

 

Revenues we are currentlyreceiving from this pilot program are less than those that we expect to receiveunder permanent market rules for two reasons. First, under pilot programmarket rules, we are not eligible for opportunity cost payments, whichrepresent approximately one-third of the revenue received by conventionalregulating generators. We are encouraging ISO-NE to develop permanent market rules thatwill provide an additional payment component for alternative technologies thatwould be approximately equal to opportunity cost. The trend at other ISOs hasbeen to incorporate features in their tariffs that intrinsically compensate allresources, including energy storage providers, for opportunity cost. Second,the current signal we are receiving from ISO-NE does not take full advantage ofour speed of response and therefore our mileage payments are not as high as weexpect them 

 

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to be in the future.  As discussed above, we are working withISO-NE to convince them to adopt a regulation signal that will better utilizeour technology’s fast response capability in order to maximize benefits to thegrid and payments for our regulation.

 

Electricity costs foroperating the 1 MW pilot Smart Energy MatrixTM in Tyngsboro through the end of March 2009are higher than what we expect our electricity costs to be in the future.  Because the 1 MW pilot project is connectedto a distribution level power line, from November 2008 through late April,2009, we paid the retail price for all the electricity that we withdrew fromthe grid instead of paying the wholesale price of electricity for the netelectricity we withdrew from the grid (withdrawals minus injections). Since our1 MW pilot resource is connected at distribution level, the price ofelectricity was determined by the retail tariff of the local distributioncompany versus the ISO wholesale tariff. The retail cost of electricity included charges for both the delivery ofthe electricity and the electricity commodity itself, and was about twice thecost of wholesale.  Furthermore, theretail tariff does not have a provision for netting the electricity withdrawnand injected back to the grid. As of late April 2009, ISO-NE and our localdistribution company implemented a change which will reduce our cost ofelectricity by netting the electricity withdrawn and injected to the grid, andbilling us for that net usage at the wholesale rate. We are working to reducethe electricity delivery charges as well. In the future, our 20 MW facilitieswill be connected to transmission level power lines and therefore our cost forelectricity will be the wholesale commodity price for electricity for our netwithdrawals, and we will not incur delivery charges.

 

Thelocation of our regulation installations and the sequence in which they will beconstructed depend on a number of factors, including but not limited to:

 

·      Comparative market pricing available forfrequency regulation in different markets

·      Our ability to receive appropriaterevenues and payments within the Market Rules of each regional market

·      Availability of the transmission lines toconnect directly to an ISO

·      Availability and cost of land

·      Receipt of all necessary environmentaland related permits

·      Grid interconnection approvals.

 

OnJuly 17, 2008, we received a land-use permit we had requested from thetown of Stephentown, New York.  Duringthe third quarter of 2008, we purchased approximately seven acres of land at asite in the town where we plan to build our first 20 MW installation. The siteis served by two transmission companies: National Grid and NYSEG. National Gridowns a 115 KVA transmission line that abuts the site, and NYSEG owns asubstation that also abuts the site.

 

Ourinterconnection request for the 20 MW plant includes National Grid as thetransmission provider.  Before we can enter into an interconnectionagreement with NYISO, a System Impact Study, which is currently underway, mustbe completed.  The purpose of the studyis to ensure that our installation can safely interface with the grid, and toidentify any utility upgrades or other equipment that may be needed beforeconstruction can begin.

 

Wemay elect to install 1 MW installations in ISOs to provide early insight tooperating within each market. The economics of these 1 MW systems may not berepresentative of expected revenues and costs for a 20 MW plant, and thereforethe non-fungible costs may be expensed. For example, in the New York market, we are planning to deploy a 1 MWresource on the Stephentown site, but interconnected to NYSEG.  On October 10, 2008, we entered into a 1MW interconnection agreement with NYSEG that would connect directly to itssubstation. Pending application for and receipt of a building permit from thetown of Stephentown for a 1 MW installation, we have the right to build andoperate a 1 MW resource connected to the NYSEG substation. We believe that thevalue of gaining early insight into the best way to operate and bid our planned20 MW resource into the NYISO market more than compensates for the costsassociated with deploying a 1 MW resource. In addition, the 1 MW resource can later be electrically connected toNational Grid’s 115 KVA transmission line should we choose to do so. Similarly,in Ohio we expect to deploy 1 MW at the AEP facility as described below. Thenon-fungible costs associated with deploying small installations which are notintended to remain in service for terms exceeding two years will be expensed.

 

On February 23,2009, we announced that we had signed a contract with American Electric Power,one of the largest generators of electricity in the U.S., and one of itsoperating subsidiaries, Columbus Southern Power Company. The contract willentail building a 1 MW Smart Energy MatrixTM regulation facility at an AEP site inGroveport, Ohio. The system, which will be connected to the grid within theoperating region of the PJM Interconnection (PJM), will provide flywheel-basedfrequency regulation services. Installation of this Smart Energy MatrixTM is scheduled tobegin in 2009. The 1 MW system will providevaluable insight into the operation of our technology on PJM’s grid and make usbetter prepared to deploy and profitably operate full scale 20 MW plants in PJM’sarea of coverage. We also expect that the facility will provide us withadditional market credibility.

 

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We have applied tothe US Department of Energy (DOE) for a loan guarantee that would enable to usto fund a majority of the planned 20 MW installation in Stephentown. Thesatisfactory completion of NYISO’s System Impact Study and clear resolution ofmarket rule issues that affect our ability to enter and operate in theNYISO market (described elsewhere) could affect the timing or success of ourDOE loan guarantee application, among other factors.  In addition, there is no guarantee that theDOE loan guarantee will be offered to us on terms that we consider acceptable.

 

By the end of 2009, we plan to have deployed up to 7 MW of frequencyregulation among three locations: Stephentown New York, Groveport Pennsylvaniaand Tyngsboro Massachusetts.  Ourdeployment schedule requires that we have sufficient funding to build these facilities. We are also identifying and developingadditional sites in our target markets.

 

In volume production, our goal is to complete 20 MW facilities at a costof approximately $25 to $30 million each, though the first 20 MW plant willcost more than $60 million which includes substantial administrative costsrelated to the Department of Energy due diligence and review process. In 2010 and 2011, we will continue to havecapital needs that will require additional funding through equity and debt tofund the ongoing deployment of frequency regulation installations.  In addition to obtaining sufficient funding, ourdeployment plans are affected by other factors and activities, including butnot limited to the following:

 

·      Component development and quality:

·      Completing the engineering and testing ofcertain components to improve highly durable operation at commercial operatingspeeds.

·      Developing multiple sources for our keycomponents. We are working to expand our supplier base to qualify theircomponents to our designs and specifications.

·      Continue working closely with oursuppliers to refine their manufacturing processes and ensure quality results.

 

·      Market rules and participation:

·      We must become a member of each ISO inorder to participate in its market. We have been a member of the PJMInterconnection since 2004. We are also members of ISO New England, New YorkISO and Midwest ISO.

·      The need to change some ISO market rules tobe compatible with our technology is requiring more time to complete than wehad previously anticipated, although in 2008 we made good progress. See “Regulatoryand Market Affairs” for details on market rule changes within each of ourtarget markets.

 

**Regulatory and Market Affairs**

 

Withineach ISO there is a market tariff and set of market rules that determinewho is allowed to bid into regulation markets, how much regulation providersare paid for their services, and what costs providers must pay to participatein markets. Each ISO has its own market rules that will govern the pace atwhich markets are opened and the degree to which our technology is allowed toparticipate. Historically, the market rules for regulation were written toconform to traditional generators’ abilities to provide regulation. This isunderstandable, because until the advent of our technology, the capabilitiesand limitations of traditional generators defined how regulation could betechnically implemented. In the markets in which we intend to compete, most ofthe ISO market rules still contain legacy terms, performancecharacteristics and other requirements that do not match our new technology.The impact of this mismatch varies from market to market, and our ability tofoster beneficial changes to ISO market rules will determine our timingfor entering these markets and building regulation facilities, as well as therevenues and costs associated with each market.

 

Wehave encountered wide variations from one ISO to another in the suitability ofits framework and market rules for commercial deployment of our systems.We have found that we must engage in significant interaction with each ISObefore the regulation market in that ISO region is ready for energy storage.FERC Order 890 has accelerated the pace of market rule changes and in 2008we made progress with several of the ISOs by working with them directly toimplement changes to market rules to allow energy storage technologies toparticipate on a non-discriminatory basis in the regulation market. The ISOshave demonstrated a heightened commitment to work collaboratively with us tointegrate our technology to their grids. In addition to market rule changes, several ISOs are evaluating orproposing changes to their regulation dispatch signal in order to ensure ourSmart Energy Systems are deployed most efficiently and effectively for thebenefit of the power grid. These changes would take better advantage of ourflywheel’s fast response capability, while recognizing our resource has limitedenergy storage capacity. The proposed market rule changes, coupled witheffective regulation dispatch signals, will allow our resource to maximize itsregulation revenue while minimizing our consumption and cost of electricity.The current status of each ISO market is as follows:

 

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·      We believe the NYISO presents the most favorablesite for the first full-scale commercial deployment of our systems. As a resultof FERC Order 890, new management at the NYISO and extensive work by us, lastyear the NYISO developed new tariff and market rules for Limited EnergyStorage Resources (LESRs) to provide frequency regulation. These new rules recognizethe unique operating characteristics of our technology and remedy key aspectsof the current regulation tariff for generators that would otherwise limit ourtechnology.  In addition the NYISO hasdeveloped a regulation dispatch method for LESRs that will take advantage ofthe LESRs fast response rates and maximize their deployment. The energy levelin our flywheels will be actively managed by the NYISO to maintain regulationcapability to the extent possible by charging/discharging as necessary.  Furthermore, the new tariff will allow us tonet our electricity costs at wholesale rates. We believe the new tariff and dispatch mechanisms will provide aneffective and efficient method for integrating flywheels into the NYSIORegulation market.  In addition to marketrules, in December 2008 the Northeast Power Coordinating Council’s (NPCC)changed its reliability rules to allow LESRs to provide frequencyregulation by removing the requirement that resources be able to generate onehour of continuous energy.  The proposedmarket, reliability and dispatch changes, coupled with the high price offrequency regulation in New York, make this a very attractive market for ourSmart Energy MatrixTM Systems. The market changes were passed by the market stakeholders in January 2009and approved by the NYISO Board of Directors in February 2009.  This new tariff was submitted to FERC forapproval in March 2009 with an effective implementation date of May 12,2009.

 

·      On November 18, 2008, ISO-NElaunched an Alternative Technologies Regulation Pilot program to comply withOrder 890.  The pilot program is designedto run for approximately 18 months until new permanent market rules forenergy storage technologies are implemented. The purpose of the AlternativeTechnologies Regulation Pilot program is to evaluate the performance of newtechnologies like ours that are unable to participate in ISO-NE’s currentregulation market, determine how these technologies can best be used to meetNew England’s regulation requirements, allow program participants to operate ina realistic market environment where they can evaluate their market viability,and provide operating experience that ISO-NE can use to formulate permanentmarket rules.  We are participating inthe pilot program with a 1 MW resource located inside our plant inTyngsboro.  To date, this resource hasdemonstrated that it is an effective provider of regulation service, but thecurrent regulation dispatch signal being sent to the facility from ISO-NE isnot taking advantage of the facility’s full regulation capability.  The current signal is similar to how one fora traditional generator is dispatched and therefore does not recognize that ourtechnology provides regulation in a different manner (most importantly, faster)than a traditional generator.  Asdiscussed above, we are working with ISO-NE to convince them to adopt aregulation dispatch signal that better recognizes our energy storage’s uniquecapabilities.  In addition, as alsodiscussed above, we are working to have opportunity cost payments included inthe permanent market rules so that the payments made to our resource arecomparable to other parties that provide a comparable service.

 

·      CAISO is in the process of opening itsfrequency regulation market to energy storage technologies and we are activelyparticipating in this endeavor.  In June 2008,CAISO took the first step to open its market by modifying its tariff to allowbids for regulation by non-generation resources that are capable of providingthe service and that meet applicable ancillary service standards and technicalrequirements. In February 2009, FERC ordered CAISO to make additionalmodifications to its tariff to ensure that non-generation resources are treatedcomparably to other resources in the CAISO regulation market.

 

In 2008, the CAISO initiated a project andstakeholder process to develop the technical and operational requirements forintegrating storage technologies into its system, to consider the extent towhich additional tariff revisions may be needed to encourage theirparticipation in the CAISO’s markets and to determine whether the CAISO shouldconduct an energy storage pilot program. In January 2009, the CAISO stated that consideration is being givento creating an optimal dispatch method for storage resources and a “pay-for-performance”component in the regulation settlement to compensate fast response capability.

 

·      On January 6, 2009, MISO implementeda new ancillary services market (ASM). However, current prices for frequencyregulation are lower than desired.  Giventhat the market just opened, and that there are certain aspects of its initial deploymentthat will change over time, we do not believe the current prices arenecessarily indicative of what pricing will be in the future. As part of itsapproval of the ASM, FERC required MISO to make further changes to its ASM toremove barriers to new technologies to provide regulation service.  On April 25, 2008, MISO fully compliedwith FERC’s directives by filing a request for an entirely new regulationresource category specifically designed for stored energy resources (“SER”),including our flywheel technology, to take effect on June 1, 2009.  FERC approved this tariff on December 18,2008.  This was the first such tariff inthe United States designed specifically to accommodate energy storage-basedregulation resources and it contains features that we expect to maximize ourrevenues in the MISO market. 

 

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We are currently working with MISO and itsstakeholders on certain details related to the implementation of this tariff,such as pricing and dispatch.  In April 2009the market stakeholders voted to enhance the dispatch algorithm for storedenergy resources to better utilize their regulation capabilities.  While the currently approved tariff isscheduled to take effect on June 1, 2009, due to delays in opening the overallASM market, MISO is proposing to implement the tariff, inclusive of theadditional enhancements for storage, on January 1, 2010, at which point wewould be able to participate in this market.

 

·      PJM amended its tariff language to complywith Order 890 and stated that its current rules allow non-generationresources like ours to fully participate in its Regulation and FrequencyResponse market. We believe PJM’s market rules allow us to enter the market.However, we intend to work with PJM in 2009 to encourage the adoption of aregulation dispatch signal for energy storage resources that takes fulladvantage of our system’s fast response capability and maximizes benefits toPJM’s grid, and pays us for the full benefits of our resource. We also arecurrently working with PJM to clarify certain aspects of PJM’s settlementmethods in order to maximize our potential revenues in the PJM market.

 

·      ERCOT’s market prices for regulationcurrently do not support market entry. Since ERCOT is not regulated by theFederal Energy Regulatory Commission, our ability to seek beneficial market rule changesthat might support higher pricing in consideration of our technology’s superiorperformance is limited at this time. As the performance of our technology isfully demonstrated at a system-wide level in other ISOs, and as wind generationin Texas increases and the demand for fast frequency regulation resourcesrises, we will re-evaluate the feasibility of encouraging beneficial market rule changesand the potential of entering this market on a more profitable basis.

 

**Defense applications**

 

Webelieve that our high-energy flywheel technology is increasingly attractive asan energy storage device for space platforms, navy vessels and other militaryhardware and/or systems. We are pursuing defense and military-related projectsthat, in addition to generating revenue to help cover operating costs,effectively provide non-dilutive R&D funding for key technology innovationsand advancements that may be transferred to commercial markets.

 

OnFebruary 3, 2009, we announced that we entered into a contract with NAVSEAto evaluate the use of flywheel energy storage for multiple shipboardapplications that we expect will lead to a conceptual design of a flywheelsystem for future naval surface combatants and possible retrofit into existingnavy ships.  NAVSEA’s objective is toadvance and improve its shipboard Integrated Power Systems (IPS) at both themajor component and system level.  Thefinal flywheel design could be based on many aspects of our Smart Energy 25flywheel.  Integrated Power Systems arean essential part of the Navy’s all-electric ship program.  Based on the anticipated power requirementsto support advanced launch systems, weapons and sensor systems, and othershipboard functions, electrical energy storage is now recognized as afundamental element of an all-electric IPS.

 

Underterms of this multiyear contract, we will perform an analysis of futureshipboard energy storage needs; identify several flywheel applications thatcould offer the greatest benefit to future naval combatants; assist the Navy’spower plant upgrade development team by characterizing the flywheelapplications under consideration and assisting in system-level studies; andvalidate results of those studies.  Basedon the results, we will develop a conceptual flywheel design and simulationmodel for one or more applications.  Thevalue of the initial research and development work is estimated at $900,000,$500,000 of which has already been appropriated.  Subsequent phases involve work estimated atup to an additional $2.1 million.

 

**Discussionof Operations**

 

We haveexperienced net losses since our inception and, as of March 31, 2009, hadan accumulated deficit of approximately $192.4 million.  We are focused onthe development and commercialization of our Smart Energy MatrixTM flywheelsystem for frequency regulation and completion of our research and developmentcontracts.  We do not expect to have positive EBITDA (earnings beforeinterest, taxes, depreciation and amortization) or positive cash flow fromoperations until at least 2011 and must raise additional equity and debt toexecute our business plan and continue as a going concern.  To achieve our objectives on EBITDA and cashflow we will need to obtain sufficient funding through a combination of equityand debt to commercially install the number of frequency regulation plantsincluded in our business plan.  In theevent that we are not able to deploy plants as planned due to capitalconstraints, positive EBITDA and cash flow would be delayed.

 

In2009 and beyond, we will need additional funding to expand our manufacturingcapabilities and to build and install frequency regulation facilities inaccordance with our business plan. We expect to raise the required funds in2009 through the DOE 

 

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loanprogram guarantee and the sale of stock in the Company.  In the future, as the number of ourregulation facilities increases and we develop sustainable cash flows fromoperations, we expect to fund additional plants from a combination of projectfinance, debt, project equity and available cash flow from existing regulationfacilities.

 

In October 2007, wewere notified by the U.S. Department of Energy (DOE) that we were selected tosubmit a full application for a DOE program that would provide loan guaranteesfor a majority of the project debt needed to finance the construction of ourfirst 20-megawatt flywheel frequency regulation installation. We have completedthe application process. On March 11, 2009, we announced that the U.S.Department of Energy (DOE) completed its formal environmental review of ourproposed 20 MW installation in Stephentown, New York, and issued a “Finding ofNo Significant Impact” (FONSI). The DOE is in the process of completing its duediligence regarding our loan application; this FONSI determination means thatour application need not be delayed by the type of time-consuming EnvironmentalImpact Statement that is sometimes mandated for projects being reviewed.

 

Thereis no assurance that we will be successful in obtaining a loan guarantee underthe DOE program, or that the loan will be offered with terms and conditionsthat are acceptable to us or that the timing of any such guarantee-backed loanswill be in a timeframe that allows us to execute our business plan. If we arenot successful in obtaining such DOE support on a timely basis for the 20 MWinstallation at Stephentown, it will affect the timing for completing theproject.

 

Since our inception in 1997 we have funded ourdevelopment primarily through the sale of common stock.  We believe that the capital raised as of April 2009will provide sufficient funding for us to continue to implement our businessplan through the third quarter of 2009. If we exercise our option to extend theSeaside stock purchase agreement, we would have sufficient cash to fund ouroperations into 2010.  We expect to raisea minimum of $30 million in 2009 inaddition to the funds from the sale of stock to Seaside, to execute ourbusiness plan.

 

*Revenues*

 

Ourrevenue during the three months ended March 31, 2009 and 2008 came fromthree sources:

 

·      Research and development contracts, forwhich revenue has been recognized using the percentage-of-completion method

·      Sales of inverters and accessories

·      Frequency regulation service revenue fromthe ISO-NE pilot program.

 

Our business plananticipates earning revenue primarily from the provision of frequencyregulation service and potentially from the sale of our Smart Energy flywheelsystems.  However, in the past, we haveearned revenue from research and development contracts with governmentagencies, and we continue to pursue similar contracts. In addition, we have asmall inventory of inverters and accessories that we sell, although thatrevenue is insignificant.

 

*Cost ofGoods Sold*

 

Costof goods sold on research and development contracts are recorded on thepercentage-of-completion method and consist primarily of direct labor andmaterial, subcontracting and associated overhead costs.  Cost of goods sold for frequency regulationservices consists of the cost of energy. Cost of goods sold does not reflectthe true cost of any inverter sales, because our inverter inventory was fullywritten-off during a prior year.

 

*Researchand Development*

 

In 2008 and prioryears, amounts reported as “Research and development” included not only thecost of our engineering staff, but also the cost of unabsorbed manufacturingoverhead since most of our activities related to development of the SmartEnergy 25 flywheel and Smart Energy MatrixTM. In 2008, we substantially completed development of the Smart EnergyMatrixTM and began limited production of commercial units and building our firstfrequency regulation installations.  Aswe have now begun commercial production activities, as of January 1, 2009,we have split the cost of operations and maintenance from the cost of ourresearch and development functions. Since our current production levels are still well below our facility’s600-unit “full capacity”, Operations and maintenance costs for the quarterended March 31, 2009 include a significant amount of unabsorbed manufacturingoverhead.  In addition, costs associatedwith running the 1 MW resource for the ISO-NE pilot program, and certainnon-fungible costs associated with certain Smart Energy MatrixTM installationsare also included in “Operations and maintenance.”  “Research and development” represents thecost of compensation and benefits for research and development staff, as wellas materials and supplies used in the engineering design and developmentprocess.  On a combined basis consistentwith reporting in prior years, total operations and research and developmentcosts for the first three months of 2009 were approximately 2% lower thanduring the equivalent period during 2008. We expect research and development expenses in 2009 to be lower than in2008 due to lower legal costs, along with lower expense material andsubcontractor costs.

 

*Selling,General and Administrative Expenses*

 

Oursales and marketing expenses consist primarily of compensation and benefits forregulatory affairs, sales and marketing personnel and related businessdevelopment expenses. During recent years, sales and marketing expenses haveincreased as we expanded regulatory activity aimed towards the modification ofmarket rules to facilitate our participation in the regulation servicesmarket.  General and administrativeexpenses consist primarily of compensation and benefits related to ourcorporate staff, professional fees, insurance and travel.  During the three months ended March 31,2009, selling, general and administrative expenses were approximately $278,000,or 12.8%, lower than during the equivalent period in 2008, in large part due toa reduction in stock-based compensation expense. Historically, the Board ofDirectors has granted equity compensation to officers and employees during thefirst quarter of each year as part of its long-term incentive compensationprogram.  In 2009, such grants weredelayed to allow the Board’s Compensation Committee time to determine the mostappropriate methodology for determining grant 

 

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size,given the recent drop in our stock price. Overall, we expect our selling,general and administrative expenses for fiscal 2009 to be lower than in 2008primarily due to lower legal costs and other planned cost reductions.

 

*Loss onContract Commitments*

 

Weestablish reserves for anticipated losses on contract commitments if, based oncost estimates to complete the commitment, we determine that a loss will beincurred.  In addition, we evaluate ourestimated costs to complete our government contracts on a quarterly basis andadjust the reserves when appropriate.

 

InApril 2008, we were awarded a subcontract to provide a flywheel energystorage system in support of a wind integration research and developmentproject in Tehachapi, California, sponsored by the California EnergyCommission.  We will receiveapproximately $250,000 expenses and will contribute an additional $87,000 ofengineering resources for the project, bringing the R&D total toapproximately $337,000.  Accordingly, werecorded a charge of approximately $87,000 to the contract loss reserve during2008 to reflect the expected “cost share” portion of the Tehachapicontract.  During the quarter ended March 31,2009, we increased the loss reserve for the Tehachapi contract by$132,500.  This increase is based uponthe difference between the overhead rate that was bid on this fixed pricecontract and our forecasted overhead rate.

 

OnFebruary 3, 2009, we announced that we entered into a contract with NAVSEAto evaluate the use of flywheel energy storage for multiple shipboardapplications that we expect will lead to a conceptual design of a flywheelsystem for future naval surface combatants and possible retrofit into existingnavy ships.  The value of the initial researchand development work is estimated at $900,000, $500,000 of which has alreadybeen appropriated.  Subsequent phasesinvolve work estimated at up to an additional $2.1 million.  This contract was awarded on a “cost plusfixed fee” basis.  Based on ourevaluation of the expected costs for the portion of the contract which has beenappropriated, no reserve for contract loss was considered necessary as of March 31,2009.

 

*Depreciationand Amortization*

 

Ourdepreciation and amortization is primarily related to depreciation on capitalexpenditures and the amortization of lease and leasehold costs related to ourfacilities.  Depreciation expense willincrease substantially in future periods as we build and deploy our frequencyregulation installations.

 

*Interestand Other Income/Expense, net*

 

Our non-operatingincome and expenses are primarily attributable to interest income resultingfrom cash on hand and funds received in settlement of a class action suitrelating to unfair practices engaged in by certain insurance brokerage firms.

 

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**Results of Operations**

 

***Comparison of Three Months ended March 31, 2009and 2008***

** **
| ** **                             | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|
| ** **                             | ** ** | **2009**                                             | ** ** | **2008** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                             | ** ** | **(in thousands)**                              | ** ** |
| Revenue                                |       | $                                                    | 111        |   | $ | 20 |   | $ | 91 |   | 455 | % |
| Cost of goods sold                     |       | 172                                                  |       | — |   | (172 | ) | 0 | % |
| Gross margin                           |       | (61                                                  | )          | 20 |   | (81 | ) | 405 | % |
| Operations and maintenance             |       | 777                                                  |       | — |   | (777 | ) | 0 | % |
| Research and development               |       | 2,191                                                |       | 3,032 |   | 841 |   | 28 | % |
| Selling, general and administrative    |       | 1,897                                                |       | 2,176 |   | 279 |   | 13 | % |
| Loss on sales and contract commitments |       | 133                                                  |       | (1 | ) | (134 | ) | 13400 | % |
| Depreciation and amortization          |       | 424                                                  |       | 280 |   | (144 | ) | 51 | % |
| Interest and other income, net         |       | (57                                                  | )          | 180 |   | (237 | ) | 132 | % |
| Net loss                               |       | $                                                    | (5,540     | ) | $ | (5,287 | ) | $ | (253 | ) | 5 | % |

 

*Revenue*

 

The following table provides details of our revenues for the threemonths ended March 31, 2009 and 2008:

 
| ** **                             | ** ** | **Percent**  | ** ** | **Three months ended March  31,** | ** ** | **Cumulative  Contract  Value  Earned as  of March** | ** ** | **Total  Contract** | ** ** | **Remaining** | ** ** |
|----------------------------------------|------------|--------------|------------|--------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------|------------|---------------|------------|
| ** **                             | ** ** | **complete** | ** ** | **2009**                                         | ** ** | **2008**                                                       | ** ** | **31, 2009**   | ** ** | **Value**     | ** ** | **Value** | ** ** |
| * *                               | * *   | * *     | * *   | * *                                         | * *   | * *                                                       | * *   | * *            | * *   | * *      | * *   | * * | * * |
| **Frequency regulation:**              |       |         |       | $                                                | 64         |                                                           | $          | —              |       |          |       |   |   |   |   |
| **Contracts:**                         |       |         |       |                                             |       |                                                           |       |                |       |          |       |   |   |
| NYSERDA PON 800                        |       | 87           | %          | $                                                | —     |                                                           | $          | —              |       | $             | 55         |   | $ | 63 |   | $ | 8 |   |
| NAVSEA                                 |       | 6            | %          | 29                                               |       | —                                                         |       | 29                  |       | 500           |       | 471 |   |
| Tehachapi                              |       | 10           | %          | 15                                               |       | —                                                         |       | 24                  |       | 250           |       | 226 |   |
| Total Contract Revenue                 |       |         |       | $                                                | 44         |                                                           | $          | —              |       | $             | 108        |   | $ | 813 |   | $ | 705 |   |
| **Other (inverters and accessories):** |       |         |       | 3                                                |       | 20                                                             |       |                |       |          |       |   |   |
| **Total**                              |       |         |       | $                                                | 111        |                                                           | $          | 20                  |       | $             | 108        |   | $ | 813 |   |   |   |

 

In the three months ended March 31,2009, we earned approximately $64,000 from frequency regulation servicesthrough our participation in the ISO-NE Pilot Program that began in November 2008.Revenues we are currentlyreceiving from this pilot program are less than those that we expect to receiveunder permanent market rules for two reasons. First, under pilot programmarket rules, we are not eligible for opportunity cost payments, whichrepresent approximately one-third of the revenue received by conventionalregulating generators. We are encouraging ISO-NE to develop permanent market rules thatwill provide an additional payment component for alternative technologies thatwould be approximately equal to opportunity cost. The trend at other ISOs hasbeen to incorporate features in their tariffs that intrinsically compensate allresources, including energy storage providers, for opportunity cost. Second,the current signal we are receiving from ISO-NE does not take full advantage ofour speed of response and therefore our mileage payments are not as high as weexpect them to be in the future.  We areworking with ISO-NE to convince them to adopt a regulation signal that will betterutilize our technology’s fast response capability in order to maximize benefitsto the grid and payments for our regulation service.

 

28

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Wecompleted most of our research and development contacts in 2007, but wereawarded two new contracts (Tehachapi and NAVSEA) subsequent to the end of thefirst quarter of 2008.  Consequently, wehad no contract revenue during the first quarter of 2008, but earned approximately$44,000 in contract revenue during the first quarter of 2009 from these newcontracts. In addition, we recorded revenue of approximately $3,000 from thesale of Smart Power M5TM inverter systems and related products, compared toapproximately $20,000 in the first three months of 2008. In 2009, we expectboth frequency regulation and contract revenue to increase, due to the expecteddeployment of additional capacity of frequency regulation and the Navy contractawarded early in 2009.

 

*Cost of Goods Sold*

 

Cost of goods sold for the three months ended March 31,2009 and 2008 is as follows:

 
| ** **            | ** ** | **Three months ended March 31, 2009** | ** ** | **Three months ended March 31, 2008** | ** ** |
|-----------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **            | ** ** | **Revenue**                                                    | ** ** | **Cost of  Sales**                                        | ** ** | **Margin** | ** ** | **Revenue** | ** ** | **Cost of  Sales** | ** ** | **Margin** | ** ** |
| Frequency regulation  |       | $                                                              | 64         |                                                           | $          | 130 |   | $ | (66 | ) | $ | — |   | $ | — |   | $ | — |   |
| Contract              |       | 44                                                             |       | 42                                                             |       | 2 |   | — |   | — |   | — |   |
| Inverters and related |       | 3                                                              |       | —                                                         |       | 3 |   | 20 |   | — |   | 20 |   |
| Total                 |       | $                                                              | 111        |                                                           | $          | 172 |   | $ | (61 | ) | $ | 20 |   | $ | — |   | $ | 20 |   |

 

Costof goods sold increased from approximately $0 in the first three months of 2008to approximately $172,000 during the equivalent period of 2009.  During the first quarter of 2009, cost ofgoods sold includes approximately $130,000 for the cost of energy associatedwith the generation of frequency regulation revenue under the ISO-NE Pilotprogram.  Cost of energy exceeded revenuefrom frequency regulation because of the manner in which we were connected tothe grid for the pilot program, which resulted in our being paid for energy weprovided to the grid at wholesale rates, but we were billed for the energy weused at retail rates.  We have reached anagreement with ISO-NE and our service provider to change the metering to a “netmeter” through ISO-NE, which was implemented during April 2009.  However, total energy costs for 2009 will behigher than in 2008 since the energy costs for 2008 represent the cost relatedto 1 MW of capacity for a only six-week period. In addition, cost of goods sold for the first quarter of 2009 includesapproximately $42,000 for research and development contracts calculated on thepercentage of completion method. Year over year, the increase in cost of salesassociated with contracts was proportional to our increase in contract revenue.In 2009, we expect to be providing more frequency regulation service capacityover a longer period of time than occurred in 2008.

 

29

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*Operations and Maintenance and Research and DevelopmentExpense*

 

As discussed above, as of January 1,2009, we classify expenses related to manufacturing, materials handling,purchasing, Smart Energy MatrixTM operations, and expensed non-fungible costsassociated with certain installations as “Operations and maintenance.” on ourincome statement. Prior to 2009, such expenses were included as “Research anddevelopment” costs, as shown below:

 
| ** **                 | ** ** | **Three months ended March 31,** | ** ** | ** ** | ** ** |
|----------------------------|------------|------------------------------------------------------|------------|------------|------------|
| ** **                 | ** ** | **2009**                                             | ** ** | **2008**   | ** ** | **Net Change** | ** ** |
| ** **                 | ** ** | **(in thousands)**                              | ** ** |
| Operations and maintenance |       | $                                                    | 777        |       | $          | — |   | $ | 777 |   |
| Research and development   |       | 2,191                                                |       | 3,032      |       | (841 | ) |
| Total                      |       | $                                                    | 2,968      |       | $          | 3,032 |   | $ | (64 | ) |

 

The net change is attributed to increases or decreases as shown below:

 
| ** **            | ** ** | **Increase (decrease) related to:** | ** ** | **Net  change,**                          | ** ** | ** **                           | ** ** |
|-----------------------|------------|----------------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|
| ** **            | ** ** | **Operations  and  maintenance  functions**        | ** ** | **Research  and  development  functions** | ** ** | **March  2009 to  March  2008** | ** ** | **Comment** | ** ** |
| ** **            | ** ** | **(in thousands)**                            | ** ** | ** **                                | ** ** |
| Expense materials     |       | $                                                  | 48         |                                      | $          | 402                                  |       | $ | 450 |   | Our  flywheels were designed to respond to the type of control signaling used by  the New York and California ISO, which required our flywheels to respond  proportionally to variable imbalances between electricity supply and demand.  The ISO-NE uses a non-proportional, trinary signal, which causes the  flywheels to operate at a higher temperature than the proportional control  method. During the first quarter, we refined the design of the  motor-generator to eliminate this issue. The increase in materials cost is  primarily due to the cost of replacing the affected components in the  flywheels operating in the ISO-NE pilot program as well as those being built  for our Stephentown plant. |   |
|                  |       |                                               |       |                                      |       |                                 |       |   |   |
| Salaries and benefits |       | 66                                                 |       | 248                                       |       | 314                                  |       | Primarily  due to increase in headcount during 2008 in engineering, manufacturing and  materials management associated with the move from development to production  activities. |   |
|                       |            |                                                    |            |                                           |            |                                      |            |  |  |  |  |  |

 

30

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| ** **                     | ** ** | **Increase (decrease) related to:** | ** ** | **Net  change,**                          | ** ** | ** **                           | ** ** |
|--------------------------------|------------|----------------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **Operations  and  maintenance  functions**        | ** ** | **Research  and  development  functions** | ** ** | **March  2009 to  March  2008** | ** ** | **Comment** | ** ** |
| Subcontractors and consultants |       | 188                                                |       | (109                                      | )          | 79                                   |       | Primarily  due to contractor costs associated with completing non-fungible costs of the  2 MW matrix in Tyngsboro, partially offset by lesser use of consultants for  Research and development. |   |
|                           |       |                                               |       |                                      |       |                                 |       |   |   |
| Legal                          |       | 28                                                 |       | (317                                      | )          | (289                                 | )          | Legal  expenses in 2008 included costs associated with the Arete lawsuit, which was  settled in November 2008. |   |
|                           |       |                                               |       |                                      |       |                                 |       |   |   |
| Allocations and overhead       |       | (200                                               | )          | (54                                       | )          | (254                                 | )          | The increase  in overhead allocation is a result in the increase in the level of production  and contract activity, resulting in an increase in overhead capitalized. |   |
|                           |       |                                               |       |                                      |       |                                 |       |   |   |
| Stock Compensation             |       | (40                                                | )          | (181                                      | )          | (221                                 | )          | Generally,  options and RSUs have been granted to management and employees during the  first quarter of the fiscal year, based on prior year performance. In 2009,  such equity grants were delayed to allow the Compensation Committee time to  determine the best way to calculate the number of options to be granted,  given our current stock price. |   |
|                           |       |                                               |       |                                      |       |                                 |       |   |   |
| Occupancy                      |       | (91                                                | )          | (45                                       | )          | (136                                 | )          | Occupancy  costs in the first quarter of 2008 included the cost of moving to our new  facility in Tyngsboro. |   |
|                           |       |                                               |       |                                      |       |                                 |       |   |   |
| Other                          |       | (43                                                | )          | 36                                        |       | (7                                   | )          |   |   |
|                           |       |                                               |       |                                      |       |                                 |       |   |   |
|                           |       | $                                                  | (44        | )                                         | $          | (20                                  | )          | $ | (64 | ) |   |   |
|                                |            |                                                    |            |                                           |            |                                      |            |  |  |  |  |  |

 

For the three months ended March 31, 2009, combined operations andmaintenance and research and development expenses decreased by approximately$64,000 or 2%, in comparison to the equivalent period in 2008. See the tableabove for explanations of the factors which were responsible for the mostsignificant changes. Costs shown for operations and maintenance would beexpected to decrease as our production volume increases, and more overhead isabsorbed and capitalized as part of the cost of our flywheels and Smart EnergyMatrix TM installations. We expect research and development costs during 2009 tobe lower than in 2008 due to lower legal costs, along with lower material andsubcontractor costs.

 

*Selling, General and Administrative Expense*

 
| ** **                          | ** ** | **Three months  ended March  31,** | ** ** | **Comment**                                                                                                                                                                                                                                                                                                                                 | ** ** |
|-------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                          | ** ** | **(in thousands)**                      | ** ** | ** **                                                                                                                                                                                                                                                                                                                                  | ** ** |
| Period Ended March 31, 2008    |       | $                                            | 2,176      |                                                                                                                                                                                                                                                                                                                                        |       |   |
|                                |       |                                         |       |                                                                                                                                                                                                                                                                                                                                        |       |
| Stock Compensation                  |       | (252                                         | )          | Generally,  options and RSUs have been granted to management during the first quarter of  the fiscal year, based on prior year performance. In 2009, such equity grants  were delayed to allow the Compensation Committee time to determine the best  way to calculate the number of options to be granted, given our current stock  price. |       |
|                                |       |                                         |       |                                                                                                                                                                                                                                                                                                                                        |       |
| Legal, audit and professional fees  |       | (112                                         | )          | Reduction in  use of outside legal services.                                                                                                                                                                                                                                                                                                |       |
|                                |       |                                         |       |                                                                                                                                                                                                                                                                                                                                        |       |
| Public company / investor relations |       | 48                                           |       | More board  of director and committee meetings in Q1’2009 than in Q1’2008.                                                                                                                                                                                                                                                        |       |
|                                |       |                                         |       |                                                                                                                                                                                                                                                                                                                                        |       |
| Salaries and benefits               |       | 51                                           |       | Increased  headcount to support regulatory efforts, combined with increased health  insurance costs.                                                                                                                                                                                                                                        |       |
|                                |       |                                         |       |                                                                                                                                                                                                                                                                                                                                        |       |
| Other                               |       | (14                                          | )          |                                                                                                                                                                                                                                                                                                                                        |       |
|                                |       |                                         |       |                                                                                                                                                                                                                                                                                                                                        |       |
| Period Ended March 31, 2009    |       | $                                            | 1,897      |                                                                                                                                                                                                                                                                                                                                        |       |   |

 

Selling,general and administrative expenses totaled approximately $1,897,000 and$2,176,000 for the three months ended March 31, 2009 and 2008,respectively, which represents a decrease of approximately $279,000, or 13%,year over year.  Significant changes inspending are explained in the table shown above. Overall, we expect ourselling, general and administrative expenses for fiscal 2009 to be lower thanin 2008 primarily due to lower legal costs and other planned cost reductions.

 

*Loss on Contract Commitments*

 

Ourcontracts have been primarily for the development of demonstration units of newproducts and the design of a frequency regulation plant. As such, the work hassupported our core research and development efforts.  Most of these contracts have been structuredon a cost-share basis, for which the expected cost-share has been recorded as acontract loss.  The Navy NAVSEA contract,which we were awarded in February 2009, is a cost-plus-fixed fee contract.

 

Eachquarter we perform an estimate-to-complete analysis, and any changes to ouroriginal estimates are recognized in the period in which they aredetermined.  In the second quarter of2008, we recorded a contract loss of approximately $86,600, which representsour expected “cost share” portion of the Tehachapi contract. During the firstquarter of 2009, we recorded an additional contract lost of approximately$132,500, which represents the difference between our overhead rate based on “fullproduction”, and the contract bid rate. No other loss reserve adjustments were considered necessary during thequarter ended March 31, 2009.

 

31

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*Depreciation and Amortization*

 

Depreciation expense increased from approximately $280,000 during thequarter ended March 31, 2008 to approximately $424,000 for the same periodin 2009, an increase of approximately $144,000, or 51%.  The increase in depreciation and amortizationresults primarily from capital expenditures relating to leasehold improvementsat our new manufacturing and office facility in Tyngsboro, as well as thepurchase of machinery and equipment required to begin commercialproduction.  As of March 31, 2009,we had approximately $12.4 million in “Construction in progress”, of whichapproximately $5.2 million are materials to build flywheels and approximately$6.7 million are costs related to the construction of Smart Energy MatrixTMsystems.  We expect depreciation expenseto continue to increase during 2009 as we build and place our frequencyregulation facilities into commercial operation.

* *

*Interest and Other Income/(Expense), net*

 

Average cash balances during the first three months of 2009 were lowerthan during the same period in 2008, as were interest rates.  In addition, in 2008, we obtained a loan fromMass Development, for which we began paying interest in October 2008.  Interest expense during the first quarter of2009 was approximately $67,000. These factors contribute to a reduction of netinterest and other income during the three months ended March 31, 2009 ofapproximately $237,000, or132%, over the equivalent period last year.

* *

*Net Loss*

 

As a result of the changes discussed above, the net loss for the threemonths ended March 31, 2009 was approximately $5,540,000 which compares toa net loss during the same period in 2008 of approximately $5,287,000, anincrease in net loss of approximately $253,000 or 5%.

** **

**Liquidity and Capital Resources**

 
| ** **                                | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                | ** ** | **2009**                                             | ** ** | **2008** | ** ** |
| ** **                                | ** ** | **(in thousands)**                              | ** ** |
| Cash and cash equivalents                 |       | $                                                    | 5,323      |   | $ | 25,037 |   |
| Working capital                           |       | 2,183                                                |       | 23,118 |   |
| Cash provided by (used in)                |       |                                                 |       |   |   |
| Operating activities                      |       | (9,544                                               | )          | (2,963 | ) |
| Investing activities                      |       | (1,054                                               | )          | (2,435 | ) |
| Financing activities                      |       | 1,564                                                |       | 18 |   |
| Net decrease in cash and cash equivalents |       | $                                                    | (9,034     | ) | $ | (5,380 | ) |
|                                      |       |                                                 |       |   |   |
| Current ratio                             |       | 1.5                                                  |       | 7.3 |   |

 

Ourcash requirements depend on many factors including, but not limited to, thecost to build our flywheels and frequency regulation facilities, research anddevelopment activities, facility costs as well as general and administrativeexpenses.  Since we are still in thedevelopment stage and have not yet generated significant revenue from ourprincipal operations, we do not generate enough cash from operations to satisfyour working capital requirements.  Weexpect to make significant expenditures to fund our operations, develop technologiesand explore opportunities to find and develop additional markets to sell ourproducts. As we completed development of the Smart Energy MatrixTM and begancommercial activity aimed at revenue generation in 2009, we increased ourheadcount and spent additional funds on production materials, capitalequipment, market analyses and the pursuit of regulatory relief to modifymarket rules in a way that ensures our ability to enter markets on atimely and profitable basis. We expect to require significant cash resourcesduring 2009 through 2011 as we increase capacity to manufacture our SmartEnergy 25 flywheels and build frequency regulation facilities.

 

In volume production, our goal is to complete a20 MW facility at an approximate cost of $25 to $30 million, while the first 20MW plant will cost more than $60 million which includes development costs andsubstantial administrative costs related to the Department of Energy duediligence and review process. In 2009,our business plan is to deploy 5 MW of capacity at our first 20MW site and anadditional megawatt in Ohio through AEP; however the number of megawatts wewill be able to deploy is dependent on obtaining sufficient funding for thesecapital outlays. We expect to fund the construction of our first 20 MW plantfrom a combination of debt and equity. Our ability to obtain sufficient fundingwill pace our ability to produce flywheel systems 

 

32

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and deploy them. In 2010 and2011, we will continue to have capital needs that will require additional equityand debt to fund the ongoing deployment of frequency regulation facilities.

 

On February 20, 2009, we entered into a commonstock purchase agreement with Seaside 88, LP, valued at up to $18 million.  The agreement requires Seaside to buy $1million of our common stock once each month for up to 18 months, beginning on February 20,2009, and on the 20th day ofeach month thereafter (or the next closest business day.)  The agreement is structured in threesix-month tranches, or segments, each covering monthly closings of $1 millioneach, for up to $6 million total.  We arecommitted to only the first six-month tranche, but we have the option,exercisable at our sole discretion, to extend the agreement for up to two additionalsix-month periods (each for up to $6 million), for a total of up to $18 millionover the three tranches. If we exercise the option to extend the agreement, wewould have sufficient cash to maintain operations into 2010.  The following stock sales have been completedunder the terms of this agreement as of April 20, 2009:

 
| **Transaction date** | ** ** | **Aggregate  value** | ** ** | **Common  Shares Sold** | ** ** | **Sale Price per  Share** | ** ** | **Stock  Closing  Price on  Date of Sale** | ** ** | **Shares Valued  at Stock  Closing Price** | ** ** |
|---------------------------|------------|----------------------|------------|------------------------------|------------|-------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| April 20, 2009       |       | $                    | 1,000,000  |                         | 1,912,777  |                                | $          | 0.52280                                                   |       | $                                                         | 0.65000    |   | $ | 1,243,305 |   |
| March 20, 2009       |       | 1,000,000            |       | 2,896,200                    |       | $                                   | 0.34528    |                                                      | $          | 0.40000                                                   |       | 1,158,480 |   |
| February 20, 2009    |       | 1,000,000            |       | 2,656,184                    |       | $                                   | 0.37648    |                                                      | $          | 0.38000                                                   |       | 1,009,350 |   |
|                      |       |                 |       |                         |       |                                |       |                                                      |       |                                                      |       |
| Total                     |       | $                    | 3,000,000  |                         | 7,465,161  |                                |       |                                                      |       |                                                      | $          | 3,411,135 |   |

 

Inorder to implement our business plan to build, operate and receive fees forfrequency regulation services and have sufficient working capital to continueto execute our business plan through 2009, in addition to the funds expectedfrom the sale of stock to Seaside, we will need to raise funds during 2009though a combination of debt and equity. Also, to achieve our out-yeardeployment plan for additional frequency regulation facilities, we will need toraise additional capital beyond 2009 either from project finance or additionalequity transactions.

 

**Operating Activities**

 

Net cash used in operating activities was approximately $9,544,000 and$2,963,000 for the three months ended March 31, 2009 and 2008,respectively.  The primary component to the negative cash flow fromoperations is from net losses.  For the three months ending March 31,2009, we had a net loss of approximately $5,540,000.  Adjustments toreconcile net loss to cash flow in 2009 include non-cash stock compensation ofapproximately $279,000, depreciation and amortization of approximately$424,000, interest expense on warrants of approximately $10,000, partiallyoffset by a net increase in deferred rent of approximately ($27,000) andchanges in operating assets and liabilities of approximately ($4,691,000).

 

During the same period in 2008, we had a net loss of approximately$5,287,000.  Adjustments to reconcile net loss to cash flow includenon-cash stock compensation of approximately $751,000, depreciation andamortization of approximately $280,000 a reduction of deferred rent ofapproximately $66,000 and cash received from our landlord as a credit forcertain building improvements of $1,430,000. These were partially offset by changes in operating assets andliabilities of approximately $203,000.

** **

**Investing Activities**

 

Net cash used in investing activities was approximately $1,054,000 and$2,435,000 for the three months ending March 31, 2009 and 2008,respectively.  The principal use of cashin 2009 was the purchase of property and equipment in the amount ofapproximately $1,054,000, primarily for the purchase and construction ofproperty and equipment.  For the threemonths ended March 31, 2008, the principal use of cash was the purchase ofproperty and equipment in the amount of approximately $2,609,000, much of whichrelated to the renovation of the Tyngsboro facility. These charges werepartially offset by a reduction in restricted cash of approximately $174,000,related to the Wilmington lease that expired in 2007.

 

33

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**Financing Activities**

 

Net cash provided by financing activities was approximately $1,564,000and $18,000 for the first three months of 2009 and 2008, respectively.  In 2009, funds were provided by the sale ofstock to Seaside of approximately $1,765,000, offset partially by cash paid forfinancing costs of approximately $201, 000 related to the due diligence for theDOE Loan Guarantee Program for which we have applied.  For the first three months of 2008, cashprovided by financing activities of approximately $18,000 related to areduction of approximately $18,000 of costs previously accrued related to thesale of stock in 2007.  We may evaluatepossible acquisitions of enterprises or technologies that we consider synergisticfrom a market, technology or product perspective. We may make investments incompanies for strategic business reasons or seek other strategic financingrelationships that benefit our business.

 

At March 31, 2009, we had firm purchase commitments with oursuppliers to acquire components for our commercial flywheel units, begin thebuild-out of the Smart Energy MatrixTM in Stephentown, and satisfy contractualobligations for our research and development programs in the amount ofapproximately $4.5 million. In addition, we have a commitment of approximately$2.2 million to purchase a key component from a supplier who has not yet beenable to meet our technical specifications. We do have another supplier for thiscomponent. However, since our objective is to have at least two suppliers for allkey components, we are working closely with the supplier to resolve this from atechnical perspective. If not, however, the contract will be cancelled due tothe supplier’s inability to perform.

** **

**Item 3.  Quantitative andQualitative Disclosure about Market Risk**

 

Ourcash equivalents, which have maturities of less than three months, may exposeour assets to interest rate risk.  At March 31, 2009, we hadapproximately $109,000 of cash equivalents that were held in non-interestbearing accounts.  Also at March 31, 2009 we had approximately$1,384,000 of cash equivalents that were held in interest-bearing checkingaccounts, and approximately $3,830,000 invested in interest-bearing moneymarket accounts at high-quality financial institutions, some of which are investedin off-shore securities.  The fair valueof these investments approximates their cost. The funds invested in moneymarket accounts may not be covered under FDIC Insurance, and therefore may besome risk of loss, which we deem to be low. The money market funds are invested primarily in government funds, suchas Treasury Bills. Approximately $3.1 million of our cash on hand at March 31,2009 was invested in mutual funds at a brokerage firm that has purchasedsupplementary insurance through Lloyd’s of London.  This insurance coverage provides protectionabove the Securities Investor Protection Corporation (SIPC) coverage in theevent that the broker becomes insolvent. SIPC protects against the loss ofsecurities up to a total of $500,000 (of which $100,000 may be in cash) perclient.  The supplemental insuranceprovided by the broker would cover investments at that brokerage firm up to amaximum of $1 billion, including up to $1.9 million per client for the cash portionof any remaining shortfall. SIPC and the supplemental insurance do not covermarket losses; however, management believes the risk of substantial marketlosses is low because our funds are invested primarily in government funds.

 

**Item 4.  Controls andProcedures**

* *

*Evaluation of Disclosure Controls and Procedures*

 

As of the end of the periodcovered by this report, we carried out an evaluation, under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures. Based on the evaluation, both the Chief Executive Officer and the ChiefFinancial Officer concluded that our disclosure controls and procedures, asdefined in Rules 13a — 15(e) and 15d — 15(e) promulgated underthe Securities Exchange Act of 1934, were effective on March 31, 2009.

* *

*Internal Control over Financial Reporting*

 

There was no change in ourinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) promulgated under the Securities Act of 1934) that materiallyaffected, or is reasonably likely to materially affect, such internal controlover financial reporting during the quarter ended on that date.

 

**Part II— OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

None.

 

34

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**Item 1A.  Risk Factors**

 

In addition to the risks below and other information set forth in thisreport, you should carefully consider the factors described in Part I,Item 1A of our Annual Report on Form 10-K for the year ended December 31,2008, filed with the SEC on March 16, 2009, which are incorporated hereinby reference.  Those factors couldmaterially affect our business, financial condition or future results. Therisks described below and in our Annual Report on Form 10-K are not theonly risks we face. Additional risks and uncertainties not currently known tous or that we currently deem to be immaterial also may materially adverselyaffect our business, financial condition and/or operating results.

** **

**The discounted pricing of our stock sales to Seaside maydepress our stock price and have a dilutive effect on existing shareholders.**

 

In February 2009, we signed a stock purchase agreement under whichwe will sell to Seaside 88, LP, a number of shares with a purchase price of $1million each month for six, 12 or 18 months (at our election), subject tocertain conditions.  The number of sharesthat we issue to Seaside each month at a scheduled closing will be based upon adiscount to the volume weighted average trading price of our Common Stock forthe five trading days prior to the closing. As a result, the lower our stockprice is at or near the time of a closing, the more shares we will issue underthe purchase agreement at that closing (subject to the floor of a $0.25 averagetrading price, corresponding to a $0.20 purchase price, below which we wouldnot have a closing for that month). If Seaside sells some or all of the sharesthat it has purchased into the market, the price may fall as a result. This inturn may lead to Seaside receiving a greater number of shares in futureclosings, sales of which could further depress the stock price.  The number of shares we sell to Seaside underthe agreement may be significant, up to a maximum of 5 million in any monthlyclosing at an average trading price at $0.25 prior to the closing, the lowestpoint at which a sale would be made.  Ifwe elect to extend the agreement from six months to 12 or 18 months, thisdilution would be proportionately greater.

** **

**We may not realize all of the planned proceeds under theSeaside agreement.**

 

As described above, if the volume weighted average trading price of ourCommon Stock falls below $0.25 for the five days prior to a scheduled monthlyclosing under our agreement with Seaside, there will not be a closing thatmonth and the sale will not be made up later. While this would avoid the dilution to our current stockholders thatwould be associated with a sale during that month, it also means that we wouldnot receive the purchase price for that month. There are other conditions toclosing, such as the continued accuracy of representations and warranties wemake in the agreement, which may prevent a closing from occurring. In addition,we cannot guarantee that even if closing conditions are satisfied, funds willbe available from Seaside. We may also decide not to exercise the options toextend the term of the purchase agreement by an additional six or twelvemonths. Any of these events may make it more difficult for us to meet thefunding requirements to commercialize or technology and deploy our Smart EnergyMatrixTM systems in accordance with our plans.

** **

**Item 2.  Unregistered Sales of Equity Securities and Useof Proceeds**

 

None.

** **

**Item 3.  Defaults Upon SeniorSecurities**

 

None.

** **

**Item 4.  Submission of Mattersto a Vote of Security Holders**

** **

None.

** **

**Item 5.  Other Information**

 

None.

 

35

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**Item 6.  Exhibits**

 
| **Exhibit** | ** ** | ** ** | ** ** | ** **                                                                                                                                                 |
|-------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Ref**    | ** ** | **Description of Document**                                                                                                                      |
|        |       |       |       |                                                                                                                                                       |
| 3.1         |       | (1)        |       | Sixth  Amended and Restated Certificate of Incorporation.                                                                                                  |
|        |       |       |       |                                                                                                                                                       |
| 3.2         |       | (1)        |       | Certificate  of Amendment of the Sixth Amended and Restated Certificate of Incorporation,  dated June 25, 2007.                                       |
|        |       |       |       |                                                                                                                                                       |
| 3.3         |       | (1)        |       | Certificate  of Amendment of the Sixth Amended and Restated Certificate of Incorporation,  dated June 26, 2007.                                       |
|        |       |       |       |                                                                                                                                                       |
| 3.4         |       | (4)        |       | Amended  and Restated Bylaws, as amended.                                                                                                                  |
|        |       |       |       |                                                                                                                                                       |
| 3.5         |       | (2)        |       | Certificate  of Designation of Series A Junior Participating Preferred Stock, filed  with The Secretary of State of Delaware on October 4, 2002. |
|        |       |       |       |                                                                                                                                                       |
| 4.1         |       | (3)        |       | Form of  specimen stock certificate.                                                                                                                  |
|        |       |       |       |                                                                                                                                                       |
| 10.1        |       | (5)        |       | Amended  and Restated Employment agreement dated April 1, 2009 between the  Company and F. William Capp                                               |
|        |       |       |       |                                                                                                                                                       |
| 10.  2      |       | (5)        |       | Amended  and Restated Employment agreement dated April 1, 2009 between the  Company and James M. Spiezio                                              |
|        |       |       |       |                                                                                                                                                       |
| 10.  3      |       | (5)        |       | Amended  and Restated Employment agreement dated April 1, 2009 between the  Company and Matthew L. Lazarewicz                                         |
|        |       |       |       |                                                                                                                                                       |
| 10.  4      |       | (5)        |       | Restricted  Stock Unit and Option Agreement dated April 3, 2009 between the Company  and F. William Capp.                                             |
|        |       |       |       |                                                                                                                                                       |
| 10.  5      |       | (5)        |       | Restricted  Stock Unit and Option Agreement dated April 3, 2009 between the Company  and James M. Spiezio.                                            |
|        |       |       |       |                                                                                                                                                       |
| 10.  6      |       | (5)        |       | Restricted  Stock Unit and Option Agreement dated April 3, 2009 between the Company  and Matthew L. Lazarewicz.                                       |
|        |       |       |       |                                                                                                                                                       |
| 10.  7      |       | +          |       | Warrant  Transfer and Cancellation Agreement dated January 21, 2009 between the  Company and Quercus Trust                                            |
|        |       |       |       |                                                                                                                                                       |
| 10.  8      |       | +          |       | Contract,  dated January 28, 2009, between the Company and the U.S. Naval Sea  Systems Command.                                                       |
|        |       |       |       |                                                                                                                                                       |
| 10.  9      |       | (6)        |       | Contract,  effective as of February 18, 2009, between the Company and American  Electric Power, as agent for Columbus Southern Power Company.         |
|        |       |       |       |                                                                                                                                                       |
| 10.  10     |       | (7)        |       | Common  Stock Purchase Agreement dated February 19, 2009 between the Company and  Seaside 88, LP.                                                     |
|        |       |       |       |                                                                                                                                                       |
| 31.1        |       | +          |       | Certification  of Principal Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                             |
|        |       |       |       |                                                                                                                                                       |
| 31.2        |       | +          |       | Certification  of Principal Financial and Accounting Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                              |

 

36

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| **Exhibit** | ** ** | ** ** | ** ** | ** **                                                                                                                                                        |
|-------------|------------|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Ref**    | ** ** | **Description of Document**                                                                                                                             |
|        |       |       |       |                                                                                                                                                              |
| 32.1        |       | +          |       | Certification  of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|        |       |       |       |                                                                                                                                                              |
| 32.2        |       | +          |       | Certification  of Principal Financial Officer pursuant to 18 U.S.C. Section 1350 as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

(1)          Incorporated by reference from the Form 10-K filed onMarch 17, 2008 (File No. 000-31973).

 

(2)          Incorporated by reference from the Form 10-K filed onMarch 30, 2006 (File No. 000-31973).

 

(3)          Incorporated by reference from the Form S-3 filed onDecember 8, 2005 (File No. 333-130207).

 

(4)          Incorporatedby reference from the Form 8-K filed on October 1, 1007 (FileNo. 000-31973).

 

(5)          Incorporated by reference from the Form 8-K filed on April 9,2009 (File No. 000-31973).

 

(6)          Incorporated by reference from the Form 8-K filed onFebruary 26, 2009 (File No. 000-31973).

 

(7)          Incorporated by reference from the Form 8-K filed onFebruary 20, 2009 (File No. 000-31973).

 

 +              Filed herewith.

 

37

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                                       |   | BEACON  POWER CORPORATION                            |
|--------------------------------------------|--------|------------------------------------------------------|
|                                       |   |                                                 |
| Date:     May 11, 2009 |   | By:                                                  | /s/  F. William Capp |
|                                       |   | F.  William Capp                                     |
|                                       |   | President  and Chief Executive Officer               |
|                                       |   | Principal  Executive Officer                         |
|                                       |   |                                                 |
| May 11, 2009                          |   | By:                                                  | /s/  James M. Spiezio |
|                                       |   | James  M. Spiezio                                    |
|                                       |   | Vice  President of Finance, Chief Financial Officer, |
|                                       |   | Treasurer  and Secretary                             |
|                                       |   | Principal  Financial Officer                         |

 

38

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