Table of Contents

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**UNITED STATESSECURITIES 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) ofthe Securities Exchange Act of 1934 for the quarterly period ended September 30,2008**

 

**or**

 

**o********Transition Report Pursuant to Section 13 or 15(d) ofthe Securities Exchange Act of 1934 (For the transition period from       to        ).**

 

**CommissionFile Number: 000-31973**

 

**Beacon Power Corporation**

(Exact name of registrant as specified in itscharter)

 

| **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, includingarea code)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15 (d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  x Yes o No

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer or a smaller reportingcompany.  See the definitions of “largeaccelerated filer,” “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 November 4, 2008 was 97,542,190.

 

 

 

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**BEACONPOWER CORPORATION AND SUBSIDIARIES**

**(ADevelopment Stage Company)**

**Table of Contents**

 
| ** **                         | ** ** | **Page** |
|------------------------------------|------------|----------|
| PART I. Financial Information |       |     |
|                               |       |     |
|                               | Item 1.    |     | Financial Statements |   |   |
|                               |       |     |   |   |   |
|                               |       |     | Consolidated Balance Sheets at  September 30, 2008 (unaudited) and December 31, 2007 (audited) |   | 1 |
|                               |       |     |   |   |   |
|                               |       |     | Unaudited Consolidated  Statements of Operations for the three and nine months ended  September 30, 2008 and 2007, and for the period from May 8, 1997  (date of inception) through September 30, 2008 |   | 2 |
|                               |       |     |   |   |   |
|                               |       |     | Unaudited Consolidated  Statements of Cash Flows for the nine months ended September 30, 2008  and 2007 and for the period from May 8, 1997 (date of inception) through  September 30, 2008 |   | 3 |
|                               |       |     |   |   |   |
|                               |       |     | Notes to  Unaudited Consolidated Financial Statements |   | 5 |
|                               |       |     |   |   |   |
|                               | Item 2.    |     | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 16 |
|                               |       |     |   |   |   |
|                               | Item 3.    |     | Quantitative  and Qualitative Disclosures about Market Risk |   | 32 |
|                               |       |     |   |   |   |
|                               | Item 4.    |     | Controls and  Procedures |   | 32 |
|                               |       |     |   |   |   |
| PART II. Other  Information   |       |     |
|                               |       |     |
|                               | Item 1.    |     | Legal Proceedings |   | 32 |
|                               |       |     |   |   |   |
|                               | Item 1A.   |     | Risk Factors |   | 32 |
|                               |       |     |   |   |   |
|                               | Item 2.    |     | Unregistered  Sales of Equity Securities and Use of Proceeds |   | 33 |
|                               |       |     |   |   |   |
|                               | Item 3.    |     | Defaults  Upon Senior Securities |   | 33 |
|                               |       |     |   |   |   |
|                               | Item 4.    |     | Submission  of Matters to a Vote of Security Holders |   | 33 |
|                               |       |     |   |   |   |
|                               | Item 5.    |     | Other Information |   | 34 |
|                               |       |     |   |   |   |
|                               | Item 6.    |     | Exhibits |   | 34 |
|                               |       |     |   |   |   |
| Signatures                         |       | 35       |

 

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**PART 1— FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**BEACONPOWER CORPORATION AND SUBSIDIARIES**

**(ADevelopment Stage Company)**

**ConsolidatedBalance Sheets**

 
| ** **                                                                                                                                                                                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                                                 | ** ** | **(unaudited)**        | ** ** | **(audited)**         | ** ** |
| **Assets**                                                                                                                                                                                 |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                            |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                  |       | $                      | 10,577,753 |                  | $          | 30,417,095 |   |
| Accounts receivable, trade, net                                                                                                                                                            |       | 90,304                 |       | 424,788               |       |
| Unbilled costs on contracts in progress                                                                                                                                                    |       | 18,193                 |       | 82,195                |       |
| Prepaid expenses and other current assets                                                                                                                                                  |       | 2,076,654              |       | 1,475,084             |       |
| Total current assets                                                                                                                                                                       |       | 12,762,904             |       | 32,399,162            |       |
| Property and equipment, net                                                                                                                                                                |       | 16,214,339             |       | 7,004,021             |       |
| Restricted cash                                                                                                                                                                            |       | 200,000                |       | 374,346               |       |
| Total assets                                                                                                                                                                               |       | $                      | 29,177,243 |                  | $          | 39,777,529 |   |
|                                                                                                                                                                                       |       |                   |       |                  |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                              |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                       |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                           |       | $                      | 2,192,285  |                  | $          | 296,463 |   |
| Accrued compensation and benefits                                                                                                                                                          |       | 1,466,519              |       | 1,024,874             |       |
| Other accrued expenses                                                                                                                                                                     |       | 2,378,886              |       | 2,183,217             |       |
| Advance billings on contracts                                                                                                                                                              |       | 12,081                 |       | 7,222                 |       |
| Accrued contract loss                                                                                                                                                                      |       | 143,385                |       | 67,419                |       |
| Lease liability - current                                                                                                                                                                  |       | 106,371                |       | —                |       |
| Total current liabilities                                                                                                                                                                  |       | 6,299,527              |       | 3,579,195             |       |
| Commitments and contingencies (Note 5)                                                                                                                                                     |       |                   |       |                  |       |
| Lease liability - long term                                                                                                                                                                |       | 918,106                |       | —                |       |
| 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; 88,754,642 and 88,658,967 shares issued and outstanding at  September 30, 2008 and December 31, 2007, respectively |       | 887,546                |       | 886,590               |       |
| Additional paid-in-capital                                                                                                                                                                 |       | 201,451,652            |       | 199,351,427           |       |
| Deficit accumulated during the development  stage                                                                                                                                          |       | (179,666,749           | )          | (163,326,844          | )          |
| Treasury stock, 421,692 shares at cost                                                                                                                                                     |       | (712,839               | )          | (712,839              | )          |
| Total stockholders’ equity                                                                                                                                                            |       | 21,959,610             |       | 36,198,334            |       |
| Total liabilities and stockholders’ equity                                                                                                                                            |       | $                      | 29,177,243 |                  | $          | 39,777,529 |   |

 

See notes to unaudited consolidated financial statements.

 

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**BEACON POWER CORPORATION AND SUBSIDIARIES**

**(A Development Stage Company)**

**Consolidated Statements ofOperations (Unaudited)**

 

 
| ** **                                 | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** | **Cumulative from  May 8, 1997  (date of inception)  through September 30,** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008**                                                                                                   | ** ** | **2007** | ** ** | **2008** | ** ** |
| Revenue                                    |       | $                                                        | 4,390      |                                                    | $          | 372,515                                                                                                    |       | $ | 52,782 |   | $ | 1,214,550 |   | $ | 4,773,329 |   |
| Cost of goods sold                         |       | 5,763                                                    |       | 351,311                                                 |       | 9,935                                                                                                      |       | 1,163,102 |   | 5,136,194 |   |
| Gross profit                               |       | (1,373                                                   | )          | 21,204                                                  |       | 42,847                                                                                                     |       | 51,448 |   | (362,865 | ) |
| Operating expenses:                        |       |                                                     |       |                                                    |       |                                                                                                       |       |   |   |   |   |
| Selling, general and administrative        |       | 1,804,595                                                |       | 1,388,185                                               |       | 6,108,836                                                                                                  |       | 4,351,578 |   | 57,083,231 |   |
| Research and development                   |       | 3,535,096                                                |       | 1,978,318                                               |       | 9,570,674                                                                                                  |       | 5,461,688 |   | 77,989,162 |   |
| Loss on contract commitments               |       | —                                                   |       | (434,348                                                | )          | 86,601                                                                                                     |       | (434,348 | ) | 2,804,062 |   |
| Depreciation and amortization              |       | 334,236                                                  |       | 42,723                                                  |       | 927,455                                                                                                    |       | 99,364 |   | 5,388,545 |   |
| Casualty loss (recovery)                   |       | —                                                   |       | (9,024                                                  | )          | —                                                                                                     |       | (69,084 | ) | — |   |
| Restructuring charges                      |       | —                                                   |       | —                                                  |       | —                                                                                                     |       | — |   | 2,159,280 |   |
| Loss on impairment of assets               |       | —                                                   |       | —                                                  |       | —                                                                                                     |       | — |   | 4,663,916 |   |
| Total operating expenses                   |       | 5,673,927                                                |       | 2,965,854                                               |       | 16,693,566                                                                                                 |       | 9,409,198 |   | 150,088,196 |   |
| Loss from operations                       |       | (5,675,300                                               | )          | (2,944,650                                              | )          | (16,650,719                                                                                                | )          | (9,357,750 | ) | (150,451,061 | ) |
| Other income (expense):                    |       |                                                     |       |                                                    |       |                                                                                                       |       |   |   |   |   |
| Interest income                            |       | 54,234                                                   |       | 124,300                                                 |       | 310,612                                                                                                    |       | 377,791 |   | 5,544,620 |   |
| Interest expense                           |       | —                                                   |       | —                                                  |       | —                                                                                                     |       | — |   | (1,093,703 | ) |
| Gain on sale of investment                 |       | —                                                   |       | —                                                  |       | —                                                                                                     |       | — |   | 3,562,582 |   |
| Other income (expense)                     |       | 334                                                      |       | 6,559                                                   |       | 202                                                                                                        |       | 10,424 |   | (222,993 | ) |
| Total other income (expense), net          |       | 54,568                                                   |       | 130,859                                                 |       | 310,814                                                                                                    |       | 388,215 |   | 7,790,506 |   |
| Net loss                                   |       | (5,620,732                                               | )          | (2,813,791                                              | )          | (16,339,905                                                                                                | )          | (8,969,535 | ) | (142,660,555 | ) |
| Preferred stock dividends                  |       | —                                                   |       | —                                                  |       | —                                                                                                     |       | — |   | (36,825,680 | ) |
| Accretion of convertible preferred stock   |       | —                                                   |       | —                                                  |       | —                                                                                                     |       | — |   | (113,014 | ) |
| Loss to common shareholders                |       | $                                                        | (5,620,732 | )                                                       | $          | (2,813,791                                                                                                 | )          | $ | (16,339,905 | ) | $ | (8,969,535 | ) | $ | (179,599,249 | ) |
| Loss per share, basic and diluted          |       | $                                                        | (0.06      | )                                                       | $          | (0.04                                                                                                      | )          | $ | (0.18 | ) | $ | (0.13 | ) |   |   |
| Weighted-average common shares outstanding |       | 88,754,642                                               |       | 72,661,975                                              |       | 88,711,837                                                                                                 |       | 69,844,813 |   |   |   |
|                                            |            |                                                          |            |                                                         |            |                                                                                                            |            |  |  |  |  |  |  |  |  |  |  |

 

See notes to unaudited consolidated financialstatements.

 

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**BEACONPOWER CORPORATION AND SUBSIDIARIES**

**(ADevelopment Stage Company)**

**ConsolidatedStatements of Cash Flows (Unaudited)**

 
| ** **                                                                   | ** ** | **Nine months ended September 30,** | ** **  | **Cumulative from  May 8, 1997  (date of inception)  through  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------------|-------------|-------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                                                | ** **  | **2007**                                                                                                    | ** ** | **2008** | ** ** |
| Cash flows from operating activities:                                        |       |                                                    |        |                                                                                                        |       |   |   |
| Net loss                                                                     |       | $                                                       | (16,339,905 | )                                                                                                           | $          | (8,969,535 | ) | $ | (142,660,555 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                                    |        |                                                                                                        |       |   |   |
| Depreciation and amortization                                                |       | 927,455                                                 |        | 99,364                                                                                                      |       | 5,388,546 |   |
| Loss (gain) on sale of fixed assets                                          |       | 132                                                     |        | (1,317                                                                                                      | )          | 193,078 |   |
| Impairment of assets, net                                                    |       | —                                                  |        | 553                                                                                                         |       | 4,551,147 |   |
| Expenses paid restructuring charge                                           |       | —                                                  |        | (310,219                                                                                                    | )          | — |   |
| Interest expense relating to issuance of  warrants                           |       | —                                                  |        | —                                                                                                      |       | 371,000 |   |
| Non-cash charge for change in option terms                                   |       | —                                                  |        | —                                                                                                      |       | 346,591 |   |
| Non-cash charge for settlement of lawsuit                                    |       | —                                                  |        | —                                                                                                      |       | 303,160 |   |
| 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                                                     |       | 1,799,652                                               |        | 1,450,635                                                                                                   |       | 4,908,326 |   |
| Deferred rent                                                                |       | 111,786                                                 |        | (610,363                                                                                                    | )          | (405,524 | ) |
|  Cash received from landlord for  build-out credit                      |       | 1,430,000                                               |        | —                                                                                                      |       | 1,430,000 |   |
| Changes in operating assets and  liabilities:                                |       |                                                    |        |                                                                                                        |       |   |   |
| Accounts receivable                                                          |       | 334,484                                                 |        | (12,007                                                                                                     | )          | (90,304 | ) |
| Unbilled costs on government contracts                                       |       | 64,002                                                  |        | (178,168                                                                                                    | )          | (18,193 | ) |
| Prepaid expenses and other current assets                                    |       | (890,933                                                | )           | 185,350                                                                                                     |       | (1,948,367 | ) |
| Accounts payable                                                             |       | 1,895,822                                               |        | 150,339                                                                                                     |       | 2,192,285 |   |
| Accrued compensation and benefits                                            |       | 441,645                                                 |        | 499,223                                                                                                     |       | 1,466,519 |   |
| Advance billings on contracts                                                |       | 4,859                                                   |        | (412,563                                                                                                    | )          | 12,081 |   |
| Accrued interest                                                             |       | —                                                  |        | —                                                                                                      |       | 275,560 |   |
| Accrued loss on contract commitments                                         |       | 75,966                                                  |        | (664,298                                                                                                    | )          | 143,385 |   |
| Other accrued expenses and current  liabilities                              |       | 195,669                                                 |        | 856,954                                                                                                     |       | 2,387,556 |   |
| Net cash used in operating activities                                        |       | (9,949,366                                              | )           | (7,916,052                                                                                                  | )          | (118,258,647 | ) |
| Cash flows from investing activities:                                        |       |                                                    |        |                                                                                                        |       |   |   |
| Purchase of investments                                                      |       | —                                                  |        | —                                                                                                      |       | (1,190,352 | ) |
| Sale of investments                                                          |       | —                                                  |        | —                                                                                                      |       | 4,752,934 |   |
| Restricted cash                                                              |       | 174,346                                                 |        | (200,000                                                                                                    | )          | (200,000 | ) |
| Increase in other assets                                                     |       | —                                                  |        | —                                                                                                      |       | (412,072 | ) |
| Purchases of property and equipment                                          |       | (10,137,905                                             | )           | (2,564,259                                                                                                  | )          | (25,684,101 | ) |
| Sale of property and equipment                                               |       | —                                                  |        | 4,077                                                                                                       |       | 202,674 |   |
| Net cash used in investing activities                                        |       | (9,963,559                                              | )           | (2,760,182                                                                                                  | )          | (22,530,917 | ) |
| Cash flows from financing activities:                                        |       |                                                    |        |                                                                                                        |       |   |   |
| Initial public stock offering, net of  expenses                              |       | —                                                  |        | —                                                                                                      |       | 49,341,537 |   |
| Stock offerings, net of expenses                                             |       | 17,204                                                  |        | 18,848,653                                                                                                  |       | 59,676,042 |   |
| Payment of dividends                                                         |       | —                                                  |        | —                                                                                                      |       | (1,159,373 | ) |
|                                                                              |            |                                                         |             |                                                                                                             |            |  |  |  |  |  |

 

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| ** **                                           | ** ** | **Nine months ended September 30,** | ** ** | **Cumulative from  May 8, 1997  (date of inception)  through  September 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                                | ** ** | **2007**                                                                                                    | ** ** | **2008** | ** ** |
| Shares issued under employee stock purchase  plan    |       | 41,197                                                  |       | 10,557                                                                                                      |       | 219,101 |   |
| Exercise of employee stock options                   |       | 15,182                                                  |       | 43,282                                                                                                      |       | 2,304,091 |   |
| Warrants issued in relation to lease                 |       | —                                                  |       | 716,614                                                                                                     |       | 716,614 |   |
| 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 |       | 73,583                                                  |       | 19,619,106                                                                                                  |       | 151,367,317 |   |
| Increase (decrease) in cash and cash  equivalents    |       | (19,839,342                                             | )          | 8,942,872                                                                                                   |       | 10,577,753 |   |
| Cash and cash equivalents, beginning of  period      |       | 30,417,095                                              |       | 5,251,337                                                                                                   |       | — |   |
| Cash and cash equivalents, end of period             |       | $                                                       | 10,577,753 |                                                                                                        | $          | 14,194,209 |   | $ | 10,577,753 |   |
| Supplemental disclosure of cash flow  information:   |       |                                                    |       |                                                                                                        |       |   |   |
| Cash paid for interest                               |       | $                                                       | —     |                                                                                                        | $          | — |   | $ | 488,126 |   |
| Cash paid for taxes                                  |       | $                                                       | —     |                                                                                                        | $          | — |   | $ | 32,750 |   |
| Assets acquired through capital lease                |       | $                                                       | —     |                                                                                                        | $          | — |   | $ | 535,445 |   |
| Warrants issued in relation to loan  (non-cash)      |       | $                                                       | 227,946    |                                                                                                        | $          | — |   | $ | 227,946 |   |

 

See notes to unaudited consolidated financialstatements.

 

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**BEACONPOWER CORPORATION AND SUBSIDIARIES**

**(ADevelopment Stage Company)**

**Notes toUnaudited Consolidated Financial Statements**

 

**Note 1.  Nature of Business and Operations**

 

*Nature of Business*

 

Beacon Power Corporation (the “Company”, “Beacon”, “we”, “our”, or “us”)(a development stage company) was incorporated on May 8, 1997.  Sinceour inception, we have been primarily engaged in the development of flywheeldevices for storing and transmitting energy.  During 2000 we completed aninitial public offering of our common stock and raised approximately $49.3million net of offering expenses. Since 2000, we have raised approximately$66.9 million through the sale of common stock and warrants, including the saleof stock and warrants in October 2008. We expect to generate revenues inthe future from the commercialization of our flywheel energy storage systems tosupply frequency regulation services to the electricity grid.  We believethat our sustainable energy storage and power conversion solutions can helpprovide reliable electric power for the utility, renewable energy, anddistributed generation markets. In addition, we believe as thecommercialization of our technologies continues, we will develop othercost-effective applications for our flywheel systems that will provideadditional revenue opportunities. Because we have not yet generated asignificant amount of revenue from our principal operations, we are accounted foras a development stage company under Statement of Financial AccountingStandards No. 7.

 

*Operations*

 

We have experienced net losses since our inception and, as of September 30,2008, had an accumulated deficit of approximately $179.7 million.  We do not expect to become profitable or cashflow positive until at least 2010. We will need to raise additional capital toexecute our business plan and continue as a going concern.  Based on our current cash usage rates andadditional expenditures expected in support of our business plan, we havesufficient cash to fund operations into approximately the first quarter of2009.  We will require substantial funds to procure components, manufactureflywheels, construct and deploy flywheel-based frequency regulation facilities,continue research and development activities and further market our productsand services.  We anticipate that suchfunds will be obtained from external sources and we intend to seek additionalequity or debt to fund future operations. We raised approximately $8 million inOctober 2008; however our business plan anticipated that in the fourthquarter of 2008 we would raise $20 million. Due to uncertainty and volatility in the equity markets, we aremodifying our business plan to ensure sufficient cash reserves into the firstquarter of 2009.  This will result in areduction in the number of megawatts we will deploy in New England ISO by theend of 2008 to three megawatts (MW).  Wenow expect a delay in deploying the additional two megawatts from the fourthquarter of 2008 to the first quarter of 2009. In volume production, we expect a 20 MW facility to cost approximately$25 million, while the first 20 MW plant will cost approximately twice thatamount. In 2009 our business plan isto deploy our first 20MW plant; however the number of megawatts we will be ableto deploy is dependent on obtaining sufficient funding for these capitaloutlays. We expect to fund the construction of our first 20 MW plant from acombination of debt and equity. Our ability to obtain sufficient funding willpace our ability to produce flywheel systems and deploy them. In 2009, 2010 and2011, we will continue to have capital needs that will require additionalequity and debt to fund the ongoing deployment of frequency regulationfacilities.

 

**Note 2.  Basis of Presentation and Summary ofSignificant Accounting Policies**

 

**Basis of Presentation**

 

The accompanying unaudited consolidated financial statements have beenprepared using accounting principles generally accepted in the United States ofAmerica except that certain information and footnote disclosures normallyincluded in consolidated financial statements prepared in accordance withgenerally accepted accounting principles have been condensed or omitted in thisForm 10-Q.  We suggest that the consolidated financial statementspresented herein be read in conjunction with our consolidated financialstatements and notes thereto included in our Annual Report on Form 10-Kfor the year ended December 31, 2007.  In our management’s opinion,all adjustments consisting of normal recurring accruals considered necessaryfor a fair presentation have been included in the accompanying unauditedfinancial statements.  Operating results for the nine months ended September 30,2008 are not necessarily indicative of the results that may be expected for thefull year ending December 31, 2008.

 

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*Going Concern*

 

The accompanying consolidated financial statements have been preparedon a going concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business.  As shown inour consolidated financial statements, we have had minimal revenues andincurred losses of approximately $179.7 million since our inception, includinglosses during the nine months ending September 30, 2008 of approximately$16.3 million.  We have approximately $10.6 million of cash and cashequivalents on hand at September 30, 2008, and have raised an additional$10.7 million in cash subsequent to the end of the quarter from our MassDevelopment Finance Agency loan and through the sale of stock andwarrants. There is an additional $1.5 million which can be drawn on theMass Development loan, to offset qualified expenditures for equipment for ourmanufacturing facility. Since our operating cash requirements far exceed anycash generated from operations, we may be unable to continue as a goingconcern.  The consolidated financial statements contained herein do notinclude any adjustments relating to the recoverability and classification ofliabilities that might be necessary should we be unable to continue as a goingconcern.

 

We recognize that our continuation as a going concern is dependent uponour ability to generate sufficient cash flow to allow us to satisfy ourobligations on a timely basis.  The generation of sufficient cash flow isdependent in the short-term on our ability to obtain additional equity and debtfinancing, and in the long-term, on our ability to successfully obtain a shareof the frequency regulation market by deploying our Smart Energy MatrixTMflywheel systems that are now entering production. To execute our businessplan, we expect to obtain financing from a combination of debt and equity.

 

*Consolidation*

 

The accompanying consolidated financial statements include the accountsof Beacon Power Corporation and our subsidiary, Beacon Power SecuritiesCorporation. In September 2008, we established two wholly-ownedsubsidiaries, Tyngsboro Regulation Services LLC and Tyngsboro Holding LLC.  As of September 30, 2008, both entitieswere inactive.  All significant inter-company accounts and transactionshave been eliminated in consolidation.

 

*Loss per Share — Basic and Diluted*

 

Basic and diluted losses per share have been computed using theweighted-average number of shares of common stock outstanding during eachperiod. Warrants, options and other securities exercisable for common sharesare used in the calculation of fully-diluted EPS only if their conversion tocommon shares would decrease income or increase loss per share from continuingoperations.  Since the three and nine month periods ended September 30,2008 and 2007 reflect losses, including the potential conversion of warrantsand options in the diluted EPS calculation would decrease loss per share.Accordingly, they are considered anti-dilutive and are not included in thecalculation of earnings per share.

 

**Summary of Significant Accounting Policies**

 

*Use of Estimates*

 

The preparation of consolidated financial statements in accordance withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the consolidated financial statements and thereported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

*Lease Obligation and Deferred Rent*

 

In July 2007, we signed a seven-year operating lease withescalating payments on a 103,000 square foot facility in Tyngsboro,Massachusetts. As part of this lease agreement, we issued to the landlord150,000 shares of our common stock and a warrant exercisable for 500,000 sharesof our common stock in return for lower cash payments under the lease. (SeeNote 5: Commitments and Contingencies.) Additionally, the landlord has reimbursed us for certain leaseholdimprovements we have made. In accordance with SFAS No. 13, “*Accounting for Leases,*” these reimbursements have beencredited to our lease liability, and we have recorded rent expense on astraight line basis. The current portion of the deferred rent is included incurrent liabilities, and the remainder is shown on the balance sheet as “Leasepayable – long term.”  Prior to ourreceipt of the landlord leasehold improvement reimbursements during the firstquarter of 2008, Deferred rent had a debit balance and was included in “Prepaidexpenses and other current assets.”  Theamount included in Prepaid expenses as of December 31, 2007 wasapproximately $517,000.

 

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*Property and Equipment*

 

Propertyand equipment, including leasehold improvements, are stated at cost anddepreciated using the straight-line method over the estimated useful lives ofthe assets. The cost of the item is defined as the purchase price of the itemas well as all of the costs necessary to bring it to the condition and locationnecessary for its intended use. Repair and maintenance costs are expensed asincurred.  Capital assets are classifiedas “Construction in Progress” (CIP) when initially acquired, and reclassifiedto the appropriate asset account after being placed into service. Depreciationexpense is not recorded on assets not yet placed into service. Materialspurchased to build flywheels for use in our frequency regulation facilities areclassified as CIP, along with related labor and overhead costs.  No overhead is generally applied for otherinternally-constructed projects not directly related to our core business.

 

*Stock-Based Compensation*

 

We account for stock-based compensation in accordance with theFinancial Accounting Standards Board’s Statement of Financial AccountingStandards No. 123R (“SFAS 123R”), “Share-Based Payment”. Under the fairvalue recognition provision of SFAS 123R, stock-based compensation cost ismeasured at the grant date based on the fair value of the award and isrecognized as an expense as it is earned over the requisite service period,which is the vesting period. We implemented this standard using themodified-prospective transition method, under which prior periods were notrevised for comparative purposes. The valuation provisions of SFAS 123R applyto new grants and to grants that were outstanding as of the effective date andare subsequently modified. Estimated compensation expense for grants that wereoutstanding as of the effective date will be recognized over the remainingvesting period using the compensation cost estimated for the SFAS 123R proforma disclosures.

 

The adoption of SFAS 123R had a material impact on our consolidatedfinancial position and results of operations.

 

*Restructuring and AssetImpairment Charges*

 

We periodically evaluate all of our property and equipment as requiredby Statement of Financial Accounting Standards No. 144 “*Accounting for the Impairment or Disposal of Long-Lived Assets*,”and record impairment charges as appropriate.

 

**Note 3.  Accounts Receivable**

 

Our trade accounts receivable include amounts due from customers andare reported net of a reserve for uncollectible accounts as follows:

 
| ** **                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Accounts receivable, trade |       | $                      | 92,872     |                  | $          | 427,356 |   |
| Reserve                    |       | (2,568                 | )          | (2,568                | )          |
| Accounts receivable, net   |       | $                      | 90,304     |                  | $          | 424,788 |   |

 

Some of our research and development contracts contain holdbackprovisions that allow our customers to withhold 10% from each invoice payment.At September 30, 2008 and December 31, 2007, we had approximately$6,000 and $68,000 respectively of holdbacks in our accounts receivablebalance.  These holdbacks are payable once work has been satisfactorilycompleted and the final reports have been delivered and approved.

 

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**Note 4.  Property and Equipment**

 

Details of our property and equipment follow:

 
| ** **                                      | ** ** | **Estimated** | ** ** | **As of:**        | ** ** |
|-------------------------------------------------|------------|---------------|------------|------------------------|------------|
| ** **                                      | ** ** | **Useful**    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                      | ** ** | **Lives**     | ** ** | **2008**               | ** ** | **2007** | ** ** |
| Construction in progress                        |       | Varied        |       | $                      | 8,462,192  |   | $ | 5,782,127 |   |
| Land                                            |       |          |       | 192,487                |       | — |   |
| Machinery and equipment                         |       | 5 - 10 years  |       | 1,661,852              |       | 1,137,946 |   |
| Service vehicles                                |       | 5 years       |       | 16,763                 |       | 16,763 |   |
| Furniture and fixtures                          |       | 7 years       |       | 780,901                |       | 603,382 |   |
| Office equipment                                |       | 3 years       |       | 976,734                |       | 828,918 |   |
| Leasehold improvements                          |       | Lease term    |       | 6,415,143              |       | — |   |
| Equipment under capital lease obligations       |       | Lease term    |       | 700,517                |       | 700,516 |   |
| Total                                           |       |          |       | $                      | 19,206,589 |   | $ | 9,069,652 |   |
| Less accumulated depreciation and  amortization |       |          |       | (2,992,250             | )          | (2,065,631 | ) |
| Property and equipment, net                     |       |          |       | $                      | 16,214,339 |   | $ | 7,004,021 |   |

 

In July 2008, we exercised our option topurchase land in Stephentown, NY, for the construction of a frequencyregulation facility, the cost of which is reflected as “Land” in the scheduleshown above.

 

The components of Construction in progress, which represents costsrelated to assets that have not yet been placed into service and for which nodepreciation expense has been taken, were as follows:

 
| ** **                                                                                  | ** ** | **As of:**        | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                  | ** ** | **2008**               | ** ** | **2007** | ** ** |
| Materials to build production flywheels                                                     |       | $                      | 3,013,824  |   | $ | 453,192 |   |
| Frequency regulation facilities                                                             |       | 5,006,341              |       | 9,527 |   |
| Deposits and other costs related to the  acquisition of land for frequency regulation plant |       | —                 |       | 17,123 |   |
| Machinery and equipment                                                                     |       | 113,184                |       | 85,725 |   |
| Office equipment                                                                            |       | 93,293                 |       | 115,647 |   |
| Leasehold improvements                                                                      |       | 235,550                |       | 5,100,913 |   |
| Construction in progress                                                                    |       | $                      | 8,462,192  |   | $ | 5,782,127 |   |

 

**               **Approximately $8million of the total shown as “Construction in progress” represents completedflywheels, materials to build flywheels and other costs related to thefrequency regulation facility being built at our Tyngsboro site, which weexpect to have in service producing 3 MW of commercial frequency regulationservice through the ISO-NE pilot program by the end of this fiscal year.  We expect to expand that facility to 5 MW bythe end of the first quarter of 2009.

 

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**Note 5.  Commitments and Contingencies**

 

The following table summarizes our commitments at September 30,2008:

 
| ** **              | ** ** | **Description of Commitment** | ** ** |
|-------------------------|------------|-----------------------------------------|------------|
| ** **              | ** ** | **Operating leases**               | ** ** | **Purchase Obligations** | ** ** | **Total** | ** ** |
| Period ending:          |       |                                    |       |   |   |   |   |
| September 30, 2008 |       | $                                       | —     |   | $ | 11,148,235 |   | $ | 11,148,235 |   |
| December 31, 2008  |       | 173,813                                 |       |   |   | 173,813 |   |
| December 31, 2009  |       | 701,687                                 |       |   |   | 701,687 |   |
| December 31, 2010  |       | 727,437                                 |       |   |   | 727,437 |   |
| December 31, 2011  |       | 753,188                                 |       |   |   | 753,188 |   |
| December 31, 2012  |       | 778,937                                 |       |   |   | 778,937 |   |
| Thereafter              |       | 1,422,689                               |       |   |   | 1,422,689 |   |
| Total Commitments       |       | $                                       | 4,557,751  |   | $ | 11,148,235 |   | $ | 15,705,986 |   |

 

At September 30, 2008, we had purchase commitments with oursuppliers in the amount of approximately $11.1 million, against which theCompany has paid cash deposits of approximately $1.4 million. These commitmentsare primarily to acquire components needed to manufacture commercial flywheelunits, complete the build-out of the Tyngsboro facility, begin development ofour initial frequency regulation facilities, and satisfy contractualobligations for research and development programs.

 

InJuly 2007, we signed a seven-year lease on our current corporateheadquarters, and relocated all 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, MA.  The 103,000-square-footfacility, which has manufacturing capacity that will allow production of morethan 1,000 flywheels per year, has been renovated and built-out to ourspecifications.  We expect to have threeMW of frequency regulation services being provided to ISO-NE by the end of2008. One megawatt of this capacity is within our current facility and theadditional two MW will be outside and adjacent to our facility. We are in theprocess of modifying our existing lease to include consent to operate a totalof five MW of frequency regulation outside the building.  ****We anticipate having thelandlord’s consent to the units outside the building by the end of 2008.****

 

We provided our lessor with an irrevocable letter of credit securingour performance under the lease with a balance at September 30, 2008 of$200,000, which is reduced periodically over the lease term.  This letterof credit is secured by a cash deposit, which is included in restricted cash inthe accompanying consolidated balance sheets. In addition to our rent payments, we are responsible for real estatetaxes and all operating expenses of the Tyngsboro facility. Total rent expensefor the nine months ended September 30, 2008 was approximately $442,000.

 

*Legal Proceedings*

 

We may from time to time be subject to legal proceedings, often likelyto involve routine litigation incidental to our business.  The outcome ofany legal proceeding is not within our complete control, may often be difficultto predict and may be resolved over a very long period of time. Estimating probable losses associated with any legal proceedings or other losscontingency is very complex and requires the analysis of many factors,including assumptions about potential actions by third parties.  A losscontingency is recorded as a liability in the consolidated financial statementswhen it is both (i) probable and known that a liability has been incurredand (ii) the amount of the loss is reasonably estimable.  If thereasonable estimate of the loss is a range and no amount within the range is abetter estimate, the minimum amount of the range is recorded as aliability.  If a loss contingency is not probable or not reasonablyestimable, a liability is not recorded in the consolidated financialstatements.

 

On October 9, 2007, Arete Power, Inc. filed a complaintagainst us claiming damages from alleged willful infringement of U.S. Patent No. 6,710,489,entitled “Axially Free Flywheel System.”  On November 30, 2007, wefiled an Answer denying infringement and a Counterclaim seeking a declaratoryjudgment that the ‘489 patent is invalid. (Beacon’s counterclaim has since been amended to assert claims that the ‘489patent should be declared unenforceable and not infringed by Beacon’sproducts).  At the same time, we filed a motion to transfer the lawsuitfrom the Northern District of California to the District ofMassachusetts.  On February 22, 2008, the Court granted our motion totransfer the lawsuit to the District of Massachusetts.  The InitialScheduling 

 

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Conferencewas held in the District Court of Massachusetts on September 15,2008.  Following this SchedulingConference, the Court issued a Scheduling Order requiring non-expert discoveryto be completed by May 15, 2009 and scheduling a Final Pretrial Conferencefor September 8, 2009.  We believethat this lawsuit is without merit and we plan to vigorously defend the Companyagainst the lawsuit.

 

**Note 6.  Notes Payable**

 

OnJune 30, 2008, we entered into an agreement with Massachusetts DevelopmentFinance Agency (“MassDev”) pursuant to which MassDev has agreed to lend to theCompany up to $5 million. This loan derives from a funding collaborationbetween the Emerging Technology Fund of MassDev and the MassachusettsTechnology Collaborative’s Business Expansion Initiative. We expect to use theproceeds from the loan to help fund the expansion of our production facility.

 

TheMassDev loan is evidenced by a promissory note under which we may make one ormore requests for advances of up to an aggregate of $5 million for the purchaseof equipment and installation of certain tenant improvements at our Tyngsboro,Massachusetts facility. We have one year following the date of the initialadvance to draw on the loan. The initial advance on the loan was made on October 1,2008 for approximately $3.5 million. The note will mature 84 months after theinitial advance and bears a fixed annual interest rate of 6.5%.

 

Loanrepayments shall commence on the first day of the calendar month following thedate the initial loan advance is made. The payments will be of interest onlyduring the first twelve months and thereafter, the balance of the principaloutstanding under the note shall be amortized in monthly payments of principaland interest in equal monthly installments over the remaining term of the note.

 

Pursuantto the note, we entered into a security agreement which grants to MassDev anexclusive first priority security interest in all equipment and tenantimprovements funded with the proceeds of the loan. We also entered into acollateral assignment of lease agreement as additional security for therepayment of borrowings.  This agreementgrants MassDev all rights, title and interest in and to our lease for theTyngsboro facility in the event that we default on our obligations.

 

Aspartial consideration for the loan, on June 30, 2008, we issued MassDevtwo warrants. Each warrant provides for the purchase of 85,979 shares of ourcommon stock at an exercise price of $1.89 per share, subject to anyadjustments as set forth in the warrants. The warrants are exercisable forseven years commencing on June 30, 2008 and provide for registrationrights for the resale of the shares issued upon their exercise. MassDevassigned one of the warrants to the Massachusetts Technology Park Corporation (“MTPC”),as part of MTPC’s participation under the Massachusetts TechnologyCollaborative’s Business Expansion Initiative. As no proceeds had been received from the loan as of September 30,2008, the fair value of the warrants is included in “Prepaid expenses and othercurrent assets.”  The amount included inPrepaids as of September 30, 2008, was approximately $228,000.

 

Additional capital expenditures will be required in the future tooptimize the plant for maximum manufacturing capacity.  The amount and timing of these expendituresare dependent on requirements for equipment needed to meet production schedulesas well as having sufficient funding.

 

 **Note 7.  StockWarrants**

 

The following schedule shows warrants outstanding as of September 30,2008:

 
| **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             |       | $                 | 1.99       |                             | 3,287,821  |   |
| November 8, 2005 Financing (Placement  Agents)     |       | 11/8/2005           |       | 11/8/2008            |       | $                 | 2.21       |                             | 450,000    |   |
| February 15, 2007 Shelf Issue                      |       | 2/15/2007           |       | 2/15/0012            |       | $                 | 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           |       | 3/10/2013            |       | $                 | 1.99       |                             | 6,122,449  |   |
| September 10, 2007 Shelf Issue  (Placement Agents) |       | 9/10/2007           |       | 3/10/2013            |       | $                 | 1.99       |                             | 153,061    |   |
| October 31, 2007 Shelf Issue                       |       | 10/31/2007          |       | 5/1/2013             |       | $                 | 2.97       |                             | 11,316,260 |   |
| June 30, 2008 Massachusetts Development  Loan      |       | 6/30/2008           |       | 6/30/2015            |       | $                 | 1.89       |                             | 171,958    |   |
| Total warrants outstanding                              |       |                |       |                 |       |              |       | 29,063,335                       |       |

 

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We have outstanding various series of warrants to purchase our commonstock. Holders of the warrants are not entitled to receive dividends, vote,receive notice of any meetings of stockholders or otherwise have any right asstockholders with respect to their warrant shares.

 

*May 2005 Financing Warrant*

 

In connection with the investment by Perseus 2000 Expansion, L.L.C., weissued a warrant for 800,000 shares of our common stock at an exercise price of$1.008, exercisable at any time until May 25, 2010.

 

*November 2005 Financing Warrants*

 

As part of a financing transaction in November 2005, we issuedwarrants to purchase an aggregate of 2,960,527 shares of our common stock toten “accredited investors.” In addition, 450,000 warrants were issued to theplacement agents.  The per-share exerciseprice for the warrant shares was $2.21. Each investor warrant is exercisable atany time until May 9, 2011, and each placement agent warrant isexercisable at any time until November 8, 2008.  The terms of the investor warrants includedanti-dilution provisions which required us to adjust the exercise price and thenumber of shares of our common stock to be issued upon exercise of the warrantsunder certain circumstances, which include:

 

·                  Subdivisions, stock dividends or combinationsof our common stock

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

·                  Reorganizations, mergers and similar transactions;and

·                  Issuance of additional shares of our commonstock, or securities convertible into our common stock, at a price per sharelower than the closing stock price on the date of this transaction, which was$1.85.

 

In February 2007, we issued stock at a price per share below the$1.85 threshold noted above.  Based onthe warrants’ anti-dilution provisions, the exercise price of these warrantswas adjusted from $2.21 to $1.99 and 327,294 additional warrants were issued tothe investors.  Warrants issued to theplacement agent were not subject to adjustment.

 

*February 2007 Shelf Warrants*

 

In February 2007, we sold 11,814,687 units of the Company at apurchase price of $0.90 per unit.  Eachunit consisted of one share of our common stock, par value $0.01 per share, anda warrant to purchase 0.5 shares of common stock at an exercise price of $1.33per share, for a total of 5,907,345 warrants. In addition, we issued 354,441warrants to the placement agents at the same price per share.  These warrants became exercisable as of August 16,2007, and expire five years from date of issue. The units were issued pursuantto a prospectus supplement filed with the Securities and Exchange Commission inconnection with an effective registration statement.

 

*July 2007 Warrants*

 

In July 2007 we entered into a lease for a new facility inTyngsboro, MA.  We agreed under the termsof the lease to issue to the landlord pursuant to an exemption fromregistration under the Securities Act of 1933, as amended, a warrant exercisablefor 500,000 shares of our common stock at an exercise price of $1.77 pershare.  This warrant became exercisableas of July 23, 2007, may be exercised at any time over the term of thelease and expires on July 22, 2014. The warrant and the shares issuable upon exercise of the warrant arerestricted securities and may not be sold without registration under theSecurities Act of 1933, as amended, and applicable state securities laws or anexemption therefrom.

 

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*September 2007 Shelf Warrants*

 

In September 2007, we sold 5,102,041 units of the Company at apurchase price of $1.96 per unit.  Eachunit consisted of one share of our common stock, par value $0.01 per share, anda warrant to purchase 1.2 shares of common stock at an exercise price of $1.99per share, for a total of 6,122,449 warrants. In addition, 153,061 warrantswere issued to the placement agents at the same price per share. The warrantsbecome exercisable as of March 10, 2008, and expire on March 11,2013. The units were issued pursuant to a prospectus supplement filed with theSecurities and Exchange Commission in connection with an effective registrationstatement.

 

*October 2007 Shelf Warrants*

 

In October 2007, we sold 11,911,852 units of the Company at apurchase price of $2.10 per unit.  Eachunit consisted of one share of our common stock, par value $0.01 per share, anda warrant to purchase 0.95 shares of common stock at an exercise price of $2.97per share, for a total of 11,316,260 warrants. The warrants became exercisablesix months and one day after their issuance, and expire May 1, 2013. Theunits were issued pursuant to a prospectus supplement filed with the Securitiesand Exchange Commission in connection with an effective registration statement.

 

*June 2008 Loan Warrants*

 

In June 2008, as part of a loan we received through a fundingcollaboration between the Emerging Technology Fund of Massachusetts DevelopmentFinance Agency and the Massachusetts Technology Collaborative’s BusinessExpansion Initiative, we issued two warrants to purchase an aggregate of171,958 shares of our common stock at an exercise price of $1.89 pershare.  Each warrant is exercisableimmediately, and expires on June 30, 2015.

 

*October 2008 Shelf Warrants*

 

                In October 2008, we sold8,700,000 units of the Company at a purchase price of $0.91 per unit.  Each unit consisted of one share of ourcommon stock, par value $0.01 per share, and a warrant to purchase one share ofcommon stock at an exercise price of $1.20 per share, for a total of 8,700,000warrants.  The warrants becomeexercisable six months and one day after their issuance, and expire April 16,2014.   The units were issued pursuant toa prospectus supplement filed with the Securities and Exchange Commission inconnection effective registration statement on Form S-3 previously filedwith the Securities and Exchange Commission.

 

**Note 8.  Stock Based Compensation**

 

**Description of Plans**

 

*Stock Option Plan*

 

Our Third Amended and Restated 1998 Stock Incentive Plan allows for thegranting of stock options to purchase up to 23,000,000 shares of our commonstock.  Options may be granted to our employees, officers, directors, consultantsand advisors. Under the terms of the option plan, incentive stock options (“ISOs”)are to be granted at the fair market value of our common stock at the date ofgrant, and nonqualified stock options (“NSOs”) are to be granted at a pricedetermined by the Board of Directors.  In general, the Board hasauthorized vesting periods of one to three years and terms of varying lengthbut in no case more than 10 years.  Our stock option program is along-term retention program that is intended to attract, retain and provideincentives for talented employees, officers and directors, and to alignstockholder and employee interests.  We consider our option programcritical to our operation and productivity; essentially all of our employeesparticipate.  At September 30, 2008, we had 12,228,317 sharesreserved for issuance under this plan, net of outstanding options and RSUs.

 

*Employee Stock Purchase Plan*

 

Our Employee Stock Purchase Plan (the “ESPP”) allows substantially allof our employees to purchase shares of our common stock at a discount throughpayroll deductions.  Participating employees may purchase our common stockat a purchase price equal to 85% of the lower of the fair market value of thecommon stock at the beginning of an offering period or on the exercisedate.  Employees may designate up to 10% of their base compensation forthe purchase of common stock under this plan.  The ESPP provides for thepurchase of up to 2,000,000 shares of our common stock.  At September 30,2008, we had 1,792,272 shares reserved for issuance under this plan.

 

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*Restricted Stock Unit Arrangements*

 

Our Third Amended and Restated 1998 Stock Incentive Plan permits thegrant of restricted stock units (“RSUs”) to our employees, officers, directorsand other service providers.  We use RSUsto (i) align our employees’ interests with those of the Company, (ii) motivateour employees 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 automaticallyconverted into shares of common stock in four equal tranches in the fiscal yearfollowing the year of performance. Certain other RSUs are granted to ourofficers as a form of equity incentive, are not tied to performance, and vestover a three-year period in equal quarterly installments.  There are alsoother performance-based restricted stock units (PSUs) granted to our officersthat cliff-vest upon the achievement of certain earnings-based milestones andupon the Company achieving a level of revenue such that it is no longer treatedas a development stage company for accounting purposes, both such vestingevents subject to the recipient officer being employed by us during the periodending with the milestones. The unvested portion of any RSU or PSU grant issubject to forfeiture upon the holder’s resignation or termination forcause.  As of December 31, 2007,certain RSUs granted under the officer employment agreements were vested butstock was not issued because the vesting date, December 31, fell duringour holiday shut-down period. Also, the RSUs that vested as of September 30,2008 were not issued because the trading window was closed to insiders.

 

Restricted stock activity as of December 31, 2007 and for the ninemonths ended September 30, 2008 is as follows:

 
| ** **                                           | ** ** | **Nine months ended  September 30, 2008** | ** ** | **Year ended  December 31, 2007** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                           | ** ** | **(number of shares)**                              | ** ** |
| Shares issued related to vested RSUs:                |       |                                                          |       |                                             |       |
| Based on prior year grants                           |       | 28,563                                                        |       | 14,044                                           |       |
| Based upon current year executive officer  agreement |       | 9,396                                                         |       | 18,030                                           |       |
|                                                 |       |                                                          |       |                                             |       |
| Vested RSUs not yet converted to stock               |       | 14,219                                                        |       | 9,521                                            |       |
|                                                 |       |                                                          |       |                                             |       |
| RSU’s granted but not vested:                   |       |                                                          |       |                                             |       |
| Based upon prior year bonus plan                     |       | —                                                        |       | —                                           |       |
| Related to 2006 executive officer agreement          |       | 3,520                                                         |       | 14,053                                           |       |
| Related to 2007 executive officer agreement          |       | 30,078                                                        |       | 48,108                                           |       |
| Related to 2008 executive officer agreement          |       | 42,300                                                        |       | —                                           |       |
| Related to performance-based executive  plan*        |       | 1,265,823                                                     |       | 1,265,823                                        |       |

 

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| *Subject to achievement of performance  requirements. |   |   |   |   |   |
|-------------------------------------------------------|--------|--------|--------|--------|--------|

 

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**Stock Option Plan Schedules**

 

Stock option activity for the first nine months of 2008 was as follows:

 
| ** **                           | ** ** | **Number of  Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Fair  Value** | ** ** |
|--------------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| Outstanding, December 31, 2007  |       | 8,712,488                  |       | $                                       | 1.18       |                                |       |   |
| Granted                              |       | 2,240,803                  |       | $                                       | 1.27       |                                | $          | 0.78 |   |
| Exercised                            |       | (19,250                    | )          | $                                       | 0.79       |                                |       |   |
| Canceled, forfeited or expired       |       | (14,666                    | )          | $                                       | 1.19       |                                |       |   |
| Outstanding, September 30, 2008 |       | 10,919,375                 |       | $                                       | 1.20       |                                |       |   |
|                                      |            |                            |            |                                         |            |                                     |            |  |  |

 

The following table summarizes information about stock optionsoutstanding at September 30, 2008:

 
| **Exercise Price** | ** ** | **Number   of Options  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Vested  Number  of Options** | ** ** | **Vested  Weighted-  Average  Exercise  Price** | ** ** |
|-------------------------|------------|------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|
| $0.26 - $0.74           |       | 3,181,138                                      |       | 5.78                                                              |       | $                                       | 0.70       |                                | 3,181,138  |                                            | $          | 0.70 |   |
| $0.82 - $1.46           |       | 5,745,517                                      |       | 7.59                                                              |       | $                                       | 1.06       |                                | 3,110,833  |                                            | $          | 0.98 |   |
| $1.51 - $2.19           |       | 1,535,470                                      |       | 7.02                                                              |       | $                                       | 1.82       |                                | 1,320,800  |                                            | $          | 1.83 |   |
| $2.50 - $3.10           |       | 130,000                                        |       | 1.60                                                              |       | $                                       | 2.64       |                                | 130,000    |                                            | $          | 2.64 |   |
| $4.10 - $5.27           |       | 222,250                                        |       | 2.41                                                              |       | $                                       | 4.40       |                                | 222,250    |                                            | $          | 4.40 |   |
| $6.00 - $9.31           |       | 105,000                                        |       | 2.06                                                              |       | $                                       | 6.40       |                                | 105,000    |                                            | $          | 6.40 |   |
| Total                   |       | 10,919,375                                     |       |                                                              |       |                                    |       | 8,070,021                           |       |                                            |       |

 

**Stock Compensation**

 

We account for our stock compensation in accordance with SFAS 123R. Weuse the Black-Scholes option pricing model to determine the fair value of stockoptions and employee stock purchase plan shares. The valuations determinedusing this model are affected by our stock price as well as assumptions we makeregarding a number of complex and subjective variables, including our stockprice volatility, expected life of the option, risk-free interest rate andexpected dividends, if any.

 

We estimate the volatility of our common stock by using historicalvolatility.  We estimate the expected term of the option grant, anddetermine a risk-free interest rate based on U.S. Treasury issues withremaining terms similar to the expected term of the stock or options. We do notanticipate paying any cash dividends in the foreseeable future and thereforeuse an expected dividend yield of zero in our valuation model. We are requiredto estimate forfeitures at the time of grant and revise those estimates insubsequent periods. All stock-based payment awards are amortized as they areearned over the requisite service periods of the awards, which are generallythe vesting periods.

 

Restricted stock units (RSUs) are valued at the stock price at date ofgrant, and expensed ratably over the performance period or vesting period, asappropriate.  The number of PSUs for which stock compensation expense iscalculated is based upon management’s assessment of the likelihood of achievingthe performance targets.

 

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The assumptions used to value stock option grants for the three monthsand six months ended September 30, 2008 and 2007, respectively, are asfollows:

 
|                                                                                     | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
|                                                                                     | ** ** | **2008**                                  | ** ** | **2007**                                 | ** ** | **2008** | ** ** | **2007** | ** ** |
| Risk-free  interest rate                                                                 |       | 2.01% - 2.90%                             |       | 4.14% - 5.02%                            |       | 2.01% - 3.33% |   | 4.14% - 5.05% |   |
| Expected  life of option                                                                 |       | 3.5 years                                 |       | 3 years                                  |       | 3.5 years |   | 3 years |   |
| Expected dividend payment rate, as a percentage of  the stock price on the date of grant |       | 0%                                        |       | 0%                                       |       | 0% |   | 0% |   |
| Assumed  volatility                                                                      |       | 88% - 91%                                 |       | 90% - 101%                               |       | 87% - 98% |   | 90% - 101% |   |
| Expected  forfeitures                                                                    |       | 10%                                       |       | 10%                                      |       | 10% |   | 10% |   |

 

Stock-basedcompensation expense recognized on our consolidated statement of operations forthe three and nine months ended September 30, 2008 and 2007 are asfollows:

 
| ** **                                     | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                     | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Selling, general and administrative            |       | $                                                        | 247,740    |                                                    | $          | 270,715 |   | $ | 935,739 |   | $ | 931,204 |   |
| Research and development                       |       | 232,349                                                  |       | 143,355                                                 |       | 863,913 |   | 519,432 |   |
| Total stock compensation expense               |       | $                                                        | 480,089    |                                                    | $          | 414,070 |   | $ | 1,799,652 |   | $ | 1,450,636 |   |
|                                           |       |                                                     |       |                                                    |       |   |   |   |   |
| Components of stock compensation expense:      |       |                                                     |       |                                                    |       |   |   |   |   |
| Compensation expense related to RSUs           |       | $                                                        | 150,225    |                                                    | $          | 148,496 |   | $ | 466,970 |   | $ | 459,097 |   |
| Compensation expense related to stock  options |       | 329,864                                                  |       | 265,574                                                 |       | 1,332,682 |   | 991,539 |   |
| Total stock compensation expense               |       | $                                                        | 480,089    |                                                    | $          | 414,070 |   | $ | 1,799,652 |   | $ | 1,450,636 |   |

 

Asof September 30, 2008, there was approximately $1,657,000 of unrecognizedcompensation cost, adjusted for estimated forfeitures, related to unvestedstock-based payments granted to our employees and directors. Total unrecognizedcompensation cost will be adjusted for future changes in estimated forfeituresand recognized over the remaining vesting periods of the stock option grants.

 

**Note 9.  SubsequentEvent**

 

On October 1, 2008, we received our initialdraw-down on the MassDev loan of approximately $3.5 million.

 

On October 15, 2008, we sold 8,700,000units of the Company at a purchase price of $0.91 per unit for a total ofapproximately $7.2 million, net of expenses. Each unit consisted of one share of our common stock, par value $0.01per share, and a warrant to purchase one share of common stock at an exerciseprice of $1.20 per share, for a total of 8,700,000 warrants.  The warrants become exercisable six monthsand one day after their issuance, and expire five and one half years aftertheir issuance.  The units were issuedpursuant to a prospectus supplement filed with the Securities and ExchangeCommission in connection with an effective registration statement on Form S-3previously filed with the Securities and Exchange Commission.

 

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

 

**Note Regarding Forward Looking Statements**

 

This Quarterly Report on Form 10-Q contains forward-lookingstatements concerning, among other things, our expected future revenues,operations and expenditures, and estimates of the potential markets for ourproducts and services.  Such statements made may fall within the meaningof the Private Securities Litigation Reform Act of 1995, as amended.  Allsuch forward-looking statements are necessarily only estimates of futureresults and the actual results we achieve may differ materially from theseprojections due to a number of factors as discussed in the section entitled “RiskFactors” of this Form 10-Q. New risks can arise and it is not possible formanagement to predict all such risks, nor can management assess the impact ofall such risks on our business or the extent to which any factor, orcombination of factors, may cause actual results to differ materially fromthose contained in any forward-looking statement.  Given these risks anduncertainties, investors should not place undue reliance on forward-lookingstatements as a prediction of actual results.  All forward-lookingstatements speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to revise or update publicly any forward-lookingstatement in order to reflect any event or circumstance that may arise afterthe date of this Quarterly Report on Form 10-Q, other than as required bylaw.

 

**Critical Accounting Policies and Estimates**

 

The preparation of financial statements requires management to makeestimates and judgments that may significantly affect the reported amounts ofassets, liabilities, revenues, expenses and related disclosures. On an ongoingbasis, management evaluates our estimates and assumptions including, but not limitedto, those related to revenue recognition, asset impairments, inventoryvaluation, warranty reserves and other assets and liabilities.  Managementbases its estimates on historical experience and various other assumptions thatit believes to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources.  Actualresults may differ from these estimates under different assumptions orconditions.

 

*Revenue Recognition*

 

Although we have sold photovoltaic inverters and recorded revenues forflywheel development contracts, our operations have not yet reached a levelthat would qualify us to emerge from the development stage.  Therefore wecontinue to be accounted for as a development stage company under Statement ofFinancial Accounting Standards No. 7 “Accounting and Reporting byDevelopment Stage Enterprises.”

 

·**                 ***Inverter Sales*

 

We recognize revenue in accordance with accounting principles generallyaccepted in the United States of America.  Generally, revenue isrecognized on transfer of title, typically when products are shipped and allrelated costs are estimable.  For sales to distributors, we make anadjustment to defer revenue until our products are subsequently sold bydistributors to their customers.

 

·**                 ***Government Contract RevenueRecognized on the Percentage-of-Completion Method*

 

We recognize contract revenue using the percentage-of-completionmethod. We use labor hours as the basis for the percentage of completioncalculation, which is measured principally by the percentage of labor hoursincurred to date for each contract to the estimated total labor hours for eachcontract at completion. Changes to total estimated contract costs or losses, ifany, are recognized in the period in which they are determined.  Revenuesrecognized in excess of amounts billed are classified as current assets, andincluded in “Unbilled costs on contracts in process” in our balancesheets.  Amounts billed to clients in excess of revenues recognized todate are classified as current liabilities under “Advance billings oncontracts.”  Changes in project performance and conditions, estimatedprofitability, and final contract settlements may result in future revisions toconstruction contract costs and revenue.

 

Someof our research and development contracts are subject to cost review bygovernment agencies. Our reported results from these contracts could changeadversely as a result of these reviews.

 

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*Loss on Contract Commitments*

 

Our contracts have been primarily for the development of demonstrationunits of new products and the design of a frequency regulation plant.  As such, the work has supported our coreresearch and development efforts.  Weestablish reserves for anticipated losses on contract commitments if, based onour cost estimates 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. Additionally, each quarter we perform an evaluation of expected costs tocomplete our in-progress contracts and adjust the contract loss reserveaccordingly.

 

*Warranty Reserves*

 

The solar inverters we have sold carry warranties that require us torepair or replace defective products returned to us during the applicablewarranty period at no cost to the customer. We record an estimate forwarranty-related costs based on actual historical return rates, anticipatedreturn rates and repair costs at the time of sale.

 

*Income Taxes*

 

Deferred tax assets and liabilities are determined based on differencesbetween the financial reporting and income tax basis of assets and liabilitiesas well as net operating loss and tax credit carryforwards, and are measuredusing the enacted tax rates and laws that will be in effect when thedifferences reverse.  Deferred tax assets are reduced by a 100% valuationallowance to reflect the uncertainty associated with their ultimaterealization.

 

Significant management judgment is required in determining theprovision for income taxes, the deferred tax assets and liabilities and anyvaluation allowance recorded against deferred tax assets.  The valuationallowance is based on our estimates of taxable income and the period over whichour deferred tax assets will be recoverable.  In the event that actualresults differ from these estimates or we adjust these estimates in futureperiods, we may need to establish an additional valuation allowance or reduceour current valuation allowance, which could materially impact our taxprovision.  We classify interest andpenalties relating to uncertain tax position in income tax expense.

 

*Fixed Assets*

 

Fixed assets are definedas tangible items with unit costs exceeding our capitalization threshold thatare used in the operation of the business, are not intended for resale andwhich have a useful life of one year or more. The cost of fixed assets isdefined as the purchase price of the item, as well as all of the costsnecessary to bring it to the condition and location necessary for its intendeduse. Repair and maintenance costs are expensed as incurred.  Capital assets are classified as “Constructionin Progress” (CIP) when initially acquired, and reclassified to the appropriateasset account when placed into service. Depreciation expense is not recorded onassets not yet placed into service. Materials purchased to build flywheels foruse in company-owned frequency regulation facilities are classified as CIP,along with the related labor and overhead costs.  No overhead is generally applied for otherinternally-constructed projects not directly related to our core business(e.g., leasehold improvements.)

 

*Impairment of Long-Lived Assets*

 

In accordance with Statement of Financial Accounting Standards No. 144“Accounting for the Impairment or Disposal of Long-Lived Assets” long-livedassets we hold and use are reviewed to determine whether any events or changesin circumstances 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 fairvalue of the asset and the carrying amount. The fair value of the asset is measured using either available marketprices or estimated discounted cash flows.

 

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**Overview**

 

We design, develop,configure and expect to begin operating flywheel-based frequency regulationfacilities that will provide services to support more reliable andcost-effective electricity grid operation. The focus of our research anddevelopment has been to establish commercially viable flywheel-based energystorage technologies that can provide highly reliable energy solutions for theworldwide electricity grid at competitive costs. Initially, we expect togenerate revenues from the commercialization of our flywheel energy storagesystems to supply frequency regulation services to the electricity grid inNorth America. We believe that as we expand our production capabilities we canbecome a provider of frequency regulation services to grid operators on a globalbasis. In addition 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 focus is onthe geographic regions of the domestic grid that provide open bid markets forregulation services. These regions and their Independent System Operator (ISO)or Regional Transmission Organization (RTO) designations are: New England (ISONew England or ISO-NE); California (California ISO or CAISO); New York (NewYork ISO or NYISO); Mid-Atlantic (PJM Interconnect) and Texas (ERCOT). Inaddition, per its updated schedule, Midwest Independent Transmission SystemOperator, Inc. (Midwest ISO or MISO) is expected to begin operating itsopen-bid ancillary services market for frequency regulation before the end of January 2009.We have been proactive in this emerging market and have added it to our initialtarget markets.  Because ERCOT is notregulated by FERC, we are not able to encourage beneficial market rule changesin ERCOT by leveraging FERC Order 890. This limitation will likely slow our entry into the ERCOT market.

 

These regional ISOs/RTOsor grid operators purchase frequency regulation services from independentproviders in open bid markets that they manage and maintain. We are seeking tobecome one such provider. We believe our technology will offer grid operatorsthe benefits of greater reliability; faster response time; cleaner operation,including zero direct emissions of carbon dioxide (CO2), nitrogenoxide, sulfur dioxide and mercury; and lower maintenance costs compared toconventional power generation facilities that also provide frequency regulationservices.  We believe that we will havelower operating costs and faster response time than the majority of otherentities that provide frequency regulation services, which we believe willallow us to have sufficient margins to make our services economically viable.

 

In North America, thefrequency regulation market in areas that were accessible via open-bid auctionmechanisms was valued at approximately $800 million in 2007.  Before the end of January, 2009 (by whichtime Midwest ISO’s regulation market is expected to be in operation) theaddressable annualized open-bid regulation market is expected to exceed $1billion per year.  Based on globalelectricity production, we believe that the worldwide frequency regulationmarket is several times this amount. Significant growth in the US open-bidmarket is expected due to a combination of factors, including:

 

 

·                  Greater useof renewable energy sources – especially wind generation and solar

·                  Anticipatedexpansion of the open-bid market method to additional regions, such as theMidwest ISO

·                  Increaseddemand for electricity

·                  Increasedfossil fuel prices

·                  Governmentand market forces aimed at reducing carbon dioxide emissions.

 

Under the open-bidmarket, grid operators forecast the need for frequency regulation as apercentage of expected power demand, and approved suppliers submit bids forthese services. Bids are stacked from lowest to highest prices until thecumulative amount of bids is sufficient to meet the calculated need. The pricesubmitted by the highest selected bidder determines the price paid to everybidder that has been scheduled to provide service.

 

To fully exploit thisregulatory-driven open-bid market, we are finalizing our design and expect tobuild, own and operate a number of frequency regulation facilities. Ourbusiness model, which is a sale-of-services model, is similar to that ofindependent power producers who also design, build, own and operate their ownpower plants. Each Smart Energy MatrixTM frequency regulation facility will beup to 20 megawatts (MW) in size. A Smart Energy MatrixTM is a multi-flywheelenergy storage system designed to provide reliable and sustainable frequencyregulation services for utility grids.  ASmart Energy MatrixTM can be scaled to any size to provide one or more megawattsof frequency regulation capacity.  SmartEnergy MatrixTM frequency regulation plants that are 20 MW or less in size offerthe advantage of being eligible to use fast-track interconnection regulationsthat allow plants of this capacity or smaller to be approved more quickly inaccordance with streamlined regulatory rules. A key aspect of our businessmodel is that we are not dependant on the lengthy procurement cycles typicallyassociated with the marketing and sale of capital equipment to the utilitysector.  Instead, our business model isto become a merchant provider of frequency regulation 

 

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services to thederegulated open bid markets.  We will bebidding the output of our plants into multiple open-bid markets for regulationservices on a daily basis.

 

A key qualification forour participation in these markets is the ability to demonstrate that ourtechnology can deliver the regulation services required by each grid operator.To attain this qualification and accelerate market entry we installed twoscale-power 100-kilowatt-hour (kWh) demonstration models of our Smart EnergyMatrixTM for evaluation by two large grid operators. Both of our scale-powersystems were comprised of multiple flywheels. In 2005, we were awarded contracts for these systems by the CaliforniaEnergy Commission (CEC) and the New York State Energy Research and DevelopmentAuthority (NYSERDA), in cooperation with the U.S. Department of Energy (DOE),to test the viability of our flywheel technologies for frequency regulation bythese grid operators.  The demonstrationsystems were scale-power prototypes of the Smart Energy MatrixTM multi-flywheelsystem.  As a result of the success ofthe pilot programs, we have focused on the design of full scale Smart EnergyMatrixTM systems.

 

Both the California andNew York systems were installed and evaluated in formal field trials. Thedemonstration units contained fully functional control, communication and interconnectionelements similar or identical to the elements of our design for 20 MW frequencyregulation facilities. The purpose of these pilot systems was twofold: 1) todemonstrate the ability of our flywheel technology to provide frequencyregulation services consistent with the technical requirements of the gridoperators, including the California ISO and New York ISO, and 2) to obtaincertification or other approval from these system operators that, from atechnical perspective, our technology is approved to provide commercialfrequency regulation services in their respective states and territories.

 

The California systemcompleted its field trial on January 31, 2007, earning a positiveevaluation from both the CEC and the CAISO. On December 26, 2006, the California ISO certified our flywheeltechnology for use as a frequency regulation resource in California.

 

TheNew York demonstration unit incorporated technology improvements as a result offield testing in California and the system contained additional voltage supportand power quality capabilities. The added capabilities were designed todemonstrate the technical efficacy of two entirely new applications for ourcore technology.

 

On March 22,2007, the New York State Energy Research and Development Authority (NYSERDA)and the U.S. DOE confirmed the successful outcome of technical field trialtesting of our scale-power flywheel frequency regulation system in New York. Atthe same time, the New York ISO determined that our technology is a viable technologyfor frequency regulation on its grid and is acceptable for provision ofcommercial frequency regulation in the State of New York. Our New York-basedflywheel system field trial reached this significant milestone after the U.S.DOE (through Sandia National Laboratories, which co-monitored the demonstrationwith NYSERDA) concluded that the unit’s performance had been successfullydemonstrated and that additional testing of the technology was not required.During the first quarter of 2008, the New York demonstration unit was retrievedfor potential future use in supporting other demonstration programs and/orR&D activities.

 

The location of ourregulation plants and the sequence in which they will be constructed depend ona number of factors, including but not limited to the availability and cost ofland, the cost of power plant construction, technical grid interconnectionrequirements, comparative market pricing available for frequency regulation inthe various regional markets, approval of environmental and related permitsrequired to build plants, and our ability to receive appropriate revenues andpayments within the Market Rules of each regional market.

 

During the third quarterof 2008, we exercised an option to purchase approximately seven acres of landat a site in Stephentown, New York. This site is served by two transmissioncompanies: National Grid and New York State Electric and Gas (NYSEG). NationalGrid owns a 115 KVA transmission line that abuts the site, and NYSEG owns asubstation that also abuts the site. Our interconnection request for a 20 MWplant includes National Grid as the transmission provider. We also submitted aseparate interconnection application for a 1 MW facility with NYSEG that wouldconnect directly to its substation. On October 10, 2008, we executed withNESEG a standardized contract for interconnection of new distributed generationunits with a capacity of 2 MW or less connected in parallel with utilitydistributions systems.  Pending finalizationof certain engineering details with NYSEG and application and receipt of abuilding permit for a 1 MW resource from the town of Stephentown, we will havethe right to build and operate a 1 MW resource connected to the NYSEGsubstation.

 

OnJuly 17, 2008, we received a land-use permit we had requested from thetown of Stephentown, New York. Pending approval of our active interconnectionrequest to NYISO and any other implementation requirements of the NYISO, apossible location for our first 20 megawatt frequency regulation plant will bein Stephentown.  We are aggressivelypursuing completion of the 

 

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requiredinterconnection processes for the Stephentown plant. This includes completionby NYISO of a System Impact Study, currently underway, the purpose of which isto ensure that our plant can safely interface with the grid, and to identifyany utility upgrades or other equipment that may be needed before operation ofthe plant can be approved.

 

Ourapplication to the DOE for a loan guarantee identifies Stephentown, New York,as the planned location for our first 20 MW plant. The satisfactory completionof NYISO’s System Impact Study and clear resolution of Market Rule issues(described below) that affect our ability to enter and operate in the NYISOmarket could impact the timing or success of our DOE loan guaranteeapplication. Lengthy delays or negative outcomes in any of the factorsidentified above could potentially require us to select another location forour first 20 MW plant. While we are working to bring matters related to the 20MW plant in Stephentown to the earliest possible successful conclusion, we alsoare actively developing alternate plant sites in multiple ISOs as a hedgeagainst these location-based risks.

 

Due to uncertainty and volatility in the equitymarkets, we are modifying our business plan to ensure sufficient cash reservesinto the first quarter of 2009.  Thiswill result in a reduction in the number of megawatts we will deploy in NewEngland ISO by the end of 2008 to three megawatts (MW).  We now expect a delay in deploying theadditional two megawatts from the fourth quarter of 2008 to the first quarterof 2009.  In volume production, we expecta 20 MW facility to cost approximately $25 million, while the first 20 MW plantwill cost approximately twice that amount. In 2009 our business plan is todeploy our first 20MW plant; however the number of megawatts we will be able todeploy is dependent on obtaining sufficient funding for these capital outlays.We expect to fund the construction of our first 20 MW plant from a combinationof debt and equity. Our ability to obtain sufficient funding will pace ourability to produce flywheel systems and deploy them. In 2010 and 2011, we willcontinue to have capital needs that will require additional equity and debt tofund the ongoing deployment of frequency regulation facilities.

 

Inaddition to obtaining sufficient funding, our deployment schedule isconditional upon the following additional factors and activities:

 

·                  Componentdevelopment and quality:

 

·                  Completetesting of certain components to ensure highly durable operation at commercialoperating speeds.

 

·                  Developmentof multiple sources for our key components. We are working to expand oursupplier base to qualify their components to our designs and specifications sothat we may complete the initial production run of Smart Energy 25 flywheelunits.

 

·                  Continuingto work closely with our suppliers to refine their manufacturing processes andensure quality results.

 

·                  Marketrules and participation:

 

·                  Toparticipate in and be paid for regulation services in our target markets,certain conditions must be met. The technology must be demonstrated andaccepted by the Independent System Operators (ISOs). We accomplished thisthrough our successful demonstration projects in California and New York.  Prior to plant construction, we must also filean interconnection application with the ISO. Our interconnect application for the Stephentown NY site was filed atthe end of 2007.  New York ISO iscurrently in the process of completing a System Impact Study for our 20 MWplant.  The purpose of the impact studyis to ensure the seamless integration of our plant to the grid.  Following the completion of this study weexpect to be granted an interconnection agreement. In ISO New England we havereceived approval to interconnect one MW in Tyngsboro to the grid and to startreceiving revenue on November 18, 2008. We are in the process of obtaining interconnection approval for up to anadditional four MWs in New England.

 

·                  Wemust become a member of each ISO and confirm that market rules specific toeach ISO are compatible with our technology. We have been a member of the PJM Interconnection since 2004 and we havefound no restrictions to market participation there.  More recently, we have been accepted as amember of ISO New England and approved as a member of New York ISO.

 

·                  Theneed to conform some market rules to be compatible with our technologywithin our target markets is requiring more time to complete than we hadpreviously thought. In some cases market rule changes are needed whichalso require time to complete.  Some ISOs(other than PJM) have not yet fully updated their market rules 

 

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to comply with the Federal Energy Regulatory Commission’s 2007 mandatethat non-generation resources (such as ours) be allowed equal access to enterthe market for regulation services.  Itis believed that these ISOs will require a number of months to come intocompliance, and we have committed adequate resources to accelerate the process.

 

**Regulatoryand 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. While three ISOs have certified or otherwise approved our flywheeltechnology for commercial deployment, each ISO has its own market rules thatwill govern the pace at which markets are opened and the degree to which ourtechnology is allowed to participate. Historically, the market rules forregulation were written to conform to traditional generators’ abilities toprovide regulation. This is understandable, because until the advent of ourtechnology, the capabilities and limitations of traditional generators definedhow regulation could be technically implemented. In the markets in which weintend to compete, most of the ISO market rules still contain legacyterms, performance characteristics and other requirements that do not alignwith our newer technology. The impact of this mismatch varies from market tomarket. Our ability to foster beneficial changes to ISO market rules willdetermine our timing for entering these markets and building regulationfacilities, as well as the revenues and costs associated with each market.

 

Ofconsiderable importance and benefit to us, on February 16, 2007, theFederal Energy Regulation Commission (FERC) issued a landmark ruling, Order890, *Preventing Undue Discrimination and Preference inTransmission Service*. This FERC ruling seeks to promote greatercompetition in electricity markets and strengthen the reliability of the grid.Included in Order 890 was a mandate by FERC that all ISOs must change theirmarket tariffs to allow non-generation resources (such as ours) capable ofproviding frequency regulation the ability to bid and sell into these markets.The ruling also stated that market rule changes must be implemented in acompletely non-discriminatory manner.

 

Webelieve that FERC Order 890 will accelerate the pace of market rule changesand we have already made progress with several of the ISOs by working with themdirectly to implement changes to market rules. We are already experiencing positive effects of Order 890 in the form ofheightened commitments by ISOs to work collaboratively with us to integrate ourtechnology to their grids. To ensure that we have the right resources toproperly address the timely opportunity represented by FERC Order 890, weobtained expert regulatory and legal counsel and have put a vigorous regulatoryaffairs program in place.

 

Asa result of FERC Order 890, all ISOs were required to submit a compliancefiling with FERC in October 2007 to define their degree of compliance withthis mandate. Once the ISO compliance filings were published, we became anactive participant in reviewing these ISO filings and providing input to FERC.We determined that most of the ISOs were deficient in some way with respect tofull Order 890 compliance. In November 2007 we intervened with FERC andsubmitted comments on each of the ISOs’ Order 890 compliance filings in aneffort to ensure that our technology is allowed to fairly participate in eachof the markets, earn revenues in proportion to the true value of servicesprovided and incur no more than a fair share of costs for market participation.

 

These FERC regulatory proceedings are ongoing.The current status of each ISO market is as follows:

 

·                  Midwest ISOis in the process of implementing a new Ancillary Services Market (ASM) to meetits compliance requirements with Order 890. We are actively engaged with MISOin the development of this market. This new ASM is in a testing phase ofimplementation. Testing has identified areas that need further work beforeimplementation can be achieved, which has changed the target implementationdate from September 9, 2008 to January 6, 2009.  Our analysis of MISO’s ASM tariff disclosedfeatures that would have increased our costs and/or decreased revenues in whatwe believe would be a discriminatory manner. In response to our FERC filing todraw attention to these issues, on February 25, 2008, FERC issued itsdecision with respect to MISO’s ASM tariff. FERC responded positively to the issues we raised in our Initial andReply Comments.  Specifically, FERCmandated that the Midwest ISO remove barriers preventing new technologies fromparticipating in the regulation market. FERC commented: “We require the MidwestISO to evaluate, through stakeholder discussions (we consider discussionsbetween the Midwest ISO and Beacon Power to be the most appropriate venue fordetermining whether new technologies qualify as generation resources)adjustments to operating requirements and ASM procedures that will removebarriers to comparable treatment of DRRs (Demand Response Resources) and newtechnologies in the regulating reserve markets and to provide a report on itsefforts to incorporate these resources into its markets within 60 days of thedate of this order.  We also require the Midwest ISO to submit 

 

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revised tariff sheets, if adjustments areproposed, in a compliance filing to be submitted concurrently with the 60-dayinformational filing.”   After working ingood faith with Beacon for that period, on April 25, 2008, MISO fullycomplied with FERC’s 60-day directives by filing a request for an entirely newregulation resource category specifically designed for Stored Energy Resources(“SER”), including our flywheel technology, to take effect on June 1,2009. This is the first such tariff in the United States designed specificallyto accommodate energy storage-based regulation resources and it containsfeatures that are expected to maximize our revenues in the MISO market.  This tariff request is currently under reviewat FERC.  Given the landmark nature ofthis specific proposed tariff and its potential to facilitate our market entryand profitable operation, we intend to pursue the creation of similar storedenergy tariffs applicable to the provision of frequency regulation services inall of our open-bid markets.

 

·                  PJM amendedits tariff language to comply with Order 890 and stated that its current rules allownon-generation resources like ours to fully participate in its Regulation andFrequency Response market. We believe PJM’s market rules allow us to enterthe market any time we choose to do so, subject to normal arrangements forinterconnection, financing, zoning and so forth.  We are currently working with PJM to clarifycertain aspects of PJM’s settlement methods in order to maximize our potentialrevenues in the PJM market.

 

·                  NYISOpostponed submitting a new tariff and market rules to allow non-generationresources and instead stated that we can qualify under the existing tariff as agenerator. While we can enter the market within the generator category, webelieve this category might expose us to unwarranted costs and potentiallyreduce our revenues.  In its November 19,2007, response to our comments to NYISO’s Order 890 Compliance Filing, NYISOnoted that: “The NYISO is currently working with Beacon to ensure that softwareand metering arrangements are in place to support its participation in themarkets as a generator when its facility actually comes on line, which isexpected to occur sometime in 2008. There is, however, no tariff obstacle toBeacon’s provision of regulation service.” Our regulatory focus includesworking with NYISO to remedy certain limitations we see within the generatorcategory. We continued to seek recourse through FERC in an effort to accelerateNYISO to remedy its limitations to market participation with respect toqualifying under the generator category. On May 23, 2008 FERC mandatedthat NYISO work with us to integrate energy storage technologies into itsregulation market and required NYISO to file quarterly reports on its progressin this regard.  In July, the NYISOpresented to its market stakeholders new regulation market rules forenergy storage resources.  These new rules recognizethe unique operating characteristics of our technology and remedy thelimitations in the current generator market. These rules are currently under review and development by themarket stakeholders.  In addition,software changes to NYISO operations and settlement system are required toimplement these new market rules.  A lineitem was included in NYISO’s proposed 2009 budget to cover the implementationof the required software changes in the second quarter of 2009.  The budget was approved by NYISO’s ManagementCommittee on October 29, 2008 and is expected to be approved by NYISO’sBoard of Directors in November 2009. In addition to market rules, participating in NYISO’s Regulation marketrequires a change in the Northeast Power Coordinating Council’s (NPCC)reliability rules.  Currently NPCCrequires Regulating Reserves to be able to produce one hour of continuous energy.  On September 29th NPCC’s TaskForce on Coordination of Operations proposed to remove this requirement fromresources providing Regulation.  Thischange is now being vetted by the entire NPCC body and if approved will removethe last remaining barrier to our participation in NYISO.  We are actively participating in the NPCC rule changeprocess.  We continue to work closelywith the NYISO and its market stakeholders to fuller open the regulation marketto energy storage technologies on a non-discriminatory basis and we anticipatethat new market rules will be in place by the end of the 2ndquarter of 2009.

 

·                  ISO-NE modified its tariff language, butstated that it needed to make changes to market rules in order to fullycomply with Order 890. Since acknowledging the need for market changes, ISO-NEhas worked with us to ensure that these modifications recognize the uniqueoperating characteristics of our technology and remedy the limitations in thecurrent market. On March 11, 2008, ISO-NE announced its plan to create a13 MW Alternative Technologies Regulation Pilot program to comply with Order890.  The pilot program is designed tobegin in November 2008 and run for approximately 18 months until newpermanent market rules for energy storage technologies are implemented.The purpose of the Alternative Technologies Regulation Pilot program will be toevaluate the performance of new technologies like ours that are unable toparticipate in ISO-NE’s current regulation market, determine how thesetechnologies can best be used to meet New England’s regulation requirements,allow program participants to operate in a realistic market environment wherethey can evaluate their market viability, and provide operating experience thatISO-NE can use to formulate permanent market rules.  On July 15, 2008 the NEPOOL MarketsCommittee unanimously voted to support the creation of the pilot program.  On August 1, 2008, the pilot program wasunanimously approved by the Northeast Power Pool (NEPOOL) ParticipantsCommittee.  On August 5, 2008,ISO-NE and NEPOOL jointly submitted to FERC new market rules forestablishing an alternative technologies pilot program that would includeflywheel energy storage.  On September 

 

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15,2008 FERC approved the pilot program. Furthermore, on October 27, 2008 FERC mandated that in order tocomply with Order 890 ISO-NE must implement permanent market rule revisionsthat result from the pilot program and file quarterly reports on its progress.We intend to participate in this pilot program and expect to generate revenuesunder this program as early as November 2008.

 

·                  CAISO submitted an Order 890 compliancefiling on June 16, 2008 which modified its tariff to allow bids forregulation by non-generation resources that are capable of providing theservice and that meet applicable Ancillary Service standards and technicalrequirements.  In addition, in May 2008the CAISO initiated a project and stakeholder process to develop the technicaland operational requirements for integrating storage technologies into itssystem and consider the extent to which additional tariff revisions may beappropriate to enhance their participation in the CAISO’s markets.  It is our understanding that CAISOis planning to issue a draft policy proposal by the end of 2008 on themarket-rule changes that would be needed to fully accommodate energystorage in its ancillary service markets.  In addition CAISO has formed aworking group that is studying the creation of a new Fast Regulationservice which would pay a premium for fast responding technologies such asours.

 

·                  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 hold the potential to support higher pricing in consideration of ourtechnology’s superior performance is limited at this time. As the performanceof our technology is fully demonstrated at a system-wide level in other ISOs,and as wind penetration in Texas increases and the demand for fast regulationresources rises, we will re-evaluate the feasibility of encouraging beneficialmarket rule changes and the potential of entering this market on a moreprofitable basis.

 

Wecompleted the move to the Tyngsboro facility in January 2008, and we havecompleted the first phase build-out of our manufacturing facility. We now havea facility capable of producing up to 600 flywheels per year, which will beramped up to commence all aspects of production once the development of allcomponents is complete.  We have a secondphase manufacturing build-out planned which will increase annual manufacturingcapacity to more than 1,000 flywheels. We expect to have three MW of frequency regulation services beingprovided to ISO-NE by the end of 2008. One megawatt of this capacity is withinour current facility and the additional two MW will be outside and adjacent toour facility. We are in the process of modifying our existing lease to includeconsent to operate a total of five MW of frequency regulation outside thebuilding.  ****We anticipate having the landlord’s consent to the units outside thebuilding by the end of 2008.****

 

Becauseour business model is based on being a service provider that owns and operatesplants and equipment as opposed to selling equipment, we will need to obtainsignificant additional funding to further expand our manufacturing capacity,procure the components and ancillary equipment needed to manufacture ourflywheel systems and construct our frequency regulation facilities.  We expect to raise additional capital in 2009through the sale of our stock.  In thefuture, we will need to raise additional capital either from project financingor additional equity transactions in order to build additional regulationfacilities.

 

As our business develops, we may from time to time evaluate possibleacquisitions of enterprises or technologies that we would consider synergisticfrom a market, technology or product perspective.

 

From inception through September 30, 2008, we have incurred lossesof approximately $179.7 million. We expect to continue to incur losses as weexpand our product development and begin to increase our manufacturing andassembly capacity.

 

*Revenues*

 

Inthe past, we were awarded fixed price research and development contracts fromgovernment agencies and are pursuing similar contracts from other governmentagencies.  We have recognized revenues onour existing contracts using the percentage of completion method.  We are continuing to evaluate markets for ourflywheel systems but we have not recognized revenues from these products.

 

*Cost of Goods Sold*

 

Cost of goods sold on fixed price research and development contractsare predominantly being recorded on the percentage of completion method andconsist of direct labor and material, subcontracting, and associated overheadcosts.

 

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*Selling, General and Administrative Expenses*

 

Oursales and marketing expenses consist primarily of compensation and benefits forsales and marketing personnel and related business development expenses. During the first quarter of 2008, we added a Director of Regulatory Affairs towork directly with the ISOs to implement changes to their market rules toallow non-generation resources (such as ours) capable of providing frequencyregulation the ability to bid and sell into these markets. We also added aDirector of Human Resources to assist us in hiring and maintaining qualifiedstaff as we transition from development into full production.  We expectsales and marketing expenses to continue to increase as we expand efforts todefine new markets for our products, expand our marketing efforts forgovernment sales and government-backed loans for new facilities, as well asincreased regulatory efforts to modify market rules to insure our abilityto compete in these markets. General and administrative expenses consistprimarily of compensation and benefits related to our corporate staff,professional fees, insurance and travel. We expect our selling, general andadministrative expenses to increase in 2008 over 2007 primarily due toadditional staffing to support the move to production.

 

*Research and Development*

 

Our cost of research anddevelopment consists primarily of the cost of compensation and benefits forresearch and development and support staff, as well as materials and suppliesused in the engineering design and development process. We expect research anddevelopment expenses to increase during 2008

 

*Loss on Contract 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.

 

In2007, we completed all but one of our existing contracts.  In April 2008we were awarded a subcontract to provide a flywheel energy storage system insupport of a wind integration research and development (R&D) projectsponsored by the California Energy Commission. We will receive approximately $250,000 to offset R&D expenses andwill contribute an additional $87,000 of engineering resources for the project,bringing the R&D total to approximately $337,000. In addition to theCalifornia Energy Commission, which is funding the project, other leadingstakeholders include Southern California Edison and the California ISO.  The flywheel system will be installed inTehachapi, California, a high-potential wind resource area where, according toa report from the California ISO, up to 4,200 megawatts of wind power may beadded in the coming years.  Our flywheelenergy storage systems may also have the potential to address shortages in transmissionline capacity, which this wind power integration project is intended toprove.  The primary goal of the projectis to demonstrate that advanced control technology with energy storage can helpexpand the delivery of renewable wind energy by effectively increasing thecapacity of constrained transmission facilities in the Tehachapi area.  This project supports California’s goal toupgrade and expand its electricity transmission and distribution infrastructureper the state’s Energy Action Plan of 2003. We recorded a charge of approximately $87,000 during the secondquarter of 2008 to reflect the expected “cost share” portion of the Tehachapicontract.

 

*Depreciation and Amortization*

 

Ourdepreciation and amortization is primarily related to depreciation on capitalexpenditures and the amortization of lease and leasehold costs related to ourfacilities.  We have intellectualproperty in the form of patents on our flywheel vacuum system, our heat pipecooling systems, DC output paralleling, metal hub, low-loss motor, co-mingledrims and earthquake-tolerant bearings on our flywheel products, anti-islandingsoftware, drawings, source code and production know-how on our Smart Power M5 inverter system, andexpect to obtain other patents during 2008 and beyond.  Due to the uncertainty of realizing anyfuture value and lack of substantial revenues to date, all costs related to thedevelopment of intellectual property have been expensed as incurred.

 

*Interest and Other Income/Expense, net*

 

Our non-operating income andexpenses are primarily attributable to interest income resulting from cash onhand and funds received in settlement of a class action suit relating to unfairpractices engaged in by certain insurance brokerage firms.

 

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**Results of Operations**

 

***Comparison of Three Months ended September 30, 2008 and2007***

 
| ** **                             | ** ** | **Three months ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                                 | ** ** | **2007** | ** ** | **$** | ** Change** | ** ** | **% Change** | ** ** |
| ** **                             | ** ** | **(in thousands)**                                  | ** ** |
| Revenue                                |       | $                                                        | 4          |   | $ | 373 |   | $ | (369 | ) | 99 | % |
| Cost of goods sold                     |       | 6                                                        |       | 352 |   | 346 |   | 98 | % |
| Gross margin                           |       | (2                                                       | )          | 21 |   | (23 | ) | 110 | % |
| Selling, general and administrative    |       | 1,805                                                    |       | 1,388 |   | (417 | ) | 30 | % |
| Research and development               |       | 3,535                                                    |       | 1,978 |   | (1,557 | ) | 79 | % |
| Loss on sales and contract commitments |       | —                                                   |       | (434 | ) | (434 | ) | 100 | % |
| Depreciation and amortization          |       | 334                                                      |       | 43 |   | (291 | ) | 677 | % |
| Casualty loss (recovery)               |       | —                                                   |       | (9 | ) | (9 | ) | 100 | % |
| Interest and other income, net         |       | 55                                                       |       | 131 |   | (76 | ) | 58 | % |
| Net loss                               |       | $                                                        | (5,621     | ) | $ | (2,814 | ) | $ | (2,807 | ) | 100 | % |

 

***Comparison of Nine Months ended September 30, 2008 and2007***

 
| ** **                          | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                          | ** ** | **2008**                                                | ** ** | **2007** | ** ** | **$** | ** Change** | ** ** | **% Change** | ** ** |
| ** **                          | ** ** | **(in thousands)**                                 | ** ** |
| Revenue                             |       | $                                                       | 53         |   | $ | 1,215 |   | $ | (1,162 | ) | 96 | % |
| Cost of goods sold                  |       | 10                                                      |       | 1,163 |   | 1,153 |   | 99 | % |
| Gross margin                        |       | 43                                                      |       | 52 |   | (9 | ) | 17 | % |
| Selling, general and administrative |       | 6,109                                                   |       | 4,352 |   | (1,757 | ) | 40 | % |
| Research and development            |       | 9,571                                                   |       | 5,462 |   | (4,109 | ) | 75 | % |
| Loss on contract commitments        |       | 87                                                      |       | (434 | ) | (521 | ) | 120 | % |
| Depreciation and amortization       |       | 927                                                     |       | 99 |   | (828 | ) | 836 | % |
| Casualty loss (recovery)            |       | —                                                  |       | (69 | ) | (69 | ) | 100 | % |
| Interest and other income, net      |       | 311                                                     |       | 388 |   | (77 | ) | 20 | % |
| Net loss                            |       | $                                                       | (16,340    | ) | $ | (8,970 | ) | $ | (7,370 | ) | 82 | % |

 

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*Revenue*

* *

Thefollowing table provides details of our revenues for the three and nine monthsended September 30, 2008 and 2007:

 
| ** **                    | ** ** | **Percent**  | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** | **Cumulative  Contract  Value  Earned as** | ** ** | **Total  Contract** | ** ** |
|-------------------------------|------------|--------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------|------------|---------------------|------------|
| ** **                    | ** ** | **Complete** | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008**                                        | ** ** | **2007**            | ** ** | **of 2008** | ** ** | **Value** | ** ** |
|                          |       |         |       | **(dollars in thousands)**                 |       |
| CEC                           |       | 100          | %          | $                                                    | —     |                                                | $          | 1                                               |       | $                   | —     |   | $ | 65 |   | $ | 1,233 |   | $ | 1,233 |   |
| NYSERDA PON 846               |       | 100          | %          | —                                               |       | —                                              |       | —                                          |       | 67                  |       | 646 |   | 646 |   |
| NYSERDA PON 800               |       | 83           | %          | —                                               |       | —                                              |       | 1                                               |       | (1                  | )          | 52 |   | 63 |   |
| Air Force Research Laboratory |       | 100          | %          | —                                               |       | 41                                                  |       | —                                          |       | 477                 |       | 750 |   | 750 |   |
| Sandia DOE Earmark            |       | 100          | %          | —                                               |       | 310                                                 |       | —                                          |       | 557                 |       | 752 |   | 752 |   |
| Tehachapi                     |       | 4            | %          | 5                                                    |       | —                                              |       | 9                                               |       | —              |       | 9 |   | 250 |   |
| Total Contract Revenue        |       |         |       | $                                                    | 5          |                                                | $          | 352                                             |       | $                   | 10         |   | $ | 1,165 |   | $ | 3,442 |   | $ | 3,694 |   |
| M5 and accessories            |       |         |       | (1                                                   | )          | 21                                                  |       | 43                                              |       | 50                  |       | — |   | — |   |
| Total                         |       |         |       | $                                                    | 4          |                                                | $          | 373                                             |       | $                   | 53         |   | $ | 1,215 |   | $ | 3,442 |   | $ | 3,694 |   |

 

Inthe three months ended September 30, 2008, we focused on preparations tobegin commercial production of our flywheel energy storage systems, and onlyrecorded minimal revenue from flywheel-related research and developmentcontracts.  In the same period for 2007,we recorded revenue from flywheel-related research and development contractscalculated using the percentage of completion method of approximately $352,000,most of which related to the Sandia contract. Revenue recorded from thesale of inverters and related products was approximately ($1,000) during thethird quarter of 2008, as compared to approximately $21,000 during the sameperiod of 2007.  During the nine monthsended September 30, 2008, we recorded approximately $10,000 of revenuefrom contract activities, compared to approximately $1,165,000 during the sameperiod of 2007.  The reduction incontract revenue was due to the completion of our larger contracts as of theend of fiscal 2007.  Inverter revenue wasapproximately $43,000 during the first nine months of 2008, versusapproximately $50,000 during the same period in 2007.

 

*Cost of Goods Sold*

 

Costof goods sold was approximately $6,000 during the third quarter of 2008,compared to approximately $352,000 during the third quarter of 2007, andapproximately $10,000 compared to approximately $1,163,000 for the nine monthsended September 30, 2008 and 2007, respectively.  Cost of goods sold includes primarily costsincurred in performance of our research and development contracts calculatedusing the percentage of completion method. The reductions in cost of goods sold are consistent with and for thesame reasons as the fluctuations in revenue.

 

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*Selling, General and Administrative Expense*

 
| ** **                           | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                              | ** ** |
| Period Ended September 30, 2007 |       | $                                                    | 1,388      |                                                | $          | 4,352 |   |
| Increases (decreases):               |       |                                                 |       |                                                |       |
| Salaries and benefits                |       | 175                                                  |       | 619                                                 |       |
| Legal and professional               |       | 80                                                   |       | 587                                                 |       |
| Subcontractors and consultants       |       | (46                                                  | )          | 292                                                 |       |
| Allocation of overhead to contracts  |       | 176                                                  |       | 176                                                 |       |
| Materials and office expenses        |       | 1                                                    |       | 56                                                  |       |
| Audit fees                           |       | (5                                                   | )          | 21                                                  |       |
| Taxes                                |       | 4                                                    |       | 20                                                  |       |
| Facility costs and utilities         |       | (12                                                  | )          | 20                                                  |       |
| Travel                               |       | 12                                                   |       | 19                                                  |       |
| Dues and subscriptions               |       | 1                                                    |       | 18                                                  |       |
| Other                                |       | 3                                                    |       | 18                                                  |       |
| Reduction of bad debt reserve        |       | 4                                                    |       | 16                                                  |       |
| Advertising and Trade shows          |       | 7                                                    |       | 8                                                   |       |
| Stock compensation expense           |       | (23                                                  | )          | 5                                                   |       |
| Hiring costs                         |       | 12                                                   |       | (14                                                 | )          |
| Public company expenses              |       | 28                                                   |       | (104                                                | )          |
| Period Ended September 30, 2008 |       | $                                                    | 1,805      |                                                | $          | 6,109 |   |

 

 Selling, general and administrative expensestotaled approximately $1,805,000 and $1,388,000 for the three months ended September 30,2008 and 2007, respectively. The increase of approximately $417,000 or 30% wasprimarily the result of higher salaries and benefits due to additional staffingof approximately $175,000, higher legal and professional fees of approximately$80,000 related primarily to regulatory efforts our efforts to work with theISOs to modify their market rules as well as costs related to raisingfunds, and lower overhead costs allocated to contracts of approximately$176,000 (the Sandia contract completed in late 2007 allowed us to charge aportion of our Sales, General and Administrative overhead costs to thecontract).  These and other smaller costincreases were slightly offset by a lower use of subcontractors and consultantsof approximately $46,000  We expect ourselling, general and administrative expenses for the remainder of 2008 to besomewhat higher than for 2007 due primarily to increases in staffing needed tosupport our transition to a production facility, increased marketing and salesexpenses associated with flywheel products and increased efforts to work withthe ISOs to modify market rules and fund-raising efforts.

 

Forthe nine months ended September 30, 2008 and 2007, selling, general andadministrative expenses increased from approximately $4,352,000 to $6,109,000,an increase of approximately $1,757,000, or 40%.  The largest increases were in salaries andbenefits of approximately $619,000, legal and professional fees ofapproximately $587,000, and subcontractors and consultants of approximately$292,000, and a reduction in overhead allocated to contracts of approximately$176,000.  These increases for the ninemonths were for the same reasons as noted for the third quarter.  These increases were offset by a reduction inpublic company expenses of approximately $104,000 during the nine month period.

 

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*Research and Development Expense*

 
| ** **                           | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                              | ** ** |
| Period Ended September 30, 2007 |       | $                                                    | 1,978      |                                                | $          | 5,462 |   |
| Increases (decreases):               |       |                                                 |       |                                                |       |
| Legal                                |       | 889                                                  |       | 1,383                                               |       |
| Allocation of overhead to contracts  |       | (220                                                 | )          | 851                                                 |       |
| Salaries and benefits                |       | 242                                                  |       | 828                                                 |       |
| Facility costs                       |       | 31                                                   |       | 403                                                 |       |
| Expense materials                    |       | 445                                                  |       | 403                                                 |       |
| Stock compensation expense           |       | 89                                                   |       | 344                                                 |       |
| Other                                |       | 9                                                    |       | 62                                                  |       |
| Repairs and Maintenance              |       | 21                                                   |       | 19                                                  |       |
| Outside testing                      |       | 6                                                    |       | 17                                                  |       |
| Software maintenance                 |       | (6                                                   | )          | 16                                                  |       |
| Travel                               |       | (7                                                   | )          | 2                                                   |       |
| Hiring costs                         |       | 29                                                   |       | (31                                                 | )          |
| Consultants and subcontractors       |       | 29                                                   |       | (188                                                | )          |
| Period Ended September 30, 2008 |       | $                                                    | 3,535      |                                                | $          | 9,571 |   |

 

Forthe three months ended September 30, 2008, research and developmentexpense increased by approximately $1,557,000 or 79%, in comparison to thethird quarter of 2007.  This increase isprimarily due to increased legal costs of approximately $889,000 most of whichrelates to the Arete lawsuit and development of new patents; increasedheadcount-related expenses resulting from hiring of engineering and supportstaff to support our flywheel development and move to production ofapproximately $242,000; increased expense material costs of approximately$445,000 related to tooling and other costs related to supplier development,increased facility costs due to our larger facility of approximately $31,000;increased stock compensation expense of approximately $89,000, and various othercosts net to an increase of approximately $81,000. These increases were offsetby higher allocation of overheads to contracts of approximately $220,000.  Although critical testing of the Smart Energy25 flywheel is complete, we continue to perform various operational tests andother development work aimed at achieving manufacturing cost reductions.

 

Researchand development expenses for the first nine months of 2008 increased fromapproximately $5,462,000 in 2007 to approximately $9,571,000 in 2008, an increaseof $4,109,000 or 75%.  Approximately 34%of the increase, $1,383,000, is due increased legal costs primarily related tothe Arete lawsuit.  Approximately 21% ofthe increase, $851,000, relates to a reduction in the overhead allocated to ourgovernment contracts, as those contracts were mostly completed during2007.  Other large increases were asfollows:  approximately $828,000 due toincreased headcount-related expenses as we ramp up to begin commercialproduction activities, approximately $403,000 increase in facility costsrelated to our larger facility, approximately $403,000 in higher expensematerial costs related to tooling and other costs of developing new suppliers,approximately $344,000 stock compensation expense primarily related to new hireoption grants and other miscellaneous increases of approximately $116,000.  Increases were offset by reductions in hiringcosts of approximately $31,000 due to a reduction in the use of outsideagencies and a reduction in the use of consultants by approximately $188,000.

 

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*Loss on Contract Commitments*

 

Our contracts have been primarily for thedevelopment of demonstration units of new products and the design of afrequency regulation plant. As such, the work has supported our core researchand development efforts.  Most of thesecontracts have been structured on a cost-share basis, for which the expectedcost-share has been recorded as a contract loss.  We recorded contract commitment losses on ourresearch and development contracts in 2005 and 2006, which we reduced in 2007as we completed all but one contract for amounts which were less thanpreviously estimated.  During the secondquarter of 2008, we recorded an additional contract loss for the requiredcost-share portion of the Tehachapi contract which was awarded in April 2008.No other loss reserve adjustments were considered necessary during the quarterended September 30, 2008.

 

*Depreciation and Amortization*

 

Depreciationexpense increased from approximately $43,000 during the quarter ended September 30,2007 to approximately $334,000 for the same period in 2008, an increase ofapproximately $291,000, or 677%. Similarly, for the nine month periods ended September 30, 2008 and2007, depreciation increased by approximately $828,000, or 836%.  For both the three and nine month periods,the increases are primarily due to capital expenditures relating to leaseholdimprovements at our new manufacturing and office facility in Tyngsboro as wellas the purchase of machinery and equipment required to begin commercialproduction.  As of September 30,2008, we had approximately $8.5 million in “construction in progress”, of whichapproximately $3.0 million are materials to build flywheels and approximately$5.0 million are costs related to the construction of frequency regulationfacilities.  We expect depreciationexpense to continue to increase during 2008 as we build and place our frequencyregulation facilities into commercial operation.

 

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

 

Averagecash balances during the third quarter of 2008 were lower than during the sameperiods in 2007, as were interest rates, resulting in a reduction of interestincome of approximately $76,000, or 58%, due to lower interest rates, over theequivalent period last year. For the nine months period ended September 30,2008, interest and other income (expense) was approximately $311,000, as comparedto approximately $388,000 for the same period in 2007.  This represents a reduction of approximately$77,000 or 20% over the prior year.

 

*Net Loss*

 

Asa result of the changes discussed above, the net loss for the three monthsended September 30, 2008 was approximately $5,621,000 which compares to anet loss during the same period in 2007 of approximately $2,814,000, anincrease in net loss of approximately $2,807,000 or 100%.  For the nine month period ended September 30,2008 and 2007, the net losses were approximately $16,340,000 and $8,970,000respectively, which represents an increase in net loss of approximately$7,370,000 or 82%.

 

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**Liquidity and Capital Resources**

 
| ** **                                | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| ** **                                | ** ** | **(in thousands)**                                 | ** ** |
| Cash and cash equivalents                 |       | $                                                       | 10,578     |   | $ | 14,194 |   |
| Working capital                           |       | 6,463                                                   |       | 12,749 |   |
| Cash provided by (used in)                |       |                                                    |       |   |   |
| Operating activities                      |       | (9,949                                                  | )          | (7,916 | ) |
| Investing activities                      |       | (9,964                                                  | )          | (2,760 | ) |
| Financing activities                      |       | 74                                                      |       | 19,619 |   |
| Net decrease in cash and cash equivalents |       | $                                                       | (19,839    | ) | $ | 8,943 |   |
| Current ratio                             |       | 2.0                                                     |       | 4.7 |   |

 

 Our cashrequirements depend on many factors including, but not limited to, cost tobuild 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 begun our principal operations, we do notgenerate enough cash from operations to satisfy our working capitalrequirements.  We expect to makesignificant expenditures to fund our operations, develop technologies and exploreopportunities to find and develop additional markets to sell our products. Inprevious years, we took significant actions to reduce our cash expenditures forproduct development, infrastructure and production readiness by significantlyreducing headcount, development spending and capital expenditures.  However, as we begin commercial activityaimed at revenue generation late in the fourth quarter of 2008, we have begunto increase our headcount, and have spent additional funds on productionmaterials, capital equipment, market analyses and the pursuit of regulatoryrelief to modify market rules in a way that ensures our ability to entermarkets on a timely basis and profitably compete.  We expect to require significant cashresources during 2009 through 2011 and as we increase capacity to manufactureour Smart Energy 25 flywheels and build frequency regulation facilities.

 

Due to uncertainty and volatility in the equity markets,we are modifying our business plan to ensure sufficient cash reserves into thefirst quarter of 2009.  This will resultin a reduction in the number of megawatts we will deploy in New England ISO bythe end of 2008 to three megawatts (MW). We now expect a delay in deploying the additional two megawatts from thefourth quarter of 2008 to the first quarter of 2009.  In volume production, we expect a 20 MWfacility to cost approximately $25 million, while the first 20 MW plant willcost approximately twice that amount. In2009 our business plan is to deploy our first 20MW plant; however the number ofmegawatts we will be able to deploy is dependent on obtaining sufficientfunding for these capital outlays. We expect to fund the construction of ourfirst 20 MW plant from a combination of debt and equity. Our ability to obtainsufficient funding will pace our ability to produce flywheel systems and deploythem. In 2010 and 2011, we will continue to have capital needs that willrequire additional equity and debt to fund the ongoing deployment of frequencyregulation facilities.

 

We must raise additional equity and/or project financing to execute ourbusiness plan.  Based on our rate ofexpenditure of cash and the additional expenditures expected to support ourbusiness plan, we have sufficient cash to fund operations into the first quarterof 2009. We need to obtain additional cash during 2009 to 2011 to fund:

 

·                  Our continuation as a going concern

·                  The ramp up of our manufacturing and assemblycapacity

·                  The build-out of facilities to providefrequency regulation services to the electricity grid

·                  Regulatory matters

·                  Working capital requirements; and

·                  The identification and development of newbusiness opportunities.

 

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, we will need to raise funds througha combination of equity and debt during 2009. Also, to achieve our long-term deployment plan for additional frequencyregulation facilities, we will need additional sources of project finance andequity.

 

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**Operating Activities**

 

Netcash used in operating activities was approximately $9,949,000 and $7,916,000for the nine months ended September 30, 2008 and 2007, respectively. The primary component to the negative cash flow from operations is from netlosses.  For the nine months ending September 30, 2008, we had a netloss of approximately $16,340,000.  Adjustments to reconcile net loss tocash flow in 2008 include non-cash stock compensation of approximately$1,800,000, depreciation and amortization of approximately $927,000, a netreduction in deferred rent of approximately $112,000 and cash received from thelandlord to offset the cost of leasehold improvements of $1,430,000. Changes inoperating assets and liabilities provided approximately $2,122,000 of cash.

 

Duringthe same period in 2007, we had a net loss of approximately $8,970,000. Adjustments to reconcile net loss to cash flow include non-cash stockcompensation of approximately $1,451,000, depreciation and amortization ofapproximately $99,000, a net reduction in the asset impairment reserve ofapproximately $1,000 and changes in operating assets and liabilities ofapproximately $425,000 offset by deferred rent of approximately $611,000, again on the sale of fixed assets of approximately $1,000 and facility-relatedcash payments charged against restructuring reserves of approximately $310,000.

 

**Investing Activities**

 

Netcash used in investing activities was approximately $9,964,000 and $2,760,000for the nine months ending September 30, 2008 and 2007, respectively.  The principal use of cash in 2008 was thepurchase of property and equipment in the amount of approximately $10,138,000,primarily for the renovation of the Tyngsboro property, materials, labor andoverhead to build flywheels to be used in our frequency regulation facilities,and costs to begin construction of such facilities.  These charges were partially offset by areduction in restricted cash of approximately $174,000, related to theWilmington lease that expired in 2007. In 2007, the principal use of cash was the purchase of property andequipment in the amount of approximately $2,564,000, much of which related tothe renovation of the Tyngsboro facility and an increase in restricted cash ofapproximately $200,000 related to the Tyngsboro property lease.  These were partially offset by the sale ofproperty and equipment of approximately $4,000 in 2007.

 

**Financing Activities**

 

Netcash provided by financing activities was approximately $73,000 and $19,619,000for the first nine months of 2008 and 2007, respectively.  In 2008, funds were provided by issuance ofstock under our employee stock purchase plan of approximately $41,000, theexercise of employee stock options of approximately $15,000 and approximately$17,000 related to the reduction of costs previously accrued related to thesale of stock in 2007.  During the firstnine months of 2007, we raised approximately $18,849,000 from the sale of stockfrom our shelf registration, approximately $717,000 from the reduction in leasepayments in exchange for stock and warrants issued to the landlord,approximately $43,000 for the exercise of employee stock options andapproximately $10,000 from the issuance of stock under our employee stockpurchase plan.

 

Wemay evaluate possible acquisitions of enterprises or technologies that weconsider synergistic from a market, technology or product perspective. We maymake investments in companies for strategic business reasons or seek otherstrategic financing relationships that benefit our business.

 

Ourcommitments and contingencies at September 30, 2008 are as follows:

 
| ** **              | ** ** | **Description of Commitment** | ** ** |
|-------------------------|------------|-----------------------------------------|------------|
| ** **              | ** ** | **Operating leases**               | ** ** | **Purchase Obligations** | ** ** | **Total** | ** ** |
| Period ending:          |       |                                    |       |   |   |   |   |
| September 30, 2008 |       | $                                       | —     |   | $ | 11,148,235 |   | $ | 11,148,235 |   |
| December 31, 2008  |       | 173,813                                 |       |   |   | 173,813 |   |
| December 31, 2009  |       | 701,687                                 |       |   |   | 701,687 |   |
| December 31, 2010  |       | 727,437                                 |       |   |   | 727,437 |   |
| December 31, 2011  |       | 753,188                                 |       |   |   | 753,188 |   |
| December 31, 2012  |       | 778,937                                 |       |   |   | 778,937 |   |
| Thereafter              |       | 1,422,689                               |       |   |   | 1,422,689 |   |
| Total Commitments       |       | $                                       | 4,557,751  |   | $ | 11,148,235 |   | $ | 15,705,986 |   |

 

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**Item 3.  Quantitative and Qualitative DisclosureAbout Market Risk**

 

Our cash equivalents, which have maturities of less than three months,may expose our assets to interest rate risk.  At September 30, 2008,we had approximately $109,000 of cash equivalents that were held innon-interest bearing accounts.  Also at September 30, 2008, we hadapproximately $1,383,000 of cash equivalents that were held in interest-bearingchecking accounts, and approximately $9,285,000 invested in interest-bearingmoney market accounts at high-quality financial institutions, some of which areinvested in off-shore securities.  Thefair value of these investments approximates their cost. The funds invested inmoney market accounts may not be covered under FDIC Insurance, and thereforemay be some risk of loss, which we deem to be low.  The money market funds are invested primarilyin government funds, such as Treasury Bills.

 

**Item 4.  Controls and Procedures**

 

*Evaluation of Disclosure Controls and Procedures*

* *

As of the end of the period covered by this report, we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures.  Based on the evaluation,both the Chief Executive Officer and the Chief Financial Officer concluded thatour disclosure controls and procedures, as defined in Rules 13a — 15(e) and15d — 15(e) promulgated under the Securities Exchange Act of 1934, wereeffective on September 30, 2008.

 

*Management’s Report on Internal Control over Financial Reporting*

* *

Our Management is responsible for establishing adequate internalcontrol over financial reporting, as that term is defined in Exchange Act rules 13a-15(f) and15d-15(f).  Under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, we conducted an evaluation of the effectiveness ofour internal control over financial reporting as of September 30, 2008based on the framework in internal control — Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO).  Based on that evaluation, our managementconcluded that our internal control over financial reporting was effective asof September 30, 2008, and that there was no change in our internalcontrol over financial reporting that materially affected, or is reasonablylikely to materially affect, such internal control during the quarter ended onthat date.

 

Management’s assessment of the effectiveness of our internal controlover financial reporting as of December 31, 2007 has been audited byMiller Wachman LLP, an independent registered public accounting firm, as statedin their report which is included in our Annual Report on Form 10-K whichwas filed with the SEC on March 17, 2008.

 

**Part II— OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

OnOctober 9, 2007, Arete Power, Inc. filed a complaint against usclaiming damages from alleged willful infringement of U.S. Patent No. 6,710,489,entitled “Axially Free Flywheel System.”  On November 30, 2007, wefiled an Answer denying infringement and a Counterclaim seeking a declaratoryjudgment that the ‘489 patent is invalid. (Beacon’s counterclaim has since been amended to assert claims that the ‘489patent should be declared unenforceable and not infringed by Beacon’s products). At the same time, we filed a motion to transfer the lawsuit from the NorthernDistrict of California to the District of Massachusetts.  On February 22,2008, the Court granted our motion to transfer the lawsuit to the District ofMassachusetts.  The Initial Scheduling Conference was held in the DistrictCourt of Massachusetts on September 15, 2008.  Following this Scheduling Conference, theCourt issued a Scheduling Order requiring non-expert discovery to be completedby May 15, 2009 and scheduling a Final Pretrial Conference for September 8,2009.  We believe that this lawsuit iswithout merit and we plan to vigorously defend the Company against the lawsuit.

 

**Item 1A.  Risk Factors**

 

Except as noted below, there have not been any material changes duringthe quarter ended September 30, 2008 to the risk factors set forth in Part I,Item 1A of our Annual Report on Form 10-K for the year ended December 31,2007 and filed with the SEC on March 17, 2008.

 

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***Reductions in energy prices mayhave a material impact on the pricing of frequency regulation services andtherefore the profitability of our flywheel systems.***

*** ***

The market pricingfor frequency regulation services tends to follow the pricing for energy, henceif the price of energy drops, frequency regulation prices could be adverselyaffected. Recent adverse developments in the U.S. and global financial marketsand the resulting impact of those developments on the U.S. economy could resultin a general reduction in economic activity and energy use in the United Statesfor an indeterminate period of time. Prolonged reduction in energy use couldlead to corresponding decreases in prices paid for frequency regulation. Suchreductions in prices paid for regulation could have a materially adverse impacton our profitability.

 

***Our ability to build plants onschedule and within budgeted cost estimates is dependent on our ability toidentify, purchase and develop appropriate sites on which to build our plants.Failure to develop such sites in a timely and cost-effective manner couldmaterially impact our profitability and business.***

*** ***

The activities required to identify, purchase and develop sites arecomplex and include, but are not limited to, completing engineering studies andISO System Impact Studies, and applying for and obtaining environmentalpermits, building permits, occupancy permits, landlord approvals and other local,state and federal regulatory approvals. We have limited experience in thesetasks. Should we fail to execute any of the tasks needed to develop appropriateplant sites in a timely and cost-effective manner, it could materially impactthe pace of revenue creation and profitability.

 

**Item 2.  Unregistered Sales ofEquity Securities and Use of Proceeds**

 

None.

 

**Item 3.  Defaults Upon SeniorSecurities**

 

None.

 

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

 

OnAugust 7, 2008, we held our annual meeting of shareholders.  At thismeeting, stockholders voted on two matters:  (1) to elect directorsfor a term of one year and (2) to ratify the selection of Miller WachmanLLP as the Corporation’s independent auditors for 2008.  The result of thevotes was as follows:

 

**Matter voted upon:**

 
| ** **                                          | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** | ** ** | ** ** |
|-----------------------------------------------------|------------|--------------------|------------|-------------------------|------------|------------|------------|
| 1. Election of Directors for a  one-year term: | ** ** | ** **         | ** ** | ** **              | ** ** | ** ** | ** ** |
|                                                |       |               |       |                    |       |       |       |
| F. William Capp                                     |       | 69,395,222         |       | 1,426,069               |       |       |       |
| Stephen P. Adik                                     |       | 69,524,768         |       | 1,296,523               |       |       |       |
| Daniel E. Kletter                                   |       | 69,439,273         |       | 1,382,018               |       |       |       |
| Virgil G. Rose                                      |       | 69,428,675         |       | 1,392,616               |       |       |       |
| Jack P. Smith                                       |       | 69,533,666         |       | 1,287,625               |       |       |       |
| Edward A. Weihman                                   |       | 69,458,713         |       | 1,362,578               |       |       |       |

 
| ** **                                                                                                            | ** ** | **Votes For:** | ** ** | **Votes Against** | ** ** | **Votes Withheld** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|-------------------------|------------|
| 2. Ratification of the selection of Miller Wachman LLP as the  Corporation’s independent auditors for 2008. |       | 70,121,956          |       | 261,640                |       | 437,695                 |       |

 

Thetotal shares outstanding and eligible to vote as of the record date of June 16,2008, were 88,305,731 shares.  Proxies representing 70,821,291 shares or80.2 percent of the eligible voting shares were received and tabulated.

 

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**Item 5.  Other Information**

 

None.

 

**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         |       | (5)        |       | 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        |       | (4)        |       | Promissory  Note dated June 30, 2008 issued by Beacon Power Corporation to  Massachusetts Development Finance Agency.                                        |
|        |       |       |       |                                                                                                                                                              |
| 10.2        |       | (4)        |       | Security  Agreement dated June 30, 2008 between Beacon Power Corporation and  Massachusetts Development Finance Agency.                                      |
|        |       |       |       |                                                                                                                                                              |
| 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.                                     |
|        |       |       |       |                                                                                                                                                              |
| 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 on March 17, 2008 (File  No. 000-31973).   |
|---------|---------------------------------------------------------------------------------------------------------------|
|    |                                                                                                          |
| (2)     | Incorporated  by reference from the Form 10-K filed on March 30, 2006 (File  No. 000-31973).   |
|    |                                                                                                          |
| (3)     | Incorporated  by reference from the Form S-3 filed on December 8, 2005 (File  No. 333-130207). |
|    |                                                                                                          |
| (4)     | Incorporated  by reference from the Form 8-K filed on July 7, 2008 (File  No. 000-31973).      |
|    |                                                                                                          |
| (5)     | Incorporated  by reference from the Form 8-K filed on October 1, 1007 (File  No. 000-31973).   |
|    |                                                                                                          |
|  + | Filed  herewith.                                                                                              |

 

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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:   | November 10,  2008                              | By: | /s/  F. William Capp |
|              |                                                 | F.  William Capp |
|              |                                                 | President  and Chief Executive Officer |
|              |                                                 | Principal  Executive  Officer |
|              |                                                 |   |
|              | November 10,  2008                              | By: | /s/  James M. Spiezio |
|              | James  M. Spiezio                                    |
|              | Vice  President of Finance, Chief Financial Officer, |
|              | Treasurer  and Secretary                             |
|              | Principal  Financial Officer                         |

 

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