**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) of the Securities Exchange  Act of 1934 for the quarterly period ended June 30, 2009** |
|-------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**or**

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

 

**Commission File Number: 000-31973**

 

**Beacon Power Corporation**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                              | ** ** | **04-3372365**       |
|-------------------------------------------|------------|----------------------|
| (State or other  jurisdiction of          |       | (I.R.S. Employer     |
| incorporation or  organization)           |       | Identification  No.) |
|                                      |       |                 |
| **65  Middlesex Road**                    |       |                 |
| **Tyngsboro,  Massachusetts**             | ** ** | **01879**            |
| (Address of  principal executive offices) |       | (Zip code)           |

 

**(978) 694-9121**

(Registrant’s telephone number, including area code)

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onit corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or such shorter period that theregistrant was required to submit and post such files).  Yes o No o

 

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

 

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

 

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

 

Thenumber of shares of the Registrant’s common stock, par value $.01 per share,outstanding as of August 4, 2009 was 120,738,553.

 

 

 

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**BEACON POWER CORPORATION ANDSUBSIDIARIES (A Development Stage Company)Table of Contents**

 
| ** **                          | **Page** |
|-------------------------------------|----------|
| PART I.  Financial Information |     |
|                                |     |
|                                | Item 1.  | Financial Statements |   |
|                                |     |   |   |
|                                |     | Consolidated  Balance Sheets at June 30, 2009 and December 31, 2008. | 1 |
|                                |     |   |   |
|                                |     | Unaudited Consolidated Statements of Operations for  the three and six months ended June 30, 2009 and 2008, and for the  period from May 8, 1997 (date of inception) through June 30, 2009. | 2 |
|                                |     |   |   |
|                                |     | Unaudited Consolidated Statements of Cash Flows for  the three and six months ended June 30, 2009 and 2008 and for the period  from May 8, 1997 (date of inception) through June 30, 2009. | 3 |
|                                |     |   |   |
|                                |     | Notes to Unaudited Consolidated Financial Statements. | 5 |
|                                |     |   |   |
|                                | Item 2.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations. | 20 |
|                                |     |   |   |
|                                | Item 3.  | Quantitative  and Qualitative Disclosures about Market Risk. | 40 |
|                                |     |   |   |
|                                | Item 4.  | Controls and  Procedures. | 41 |
|                                |     |   |   |
| PART II.  Other Information    |     |
|                                |     |   |   |
|                                | Item 1.  | Legal Proceedings. | 41 |
|                                |     |   |   |
|                                | Item 1A. | Risk Factors. | 41 |
|                                |     |   |   |
|                                | Item 2.  | Unregistered  Sales of Equity Securities and Use of Proceeds. | 42 |
|                                |     |   |   |
|                                | Item 3.  | Defaults  Upon Senior Securities. | 42 |
|                                |     |   |   |
|                                | Item 4.  | Submission  of Matters to a Vote of Security Holders. | 42 |
|                                |     |   |   |
|                                | Item 5.  | Other Information. | 43 |
|                                |     |   |   |
|                                | Item 6.  | Exhibits. | 43 |
|                                |     |   |   |
| Signatures                          | 45       |

 

ii

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**PART 1 — FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

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

**Consolidated Balance Sheets**

 
| ** **                                                                                                                                                               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                               | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| ** **                                                                                                                                                               | ** ** | **(unaudited)**   | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                               |       |              |       |                  |       |
| Current  assets:                                                                                                                                                         |       |              |       |                  |       |
| Cash  and cash equivalents                                                                                                                                               |       | $                 | 3,195,891  |                  | $          | 14,357,475 |   |
| Accounts  receivable, net                                                                                                                                                |       | 62,998            |       | 11,840                |       |
| Unbilled  costs on contracts in progress                                                                                                                                 |       | 239,567           |       | 16,804                |       |
| Prepaid  expenses and other current assets                                                                                                                               |       | 456,799           |       | 880,729               |       |
| Total  current assets                                                                                                                                                    |       | 3,955,255         |       | 15,266,848            |       |
| Property  and equipment, net                                                                                                                                             |       | 24,118,594        |       | 23,027,909            |       |
| Restricted  cash                                                                                                                                                         |       | 205,048           |       | 205,020               |       |
| Deferred  financing costs and other assets                                                                                                                               |       | 1,522,610         |       | 96,033                |       |
| Total  assets                                                                                                                                                            |       | $                 | 29,801,507 |                  | $          | 38,595,810 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                            |       |              |       |                  |       |
| Current  liabilities:                                                                                                                                                    |       |              |       |                  |       |
| Accounts  payable                                                                                                                                                        |       | $                 | 1,565,416  |                  | $          | 3,825,520 |   |
| Accrued  compensation and benefits                                                                                                                                       |       | 1,208,765         |       | 1,410,038             |       |
| Other  accrued expenses                                                                                                                                                  |       | 1,702,113         |       | 3,253,407             |       |
| Advance  billings on contracts                                                                                                                                           |       | 24,623            |       | 10,811                |       |
| Accrued  contract loss                                                                                                                                                   |       | 229,623           |       | 132,526               |       |
| Deferred  rent - current                                                                                                                                                 |       | 125,683           |       | 112,808               |       |
| Current  portion of long term debt                                                                                                                                       |       | 330,832           |       | 117,023               |       |
| Total  current liabilities                                                                                                                                               |       | 5,187,055         |       | 8,862,133             |       |
| Long  term liabilities:                                                                                                                                                  |       |              |       |                  |       |
| Deferred  rent - long term                                                                                                                                               |       | 819,016           |       | 885,076               |       |
| Long  term debt, net of unamortized discount                                                                                                                             |       | 3,051,781         |       | 3,237,061             |       |
| Total  long term liabilities                                                                                                                                             |       | 3,870,797         |       | 4,122,137             |       |
| Commitments  and contingencies (Note 6)                                                                                                                                  |       |              |       |                  |       |
| Stockholders’  equity:                                                                                                                                              |       |              |       |                  |       |
| Preferred  Stock, $.01 par value; 10,000,000 shares authorized; no shares issued or  outstanding                                                                         |       | —            |       | —                |       |
| Common  stock, $.01 par value; 400,000,000 shares authorized; 118,160,245 and  107,433,190 shares issued at June 30, 2009 and December 31, 2008,  respectively |       | 1,181,602         |       | 1,074,332             |       |
| Additional  paid-in-capital                                                                                                                                              |       | 217,476,726       |       | 212,145,254           |       |
| Deficit  accumulated during the development stage                                                                                                                        |       | (197,201,834      | )          | (186,895,207          | )          |
| Treasury  stock, 421,692 shares at cost                                                                                                                                  |       | (712,839          | )          | (712,839              | )          |
| Total  stockholders’ equity                                                                                                                                         |       | 20,743,655        |       | 25,611,540            |       |
| Total  liabilities and stockholders’ equity                                                                                                                         |       | $                 | 29,801,507 |                  | $          | 38,595,810 |   |

 

See notes tounaudited consolidated financial statements.

 

1

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**BEACONPOWER CORPORATION AND SUBSIDIARIES**

**(A Development Stage Company)Consolidated Statements of Operations (Unaudited)**

 
| ** **                                  | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** **                 | ** ** | ** **  | ** **  | **Cumulative  from**     | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|----------------------------|------------|-------------|-------------|--------------------------|------------|
| ** **                                  | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** **                 | ** ** | ** **  | ** **  | **May 8,  1997**    | ** ** |
| ** **                                  | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** **                 | ** ** | ** **  | ** **  | **(date  of inception)** | ** ** |
| ** **                                  | ** ** | **Three months ended June 30,** | ** ** | **Six  months ended June 30,** | ** ** | **through  June 30,** | ** ** |
| ** **                                  | ** ** | **2009**                             | ** ** | **2008**                            | ** ** | **2009**                   | ** ** | **2008**    | ** **  | **2009**                 | ** ** |
| Revenue                                     |       | $                                    | 281,705    |                                | $          | 28,188                     |       | $           | 392,641     |                     | $          | 48,392 |   | $ | 5,181,319 |   |
| Cost  of goods sold                         |       | 285,643                              |       | 4,116                               |       | 457,677                    |       | 4,172       |        | 5,636,941                |       |
| Gross  profit                               |       | (3,938                               | )          | 24,072                              |       | (65,036                    | )          | 44,220      |        | (455,622                 | )          |
| Operating  expenses:                        |       |                                 |       |                                |       |                       |       |        |        |                     |       |
| Operations  and maintenance                 |       | 768,957                              |       | —                              |       | 1,546,093                  |       | —      |        | 1,546,093                |       |
| Research  and development                   |       | 1,485,649                            |       | 3,003,236                           |       | 3,676,703                  |       | 6,035,579   |        | 87,493,565               |       |
| Selling,  general and administrative        |       | 1,995,349                            |       | 2,128,580                           |       | 3,892,811                  |       | 4,304,241   |        | 61,941,417               |       |
| Loss  on contract commitments               |       | —                               |       | 86,601                              |       | 132,500                    |       | 86,601      |        | 2,936,562                |       |
| Depreciation  and amortization              |       | 442,530                              |       | 313,477                             |       | 866,418                    |       | 593,218     |        | 6,622,040                |       |
| Restructuring  charges                      |       | —                               |       | —                              |       | —                     |       | —      |        | 2,159,280                |       |
| Loss  on impairment of assets               |       | —                               |       | —                              |       | —                     |       | —      |        | 4,663,916                |       |
| Total  operating expenses                   |       | 4,692,485                            |       | 5,531,894                           |       | 10,114,525                 |       | 11,019,639  |        | 167,362,873              |       |
| Loss  from operations                       |       | (4,696,423                           | )          | (5,507,822                          | )          | (10,179,561                | )          | (10,975,419 | )           | (167,818,495             | )          |
| Other  income (expense):                    |       |                                 |       |                                |       |                       |       |        |        |                     |       |
| Interest  income                            |       | 1,736                                |       | 75,985                              |       | 12,256                     |       | 256,378     |        | 5,587,743                |       |
| Interest  expense                           |       | (75,712                              | )          | —                              |       | (143,013                   | )          | —      |        | (1,308,168               | )          |
| Gain  on sale of investment                 |       | —                               |       | —                              |       | —                     |       | —      |        | 3,562,582                |       |
| Other  income (expense)                     |       | 3,691                                |       | —                              |       | 3,691                      |       | (132        | )           | (219,302                 | )          |
| Total  other income (expense), net          |       | (70,285                              | )          | 75,985                              |       | (127,066                   | )          | 256,246     |        | 7,622,855                |       |
| Net  loss                                   |       | (4,766,708                           | )          | (5,431,837                          | )          | (10,306,627                | )          | (10,719,173 | )           | (160,195,640             | )          |
| Preferred  stock dividends                  |       | —                               |       | —                              |       | —                     |       | —      |        | (36,825,680              | )          |
| Accretion  of convertible preferred stock   |       | —                               |       | —                              |       | —                     |       | —      |        | (113,014                 | )          |
| Loss  to common shareholders                |       | $                                    | (4,766,708 | )                                   | $          | (5,431,837                 | )          | $           | (10,306,627 | )                        | $          | (10,719,173 | ) | $ | (197,134,334 | ) |
| Loss  per share, basic and diluted          |       | $                                    | (0.04      | )                                   | $          | (0.06                      | )          | $           | (0.09       | )                        | $          | (0.12 | ) |   |   |
| Weighted-average  common shares outstanding |       | 115,486,517                          |       | 88,712,016                          |       | 112,262,766                |       | 88,690,200  |        |                     |       |

 

See notes tounaudited consolidated financial statements.

 

2

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**BEACON POWER CORPORATION ANDSUBSIDIARIES (A Development Stage Company)Consolidated Statements of Cash Flows (Unaudited)**

 
| ** **                                                                   | ** ** | ** **                         | ** **  | ** **        | ** ** | **Cumulative from**     | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------|-------------|-------------------|------------|-------------------------|------------|
| ** **                                                                   | ** ** | ** **                         | ** **  | ** **        | ** ** | **May 8, 1997**    | ** ** |
| ** **                                                                   | ** ** | ** **                         | ** **  | ** **        | ** ** | **(date of inception)** | ** ** |
| ** **                                                                   | ** ** | ** **                         | ** **  | ** **        | ** ** | **through**             | ** ** |
| ** **                                                                   | ** ** | **Six months ended June 30,** | ** **  | **June 30,** | ** ** |
| ** **                                                                   | ** ** | **2009**                           | ** **  | **2008**          | ** ** | **2009**                | ** ** |
| Cash  flows from operating activities:                                       |       |                               |        |              |       |                    |       |
| Net  loss                                                                    |       | $                                  | (10,306,627 | )                 | $          | (10,719,173             | )          | $ | (160,195,640 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                               |        |              |       |                    |       |
| Depreciation  and amortization                                               |       | 866,418                            |        | 593,218           |       | 6,622,042               |       |
| Loss  (gain) on sale of fixed assets                                         |       | 347                                |        | 132               |       | 193,425                 |       |
| Impairment  of assets, net                                                   |       | —                             |        | —            |       | 4,551,147               |       |
| Interest  expense relating to issuance of warrants                           |       | 28,529                             |        | —            |       | 409,568                 |       |
| Non-cash  charge for change in option terms                                  |       | —                             |        | —            |       | 346,591                 |       |
| Non-cash  charge for settlement of lawsuit                                   |       | —                             |        | —            |       | 821,160                 |       |
| Amortization  of deferred consulting expense, net                            |       | —                             |        | —            |       | 1,160,784               |       |
| Amortization  of deferred stock compensation                                 |       | —                             |        | —            |       | 3,699,721               |       |
| Options  and warrants issued for consulting services                         |       | —                             |        | —            |       | 1,585,654               |       |
| Services  and interest expense paid in preferred stock                       |       | —                             |        | —            |       | 11,485                  |       |
| Gain  on sale of investments                                                 |       | —                             |        | —            |       | (3,562,582              | )          |
| Stock-based  compensation                                                    |       | 564,723                            |        | 1,319,563         |       | 4,532,091               |       |
| Deferred  rent                                                               |       | (53,185                            | )           | 131,942           |       | (485,302                | )          |
| Cash  received from landlord for build-out credit                            |       | —                             |        | 1,430,000         |       | 1,430,000               |       |
| Changes  in operating assets and liabilities:                                |       |                               |        |              |       |                    |       |
| Accounts  receivable                                                         |       | (51,158                            | )           | 263,433           |       | (62,998                 | )          |
| Unbilled  costs on government contracts                                      |       | (222,763                           | )           | 68,400            |       | (239,567                | )          |
| Prepaid  expenses and other current assets                                   |       | 423,930                            |        | (1,336,959        | )          | (652,493                | )          |
| Accounts  payable                                                            |       | (2,260,104                         | )           | 427,786           |       | 1,565,416               |       |
| Accrued  compensation and benefits                                           |       | (201,273                           | )           | 8,948             |       | 1,208,765               |       |
| Advance  billings on contracts                                               |       | 13,812                             |        | 1,289             |       | 24,623                  |       |
| Accrued  interest                                                            |       | —                             |        | —            |       | 275,560                 |       |
| Accrued  loss on contract commitments                                        |       | 97,097                             |        | 78,577            |       | 229,623                 |       |
| Other  accrued expenses and current liabilities                              |       | (1,551,294                         | )           | 14,653            |       | 1,710,783               |       |
| Net  cash used in operating activities                                       |       | (12,651,548                        | )           | (7,718,191        | )          | (134,820,144            | )          |
| Cash  flows from investing activities:                                       |       |                               |        |              |       |                    |       |
| Purchase  of investments                                                     |       | —                             |        | —            |       | (1,190,352              | )          |
| Sale  of investments                                                         |       | —                             |        | —            |       | 4,752,934               |       |
| Restricted  cash                                                             |       | (28                                | )           | 174,346           |       | (205,048                | )          |
| Increase  in other assets                                                    |       | —                             |        | —            |       | (412,072                | )          |
| Purchases  and manufacture of property and equipment                         |       | (1,951,154                         | )           | (6,261,987        | )          | (34,812,755             | )          |
| Sale  of property and equipment                                              |       | —                             |        | —            |       | 202,674                 |       |
|                                                                         |       |                               |        |              |       |                    |       |
| Net  cash used in investing activities                                       |       | (1,951,182                         | )           | (6,087,641        | )          | (31,664,619             | )          |
| Cash  flows from financing activities:                                       |       |                               |        |              |       |                    |       |
| Initial  public stock offering, net of expenses                              |       | —                             |        | —            |       | 49,341,537              |       |
| Stock  offerings, net of expenses                                            |       | 4,813,757                          |        | 17,204            |       | 75,736,425              |       |
|                                                                              |            |                                    |             |                   |            |                         |            |  |  |  |

 

3

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| ** **                                         | ** ** | ** **                         | ** ** | ** **        | ** ** | **Cumulative from**     | ** ** |
|----------------------------------------------------|------------|------------------------------------|------------|-------------------|------------|-------------------------|------------|
| ** **                                         | ** ** | ** **                         | ** ** | ** **        | ** ** | **May 8, 1997**    | ** ** |
| ** **                                         | ** ** | ** **                         | ** ** | ** **        | ** ** | **(date of inception)** | ** ** |
| ** **                                         | ** ** | ** **                         | ** ** | ** **        | ** ** | **through**             | ** ** |
| ** **                                         | ** ** | **Six months ended June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                         | ** ** | **2009**                           | ** ** | **2008**          | ** ** | **2009**                | ** ** |
| Payment  of dividends                              |       | —                             |       | —            |       | (1,159,373              | )          |
| Shares  issued under employee stock purchase plan  |       | 60,262                             |       | 41,197            |       | 336,083                 |       |
| Exercise  of employee stock options                |       | —                             |       | 15,182            |       | 2,304,091               |       |
| Issuance  of debt                                  |       | —                             |       | —            |       | 3,571,993               |       |
| Warrants  issued in relation to lease              |       | —                             |       | —            |       | 716,614                 |       |
| Cash  paid for financing costs and other assets    |       | (1,432,873                         | )          | —            |       | (1,436,021              | )          |
| 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 financing activities         |       | 3,441,146                          |       | 73,583            |       | 169,680,654             |       |
| (Decrease)  increase in cash and cash equivalents  |       | (11,161,584                        | )          | (13,732,249       | )          | 3,195,891               |       |
| Cash  and cash equivalents, beginning of period    |       | 14,357,475                         |       | 30,417,095        |       | —                  |       |
| Cash  and cash equivalents, end of period          |       | $                                  | 3,195,891  |              | $          | 16,684,846              |       | $ | 3,195,891 |   |
| Supplemental  disclosure of cash flow information: |       |                               |       |              |       |                    |       |
| Cash  paid for interest                            |       | $                                  | 116,735    |              | $          | —                  |       | $ | 664,155 |   |
| 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 financial statements.

 

4

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

**Notes to Unaudited ConsolidatedFinancial Statements**

 

**Note1.  Nature of Business and Operations**

 

*Natureof Business*

 

Beacon PowerCorporation (the “Company”, “Beacon”, “we”, “our”, or “us”) (a developmentstage company) was incorporated on May 8, 1997.  Since our inception,we have been primarily engaged in the development of flywheel devices forstoring and transmitting kinetic energy.  We have experienced net lossessince our inception and, as of June 30, 2009, had an accumulated deficitof approximately $197.2 million.  We aregenerating some revenues from the provision of frequency regulation services tothe grid. We expect increased revenues in the future from the continued deploymentand commercialization of our flywheel energy storage systems. Because wehave not yet generated a significant amount of revenue from our principaloperations, we are accounted for as a development stage company under theFinancial Accounting Standards Board’s Statement of Financial AccountingStandards (SFAS) No. 7.

 

In February 2009,we entered into a Stock Purchase Agreement with an investor, Seaside 88, LP, (“Seaside”),which was amended (the “First Amendment”) on June 19, 2009. Under theterms of the original agreement, Seaside would have invested one milliondollars on a monthly basis for at least 6 months, and up to 18 months, throughthe purchase of our common stock at a discount of 20% from the 5-day volumeweighted average price. Under the First Amendment, Seaside will buy 1,500,000shares of our stock twice per month at discount of 14% from the 10-day volumeweighted average price, up to an aggregate purchase price of $18,000,000.  (See Note 8 for additional information.)During 2000, we completed an initial public offering of our common stock andraised approximately raised approximately $49.3 million, net of offeringexpenses.  Since 2000, we have raisedapproximately $78.6 million, net of expenses, through the sale of common stockand warrants, including the sale of stock to Seaside during February through August 5,2009.

 

*Operations*

 

Our focus is todesign, manufacture and market flywheel-based energy storage systems thatprovide frequency regulation and other highly reliable energy solutions for theworldwide electricity grid at competitive costs. We also plan to sellindividual and large-scale systems outright or on a fractional basis. As weexpand our flywheel production and continue to lower system costs, we believewe will be able to market other cost-effective applications for our flywheelsystems that will further expand our revenues.

 

Our principalmarket focus is on the geographic regions of the domestic grid that provideopen bid markets for regulation services. These regions and their IndependentSystem Operator (ISO) or Regional Transmission Operator (RTO) designations are:New England (ISO New England or ISO-NE); California (California ISO or CAISO);New York (New York ISO or NYISO); Mid-Atlantic (PJM Interconnection); MidwestISO (MISO) and Texas (ERCOT). Because ERCOT is not regulated by the FederalEnergy Regulatory Commission (FERC), we are not able to encourage beneficialmarket rule changes there by leveraging FERC Order No. 890. ThisOrder was intended to promote greater competition in electricity markets, inpart by allowing non-generation resources (i.e., generators other than fossilfuel-based or hydroelectric) to bid and sell into frequency regulation marketsand be compensated on equal terms with traditional generation resources. As aresult, we are focusing on the FERC-regulated open bid markets first and willbegin to work on entry into ERCOT once we are operating in the other markets.

 

To execute ourbusiness plan and continue as a going concern will require substantialadditional outlays of capital from equity and/or project financing to buildregulation facilities and support operations at our Tyngsboro and otherfacilities. Until the U.S. Department of Energy (DOE) loan is closed anddisbursements begin, we will not make substantial expenditures for constructionof the Stephentown facility.  Apart fromsuch expenditures, we will have sufficient cash to fund operations into 2010based on continuing funding from Seaside. We expect to complete the 20 MW facility in Stephentown, New York,within 12 to 18 months from the date we obtain the first disbursement of fundsavailable from the loan guaranteed by the DOE. The loan, which would be funded by the U.S. Treasury’s Federal FinancingBank, is expected to provide debt financing for 62.5%, or $43 million, of theestimated $69 million total project cost. Approximately $50 million of thistotal cost is direct equipment and facility costs.  The remainder includes substantialcontingency, legal, due diligence, consulting and administrative costs.  Some of these costs are either unique to theDOE loan guarantee process, or are greater than we expect to apply tosubsequent similar facilities.  Of the$26 million not financed by the loan, we have already incurred approximately$13 million in eligible project expenditures which will be considered part ofour equity contribution to the project. A significant portion of this in-kind contribution will come from theredeployment of up to 4 MW of energy storage from Tyngsboro to the Stephentownsite. We are exploring funding alternatives for the remaining $13 million,including a direct equity investment by one or more third parties in the NewYork regulation plant and/or the sale of our common stock.

 

We do not expectto become profitable or have positive cash flow until at least 2012. Through August5, 2009, we have raised approximately $7.7 million of net proceeds from thesale of stock to Seaside. We have elected to exercise our option to extend theSeaside stock purchase agreement for six additional semi-monthly closing datesover a period scheduled to end with the October 5, 2009 closing date. Wealso have an option to extend the agreement, at our sole discretion, for anadditional period covering six further semi-monthly closings scheduled tocommence on October 20, 2009.  Ourbusiness plan for 2009 includes legal and other costs required to finalize theloan guaranteed by the DOE, begin site work at our Stephentown, NY facility aswell as begin procurement of 

 

5

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materials andmanufacturing of flywheels for that site. Our business plan for 2010 includes the construction of the Stephentown20 MW facility, installation of most of the flywheel systems and the start ofwork on a second 20 MW facility. In order to execute our business plans for2009 and 2010, in addition to the $43 million from the DOE loan, we willrequire funding as follows:

 

·        $15 million to complete duediligence and close the loan guaranteed by the DOE

·        $25 million to fund on-goingoperations for the remainder of 2009 and all of 2010, of which we expect toreceive an additional approximately $10 million from our existing agreementwith Seaside.

 

The timing of thedisbursement of the DOE loan is directly affected by the timing of theexecution of an interconnection agreement with NYISO; hence the ramp up of cashburn will be affected by the same timing. We will require additional fundsfrom a combination of equity and project finance for the deployment ofadditional 20 MW facilities in the future.

 

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

 

**Basis ofPresentation**

 

The accompanyingunaudited consolidated financial statements have been prepared using accountingprinciples generally accepted in the United States of America except thatcertain information and footnote disclosures normally included in consolidatedfinancial statements prepared in accordance with generally accepted accountingprinciples have been condensed or omitted in this Form 10-Q.  Wesuggest that the consolidated financial statements presented herein be read inconjunction with our consolidated financial statements and notes theretoincluded in our Annual Report on Form 10-K for the year ended December 31,2008.  In our management’s opinion, all adjustments consisting of normalrecurring accruals considered necessary for a fair presentation have beenincluded in the accompanying unaudited financial statements.  Operatingresults for the six months ended June 30, 2009 are not necessarilyindicative of the results that may be expected for the full year ending December 31,2009.

 

*GoingConcern*

 

The accompanyingconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business.  As shown in ourconsolidated financial statements, since our inception, we have had minimalrevenues and incurred losses of approximately $197.2 million, including lossesof approximately $10.3 million during the six months ending June 30, 2009.We had approximately $3.2 million of cash and cash equivalents on hand at June 30,2009, and have raised an additional $2.8 million in cash subsequent to the endof the quarter through the sale of stock to Seaside through August 5, 2009.  Under an existing debt facility with MassDevelopment, we also have remaining approximately $1.4 million that can bedrawn down for qualified capital equipment purchases made by October 2009for our Tyngsboro, Massachusetts facility. As of June 30, 2009, we have made expenditures that may qualify fora drawdown of approximately $443,000 under the loan program. Since ouroperating cash requirements far exceed any cash generated from operations, wemay be unable to continue as a going concern.  The consolidated financialstatements contained herein do not include any adjustments relating to therecoverability and classification of liabilities that might be necessary shouldwe be unable to continue as a going concern.

 

Werecognize that our continuation as a going concern is dependent upon ourability to generate sufficient cash flow to allow us to satisfy our obligationson a timely basis.  The generation ofsufficient cash flow is dependent in the short term on our ability to obtainadditional equity and debt financing, and in the long term, on the successfulcommercialization of our Smart Energy MatrixTM. We believe that the achievementof these initiatives should provide us with sufficient resources to meet our long-termcash requirements.  In addition we arealso considering a number of other strategic financing alternatives and haveincurred substantial costs in these efforts; however, no assurance can be madewith respect to the success of these efforts or the viability of our company.

 

*Reclassificationof prior period amounts*

 

Certain prior period amounts have been reclassified to be consistentwith current period reporting.

 

*Consolidation*

 

The accompanyingconsolidated financial statements include the accounts of Beacon PowerCorporation and our subsidiary, Beacon Power Securities Corporation. In September 2008,we established two wholly-owned subsidiaries, Tyngsboro Regulation Services LLCand Tyngsboro Holding LLC. As of June 30, 2009, these entities remain inactive. The frequency regulation service revenue and costs from the ISO-NE pilotprogram are accounted for as part of Beacon Power Corporation. All significantinter-company accounts and transactions have been eliminated in consolidation.  In July 2009, we established twoadditional wholly-owned subsidiaries, Stephentown Holding LLC and StephentownRegulation Services, LLC.

 

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*Lossper Share — Basic and Diluted*

 

Basic and dilutedlosses per share have been computed using the weighted-average number of sharesof common stock outstanding during each period. Warrants, options and othersecurities exercisable for common shares are used in the calculation offully-diluted EPS only if their conversion to common shares would decreaseincome or increase loss per share from continuing operations.  Since thethree and six month periods ended June 30, 2009 and 2008 reflect losses,including the potential conversion of warrants and options in the diluted EPScalculation would decrease loss per share. Accordingly, they are consideredanti-dilutive and are not included in the calculation of earnings per share.

 

**Summaryof Significant Accounting Policies**

 

*Use ofEstimates*

 

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

 

*LeaseObligation and Deferred Rent*

 

In July 2007,we signed a seven-year operating lease with escalating payments on a 103,000square foot facility in Tyngsboro, Massachusetts. As part of this leaseagreement, we issued to the landlord 150,000 shares of our common stock and awarrant exercisable for 500,000 shares of our common stock in return for lowercash payments under the lease. (See Note 6: Commitments andContingencies.)  Additionally, thelandlord has reimbursed us for certain leasehold improvements we have made. Inaccordance with SFAS No. 13, “*Accounting for Leases,*”these reimbursements have been credited to “Deferred rent”, and we haverecorded rent expense on a straight line basis. The current portion of thedeferred rent is included in current liabilities, and the remainder is shown onthe balance sheet as “Deferred rent — long term.”

 

*Property and Equipment*

 

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

 

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

 

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

 

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*Stock-BasedCompensation*

 

We account forstock-based compensation in accordance with the Financial Accounting StandardsBoard’s SFAS No. 123R (“SFAS 123R”), “Share-Based Payment”. Under the 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.

 

*Restructuring and Asset Impairment Charges*

 

Inaccordance with SFAS No. 144, “*Accounting for theImpairment or Disposal of Long-Lived Assets*,” long-lived assets tobe held and used are reviewed to determine whether any events or changes incircumstances indicate that the carrying value of the asset may not berecoverable.  The conditions consideredinclude whether or not the asset is in service, has become obsolete, or whetherexternal market circumstances indicate that the carrying amount may not berecoverable.  We recognize a loss for thedifference between the estimated fair value of the asset and the carryingamount or the cost to repair the asset. The fair value of the asset is measuredusing either available market prices or estimated discounted cash flows.

 

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

 

No asset impairmentcharges were considered necessary for the three or six months ended June 30,2009 or 2008.

 

*RevenueRecognition*

 

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

 

·                  *Frequency Regulation Revenue*

 

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

 

·                  *Inverter Sales*

 

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

 

·                  *Research and Development Contract Revenue Recognized on thePercentage-of-Completion Method*

 

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

 

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

 

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Each quarter we perform an estimate-to-completeanalysis, and any changes to our original estimates are recognized in theperiod in which they are determined.  Inthe second quarter of 2008, we recorded a contract loss of approximately$87,000, which represents our expected “cost share” portion of the Tehachapicontract. During the first quarter of 2009, we recorded an additional contractloss on the Tehachapi contract of approximately $132,500, which represents thedifference between our overhead applied based on a “full production” rate, andthe contract bid rate.  Our contract lossreserves are as follows:
| ** **              | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------|------------|------------------------------------|------------|
| ** **              | ** ** | **2009**                           | ** ** | **2008** | ** ** |
| Beginning  balance      |       | $                                  | 132,526    |   | $ | 67,419 |   |
| Charges  for the period |       | 132,500                            |       | 86,601 |   |
| Reductions              |       | (35,403                            | )          | (8,024 | ) |
| Ending  balance         |       | $                                  | 229,623    |   | $ | 145,996 |   |

 

*Costof Goods Sold*

 

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

 

Forfrequency regulation revenue, cost of goods sold represents the cost ofenergy.  In the future, we expect ourenergy costs to be for the nominal energy losses associated with operating ourflywheel systems.  From November 2008(when the ISO-NE pilot program began) until late April 2009, we were billedat retail for all of the energy stored on our flywheels, rather than for ournet energy usage. Since late April 2009, our energy costs have decreasedsubstantially as we have been billed the wholesale rate for our net energyused, plus retail transmission and distribution charges.  See further discussion in ManagementDiscussion and Analysis.

 

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

 

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

 

**RecentlyIssued Accounting Pronouncements and Regulations**

 

InJune, 2009, the Financial Accounting Standards Board (FASB) issued Statement ofFinancial Accounting Standard (SFAS) No. 168, “*FASBAccounting Standards CodificationTM*.” SFAS No. 168 and the Codification are effective for financialstatements issued for interim and annual periods ending after September 15,2009.  When effective, the Codificationwill supersede all existing non-SEC accounting and reporting standards. Theadoption of this standard is not expected to have a material impact on ourfinancial statements; however, it will impact the manner in which we refer toaccounting policy in our financial statement disclosures.

 

InJune, 2009, the FASB issued SFAS No. 166, “*Accountingfor Transfers of Financial Assets*,” which is a revision of FASBStatement No. 140, “*Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities*,”and will require more information about transfers of financial assets,including securitization transactions, and where entities have continuingexposures to the risks related to transferred financial assets.  It eliminates the concept of a “qualifiedspecial-purpose entity,” changes the requirements for derecognizing financialassets, and requires additional disclosures. SFAS No. 166 will be effective for our Company as of January 1,2010.  Early application is notpermitted.  Our business plan anticipatesthe use of project financing to fund the construction of frequency regulationinstallations, which we would then operate. This standard may impact our reporting for such transactions.

 

InJune, 2009, the FASB issued SFAS No. 167, “*Amendmentsto FASB Interpretation No.  46(R*),” which is a revision to FASBInterpretation No. 46 (Revised December 2003), “*Consolidationof Variable Interest Entities*,” and changes how a reporting entitydetermines when an entity that is insufficiently capitalized or is notcontrolled through voting (or similar rights) should be consolidated.  The determination of whether a reportingentity is required to consolidate another entity is based on, among otherthings, the other entity’s purpose and design and the reporting entity’s abilityto direct the activities of the other entity that most significantly impact theother entity’s economic performance.  This new standard will require a number of new disclosures, and enhancesinformation reported to users of financial statements by providing greatertransparency about transfers of financial assets and an entity’s continuinginvolvement in transferred financial assets. SFAS No. 167 will be effective for our Company as of January 1,2010.  Early application is notpermitted.  In the future, should webecome fractional owners of certain frequency regulation installations, thisstandard may impact our reporting for such entities.

 

**Recently Adopted AccountingPronouncements and Regulations**

We adopted Statement ofFinancial Accounting Standard (SFAS) No. 165, “*SubsequentEvents*”, which we adopted for the period ended June 30,2009.  SFAS No. 165 sets forth:

·                  The periodafter the balance sheet date during which management of a reporting entityshall evaluate events or transactions that may occur for potential recognitionor disclosure in the financial statements

·                  Thecircumstances under which an entity shall recognize events or transactionsoccurring after the balance sheet date in its financial statements

·                  The disclosuresthat an entity shall make about events or transactions that occurred after thebalance sheet date.

 

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Theadoption of this standard did not have a material impact on financialaccounting or reporting during the current reporting period; however, itsimpact on future reporting periods cannot be determined at this time.

 

**Note3.  Accounts Receivable**

 

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

 
|                        | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-------------------|------------|-----------------------|------------|
|                        | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| Accounts  receivable, trade |       | $                 | 62,998     |                  | $          | 11,840 |   |
| Reserve                     |       | —            |       | —                |       |
| Accounts  receivable, net   |       | $                 | 62,998     |                  | $          | 11,840 |   |

 

Some of ourresearch and development contracts contain holdback provisions that allow ourcustomers to withhold 10% from each invoice payment. At June 30, 2009 and December 31,2008, we had approximately $6,000 of holdbacks in our accounts receivablebalance.  These holdbacks are payable once work has been satisfactorilycompleted and the final reports have been delivered and approved.

 

**Note4.  Property and Equipment**

 

Details of ourproperty and equipment follow:

 
| ** **                                      | ** ** | **Estimated** | ** ** | **As  of:**       | ** ** |
|-------------------------------------------------|------------|---------------|------------|-------------------|------------|
| ** **                                      | ** ** | **Useful**    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                      | ** ** | **Lives**     | ** ** | **2009**          | ** ** | **2008** | ** ** |
| Construction  in Progress                       |       | Varied        |       | $                 | 12,961,906 |   | $ | 11,629,918 |   |
| Land                                            |       |          |       | 192,487           |       | 192,487 |   |
| Smart  Energy 25 flywheels                      |       | 20 years      |       | 2,009,419         |       | 2,009,419 |   |
| Machinery  and equipment                        |       | 5 - 10 years  |       | 2,830,851         |       | 2,600,410 |   |
| Service  vehicles                               |       | 5 years       |       | 16,763            |       | 16,763 |   |
| Furniture  and fixtures                         |       | 7 years       |       | 700,832           |       | 634,294 |   |
| Office  equipment and software                  |       | 3 years       |       | 994,853           |       | 1,028,037 |   |
| Leasehold  improvements                         |       | Lease term    |       | 7,802,927         |       | 7,572,244 |   |
| Equipment  under capital lease obligations      |       | Lease term    |       | 698,677           |       | 700,517 |   |
| Total                                           |       |          |       | $                 | 28,208,715 |   | $ | 26,384,089 |   |
| Less  accumulated depreciation and amortization |       |          |       | (4,090,121        | )          | (3,356,180 | ) |
| Property  and equipment, net                    |       |          |       | $                 | 24,118,594 |   | $ | 23,027,909 |   |

 

InNovember 2008, we deployed 1 MW of capacity under the ISO-NE AlternativeEnergy Storage Technology Pilot Program (Pilot Program) with a system installedinside our Tyngsboro facility. The Smart Energy 25 flywheels shown aboverepresent the cost of the flywheels and electronic control modules in use forthis pilot program. An additional 1 MW of capacity was deployed in July 2009.

 

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

 

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

 
| ** **                               | ** ** | **As of:**        | ** ** |
|------------------------------------------|------------|-------------------|------------|
| ** **                               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                               | ** ** | **2009**          | ** ** | **2008** | ** ** |
| Materials  to build production flywheels |       | $                 | 5,801,451  |   | $ | 6,553,828 |   |
| Smart  Energy 25 flywheels               |       | 4,005,649         |       | 2,199,164 |   |
| Smart  Energy MatrixTM in progress   |       | 2,986,791         |       | 2,296,608 |   |
| Machinery  and equipment                 |       | 131,517           |       | 302,267 |   |
| Leasehold  improvements                  |       | 36,498            |       | 278,051 |   |
| Construction  in progress                |       | $                 | 12,961,906 |   | $ | 11,629,918 |   |

 

As of June 30, 2009 and December 31, 2008,approximately $12,800,000 and $11,000,000, respectively, of the totalshown as CIP represents completed flywheels, materials to build flywheels andother costs related to the Smart Energy MatrixTM installations underconstruction at our Tyngsboro and Stephentown sites.  The Smart Energy MatrixTM installation costsincluded in

 

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CIPat June 30, 2009 and December 31, 2008 include approximately$2,400,000 and $1,900,000, respectively, for fungible components we expect todeploy at either our site in Stephentown, New York or in Groveport, Ohio, andapproximately $589,000 and $385,000, respectively, in site costs related toStephentown.  The remaining costs in CIPrelated to various machinery, equipment, tooling, software and computerequipment which were not in service as of the periods reported.

 

**Note5.  Deferred Financing Costs and OtherAssets**

 

Deferred financing costs represent legal and due diligence costs incurredto obtain debt.  Such costs are amortizedover the life of the debt.  Other assetsrepresent advance payments to suppliers for custom materials used in themanufacture of our flywheels or frequency regulation facilities.  Details of our Deferred financing costs andother assets are as follows:

 
| ** **                                                      | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | **2009**          | ** ** | **2008**              | ** ** |
| Prepaid  financing costs associated with the DOE loan guarantee |       | $                 | 1,002,830  |                  | $          | — |   |
| Deferred  finance charges associated with the MassDev loan      |       | 79,738            |       | 96,033                |       |
| Supplier  prepayments                                           |       | 440,042           |       | —                |       |
| Total                                                           |       | $                 | 1,522,610  |                  | $          | 96,033 |   |

 

**Note6.  Commitments and Contingencies**

 

The followingtable summarizes our purchase obligations and the aggregate maturities andpayments due for our contractual obligations for the five years following June 30,2009:

 
| ** **              | ** ** | **Description of Commitment** | ** ** |
|-------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **Operating leases**          | ** ** | **Purchase    Obligations** | ** ** | **Total** | ** ** |
| Period  ending:         |       |                          |       |   |   |   |   |
| June 30,  2009     |       | $                             | —     |   | $ | 2,853,989 |   | $ | 2,853,989 |   |
| December 31,  2009 |       | 354,062                       |       |   |   | 354,062 |   |
| December 31,  2010 |       | 727,437                       |       |   |   | 727,437 |   |
| December 31,  2011 |       | 753,188                       |       |   |   | 753,188 |   |
| December 31,  2012 |       | 778,937                       |       |   |   | 778,937 |   |
| December 31,  2013 |       | 804,689                       |       |   |   | 804,689 |   |
| December 31,  2014 |       | 618,000                       |       |   |   | 618,000 |   |
| Total  Commitments      |       | $                             | 4,036,313  |   | $ | 2,853,989 |   | $ | 6,890,302 |   |

 

At June 30,2009, we had firm purchase commitments with our suppliers to acquire componentsfor our commercial flywheel units, begin the build-out of the Smart EnergyMatrixTM in Stephentown, and satisfy contractual obligations for our researchand development programs in the amount of approximately $2.9 million. We havean additional $2.8 million conditional material purchase commitment to a secondsource supplier who is working to meet our qualification requirements.

 

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

 

We provided ourlandlord with an irrevocable letter of credit securing our performance underthe lease with a balance at June 30, 2009 of $200,000, which is reducedperiodically over the lease term.  This letter of credit is secured by acash deposit, which is included in restricted cash in the accompanyingconsolidated balance sheets.  In additionto our rent payments, we are responsible for real estate taxes and alloperating expenses of the Tyngsboro facility. Rent expense was approximately $294,000 and $291,000 during the sixmonths ended June 30, 2009 and 2008, respectively.

 

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

 

*LegalProceedings*

 

We may from timeto time be subject to legal proceedings, often likely to involve routinelitigation incidental to our business.  The outcome of any legalproceeding is not within our complete control, may often be difficult topredict and may be resolved over a very long period of time.  Estimatingprobable losses associated with any legal proceedings or other loss contingencyis very complex and requires the analysis of many factors, includingassumptions about potential actions by third parties.  A loss contingencyis recorded as a liability in the consolidated financial statements when it isboth (i) probable and known that a liability has been incurred and (ii) theamount of the loss is reasonably estimable.  If the reasonable estimate ofthe loss is a range and no amount within the range is a better estimate, theminimum amount of the range is recorded as a liability.  If a losscontingency is not probable or not reasonably estimable, a liability is notrecorded in the consolidated financial statements.

 

**Note7.  Long-Term Debt**

 

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

 
| ** **                                            | ** ** | **As of:**        | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|
| ** **                                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                            | ** ** | **2009**          | ** ** | **2008** | ** ** |
| 6.5%  Note Payable to MassDev, due November 2015 |       | $                 | 3,571,993  |   | $ | 3,571,993 |   |
| Less  unamortized discount (warrants)                 |       | (189,380          | )          | (217,909 | ) |
| Total                                                 |       | 3,382,613         |       | 3,354,084 |   |
| Less  current portion of long term debt               |       | (330,832          | )          | (117,023 | ) |
| Net  long-term debt                                   |       | $                 | 3,051,781  |   | $ | 3,237,061 |   |

 

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

 

The MassDev loan isevidenced by a promissory note under which we may make one or more requests foradvances of up to an aggregate of $5 million for the purchase of equipment andinstallation of certain building improvements at our Tyngsboro, Massachusettsfacility. We have one year following the date of the initial advance to draw onthe loan for manufacturing equipment that qualify under the terms of theagreement. The initial advance on the loan was made in October 2008 forapproximately $3.6 million. The note will mature 84 months after the initialadvance and bears a fixed annual interest rate of 6.5%.

 

Payments to MassDev beganin November 2008. The payments will be of interest only during the first12 months and thereafter, the balance of the principal outstanding under thenote shall be amortized in equal monthly installments of principal and interestover the remaining term of the note.

 

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

 
| ** **              | ** ** | **Amount** | ** ** |
|-------------------------|------------|------------|------------|
| Period  ending:         |       |       |       |
| December 31,  2009 |       | $          | 118,749    |   |
| December 31,  2010 |       | 494,718    |       |
| December 31,  2011 |       | 527,851    |       |
| December 31,  2012 |       | 563,202    |       |
| December 31,  2013 |       | 600,920    |       |
|                         |            |            |            |  |

 

12

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|                    |   | **Amount** |      |
|-------------------------|--------|------------|-----------|
| December 31,  2014 |   | 641,165    |      |
| Thereafter              |   | 625,388    |      |
| Total  Payments         |   | $          | 3,571,993 |   |
|                         |        |            |           |  |

 

Pursuant to the note, weentered into a security agreement which grants to MassDev an exclusive firstpriority security interest in all equipment and tenant improvements funded withthe proceeds of the loan with an approximate carrying value of $6,122,000 and $6,135,000at June 30, 2009 and December 31, 2008, respectively. We also enteredinto a collateral 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.

 

As partial considerationfor the loan, on June 30, 2008, we issued MassDev two warrants. Eachwarrant provides for the purchase of 85,979 shares of our common stock at anexercise price of $1.89 per share, subject to any adjustments as set forth inthe warrants. The warrants are exercisable for seven years commencing on June 30,2008. MassDev assigned one of the warrants to the Massachusetts Technology ParkCorporation (“MTPC”), as part of MTPC’s participation under the MassachusettsTechnology Collaborative’s Business Expansion Initiative.  The Black-Scholes fair value of the warrantsis shown as a discount against the loan, and is being amortized over the lifeof the loan using the effective interest method at an imputed interest rate of1.44%.  The amortization of this discountresulted in approximately $28,500 charged to interest expense during the firstsix months of 2009.  The effectiveinterest rate of the loan, including the cost of the warrants and otherdeferred loan costs, is approximately 8.4%.

 

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

 

**Note8.  Sale of Stock**

 

OnFebruary 19, 2009, we entered into a common stock purchase agreement withSeaside, (the “Original Agreement”) valued at up to $18 million. On June 19,2009, we entered into a first amendment (the “First Amendment”) to the stockpurchase agreement.

 

TheOriginal Agreement required Seaside to buy $1 million of common stock from usonce each month for up to 18 months, beginning on February 20, 2009, andon the 20th day of each month thereafter (orthe next closest business day.)  Theagreement was structured in three six-month tranches, or segments, eachcovering 6 monthly closings of $1 million each. Our initial commitment was forthe first six-month tranche, but we had the option, exercisable at our solediscretion, to extend the agreement for up to two additional six-month periods,for a total of up to $18 million over the three tranches.  We paid Seaside $100,000 for the right toexercise the first optional extension and would pay an additional $50,000 if wewish to exercise the second such extension. Additionally, at our sole discretion, we could freeze the monthlytransactions for up to six months by paying a fee to Seaside of $100,000.  At each monthly closing, the number of sharesof common stock to be issued will be determined by applying a 20% discount tothe volume weighted average trading price during the five trading dayspreceding the closing.  If in any monththe five-day weighted average trading price of our common stock is below $0.25,then the closing for that month will not occur and will not be made up.  The issuance of shares that would constitutemore than 19.9% of the total shares outstanding on the date of the agreementwas subject to shareholder approval.  On June 11,2009, our shareholders approved the issuance of the common stock to Seaside.

 

TheFirst Amendment requires Seaside to buy 1,500,000 shares of our common stocktwice each month at closings on the 5th day and 20th day of each month thereafter (or the nextclosest business day) at a purchase price equal to 86% of our stock’s volumeweighted average trading price over the ten trading days immediately precedingeach closing, but in no event below $0.20 per share, up to an aggregatepurchase price of $18,000,000.  The FirstAmendment clarified that the initial period of six closings under the OriginalAgreement ended at the closing scheduled for the first business day following July 5,2009.  In addition, we have elected toexercise our option to extend the Agreement for six additional semi-monthlyclosing dates over a period scheduled to end with the October 5, 2009closing date.  The Agreement also givesus an additional option, exercisable in our sole discretion, to extend theAgreement for an additional period covering six further semi-monthly closingsscheduled to begin on October 20, 2009, at which Seaside would purchaseour stock on the same terms as described above. If we exercise this second option, we will pay Seaside $50,000.  In addition, we may, at our sole discretion,suspend the semi-monthly closings by making a $100,000 payment to Seaside.  We can exercise this right no more than onceduring each period of six semi-monthly closings.  All other terms and conditions not addressedby the First Amendment are governed by the Original Agreement.

 

13

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Sales of stock to Seasideunder the Original Agreement and First Amendment through June 30, 2009 areas follows:

 
| **Transaction Date**   | ** ** | **Aggregate    Value** | ** ** | **Common    Shares Sold** | ** ** | **Sale  Price   per Share** | ** ** | **Volume    Weighted   Average Price   (VWAP)*** | ** ** | **Net  Proceeds** | ** ** |
|------------------------|------------|------------------------|------------|---------------------------|------------|-----------------------------|------------|--------------------------------------------------|------------|-------------------|------------|
| June 22, 2009     |       | $                      | 1,193,895  |                      | 1,500,000  |                        | $          | 0.79593                                          |       | $                 | 0.925500   |   | $ | 1,120,078 |   |
| May 20, 2009      |       | 1,000,000              |       | 1,647,772                 |       | $                           | 0.60688    |                                             | $          | 0.758600          |       | 942,000 |   |
| April 20, 2009    |       | 1,000,000              |       | 1,912,777                 |       | $                           | 0.52280    |                                             | $          | 0.653500          |       | 918,258 |   |
| March 20, 2009    |       | 1,000,000              |       | 2,896,200                 |       | $                           | 0.34528    |                                             | $          | 0.431600          |       | 931,072 |   |
| February 20, 2009 |       | 1,000,000              |       | 2,656,184                 |       | $                           | 0.37648    |                                             | $          | 0.470600          |       | 890,767 |   |
| Total  Investment      |       | $                      | 5,193,895  |                      | 10,612,933 |                        |       |                                             |       |              | $          | 4,802,175 |   |

 

----

* Note:  Under the Original Agreement, the sale pricewas based upon a 5-day VWAP, discounted by 20%.

Under the FirstAmendment, beginning with the June 22, 2009 closing, the sale price isbased upon a 10-day VWAP, discounted by 14%.

 

On July 6, July 20,and August 5, 2009, Seaside purchased additional stock under this agreement, asdiscussed in Note 10, “Subsequent Events.” Because the stock was sold at a price below $1.85 per share, certainwarrants issued in November 2005 were adjusted according to the terms ofthose warrants, as discussed in Notes 9 and 11 below.

 

**Note9.  Stock Warrants**

 

We haveoutstanding various series of warrants to purchase our common stock. Holders ofthe warrants are not entitled to receive dividends, vote, receive notice of anymeetings of stockholders or otherwise have any right as stockholders withrespect to their warrant shares. The following schedule shows warrantsoutstanding as of June 30, 2009:

 
| **Description**                                         | ** ** | **Grant  Date** | ** ** | **Expiration    Date** | ** ** | **Strike  Price** | ** ** | **Issued  and   Outstanding** | ** ** |
|---------------------------------------------------------|------------|-----------------|------------|------------------------|------------|-------------------|------------|-------------------------------|------------|
| May 24,  2005 Financing                            |       | 5/24/2005       |       | 5/25/2010              |       | $                 | 1.008      |                          | 800,000    |   |
| November 8,  2005 Financing (Investors)            |       | 11/8/2005       |       | 5/9/2011               |       | $                 | 1.55       |                          | 4,221,146  |   |
| February 15,  2007 Shelf Issue                     |       | 2/15/2007       |       | 2/15/2012              |       | $                 | 1.33       |                          | 6,261,786  |   |
| GFI  Tyngsboro Lease                                    |       | 7/23/2007       |       | 7/22/2014              |       | $                 | 1.77       |                          | 500,000    |   |
| September 10,  2007 Shelf Issue (Investors)        |       | 9/10/2007       |       | 3/10/2013              |       | $                 | 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       |                          | 5,431,805  |   |
| June 30,  2007 Massachusetts Development Loan      |       | 6/30/2008       |       | 6/30/2015              |       | $                 | 1.89       |                          | 171,958    |   |
| October 15,  2008 Shelf Issue                      |       | 10/15/2008      |       | 4/16/2014              |       | $                 | 1.20       |                          | 8,700,000  |   |
| December 24,  2008 Shelf Issue                     |       | 12/24/2008      |       | 6/25/2014              |       | $                 | 0.74       |                          | 8,966,000  |   |
| Total  warrants outstanding                             | ** ** | ** **      | ** ** | ** **             |       |              |       | 41,328,205                    |       |

 

The followingshows changes to the warrants outstanding from December 31, 2008 through June 30,2009:

 

14

----

 
|                                                                |   | **#  Warrants** |   |
|---------------------------------------------------------------------|--------|-----------------|--------|
| Warrants  outstanding as of December 31, 2008                  |   | 46,932,939      |   |
| 1/21/2009  Surrender of warrants issued 10/31/2007 by Quercus Trust |   | (5,884,455      | )      |
| Warrant  Ratchet 11/8/2005 warrant due to pricing (Seaside 2/20/09) |   | 72,542          |   |
| Warrant  Ratchet 11/8/2005 warrant due to pricing (Seaside 3/20/09) |   | 75,260          |   |
| Warrant  Ratchet 11/8/2005 warrant due to pricing (Seaside 4/20/09) |   | 51,764          |   |
| Warrant  Ratchet 11/8/2005 warrant due to pricing (Seaside 5/20/09) |   | 53,092          |   |
| Warrant  Ratchet 11/8/2005 warrant due to pricing (Seaside 6/22/09) |   | 27,063          |   |
| Warrants  outstanding as of June 30, 2009                      |   | 41,328,205      |   |

 

Warrants withactivity during the six months ended June 30, 2009 are described below:

 

*October 2007Shelf Warrants*

 

In October 2007,we sold 11,911,852 units of the Company at a purchase price of $2.10 perunit.  Each unit consisted of one shareof our common stock, par value $0.01 per share, and a warrant to purchase 0.95shares of common stock at an exercise price of $2.97 per share, for a total of11,316,260 warrants, of which 5,431,805 were outstanding as of June 30,2009. The warrants became exercisable six months and one day after theirissuance, and expire May 1, 2013. The units were issued pursuant to aprospectus supplement filed with the Securities and Exchange Commission inconnection with an effective registration statement.  On January 29, 2009, Quercus Trustsurrendered their 5,884,455 warrants.

 

*November 2005Financing Warrants*

 

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

 

·                  Subdivisions, stock dividends or combinations of ourcommon stock

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

·                  Reorganizations, mergers and similar transactions; and

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

 

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

 
|                                          |   | **# Warrants** | ** ** | **Exercise  Price** |   |
|-----------------------------------------------|--------|----------------|------------|---------------------|--------|
| Original  Warrant                             |   | 2,960,527      |       | $                   | 2.21   |   |
| Adjustment  based on anti-dilution provision: |   |           |       |                |   |
| Financing  February 2007                 |   | 327,294        |       | $                   | 1.99   |   |
| Financing  October 2008                  |   | 248,808        |       | $                   | 1.85   |   |
| Financing  December 2008                 |   | 404,796        |       | $                   | 1.66   |   |
| Seaside  2/20/09 purchase                     |   | 72,542         |       | $                   | 1.63   |   |
| Seaside  3/20/09 purchase                     |   | 75,260         |       | $                   | 1.60   |   |
| Seaside  4/20/09 purchase                     |   | 51,764         |       | $                   | 1.58   |   |
| Seaside  5/20/09 purchase                     |   | 53,092         |       | $                   | 1.56   |   |
| Seaside  6/22/09 purchase                     |   | 27,063         |       | $                   | 1.55   |   |
| Adjusted  Warrant as of June 30, 2009         |   | 4,221,146      |       | $                   | 1.55   |   |

 

15

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**Note10.  Stock Based Compensation**

 

**Descriptionof Plans**

 

*StockOption Plan*

 

Our Third Amendedand Restated 1998 Stock Incentive Plan allows for the granting of stock optionsto purchase up to 23,000,000 shares of our common stock.  Options may begranted to our employees, officers, directors, consultants and advisors. Underthe terms of the option plan, incentive stock options (“ISOs”) are to begranted at the fair market value of our common stock at the date of grant, andnonqualified stock options (“NSOs”) are to be granted at a price determined bythe Board of Directors.  In general, the Board has authorized vestingperiods of one to three years and terms of varying length but in no case longerthan 10 years.  Our stock option program is a long-term retention programthat is intended to attract, retain and provide incentives for talentedemployees, officers and directors, and to align stockholder and employeeinterests.  We consider our option program critical to our operation andproductivity; essentially all of our employees participate.  At June 30,2009, we had 18,408,936 shares reserved for issuance under this plan, of which13,336,652 relate to outstanding options and RSUs.

 

*EmployeeStock Purchase Plan*

 

Our Employee StockPurchase Plan (the “ESPP”) allows substantially all of our employees topurchase shares of our common stock at a discount through payrolldeductions.  Participating employees may purchase our common stock at apurchase price equal to 85% of the lower of the fair market value of the commonstock at the beginning of an offering period or on the exercise date. Employees may designate up to 10% of their base compensation for the purchaseof common stock under this plan.  The ESPP provides for the purchase of upto 2,000,000 shares of our common stock.  At June 30, 2009, we had1,635,397 shares reserved for issuance under this plan.

 

*RestrictedStock Unit Arrangements*

 

Our Third Amendedand Restated 1998 Stock Incentive Plan permits the grant of restricted stockunits (“RSUs”) to our employees, officers, directors and other serviceproviders.  We use RSUs to (i) alignour employees’ interests with those of the Company, (ii) motivate ouremployees to achieve key product development milestones and thus createstockholder value, (iii) retain key employees by providing equity to suchemployees and (iv) conserve cash, by paying bonuses in the form of RSUs,rather than in cash, but with the number of such RSUs calculated on adiscounted basis to compensate for the reduced liquidity as compared to cash. With respect to the RSUs that are granted in lieu of cash bonuses, the numberof RSUs granted are based on performance, and are automatically converted intoshares of common stock in four equal tranches in the fiscal year following theyear of performance. Certain other RSUs are granted to our officers as a formof equity incentive, are not tied to performance, and vest over a three-yearperiod in equal quarterly installments.  There are also otherperformance-based restricted stock units (PSUs) granted to our officers thatcliff-vest upon the achievement of certain earnings-based milestones and uponthe Company achieving a level of revenue such that it is no longer treated as adevelopment stage company for accounting purposes, both such vesting events subjectto the recipient officer being employed by us during the period ending with themilestones. The unvested portion of any RSU or PSU grant is subject toforfeiture upon the holder’s resignation or termination for cause.  As of June 30, 2009, certain RSUsgranted under the officer employment agreements were vested but stock was notissued because the trading window was closed to insiders as of the respectivevesting dates.

 

Restricted stockunit activity as of December 31, 2008 and for the six months ended June 30,2009 is as follows:

 
| ** **                                           | ** **   | **Six  months ended   June 30,** | ** **   | **Year  ended   December 31,** | ** ** |
|------------------------------------------------------|--------------|---------------------------------------|--------------|-------------------------------------|------------|
| ** **                                           | ** **   | **2009**                              | ** **   | **2008**                            | ** ** |
| *** ***                                         | *** *** | **(number of shares)**                | *** *** |
| Shares  issued related to vested RSUs:               |         |                                  |         |                                |       |
| Based  on prior year grants                          |         | 24,936                                |         | 38,084                              |       |
| Based  upon current year executive officer agreement |         | 5,640                                 |         | 14,094                              |       |
|                                                 |         |                                  |         |                                |       |

 

16

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| ** **                                    | ** ** | **Six  months ended   June 30,** | ** ** | **Year  ended   December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                    | ** ** | **2009**                              | ** ** | **2008**                            | ** ** |
| Vested  RSUs not yet converted to stock**     |       | 16,348                                |       | 14,228                              |       |
|                                          |       |                                  |       |                                |       |
| RSU’s  granted but not vested:           |       |                                  |       |                                |       |
| Related  to 2006 executive officer agreement  |       | —                                |       | —                              |       |
| Related  to 2007 executive officer agreement  |       | 12,048                                |       | 24,068                              |       |
| Related  to 2008 executive officer agreement  |       | 28,206                                |       | 37,602                              |       |
| Related  to 2009 executive officer agreement  |       | 56,393                                |       | —                              |       |
| Related  to performance-based executive plan* |       | 1,265,823                             |       | 1,265,823                           |       |

 

----

*                 Vesting of the performance-based RSUs (PSUs) issubject to the achievement of performance requirements. Based on our businessplan as of December 2008, which slows the deployment of frequency regulationinstallations due primarily to the tightening of credit markets, our executivemanagement does not believe that it is probable that the award will beearned.  Accordingly, the cumulativecompensation expense recorded as of December 31, 2008, was reversed duringthat period, and no compensation expense was recorded for these PSUs for thesix months ended June 30, 2009.

**          RSUs vesting December 31, 2008 were issued on March 10,2009.

 

**StockOption Plan Schedules**

 

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

 
| ** **                           | ** ** | ** **     | ** ** | **Weighted-** | ** ** | **Weighted-** | ** ** |
|--------------------------------------|------------|----------------|------------|---------------|------------|---------------|------------|
| ** **                           | ** ** | ** **     | ** ** | **Average**   | ** ** | **Average**   | ** ** |
| ** **                           | ** ** | **Number  of** | ** ** | **Exercise**  | ** ** | **Fair**      | ** ** |
| ** **                           | ** ** | **Shares**     | ** ** | **Price**     | ** ** | **Value**     | ** ** |
| Outstanding,  December 31, 2008 |       | 11,338,470     |       | $             | 1.18       |          |       |   |
| Granted                              |       | 629,364        |       | $             | 0.50       |          | $          | 0.25 |   |
| Exercised                            |       | —         |       | $             | —     |          |       |   |
| Canceled,  forfeited or expired      |       | (10,000        | )          | $             | (0.89      | )             |       |   |
| Outstanding,  June 30, 2009     |       | 11,957,834     |       | $             | 1.14       |          |       |   |
|                                      |            |                |            |               |            |               |            |  |  |

 

The following tablesummarizes information about stock options outstanding at June 30, 2009:

 
| ** **     | ** ** | ** **      | ** ** | **Weighted-**     | ** ** | ** **    | ** ** | ** **      | ** ** | **Vested**    | ** ** |
|----------------|------------|-----------------|------------|-------------------|------------|---------------|------------|-----------------|------------|---------------|------------|
| ** **     | ** ** | ** **      | ** ** | **Average**       | ** ** | **Weighted-** | ** ** | ** **      | ** ** | **Weighted-** | ** ** |
| ** **     | ** ** | **Number**      | ** ** | **Remaining**     | ** ** | **Average**   | ** ** | **Number**      | ** ** | **Average**   | ** ** |
| **Exercise**   | ** ** | **of  Options** | ** ** | **Contractual**   | ** ** | **Exercise**  | ** ** | **Of  Options** | ** ** | **Exercise**  | ** ** |
| **Price**      | ** ** | **Outstanding** | ** ** | **Life  (Years)** | ** ** | **Price**     | ** ** | **Vested**      | ** ** | **Price**     | ** ** |
| $0.26  - $0.74 |       | 4,162,597       |       | 6.13              |       | $             | 0.66       |            | 3,463,745  |          | $          | 0.69 |   |
| $0.80  - $1.46 |       | 5,802,517       |       | 6.85              |       | $             | 1.06       |            | 4,060,857  |          | $          | 1.00 |   |
| $1.51  - $2.19 |       | 1,535,470       |       | 6.24              |       | $             | 1.82       |            | 1,471,630  |          | $          | 1.82 |   |
| $2.50  - $3.10 |       | 130,000         |       | 0.85              |       | $             | 2.64       |            | 130,000    |          | $          | 2.64 |   |
| $4.10  - $5.27 |       | 222,250         |       | 1.66              |       | $             | 4.40       |            | 222,250    |          | $          | 4.40 |   |
| $6.00  - $9.31 |       | 105,000         |       | 1.31              |       | $             | 6.40       |            | 105,000    |          | $          | 6.40 |   |
| Total          |       | 11,957,834      |       |              |       |          |       | 9,453,482       |       |          |       |

 

17

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**StockCompensation**

 

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

 

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

 

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

 

During the firstquarter of 2009, 20,000 options were granted to a consultant.  Half of these options vested on May 5,2009, and the remainder was scheduled to vest on November 5, 2009, subjectto the consultant’s continued service to the Company.  In accordance with EITF 96-18, “*Accounting for equity instruments that are issued to other thanemployees for acquiring, or in conjunction with selling, goods or services*,”the measurement dates for these options has been determined to be the vestingdates.  The consultant’s services wereterminated as of the end of June 2009. Under the terms of the optionagreement, the consultant must exercise the vested options within 3 months ofthe termination date, or they will be forfeited.  The non-vested options were forfeited as ofthe termination date.  The optionsvesting in May 2009 were valued with a life of .75 years (9 months), usingan effective interest rate that corresponds to U.S. Treasury instruments with asimilar maturity.  Options granted toofficers, employees and directors have been valued with an expected life of 3.5years in 2009 and 2008.

 
| ** **                                                                                | ** ** | **Three  months ended June 30,** | ** ** | **Six  months ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                | ** ** | **2009**                              | ** ** | **2008**                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| Risk-free  interest rate                                                                  |       | 0.34% - 1.36%                         |       | 2.54% - 3.33%                       |       | 0.34% - 1.36% |   | 2.15% - 3.33% |   |
| Expected  life of option                                                                  |       | .75 - 3.5 years                       |       | 3.5 years                           |       | .75 - 3.5 years |   | 3.5 years |   |
| Expected  dividend payment rate, as a percentage of the stock price on the date of  grant |       | 0%                                    |       | 0%                                  |       | 0% |   | 0% |   |
| Assumed  volatility                                                                       |       | 77% - 90%                             |       | 89% - 95%                           |       | 77% - 90% |   | 87% - 98% |   |
| Expected  forfeitures                                                                     |       | 8.3%                                  |       | 10%                                 |       | 8.3% |   | 10% |   |

 

Stock-basedcompensation expense recognized on our consolidated statement of operations forthe three and six months ended June 30, 2009 and 2008 are as follows:

 
| ** **                                     | ** ** | **Three  months ended June 30,** | ** ** | **Six  months ended June 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                     | ** ** | **2009**                              | ** ** | **2008**                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| Operations  and maintenance                    |       | $                                     | 29,615     |                                | $          | — |   | $ | 64,112 |   | $ | — |   |
| Research  and development                      |       | 101,694                               |       | 268,655                             |       | 209,387 |   | 631,564 |   |
| Selling,  general and administrative           |       | 154,402                               |       | 299,598                             |       | 291,224 |   | 687,999 |   |
| Total  stock compensation expense              |       | $                                     | 285,711    |                                | $          | 568,253 |   | $ | 564,723 |   | $ | 1,319,563 |   |
|                                           |       |                                  |       |                                |       |   |   |   |   |
| Components  of stock compensation expense:     |       |                                  |       |                                |       |   |   |   |   |
| Compensation  expense related to RSUs and PSUs |       | $                                     | 20,671     |                                | $          | 154,599 |   | $ | 28,725 |   | $ | 316,745 |   |
| Compensation  expense related to stock options |       | 265,040                               |       | 413,654                             |       | 535,998 |   | 1,002,818 |   |
| Total  stock compensation expense              |       | $                                     | 285,711    |                                | $          | 568,253 |   | $ | 564,723 |   | $ | 1,319,563 |   |

 

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As of June 30, 2009,there was approximately $579,000 of unrecognized compensation cost, adjustedfor estimated forfeitures, related to unvested stock-based payments granted toour employees and directors. Total unrecognized compensation cost will beadjusted for future changes in estimated forfeitures and recognized over theremaining vesting periods of the stock option grants.

 

**Note11.  Subsequent Events**

 

Subsequent events havebeen evaluated through August 6, 2009, which is the date financialstatements were issued.

 

On July 2, 2009, weannounced that we received a conditional commitment from the DOE for a loanguarantee of approximately $43 million. The DOE’s offer outlines terms for aloan that would finance more than 60% of our planned 20-megawatt (MW)flywheel-based energy storage installation to be located in Stephentown, New York.

 

The loan, which would befunded by the U.S. Treasury’s Federal Financing Bank, is expected to providedebt financing for 62.5%, or $43 million, of the estimated $69 million totalproject cost. Approximately $50 million of this total cost is direct equipmentand facility costs. The remainder includes substantial contingency, legal, duediligence, consulting and administrative costs.  Some of these costs are either unique to theDOE loan guarantee process, or are greater than we expect to apply to subsequentsimilar facilities.  Of the $26 millionnot financed by the loan, we have already incurred approximately $13 million ineligible project expenditures which will be considered part of our equitycontribution to the project.  Asignificant portion of this in-kind contribution will come from theredeployment of up to 4 MW of energy storage from Tyngsboro to the Stephentownsite. We are exploring funding alternatives for the remaining $13 million,including a direct equity investment by one or more third parties in the NewYork regulation plant and/or the sale of our common stock.

 

The closing of the loanis subject to the execution of a Loan Guarantee Agreement, under which a numberof additional conditions will need to be met and ancillary agreements negotiatedand signed.  For example, one of the conditions is the payment of thecredit subsidy cost, representing the “cost of a loan guarantee,” as set forthin section 502(5)(C) of the Federal Credit Reform Act of 1990.  Thiswill be a material amount.  We have taken steps to obtain fundingfrom the government for the credit subsidy cost, and believe that funding hasbeen authorized by the American Recovery and Reinvestment Act of2009.  We have received a letter from the DOE confirming that the projectmay qualify for such funding if physical construction commences no later than September 30,2011 and if laborers and mechanics employed in performing the project are paidin accordance with the Davis-Bacon Act.  However, if such governmentfunds cannot be obtained, we will be required to pay the credit subsidy costourselves and to raise additional funding to cover thatamount.  There is no guarantee that the government will pay thecredit subsidy cost, or if necessary, that we can raise additional funding on reasonableterms, or at all, to cover that amount.

 

The closing of this loan,and the closing of all such loans to all borrowers under the loan guaranteeprogram, is also subject to the Secretary of the Department of Energy’s rightof termination of the conditional commitment for any reason at any time beforethe execution of the Loan Guarantee Agreement pursuant to the regulations whichimplement the loan guarantee program.

 

Oneach of July 6, July 20, and August 5, 2009 we sold Seaside 1,500,000 shares ofCommon Stock (4,500,000 shares total) for a purchase price of $0.74562,$0.62178 and $0.62617 per share, respectively, (calculated based upon a 14%discount to the volume weighted average market price of $0.867, $0.723 and$0.72810 per share, respectively, over a period of 10 days prior to the sale toSeaside). From February 2009 through August 5, 2009, Seaside has purchased atotal of 15,112,933 shares at a total price of approximately $8.2 million.

 

Becausethe stock was sold at a price below $1.85 per share, certain warrants issued inNovember 2005 were adjusted according to the terms of those warrants.  The July 6, July 20 and August 5, 2009 stocksales to Seaside resulted in an increase in the number of shares exercisablefor the November 2005 warrants of 27,411, 27,766 and 28,132, respectively, andan adjusted exercise price as of August 5, 2009 of $1.52.

 

In July 2009, we established two additional wholly-owned subsidiaries,Stephentown Holding LLC and Stephentown Regulation Services, LLC.

 

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

 

**NoteRegarding Forward Looking Statements**

 

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

 

**CriticalAccounting Policies and Estimates**

 

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

 

*Loss onResearch and Development Contract Commitments*

 

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

 

During the quarterended March 31, 2009, we increased the loss reserve for the Tehachapicontract by approximately $133,000 to reflect the difference between theoverhead rate used when we bid on the contract, and our current “full-capacity”rate.  Our current facility’smanufacturing capacity is 600 flywheels per year, and current overhead ratesare based on our forecasted costs at this capacity.  Because we are not yet operating at thiscapacity, use of this rate results in a significant portion of our costs beingexpensed as period costs.  However, webid on the Tehachapi contract mid-2007, prior to our move to the Tyngsborofacility.  At the time, we hadanticipated expanding our manufacturing capacity to 1,000 units per year, andhad calculated the overhead rate used in our bid based on that capacity.  Our engineering and manufacturing overheadrates are based upon direct labor hours, and thus are sensitive to changes incapacity or headcount. Cost estimates for our contracts are also subject tochange based upon the number of hours required to complete the project as wellas the cost of direct materials, contract-related travel and outside servicessuch as consultants.

 

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

 

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*FixedAssets*

 

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

 

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

 

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

 

*Impairmentof Long-Lived Assets*

 

In accordance withSFAS No. 144 “Accounting for the Impairment or Disposal of Long-LivedAssets” long-lived assets we hold and use are reviewed to determine whether anyevents or changes in circumstances indicate that the carrying value of theasset may not be recoverable.  Theconditions to be considered include whether or not the asset is in service, hasbecome obsolete, is damaged, or whether external market circumstances indicatethat the carrying amount may not be recoverable.  When appropriate we recognize a loss for thedifference between the estimated fair value of the asset and the carrying amount.  The fair value of the asset is measured usingeither available market prices or estimated discounted cash flows.

 

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

 

As of June 30, 2009,in order to determine whether or not the current inventory of flywheels andrelated equipment on hand is impaired, we reviewed the current status of the 20MW system, and noted the following:

 

·                  The first 20 MW installation, planned for Stephentown,NY, is expected to cost approximately $69 million, which includes substantialcontingency, legal, consulting and administrative costs.  Some of these costs are either unique to theDOE loan guarantee process, or are greater than we expect to apply tosubsequent similar facilities.  All ofthese costs are eligible project expenses under the loan program rules.

 

·                  The second 20 MW installation is expected to costapproximately 35% less than the first 20 MW plant.  Cost reductions for the second plant areexpected to occur due to savings from

·                  Reduced legal, consulting andadministrative costs

·                  Volume supplier agreements, and

·                  Production and construction optimization.

 

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·                  The location for the first 20 MW installation will bein the NYISO region.  This is currentlythe most attractive market for regulation services. Historically, it hasoffered attractive frequency regulation clearing prices and is expected toprovide us with a control signal that is well-suited to our type of energystorage-based regulation resource.

 

·                  We performed cash flow testing based upon a variety ofscenarios, using historical 12-month average day-ahead and real-time clearingprices for regulation in NYISO.  Ouranalysis included the potential impact of various “worst case” scenarios basedupon potential negative factors, individually and in combination, such as areduction in the frequency regulation clearing price of up to 20%; increases inenergy costs of up to 20%; higher construction costs of up to 30%; or certainchanges in control signals.

 

·                  Our forecast and models indicate that we can expectpositive cash flows from a 20 MW frequency regulation installation in New York,and that consequently, as of June 30, 2009 no impairment reserve isrequired for our current supply of flywheels and related fungible Smart EnergyMatrixTM components.

 

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**Overview**

 

We design,manufacture and market flywheel-based energy storage systems that providefrequency regulation and other highly reliable energy solutions for theworldwide electricity grid at competitive costs. We also plan to sellindividual and large-scale systems outright or on a fractional basis. As weexpand our flywheel production and continue to lower system costs, we believewe will be able to market other cost-effective applications for our flywheelsystems that will further expand our revenues.

 

Our principalmarket focus is on the geographic regions of the domestic grid that provideopen bid markets for regulation services. These regions and their IndependentSystem Operator (ISO) or Regional Transmission Operator (RTO) designations are:New England (ISO New England or ISO-NE); California (California ISO or CAISO);New York (New York ISO or NYISO); Mid-Atlantic (PJM Interconnection); MidwestISO (MISO) and Texas (ERCOT). Because ERCOT is not regulated by the FederalEnergy Regulatory Commission (FERC), we are not able to encourage beneficialmarket rule changes there that are mandated by FERC Order No. 890.This Order was intended to promote greater competition in electricity markets,in part by allowing non-generation resources such as ours to bid and sell intofrequency regulation markets and be compensated on equal terms with traditionalgeneration resources. As a result, we are focusing on the FERC-regulated openbid markets first and will begin to work on entry into ERCOT once we areoperating in the other markets.

 

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

 

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

 

OurSmart Energy MatrixTM recycles excess energy when generated power exceeds loadand delivers it when load exceeds generated power. We believe that our lowoperating costs will allow us to participate with a very favorable profitmargin in the open-bid markets. Also, our systems respond up to 100 timesfaster than fossil fuel generators providing frequency regulation. Certain ISOshave implemented or are considering tariff changes that would provideadditional or enhanced payment mechanisms to compensate resources, such asours, for faster regulation response.  Ifsuch performance-based tariffs are approved, we believe that there is potentialfor us to receive greater revenues and even higher than projected profit marginsfor providing regulation services.

 

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

 

·                  Participatein pilot programs to demonstrate our technology, such as the ISO-NE AlternativeEnergy Storage Pilot Program, under rules that may provide alternativebidding and payment plans than those provided by the permanent market rules

·                  Sell SmartEnergy MatrixTM systems on an equipment-sale basis in both the US and overseasmarkets

·                  Shareownership of some plants together with investors as a means of acceleratingcash flow during the early years of our commercial deployment

 

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·                  Enter intobilateral contracts with utilities that currently self-provide or purchaseregulation services to satisfy their obligations to pay for or self-provideregulation services in their respective grid regions.

 

Our Smart Energy 25 flywheel system includes theflywheel and its associated power electronics. A Smart Energy MatrixTM is anarray of ten Smart Energy 25 flywheel systems that provides 1 MW of energystorage. A frequency regulation installation includes one or more Smart EnergyMatricesTM, along with ancillary equipment and site work. A typical full-scaleinstallation would have a capacity of 20 MW. The components of a frequencyregulation installation are divided into three categories:

 

·                  Non-fungiblelocation-based costs such as legal or site development costs, which would notbe economically viable for redeployment

·                  Fungiblelocation-based investments for equipment which would be economically viable forredeployment

·                  Fungibleflywheel and power electronics costs which would be economically viable forredeployment.

 

On November 18,2008, we connected our first 1 MW Smart Energy MatrixTM to the electric grid inTyngsboro, Massachusetts. The 1 MW system was installed under the ISO NewEngland Alternative Technologies Pilot Program, which allows us to generaterevenue for regulation services while we, and ISO-NE, explore ways to optimizethe beneficial impact of the technology and while ISO-NE develops permanentmarket rules that will govern the application of the technology. Anadditional 1 MW of capacity was connected to the grid in July 2009. Weexpect to redeploy this second megawatt to the Stephentown site as part of ourin-kind equity contribution required under the terms of the DOE loan guaranteeprogram.

 

The pilot program and itsrevenue component will continue until permanent rules are in place. Thisprocess is expected to be completed by May 2010, or earlier. The pilotprogram was approved by FERC as part of ISO-NE’s compliance with FERC Order No. 890,which is intended to promote greater competition in electricity markets,strengthen the reliability of the grid, and allow so-called non-generationresources (which include our flywheel technology), to participate in frequencyregulation markets on a non-discriminatory basis.

 

As part of the process ofmodifying its market rules, ISO-NE has been adjusting the control signal itsends to our Smart Energy MatrixTM to help maximize our regulationeffectiveness.  ISO-NE has a three-partpayment model for regulation service:

 

1.               Payment for the resource’s MWs ofcapacity that are scheduled to perform regulation, referred to as “Time-On-Regulation.”

 

2.               Payment based on the degree to which aresource changes its output, referred to as “Regulation Service” or “Mileage.”  Fast-response resources receive highermileage payments than slower-responding resources.

 

3.               Payment to compensate generators for lost revenue as aconsequence of providing frequency regulation rather than conventional powergeneration, referred to as “Opportunity Cost.”

 

Revenues that we arecurrently receiving from this pilot program are lower than those that we expectto receive under permanent market rules, principally because under ISO-NE’spilot program market rules, we are not eligible for opportunity cost payments,which represent approximately one-third of the revenue received by conventionalregulating generators. We are encouraging ISO-NE to develop permanent market rules thatwill provide an additional payment component for alternative technologies thatwould be approximately equal to opportunity cost. The trend at other ISOs hasbeen to incorporate features in their tariffs that intrinsically compensate allresources, including energy storage providers, for opportunity cost.

 

Electricity costs for operatingthe 1 MW pilot Smart Energy MatrixTM in Tyngsboro through the end of April 2009were higher than what we expect our electricity costs to be in the future.  Because the 1 MW pilot project is connectedto a distribution-level power line, from November 2008 through late April 2009,we paid the retail price for our gross withdrawals from the grid, instead ofpaying the wholesale price for the net electricity (withdrawals minusinjections), plus retail transmission and distribution charges. Since our 1 MWpilot resource is connected at distribution level, the price of electricity wasdetermined by the retail tariff of the local distribution company, as comparedto the ISO wholesale tariff, and the retail tariff does not have a provisionfor netting the electricity withdrawn and injected back to the grid. In late April 2009,ISO-NE and our local distribution company implemented a change which reducedour commodity cost of electricity by netting the electricity withdrawn andinjected into the grid, and billing for that net usage at the wholesalerate.  In addition, a new regulationdispatch signal implemented by the ISO-NE in May 2009 has reduced theamount of net electricity we need to purchase. We are still paying retail transmission and distribution charges. Thesefavorable adjustments now enable us to earn positive gross margin for theremainder of the pilot program.  Ofcourse, the cost of electricity will be even further reduced for our 20 MWfacilities, as we will be connected to transmission-level (rather than todistribution-level) power lines, and will be charged the lower wholesalecommodity price for our net energy usage and will not be subject to retailtransmission and distribution fees.

 

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

 

·      Comparative market pricing available forfrequency regulation in different markets

·      Our ability to receive appropriaterevenues and payments according to the market rules of each regionalmarket

·      Availability of transmission lines

·      Availability and cost of land

·      Ability to secure all necessaryenvironmental and other permits and approvals

·      Ability to obtain grid interconnectionapprovals.

 

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

 

Ourinterconnection request for the 20 MW plant includes National Grid as thetransmission provider.  Before we can enter into an interconnectionagreement with NYISO, we must complete a System Impact Study, which iscurrently under way, followed by a Facilities Study.  The purpose of the studies is to confirm thatour installation can appropriately interface with the grid, and to identify anyutility upgrades or other equipment that may be needed before construction canbegin.  Construction and development of thissite is also subject to certain state and local permitting processes. Afterexecuting an interconnection agreement, necessary upgrades to grid equipment topermit such interconnection will begin, in a timeline roughly parallel to ourconstruction of the facility.

 

On June 10, 2009, weannounced that we and the New York State Energy Research and DevelopmentAuthority (NYSERDA) are in the process of negotiating a statement of workrelating to a portion of the interconnection and other aspects of the Stephentownfacility. The contract value is expected to be approximately $2 million.

 

Wemay elect to install 1 MW installations in ISOs to provide early insight tooperating within each market. The economics of these 1 MW systems may not berepresentative of expected revenues and costs for a 20 MW plant, and thereforethe non-fungible costs may be expensed on our income statement rather thanbeing booked as a fixed asset on our balance sheet.  For example, in the New York market, we maydeploy a 1 MW resource on the Stephentown site, but initially interconnected toNYSEG (later interconnected to National Grid, when such interconnection isapproved).  Similarly, in Ohio we expectto deploy 1 MW at the AEP facility as described below. The non-fungible costsassociated with deploying small installations (such as at the AEP facility)which are not intended to remain in service for terms exceeding two years willbe expensed.

 

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

 

On July 2, 2009, weannounced that we received a conditional commitment from the U.S. Department ofEnergy (DOE) for a loan guarantee of approximately $43 million.  The DOE’s offer outlines terms for a loanthat would finance more than 60% of our planned 20-megawatt (MW) flywheel-basedenergy storage installation to be located in Stephentown, New York. The loan,which would be funded by the U.S. Treasury’s Federal Financing Bank, isexpected to provide debt financing for 62.5%, or $43 million, of the estimated$69 million total project cost. Approximately $50 million of this total cost isdirect equipment and facility costs. The remainder includes substantialcontingency, legal, due diligence, consulting and administrative costs.  Some of these costs are either unique to theDOE loan guarantee process, or are greater than we expect to apply tosubsequent similar facilities.  Of the$26 million not financed by the loan, we have already incurred approximately$13 million in eligible project expenditures which will be considered part ofour equity contribution to the project. A significant portion of this in-kind contribution will come from theredeployment of up to 4 MW of energy storage from Tyngsboro to the Stephentownsite. We are exploring funding alternatives for the remaining $13 million,including a direct equity investment by one or more third parties in the NewYork regulation plant and/or the sale of our common stock.

 

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We plan to have an aggregate of up to 5 MW of flywheel energy storagecapacity produced by year-end. In addition to our Stephentown, New York siteand an identified site within AEP, we are also identifying and developingadditional sites in our target markets.

 

In volume production, our goal is to complete 20 MW facilities at a costof approximately $25 to $30 million each, though the first 20 MW plant willcost approximately $69 million, of which approximately $50 million is directequipment and facility costs. The remainder of the cost estimate includessubstantial contingency, legal, consulting and administrative costs.  Some of these costs are either unique to theDOE loan guarantee process, or are greater than we expect to apply tosubsequent similar facilities.  In 2010 and 2011, we will continue to havecapital needs that will require additional funding through equity and projectfinancing to fund the ongoing deployment of frequency regulationinstallations.  Our deployment plans are affected by anumber of factors and activities, including but not limited to the following:

 

·      Timing of the anticipated closing of theDOE loan and other fund-raising

 

·      Component development and quality:

 

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

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

·      Continuing to work closely with oursuppliers to refine their manufacturing processes and ensure quality results.

 

·      Need to change market rules in someISOs to be compatible with our technology and to permit revenue to be achievedat the same level as traditional providers. See “Regulatory and Market Affairs” for details on market rule changeswithin each of our target markets

 

·      Ability to secure all necessaryenvironmental, interconnection and other permits and approvals.

 

**Market Affairs**

 

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

 

Wehave encountered wide variations from one ISO to another in the suitability ofits framework and market rules for commercial deployment of our systems.We have found that we must engage in significant interaction with each ISObefore the regulation market in that ISO region is ready for energy storage.FERC Order 890 has accelerated the pace of market rule changes. In 2008and the first half of 2009 we made progress with several of the ISOs by workingwith them directly to implement changes to market rules to allow energystorage technologies to participate on a non-discriminatory basis in theregulation market. The ISOs have demonstrated a heightened commitment to workcollaboratively with us to integrate our technology to their grids.  In addition to market rule changes,several ISOs are evaluating or proposing changes to their regulation dispatchsignal in order to ensure our Smart Energy Systems are deployed mostefficiently and effectively for the benefit of the power grid. These changeswould take better advantage of our flywheel’s fast response capability, whilerecognizing our resource has limited energy storage capacity. The proposedmarket rule changes, coupled with effective regulation dispatch signals,will allow our resource to maximize its regulation revenue while minimizing ourconsumption and cost of electricity. The current status of each ISO market isas follows:

 

·      We believe NYISO presents the mostfavorable site for the first full-scale commercial deployment of our systems.As a result of FERC Order 890, new management at NYISO and extensive work byus, NYISO has developed and FERC has approved new tariff and market rules forLimited Energy Storage Resources (LESRs) to provide frequency regulation to theNY power grid. These new rules recognize the unique operatingcharacteristics of our technology and remedy key

 

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aspects of the current regulation tariff forgenerators that would otherwise limit our technology.  In addition, NYISO has developed a regulationdispatch method for LESRs that will take advantage of the LESRs’ fast responserates and maximize their deployment. The energy level in our flywheels will beactively managed by NYISO to maintain regulation capability to the extentpossible by charging/discharging as necessary. Furthermore, the new tariff will allow us to net our electricity costsat wholesale rates.  We believe the newtariff and dispatch mechanisms will provide an effective and efficient methodfor integrating flywheels into the NYISO Regulation market.  In addition to market rules, in December 2008the Northeast Power Coordinating Council’s (NPCC) changed its reliability rules toallow LESRs to provide frequency regulation by removing the requirement thatresources be able to generate one hour of continuous energy.  The proposed market, reliability and dispatchchanges, coupled with the high price of frequency regulation in New York, makethis a very attractive market for our Smart Energy MatrixTM Systems.  The tariff and market changes were passed bythe market stakeholders in January 2009, approved by the NYISO Board ofDirectors in February 2009 and submitted to FERC for approval in March 2009.  FERC approved the LESR tariff on May 15,2009 with an effective implementation date of May 12, 2009.  The NYISO Regulation Service market is nowfully open to flywheel energy storage.

 

·      On November 18, 2008, ISO-NElaunched an Alternative Technologies Regulation Pilot program to comply withOrder 890.  The pilot program is designedto run for approximately 18 months until new permanent market rules forenergy storage technologies are implemented. The purpose of the AlternativeTechnologies Regulation Pilot program is to evaluate the performance of new technologieslike ours that are unable to participate in ISO-NE’s current regulation market,determine how these technologies can best be used to meet New England’sregulation requirements, allow program participants to operate in a realisticmarket environment where they can evaluate their market viability, and provideoperating experience that ISO-NE can use to formulate permanent marketrules.  We began participating in thepilot program with a 1 MW resource located inside our plant in Tyngsboro in November 2008and added an additional 1 MW outside our Tyngsboro facility in July 2009.  Until April 2009, the pilot resource wassent a regulation signal that was similar to one for a traditional generatorand therefore did not recognize that our technology provides regulation in adifferent manner (most importantly, faster) than a traditional generator.  After discussions with ISO-NE, in May 2009,we convinced them to implement a regulation dispatch signal for our pilotproject that better recognizes our energy storage’s unique capabilities and issimilar to the dispatch method developed by the NYISO. This new dispatch signalhas improved the economics of our pilot resources.  We are continuing to work with ISO-NE toimplement this type of dispatch signal in the permanent rules at theconclusion of the pilot program. In addition, as also discussed above, we areworking to have opportunity cost payments included in the permanent market rules sothat the payments made to our resource are comparable to other parties thatprovide a comparable service.

 

·      CAISO is in the process of opening itsfrequency regulation market to energy storage technologies and we are activelyparticipating in this endeavor.  In June 2008,CAISO took the first step to open its market by modifying its tariff to allowbids for regulation by non-generation resources that are capable of providingthe service and that meet applicable ancillary service standards and technicalrequirements. In February 2009, FERC ordered CAISO to make additionalmodifications to its tariff to ensure that non-generation resources are treatedcomparably to other resources in the CAISO regulation market.  We are actively engaged in this FERCproceeding.  In addition, we continue towork with CAISO and its stakeholders to promote the lessons learned and bestpractices from other ISOs for integrating energy storage into the regulationmarket.  In January 2009, CAISOstated that consideration is being given to creating an optimal dispatch methodfor storage resources.

 

·      On January 6, 2009 MISO implementeda new ancillary services market (ASM). However, current prices for frequencyregulation are lower than desired.  Giventhat the market just opened, and that there are certain aspects of its initialdeployment that will change over time, we do not believe the current prices arenecessarily indicative of what pricing will be in the future. As part of itsapproval of the ASM, FERC required MISO to make further changes to its ASM toremove barriers to new technologies to provide regulation service.  On April 25, 2008, MISO fully compliedwith FERC’s directives by filing a request for an entirely new regulationresource category specifically designed for stored energy resources (“SER”),including our flywheel technology, initially to take effect on June 1,2009.  FERC approved this tariff on December 18,2008.  This was the first such tariff inthe United States designed specifically to accommodate energy storage-basedregulation resources and it contains features that we expect to maximize ourrevenues in the MISO market. * *We are currently working with MISOand its stakeholders on certain details related to the implementation of thistariff, such as pricing and dispatch.  InMay 2009, MISO, with the support of its market stakeholders, submitted toFERC an additional tariff modification to enhance the dispatch algorithm forstored energy resources to better utilize their regulation capabilities.  MISO is proposing to implement the tariff,inclusive of the additional enhancements for storage, on January 1, 2010,at which point we would be able to participate in this market.

 

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·      PJM amended its tariff language to complywith Order 890 and stated that its current rules allow non-generationresources like ours to fully participate in its Regulation and FrequencyResponse market. We believe PJM’s market rules allow us to enter themarket. However, we are now working with PJM to encourage the adoption of aregulation dispatch signal for energy storage resources that takes fulladvantage of our system’s fast response capability and maximizes benefits toPJM’s grid, and pays us for the full benefits of our resource.  PJM has developed a new fast regulationsignal for storage.  We are in theprocess of analyzing and developing models to evaluate this signal.  We are also working with PJM and marketstakeholders to clarify and/or amend certain aspects of PJM’s tariff in orderto maximize our potential revenues in the PJM market.

 

·      Since ERCOT is not regulated by theFederal Energy Regulatory Commission, in the past, we have focused our effortsin the other ISOs.  As the performance ofour technology is fully demonstrated at a system-wide level in other ISOs, andas wind generation in Texas increases and therefore the demand for fastfrequency regulation resources rises, we will begin to focus our attention onthis market.

 

**Defenseapplications**

 

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

 

OnFebruary 3, 2009, we announced that we entered into a contract with NAVSEAto evaluate the use of flywheel energy storage for multiple shipboardapplications that we expect will lead to a conceptual design of a flywheelsystem for future naval surface combatants and possible retrofit into existingNavy ships.  NAVSEA’s objective is toadvance and improve its shipboard Integrated Power Systems (IPS) at both themajor component and system level.  IntegratedPower Systems are an essential part of the Navy’s all-electric shipprogram.  Based on the anticipated powerrequirements to support advanced launch systems, weapons and sensor systems,and other shipboard functions, electrical energy storage is now recognized as afundamental element of an all-electric IPS.

 

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

 

**Discussionof Operations**

 

We haveexperienced net losses since our inception and, as of June 30, 2009, hadan accumulated deficit of approximately $197.2 million.  We are focused onthe development and commercialization of our Smart Energy MatrixTM flywheelsystem for frequency regulation and completion of our research and developmentcontracts.  We do not expect to have positive EBITDA (earnings beforeinterest, taxes, depreciation and amortization) or positive cash flow fromoperations until at least 2012. To execute our business plan, we must raiseadditional funds through a combination of equity and/or debt.

 

In2009/2010 and beyond, we will need additional funding to expand ourmanufacturing capabilities and to build and install frequency regulationfacilities in accordance with our business plan. We expect to raise therequired funds in 2009 and 2010 through the DOE loan program guarantee and thesale of stock in the Company.  In thefuture, as the number of our regulation facilities increases and we developsustainable cash flows from operations, we expect to fund additionalinstallations from a combination of project financing, equity and availablecash flow from existing regulation facilities.

 

The closing of the DOE loanis subject to the execution of a Loan Guarantee Agreement, under which a numberof additional conditions will need to be met and ancillary agreementsnegotiated and signed.  For example, one of the conditions is thepayment of the credit subsidy cost, representing the “cost of a loan guarantee,”as set forth in section 502(5)(C) of the Federal Credit Reform Act of1990.  This will be a material amount.  We have taken stepsto obtain funding from the government for the credit subsidy cost, and believethat funding has been authorized by the American Recovery and Reinvestment Actof 2009.  We have

 

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received a letter fromthe DOE confirming that the project may qualify for such funding if physicalconstruction commences no later than September 30, 2011 and if laborersand mechanics employed in performing the project are paid in accordance withthe Davis-Bacon Act.  However, if such government funds cannot beobtained, we will be required to pay the credit subsidy cost ourselves and toraise additional funding to cover that amount.  There is no guaranteethat the government will pay the credit subsidy cost, or if necessary, that wecan raise additional funding on reasonable terms, or at all, to cover that amount.

 

The closing of this loan,and the closing of all such loans to all borrowers under the loan guaranteeprogram, is also subject to the Secretary of the Department of Energy’s rightof termination of the conditional commitment for any reason at any time beforethe execution of the Loan Guarantee Agreement pursuant to the regulations whichimplement the loan guarantee program.

 

If the loanguaranteed by the DOE does not close on a timely basis, or if government fundsare not available to pay the credit subsidy costs, it will affect the timingfor completing the Stephentown project. We expect to complete the 20 MW facility in Stephentown, New York,within 12 to 18 months from the date we obtain the first disbursement of fundsavailable from the loan guaranteed by the DOE.  In the event that government funds are not available to cover the creditsubsidy cost, we would need to find alternative funding for the project, andconstruction would likely be delayed. Apart from expenditures to construct the Stephentown facility, we willhave sufficient cash to fund operations into 2010 based on continuing fundingfrom Seaside.

 

*Revenues*

 

Ourrevenue during the six months ended June 30, 2009 and 2008 came from threesources:

 

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

·      Frequency regulation service revenue fromthe ISO-NE pilot program

·      Sales of inverters and accessories.

 

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

 

*Cost ofGoods Sold*

 

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

 

*Researchand Development*

 

In 2008 and prioryears, amounts reported as “Research and development” included not only thecost of our engineering staff, but also the cost of unabsorbed manufacturingoverhead since most of our activities related to development of the SmartEnergy 25 flywheel and Smart Energy MatrixTM. In 2008, we substantially completed development of the Smart EnergyMatrixTM and began limited production of commercial units and building our firstfrequency regulation installations.  Asof January 1, 2009, we have split the cost of operations and maintenancefrom the cost of our research and development functions.  Since our current production levels are stillwell below our facility’s full capacity, operations and maintenance costs forthe six months ended June 30, 2009 include a significant amount ofunabsorbed manufacturing overhead.  Inaddition, costs associated with running the 1 MW resource for the ISO-NE pilotprogram, and certain non-fungible costs associated with certain Smart EnergyMatrixTM installations are also included in “Operations and maintenance.”  “Research and development” represents thecost of compensation and benefits for research and development staff, as wellas materials and supplies used in the engineering design and developmentprocess.  On a combined basis consistentwith reporting in prior years, total operations and maintenance and researchand development costs for the first six months of 2009 were approximately$813,000, or 13.5%, lower than during the comparable period in 2008.  We expect research and development expensesin 2009 to be lower than in 2008 due to lower legal costs, along with lower expensematerial and subcontractor costs.

 

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*Selling,General and Administrative Expenses*

 

Oursales and marketing expenses consist primarily of compensation and benefits forregulatory affairs, sales and marketing personnel and related business developmentexpenses. General and administrative expenses consist primarily of compensationand benefits related to our corporate staff, professional fees, insurance andtravel.  During the six months ended June 30,2009, selling, general and administrative expenses were approximately $411,000,or 9.6%, lower than during the equivalent period in 2008, in large part due toa reduction in stock-based compensation expense and a reduction in legal andprofessional fees.   Historically, theBoard of Directors has granted equity compensation to officers and employeesduring the first quarter of each year as part of its long-term incentivecompensation program.  In 2009, suchgrants were delayed to allow the Board’s Compensation Committee time todetermine the most appropriate methodology for determining grant size, giventhe recent drop in our stock price. These reductions were partially offset by an increase in public companyexpenses, primarily related to the periodic stock sales to Seaside. Overall, weexpect our selling, general and administrative expenses for fiscal 2009 to belower than in 2008 primarily due to lower legal costs and other planned costreductions.

 

*Loss onContract Commitments*

 

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

 

InApril 2008, we were awarded a subcontract to provide a flywheel energystorage system in support of a wind integration research and developmentproject in Tehachapi, California, sponsored by the California EnergyCommission.  We will receiveapproximately $250,000 to offset expenses and will contribute an additional$87,000 of engineering resources for the project, bringing the R&D total toapproximately $337,000.  Accordingly, werecorded a charge of approximately $87,000 to the contract loss reserve during2008 to reflect the expected “cost share” portion of the Tehachapicontract.  During the quarter ended March 31,2009, we increased the loss reserve for the Tehachapi contract by$132,500.  This increase is based uponthe difference between the overhead rate that was bid on this fixed pricecontract and our forecasted overhead rate. No changes were considered necessaryto the loss reserve for the quarter ended June 30, 2009.

 

OnFebruary 3, 2009, we announced that we entered into a contract with NAVSEAto evaluate the use of flywheel energy storage for multiple shipboardapplications that we expect will lead to a conceptual design of a flywheelsystem for future naval surface combatants and possible retrofit into existingnavy ships.  The value of the initial researchand development work is estimated at $900,000, $500,000 of which has alreadybeen appropriated.  Subsequent phasesinvolve work estimated at up to an additional $2.1 million.  This contract was awarded on a “cost plusfixed fee” basis.  Based on our evaluationof the expected costs for the portion of the contract which has beenappropriated, no reserve for contract loss was considered necessary as of June 30,2009.

 

*Depreciationand Amortization*

 

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

 

*Interestand Other Income/Expense, net*

 

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

 

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**Resultsof Operations**

 

***Comparison of Three and Six Months ended June 30, 2009and 2008***

** **
| ** **                                | ** **   | **Three  months ended June 30,** | ** **   |
|-------------------------------------------|--------------|---------------------------------------|--------------|
| ** **                                | ** **   | **2009**                              | ** **   | **2008** | ** ** | **$ Change** | ** ** | **%  Change** | ** ** |
| *** ***                              | *** *** | **(in thousands)**                    | *** *** |
| Revenue                                   |         | $                                     | 282          |   | $ | 28 |   | $ | 254 |   | 907 | % |
| Cost  of goods sold                       |         | 286                                   |         | 4 |   | (282 | ) | -7050 | % |
| Gross  margin                             |         | (4                                    | )            | 24 |   | (28 | ) | -117 | % |
| Operations  and maintenance               |         | 769                                   |         | — |   | (769 | ) | — |   |
| Research  and development                 |         | 1,486                                 |         | 3,003 |   | 1,517 |   | 51 | % |
| Selling,  general and administrative      |         | 1,995                                 |         | 2,129 |   | 134 |   | 6 | % |
| Loss  on sales and contract commitments   |         | —                                |         | 87 |   | 87 |   | 100 | % |
| Depreciation  and amortization            |         | 443                                   |         | 313 |   | (130 | ) | -42 | % |
| Interest  and other income (expense), net |         | (70                                   | )            | 76 |   | (146 | ) | -192 | % |
| Net  loss                                 |         | $                                     | (4,767       | ) | $ | (5,432 | ) | $ | 665 |   | -12 | % |

* *
| ** **                                | ** **   | **Six  months ended June 30,** | ** **   |
|-------------------------------------------|--------------|-------------------------------------|--------------|
| ** **                                | ** **   | **2009**                            | ** **   | **2008** | ** ** | **$ Change** | ** ** | **%  Change** | ** ** |
| *** ***                              | *** *** | **(in thousands)**                  | *** *** |
| Revenue                                   |         | $                                   | 393          |   | $ | 48 |   | $ | 345 |   | 719 | % |
| Cost  of goods sold                       |         | 458                                 |         | 4 |   | (454 | ) | -11350 | % |
| Gross  margin                             |         | (65                                 | )            | 44 |   | (109 | ) | -248 | % |
| Operations  and maintenance               |         | 1,546                               |         | — |   | (1,546 | ) | — |   |
| Research  and development                 |         | 3,677                               |         | 6,035 |   | 2,358 |   | 39 | % |
| Selling,  general and administrative      |         | 3,893                               |         | 4,304 |   | 411 |   | 10 | % |
| Loss  on contract commitments             |         | 133                                 |         | 87 |   | (46 | ) | -53 | % |
| Depreciation  and amortization            |         | 866                                 |         | 593 |   | (273 | ) | -46 | % |
| Interest  and other income (expense), net |         | (127                                | )            | 256 |   | (383 | ) | -150 | % |
| Net  loss                                 |         | $                                   | (10,307      | ) | $ | (10,719 | ) | $ | 412 |   | -4 | % |

 

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*Revenue*

 

The followingtable provides details of our revenues for the three and six months ended June 30,2009 and 2008:

 

 
| ** **                     | ** ** | **Percent**  | ** ** | **Three  months ended  June 30,** | ** ** | **Six  months ended  June 30,** | ** ** | **Cumulative  Contract  Value Earned  as of June 30,** | ** ** | **Total  Contract** | ** ** | **Remaining  Value** | ** ** |
|--------------------------------|------------|--------------|------------|----------------------------------------|------------|--------------------------------------|------------|-------------------------------------------------------------|------------|---------------------|------------|----------------------|------------|
| ** **                     | ** ** | **complete** | ** ** | **2009**                               | ** ** | **2008**                             | ** ** | **2009**                                                    | ** ** | **2008**            | ** ** | **2009**             | ** ** | **Value** | ** ** | **(Backlog)** | ** ** |
| ** **                     |       |         |       | **(dollars in thousands)**             |       |
| **Frequency regulation:**      |       |         |       | $                                      | 52         |                                 | $          | —                                                      |       | $                   | 116        |                 | $          | — |   |   |   |   |   |   |   |
| **Contracts:**                 |       |         |       |                                   |       |                                 |       |                                                        |       |                |       |                 |       |   |   |   |   |
| NYSERDA  PON 800               |       | 86.8         | %          | $                                      | —     |                                 | $          | 1                                                           |       | $                   | —     |                 | $          | 1 |   | $ | 55 |   | $ | 63 |   | $ | 8 |   |
| NAVSEA                         |       | 35.5         | %          | 149                                    |       | —                               |       | 178                                                         |       | —              |       | 178                  |       | 500 |   | 322 |   |
| Tehachapi                      |       | 42.2         | %          | 81                                     |       | 3                                    |       | 96                                                          |       | 3                   |       | 105                  |       | 250 |   | 145 |   |
| Total  Contract Revenue        |       |         |       | $                                      | 230        |                                 | $          | 4                                                           |       | $                   | 274        |                 | $          | 4 |   | $ | 338 |   | $ | 813 |   | $ | 475 |   |
| **Inverters and accessories:** |       |         |       | —                                 |       | 24                                   |       | 3                                                           |       | 44                  |       |                 |       |   |   |   |   |
| Total                          |       |         |       | $                                      | 282        |                                 | $          | 28                                                          |       | $                   | 393        |                 | $          | 48 |   |   |   |   |   |   |   |

 

In the six months ended June 30,2009, we earned approximately $116,000 from frequency regulation servicesthrough our participation in the ISO-NE Pilot Program that began in November 2008.Revenues we are currently receiving fromthis pilot program are less than those that we expect to receive underpermanent market rules. Under pilot program market rules, we are not eligiblefor opportunity cost payments, which represent approximately one-third of therevenue received by conventional regulating generators. We are encouragingISO-NE to develop permanent market rules that will provide an additionalpayment component for alternative technologies that would be approximatelyequal to opportunity cost. The trend at other ISOs has been to incorporatefeatures in their tariffs that intrinsically compensate all resources,including energy storage providers, for opportunity cost.

 

Wecompleted most of our research and development contacts in 2007, but wereawarded two new contracts (Tehachapi and NAVSEA) subsequent to the end of thefirst quarter of 2008.  Consequently,contract revenue during the first six months of 2008 was only approximately$4,000, but we earned approximately $274,000 in contract revenue during thefirst six months of 2009.  In addition,we recorded revenue of approximately $3,000 from the sale of Smart Power M5TMinverter systems and related products during the first half of 2009, comparedto approximately $44,000 in the first six months of 2008. In 2009, we expectboth frequency regulation and contract revenue to increase, due to the expecteddeployment of additional capacity of frequency regulation and the Navy contractawarded early in 2009.

 

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*Cost ofGoods Sold*

 

Costof goods sold for the three and six months ended June 30, 2009 and 2008 isas follows:

 
| ** **             | ** **   | **Three  months ended June 30, 2009** | ** **   | **Three  months ended June 30, 2008** | ** ** |
|------------------------|--------------|--------------------------------------------|--------------|--------------------------------------------|------------|
| ** **             | ** **   | **Revenue**                                | ** **   | **Cost  of  Sales**                        | ** ** | **Margin** | ** ** | **Revenue** | ** ** | **Cost  of  Sales** | ** ** | **Margin** | ** ** |
| *** ***           | *** *** | **(in  thousands)**                        | *** *** |
| Frequency  regulation  |         | $                                          | 52           |                                       | $          | 67 |   | $ | (15 | ) | $ | — |   | $ | — |   | $ | — |   |
| Contract               |         | 230                                        |         | 219                                        |       | 11 |   | 4 |   | 4 |   | — |   |
| Inverters  and related |         | —                                     |         | —                                     |       | — |   | 24 |   | — |   | 24 |   |
| Total                  |         | $                                          | 282          |                                       | $          | 286 |   | $ | (4 | ) | $ | 28 |   | $ | 4 |   | $ | 24 |   |

 
| ** **             | ** **   | **Six  months ended June 30, 2009** | ** **   | **Six  months ended June 30, 2008** | ** ** |
|------------------------|--------------|------------------------------------------|--------------|------------------------------------------|------------|
| ** **             | ** **   | **Revenue**                              | ** **   | **Cost  of  Sales**                      | ** ** | **Margin** | ** ** | **Revenue** | ** ** | **Cost  of  Sales** | ** ** | **Margin** | ** ** |
| *** ***           | *** *** | **(in  thousands)**                      | *** *** |
| Frequency  regulation  |         | $                                        | 116          |                                     | $          | 197 |   | $ | (81 | ) | $ | — |   | $ | — |   | $ | — |   |
| Contract               |         | 274                                      |         | 261                                      |       | 13 |   | 4 |   | 4 |   | — |   |
| Inverters  and related |         | 3                                        |         | —                                   |       | 3 |   | 44 |   | — |   | 44 |   |
| Total                  |         | $                                        | 393          |                                     | $          | 458 |   | $ | (65 | ) | $ | 48 |   | $ | 4 |   | $ | 44 |   |

 

Costof goods sold increased from approximately $4,000 in the first six months of2008 to approximately $458,000 during the equivalent period of 2009.  During the first six months of 2009, cost ofgoods sold includes approximately $197,000 for the cost of energy associatedwith the generation of frequency regulation revenue under the ISO-NE Pilotprogram.  Cost of energy exceeded revenuefrom frequency regulation because of the manner in which we were connected tothe grid for the pilot program, which resulted in our being paid for energy weprovided to the grid at wholesale rates, while we were billed for the energy weused at retail rates.  As of the end of April 2009,with ISO-NE and our service provider changed the metering to a “net meter”through ISO-NE.  However, total energycosts for 2009 will be higher than in 2008 since the energy costs for 2008represent the cost related to 1 MW of capacity for a only six-week period.  In addition, cost of goods sold for the firsttwo quarters of 2009 includes approximately $261,000 for research anddevelopment contracts calculated on the percentage of completion method. Yearover year, the increase in cost of sales associated with contracts wasproportional to our increase in contract revenue. In 2009, we expect to beproviding more frequency regulation service capacity over a longer period oftime than occurred in 2008.

 

*Operationsand Maintenance and Research and Development Expense*

 

As discussed above, as of January 1, 2009, we classify expensesrelated to manufacturing, materials handling, purchasing, Smart Energy MatrixTMoperations, and expensed non-fungible costs associated with certaininstallations as “Operations and maintenance.” on our income statement. Priorto 2009, such expenses were included as “Research and development” costs, asshown below:

 
| ** **                  | ** **   | **Three  months ended June 30,** | ** **   | **Six  months ended June 30,** | ** ** |
|-----------------------------|--------------|---------------------------------------|--------------|-------------------------------------|------------|
| ** **                  | ** **   | **2009**                              | ** **   | **2008**                            | ** ** | **Net  Change** | ** ** | **2009** | ** ** | **2008** | ** ** | **Net  Change** | ** ** |
| *** ***                | *** *** | **(in thousands)**                    | *** *** |
| Operations  and maintenance |         | $                                     | 769          |                                | $          | — |   | $ | 769 |   | $ | 1,546 |   | $ | — |   | $ | 1,546 |   |
| Research  and development   |         | 1,486                                 |         | 3,003                               |       | (1,517 | ) | 3,677 |   | 6,036 |   | (2,359 | ) |
| Total                       |         | $                                     | 2,255        |                                | $          | 3,003 |   | $ | (748 | ) | $ | 5,223 |   | $ | 6,036 |   | $ | (813 | ) |

 

The net change isattributed to increases or decreases as shown below:

 

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| ** **                      | ** ** | ** Increase (decrease) related to:**   | ** ** | **Increase  (decrease) related to:**      | ** ** | ** **                              | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                      | ** ** | **Operations  and  maintenance  functions** | ** ** | **Research  and  development  functions** | ** ** | **Three  months  ended June  30,** | ** ** | **Operations  and  maintenance  functions** | ** ** | **Research  and  development  functions** | ** ** | **Six  months  ended  June 30,** | ** ** | **Comments** | ** ** |
|                            |       | **(in thousands)**                          |       |                                      |       |
| Materials                       |       | $                                           | (22        | )                                         | $          | (269                                    | )          | $ | (291 | ) | $ | 26 |   | $ | 133 |   | $ | 159 |   | Research and  development material costs were considerably higher during the second quarter  of 2008 primarily due to costs associated with the development of the  electronic control module used in our Smart Energy 25 flywheel. Cost increase  year to date relates primarily to engineering projects to reduce costs and  improve performance of the 25 kWh. These projects include the refinement of  the motor-rotor design to reduce the operating temperature of the flywheels  when used with the non-proportional, trinary signal. |   |
|                            |       |                                        |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
| Salaries  and benefits          |       | 16                                          |       | 191                                       |       | 207                                     |       | 81 |   | 439 |   | 520 |   | Primarily due to  increase in headcount during 2008 in engineering, manufacturing and materials  management associated with the move from development to production  activities. |   |
|                            |       |                                        |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
| Subcontractors  and consultants |       | 206                                         |       | (41                                       | )          | 165                                     |       | 393 |   | (150 | ) | 243 |   | Primarily due to  contractor costs associated with completing non-fungible costs of the 2 MW  matrix in Tyngsboro, partially offset by lesser use of consultants for  Research and Development. |   |
|                            |       |                                        |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
| Legal                           |       | 58                                          |       | (220                                      | )          | (162                                    | )          | 86 |   | (537 | ) | (451 | ) | R&D Legal expenses  in 2008 included costs associated with the Arete lawsuit, which was settled  in November 2008. Operations and maintenance legal and tax advice  represents primarily costs associated with the set up of our frequency  regulation operations in New York. |   |
|                            |       |                                        |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
| Allocations  and overhead       |       | (175                                        | )          | (205                                      | )          | (380                                    | )          | (375 | ) | (259 | ) | (634 | ) | The increase in  overhead allocation is a result in the increase in the level of production  and contract activity, resulting in an increase in overhead capitalized. |   |
|                            |       |                                        |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
| Stock  Compensation             |       | (24                                         | )          | (113                                      | )          | (137                                    | )          | (64 | ) | (294 | ) | (358 | ) | Generally, options and  RSUs have been granted to management and employees during the first quarter  of the fiscal year, based on prior year performance, and to new hires. In  2009, such equity grants were delayed to allow the Compensation Committee  time to consider whether the number of options granted should continue to be  based on Black Scholes valuation, given the Company’s current stock price.  Grants were made to officers only during the second quarter of 2009. In  addition, there were no new hires during the first half of 2009. |   |
|                                 |            |                                             |            |                                           |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

34

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| ** **                       | ** ** | ** Increase (decrease) related to:**   | ** ** | **Increase  (decrease) related to:**      | ** ** | ** **                              | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                       | ** ** | **Operations  and  maintenance  functions** | ** ** | **Research  and  development  functions** | ** ** | **Three  months  ended June  30,** | ** ** | **Operations  and  maintenance  functions** | ** ** | **Research  and  development  functions** | ** ** | **Six  months  ended  June 30,** | ** ** | **Comments** | ** ** |
| Occupancy                        |       | (19                                         | )          | (75                                       | )          | (94                                     | )          | (152 | ) | (86 | ) | (238 | ) | Occupancy costs in the  first two quarters of 2008 included the cost of moving to our new facility in  Tyngsboro, along with impact of cost cutting efforts in 2009. |   |
|                             |       |                                        |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
| Outside  documentation / testing |       | (8                                          | )          | (8                                        | )          | (16                                     | )          | (13 | ) | (2 | ) | (15 | ) |   |   |
|                             |       |                                        |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
| Travel                           |       | (7                                          | )          | (5                                        | )          | (12                                     | )          | (12 | ) | (15 | ) | (27 | ) | Travel reduced. |   |
|                             |       |                                        |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
| Other                            |       | (10                                         | )          | (18                                       | )          | (28                                     | )          | 1 |   | (13 | ) | (12 | ) | Cost cutting efforts  have been made to conserve cash, given the economic climate during the first  six months of 2009. |   |
|                             |       |                                        |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
|                             |       | $                                           |  15   |                                      | $          | (763                                    | )          | $ | (748 | ) | $ | (29 | ) | $ | (784 | ) | $ | (813 | ) |   |   |
|                                  |            |                                             |            |                                           |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For the three and sixmonths ended June 30, 2009, combined operations and maintenance andresearch and development expenses decreased by approximately $748,000 or 25%,and $813,000 or 13%  in comparison to theequivalent periods in 2008. See the table above for explanations of the factorswhich were responsible for the most significant changes. We expect costs shownfor operations and maintenance to decrease as our production volume increases,and more overhead is absorbed and capitalized as part of the cost of ourflywheels and Smart Energy Matrix TM installations. We expect research anddevelopment costs during 2009 to be lower than in 2008 due to lower legal costs,along with lower material and subcontractor costs.

 

35

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*Selling,General and Administrative Expense*

 
| ** **                           | ** ** | **Three  months  ended June 30,** | ** ** | **Six  months  ended June 30,** | ** ** | **Comment**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                     | ** ** | ** **                           | ** ** |
| Period  Ended June 30, 2008     |       | $                                      | 2,129      |                                 | $          | 4,304                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       |   |   |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Stock  Compensation                  |       | (145                                   | )          | (397                                 | )          | Generally, options and  RSUs have been granted to the officers and employees during the first quarter  of the fiscal year, based on prior year performance, and to new hires. In  2009, performance equity grants were delayed to allow the Compensation  Committee time to consider whether the number of options granted should  continue to be based on Black Scholes valuation, given the Company’s current  stock price. Options and RSU grants were made to the officers only during the  second quarter of 2009. In addition, there were no new hires during the first  half of 2009. |       |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Legal,  audit and professional fees  |       | (87                                    | )          | (199                                 | )          | Reduction in use of  outside legal services.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Public  company / investor relations |       | 179                                    |       | 227                                  |       | Increase primarily due  to costs associated with the periodic stock issuances to Seaside. In  addition, there were more Board/Committee meetings in Q1’2009 than in  Q1’2008.                                                                                                                                                                                                                                                                                                                                                                                                           |       |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Salaries  and benefits               |       | 61                                     |       | 112                                  |       | Three G&A employees  were hired during 2008, primarily to support regulatory efforts. The increase  represents a full six months of salaries for these individuals, combined with  increased health insurance costs.                                                                                                                                                                                                                                                                                                                                                                          |       |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Subcontractors  and consultants      |       | (95                                    | )          | (80                                  | )          | Decreased use of  outside consultants.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |       |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Allocations  and overhead            |       | (31                                    | )          | (38                                  | )          | Represents G&A overhead  allocated to the Navy contract.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Office  Supply                       |       | (16                                    | )          | (16                                  | )          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Dues  and subscriptions              |       | 16                                     |       | 19                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Software  maintenance                |       | 5                                      |       | 13                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
|                                 |       |                                   |       |                                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| Other                                |       | (21                                    | )          | (52                                  | )          | Cost cutting efforts  have been made to conserve cash.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |       |
| Period  Ended June 30, 2009     |       | $                                      | 1,995      |                                 | $          | 3,893                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       |   |   |

 

Selling, generaland administrative expenses totaled approximately $3,893,000 and $4,304,000 forthe six months ended June 30, 2009 and 2008, respectively, whichrepresents a decrease of approximately $411,000, or 10%, period over period.For the quarter ended June 30, 2009 and 2008, selling, general andadministrative expenses totaled approximately $1,995,000 and $2,129,000,respectively, a decrease of approximately $134,000, or 6%.  Significant changes in spending are explainedin the table shown above. Overall, we expect our selling, general andadministrative expenses for fiscal 2009 to be lower than in 2008 primarily dueto lower legal costs and other planned cost reductions.

 

36

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*Loss onContract Commitments*

 

Ourcontracts have been primarily for the development of demonstration units of newproducts and the design of a frequency regulation plant. As such, the work hassupported our core research and development efforts.  Most of these contracts have been structuredon a cost-share basis, for which the expected cost-share has been recorded as acontract loss.  The Navy NAVSEA contract,which we were awarded on January 28, 2009, is a cost-plus-fixed feecontract.

 

Eachquarter we perform an estimate-to-complete analysis, and any changes to ouroriginal estimates are recognized in the period in which they aredetermined.  In the second quarter of2008, we recorded a contract loss of approximately $86,600, which representsour expected “cost share” portion of the Tehachapi contract. During the firstquarter of 2009, we recorded an additional contract loss on the Tehachapicontract of approximately $132,500, which represents the difference between ouroverhead rate based on “full production”, and the contract bid rate.  No loss reserve adjustments were considerednecessary during the quarter ended June 30, 2009.

 

*Depreciationand Amortization*

 

Depreciation andamortization expense increased from approximately $593,000 during the sixmonths ended June 30, 2008 to approximately $866,000 for the same periodin 2009, an increase of approximately $273,000, or 46%.  Similarly, depreciation and amortizationexpense for the quarter ended June 30, 2009 was 42% higher than for thesame quarter in the prior year. The increase in depreciation and amortizationresults primarily from capital expenditures relating to leasehold improvementsat our new manufacturing and office facility in Tyngsboro, as well as thepurchase of machinery and equipment required to begin commercialproduction.  As of June 30, 2009, wehad approximately $13 million in “Construction in progress”, of whichapproximately $9.8 million are flywheels or materials to build flywheels andapproximately $3 million are costs related to the construction of Smart EnergyMatrixTM systems.  We expect depreciationexpense to continue to increase during 2009 as we build and place our frequencyregulation facilities into commercial operation.

 

*Interestand Other Income/(Expense), net*

 

Average cashbalances during the first six months of 2009 were lower than during the sameperiod in 2008, as were interest rates, resulting in a reduction of interestincome for the first half of 2009 of approximately $244,000 as compared tointerest income for the first half of 2008. In addition, in 2008, we obtained a loan from Mass Development, forwhich we began paying interest in October 2008.  Interest expense during the first twoquarters of 2009 was approximately $143,000. These factors contribute to areduction of net interest and other income during the six months ended June 30,2009 of approximately $383,000, or 150%, over the equivalent period last year.

 

*NetLoss*

 

As a result of thechanges discussed above, the net loss for the six months ended June 30,2009 was approximately $10,307,000 which compares to a net loss during the sameperiod in 2008 of approximately $10,719,000, a decrease in net loss ofapproximately $412,000 or 4%.  Net lossfor the quarter ended June 30, 2009 was approximately $4,767,000, comparedto a net loss for the quarter ended June 30, 2008 of $5,432,000, areduction in the net loss of approximately $665,000, or 12%, quarter overquarter.

 

37

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**Liquidityand Capital Resources**

** **
| ** **                                 | ** **   | **Six  months ended June 30,** | ** **   |
|--------------------------------------------|--------------|-------------------------------------|--------------|
| ** **                                 | ** **   | **2009**                            | ** **   | **2008** | ** ** |
| *** ***                               | *** *** | **(in thousands)**                  | *** *** |
| Cash  and cash equivalents                 |         | $                                   | 3,196        |   | $ | 16,685 |   |
| Working  capital                           |         | (1,232                              | )            | 15,172 |   |
| Cash  provided by (used in)                |         |                                |         |   |   |
| Operating  activities                      |         | (12,652                             | )            | (7,718 | ) |
| Investing  activities                      |         | (1,951                              | )            | (6,088 | ) |
| Financing  activities                      |         | 3,441                               |         | 74 |   |
| Net  decrease in cash and cash equivalents |         | $                                   | (11,162      | ) | $ | (13,732 | ) |
| Current  ratio                             |         | 0.8                                 |         | 4.6 |   |

 

Working capital as of June 30, 2009 has a deficitof approximately $1.2 million.  Thisdeficit is primarily due to the use of cash for investment in flywheels,materials to build flywheels and other costs related to the construction of theStephentown site and for legal, consulting and other costs associated with thedue diligence for the loan guaranteed by the DOE.   All of these costs are eligible projectexpenses under the loan program rules. Accordingly, we expect the working capital deficit to be corrected oncewe are able to begin drawing down on this loan.

 

Ourcash requirements depend on many factors including, but not limited to, thecost to build our flywheels and frequency regulation facilities, research anddevelopment activities, facility costs as well as general and administrativeexpenses.  Since we are still in thedevelopment stage and have not yet generated significant revenue from ourprincipal operations, we do not generate enough cash from operations to satisfyour working capital requirements.

 

OnFebruary 19, 2009, we entered into a common stock purchase agreement withSeaside 88, LP, valued at up to $18 million. This agreement was amended on June 19,2009.  The Original Agreement requiredSeaside to buy $1 million of our common stock once each month for up to 18months, beginning on February 20, 2009, and on the 20th day of each month thereafter (or the nextclosest business day) at a discount rate of 20% of the volume weighted averagetrading price over the five day trading period immediately before thepurchase.  The June 19th amendment maintains the $18 million aggregatemaximum purchase price, but accelerates the purchase to 1.5 million sharestwice per month at a 14% discount to the 10-day volume weighted average tradingprice.  The agreement is structured inthree six-month tranches, or segments. The first tranche ended with the July 6, 2009 stock purchase.  We have exercised our option to extend theagreement for the second tranche, which ends with the October 5, 2009closing date, and we have an additional option to extend the agreement for athird 6-month tranche (subject to the overall limit). If we exercise the optionto extend the agreement, we would have sufficient cash to maintain operationsinto 2010.  The following stock saleshave been completed as of August 5, 2009:

 
| **Transaction date** | ** ** | **Aggregate value** | ** ** | **Common Shares Sold** | ** ** | **Sale Price per Share** | ** ** |
|----------------------|------------|---------------------|------------|------------------------|------------|--------------------------|------------|
| February 20, 2009    |       | $                   | 1,000,000  |                   | 2,656,184  |                     | $          | 0.37648 |   |
| March 20, 2009       |       | 1,000,000           |       | 2,896,200              |       | $                        | 0.34528    |   |
| April 20, 2009       |       | 1,000,000           |       | 1,912,777              |       | $                        | 0.52280    |   |
| May 20, 2009         |       | 1,000,000           |       | 1,647,772              |       | $                        | 0.60688    |   |
| June 22, 2009        |       | 1,193,895           |       | 1,500,000              |       | $                        | 0.79593    |   |
| July 6, 2009         |       | 1,118,430           |       | 1,500,000              |       | $                        | 0.74562    |   |
| July 20, 2009        |       | 932,670             |       | 1,500,000              |       | $                        | 0.62178    |   |
| August 5, 2009       |       | 939,255             |       | 1,500,000              |       | $                        | 0.62617    |   |
| Total Investment     |       | $                   | 8,184,250  |                   | 15,112,933 |                     |       |   |

 

Our ability to obtainsufficient funding will pace our ability to produce and deploy flywheelsystems. 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.

 

Ourbusiness plan for 2009 includes legal and other costs required to finalize theloan guaranteed by the DOE, begin site work at our Stephentown, NY facility aswell as begin procurement of materials and manufacturing of flywheels for thatsite.  Our business plan for 2010includes the construction of the Stephentown 20 MW facility, installation ofmost of the flywheel systems, and the start of work on a second 20 MW facility.In order to execute our business plans for 2009 and 2010, in addition to theloan guaranteed by the DOE, we will require funding as follows:

 

·        $15 million to complete duediligence and close the loan guaranteed by the DOE

·        $25 million to fund on-goingoperations for the remainder of 2009 and all of 2010, of which we expect toreceive an additional approximately $10 million from our existing agreementwith Seaside.

 

The timing of thedisbursement of the DOE loan is directly affected by the timing of theexecution of the interconnection agreement with NYISO; hence the ramp up ofcash burn will be affected by the same timing. We will require additional fundsfrom a combination of equity and project finance for the deployment ofadditional 20 MW facilities in the future.

 

38

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**Operating Activities**

 

Net cash used inoperating activities was approximately $12,652,000 and $7,718,000 for the sixmonths ended June 30, 2009 and 2008, respectively.  The primarycomponent to the negative cash flow from operations is from net losses. For the six months ended June 30, 2009, we had a net loss of approximately$10,307,000.  Adjustments to reconcile net loss to cash flow in 2009include non-cash stock compensation of approximately $565,000, depreciation andamortization of approximately $866,000, interest expense on warrants ofapproximately $29,000, partially offset by a net increase in deferred rent ofapproximately ($53,000) and changes in operating assets and liabilities ofapproximately ($3,752,000).

 

During the sameperiod in 2008, we had a net loss of approximately $10,719,000. Adjustments to reconcile net loss to cash flow for the period include non-cashstock compensation of approximately $1,320,000, depreciation and amortizationof approximately $593,000, an increase in deferred rent of approximately$132,000 and cash received from our landlord as a credit for certain buildingimprovements of $1,430,000.  These werepartially offset by changes in operating assets and liabilities ofapproximately ($474,000).

 

**InvestingActivities**

 

Net cash used ininvesting activities was approximately $1,951,000 and $6,088,000 for the sixmonths ending June 30, 2009 and 2008, respectively.  The principal use of cash in 2009 was thepurchase of property and equipment in the amount of approximately $1,951,000,primarily for the purchase and construction of property and equipment.  For the six months ended June 30, 2008,the principal use of cash was the purchase of property and equipment in theamount of approximately $6,262,000, much of which related to the renovation ofthe Tyngsboro facility. These charges were partially offset by a reduction inrestricted cash of approximately $174,000, related to the Wilmington lease thatexpired in 2007.

 

**FinancingActivities**

 

Net cash providedby financing activities was approximately $3,441,000 and $74,000 for the first sixmonths of 2009 and 2008, respectively. In 2009, funds were provided by the sale of stock to Seaside ofapproximately $4,814,000 and issuance of stock under the employee stockpurchase plan of approximately $60,000, offset partially by cash paid for financingcosts related to the due diligence for the DOE Loan Guarantee Program andadvances to suppliers of approximately $1,433,000.  For the first six months of 2008, cashprovided by financing activities of approximately $18,000 related to areduction of costs previously accrued related to the sale of stock in 2007,issuance of stock under the employee stock purchase plan of approximately$41,000, and the exercise of employee stock options of approximately$15,000.  We may evaluate possibleacquisitions of enterprises or technologies that we consider synergistic from amarket, technology or product perspective. We may make investments in companiesfor strategic business reasons or seek other strategic financing relationshipsthat benefit our business.

 

At June 30,2009, we had firm purchase commitments with our suppliers to acquire componentsfor our commercial flywheel units, begin the build-out of the Smart EnergyMatrixTM in Stephentown, and satisfy contractual obligations for our researchand development programs in the amount of approximately $2.9 million. We havean additional $2.8 million conditional material purchase commitment to a secondsource supplier who is working to meet our qualification requirements.

 

**Item 3.  Quantitative and Qualitative Disclosure aboutMarket Risk**

 

Ourcash equivalents, which have maturities of less than three months, may exposeour assets to interest rate risk.  At June 30, 2009, we hadapproximately $109,000 of cash equivalents that were held in non-interestbearing accounts.  Also at June 30, 2009 we had approximately$755,000 of cash equivalents that were held in interest-bearing checkingaccounts, and approximately $2,332,000 invested in interest-bearing moneymarket accounts at high-quality financial institutions, some of which areinvested 

 

39

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off-shore.  The fair value of these investmentsapproximates their cost. The funds invested in money market accounts may not becovered under FDIC Insurance, and therefore may be at some risk of loss, whichwe deem to be low.  The money marketfunds are invested primarily in government funds, such as Treasury Bills.Approximately $1.6 million of our cash on hand at June 30, 2009 wasinvested in mutual funds at a brokerage firm that has purchased supplementaryinsurance through Lloyd’s of London. This insurance coverage provides protection above the SecuritiesInvestor Protection Corporation (SIPC) coverage in the event that the brokerbecomes insolvent. SIPC protects against the loss of securities up to a totalof $500,000 (of which $100,000 may be in cash) per client.  The supplemental insurance provided by thebroker would cover investments at that brokerage firm up to a maximum of $1billion, including up to $1.9 million per client for the cash portion of anyremaining shortfall. SIPC and the supplemental insurance do not cover marketlosses; however, management believes the risk of substantial market losses islow because our funds are invested primarily in government funds.

 

**Item 4.  Controls and Procedures**

 

*Evaluationof Disclosure Controls and Procedures*

 

As of the end of the period covered by this report, wecarried out an evaluation, under the supervision and with the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures.  Based on theevaluation, both the Chief Executive Officer and the Chief Financial Officerconcluded that our disclosure controls and procedures, as defined in Rules 13a— 15(e) and 15d — 15(e) promulgated under the Securities Exchange Actof 1934, were effective as of June 30, 2009.

 

*InternalControl over Financial Reporting*

 

There was no change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) promulgatedunder the Securities Act of 1934) that materially affected, or is reasonablylikely to materially affect, such internal control over financial reportingduring the quarter ended on that date.

 

**Part II — OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

None.

 

**Item 1A.  Risk Factors**

 

In addition to therisks below and other information set forth in this report, you shouldcarefully consider the factors described in Part I, Item 1A of our AnnualReport on Form 10-K for the year ended December 31, 2008, filed withthe SEC on March 16, 2009 and in Part II, Item 1A of our QuarterlyReport on Form 10-Q for the quarter ended March 31, 2009, filed withthe SEC on May 11, 2009, which are incorporated herein by reference.  Those factors could materially affect ourbusiness, financial condition or future results. The risks described in suchreports are not the only risks we face. Additional risks and uncertainties notcurrently known to us or that we currently deem to be immaterial also maymaterially adversely affect our business, financial condition and/or operatingresults.

 

***The DOE loan guarantee program requires a credit subsidy from allparticipants and this credit subsidy could make DOE-related funding for theStephentown facility unobtainable.***

 

The closing of the DOEloan is subject to the execution of a Loan Guarantee Agreement, under which anumber of additional conditions will need to be met and ancillary agreementsnegotiated and signed.  For example, one of the conditions is thepayment of the credit subsidy cost, representing the “cost of a loan guarantee,”as set forth in section 502(5)(C) of the Federal Credit Reform Act of1990.  This will be a material amount.  We have taken stepsto obtain funding from the government for the credit subsidy cost, and believethat funding has been authorized by the American Recovery and Reinvestment Actof 2009.  We have received a letter from the DOE confirming that theproject may qualify for such funding if physical construction commences nolater than September 30, 2011 and if laborers and mechanics employed inperforming the project are paid in accordance with the Davis-BaconAct.  However, if such government funds cannot be obtained, we willbe required to pay the credit subsidy cost ourselves and 

 

40

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to raise additionalfunding to cover that amount.  There is no guarantee that thegovernment will pay the credit subsidy cost, or if necessary, that we can raiseadditional funding on reasonable terms, or at all, to cover that amount.

 

***TheSecretary of the Department of Energy has the right to terminate the commitmentfor the DOE loan guarantee.***

 

The closing of the loanunder the DOE loan guarantee program, and the closing of all such loans to allborrowers under the program, is also subject to the Secretary of the Departmentof Energy’s right of termination of the conditional commitment for anyreason at any time prior to the execution of the Loan Guarantee Agreementpursuant to the regulations which implement the loan guarantee program. We havecompleted the initial due diligence process with the DOE and their designatedconsultants, and therefore have obtained a conditional term sheet which wasapproved by the Secretary of the Department of Energy.  There can be no assurance, however, that theprogram will ultimately be made available to us, until the definitive loanguarantee agreement is signed.

 

***Wemay need to begin making payments on the loan guaranteed by the DOE before weare able to begin generating revenue from the Stephentown facility.***

 

We must execute aninterconnection agreement with NYISO before we can obtain our initial drawdownon the loan guaranteed by the DOE, and we plan to complete the 20 MW facilityin Stephentown, NY within 12 to 18 months from that date.  After executing an interconnection agreement,necessary upgrades to grid equipment to permit such interconnection will begin,in a timeline roughly parallel to our construction of the facility. We have notreceived a firm schedule for the execution of our interconnection agreement.Construction and development of the Stephentown site is also subject to certainstate and local permitting processes. Based on the preliminary term sheet forthe loan guaranteed by the DOE, we must begin making payments 24 months afterwe close on the loan.  If completion ofthe grid upgrades, receipt of any the requisite permits or construction is delayed, we may need to begin making payments on theloan before we begin generating revenue from the Stephentown facility.  If we are unable to begin making payments, itwould constitute a default under the loan and have an adverse effect on ourliquidity and ability to continue as a going concern.

 

***We have a deficit of working capital as of June 30,2009.***

 

Workingcapital as of June 30, 2009 has a deficit of approximately $1.2million.  This deficit is primarily dueto the use of cash for investment in flywheels, materials to build flywheelsand other costs related to the construction of the Stephentown site and forlegal, consulting and other costs associated with the due diligence for theloan guaranteed by the DOE.   All ofthese costs are eligible project expenses under the loan program rules.  Accordingly, we expect the working capitaldeficit to be corrected once we are able to begin drawing down on this loan.  However, there is no assurance that we will besuccessful in obtaining this loan or that the timing will be in the periodrequired for us to achieve our near-term business plan.  In the event that we are not successful inobtaining this loan on a timely basis, it could have a material adverse effecton our financial position. If we raise funds by issuing debt securities orequity securities, existing stockholders may be adversely affected because newinvestors may have rights that are superior to current stockholders or throughthe dilutive effect of new equity securities on current stockholders.

 

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

 

None.

 

**Item 3.  Defaults Upon Senior Securities**

 

None.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

On June 11, 2009, weheld our Annual Meeting of Stockholders. The following matters were consideredand voted upon: (1) the election of six members of our Board of Directorsfor the ensuing year and until each of their successors is duly elected andqualified; (2) a proposal to amend the Company’s Sixth Amended andRestated Certificate of Incorporation to increase the authorized number ofshares of common stock of the Company to 400,000,000; (3) a proposal toapprove the issuance and sale of shares of common stock to Seaside 88, LP,pursuant to a Common Stock Purchase Agreement between Seaside and us dated February 19,2009, in an amount greater than 19.9% of our outstanding shares of common stockas of the date of such agreement, for the purpose of complying with NasdaqMarketplace Rules 5635(b) and 5635(d); and (4) a proposal toratify the selection of Miller Wachman LLP as independent auditors toaudit our books and accounts for the fiscal year ending December 31, 2009.

 

41

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Only stockholders ofrecord as of the close of business on April 24, 2009 were entitled to voteat the Annual Meeting.  As of that date, 114,490,887 shares of commonstock were outstanding and entitled to vote at the Annual Meeting. Set forthbelow is the vote tabulation relating to the four items presented to thestockholders at the Annual Meeting:

 

(1)  Thestockholders elected each of the six nominees to the Board of Directors:

 
| **Name of Director Nominees** | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|-------------------------------|------------|------------|------------|--------------|------------|
| F.  William Capp              |       | 88,776,925 |       | 3,340,836    |       |
| Stephen  P. Adik              |       | 86,304,106 |       | 5,813,655    |       |
| Daniel  E. Kletter            |       | 86,898,742 |       | 5,219,019    |       |
| Virgil  G. Rose               |       | 86,906,489 |       | 5,211,272    |       |
| Jack  P. Smith                |       | 86,268,838 |       | 5,848,923    |       |
| Edward  A. Weihman            |       | 86,880,020 |       | 5,237,741    |       |

 

(2)  Thestockholders approved the amendment to the Company’s Sixth Amended and RestatedCertificate of Incorporation:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker  Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|-----------------------|------------|
| 77,044,778 |       | 14,383,034  |       | 689,949     |       | 0                     |       |

 

(3)  Thestockholders approved the issuance and sale of shares representing more than19.9% of the Company’s outstanding common stock to Seaside 88, LP, for thepurposes of complying with applicable Nasdaq rules:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker  Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|-----------------------|------------|
| 25,749,055 |       | 6,059,006   |       | 538,694     |       | 59,771,006            | ** ** |

 

(4)  Thestockholders ratified the appointment of the Company’s independent auditors:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker  Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|-----------------------|------------|
| 88,795,936 |       | 747,118     |       | 2,574,707   |       | 0                     |       |

 

**Item 5.  Other Information**

 

None.

 

**Item6.  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         |       | +          |       | Certificate of  Amendment of the Sixth Amended and Restated Certificate of Incorporation,  dated June 11, 2009. |
|        |       |       |       |                                                                                                                 |
| 3.5         |       | (4)        |       | Amended and Restated  Bylaws, as amended.                                                                            |

 

42

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| **Exhibit** | ** ** | ** ** | ** ** | ** **                                                                                                                                                        |
|-------------|------------|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Ref**    | ** ** | **Description of Document**                                                                                                                                       |
|        |       |       |       |                                                                                                                                                              |
| 3.6         |       | (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)        |       | Amendment No. 5 to  Rights Agreement dated as of June 19, 2009.                                                                                         |
|        |       |       |       |                                                                                                                                                              |
| 10.1        |       | (5)        |       | Amended and Restated  Employment agreement dated April 1, 2009 between the Company and F.  William Capp                                                      |
|        |       |       |       |                                                                                                                                                              |
| 10. 2       |       | (5)        |       | Amended and Restated  Employment agreement dated April 1, 2009 between the Company and James  M. Spiezio                                                     |
|        |       |       |       |                                                                                                                                                              |
| 10. 3       |       | (5)        |       | Amended and Restated  Employment agreement dated April 1, 2009 between the Company and Matthew  L. Lazarewicz                                                |
|        |       |       |       |                                                                                                                                                              |
| 10. 4       |       | (5)        |       | Restricted Stock Unit  and Option Agreement dated April 3, 2009 between the Company and F.  William Capp.                                                    |
|        |       |       |       |                                                                                                                                                              |
| 10. 5       |       | (5)        |       | Restricted Stock Unit  and Option Agreement dated April 3, 2009 between the Company and James  M. Spiezio.                                                   |
|        |       |       |       |                                                                                                                                                              |
| 10. 6       |       | (5)        |       | Restricted Stock Unit  and Option Agreement dated April 3, 2009 between the Company and Matthew  L. Lazarewicz.                                              |
|        |       |       |       |                                                                                                                                                              |
| 10. 7       |       | (3)        |       | First Amendment to  Common Stock Purchase Agreement, dated June 19, 2009, by and between the  Company and Seaside 88, LP.                                    |
|        |       |       |       |                                                                                                                                                              |
| 31.1        |       | +          |       | Certification of  Principal Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                    |
|        |       |       |       |                                                                                                                                                              |
| 31.2        |       | +          |       | Certification of  Principal Financial and Accounting Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                     |
|        |       |       |       |                                                                                                                                                              |
| 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. |

 

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(1)                      Incorporated by reference from the Form 10-Kfiled on March 17, 2008 (File No. 000-31973).

 

(2)                      Incorporated by reference from the Form 10-Kfiled on March 30, 2006 (File No. 000-31973).

 

(3)                      Incorporated by reference from the Form 8-Kfiled on June 22, 2009 (File No. 000-31973).

 

(4)                      Incorporated by reference from the Form 8-Kfiled on October 1, 1007 (File No. 000-31973).

 

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

 

+            Filed herewith.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|   |   | BEACON POWER  CORPORATION |
|--------|--------|---------------------------|
|   |   |                      |
|   | Date:  | August 6, 2009       | By: | /s/ F. William Capp |
|   |   |                      | F. William Capp |
|   |   |                      | President and Chief  Executive Officer |
|   |   |                      | Principal Executive  Officer |
|   |   |                      |   |
|   |   | August 6, 2009       | 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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