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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

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**x QuarterlyReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

**for the quarterly period ended June 30, 2008**

 

**or**

 

**o TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934**

**(For the transition period from       to        ).**

 

**CommissionFile Number: 000-31973**

 

**Beacon Power Corporation**

(Exact name of registrant as specified in itscharter)

 

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

 

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

 

**(978)694-9121**

(Registrant’s telephone number, includingarea code)

 

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

 

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

 

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

 

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

 

Thenumber of shares of the Registrant’s common stock, par value $.01 per share,outstanding as of August 4, 2008 was 88,754,642.

 

 

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**BEACONPOWER CORPORATION AND SUBSIDIARY(A Development Stage Company)Table of Contents**

 
|                                     | ** ** | ** ** | ** **                                                                                                                                                                                                 | ** ** | **Page** | ** ** |
|-------------------------------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I.  Financial Information |       |       |                                                                                                                                                                                                       |
|                                |       |       |                                                                                                                                                                                                       |
|                                | Item 1.    |       | Financial Statements                                                                                                                                                                                       |       |     |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                |       |       | Consolidated  Balance Sheets at June 30, 2008 (unaudited) and December 31, 2007  (audited)                                                                                                       |       | 1        |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                |       |       | Unaudited  Consolidated Statements of Operations for the three and six months ended  June 30, 2008 and 2007, and for the period from May 8, 1997 (date  of inception) through June 30, 2008 |       | 2        |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                |       |       | Unaudited  Consolidated Statements of Cash Flows for the six months ended June 30, 2008  and 2007 and for the period from May 8, 1997 (date of inception) through  June 30, 2008            |       | 3        |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                |       |       | Notes to Unaudited Consolidated Financial Statements                                                                                                                                                       |       | 4        |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                | Item 2.    |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                                                                |       | 14       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                | Item 3.    |       | Quantitative  and Qualitative Disclosures about Market Risk                                                                                                                                                |       | 29       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                | Item 4.    |       | Controls and  Procedures                                                                                                                                                                                   |       | 29       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
| PART II.  Other Information    |       |       |                                                                                                                                                                                                       |
|                                |       |       |                                                                                                                                                                                                       |
|                                | Item 1.    |       | Legal Proceedings                                                                                                                                                                                          |       | 30       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                | Item 1A.   |       | Risk Factors                                                                                                                                                                                               |       | 30       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                | Item 2.    |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                                                                               |       | 30       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                | Item 3.    |       | Defaults  Upon Senior Securities                                                                                                                                                                           |       | 30       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                | Item 4.    |       | Submission  of Matters to a Vote of Security Holders                                                                                                                                                       |       | 31       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                | Item 5.    |       | Other Information                                                                                                                                                                                          |       | 31       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
|                                | Item 6.    |       | Exhibits                                                                                                                                                                                                   |       | 32       |       |
|                                |       |       |                                                                                                                                                                                                       |       |     |       |
| Signatures                          |       | 33         |                                                                                                                                                                                                       |

 

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**PART 1— FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**BEACONPOWER CORPORATION AND SUBSIDIARY(A Development Stage Company)Consolidated Balance Sheets**

 
| ** **                                                                                                                                                                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                            | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                                            |       |              |       |                  |       |
| **Assets**                                                                                                                                                                            |       |              |       |                  |       |
| Current assets:                                                                                                                                                                       |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                             |       | $                 | 16,684,846 |                  | $          | 30,417,095 |   |
| Accounts receivable, trade, net                                                                                                                                                       |       | 161,355           |       | 424,788               |       |
| Unbilled costs on contracts in progress                                                                                                                                               |       | 13,795            |       | 82,195                |       |
| Prepaid expenses and other current assets                                                                                                                                             |       | 2,522,679         |       | 1,475,084             |       |
| Total current assets                                                                                                                                                                  |       | 19,382,675        |       | 32,399,162            |       |
| Property and equipment, net                                                                                                                                                           |       | 12,672,658        |       | 7,004,021             |       |
| Restricted cash                                                                                                                                                                       |       | 200,000           |       | 374,346               |       |
| Total assets                                                                                                                                                                          |       | $                 | 32,255,333 |                  | $          | 39,777,529 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                         |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                                  |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                      |       | $                 | 724,249    |                  | $          | 296,463 |   |
| Accrued compensation and benefits                                                                                                                                                     |       | 1,033,822         |       | 1,024,874             |       |
| Other accrued expenses                                                                                                                                                                |       | 2,197,870         |       | 2,183,217             |       |
| Advance billings on contracts                                                                                                                                                         |       | 8,511             |       | 7,222                 |       |
| Accrued contract loss                                                                                                                                                                 |       | 145,996           |       | 67,419                |       |
| Lease liability - current                                                                                                                                                             |       | 99,933            |       | —                |       |
| Total current liabilities                                                                                                                                                             |       | 4,210,381         |       | 3,579,195             |       |
| Commitments and contingencies (Note 5)                                                                                                                                                |       |              |       |                  |       |
| Lease liability - long term                                                                                                                                                           |       | 944,699           |       | —                |       |
| Stockholders’ equity:                                                                                                                                                            |       |              |       |                  |       |
| Preferred Stock, $.01 par value; 10,000,000  shares authorized; no shares issued or outstanding                                                                                       |       | —            |       | —                |       |
| Common stock, $.01 par value; 200,000,000  shares authorized; 88,754,642 and 88,658,967 shares issued and outstanding at  June 30, 2008 and December 31, 2007, respectively |       | 887,546           |       | 886,590               |       |
| Additional paid-in-capital                                                                                                                                                            |       | 200,971,563       |       | 199,351,427           |       |
| Deficit accumulated during the development  stage                                                                                                                                     |       | (174,046,017      | )          | (163,326,844          | )          |
| Treasury stock, 421,692 shares at cost                                                                                                                                                |       | (712,839          | )          | (712,839              | )          |
| Total stockholders’ equity                                                                                                                                                       |       | 27,100,253        |       | 36,198,334            |       |
| Total liabilities and stockholders’ equity                                                                                                                                       |       | $                 | 32,255,333 |                  | $          | 39,777,529 |   |

 

See notes to unauditedconsolidated financial statements.

 

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**BEACONPOWER CORPORATION AND SUBSIDIARY**

**(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,** | ** ** |
| ** **                                 | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008**                       | ** ** | **2007**   | ** **  | **2008**                          | ** ** |
| Revenue                                    |       | $                                                   | 28,188     |                                              | $          | 449,328                        |       | $          | 48,392      |                              | $          | 842,034 |   | $ | 4,768,939 |   |
| Cost of goods sold                         |       | 4,116                                               |       | 419,544                                           |       | 4,172                          |       | 811,790    |        | 5,130,431                         |       |
| Gross profit                               |       | 24,072                                              |       | 29,784                                            |       | 44,220                         |       | 30,244     |        | (361,492                          | )          |
| Operating expenses:                        |       |                                                |       |                                              |       |                           |       |       |        |                              |       |
| Selling, general and administrative        |       | 2,128,580                                           |       | 1,549,033                                         |       | 4,304,241                      |       | 2,963,393  |        | 55,278,636                        |       |
| Research and development                   |       | 3,003,236                                           |       | 1,823,812                                         |       | 6,035,579                      |       | 3,483,370  |        | 74,454,067                        |       |
| Loss on contract commitments               |       | 86,601                                              |       | —                                            |       | 86,601                         |       | —     |        | 2,804,062                         |       |
| Depreciation and amortization              |       | 313,477                                             |       | 30,673                                            |       | 593,218                        |       | 56,641     |        | 5,054,308                         |       |
| Casualty loss (recovery)                   |       | —                                              |       | (168,003                                          | )          | —                         |       | (60,060    | )           | —                            |       |
| Restructuring charges                      |       | —                                              |       | —                                            |       | —                         |       | —     |        | 2,159,280                         |       |
| Loss on impairment of assets               |       | —                                              |       | —                                            |       | —                         |       | —     |        | 4,663,916                         |       |
| Total operating expenses                   |       | 5,531,894                                           |       | 3,235,515                                         |       | 11,019,639                     |       | 6,443,344  |        | 144,414,269                       |       |
| Loss from operations                       |       | (5,507,822                                          | )          | (3,205,731                                        | )          | (10,975,419                    | )          | (6,413,100 | )           | (144,775,761                      | )          |
| Other income (expense):                    |       |                                                |       |                                              |       |                           |       |       |        |                              |       |
| Interest income                            |       | 75,985                                              |       | 139,605                                           |       | 256,378                        |       | 253,491    |        | 5,490,386                         |       |
| Interest expense                           |       | —                                              |       | —                                            |       | —                         |       | —     |        | (1,093,703                        | )          |
| Gain on sale of investment                 |       | —                                              |       | —                                            |       | —                         |       | —     |        | 3,562,582                         |       |
| Other income (expense)                     |       | —                                              |       | —                                            |       | (132                           | )          | 3,865      |        | (223,327                          | )          |
| Total other income (expense), net          |       | 75,985                                              |       | 139,605                                           |       | 256,246                        |       | 257,356    |        | 7,735,938                         |       |
| Net loss                                   |       | (5,431,837                                          | )          | (3,066,126                                        | )          | (10,719,173                    | )          | (6,155,744 | )           | (137,039,823                      | )          |
| Preferred stock dividends                  |       | —                                              |       | —                                            |       | —                         |       | —     |        | (36,825,680                       | )          |
| Accretion of convertible preferred stock   |       | —                                              |       | —                                            |       | —                         |       | —     |        | (113,014                          | )          |
| Loss to common shareholders                |       | $                                                   | (5,431,837 | )                                                 | $          | (3,066,126                     | )          | $          | (10,719,173 | )                                 | $          | (6,155,744 | ) | $ | (173,978,517 | ) |
| Loss per share, basic and diluted          |       | $                                                   | (0.06      | )                                                 | $          | (0.04                          | )          | $          | (0.12       | )                                 | $          | (0.09 | ) |   |   |
| Weighted-average common shares outstanding |       | 88,712,016                                          |       | 71,360,328                                        |       | 88,690,200                     |       | 68,412,886 |        |                              |       |

 

See notes to unaudited consolidated financialstatements.

 

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**BEACONPOWER CORPORATION AND SUBSIDIARY(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,** | ** ** |
| ** **                                                                   | ** ** | **2008**                                          | ** **        | **2007**          | ** ** | **2008**                                                                       | ** ** |
| Cash flows from operating activities:                    |       |                                              |              |              |       |                                                                           |       |
| Net loss                                                                |       | $                                                 |  (10,719,173 | )                 | $          |  (6,155,744                                                               | )          | $ | (137,039,823 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                              |              |              |       |                                                                           |       |
| Depreciation and amortization                                                |       | 593,218                                           |              | 56,641            |       | 5,054,309                                                                      |       |
| Loss (gain) on sale of fixed assets                                          |       | 132                                               |              | (3,865            | )          | 193,078                                                                        |       |
| Impairment of assets, net                                                    |       | —                                            |              | 553               |       | 4,551,147                                                                      |       |
| (Expenses paid) restructuring charge                                         |       | —                                            |              | (218,704          | )          | —                                                                         |       |
| Interest expense relating to issuance of  warrants                           |       | —                                            |              | —            |       | 371,000                                                                        |       |
| Non-cash charge for change in option terms                                   |       | —                                            |              | —            |       | 346,591                                                                        |       |
| Non-cash charge for settlement of lawsuit                                    |       | —                                            |              | —            |       | 303,160                                                                        |       |
| Amortization of deferred consulting  expense, net                            |       | —                                            |              | —            |       | 1,160,784                                                                      |       |
| Amortization of deferred stock compensation                                  |       | —                                            |              | —            |       | 3,699,721                                                                      |       |
| Options and warrants issued for consulting  services                         |       | —                                            |              | —            |       | 1,585,654                                                                      |       |
| Services and interest expense paid in  preferred stock                       |       | —                                            |              | —            |       | 11,485                                                                         |       |
| Gain on sale of investments                                                  |       | —                                            |              | —            |       | (3,562,582                                                                     | )          |
| Stock-based compensation                                                     |       | 1,319,563                                         |              | 1,036,564         |       | 4,428,237                                                                      |       |
| Deferred rent                                                                |       | 131,942                                           |              | —            |       | (385,368                                                                       | )          |
| Cash received from landlord for build-out  credit                            |       | 1,430,000                                         |              | —            |       | 1,430,000                                                                      |       |
| Changes in operating assets and  liabilities:                                |       |                                              |              |              |       |                                                                           |       |
| Accounts receivable                                                          |       | 263,433                                           |              | 421,802           |       | (161,355                                                                       | )          |
| Unbilled costs on government contracts                                       |       | 68,400                                            |              | (250,614          | )          | (13,795                                                                        | )          |
| Prepaid expenses and other current assets                                    |       | (1,336,959                                        | )                 | 29,667            |       | (2,394,393                                                                     | )          |
| Accounts payable                                                             |       | 427,786                                           |              | 236,326           |       | 724,249                                                                        |       |
| Accrued compensation and benefits                                            |       | 8,948                                             |              | 174,937           |       | 1,033,822                                                                      |       |
| Advance billings on contracts                                                |       | 1,289                                             |              | (268,426          | )          | 8,511                                                                          |       |
| Accrued interest                                                             |       | —                                            |              | —            |       | 275,560                                                                        |       |
| Accrued loss on contract commitments                                         |       | 78,577                                            |              | (451,992          | )          | 145,996                                                                        |       |
| Other accrued expenses and current  liabilities                              |       | 14,653                                            |              | 362,108           |       | 2,206,540                                                                      |       |
| Net cash used in operating activities                                        |       | (7,718,191                                        | )                 | (5,030,747        | )          | (116,027,472                                                                   | )          |
| Cash flows from investing activities:                                        |       |                                              |              |              |       |                                                                           |       |
| Purchase of investments                                                      |       | —                                            |              | —            |       | (1,190,352                                                                     | )          |
| Sale of investments                                                          |       | —                                            |              | —            |       | 4,752,934                                                                      |       |
| Restricted cash                                                              |       | 174,346                                           |              | —            |       | (200,000                                                                       | )          |
| Increase in other assets                                                     |       | —                                            |              | —            |       | (412,072                                                                       | )          |
| Purchases of property and equipment                                          |       | (6,261,987                                        | )                 | (492,372          | )          | (21,808,183                                                                    | )          |
| Sale of property and equipment                                               |       | —                                            |              | 4,077             |       | 202,674                                                                        |       |
| Net cash used in investing activities                                        |       | (6,087,641                                        | )                 | (488,295          | )          | (18,654,999                                                                    | )          |
| Cash flows from financing activities:                                        |       |                                              |              |              |       |                                                                           |       |
| Initial public stock offering, net of  expenses                              |       | —                                            |              | —            |       | 49,341,537                                                                     |       |
| Stock offerings, net of expenses                                             |       | 17,204                                            |              | 9,652,095         |       | 59,676,042                                                                     |       |
| Payment of dividends                                                         |       | —                                            |              | —            |       | (1,159,373                                                                     | )          |
| Shares issued under employee stock purchase  plan                            |       | 41,197                                            |              | 10,557            |       | 219,101                                                                        |       |
| Exercise of employee stock options                                           |       | 15,182                                            |              | —            |       | 2,304,091                                                                      |       |
| Warrants issued in relation to lease                                         |       | —                                            |              | —            |       | 716,614                                                                        |       |
| Issuance of preferred stock                                                  |       | —                                            |              | —            |       | 32,868,028                                                                     |       |
| Repayment of subscription receivable                                         |       | —                                            |              | —            |       | 5,000,000                                                                      |       |
| Proceeds from capital leases                                                 |       | —                                            |              | —            |       | 495,851                                                                        |       |
| Repayment of capital leases                                                  |       | —                                            |              | —            |       | (1,031,395                                                                     | )          |
| Repurchase company stock                                                     |       | —                                            |              | —            |       | (613,179                                                                       | )          |
| Proceeds from notes payable issued to  investors                             |       | —                                            |              | —            |       | 3,550,000                                                                      |       |
| Net cash provided by (used in) financing  activities                         |       | 73,583                                            |              | 9,662,652         |       | 151,367,317                                                                    |       |
| (Decrease) increase in cash and cash  equivalents                            |       | (13,732,249                                       | )                 | 4,143,610         |       | 16,684,846                                                                     |       |
| Cash and cash equivalents, beginning of  period                              |       | 30,417,095                                        |              | 5,251,337         |       | —                                                                         |       |
| Cash and cash equivalents, end of period                                     |       | $                                                 | 16,684,846        |              | $          | 9,394,947                                                                      |       | $ | 16,684,846 |   |
| Supplemental disclosure of cash flow  information:                           |       |                                              |              |              |       |                                                                           |       |
| Cash paid for interest                                                       |       | $                                                 | —            |              | $          | —                                                                         |       | $ | 488,126 |   |
| Cash paid for taxes                                                          |       | $                                                 | —            |              | $          | —                                                                         |       | $ | 32,750 |   |
| Assets acquired through capital lease                                        |       | $                                                 | —            |              | $          | —                                                                         |       | $ | 535,445 |   |
| Warrants issued in relation to loan  (non-cash item)                         |       | $                                                 | 227,946           |              | $          | —                                                                         |       | $ | 227,946 |   |

 

See notes to unauditedconsolidated financial statements.

 

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**BEACON POWER CORPORATION ANDSUBSIDIARY(A Development Stage Company)Notes to Unaudited Consolidated Financial Statements**

 

**Note 1.  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 energy.  During 2000 we completed an initialpublic offering of our common stock and raised approximately $49.3 million netof offering expenses. Since 2000, we have raised approximately $59.7 millionthrough the sale of common stock and warrants. We expect to generate revenuesin the future from the commercialization of our flywheel energy storage systemsto supply frequency regulation services to the electricity grid.  Webelieve that our sustainable energy storage and power conversion solutions canhelp provide reliable electric power for the utility, renewable energy, anddistributed generation markets. In addition, we believe as thecommercialization of our technologies continues, we will develop other cost-effectiveapplications for our flywheel systems that will provide additional revenueopportunities. Because we have not yet generated a significant amount ofrevenue from our principal operations, we are accounted for as a developmentstage company under Statement of Financial Accounting Standards No. 7.

 

*Operations*

 

We haveexperienced net losses since our inception and, as of June 30, 2008, hadan accumulated deficit of approximately $174 million.  We do not expect to become profitable or cashflow positive until at least 2010. We will need to raise additional capital toexecute our business plan and continue as a going concern.  Based on our current cash usage rates andadditional expenditures expected in support of our business plan, we haveenough cash to fund operations into approximately the fourth quarter of2008.  We will require substantial funds to procure components, manufactureflywheels, construct and deploy flywheel-based frequency regulation facilities,continue research and development activities and further market our productsand services.  We anticipate that suchfunds will be obtained from external sources and we intend to seek additionalequity or debt to fund future operations. We estimate that we will need toraise an additional $20 million during 2008 through the issuance of equitysecurities in order to continue development of the Smart Energy MatrixTMflywheel system, and to build, operate and receive fees for frequencyregulation services, and have sufficient working capital to continue to executeour business plan. Our short-term business plan includes manufacturing flywheelsystems and beginning construction of megawatt-level frequency regulationfacilities in at least two of our initial target markets which are the New YorkISO, New England ISO, Midwest ISO and PJM.  Beyond 2008 we will continue tohave capital needs that will require additional equity or debt to fund theongoing deployment of frequency regulation facilities.

 

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

 

**Basisof Presentation**

 

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 31,2007.  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, 2008 are not necessarilyindicative of the results that may be expected for the full year ending December 31,2008.

 

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*GoingConcern*

 

The accompanyingconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business.  As shown in ourconsolidated financial statements, we have had minimal revenues and incurredlosses of approximately $174 million since our inception, including lossesduring the six months ending June 30, 2008 of approximately $10.7million.  We have approximately $16.7 million of cash and cash equivalentson hand at June 30, 2008.  Since our operating cash requirements farexceed any cash generated from operations, we may be unable to continue as agoing concern.  The consolidated financial statements contained herein donot include any adjustments relating to the recoverability and classification ofliabilities that might be necessary should we be unable to continue as a goingconcern.

 

We recognize thatour continuation as a going concern is dependent upon our ability to generatesufficient cash flow to allow us to satisfy our obligations on a timely basis. The generation of sufficient cash flow is dependent in the short-term on ourability to obtain additional equity and debt financing, and in the long-term,on our ability to successfully obtain a share of the frequency regulationmarket by deploying our Smart Energy MatrixTM flywheel systems that are nowentering production. To execute our business plan, we expect to obtainfinancing from a combination of debt and equity.

 

*Consolidation*

 

The accompanyingconsolidated financial statements include the accounts of Beacon PowerCorporation and our subsidiary, Beacon Power Securities Corporation.  Allsignificant inter-company accounts and transactions have been eliminated inconsolidation.

 

*Loss per 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, 2008 and 2007 reflect losses,including the potential conversion of warrants and options in the diluted EPS calculationwould decrease loss per share. Thus, they are considered anti-dilutive and arenot included in the calculation of earnings per share.

 

**Summaryof Significant Accounting Policies**

 

*Useof Estimates*

 

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

 

*LeaseObligation and Deferred Rent*

 

During July 2007,we signed a seven-year operating lease with escalating payments on a 103,000square foot facility in Tyngsboro, Massachusetts. As part of this leaseagreement, we issued to the landlord 150,000 shares of our common stock and awarrant exercisable for 500,000 shares of our common stock in return for lowercash payments under the lease. (See Note 5: Commitments andContingencies.)  Additionally, thelandlord has reimbursed us for certain leasehold improvements we have made. Inaccordance with SFAS No. 13, “*Accounting for Leases,*”these reimbursements have been credited to our lease liability, 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 “Lease payable – long term.”  Prior to our receipt of the landlordleasehold improvement reimbursements during the first quarter of 2008, DeferredRent had a debit balance and was included in “Prepaid expenses and othercurrent assets.”  The amount included inprepaid expenses as of December 31, 2007 was approximately $517,000.

 

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*Property and Equipment*

 

Property and equipment,including leasehold improvements, are stated at cost and depreciated using thestraight-line method over the estimated useful lives of the assets. The cost ofthe item is defined as the purchase price of the item as well as all of thecosts necessary to bring it to the condition and location necessary for itsintended use. Repair and maintenance costs are expensed as incurred.  Capital assets are classified as “Constructionin Progress” (CIP) when initially acquired, and reclassified to the appropriateasset account after being placed into service. Depreciation expense is notrecorded on assets not yet placed into service. Materials purchased to buildflywheels for use in our frequency regulation facilities are classified as CIP,along with related labor and overhead costs. No overhead is generally applied for other internally-constructedprojects not directly related to our core business.

 

*Stock-BasedCompensation*

 

We account forstock-based compensation in accordance with the Financial Accounting StandardsBoard’s Statement of Financial Accounting Standards No. 123R (“SFAS 123R”),“Share-Based Payment”. Under the fair value recognition provisions of SFAS123R, stock-based compensation cost is measured at the grant date based on thefair value of the award and is recognized as an expense as it is earned overthe requisite service period, which is the vesting period. We implemented thisstandard using the modified-prospective transition method, under which priorperiods were not revised for comparative purposes. The valuation provisions ofSFAS 123R apply to new grants and to grants that were outstanding as of theeffective date and are subsequently modified. Estimated compensation expensefor grants that were outstanding as of the effective date will be recognizedover the remaining vesting period using the compensation cost estimated for theSFAS 123R pro forma disclosures.

 

The adoption ofSFAS 123R had a material impact on our consolidated financial position andresults of operations.

 

*Restructuring and Asset Impairment Charges*

 

We periodicallyevaluate all of our property and equipment as required by Statement ofFinancial Accounting Standards No. 144 “*Accountingfor the Impairment or Disposal of Long-Lived Assets*,” and recordimpairment charges as appropriate.

 

**Note3.  Accounts Receivable**

 

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

 
| ** **                 | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Accounts receivable, trade |       | $                 | 163,923    |                  | $          | 427,356 |   |
| Reserve                    |       | (2,568            | )          | (2,568                | )          |
| Accounts receivable, net   |       | $                 | 161,355    |                  | $          | 424,788 |   |

 

Two of ourresearch and development contracts contain holdback provisions that allow ourcustomers to withhold 10% from each invoice payment. At June 30, 2008 and December 31,2007 we had approximately $69,000 and $68,000 of holdbacks, respectively, inour accounts receivable balance.  These holdbacks are payable once workhas been satisfactorily completed and the final reports have been delivered andapproved.

 

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**Note 4.  Property and Equipment**

 

Details of our propertyand equipment follow:

 
| ** **                                     | ** ** | **Estimated** | ** ** | **As of:**   | ** ** |
|------------------------------------------------|------------|---------------|------------|-------------------|------------|
| ** **                                     | ** ** | **Useful**    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                     | ** ** | **Lives**     | ** ** | **2008**          | ** ** | **2007** | ** ** |
| Construction in Progress                       |       | Varied        |       | $                 | 5,176,433  |   | $ | 5,782,127 |   |
| Machinery and equipment                        |       | 5  - 10 years |       | 1,586,722         |       | 1,137,946 |   |
| Service vehicles                               |       | 5  years      |       | 16,763            |       | 16,763 |   |
| Furniture and fixtures                         |       | 7  years      |       | 756,127           |       | 603,382 |   |
| Office equipment                               |       | 3  years      |       | 938,933           |       | 828,918 |   |
| Leasehold improvements                         |       | Lease  term   |       | 6,155,177         |       | — |   |
| Equipment under capital lease obligations      |       | Lease  term   |       | 700,517           |       | 700,516 |   |
| Total                                          |       |          |       | $                 | 15,330,672 |   | $ | 9,069,652 |   |
| Less accumulated depreciation and amortization |       |          |       | (2,658,014        | )          | (2,065,631 | ) |
| Property and equipment, net                    |       |          |       | $                 | 12,672,658 |   | $ | 7,004,021 |   |

 

The components ofconstruction in progress, which represents costs related to assets that havenot yet been placed into service and for which no depreciation expense has beentaken, were as follows:

 
| ** **                                                                                  | ** ** | **As of:**   | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                                  | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                  | ** ** | **2008**          | ** ** | **2007** | ** ** |
| Materials to build production flywheels                                                     |       | $                 | 3,335,307  |   | $ | 453,192 |   |
| Frequency regulation facilities                                                             |       | 1,159,352         |       | 9,527 |   |
| Deposits and other costs related to the acquisition of land for  frequency regulation plant |       | 165,032           |       | 17,123 |   |
| Machinery and equipment                                                                     |       | 25,057            |       | 85,725 |   |
| Office equipment                                                                            |       | 71,393            |       | 115,647 |   |
| Leasehold improvements                                                                      |       | 420,292           |       | 5,100,913 |   |
| Construction in progress                                                                    |       | $                 | 5,176,433  |   | $ | 5,782,127 |   |

 

In July 2008, we exercised our option to purchase land inStephentown, NY, a possible location for a frequency regulation facility.

 

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**Note5.  Commitments and Contingencies**

 

The followingtable summarizes our commitments at June 30, 2008:

 
| ** **             | ** ** | **Description of Commitment** | ** ** |
|------------------------|------------|-----------------------------------------|------------|
| ** **             | ** ** | **Operating leases**               | ** ** | **Purchase  Obligations** | ** ** | **Total** | ** ** |
| Period ending:         |       |                                    |       |   |   |   |   |
| June 30, 2008     |       | $                                       | —     |   | $ | 10,121,580 |   | $ | 10,121,580 |   |
| December 31, 2008 |       | 341,188                                 |       |   |   | 341,188 |   |
| December 31, 2009 |       | 701,687                                 |       |   |   | 701,687 |   |
| December 31, 2010 |       | 727,437                                 |       |   |   | 727,437 |   |
| December 31, 2011 |       | 753,188                                 |       |   |   | 753,188 |   |
| December 31, 2012 |       | 778,937                                 |       |   |   | 778,937 |   |
| Thereafter             |       | 1,422,689                               |       |   |   | 1,422,689 |   |
| Total Commitments      |       | $                                       | 4,725,126  |   | $ | 10,121,580 |   | $ | 14,846,706 |   |

 

At June 30,2008, we had firm purchase commitments with our suppliers in the amount ofapproximately $10.1 million. These commitments are primarily to acquirecomponents needed to manufacture commercial flywheel units, complete thebuild-out of the Tyngsboro facility, begin development of our initial frequencyregulation facilities, and satisfy contractual obligations for research anddevelopment programs.

 

In July 2007,we signed a seven-year lease on our new corporate headquarters, and relocatedall of our operations to the new facility in January 2008.  This facility significantly expands ourmanufacturing capacity and provides sufficient space to continue our researchand development activities. Our new facility is located at 65 Middlesex Road,Tyngsboro, MA.  The 103,000-square-footfacility, which has manufacturing capacity that will allow production of morethan 1,000 flywheels per year, has been renovated and is being built-out to ourspecifications.

 

We provided theTyngsboro lessor with an irrevocable letter of credit securing our performanceunder the lease with a balance at June 30, 2008 of $200,000, which isreduced periodically over the lease term.  This letter of credit issecured by a cash deposit, which is included in restricted cash in theaccompanying consolidated balance sheets. In addition to our rent payments, we are responsible for real estatetaxes and all operating expenses of the Tyngsboro facility.

 

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. We expect to use the proceeds from the loan to help fundthe expansion of our 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 tenant improvements at our Tyngsboro, Massachusettsfacility. We have one year following the date of the initial advance to draw onthe loan. The note bears a fixed annual interest rate of 6.5% and will mature84 months after the initial advance. As of June 30, 2008, we had not madeany requests for advances on the loan. We expect to request the first draw for approximately $3.7 millionduring August 2008.

 

Loan repayments shallcommence on the first day of the calendar month following the date the initialloan advance is made. The payments will be of interest only during the firsttwelve months and thereafter, the balance of the principal outstanding underthe note shall be amortized in monthly payments of principal and interest inequal monthly installments over the remaining term of the note.

 

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. We also entered into a collateral assignment of leaseagreement as additional security for the repayment of borrowings.  This agreement grants MassDev all rights,title and interest in and to our lease for the Tyngsboro facility in the eventthat we default on our obligations.

 

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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 and provide for registration rights for the resale of the shares issuedupon their exercise. MassDev assigned one of the warrants to the MassachusettsTechnology Park Corporation (“MTPC”), as part of MTPC’s participation under theMassachusetts Technology Collaborative’s Business Expansion Initiative.  As no funds had been drawn down on the loanas of June 30, 2008, the fair value of the warrants is included in “Prepaidexpenses and other current assets.”  Theamount included in Prepaids as of June 30, 2008, was approximately$228,000.

 

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.

 

*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.

 

On October 9, 2007,Arete Power, Inc. filed a complaint against us claiming damages fromalleged willful infringement of U.S. Patent No. 6,710,489, entitled “AxiallyFree Flywheel System.”  On November 30,2007, we filed an Answer denying infringement and a Counterclaim seeking adeclaratory judgment that the ‘489 patent is invalid.  At the same time, we filed a motion totransfer the lawsuit from the Northern District of California to the Districtof Massachusetts.  On February 22,2008, the Court granted our motion to transfer the lawsuit to the District ofMassachusetts.  The District Court ofMassachusetts set an Initial Conference for August 5, 2008, but theparties filed an Assented to Motion to reschedule that Conference for August 25,2008. We believe that this lawsuit is without merit and we plan to vigorouslydefend the Company against the lawsuit.

 

 **Note 6.  Stock Warrants**

 

The following scheduleshows warrants outstanding as of June 30, 2008:

 
| **Description**                                        | ** ** | **Grant Date** | ** ** | **Expiration  Date** | ** ** | **Strike  Price** | ** ** | **Issued and  Outstanding** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|----------------------|------------|-------------------|------------|----------------------------------|------------|
| May 24, 2005 Financing                            |       | 5/24/2005           |       | 5/25/2010            |       | $                 | 1.008      |                             | 800,000    |   |
| November 8, 2005 Financing (Investors)            |       | 11/8/2005           |       | 5/9/2011             |       | $                 | 1.99       |                             | 3,287,821  |   |
| November 8, 2005 Financing (Placement Agents)     |       | 11/8/2005           |       | 11/8/2008            |       | $                 | 2.21       |                             | 450,000    |   |
| February 15, 2007 Shelf Issue                     |       | 2/15/2007           |       | 2/15/0012            |       | $                 | 1.33       |                             | 6,261,786  |   |
| GFI Tyngsboro Lease                                    |       | 7/23/2007           |       | 7/22/2014            |       | $                 | 1.77       |                             | 500,000    |   |
| September 10, 2007 Shelf Issue (Investors)        |       | 9/10/2007           |       | 3/10/2013            |       | $                 | 1.99       |                             | 6,122,449  |   |
| September 10, 2007 Shelf Issue (Placement Agents) |       | 9/10/2007           |       | 3/10/2013            |       | $                 | 1.99       |                             | 153,061    |   |
| October 31, 2007 Shelf Issue                      |       | 10/31/2007          |       | 5/1/2013             |       | $                 | 2.97       |                             | 11,316,260 |   |
| June 30, 2007 Massachusetts Development Loan      |       | 6/30/2008           |       | 6/30/2015            |       | $                 | 1.89       |                             | 171,958    |   |
| Total warrants outstanding                             |       |                |       |                 |       |              |       | 29,063,335                       |       |

 

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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.

 

*May 2005 Financing Warrant*

 

In connection withthe investment by Perseus 2000 Expansion, L.L.C., we issued a warrant for800,000 shares of our common stock at an exercise price of $1.008, exercisableat any time until May 25, 2010.

 

*November 2005 Financing 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, and each placement agent warrant is exercisable at any time until November 8,2008.  The terms of the investor warrantsincluded anti-dilution provisions which required us to adjust the exerciseprice and the number of shares of our common stock to be issued upon exerciseof the warrants under certain circumstances, which include:

 

·                  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.

 

In February 2007,we issued stock at a price per share below the $1.85 threshold notedabove.  Based on the warrants’anti-dilution provisions, the exercise price of these warrants was adjustedfrom $2.21 to $1.99 and 327,294 additional warrants were issued to theinvestors.  Warrants issued to theplacement agent were not subject to adjustment.

 

*February 2007Shelf Warrants*

 

In February 2007,we sold 11,814,687 units of the Company at a purchase price of $0.90 perunit.  Each unit consisted of one share ofour common stock, par value $0.01 per share, and a warrant to purchase 0.5shares of common stock at an exercise price of $1.33 per share, for a total of5,907,345 warrants. In addition, we issued 354,441 warrants to the placementagents at the same price per share. These warrants became exercisable as of August 16, 2007, and expirefive years from date of issue. The units were issued pursuant to a prospectussupplement filed with the Securities and Exchange Commission in connection withour registration statement on an effective registration statement.

 

*July 2007Warrants*

 

In July 2007we entered into a lease for a new facility in Tyngsboro, MA.  We agreed under the terms of the lease toissue to the landlord pursuant to an exemption from registration under theSecurities Act of 1933, as amended, a warrant exercisable for 500,000 shares ofour common stock at an exercise price of $1.77 per share.  This warrant became exercisable as of July 23,2007, may be exercised at any time over the term of the lease and expires on July 22,2014.  The warrant and the sharesissuable upon exercise of the warrant are restricted securities and may not besold without registration under the Securities Act of 1933, as amended, andapplicable state securities laws or an exemption there-from.

 

*September 2007Shelf Warrants*

 

In September 2007,we sold 5,102,041 units of the Company at a purchase price of $1.96 perunit.  Each unit consisted of one shareof our common stock, par value $0.01 per share, and a warrant to purchase 1.2shares of common stock at an exercise price of $1.99 per share, for a total of6,122,449 warrants. In addition, 153,061 warrants were issued to the placementagents at the same price per share. The warrants become exercisable as of March 10,2008, and expire on March 11, 2013. The units were issued pursuant to aprospectus supplement filed with the Securities and Exchange Commission inconnection with our registration statement on an effective registrationstatement.

 

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*October 2007 Shelf 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. The warrants become exercisable six months and one dayafter their issuance, and expire May 1, 2013. The units were issuedpursuant to a prospectus supplement filed with the Securities and ExchangeCommission in connection with our registration statement on an effectiveregistration statement.

 

*June 2008Loan Warrants*

 

In June 2008,as part of a loan we received through a funding collaboration between theEmerging Technology Fund of Massachusetts Development Finance Agency and theMassachusetts Technology Collaborative’s Business Expansion Initiative, weissued two warrants to purchase an aggregate of 171,958 shares of our commonstock at an exercise price of $1.89 per share. Each warrant is exercisable immediately, and expires on June 30,2015.

 

**Note7.  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 morethan 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 30,2008, we had 12,178,983 shares reserved for issuance under this plan, net ofoutstanding 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, 2008, we had1,792,272 shares reserved for issuance under this plan.

 

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*RestrictedStock Unit Arrangements*

 

Our Third Amendedand Restated 1998 Stock Incentive Plan permits the grant of restricted stockunits (“RSUs”) to our employees, officers, directors and other serviceproviders.  We use RSUs to (i) alignour employees’ interests with those of the Company, (ii) motivate ouremployees to achieve key product development milestones and thus createstockholder value, (iii) retain key employees by providing equity to suchemployees and (iv) conserve cash, by paying bonuses in the form of RSUs,rather than in cash, but with the number of such RSUs calculated on adiscounted basis to compensate for the reduced liquidity as compared tocash.  With respect to the RSUs that are granted in lieu of cash bonuses,the number of RSUs granted are based on performance, and are automaticallyconverted into shares of common stock in four equal tranches in the fiscal yearfollowing the year of performance. Certain other RSUs are granted to ourofficers as a form of equity incentive, are not tied to performance, and vestover a three-year period in equal quarterly installments.  There are alsoother performance-based restricted stock units (PSUs) granted to our officersthat cliff-vest upon the achievement of certain earnings-based milestones andupon the Company achieving a level of revenue such that it is no longer treatedas a development stage company for accounting purposes, both such vestingevents subject to the recipient officer being employed by us during the periodending with the milestones. The unvested portion of any RSU or PSU grant issubject to forfeiture upon the holder’s resignation or termination forcause.  As of December 31, 2007,certain RSUs granted under the officer employment agreements were vested butstock was not issued because the vesting date, December 31, fell duringour holiday shut-down period.

 

Restricted stock activityas of December 31, 2007 and for the six months ended June 30, 2008 isas follows:

 
| ** **                                          | ** ** | **Six months ended  June 30,  2008** | ** ** | **Year ended  December 31,  2007** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------|------------|
| * *                                            | * *   | **(number  of shares)**                             | * *   |
| Shares issued related to vested RSUs:               |       |                                                |       |                                         |       |
| Based on prior year grants                          |       | 28,563                                              |       | 14,044                                       |       |
| Based upon current year executive officer agreement |       | 14,094                                              |       | 18,030                                       |       |
|                                                |       |                                                |       |                                         |       |
| Vested RSUs not yet converted to stock              |       | —                                              |       | 9,521                                        |       |
|                                                |       |                                                |       |                                         |       |
| RSU’s granted but not vested:                  |       |                                                |       |                                         |       |
| Based upon prior year bonus plan                    |       | —                                              |       | —                                       |       |
| Related to 2006 executive officer agreement         |       | 7,031                                               |       | 14,053                                       |       |
| Related to 2007 executive officer agreement         |       | 36,088                                              |       | 48,108                                       |       |
| Related to 2008 executive officer agreement         |       | 46,998                                              |       | —                                       |       |
| Related to performance-based executive plan*        |       | 1,265,823                                           |       | 1,265,823                                    |       |

 

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*Subjectto achievement of performance requirements.

 

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**StockOption Plan Schedules**

 

Stock option activity forthe first six months of 2008 was as follows:

 
| ** **                          | ** ** | **Number of  Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Fair  Value** | ** ** |
|-------------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| Outstanding, December 31, 2007 |       | 8,712,488                  |       | $                                       | 1.18       |                                |       |   |
| Granted                             |       | 2,184,803                  |       | $                                       | 1.43       |                                | $          | 0.79 |   |
| Exercised                           |       | (19,250                    | )          | $                                       | 0.79       |                                |       |   |
| Canceled, forfeited or expired      |       | (8,000                     | )          | $                                       | 1.37       |                                |       |   |
| Outstanding, June 30, 2008     |       | 10,870,041                 |       | $                                       | 1.20       |                                |       |   |
|                                     |            |                            |            |                                         |            |                                     |            |  |  |

 

The following tablesummarizes information about stock options outstanding at June 30, 2008:

 
| **Exercise   Price** | ** ** | **Number  of Options  Outstanding** | ** ** | **Weighted-  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Vested  Number  of Options** | ** ** | **Vested  Weighted-  Average  Exercise  Price** | ** ** |
|---------------------------|------------|------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|
| $0.26 - $0.74             |       | 3,181,138                                |       | 6.03                                                              |       | $                                       | 0.70       |                                | 3,181,138  |                                            | $          | 0.70 |   |
| $0.82 - $1.46             |       | 5,696,183                                |       | 7.81                                                              |       | $                                       | 1.06       |                                | 2,774,074  |                                            | $          | 0.97 |   |
| $1.51 - $2.19             |       | 1,535,470                                |       | 7.27                                                              |       | $                                       | 1.82       |                                | 1,218,138  |                                            | $          | 1.85 |   |
| $2.50 - $3.10             |       | 130,000                                  |       | 1.85                                                              |       | $                                       | 2.64       |                                | 130,000    |                                            | $          | 2.64 |   |
| $4.10 - $5.27             |       | 222,250                                  |       | 2.66                                                              |       | $                                       | 4.40       |                                | 222,250    |                                            | $          | 4.40 |   |
| $6.00 - $9.31             |       | 105,000                                  |       | 2.38                                                              |       | $                                       | 6.40       |                                | 105,000    |                                            | $          | 6.40 |   |
| Total                     |       | 10,870,041                               |       |                                                              |       |                                    |       | 7,630,600                           |       |                                            |       |

 

**Stock Compensation**

 

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, expectedlife of the option, risk-free interest rate and expected dividends, if any.

 

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.

 

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The assumptions used tovalue stock option grants for the three months and six months ended June 30,2008 and 2007, respectively, are as follows:

 
| ** **                                                                               | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Risk-free interest rate                                                                  |       | 2.54%  - 3.33%                                      |       | 4.52%  - 5.05%                                    |       | 2.15%  - 3.33% |   | 4.48%  - 5.05% |   |
| Expected life of option                                                                  |       | 3.5  years                                          |       | 3  years                                          |       | 3.5  years |   | 3  years |   |
| Expected dividend payment rate, as a percentage of the stock price on  the date of grant |       | 0%                                                  |       | 0%                                                |       | 0% |   | 0% |   |
| Assumed volatility                                                                       |       | 89%  - 95%                                          |       | 95%  - 100%                                       |       | 87%  - 98% |   | 95%  - 100% |   |
| Expected forfeitures                                                                     |       | 10%                                                 |       | 10%                                               |       | 10% |   | 10% |   |

 

Stock-based compensationexpense recognized on our consolidated statement of operations for the threeand six months ended June 30, 2008 and 2007 are as follows:

 
| ** **                                    | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                    | ** ** | **2008**                                            | ** ** | **2007**                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
| Selling, general and administrative           |       | $                                                   | 299,598    |                                              | $          | 297,280 |   | $ | 687,999 |   | $ | 660,488 |   |
| Research and development                      |       | 268,655                                             |       | 159,028                                           |       | 631,564 |   | 376,076 |   |
| Total stock compensation expense              |       | $                                                   | 568,253    |                                              | $          | 456,308 |   | $ | 1,319,563 |   | $ | 1,036,564 |   |
|                                          |       |                                                |       |                                              |       |   |   |   |   |
| Components of stock compensation expense:     |       |                                                |       |                                              |       |   |   |   |   |
| Compensation expense related to RSU or PSUs   |       | $                                                   | 154,599    |                                              | $          | 152,081 |   | $ | 316,745 |   | $ | 310,600 |   |
| Compensation expense related to stock options |       | 413,654                                             |       | 304,227                                           |       | 1,002,818 |   | 725,964 |   |
| Total stock compensation expense              |       | $                                                   | 568,253    |                                              | $          | 456,308 |   | $ | 1,319,563 |   | $ | 1,036,564 |   |

 

As of June 30, 2008,there was approximately $ 2,099,000 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.

 

**Note8.  Subsequent Event**

 

None.

 

**Item2. Management’s Discussion and Analysis of Financial Condition 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 actual resultswe achieve may differ materially from these projections due to a number offactors 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.

 

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**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.

 

*RevenueRecognition*

 

Although we havesold photovoltaic inverters and recorded revenues for flywheel developmentcontracts, our operations have not yet reached a level that would qualify us toemerge from the development stage.  Therefore we continue to be accountedfor as a development stage company under Statement of Financial AccountingStandards No. 7 “Accounting and Reporting by Development StageEnterprises.”

 

*InverterSales*

 

 We recognize revenue in accordance withaccounting principles generally accepted in the United States of America. Generally, revenue is recognized on transfer of title, typically when productsare shipped and all related costs are estimable.  For sales todistributors, we make an adjustment to defer revenue until our products aresubsequently sold by distributors to their customers.

 

*Government Contract Revenue Recognized on thePercentage-of-Completion Method*

 

We recognizecontract revenue using the percentage-of-completion method. We use labor hoursas the basis 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.  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 ourresearch and development contracts are subject to cost review by governmentagencies. Our reported results from these contracts could change adversely as aresult of these reviews.

 

*Losson Contract Commitments*

 

Our contracts havebeen primarily for the development of demonstration units of new products andthe design of a frequency regulation plant. As such, the work has supported our core research and developmentefforts.  We establish reserves foranticipated losses on contract commitments if, based on our cost estimates tocomplete the commitment, we determine that the cost to complete the contractwill exceed the total expected contract revenue.  Most of our contracts have been granted on acost-share basis, for which the expected cost-share is recorded as a contractloss. Additionally, each quarter we perform an evaluation of expected costs tocomplete our in-progress contracts and adjust the contract loss reserveaccordingly.

 

*WarrantyReserves*

 

The solarinverters we have sold carry warranties that require us to repair or replacedefective products returned to us during the applicable warranty period at nocost to the customer. We record an estimate for warranty-related costs based onactual historical return rates, anticipated return rates and repair costs atthe time of sale.

 

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*IncomeTaxes*

 

Deferred taxassets and liabilities are determined based on differences between thefinancial reporting and income tax basis of assets and liabilities as well asnet operating loss and tax credit carryforwards, and are measured using theenacted tax rates and laws that will be in effect when the differencesreverse.  Deferred tax assets are reduced by a 100% valuation allowance toreflect the uncertainty associated with their ultimate realization.

 

Significantmanagement judgment is required in determining the provision for income taxes,the deferred tax assets and liabilities and any valuation allowance recordedagainst deferred tax assets.  The valuation allowance is based on ourestimates of taxable income and the period over which our deferred tax assetswill be recoverable.  In the event that actual results differ from theseestimates or we adjust these estimates in future periods, we may need toestablish an additional valuation allowance or reduce our current valuationallowance, which could materially impact our tax provision.  We classify interest and penalties relatingto uncertain tax position in income tax expense.

 

*Impairmentof Long-Lived Assets*

 

In accordance withStatement of Financial Accounting Standards No. 144 “Accounting for theImpairment or Disposal of Long-Lived Assets” long-lived assets we hold and useare reviewed to determine whether any events or changes in circumstancesindicate that the carrying value of the asset may not be recoverable.  The conditions to be considered includewhether or not the asset is in service, has become obsolete, is damaged, orwhether external market circumstances indicate that the carrying amount may notbe recoverable.  When appropriate werecognize a loss for the difference between the estimated fair value of theasset and the carrying amount.  The fairvalue of the asset is measured using either available market prices orestimated discounted cash flows.

 

**Overview**

 

We design, develop,configure and expect to begin operating flywheel-based frequency regulationfacilities that will provide services to support more reliable andcost-effective electricity grid operation. The focus of our research anddevelopment has been to establish commercially viable flywheel-based energy storagetechnologies that can provide highly reliable energy solutions for theworldwide electricity grid at competitive costs. Initially, we expect togenerate revenues from the commercialization of our flywheel energy storagesystems to supply frequency regulation services to the electricity grid inNorth America. We believe that as we expand our production capabilities we canbecome a provider of frequency regulation services to grid operators on aglobal basis. In addition we believe that as the commercialization of ourtechnologies continues, we will develop other cost-effective applications forour flywheel systems that will provide additional revenue opportunities.

 

Our market focus is onthe geographic regions of the domestic grid that provide open bid markets forregulation services. These regions and their Independent System Operator (ISO)or Regional Transmission Operator (RTO) designations are: New England (ISO NewEngland or ISONE); California (California ISO or CAISO); New York (New York ISOor NYISO); Mid-Atlantic (PJM Interconnect) and Texas (ERCOT). In addition,during 2008 Midwest Independent Transmission System Operator, Inc.(Midwest ISO or MISO) is expected to begin operating its open-bid ancillaryservices market for frequency regulation. We have been proactive in thisemerging market and have added it to our initial target markets.

 

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

 

In North America, thefrequency regulation market in areas that were accessible via open-bid auctionmechanisms was valued at approximately $800 million in 2007.  Before the end of 2008 (by which time MidwestISO’s regulation market is expected to be in operation) the addressableopen-bid regulation market on an annualized basis is expected to exceed $1billion per year.  Based on globalelectrical production, we believe that the worldwide frequency regulationmarket is several times this amount. Significant growth in the US open-bidmarket is expected due to a combination of factors, including:

 

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

·                  Anticipatedexpansion of open-bid grid operating regions such as the Midwest ISO

·                  Increaseddemand for electricity

·                  Increasedfossil fuel prices

·                  Governmentand market forces aimed at reducing carbon dioxide emissions.

 

Underthe open-bid market, grid operators forecast the need for frequency regulationas a percentage of expected power demand, and approved suppliers submit bidsfor these services. Bids are stacked from lowest to highest prices until thecumulative amount of bids is sufficient to meet the calculated need. The pricesubmitted by the highest selected bidder determines what every bidder is paid.

 

Tofully exploit this regulatory-driven open-bid market, we are finalizing ourdesign and expect to build, own and operate a number of frequency regulationfacilities. Our business model, which is a sale-of-services model, is similarto that of independent power producers who also design, build, own and operatetheir own power plants. Each Smart Energy MatrixTM frequency regulation facilitywill be up to 20 megawatts (MW) in size. A Smart Energy MatrixTM is amulti-flywheel energy storage system designed to provide reliable andsustainable frequency regulation services for utility grids.  A Smart Energy MatrixTM can be scaled to anysize to provide one or more megawatts of frequency regulation capacity.  Smart Energy MatrixTM frequency regulationplants that are 20 MW or less in size offer the advantage of being eligible touse fast-track interconnection regulations that allow plants of this capacityor smaller to be approved more quickly in accordance with streamlinedregulatory rules. A key aspect of our business model is that we are notdependant on the lengthy procurement cycles typically associated with the marketingand sale of capital equipment to the utility sector.  Instead, our business model is to become amerchant provider of frequency regulation services to the deregulated open bidmarkets.  We will be bidding the outputof our plants into multiple open-bid markets for regulation services on a dailybasis.

 

Akey qualification for our participation in these markets is the ability todemonstrate that our technology can deliver the regulation services required byeach grid operator. To attain this qualification and accelerate market entry weinstalled two scale-power 100-kilowatt-hour (kWh) demonstration models of ourSmart Energy MatrixTM for evaluation by two large grid operators. Both of ourscale-power systems were comprised of multiple flywheels.  In 2005, we were awarded contracts for thesesystems by the California Energy Commission (CEC) and the New York State EnergyResearch and Development Authority (NYSERDA), in cooperation with the U.S.Department of Energy (DOE), to test the viability of our flywheel technologiesfor frequency regulation by these grid operators.  The demonstration systems were scale-powerprototypes of the Smart Energy MatrixTM multi-flywheel system.  As a result of the success of the pilotprograms, we have focused on the design of full scale Smart Energy MatrixTMsystems.

 

Boththe California and New York systems were installed and evaluated in formalfield trials. The demonstration units contained fully functional control,communication and interconnection elements similar or identical to the elementsof our design for 20 MW frequency regulation facilities. The purpose of thesepilot systems was twofold: 1) to demonstrate the ability of our flywheeltechnology to provide frequency regulation services consistent with thetechnical requirements of the grid operators, including the California ISO andNew York ISO, and 2) to obtain certification or other approval from these systemoperators that, from a technical perspective, our technology is approved toprovide commercial frequency regulation services in their respective states andterritories.

 

TheCalifornia system completed its field trial on January 31, 2007, earning apositive evaluation from both the CEC and the CAISO.  On December 26, 2006, the California ISOcertified our flywheel technology for use as a frequency regulation resource inCalifornia.

 

The New York demonstration unit incorporatedtechnology improvements as a result of field testing in California and thesystem contained additional voltage support and power quality capabilities. Theadded capabilities were designed to demonstrate the technical efficacy of twoentirely new applications for our core technology.

 

On March 22, 2007, the New York State EnergyResearch and Development Authority (NYSERDA) and the U.S. DOE confirmed thesuccessful outcome of technical field trial testing of our scale-power flywheelfrequency regulation system in New York. At the same time, the New York ISOdetermined that our technology is a viable technology for frequency regulationon its grid and is acceptable for provision of commercial frequency regulationin the State of New York. Our New York-based flywheel system field trial reachedthis significant milestone after the U.S. DOE (through Sandia NationalLaboratories, which co-monitored the demonstration with NYSERDA) concluded thatthe unit’s performance had been successfully demonstrated and that additional 

 

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testing of the technology was not required. During the first quarter of2008, the New York demonstration unit was retrieved for potential future use insupporting other demonstration programs and/or R&D activities.

 

Thelocation of our regulation plants and the sequence in which they will be constructeddepend on a number of factors, including but not limited to the availabilityand cost of land, the cost of power plant construction, technical gridinterconnection requirements, comparative market pricing available forfrequency regulation in the various regional markets, approval of environmentaland related permits required to build plants, and our ability to receiveappropriate revenues and payments within the Market Rules of each regionalmarket.

 

Subsequentto the end of the quarter, we exercised an option to purchase approximatelyseven acres of land at a site in Stephentown, New York. This site is served bytwo transmission companies: National Grid and New York State Electric and Gas(NYSEG). National Grid owns a 115 KVA transmission line that abuts the site,and NYSEG owns a substation that also abuts the site. Our interconnectionrequest for a 20 MW plant includes National Grid as the transmission provider.We also recently submitted a separate interconnection application for a 1 MWfacility with NYSEG that would connect directly to its substation.

 

On July 17,2008, we received a land-use permit we had requested from the town ofStephentown, New York. Pending approval of our active interconnection requestto NYISO and any other implementation requirements of the NYISO, a possiblelocation for our first 20 megawatt frequency regulation plant will be inStephentown.  We are aggressivelypursuing completion of the required interconnection processes for the Stephentownplant. This includes completion by NYISO of a System Impact Study, currentlyunderway, whose purpose is to ensure that our plant can safely interface withthe grid, and to identify any utility upgrades or other equipment that may beneeded before operation of the plant can be approved.

 

Our application tothe DOE for a loan guarantee identifies Stephentown, New York, as the plannedlocation for our first 20 MW plant. The satisfactory completion of NYISO’sSystem Impact Study and clear resolution of Market Rule issues (describedbelow) that affect our ability to enter and operate in the NYISO market couldimpact the timing or success of our DOE loan guarantee application. Lengthydelays or negative outcomes in any of the factors identified above couldpotentially require us to select another location for the first 20 MW plant.While we are working to bring matters related to the 20 MW plant in Stephentownto the earliest possible successful conclusion, we are also actively developingalternate plant sites in multiple ISOs as a contingency against theselocation-based risks.

 

We expect to havefrequency regulation facilities in two locations before the end of 2008 with atotal of five megawatts of capacity. To that end, we have initiated the processof establishing up to five megawatts of frequency regulation capacity on ourTyngsboro site, and potential locations are being actively pursued in the PJMInterconnection in addition to the Stephentown site.

 

Our deployment scheduleis conditional upon the following additional factors and activities:

 

·                  Component development and quality:

 

·                  Complete testing of certain components toensure highly durable operation at commercial operating speeds.

 

·                  Development of multiple sources for ourkey components. We are working to expand our supplier base to qualify theircomponents to our designs and specifications so that we may complete theinitial production run of Smart Energy 25 flywheel units.

 

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

 

·                  Market rules and participation:

 

·                  To participate in and be paid forregulation services in our target markets, certain conditions must be met. Thetechnology must be demonstrated and accepted by the Independent SystemOperators (ISOs). We accomplished this through our successful demonstrationprojects in California and New York. Prior to plant construction, we must also file an interconnectionapplication with the ISO.  Ourinterconnect application for the Stephentown NY site was filed at the end of2007.  New York ISO is currently in theprocess of completing a System Impact Study for our 20MW plant.  The purpose of the impact study is to ensurethe seamless integration of our plant to the grid.  Following the completion of this study weexpect to be granted an interconnection agreement.

 

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·                  We must become a member of each ISO andconfirm that market rules specific to each ISO are compatible with ourtechnology.  We have been a member of thePJM Interconnection since 2004 and we have found no restrictions to marketparticipation there.  More recently, wehave been accepted as a member of ISO New England and approved as a member ofNew York ISO.

 

·                  The need to conform some market rules tobe compatible with our technology within our target markets is requiring moretime to complete than we had previously thought. In some cases market rule changesare needed which also require time to complete. Some ISOs (other than PJM) have not yet fully updated their market rules tocomply with the Federal Energy Regulatory Commission’s 2007 mandate that non-generationresources (such as ours) be allowed equal access to enter the market forregulation services.  It is believed thatthese ISOs will require a number of months to come into compliance, and we haveadded more resources to accelerate the process.

 

**Regulatoryand Market Affairs**

 

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

 

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

 

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

 

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

 

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

 

·                  Midwest ISOis in the process of implementing a new Ancillary Services Market (ASM) to meetits compliance requirements with Order 890. We are actively engaged with MISOin the development of this market. This new ASM is in a testing phase and isexpected to start on September 9, 2008. Our analysis of MISO’s ASM tariff disclosed features that would haveincreased our costs and/or decreased revenues in what we believe would be adiscriminatory manner. In response to our FERC filing to draw attention to theseissues, on February 25, 2008, FERC issued its decision with respect toMISO’s ASM tariff.  FERC respondedpositively to the issues we raised in our Initial and Reply Comments.  

 

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Specifically, FERC mandated that the Midwest ISPremove barriers preventing new technologies from participating in theregulation market. FERC commented: “We require the Midwest ISO to evaluate,through stakeholder discussions (we consider discussions between the MidwestISO and Beacon Power to be the most appropriate venue for determining whethernew technologies qualify as generation resources) adjustments to operatingrequirements and ASM procedures that will remove barriers to comparabletreatment of DRRs (Demand Response Resources) and new technologies in theregulating reserve markets and to provide a report on its efforts toincorporate these resources into its markets within 60 days of the date of thisorder.  We also require the Midwest ISO to submit revised tariff sheets,if adjustments are proposed, in a compliance filing to be submittedconcurrently with the 60-day informational filing.”   After working in good faith with Beacon forthat period, on April 25, 2008, MISO fully complied with FERC’s 60-daydirectives by filing a request for an entirely new regulation resource categoryspecifically designed for Stored Energy Resources (“SER”), including ourflywheel technology, to take effect on June 1, 2009. This is the firstsuch tariff in the United States designed specifically to accommodate energystorage-based regulation resources and it contains features that are expectedto maximize our revenues in the MISO market. This tariff request is currently under review at FERC.  Given the landmark nature of this specificproposed tariff and its potential to facilitate our market entry and profitableoperation, we intend to pursue the creation of similar stored energy tariffsapplicable to the provision of frequency regulation services in all of ouropen-bid markets.

 

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

 

·                  NYISOpostponed submitting a new tariff and market rules to allow non-generationresources and instead stated that we can qualify under the existing tariff as agenerator. While we can enter the market within the generator category, webelieve this category might expose us to unwarranted costs and potentiallyreduce our revenues.  In its November 19,2007, response to our comments to NYISO’s Order 890 Compliance Filing, NYISOnoted that: “The NYISO is currently working with Beacon to ensure that softwareand metering arrangements are in place to support its participation in themarkets as a generator when its facility actually comes on line, which isexpected to occur sometime in 2008. There is, however, no tariff obstacle toBeacon’s provision of regulation service.” Our regulatory focus includesworking with NYISO to remedy certain limitations we see within the generatorcategory.  NYISO has been slow to engagein constructive interaction; consequently we continued to seek recourse throughFERC in an effort to accelerate NYISO’s delivery on its past commitment to workwith us to remedy limitations to market participation with respect toqualifying under the generator category. On May 23, 2008 FERC mandatedthat NYISO work with us to integrate energy storage technologies into itsregulation market and required NYISO to file quarterly reports on its progressin this regard.  On July 1, 2008,the NYISO presented to its market stakeholders new Regulation market rules forlimited energy resources.  The new rules recognizethe unique operating characteristics of our technology and remedy thelimitations in the current generator market. These rules are currently under review by the marketstakeholders.  In addition, we areworking with both the NYISO and market stakeholders to have a line item inNYISO’s 2009 budget for the necessary software changes to implement these newRegulation rules.

 

·                  ISONE modified its tariff language, butstated that it needed to make changes to market rules in order to fullycomply with Order 890. Since acknowledging the need for market changes, ISONEhas worked with us in good faith. On March 11, 2008, ISONE announced itsplan to create a 13 MW Alternative Technologies Regulation Pilot program tocomply with Order 890.  The pilot programis designed to begin in November 2008 and run for approximately 18 months.The purpose of the Non-Generation Regulation Pilot program will be to evaluatethe performance of new energy storage-based technologies like ours that areunable to participate in ISONE’s current regulation market, determine how thesetechnologies can best be used to meet New England’s regulation requirements,allow program participants to operate in a realistic market environment wherethey can evaluate their market viability, and provide operating experience thatISONE can use to formulate permanent market rules.  On July 15, 2008 the NEPOOL MarketsCommittee unanimously voted to support the creation of the pilot program.  On August 1, 2008, the program wasunanimously approved by the NEPOOL Participants Committee.  On August 5, 2008, ISO New England and theNortheast Power Pool (NEPOOL), its member companies, jointly submitted to FERCnew market rules for establishing an alternative technologies pilot programthat would include flywheel energy storage. Pending FERC approval, which isexpected within sixty days, we intend to participate in this pilot program andexpect to generate revenues under this program as early as November 2008.ISONE typically uses such pilot programs to launch major and permanent changesto its market rules, so we see this program as a direct and appropriateresponse to FERC’s Order 890 directives.

 

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·                  CAISO submitted an Order 890 compliancefiling on June 16, 2008 which modified its tariff to allow bids forregulation by non-generation resources that are capable of providing theservice and that meet applicable Ancillary Service standards and technicalrequirements.  In addition, in May 2008the CAISO initiated a project and stakeholder process to develop the technicaland operational requirements for integrating storage technologies into thesystem and consider the extent to which additional tariff revisions may beappropriate to enhance their participation in the CAISO’s markets.

 

·                  ERCOT’s market prices for regulation currently do notsupport market entry. Since ERCOT is not regulated by the Federal EnergyRegulatory Commission, our ability to seek beneficial market rule changesthat hold the potential to support higher pricing in consideration of ourtechnology’s superior performance is limited at this time. As the performanceof our technology is fully demonstrated at a system-wide level in other ISOs,and as wind penetration in Texas increases and the demand for fast regulation resourcesrises, we will re-evaluate the feasibility of encouraging beneficial market rule changesand the potential of entering this market on a more profitable basis.

 

We completed themove to our new facility in January 2008, and we have completed the firstphase build-out of our manufacturing facility. We now have a facility capableof producing up to 600 flywheels per year, which will be ramped up to commenceall aspects of production once the development of all components is complete.  We have a second phase manufacturingbuild-out planned which will increase annual manufacturing capacity to morethan 1,000 flywheels.

 

Becauseour business model is based on being a service provider that owns and operatesplants and equipment as opposed to selling equipment, we will need to obtainsignificant additional funding to further expand our manufacturing capacity,procure the components and ancillary equipment needed to manufacture ourflywheel systems and construct our frequency regulation facilities.  We expect to raise additional capital in 2008through the sale of our stock.  In thefuture, we will need to raise additional capital either from project financingor additional equity transactions in order to build additional regulationfacilities.

 

As our business develops,we may from time to time evaluate possible acquisitions of enterprises ortechnologies that we would consider synergistic from a market, technology orproduct perspective.

 

From inception through June 30, 2008, we haveincurred losses of approximately $174 million. We expect to continue to incurlosses as we expand our product development and begin to increase ourmanufacturing and assembly capacity.

 

*Revenues*

 

In the past, we wereawarded fixed price research and development contracts from government agenciesand are pursuing similar contracts from other government agencies.  We have recognized revenues on our existingcontracts using the percentage of completion method.  We are continuing to evaluate markets for ourflywheel systems but we have not recognized revenues from these products.

 

*Costof Goods Sold*

 

Cost of goods soldon fixed price research and development contracts are predominantly beingrecorded on the percentage of completion method and consist of direct labor andmaterial, subcontracting, and associated overhead costs.

 

*Selling,General and Administrative Expenses*

 

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

 

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*Researchand Development*

 

Our cost ofresearch and development consists primarily of the cost of compensation andbenefits for research and development and support staff, as well as materialsand supplies used in the engineering design and development process. We expectresearch and development expenses to increase during 2008.

 

*Losson Contract Commitments*

 

We establish reservesfor anticipated losses on contract commitments if, based on cost estimates tocomplete the commitment, we determine that a loss will be incurred.  In addition, we evaluate our estimated coststo complete our government contracts on a quarterly basis and adjust thereserves when appropriate.

 

In 2007, we completedall but one of our existing contracts.   In April 2008 we were awarded asubcontract to provide a flywheel energy storage system in support of a windintegration research and development (R&D) project sponsored by theCalifornia Energy Commission.  We willreceive approximately $250,000 to offset R&D expenses and will contributean additional $87,000 of engineering resources for the project, bringing theR&D total to approximately $340,000. In addition to the California EnergyCommission, which is funding the project, other leading stakeholders includeSouthern California Edison and the California ISO.  The flywheel system will be installed inTehachapi, California, a high-potential wind resource area where, according toa report from the California ISO, up to 4,200 megawatts of wind power may beadded in the coming years.  Our flywheelenergy storage systems may also have the potential to address shortages intransmission line capacity, which this wind power integration project isintended to prove.  The primary goal ofthe project is to demonstrate that advanced control technology with energystorage can help expand the delivery of renewable wind energy by effectivelyincreasing the capacity of constrained transmission facilities in the Tehachapiarea.  This project supports California’sgoal to upgrade and expand its electricity transmission and distributioninfrastructure per the state’s Energy Action Plan of 2003.We recorded acharge of approximately $87,000 during the period ended June 30, 2008,which reflects the expected “cost share” portion of the Tehachapi contract.

 

*Depreciationand Amortization*

 

Our depreciation andamortization is primarily related to depreciation on capital expenditures andthe amortization of lease and leasehold costs related to our facilities.  We have intellectual property in the form ofpatents on our flywheel vacuum system, our heat pipe cooling systems, DC outputparalleling, metal hub, low-loss motor, co-mingled rims and earthquake-tolerantbearings on our flywheel products, anti-islanding software, drawings, sourcecode and production know-how on our SmartPower M5 inverter system, and expect to obtain other patents during 2008and beyond.  Due to the uncertainty ofrealizing any future value and lack of substantial revenues to date, all costsrelated to the development of intellectual property have been expensed asincurred.

 

*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 Months ended June 30, 2008 and 2007***

 
| ** **                             | ** ** | **Three months ended June 30,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                            | ** ** | **2007** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                             | ** ** | **(in  thousands)**                                 | ** ** |
| Revenue                                |       | $                                                   | 28         |   | $ | 449 |   | $ | (421 | ) | 94 | % |
| Cost of goods sold                     |       | 4                                                   |       | 419 |   | 415 |   | 99 | % |
| Gross margin                           |       | 24                                                  |       | 30 |   | (6 | ) | 20 | % |
| Selling, general and administrative    |       | 2,129                                               |       | 1,549 |   | (580 | ) | 37 | % |
| Research and development               |       | 3,003                                               |       | 1,824 |   | (1,179 | ) | 65 | % |
| Loss on sales and contract commitments |       | 87                                                  |       | — |   | (87 | ) | 0 | % |
| Depreciation and amortization          |       | 313                                                 |       | 31 |   | (282 | ) | 910 | % |
| Casualty loss (recovery)               |       | —                                              |       | (168 | ) | (168 | ) | 100 | % |
| Interest and other income, net         |       | 76                                                  |       | 140 |   | (64 | ) | 46 | % |
| Net loss                               |       | $                                                   | (5,432     | ) | $ | (3,066 | ) | $ | (2,366 | ) | 77 | % |

 

***Comparison of Six Months ended June 30, 2008 and 2007***

 
| ** **                               | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                               | ** ** | **2008**                                          | ** ** | **2007** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                               | * *   | **(in  thousands)**                               | * *   |
| Revenue                                  |       | $                                                 | 48         |   | $ | 842 |   | $ | (794 | ) | 94 | % |
| Cost of goods sold                       |       | 4                                                 |       | 812 |   | 808 |   | 100 | % |
| Gross margin                             |       | 44                                                |       | 30 |   | 14 |   | 47 | % |
| Selling, general and administrative      |       | 4,304                                             |       | 2,963 |   | (1,341 | ) | 45 | % |
| Research and development                 |       | 6,035                                             |       | 3,483 |   | (2,552 | ) | 73 | % |
| Loss on contract commitments             |       | 87                                                |       | — |   | (87 | ) | 0 | % |
| Depreciation and amortization            |       | 593                                               |       | 57 |   | (536 | ) | 940 | % |
| Casualty loss (recovery)                 |       | —                                            |       | (60 | ) | (60 | ) | 100 | % |
| Interest and other income (expense), net |       | 256                                               |       | 257 |   | (1 | ) | 0 | % |
| Net loss                                 |       | $                                                 | (10,719    | ) | $ | (6,156 | ) | $ | (4,563 | ) | 74 | % |

 

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*Revenue*

 

The following tableprovides details of our revenues for the three and six months ended June 30,2008 and 2007:

 
| ** **                    | ** ** | **Percent**                 | ** ** | **Three months  ended June 30,** | ** ** | **Six months ended  June 30,** | ** ** | **Cumulative   Contract  Value  Earned as** | ** ** | **Total  Contract ** | ** ** |
|-------------------------------|------------|-----------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------------------------------|------------|---------------------------|------------|
| ** **                    | ** ** | **complete**                | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008**                                              | ** ** | **2007**                  | ** ** | **of 2008** | ** ** | **Value** | ** ** |
| ** **                    | * *   | **(dollars  in thousands)** | * *   |
| CEC                           |       | 100%                        |       | $                                               | —     |                                          | $          | 43                                                    |       | $                         | —     |   | $ | 64 |   | $ | 1,233 |   | $ | 1,233 |   |
| NYSERDA PON 846               |       | 100%                        |       | —                                          |       | 19                                            |       | —                                                |       | 67                        |       | 646 |   | 646 |   |
| NYSERDA PON 800               |       | 83%                         |       | 1                                               |       | (5                                            | )          | 1                                                     |       | (1                        | )          | 51 |   | 63 |   |
| Air Force Research Laboratory |       | 100%                        |       | —                                          |       | 246                                           |       | —                                                |       | 437                       |       | 750 |   | 750 |   |
| Sandia DOE Earmark            |       | 100%                        |       | —                                          |       | 117                                           |       | —                                                |       | 247                       |       | 752 |   | 752 |   |
| Tehachapi                     |       | 1%                          |       | 3                                               |       | —                                        |       | 3                                                     |       | —                    |       | 3 |   | 250 |   |
| Total Contract Revenue        |       |                        |       | $                                               | 4          |                                          | $          | 420                                                   |       | $                         | 4          |   | $ | 814 |   | $ | 3,435 |   | $ | 3,694 |   |
| M5 and accessories            |       |                        |       | 24                                              |       | 29                                            |       | 44                                                    |       | 28                        |       |   |   |   |   |
| Total                         |       |                        |       | $                                               | 28         |                                          | $          | 449                                                   |       | $                         | 48         |   | $ | 842 |   | $ | 3,435 |   | $ | 3,694 |   |

 

In the threemonths ended June 30, 2008, we focused on preparations to begin commercialproduction of our flywheel energy storage systems, and only recorded minimalrevenue from flywheel-related research and development contracts.  In the same period for 2007, we recordedrevenue from flywheel-related research and development contracts calculatedusing the percentage of completion method of approximately$420,000. Revenue recorded from the sale of inverters and related productswas approximately $24,000 during the first quarter of 2008, as compared toapproximately $29,000 during the same period of 2007.  During the six months ended June 30,2008, we recorded approximately $4,000 of revenue from contract activities,compared to approximately $814,000 during the same period of 2007.  The reduction in contract revenue was due tothe completion of our larger contracts as of the end of fiscal 2007.  Inverter revenue was approximately $44,000during the first half of 2008, versus approximately $28,000 during the firsthalf of 2007.

 

*Costof Goods Sold*

 

Cost of goods soldwas approximately $4,000 during the second quarter of 2008, compared toapproximately $420,000 during the second quarter of 2007, and approximately$4,000 compared to approximately $812,000 for the six months ended June 30,2008 and 2007, respectively.  The changesin cost of goods sold are consistent with and for the same reasons as thefluctuations in revenue.

 

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*Selling,General and Administrative Expense*

 
| ** **                      | ** ** | **Three months  ended June 30,** | ** ** | **Six months  ended June 30,** | ** ** |
|---------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                      | ** ** | **(in thousands)**                         | ** ** |
| Period Ended June 30, 2007 |       | $                                               | 1,549      |                                          | $          | 2,963 |   |
| Increases (decreases):          |       |                                            |       |                                          |       |
| Legal and professional          |       | 316                                             |       | 507                                           |       |
| Salaries and benefits           |       | 206                                             |       | 445                                           |       |
| Subcontractors and consultants  |       | 125                                             |       | 337                                           |       |
| Materials and office expenses   |       | 30                                              |       | 55                                            |       |
| Taxes                           |       | 13                                              |       | 16                                            |       |
| Facility costs                  |       | 11                                              |       | 25                                            |       |
| Audit fees                      |       | 8                                               |       | 26                                            |       |
| Dues and subscriptions          |       | 3                                               |       | 17                                            |       |
| Stock compensation expense      |       | 2                                               |       | 28                                            |       |
| Reduction of bad debt reserve   |       | —                                          |       | 12                                            |       |
| Other                           |       | (1                                              | )          | 24                                            |       |
| Travel                          |       | (9                                              | )          | 7                                             |       |
| Hiring costs                    |       | (21                                             | )          | (26                                           | )          |
| Public company expenses         |       | (103                                            | )          | (132                                          | )          |
| Period Ended June 30, 2008 |       | $                                               | 2,129      |                                          | $          | 4,304 |   |

 

Selling, generaland administrative expenses totaled approximately $2,129,000 and $1,549,000 forthe three months ended June 30, 2008 and 2007, respectively. The increaseof approximately $580,000 or 37% was primarily the result of higher salariesand benefits due to additional staffing of approximately $206,000, increaseduse of subcontractors and consultants of approximately $125,000 relatedprimarily to our efforts to work with the ISO to modify their market rules andperform market studies, higher legal and professional fees of approximately$316,000 (also related primarily to regulatory efforts noted above as well ascosts related to raising funds), and increases in various other selling,general and administrative expense related to the maintenance of a largerfacility and staff and our transition from research and development toproduction activities.  In the firstquarter of 2007, we had a bad debt recovery of approximately $12,000; therewere no bad debt write-offs or recoveries during the first two quarters of2008. We expect our selling, general and administrative expenses to be somewhathigher in 2008 than 2007 due primarily to increases in staffing needed tosupport our transition to a production facility, increased marketing and salesexpenses associated with flywheel products and increased efforts to work withthe ISOs to modify market rules and fund-raising efforts.

 

For the six monthsended June 30, 2008 and 2007, selling, general and administrative expensesincreased from approximately $2,963,000 to $4,304,000, an increase ofapproximately $1,341,000, or 45%.  Thelargest increases were in legal and professional fees of approximately$507,000, salaries and benefits of approximately $445,000 and subcontractorsand consultants of approximately $337,000, for the same reasons as noted duringthe second quarter.  These increases wereoffset by a reduction in public company expenses of approximately $132,000during the six month period.

 

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*Researchand Development Expense*

 
| ** **                          | ** ** | **Three months  ended June 30,** | ** ** | **Six months  ended June 30,** | ** ** |
|-------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                          | ** ** | **(in thousands)**                         | ** ** |
| Period Ended June 30, 2007     |       | $                                               | 1,824      |                                          | $          | 3,483 |   |
| Increases (decreases):              |       |                                            |       |                                          |       |
| Allocation of overhead to contracts |       | 595                                             |       | 1,071                                         |       |
| Salaries and benefits               |       | 318                                             |       | 576                                           |       |
| Legal                               |       | 198                                             |       | 494                                           |       |
| Facility costs                      |       | 156                                             |       | 373                                           |       |
| Stock compensation expense          |       | 110                                             |       | 255                                           |       |
| Other                               |       | 39                                              |       | 59                                            |       |
| Outside testing                     |       | 20                                              |       | 11                                            |       |
| Expense materials                   |       | 17                                              |       | (42                                           | )          |
| Software maintenance                |       | 4                                               |       | 23                                            |       |
| Travel                              |       | 2                                               |       | 9                                             |       |
| Hiring costs                        |       | (57                                             | )          | (59                                           | )          |
| Consultants and subcontractors      |       | (223                                            | )          | (217                                          | )          |
| Period Ended June 30, 2008     |       | $                                               | 3,003      |                                          | $          | 6,036 |   |

 

For the threemonths ended June 30, 2008, research and development expense increased byapproximately $1,179,000 or 65%, in comparison to the equivalent period in2007.  This increase is primarily due toa reduction in the overhead allocated to our government contracts ofapproximately $595,000, as those contracts were mostly completed during 2007;increased legal costs of approximately $198,000 related to the Arete lawsuit;increased headcount-related expenses resulting from hiring of engineering andsupport staff to support our flywheel development and move to production ofapproximately $318,000; increased facility costs due to our larger facility ofapproximately $156,000; increased stock compensation expense of approximately$110,000 and increases in various other costs of approximately $82,000.  These increases were partially offset by areduction in hiring costs of approximately $57,000, resulting from lower usageof outside agencies because we hired a Director of Human Resources during thefirst quarter of 2008.  In addition, asinternal staffing has increased, we have reduced our use of consultants andcontractors by approximately $223,000. Although critical testing of the SmartEnergy 25 flywheel is complete, we continue to perform various operationaltests and other development work aimed at achieving manufacturing costreductions.  Additionally, we expectoccupancy costs in our new, larger facility in Tyngsboro to be higher thanthose at our Wilmington facility.

 

Research anddevelopment expenses for the first six months of 2008 increased fromapproximately $3,483,000 in 2007 to approximately $6,036,000 in 2008, anincrease of $2,553,000 or 73%.  Approximately42% of the increase, $1,071,000, is due to a reduction in the overheadallocated to our government contracts, as those contracts were mostly completedduring 2007.  Other large increases wereas follows:  approximately $576,000 dueto increased headcount-related expenses as we ramp up to begin commercialproduction activities, approximately $494,000 legal expenses related to theArete lawsuit, approximately $373,000 increase in facility costs related to ourlarger facility, approximately $255,000 stock compensation expense primarilyrelated to new hire option grants and other miscellaneous increases ofapproximately $102,000.  Increases wereoffset by reductions in expense materials of approximately $42,000, a drop inhiring costs of approximately $59,000 due to a reduction in the use of outsideagencies and a reduction in the use of consultants by approximately $217,000.

 

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*Losson Contract Commitments*

 

Our contracts have beenprimarily for the development of demonstration units of new products and thedesign of a frequency regulation plant. As such, the work has supported ourcore research and development efforts. Most of these contracts have been structured on a cost-share basis, forwhich the expected cost-share has been recorded as a contract loss.  We recorded contract commitment losses on ourresearch and development contracts in 2005 and 2006, which we reduced in 2007as we completed all but one contract for amounts which were less thanpreviously estimated.  During the secondquarter of 2008, we recorded an additional contract loss for the requiredcost-share portion of the Tehachapi contract which was awarded in April 2008.

 

*Depreciationand Amortization*

 

Depreciationexpense increased from approximately $31,000 during the quarter ended June 30,2007 to approximately $313,000 for the same period in 2008, an increase ofapproximately $282,000, or 910%. Similarly, for the six month periods ended June 30, 2008 and 2007,depreciation increased by approximately $536,000, or 940%.  For both the three and six month periods, theincreases are primarily due to capital expenditures relating to leaseholdimprovements at our new manufacturing and office facility in Tyngsboro as wellas the purchase of machinery and equipment required to begin commercialproduction.  As of June 30, 2008, wehad approximately $5.2 million in “construction in progress”, of whichapproximately $3.3 million are materials to build flywheels and approximately$1.3 million are costs related to the construction of frequency regulationfacilities.  We expect depreciationexpense to continue to increase during 2008 as we build and place our frequencyregulation facilities into commercial operation.

 

*Interestand Other Income/(Expense), net*

 

Although averagecash balances during the second quarter of 2008 were higher than during thesame periods in 2007, interest income dropped by approximately $64,000, or 46%,due to lower interest rates. For the six months period ended June 30,2008, interest and other income (expense) was approximately $256,000, which wasonly slightly lower than for the same period in 2007 of approximately $257,000.

 

*NetLoss*

 

As a result of thechanges discussed above, the net loss for the three months ended June 30,2008 was approximately $5,432,000 which compares to a net loss during the sameperiod in 2007 of approximately $3,066,000, an increase in net loss ofapproximately $2,366,000 or 77%.  For thesix month period ended June 30, 2008 and 2007, the net losses wereapproximately $10,719,000 and $6,156,000 respectively, which represents anincrease in net loss of approximately $4,563,000 or 74%.

 

**Liquidityand Capital Resources**

 
| ** **                                | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| ** **                                | ** ** | **(in thousands)**                           | ** ** |
| Cash and cash equivalents                 |       | $                                                 | 16,685     |   | $ | 9,395 |   |
| Working capital                           |       | 15,172                                            |       | 7,419 |   |
| Cash provided by (used in)                |       |                                              |       |   |   |
| Operating activities                      |       | (7,718                                            | )          | (5,031 | ) |
| Investing activities                      |       | (6,088                                            | )          | (488 | ) |
| Financing activities                      |       | 74                                                |       | 9,663 |   |
| Net decrease in cash and cash equivalents |       | $                                                 | (13,732    | ) | $ | 4,144 |   |
| Current ratio                             |       | 4.6                                               |       | 3.3 |   |

 

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Our cash requirements depend on many factorsincluding, but not limited to, cost to build our flywheels and frequencyregulation facilities, research and development activities, facility costs aswell as general and administrative expenses. Since we are still in the development stage and have not yet begun ourprincipal operations, we do not generate enough cash from operations to satisfyour working capital requirements.  Weexpect to make significant expenditures to fund our operations, developtechnologies and explore opportunities to find and develop additional marketsto sell our products. In previous years, we took significant actions to reduceour cash expenditures for product development, infrastructure and productionreadiness by significantly reducing headcount, development spending and capitalexpenditures.  However, as we completethe development of the Smart Energy MatrixTM and begin commercial activity aimedat revenue generation in 2008, we have begun to increase our headcount, andhave spent additional funds on production materials, capital equipment, marketanalyses and the pursuit of regulatory relief to modify market rules in away that ensures our ability to enter markets on a timely basis and profitablycompete.  We expect to requiresignificant cash resources during 2008 as we increase capacity to manufactureour Smart Energy 25 flywheels and begin to have revenue from frequencyregulation services late in the fourth quarter of 2008.

 

We must raise additional equity and/or project financing to execute ourbusiness plan.  Based on our rate ofexpenditure of cash and the additional expenditures expected to support ourbusiness plan, we have sufficient cash to fund operations into the fourthquarter of 2008. We need to obtain additional cash during 2008 to fund:

 

·                  Our continuation as a going concern

·                  Ongoing research and development of the Smart Energy25 flywheel and the Smart Energy MatrixTM multi-flywheel system

·                  The ramp up of our manufacturing and assembly capacity

·                  The build-out of facilities to provide frequencyregulation services to the electricity grid

·                  Regulatory matters

·                  Working capital requirements; and

·                  The identification and development of new businessopportunities.

 

We are completing thedevelopment the Smart Energy 25 flywheel, which is the core component of theSmart Energy MatrixTM flywheel system.  In order to do so and to build,operate and receive fees for frequency regulation services and have sufficientworking capital to continue to execute our business plan through 2008, we willneed to raise approximately $20 million of funding during the remainder of 2008.  Also, to achieve our long-term deploymentplan for additional frequency regulation facilities, we will need to raiseadditional capital from a combination of project finance and equitytransactions.

 

**OperatingActivities**

 

Net cash used inoperating activities was approximately $7,718,000 and $5,031,000 for the sixmonths ended June 30, 2008 and 2007, respectively.  The primarycomponent to the negative cash flow from operations is from net losses. For the six months ending June 30, 2008, we had a net loss ofapproximately $10,719,000.  Adjustments to reconcile net loss to cash flowin 2008 include non-cash stock compensation of approximately $1,320,000,depreciation and amortization of approximately $593,000, a net reduction indeferred rent of approximately $132,000, cash received from the landlord tooffset the cost of leasehold improvements of $1,430,000. Changes in operatingassets and liabilities used approximately $474,000 of cash.

 

During the same period in2007, we had a net loss of approximately $6,156,000.  Adjustments toreconcile net loss to cash flow include non-cash stock compensation ofapproximately $1,037,000, depreciation and amortization of approximately$56,000, a net reduction in the asset impairment reserve of approximately $1,000and cash provided by changes in operating assets and liabilities ofapproximately $254,000.  These wereoffset by a gain on the sale of fixed assets of approximately $4,000 andfacility-related cash payments charged against restructuring reserves of approximately$219,000.

 

**InvestingActivities**

 

Net cash used ininvesting activities was approximately $6,088,000 and $488,000 for the sixmonths ending June 30, 2008 and 2007, respectively.  The principal use of cash in 2008 and 2007,respectively, was the purchase of property and equipment in the amount ofapproximately $6,262,000 in 2008 and $492,000 in 2007, offset by the sale ofproperty and equipment of approximately $4,000 in 2007.  A reduction inrestricted cash related to the Wilmington lease that expired in 2007 providedapproximately $174,000 in cash in 2008.

 

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**FinancingActivities**

 

Net cash provided byfinancing activities was approximately $74,000 and $9,663,000 for the first sixmonths of 2008 and 2007, respectively. In 2008, funds were provided by issuance of stock under our employeestock purchase plan of approximately $41,000, the exercise of employee stockoptions of approximately $15,000 and approximately $18,000 related to thereduction of costs previously accrued related to the sale of stock in2007.  For 2007, we raised approximately$9,652,000 from the sale of stock from our shelf registration, andapproximately $11,000 from the issuance of stock under our employee stockpurchase plan.

 

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.

 

**Item3.  Quantitative and Qualitative Disclosure About Market Risk**

 

Our cashequivalents, which have maturities of less than three months, may expose ourassets to interest rate risk.  At June 30, 2008, we had approximately$109,000 of cash equivalents that were held in non-interest bearingaccounts.  Also at June 30, 2008, we had approximately $1,541,000 ofcash equivalents that were held in interest bearing checking accounts, andapproximately $15,035,000 invested in interest-bearing money market accounts athigh-quality financial institutions, some of which are invested in off-shoresecurities.  The fair value of theseinvestments approximates their cost. The funds invested in money marketaccounts may not be covered under FDIC Insurance, and therefore may be somerisk of loss, which we deem to be low.

 

**Item4.  Controls and Procedures**

 

*Evaluationof Disclosure Controls and Procedures*

 

As of the end ofthe period covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures.  Based on the evaluation, both the ChiefExecutive Officer and the Chief Financial Officer concluded that our disclosurecontrols and procedures, as defined in Rules 13a – 15(e) and 15d – 15(e)promulgated under the Securities Exchange Act of 1934, were effective on June 30,2008.

 

*Management’sReport on Internal Control over Financial Reporting*

 

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

 

Management’sassessment of the effectiveness of our internal control over financialreporting as of December 31, 2007 has been audited by Miller Wachman LLP,an independent registered public accounting firm, as stated in their reportwhich is included in our Annual Report on Form 10-K which was filed withthe SEC on March 17, 2008.

 

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**Part II — OTHER INFORMATION**

 

**Item1.  Legal Proceedings**

 

On October 9, 2007, Arete Power, Inc.filed a complaint against us claiming damages from alleged willful infringementof U.S. Patent No. 6,710,489, entitled “Axially Free Flywheel System.”  On November 30, 2007, we filed an Answerdenying infringement and a Counterclaim seeking a declaratory judgment that the‘489 patent is invalid.  At the sametime, we filed a motion to transfer the lawsuit from the Northern District ofCalifornia to the District of Massachusetts. On February 22, 2008, the Court granted our motion to transfer thelawsuit to the District of Massachusetts. The District Court of Massachusetts set an Initial Conference for August 5,2008, but the parties filed an Assented to Motion to reschedule that Conferencefor August 25, 2008. We believe that this lawsuit is without merit and weplan to vigorously defend the Company against the lawsuit.

 

**Item1A.  Risk Factors**

 

There have not beenany material changes during the quarter ended June 30, 2008 to the riskfactors set forth in Part I, Item 1A of our Annual Report on Form 10-Kfor the year ended December 31, 2007 and filed with the SEC on March 17,2008.

 

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

 

On June 30, 2008, weentered into an agreement with Massachusetts Development Finance Agency (“MassDev”)pursuant to which MassDev agreed to lend us up to $5 million. The 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 tenant improvements at our Tyngsboro, Massachusettsfacility. We have one year following the date of the initial advance to draw onthe loan. The note bears a fixed annual interest rate of 6.5% and will mature84 months after the initial advance. As of June 30, 2008, we had not madeany requests for advances on the loan. We expect to request the first draw for approximately $3.7 millionduring August 2008.

 

Loan repayments shallcommence on the first day of the calendar month following the date the initialadvance is made. The payments will be of interest only during the first twelvemonths. Thereafter, the balance of the principal outstanding under the noteshall be amortized in monthly payments of principal and interest in equalmonthly installments over the remaining term of the note.

 

We also entered into asecurity agreement and a collateral assignment of lease agreement with MassDevon June 30, 2008. The security agreement grants to MassDev an exclusivefirst priority security interest in all equipment and tenant improvements paidfor with the proceeds of the loan. The collateral assignment grants to MassDevall of our rights, title and interest in and to the lease for our Tyngsborofacility.

 

As partial considerationfor the loan, on June 30, 2008, we issued to MassDev two warrants, eachwarrant to purchase 85,979 shares of our common stock at an exercise price of$1.89 per share, subject to any adjustments as set forth in the warrants. Thewarrants are exercisable at any time before July 1, 2015 and provide forregistration rights for the resale of the shares issued upon exercise of thewarrants.

 

The note and warrantswere issued to MassDev in reliance on the exemption from registration providedunder the provisions of Section 4(2) of the Securities Act of 1933(and the regulations promulgated thereunder, including Regulation D) relatingto sales by an issuer not involving a public offering.  MassDev has assigned one of the warrants tothe Massachusetts Technology Park Corporation (“MTPC”), as part of MTPC’sparticipation in the loan under the Massachusetts Technology Collaborative’sBusiness Expansion Initiative.

 

**Item 3.  Defaults Upon Senior Securities**

 

None.

 

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

 

None.

 

**Item 5.  Other Information**

 

None.

 

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**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         |       | (5)        |       | Amended and Restated  Bylaws, as amended.                                                                                                                         |
|        |       |       |       |                                                                                                                                                              |
| 3.5         |       | (2)        |       | Certificate of Designation  of Series A Junior Participating Preferred Stock, filed with The  Secretary of State of Delaware on October 4, 2002.        |
|        |       |       |       |                                                                                                                                                              |
| 4.1         |       | (3)        |       | Form of specimen  stock certificate.                                                                                                                         |
|        |       |       |       |                                                                                                                                                              |
| 10.1        |       | (4)        |       | Promissory Note dated June 30,  2008 issued by Beacon Power Corporation to Massachusetts Development Finance  Agency.                                        |
|        |       |       |       |                                                                                                                                                              |
| 10.2        |       | (4)        |       | Security Agreement  dated June 30, 2008 between Beacon Power Corporation and Massachusettts  Development Finance Agency.                                     |
|        |       |       |       |                                                                                                                                                              |
| 10.3        |       | (4)        |       | Collateral Assignment  of Lease Agreement dated June 30, 2008 between Beacon Power Corporation  and Massachusetts Development Finance Agency.                |
|        |       |       |       |                                                                                                                                                              |
| 10.4        |       | (4)        |       | Form of Warrants  issued on June 30, 2008 to Massachusetts Development Finance Agency.                                                                  |
|        |       |       |       |                                                                                                                                                              |
| 31.1        |       | +          |       | Certification of  Principal Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                    |
|        |       |       |       |                                                                                                                                                              |
| 31.2        |       | +          |       | Certification of  Principal Financial and Accounting Officer pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002.                                     |
|        |       |       |       |                                                                                                                                                              |
| 32.1        |       | +          |       | Certification of  Principal Executive Officer pursuant to 18 U.S.C. Section 1350 as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|        |       |       |       |                                                                                                                                                              |
| 32.2        |       | +          |       | Certification of  Principal Financial Officer pursuant to 18 U.S.C. Section 1350 as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

(1)                       Incorporated by reference from the Form 10-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 S-3filed on December 8, 2005 (File No. 333-130207).

 

(4)                       Incorporated by reference from the Form 8-Kfiled on July 7, 2008 (File No. 000-31973).

 

(5)                       Incorporated by reference from the Form 8-Kfiled on October 1, 1007 (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 11, 2008                                                 | By:                                                  | /s/ F. William Capp |
|                                                                                                                                                                                                                                                                                                                                                                                                 | F. William Capp                                      |
|                                                                                                                                                                                                                                                                                                                                                                                                 | President and Chief  Executive Officer               |
|                                                                                                                                                                                                                                                                                                                                                                                                 | Principal  Executive  Officer                   |
|                                                                                                                                                                                                                                                                                                                                                                                                 |                                                 |
|                                                                                                                                                                                                                                                                                                                                                                                                 |                                                 |   |
|                                                                August 11, 2008 | By:                                                  | /s/ James M. Spiezio |
|                                                                                                                                                                                                                                                                                                                                                                                                 | James M. Spiezio                                     |
|                                                                                                                                                                                                                                                                                                                                                                                                 | Vice President of  Finance, Chief Financial Officer, |
|                                                                                                                                                                                                                                                                                                                                                                                                 | Treasurer and Secretary                              |
|                                                                                                                                                                                                                                                                                                                                                                                                 | Principal Financial  Officer                         |

 

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