UNITED STATES SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





x
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For the quarterly period ended March 31, 2011


or





o
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For the transition period from __________ to __________





Commission File Number 0-29185





SAVE THE WORLD AIR, INC.


(Exact name of registrant as specified in its charter)





Nevada
52-2088326(State or other jurisdiction of

incorporation or organization)
(I.R.S. Employer

Identification No.)





735 State Street, Suite 500


Santa Barbara, California 93101


(Address, including zip code, of principal executive offices


(805)-845-3561


(Registrant’s telephone number, including area code)





Securities registered pursuant to Section 12(b) of the Exchange Act: None.





Securities registered pursuant to Section 12(g) of the Exchange Act: Common Stock, $0.001 par value.





Check whether the Registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x   No o





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





Large accelerated filero
Accelerated filer  oNon-accelerated filer  o  (Do not check if a smaller reporting company)
Smaller reporting company  x





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





The number of shares of the Registrant’s Common Stock outstanding as of May 10, 2011 was 102,231,402










SAVE THE WORLD AIR, INC.


FORM 10-Q


INDEX





PagePART I

3ITEM 1. Financial Statements

3Condensed consolidated balance sheets (unaudited)

3Condensed consolidated statements of operations (unaudited)

4Condensed consolidated statement of changes in stockholders’ deficiency (unaudited)

5Condensed consolidated statements of cash flows (unaudited)

6Notes to condensed consolidated financial statements (unaudited)

8ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

20ITEM 3. Quantitative and Qualitative Disclosure About Market Risk

27ITEM 4. Controls and Procedures

27PART II

29ITEM 1. Legal Proceedings

29ITEM 1A. Risk Factors

29ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

29ITEM 3. Defaults Upon Senior Securities

30ITEM 4. Submission of Matters to a Vote of Security Holders

30ITEM 5. Other Information

30ITEM 6. Exhibits

31SIGNATURES

32EXHIBIT INDEX

33EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32





2





PART I





Item 1. Financial Statements





SAVE THE WORLD AIR, INC. AND SUBSIDIARY


(A DEVELOPMENT STAGE ENTERPRISE)





CONDENSED CONSOLIDATED BALANCE SHEETS





March 31, 2011

(unaudited)


December 31,

2010ASSETSCash

$
325,218


$
101,645Other current assets


42,210



29,425Total current assets


367,428



131,070Property and Equipment, net of accumulated depreciation of $186,320 and $178,246

at March 31, 2011 and December 31, 2010, respectively


70,009



78,083Other assets


13,850



8,020Total assets

$
451,287


$
217,173LIABILITIES AND STOCKHOLDERS’ DEFICIENCYCurrent liabilitiesAccounts payable-related parties

$
73,566


$
241,176Accounts payable-license agreements


—



721,785Accounts payable-other


571,616



450,411Accrued expenses


841,408



959,827Accrued professional fees


444,574



431,704Loans payable-related parties and shareholders


63,004



86,947Convertible debentures, net-of- discount


258,213



76,947Fair value of derivative liabilities


2,447,078



3,664,675Total current liabilities


4,699,459



6,633,472Commitments and contingenciesStockholders’ deficiencyCommon stock, $.001par value: 200,000,000 shares authorized, 93,221,916 and 91,453,194, shares issued and outstanding at March 31, 2011 and December 31, 2010, respectively


93,222



91,453Additional paid-in capital


54,954,317



51,925,168Deficit accumulated during the development stage


(59,295,711
)


(58,432,920
)Total stockholders’ deficiency


(4,248,172
)


(6,416,299
)Total liabilities and stockholders’ deficiency

$
451,287


$
217,173








See notes to condensed consolidated financial statements.




3





SAVE THE WORLD AIR, INC.


(A DEVELOPMENT STAGE ENTERPRISE)




CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)





Inception(February 18,Three months ended

March 31,


1998) to

March 31,2011


2010


2011Net sales

$
—


$
—


$
69,000Cost of goods sold


—



—



24,120Gross profit


—



—



44,880Operating expenses


1,082,984



1,563,536



38,340,938Research and development expenses


471,355



174,293



6,786,069Non-cash patent settlement cost


—



—



1,610,066Loss before other income


(1,554,339
)


(1,737,829
)


(46,692,193
)Other income (expense)Other income


65,363



5,196



209,335Interest income


—



—



16,342Interest and financing expense


(591,412
)


(1,407,879
)


(12,183,776
)Change in fair value of derivative liabilities


1,217,597



(1,238,763
)


1,324,262Costs of private placement


—



(1,129,212
)


(1,640,715
)Costs to induce conversion of notes


—



—



(469,043
)Loss on disposition of equipment


—



—



(14,426
)Settlement of Debt Due Morale/ Matthews


—



—



(927,903
)Settlement of litigation and debt


—



—



1,089,088Loss before provision for income taxes


(862,791
)


(5,508,487
)


(59,289,029
)Provision for income taxes


—



800



6,682Net loss

$
(862,791
)

$
(5,509,287
)

$
(59,295,711
)Net loss per common share, basic and diluted

$
(.01
)

$
(.07
)Weighted average common shares outstanding, basic and diluted


92,826,589



73,652,591








See notes to condensed consolidated financial statements.




4





SAVE THE WORLD AIR, INC.


(A DEVELOPMENT STAGE ENTERPRISE)





CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ DEFICIENCY (UNAUDITED)


THREE MONTHS ENDED MARCH 31, 2011





Price per

Total Stockholders’


Common

Stock

to be


Additional

Paid-in


Deficit

Accumulated

During the

Development


Total

Stockholders’Share

Shares


Amount


Issued


Capital


Stage


DeficiencyBalance, December 31, 2010




91,453,194


$
91,453


$
—


$
51,925,168


$
(58,432,920
)

$
(6,416,299
)Common stock issued for conversion of convertible debt

$.25


1,609,924



1,610



—



400,871



—



402,481Common stock issued upon exercise of warrants

$.47


81,020



81



—



(81
)


—



—Fair value of options issued as compensation

—


—



—



—



254,326



—



254,326Common stock issued upon exercise of options

$.27


77,778



78



—



20,922



—



21,000Fair value of warrants and beneficial conversion feature of issued convertible notes

—


—



—



—



2,353,111



—



2,353,111Net loss for the three months ended March 31, 2011

—


—



—



—



—



(862,791
)


(862,791
)Balance, March 31, 2011




93,221,916


$
93,222


$
—


$
54,954,317


$
(59,295,711
)

$
(4,248,172
)








See notes to condensed consolidated financial statements.





5




SAVE THE WORLD AIR, INC. AND SUBSIDIARY


(A DEVELOPMENT STAGE ENTERPRISE)





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)





Inception

(February 18, 1998)Three Months Ended March 31,


to March, 312011


2010


2011Cash flows from operating activitiesNet Loss

$
(862,791
)

$
(5,509,287
)

$
(59,295,711
)Adjustments to reconcile net loss to net cash used in operating activities:Write off of intangible assets


—



—



505,000Settlement of litigation and debt


(65,363
)


—



(1,227,683
)Settlement of debt due Morale/Matthews


—



—



927,903Stock based compensation expense


254,326



129,813



4,189,482Issuance of common stock for services


—



470,000



7,172,788Issuance of options for legal settlement


—



—



31,500Issuance of warrants for legal settlement


—



—



4,957Issuance of warrants for financing fees


—



—



153,501Issuance of warrants for consulting fees


—



—



126,000Increase in convertible notes related to default


948



17,336



297,427Interest on related party loans


—



—



22,305Patent acquisition cost


—



—



1,610,066Amortization of issuance costs and original issue debt discounts including beneficial conversion feature-part of interest expense


582,799



1,385,826



11,647,430Fair value of common stock and warrants issued to induce conversion of notes


—



—



469,043Costs of private placement convertible notes


—



1,129,212



1,640,715Change in fair value of derivative liability


(1,217,597
)


1,238,763



(1,324,262
)Amortization of deferred compensation


—



—



3,060,744Loss on disposition of assets


—



—



14,426Depreciation and amortization of leasehold improvements


8,074



8,625



468,256Bad debt


—



—



1,300Changes in operating assets and liabilities:Accounts receivable


—



—



(1,380
)Inventory


—



—



—Prepaid expenses and other


(12,785
)


759



(42,130
)Other assets


(5,830
)


—



(13,850
)Accounts payable and accrued expenses


124,436



(202,721
)


4,736,767Accounts payable – license agreements


(656,422
)


(77,997
)


(651,137
)Accounts payable – related parties


(167,610
)


2,446



(19,437
)Net cash used in operating activities


(2,017,815
)


(1,407,225
)


(25,495,980
)Cash flows from investing activitiesPurchase of equipment


—



(9,081
)


(566,619
)Proceeds from sale of equipment


—



—



17,478Net cash used in investing activities


—



(9,081
)


(549,141
)Cash flows from financing activitiesNet proceeds under equity line of credit


—



—



1,262,386(Decrease) increase in payables to related parties and stockholder


(23,943
)


(19,470
)


599,983Advances from founding executive officer


—



—



517,208Net proceeds from issuance of convertible notes and warrants


2,251,831



1,745,255



13,456,809Repayment of convertible notes


—



—



(282,121
)Proceeds from sale of stock and exercise of warrants and options


13,500



15,300



10,816,074Net cash provided by financing activities


2,241,388



1,741,085



26,370,339Net increase in cash


223,573



324,779



325,218Cash, beginning of period


101,645



33,611



—Cash, end of period

$
325,218


$
358,390


$
325,218








(continued)




6





SAVE THE WORLD AIR, INC. AND SUBSIDIARY


(A DEVELOPMENT STAGE ENTERPRISE)





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)


(continued)





Inception

(February 18, 1998)Three Months Ended March 31,


to March 31,2011


2010


2011





Supplemental disclosures of cash flow informationCash paid during the year for:Interest

$
6,607


$
338


$
165,973Income taxes

$
—


$
800


$
6,682Non-cash investing and financing activitiesAcquisition of intangible asset through advance from related party and issuance of common stock

$
—


$
—


$
505,000Deferred compensation for stock options issued for services


—



—



3,202,931Purchase of property and equipment financed by advance from related party


—



—



3,550Conversion of related party debt to equity


—



—



515,000Issuance of common stock in settlement of payable


—



4,121



247,584Cancellation of stock


—



—



8,047Conversion of accounts payable and accrued expenses to common stock


—



—



612,521Conversion of accounts payable and accrued expenses to convertible debentures


101,280



303,700



432,480Conversion of related party debt to convertible debentures


—



—



72,500Conversion of convertible debentures to common stock


402,481



1,425,138



11,188,462Issuance of shares for settlement of loans and other payable to Morale/Matthews


—



—



2,783,711Write off of deferred compensation


—



—



142,187Fair value of derivative liability recorded as note discount


—



1,243,625



2,130,625Proceeds of exercise of options applied to accounts payable


7,500



—



67,500Fair value of warrants and beneficial conversion feature associated with issued convertible notes


2,353,111



805,330



10,599,499








See notes to condensed consolidated financial statements.




7





SAVE THE WORLD AIR, INC. AND SUBSIDIARY


(A DEVELOPMENT STAGE ENTERPRISE)





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


THREE MONTHS ENDED MARCH 31, 2011and 2010 (UNAUDITED)


1.  Organization and basis of presentation





Description of business





Save the World Air, Inc. (“STWA”) designs, licenses and develops products to reduce operational costs for oil pipelines, and improve fuel economy and reduce emissions from diesel-powered internal combustion engines.  The Company is a green technology company that leverages a suite of patented, patent-pending and licensed intellectual properties related to the treatment of fuels. Technologies patented by or licensed to us utilize either magnetic or uniform electrical fields to alter physical characteristics of fuels and are designed to create cleaner combustion. Cleaner combustion has been shown to improve performance, enhance fuel economy and/or reduce harmful emissions in laboratory testing.





The Company was incorporated on February 18, 1998, as a Nevada corporation, under the name Mandalay Capital Corporation. The Company changed its name to Save the World Air, Inc. on February 11, 1999, following the acquisition of marketing and manufacturing rights of the ZEFS technologies. Our executive offices are at 735 State Street, Suite 500, Santa Barbara, California 93101.  The telephone number is (805)-845-3561. Our research and development facility is at 235 Tennant Avenue, Morgan Hill, California 95037. The telephone number is (408) 778-0101. The corporate website is www.stwa.com.  The common stock is quoted under the symbol “ZERO” on the Over-the-Counter Bulletin Board





The Company’s technology has two commercial applications; AOTTM (Applied Oil Technology) and ELEKTRATM and legacy technologies of ZEFS and MK IV.  AOTTM and ELEKTRATM are nearing the end of the product development cycle, which will culminate at the U.S. Department of Energy’s Rocky Mountain Oilfield Testing Center (RMOTC).  We believe the testing of AOTTM at the RMOTC will determine the value of savings the product presents at full scale operation on an active pipeline.





The AOTTM and ELEKTRATM are technologies, which use electric fields to alter some physical properties of petrochemical fluids to reduce viscosity of the fluids.  The Company differentiates AOTTM and ELEKTRATM products based on their differing attributes and marketing focus.  AOTTM products are primarily designed to reduce operation costs for oil pipelines, and ELEKTRATM products are primarily designed to improve fuel economy and reduce emissions from diesel-powered internal combustion engines.  Our AOTTM products are intended to reduce the viscosity of crude oil, thereby making it less restrictive to pipeline transport.  Our AOTTM products will be marketed primarily to pipeline operators as well as to pilot and government mandated delivery programs.  Our ELEKTRATM products are intended to increase fuel efficiency and reduce emissions.  ELEKTRATM will be marketed primarily to specialty consumer accessories market for many types of diesel-fueled vehicles, including but not limited to trucks, trains, maritime, military and aviation.





Basis of presentation





The accompanying unaudited condensed consolidated financial statements of Save the World Air, Inc. (the "Company") have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Regulation S-K for scaled disclosures for smaller reporting companies. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in United States of America for complete financial statements. However, such information reflects all adjustments (consisting solely of normal recurring adjustments), which are, in the opinion of management, necessary for the fair presentation of the consolidated financial position and the consolidated results of operations. Results shown for interim periods are not necessarily indicative of the results to be obtained for a full fiscal year.





The condensed consolidated balance sheet information as of December 31, 2010 was derived from the audited consolidated financial statements included in the Company's Annual Report on Form 10-K filed with the SEC. These interim financial statements should be read in conjunction with that report.




Going concern





Since its inception, the Company has been primarily engaged in organizational and pre-operating activities. The Company has generated insignificant revenues and has incurred accumulated losses of $59,295,711 from February 18, 1998 (Inception) through March 31, 2011. As reflected in the accompanying condensed consolidated financial statements, the Company had a net loss of $862,791 and a negative cash flow from operations of $2,017,815 for the three months ended March 31, 2011, and had a working capital deficiency (excluding derivative liabilities) of $1,884,953 and a stockholders' deficiency of $4,248,172 at March 31, 2011.  As a result, the Company’s independent registered public accounting firm, in their report on the Company’s 2010 consolidated financial statements, raised substantial doubt about the Company’s ability to continue as a going concern.  The financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern.




8





On March 28, 2011, the Company completed its final adjusted payment to Temple University for all outstanding obligations on the License Agreements and the R&D Agreement. The Company is currently in negotiations with Temple to replace the current License Agreements and to execute new License Agreements to reflect updated technologies. (See “Note 10. Subsequent Events”).





The ability of the Company to continue as a going concern is dependent upon the Company’s ability to raise additional funds and implement its business plan.  The Company’s operations from inception, February 18, 1998 to March 31, 2011 have been funded through issuances of its common stock and convertible notes.  During this period, the Company raised an aggregate of $24,272,883 of which $13,456,809 was from the sale of convertible notes.  As of March 31, 2011, the outstanding balance of convertible notes was $2,651,221, of which $2,588,422 represented the 2011 Winter Offering which closed February 28, 2011 (see “Note 4. Convertible Debentures”). The Company expects substantially all of the outstanding notes will be converted into shares of common stock of the Company. (see “Note 10 Subsequent events”).




On March 31, 2011, the Company had cash on hand in the amount of $325,218.  In addition to the funds on hand, the Company will  require additional funds  to continue to operate our business.  This includes expenses we will incur in connection with license agreements; product development and commercialization of the AOT and ELEKTRA technologies; costs to manufacture and ship our products; costs to design and implement an effective system of internal controls and disclosure controls and procedures; costs of maintaining our status as a public company by filing periodic reports with the SEC and costs required to protect our intellectual property. In addition, the Company has contractual commitments for salaries to one of the executive officers pursuant to an employment agreement, severance payments to a former officer and consulting fees, during 2011 and beyond.  In light of the Company’s financial commitments over the next several months and its liquidity constraints, we have implemented cost reduction measures in all areas of operations. The Company intends to review these measures on an ongoing basis and make additional decisions as may be required.





2.  Summary of significant accounting policies





Development stage enterprise





The Company is a development stage enterprise.  All losses accumulated since the inception of the Company have been considered as part of the Company’s development stage activities.





The Company’s focus is on product development and marketing of proprietary devices that are designed to reduce operation costs of petrochemical pipeline transport and fuel efficiency of diesel engines and has not yet generated meaningful revenues.  The technologies are called “AOT” and “ELEKTRA”.  The Company is currently in the mid-late stages of developing its AOTTM and ELEKTRATM technologies for commercial applications.  Expenses have been funded though the sale of company stock, convertible notes and the exercise of warrants.  The Company has taken actions to secure the intellectual property rights to the AOTTM and ELEKTRATM technologies and is the worldwide exclusive licensee for patent pending technologies associated with the development of ELEKTRATM.





Estimates





The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Certain significant estimates were made in connection with preparing the Company’s financial statements. Actual results could differ from those estimates.





Loss per share





Basic loss per share is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted loss per share reflects the potential dilution, using the treasury stock method that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the loss of the Company. In computing diluted loss per share, the treasury stock method assumes that outstanding options and warrants are exercised and the proceeds are used to purchase common stock at the average market price during the period. Options and warrants may have a dilutive effect under the treasury stock method only when the average market price of the common stock during the period exceeds the exercise price of the options and warrants. For the three month period ended March 31, 2011 and 2010, the dilutive impact of outstanding stock options of 22,177,892 and 4,976,376 respectively, and outstanding warrants of 31,806,292 and 19,264,520 have been excluded because their impact on the loss per share is anti-dilutive.





9


Stock-Based Compensation





The Company periodically issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by the Financial Accounting Standards Board whereas the value of the award is measured on the date of grant and recognized over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the Financial Accounting Standards Board whereas the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period of the measurement date.





The fair value of the Company's common stock option grant is estimated using the Black-Scholes option pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation expense is recorded based upon the value derived from the Black-Scholes option pricing model, and based on actual experience. The assumptions used in the Black-Scholes option pricing model could materially affect compensation expense recorded in future periods.




Accounting for Warrants and Derivatives





The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported in the consolidated statements of operations.  For stock-based derivative financial instruments, the Company uses a probability weighted average series Black-Scholes-Merton option pricing models to value the derivative instruments at inception and on subsequent valuation dates.





The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is evaluated at the end of each reporting period.  Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.





Fair value of financial instruments





Effective January 1, 2008, fair value measurements are determined by the Company's adoption of authoritative guidance issued by the FASB, with the exception of the application of the statement to non-recurring, non-financial assets and liabilities as permitted. The adoption of the authoritative guidance did not have a material impact on the Company's fair value measurements.  Fair value is defined in the authoritative guidance as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy was established, which prioritizes the inputs used in measuring fair value into three broad levels as follows:




Level 1—Quoted prices in active markets for identical assets or liabilities.




Level 2—Inputs, other than the quoted prices in active markets, are observable either directly or indirectly.




Level 3—Unobservable inputs based on the Company's assumptions.





The Company is required to use observable market data if such data is available without undue cost and effort





The following table presents certain investments and liabilities of the Company’s financial assets measured and recorded at fair value on the Company’s condensed consolidated balance sheets on a recurring basis and their level within the fair value hierarchy as of March 31, 2011 and December 31, 2010.





Level 1


Level 2


Level 3


TotalFair value of Derivative Liability - March 31, 2011
$
-0-


$
-0-


$
2,447,078


$
2,447,078Fair value of Derivative Liability - December 31, 2010
$
-0-


$
-0-


$
3,664,675


$
3,664,675





10





Recent Accounting Pronouncements




Recent accounting pronouncementsdid not or are not believed to have a material impact on the Company’s present or future consolidated financial statements.





3.  Certain relationships and related transactions





Loans from related parties





As at March 31, 2011, and December 31, 2010, the Company had  loan payable to an officer of the Company in the amount of $63,004 and $86,947, respectively. These loans are unsecured, are due on demand and bear interest at 6% per annum.





Accounts Payable to related parties





As of March 31, 2011 and December 31, 2010, the Company had accounts payable to related parties in the amount of $73,566 and $241,176, respectively. These amounts are unpaid Directors Fees and  expenses incurred by officers and directors.




11


4.  Convertible Debentures





Convertible debentures consist of the following:





Maturity dates

March,

2011


December 31,

20102008 Winter Offering
December 5, 2009


6,846



6,6972009 Spring
April 30, 2010


6,604



6,4552009 Wellfleet
September 28, 2012


27,477



27,0112009 Fall Offering
January 15, 2012


10,872



37,4092010 Fall Offering #2
November 30, 2011


11,000



386,7602011 Winter Offering
February 28, 2012


2,588,422



—Sub-total



2,651,221



464,332Less, remaining debt discount



(2,393,008
)


(387,385
)Convertible debentures, net


$
258,213



76,947





2008 Winter Offering.  From November 24, 2008 to December 5, 2008, the Company conducted an offering (the “2008 Winter Offering”) of up to $500,000 aggregate face amount of its Convertible Notes.  A total of $524,700 aggregate face amount of the 2008 Winter Notes were sold for an aggregate purchase price of $477,000 net proceeds.  Therefore, while the stated interest on the 2008 Winter Notes is 0%, the implied interest rate on the 2008 Winter Notes is 10%.  The 2008 Winter Notes matured on the first anniversary of the date of issuance.  The 2008 Winter Notes are convertible, at the option of the note holders, into shares of common stock of the Company (the “Conversion Shares”) at a conversion price equal to the average of the closing bid price of the Company’s common stock for the five trading days preceding the closing date of the 2008 Winter Offering (the “Conversion Price”).  Up to 3,086,470 Conversion Shares are issuable at a Conversion Price of $0.17 per share.





Each of the investors in the 2008 Winter Offering received, for no additional consideration, a warrant (the “ 2008 Winter Warrants”), entitling the holder to purchase a number of shares of the Company’s common stock equal to 50% of the number of shares of common stock into which the ( 2008 Winter Notes) are convertible (the “2008 Winter Warrant Shares”). Each 2008 Winter Warrant is exercisable on a cash basis only at a price of $0.30 per share, and is exercisable for a period of two years from the date of issuance.  Up to 1,543,235 2008 Winter Warrant Shares are initially issuable upon exercise of the 2008 Winter Warrants.





The aggregate value of the Winter 2008 Offering Warrants issued in connection with the December 5, 2008 closing were valued at $168,925 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of 3.42%; dividend yield of 0%; volatility factors of the expected market price of common stock of 153.56%; and an expected life of two years (statutory term) and vest immediately upon issuance.  The Company also determined that the notes contained a beneficial conversion feature of $308,075.  The value of the Winter 2008 Offering Warrants, the beneficial conversion feature, and the transaction fees of $47,700 were considered as debt discount and were amortized over the life of the Note.





As March 31, 2011, investors have converted $519,200 of the Convertible Notes into 3,054,117 shares of the Company’s common stock.  As of March 31, 2011, one note for $5,500 was in default and outstanding ($6,846 in total including $1,346 in penalties and interest).




2009 Spring Offering.  From March 17, 2009 to April 30, 2009, the Company conducted and concluded a private offering (the “Spring 2009 Offering”) of up to $300,000 aggregate face amount of its convertible notes (the “Spring 2009 Notes”) with 11 accredited investors. A total of $181,500 aggregate face amount of the Spring 2009 Notes were sold for an aggregate purchase price of $165,000.  The Spring 2009 Notes matured on the first anniversary of their date of issuance, are convertible, at the option of the noteholder, into up to 672,222 shares of common stock of the Company at a conversion price of $0.27 per share.





12




Each of the investors in the Spring 2009 Offering received, for no additional consideration, a warrant (the “Spring 2009 Warrants”), entitling the holder to purchase a number of shares of the Company’s common stock equal to 50% of the number of shares of common stock into which the Spring 2009 Notes are convertible (the “Warrant Shares”).  Each Spring 2009 Warrant is exercisable on a cash basis only at an initial price of $0.50 per share, and is exercisable for a period of two years.  Up to 336,111 Warrant Shares are initially issuable on exercise of the Spring 2009 Warrants.





The Company received $165,000 in net proceeds in the Spring 2009 Offering which was used for general corporate purposes and working capital. The aggregate value of the Spring 2009 Offering Warrants issued in connection with the April 30, 2009 closing were valued at $39,994 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of 0.94%; dividend yield of 0%; volatility factors of the expected market price of common stock of 156.39%; and an expected life of two years (statutory term) and vest immediately upon issuance.  The Company also determined that the notes contained a beneficial conversion feature of $96,827.  The value of the Spring 2009 Offering Warrants, the beneficial conversion feature, and the transaction fees of $16,500 were considered as debt discount and were amortized over the life of the Note.





As of March 31, 2011, investors have converted $176,000 of the Convertible Notes plus penalty and interest of $7,538 into 679,768 shares of the Company’s common stock.  As of March 31, 2011, one note in the amount of $5,500 was in default and outstanding ($6,604 in total which includes $1,104 of penalty and interest).




2009 Wellfleet Offering. On November 20, 2009, the Company completed a private financing of $75,000 principal amount of 7% Convertible Promissory Notes (the “Notes”) due September 28, 2012 and 300,000 Common Stock Purchase Warrants exercisable at $.30 per share (the “Warrants”), pursuant to a Securities Purchase Agreement (the “Purchase Agreement”) with 3 accredited investors (the “Note Offering”), through Sandgrain Securities, Inc., as placement agent.





The Notes are initially convertible into the Company’s common stock at a price of $.25 per share and accrue interest at 7% per year with a default rate of 10%, payable quarterly in cash.  Interest payments are payable in stock at the sole discretion of the Note holders, or, in the event that shares issuable thereon are registered under the Securities Act of 1933, as amended (the “Act”), or otherwise freely tradable pursuant to Rule 144, at the discretion of the Company as well. The Notes and any unpaid interest are due and fully payable on September 28, 2012.  The conversion price of the Notes is adjustable for corporate events such as merger, reclassification or stock splits.





Pursuant to the terms of the Purchase Agreement, and among other terms, in the event the Company conducts any subsequent financings (each, a “Follow On Offering”) of any kind other than an offering of securities substantially similar to the Notes and Warrants or certain other exempted issuances enumerated in the Notes, the Notes may, at the discretion of each holder thereof,  be exchanged in whole or in part to the extent of outstanding principal and/or interest in such Note, into the securities offered in the Follow On Offering, by applying and exchanging the outstanding principal and interest of such Notes towards the purchase price of the securities offered in such Follow On Offering, at the same price and terms of the Follow On Offering.





The Company paid a placement agent fee to Sandgrain Securities, Inc. of (i) $6,000 in cash, (ii) 24,000 shares of Common Stock constituting 8% of the number of Conversion Shares initially issuable upon exercise of the Notes, and (iii) 24,000 warrants, substantially similar to the Warrants sold to investors (the “Placement Agent Warrants”), in connection with the Note Offering, in addition to legal fees.





Each of the warrant agreements included an anti-dilution provision that allowed for the automatic reset of the exercise price upon any future sale of common stock or warrants at or below the current exercise price.  The Company considered the current Financial Accounting Standards Board guidance of “Determining Whether an Instrument Indexed to an Entity’s Own Stock” which indicates that any adjustment to the fixed amount (either conversion price or number of shares) of the instrument regardless of the probability or whether or not within the issuers’ control, means the instrument is not indexed to the issuers own stock. Accordingly, the Company determined that as the strike price of these warrants contain exercise prices that may fluctuate based on the occurrence of future offerings or events, and as such is not a fixed amount..  As a result, the Company determined that these warrants are not considered indexed to the Company’s own stock and characterized the fair value of these warrants as derivative liabilities upon issuance.





The Company determined that the fair value of the warrant liability at issuance on November 20, 2009 to be $75,000 based upon a probability weighted average Black-Sholes-Merton calculation. The Company recorded the full value of the derivative as a liability at issuance with an offset to valuation discount.  The fair value of the warrant liability as of March 31, 2011 was $28,231 (see Note 8).





As of March 31, 2011, investors have converted $50,000 of the Convertible Notes plus $1,750 of accrued interest into 207,000 shares of the Company’s common stock.  The outstanding balance at March 31, 2011 was $27,477 which includes $2,477 of accrued interest.





13





2009  Fall Offering. From October 2, 2009 to January 15, 2010, the Company conducted and completed a private offering (the “Fall 2009 Offering”) consisting of an aggregate of $1,588,125 of 7% Convertible Promissory Notes (the “Notes”) with interest compounded quarterly at the annual rate of 7% payable at maturity, and warrants to purchase an aggregate of 6,352,500 shares of our common stock (the “Fall 2009 Warrants”).  The Company received $1,284,425 net proceeds, of which $344,500 was received as of December 31, 2009.  The Fall 2009 Notes mature on the second anniversary of the closing of this offering and will be convertible, at the option of the note holder, into up to 6,352,500 shares of our common stock at a conversion price of $0.25 per share.  The Fall 2009 Warrants are for a term of three years at an exercise price of $0.30 per share.





Each of the warrant agreements included an anti-dilution provision that allowed for the automatic reset of the exercise price upon any future sale of common stock or warrants at or below the current exercise price.  The Company considered the current Financial Accounting Standards Board guidance of “Determining Whether an Instrument Indexed to an Entity’s Own Stock” which indicates that any adjustment to the fixed amount (either conversion price or number of shares) of the instrument regardless of the probability or whether or not within the issuers’ control, means the instrument is not indexed to the issuers own stock. Accordingly, the Company determined that as the strike price of these warrants contain exercise prices that may fluctuate based on the occurrence of future offerings or events, and as such is not a fixed amount. As a result, the Company determined that these warrants are not considered indexed to the Company’s own stock and characterized the fair value of these warrants as derivative liabilities upon issuance.





The Company determined that the fair value of the warrant liability at issuances to be $3,027,815 based upon a probibility weighted average Black-Scholes-Merton calculation (See Note 8), of which, $654,978 was recorded on December 31, 2009 and $2,372,837 was recorded on January 15, 2010.  The Company recorded the full value of the derivative of $2,372,837 as a liability at issuance with an offset to valuation discount. As the fair value of the liability of $2,372,837 exceeded the note value of $1,243,625, the excess of the liability over the note amount of $1,129,212 was considered to be cost of the private placement and was charged to expense upon issuance.  The fair value of the warrant liability as of March 31, 2011 was $1,890,935 (see Note 8).





As of March 31, 2011, investors have converted $1,578,125 of the Convertible Notes plus interest of $11,502 into 6,358,507 shares of the Company’s common stock.  The outstanding balance at March 31, 2011 is $10,872 which includes $872 in accrued interest.




2010 Fall Offering #2





From October 4, 2010 to November 30, 2010, the Company conducted and concluded a private offering (the “Fall 2010 Offering #2”) consisting of up to $3,000,000 aggregate face amount of its convertible notes (the “ Fall 2010 Notes). A total of $940,347 Fall 2010 #2 Notes were sold to ten accredited investors for an aggregate purchase price of $849,861.  While there was no stated interest rate on the Fall 2010 #2 Notes, the implied effective interest rate on the Fall 2010 #2 Notes is 10% per annum. The Fall 2010 #2 Notes mature on the first anniversary of the closing of this offering and will be convertible, at the option of the noteholder into 3,761,386 shares of the Company’s common stock at a conversion price of $0.25 per share (the “Conversion Price”).





Each of the investors in the Fall 2010 #2 Offering will receive, for no additional consideration, a warrant (the “Fall 2010 #2 Warrants”), entitling the holder to purchase a number of shares of our common stock equal to 100% of the number of shares of common stock into which the Fall 2010 #2 Notes are convertible (the “Warrant Shares”).  Each Fall 2010 Warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable for a period of twenty four months.  Up to 3,761,386 Warrant Shares are initially issuable on exercise of the Fall 2010 #2 Warrants.




The Company received $849,861 in net proceeds in the Fall 2010 #2 Offering which was used for general corporate purposes and working capital. The aggregate value of the Fall 2010 #2 Offering Warrants issued were valued at $436,986 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of .27; dividend yield of 0%; volatility factors of the expected market price of common stock of 121%; and an expected life of two years (statutory term) and vest immediately upon issuance.  The Company also determined that the notes contained a beneficial conversion feature of $417,875.  As of March 31, 2011, the aggregate value of the Fall 2010 #2 Offering Warrants, the beneficial conversion feature and the transaction fees of $85,486 are considered as debt discount and will be amortized over the life of the notes.





As of March 31, 2011, investors have converted $929,347 of the Convertible Notes into 3,717,386 shares of the Company’s common stock.  The outstanding balance at March 31, 2011 was $11,000.





14





2011 Winter Offering





From December 13, 2010 through February 28, 2011, the Company  conducted a private offering (the “Winter 2011 Offering”) of up to $3,000,000 aggregate face amount of its convertible notes (the “Winter 2011  Notes”). A total of $2,588,422 aggregate face amount of the Winter 2011  Notes were sold for an aggregate purchase price of $2,353,111.  While there was no stated interest rate on the Winter 2011 Notes, the implied effective interest rate on the Winter 2011 Notes is 10% per annum. The Winter 2011 Notes mature on the first anniversary of their date of issuance. The Winter 2011 Notes are convertible, at the option of the note holder, into 10,353,688 shares of common stock of the Company (the “Conversion Shares”) at an initial conversion price of $0.25 per share (the “Conversion Price”).




Each of the investors in the Winter 2011 Offering received, for no additional consideration, a warrant (the “Winter 2011 Warrants”), entitling the holder to purchase a number of shares of the Company’s common stock equal to 100% of the number of shares of common stock into which the Winter 2011 Notes are convertible (the “Warrant Shares”).  Each Winter 2011 Warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable immediately upon issuance and for a period of two (2) years from the date of issuance. Up to 10,353,688 Warrant Shares are initially issuable to date on exercise of the Winter 2011 Warrants.





The Company received $2,353,111 in net proceeds in the 2011 Winter Offering which was used for general corporate purposes and working capital. The aggregate value of the 2011 Offering Warrants issued were valued at $1,368,888 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of .25; dividend yield of 0%; volatility factors of the expected market price of common stock of 130%; and an expected life of two years (statutory term) and vest immediately upon issuance.  The Company also determined that the notes contained a beneficial conversion feature valued at $984,223.  As of March 31, 2011, the aggregate value of the 2011 Winter Offering Warrants, the beneficial conversion feature and the transaction fees of $235,311 are considered as debt discount and will be amortized over the life of the notes.





As of March 31, 2011, the outstanding balance of the Winter 2011 Notes was $2,588,422.





5. Capital stock





During the three months ended March 31, 2011, the Company issued 1,609,924 shares of common stock in exchange for conversion of $402,481 of Convertible Notes.





During the three months ended March 31, 2011, the Company issued 81,020 shares of common stock upon cashless exercise of 224,000 warrants.





During the three months ended March 31, 2011, the Company issued 77,778 shares of common stock upon exercise of options at $0.27 per share and valued at $21,000.





6.  Stock options and warrants





The Company periodically issues stock options and warrants to employees and non-employees in capital raising transactions, for services and for financing costs.  Stock-based compensation is measured at the grant date, based on the fair value of the award, and is recognized as expense over the requisite service period.  Options vest and expire according to terms established at the grant date.





Options





The Company currently issues stock options to employees, directors and consultants under the 2004 Stock Option Plan (the Plan). The Company could issue options under the Plan to acquire up to 5,000,000 shares of common stock. In February 2006, the board approved an amendment to the Plan (approved by the Shareholders in May 2006), increasing the authorized shares by 2,000,000 shares to 7,000,000 shares. At March 31, 2011, 2,672,108 were available to be granted under the Plan. Prior to 2004, the Company granted 3,250,000 options outside the Plan to officers of the Company of which 250,000 are still outstanding.





Employee options vest according to the terms of the specific grant and expire from 5 to 10 years from date of grant. Non-employee option grants to date are vested upon issuance. The weighted-average, remaining contractual life of employee options outstanding at March 31, 2011 was 9 years. Stock option activity for the period January 1, 2011 to March 31, 2011, was as follows:





Weighted

Avg.

Options


Weighted

Avg.

Exercise

PriceOptions outstanding, January 1, 2011


4,837,488


$
0.53Options granted


17,600,000



0.25Options exercised


(77,778
)


0.27Options forfeited


(181,818
)


0.55Options cancelled


—



—Options outstanding, March 31, 2011


22,177,892


$
0.31


15


The weighted average exercise prices, remaining contractual lives for options granted, exercisable, and expected to vest under the Plan as of March 31, 2011 were as follows:





Outstanding Options

Exercisable OptionsWeighted



WeightedOption



Life

Average Exercise



Average ExerciseExercise Price Per Share

Shares

(Years)

Exercise Price

Shares

Price$ 0.21 - $ 0.99

21,790,346

9.2

$
.29


4,190,346

$
0.46$ 1.00 - $ 1.99

327,546

4.1


1.25


327,546


1.25$ 2.00 - $ 2.26

60,000

0.4


2.26


60,000


2.2622,177,892

9.0

$
0.31


4,577,892

$
0.54





On January 29, 2011, the Company issued 17,600,000 options to Cecil Bond Kyte, its chairman and chief executive officer. The options have an exercise price of $.25 per share, vest over a five year period, and expire ten years from date of grant.   Twenty percent of the options shall vest on each of the first five anniversary dates.  In the event of a change of control of the Company, all unvested options shall vest on the date of the change of control.  During the three months ended March 31, 2011, the Company amortized $254,326 of compensation cost based on the vesting of the options.  Future unamortized compensation expense on the outstanding options at March 31, 2011 is $6,587,938.  As of March 31, 2011, the market price  of the Company’s stock was $0.43 per share and the aggregate intrinsic value of the options outstanding and exercisable was $396,267.


Black-Scholes-Merton value of options





During the three months ended March 31, 2011 and 2010, the Company valued options at the grant date using the Black-Scholes-Merton pricing model with the following average assumptions:





March 31,2011



2010Expected life (years)


6.0



5.5Risk free interest rate


1.95%



3.63%Volatility


135.00%



129.95%Expected dividend yield


0.00%



0.00%





The weighted average fair value for options granted in 2010 was $0.53.  The weighted average fair value for options granted during the three months ended March 31, 2011 was $0.39.




Warrants





The following table summarizes certain information about the Company’s stock purchase warrants from January 1, 2011 to March 31, 2011:





Warrants


Weighted

Avg.

Exercise

PriceWarrants outstanding, January 1, 2011


22,979,068


$
0.40Warrants granted


10,353,688



0.30Warrants exercised


(224,000
)


0.47Warrants cancelled


(1,302,464
)


0.50Warrants outstanding, March 31, 2011


31,806,292


$
0.36





16




Outstanding Warrants

Exercisable WarrantsWarrant






Weighted




WeightedExercise Price




Life

Average Exercise




Average ExercisePer Share

Shares

(Years)

Price

Shares

Price$ 0.30 - $ 0.99


30,718,990

1.6

$
0.33


30,718,990

$
0.33$ 1.00 - $ 1.99


1,000,000

2.2

$
1.00


1,000,000

$
1.00$ 2.00 - $ 2.70


87,302

.2

$
2.70


87,302

$
2.7031,806,292

1.6

$
0.36


31,806,292

$
0.36





As of March 31, 2011 the market value of the Company's stock was $0.43 per share, and the aggregate intrinsic value of the warrants outstanding was $3,321,234.





7.  Research and development





The Company has research and development facilities in Morgan Hill, California. The Company has tested products incorporating our ZEFS, MK IV, ELEKTRA and AOT technologies for multiple makes and models diesel engines, motorbikes, boats, generators, lawnmowers, other small engines and pipelines. The Company has purchased test vehicles, test engines and testing equipment. The Company incurred $471,355 and $174,293 for the three months ended March 31, 2011 and 2010, respectively, on its research and development activities.




AOT TESTING





In mid-July, 2010, the Company entered into a Letter of Intent with the U.S. Department of Energy-Naval Petroleum Reserve/Rocky Mountain Oilfield Testing Center (RMOTC) in Wyoming.  On December 22, 2010, a formal Agreement was entered into with RMOTC for testing of our Applied Oil Technology (AOT).  Colfax Corporation built the prototype to be used at the testing site and other suppliers furnished hardware, electrical supplies, oil tanks and engineering testing devices.  Costs incurred for the testing during the three months ended March 31, 2011 was $466,449.  Testing began in February 2011 and is scheduled to be completed in early May, 2011.




8. Derivative liability





In June 2008, the FASB issued authoritative guidance on determining whether an instrument (or embedded feature) is indexed to an entity’s own stock.  Under the authoritative guidance, effective January 1, 2009, instruments which do not have fixed settlement provisions are deemed to be derivative instruments.  The strike price of the warrants issued by the Company in connection with certain convertible note offerings made during 2009 and 2010 in the aggregate of 8,522,500 warrants, exercisable at $.30 per share, contain exercise prices that may fluctuate based on the occurrence of future offerings or events.  As a result, theses warrants are not considered indexed to the Company’s own stock.  The Company characterized the fair value of these warrants as derivative liabilities upon issuance.  The FASB’s guidance requires the fair value of these liabilities be re-measured at the end of every reporting period with the change in value reported in the statement of operations.





17





The derivative liabilities were valued using a probability weighted average series of Black-Scholes-Merton models as a valuation technique with the following assumptions:





Fair Value of WarrantsMarch 31,

2011


December 31,

2010Risk-free interest rate


0.80%



0.61%Expected volatility


117%-119%



120%Expected life (in years)


1.50 – 1.75



1.75 – 2.00Expected dividend yield


0%



0%Fair Value:2009 Summer Warrants

$
527,912


$
804,1002009 Wellfleet Warrants


28,231



129,0002009 Fall Warrants


1,890,935



2,731,575Total Fair Value

$
2,447,078


$
3,664,675





The risk-free interest rate is based on the yield available on U.S. Treasury securities.  The Company estimates volatility based on the historical volatility of its common stock.  The expected life warrants are based on the expiration date of the related warrants.  The expected dividend yield was based on the fact that the Company has not paid dividends to common shareholders in the past and does not expect to pay dividends to common shareholders in the future.





As of March 31, 2011, the Company re-measured the derivative liabilities and determined the fair value to be $2,447,078. For the three months ended March 31, 2011, the Company recorded a gain on the change in fair value of derivatives of $1,217,597.





9.  Commitments and contingencies





Legal matters





We have concluded our litigation in previous matters involving the Company’s prior Chairman and Chief Executive, Jeffrey Muller and all related matters and are of the current opinion that the Company no longer faces litigation liability in connection with those cases. We are continuing to ensure the Company’s obligations are fully in compliance with a previous injunction order entered by a Federal District Court over six years ago to timely file all of the Company’s financial and related reports.  The Company will shortly be petitioning the Federal District Court to dissolve the compliance injunction on the basis that for more than a six-year period, under the Company’s new administrative and executive leadership, it has been in full compliance with the Company’s SEC financial and reporting obligations. We can provide no assurance that such action to dissolve the injunction would be successful.





There is no other litigation of any significance with the exception of the matters that have arisen under, and are being handled in, the normal course of business.




Litigation Involving Former Executive Officer





As previously reported, on April 7, 2010, Bruce McKinnon, the former CEO of the Company, and the Company entered into an Agreement Re: Collection on Judgment (“Judgment”) (the “Settlement Agreement”),  wherein McKinnon, among other things, agreed to cease further collection efforts on the Judgment, and the Company, among other things, agreed to satisfy the Judgment for, and McKinnon agreed to accept as full and final satisfaction of the Judgment, subject to certain payment waivers described below, a total amount of $360,000, plus interest of ten percent (10%) per annum from March 15, 2010, on the unpaid balance until paid, payable as follows:  $30,000 on April 7, 2010; $85,000 on or before April 15, 2010; and, $15,000 per month commencing on June 1, 2010, until paid.   As of March 31, 2011, all payments have been made on time and the balance due is $116,355.  The Settlement Agreement also provides that if the Company makes all payments thereunder, on a timely basis, McKinnon will waive final payments due him in the amount of $35,000.




There is no other litigation of any significance with the exception of the matters that have arisen under, and are being handled in, the normal course of business.




18


10.  Subsequent events





Stock Issuance





From April 1, 2011 through May 10, 2011, the Company issued 9,009,486 additional shares of our common stock in exchange for the conversion of $2,252,372 Convertible Notes.  The outstanding balance of Convertible Notes at May 10, 2011 is $398,849.




2011 Spring Offering





Since March 14, 2011 the Company has been conducting a private offering (the “Spring 2011 Offering”) of up to $1,100,000 aggregate face amount of its convertible notes (the “Spring 2011  Notes”). The Spring 2011 Offering will close on or before May 31, 2011. As of May 6, 2011 a total aggregate face amount of $401,720 the Spring 2011 Notes have been sold for an aggregate purchase price of $365,200.  While there is no stated interest rate on the Spring 2011 Notes, the implied effective interest rate on the Spring 2011 Notes is 10% per annum. The Spring 2011 Notes mature on the first anniversary of their date of issuance. The Spring 2011 Notes are convertible, at the option of the note holder, into 1,606,880 shares of common stock of the Company (the “Conversion Shares”) at an initial conversion price of $0.25 per share (the “Conversion Price”).





Each of the investors in the Spring 2011 Offering will receive, for no additional consideration, a warrant (the “Spring 2011 Warrants”), entitling the holder to purchase a number of shares of the Company’s common stock equal to 100% of the number of shares of common stock into which the Spring 2011 Notes are convertible (the “Warrant Shares”).  Each Spring 2011 Warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable immediately upon issuance and for a period of two (2) years from the date of issuance. Up to 1,606,880 Warrant Shares are initially issuable to date on exercise of the Spring 2011 Warrants.





19





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





This Quarterly Report on Form 10-Q contains forward-looking statements. These forward-looking statements include predictions regarding our future:





●
revenues and profits;●
customers;●
research and development expenses and efforts;●
scientific and other third-party test results;●
sales and marketing expenses and efforts;●
liquidity and sufficiency of existing cash;●
technology and products;●
the outcome of pending or threatened litigation; and●
the effect of recent accounting pronouncements on our financial condition and results of operations





You can identify these and other forward-looking statements by the use of words such as “may,” “will,” “expects”, “anticipates,” “believes,” “estimates,” “continues,” or the negative of such terms, or other comparable terminology.





Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements.





Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under the heading “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009. All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any forward-looking statements.




Overview




Save the World Air, Inc. (“STWA” or “Company” or “we”) designs, licenses and develops products to improve energy efficiency of large-scale energy production and improve diesel engine performance reducing emissions and improving fuel economy. We are a green technology company that leverages a suite of patented, patent-pending and licensed intellectual properties related to the treatment of fuels. Technologies patented by or licensed to us utilize either magnetic or uniform electrical fields to alter physical characteristics of fuels and are designed to create cleaner combustion. Cleaner combustion has been shown to improve performance, enhance fuel economy and/or reduce harmful emissions in laboratory testing.





We have two product lines;  Applied Oil Technology (“AOT”) and ELEKTRATM.





Applied Oil Technology is transitioning from the research and development stage to full-scale commercial prototypes, and is in testing with the U.S. Department of Energy.  ELEKTRA is in the research and development stage.





We obtained three licenses (the “Licenses”) from Temple University for their patent-pending uniform electric field technology, which provide the intellectual property foundations upon which the AOT and ELEKTRA products are based.  The AOT technology consists of passing crude oil through an array of dynamically-controlled electrical fields to reduce the viscosity of the oil, making it easier to pump through oil pipelines.  The ELEKTRA technology consists of passing fuel through a dynamically-controlled electrical field to assist in the atomization of fuel via fuel injectors.  ELEKTRA introduces a uniform electrical field into the fuel flow to reduce the viscosity of diesel fuel, enabling smaller droplets to be released into the combustion chamber of a diesel engine.  At December 31, 2010, the Company owed to Temple University a total of $721,785 for the License Agreement, Maintenance Fees, R&D Agreement and penalties and we were in default in those payments.  On March 28, 2011, we completed our final adjusted payment to Temple University for all outstanding obligations on the License Agreements and the R&D Agreement. We are currently in negotiations with Temple to replace the current License Agreements and to execute new License Agreements to reflect updated technologies.





20





The Company holds US Patent # 6901917, effective May 21, 2001 for “DEVICE FOR SAVING FUEL AND REDUCING EMISSIONS” covered in the United States, Australia, Canada, China, Russia, India, Indonesia and Mexico for the legacy technology.





We are also working with Temple University and Colfax Corporation (NYSE: CFX) to assist in the development of the commercial version of the AOT technology product line for oil refineries and pipelines.  The AOT product line uses the same dynamically-controlled strong electrical field concepts to reduce viscosity as ELEKTRA but is designed for pipeline applications that use thicker, more viscous fuels than the ELEKTRA market.  The AOT product is intended to improve the speed of highly viscous fluids such as crude oil traveling through pipelines.





We operate in a highly competitive industry.  Many of our activities are subject to governmental regulation.  We have taken aggressive steps to protect our intellectual property.





There are significant risks associated with our business, our Company and our stock.





We are a development stage Company that generated minimal revenues in 2006 and 2007. We did not generate any sales or revenues in 2008, 2009 or 2010. Our expenses to date have been funded primarily through the sale of stock and convertible debt, as well as proceeds from the exercise of stock purchase warrants. We raised capital in 2010 and will need to raise substantial additional capital in 2011, and beyond, to fund our sales and marketing efforts, continuing research and development, and certain other expenses, until our revenue base grows sufficiently to cover such expenditures.  See “Management’s Discussion and Analysis” below.





Our company was incorporated on February 18, 1998, as a Nevada corporation, under the name Mandalay Capital Corporation. We changed our name to Save the World Air, Inc. on February 11, 1999, following the acquisition of marketing and manufacturing rights of the ZEFS (legacy) technologies. Our mailing address is 735 State Street, Suite 500, Santa Barbara, California 93101. Our telephone number is (805) 845-3581. Our corporate website is www.stwa.com.




Our common stock is quoted under the symbol “ZERO” on the Over-the-Counter Bulletin Board





Results of Operations





We did not generate any revenue for the three-month period ended March 31, 2011 and 2010.





Operating expenses were $1,082,984 for the three-month period ended March 31, 2011, compared to $1,563,536 for the three-month period ended March 31, 2010, a decrease $480,552. This decrease is attributable to decreases in non-cash expenses of $346,038 and cash expenses of $134,514. Specifically, the decrease in non-cash expense is attributable to decreases in stocks given to consultants and employees of $561,700 and depreciation of $551, offset by an increase in valuation of options given to employees as compensation of $216,213. Specifically, the decrease in cash expense is attributable to decreases in consulting and professional fees of $85,257, office and other expenses of $51,983 and travel and related expenses of $3,058, offset by increases in salaries and benefits of $5,137 and corporate expenses of $647.





Research and development expenses were $471,355 for the three-month period ended March 31, 2011, compared to $174,293 for the three-month period ended March 31, 2010, an increase of $297,062. This increase is attributable to an increase in product testing, research and supplies of $471,065, offset by a decrease in contract fees of $174,003.





Other income and expense were $691,548 income for the three-month period ended March 31, 2011, compared to $3,770,658 expense for the three-month period ended March 31, 2010, a decrease of $4,462,206. This decrease is attributable to decreases in change in fair value of derivative liabilities of $2,456,360, cost of private placement of $1,129,212, interest and financing expense of $816,467 and an increase in other income of $60,167.




We had a net loss of $862,791, or $0.01 per share, for the three-month period ended March 31, 2011, compared to a net loss of $5,509,287, or $0.07 per share, for the three-month period ended March 31, 2010. We expect to incur additional net loss in the fiscal year ending December 31, 2011 primarily attributable to continued operating and marketing-related expenditures without the benefit of any significant revenue for the remainder of the year.





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Liquidity and Capital Resources




Since its inception, we have been primarily engaged in organizational and pre-operating activities. We have generated insignificant revenues and have incurred accumulated losses of $59,295,711 from February 18, 1998 (Inception) through   March 31, 2011. As reflected in the accompanying condensed consolidated financial statements, we had a net loss of $862,791 and a negative cash flow from operations of $2,017,815 for the three months ended March 31, 2011, and had a working capital deficiency (excluding derivative liabilities) of $1,884,953 and a stockholders' deficiency of $4,248,172 at March 31, 2011.  As a result, our independent registered public accounting firm, in their report on our 2010 consolidated financial statements, raised substantial doubt about our ability to continue as a going concern.  The financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern.




On March 28, 2011, we completed our final adjusted payment to Temple University for all outstanding obligations on the License Agreements and the R&D Agreement. We are currently in negotiations with Temple to replace the current License Agreements and to execute new License Agreements to reflect updated technologies (see “Item 5  Other information”).




Our ability to continue as a going concern is dependent upon our ability to raise additional funds and implement our business plan.  Our operations from inception, February 18, 1998 to March 31, 2011 have been funded through issuances of our common stock and convertible notes.  During this period, we raised an aggregate of $24,272,883 of which $13,456,809 was from the sale of convertible notes. As of March 31, 2011, the outstanding balance of convertible notes was $2,651,221, of which $2,588,422 represented the 2011 Winter Offering which closed February 28, 2011. (see “Note 4. Convertible debentures”). We expect substantially all of the outstanding notes will be converted into shares of common stock of the Company (see “Item 5 Other Information”).




On March 31, 2011, we had cash on hand in the amount of $325,218.  In addition to the funds on hand, we will  require additional funds  to continue to operate our business.  This includes expenses we will incur in connection with license agreements; product development and commercialization of the AOT and ELEKTRA technologies; costs to manufacture and ship our products; costs to design and implement an effective system of internal controls and disclosure controls and procedures; costs of maintaining our status as a public company by filing periodic reports with the SEC and costs required to protect our intellectual property. In addition ,we have contractual commitments for salaries to one of our executive officers pursuant to an employment agreement, severance payments to a former officer and consulting fees, during 2011 and beyond.  In light of our financial commitments over the next several months and its liquidity constraints, we have implemented cost reduction measures in all areas of operations. We intend to review these measures on an ongoing basis and make additional decisions as may be required.




Since March 14, 2011 the Company has been conducting a private offering (the “Spring 2011 Offering”) of up to $1,100,000 aggregate face amount of its convertible notes (the “Spring 2011  Notes”). The Spring 2011 Offering will close on or before May 31, 2011. As of May 6, 2011 a total aggregate face amount of $401,720 the Spring 2011 Notes have been sold for an aggregate purchase price of $365,200.  While there is no stated interest rate on the Spring 2011 Notes, the implied effective interest rate on the Spring 2011 Notes is 10% per annum. The Spring 2011 Notes mature on the first anniversary of their date of issuance. The Spring 2011 Notes are convertible, at the option of the note holder, into 1,606,880 shares of common stock of the Company (the “Conversion Shares”) at an initial conversion price of $0.25 per share (the “Conversion Price”).




Details of Recent Financing Transactions




2009  Fall Offering. From October 2, 2009 to January 15, 2010, we conducted and completed a private offering (the “Fall 2009 Offering”) consisting of an aggregate of $1,588,125 of 7% Convertible Promissory Notes (the “Notes”) with interest compounded quarterly at the annual rate of 7% payable at maturity, and warrants to purchase an aggregate of 6,352,500 shares of our common stock (the “Fall 2009 Warrants”).  We received $1,186,875 net proceeds, of which $344,500 was received as of December 31, 2009.  The Fall 2009 Notes mature on the second anniversary of the closing of this offering and will be convertible, at the option of the note holder, into up to 6,352,500 shares of our common stock at a conversion price of $0.25 per share.  The Fall 2009 Warrants are for a term of three years at an exercise price of $0.30 per share.





Each of the warrant agreements included an anti-dilution provision that allowed for the automatic reset of the exercise price upon any future sale of common stock or warrants at or below the current exercise price.  We considered the current Financial Accounting Standards Board guidance of “Determining Whether an Instrument Indexed to an Entity’s Own Stock” which indicates that any adjustment to the fixed amount (either conversion price or number of shares) of the instrument regardless of the probability or whether or not within the issuers’ control, means the instrument is not indexed to the issuers own stock. Accordingly, we determined that as the strike price of these warrants contain exercise prices that may fluctuate based on the occurrence of future offerings or events, and as such is not a fixed amount. As a result, we determined that these warrants are not considered indexed to our own stock and characterized the fair value of these warrants as derivative liabilities upon issuance.





We determined that the fair value of the warrant liability at issuances to be $3,027,815 based upon a probability weighted average Black-Scholes-Merton calculation (See Note 8), of which, $654,978 was recorded on December 31, 2009 and $2,372,837 was recorded on January 15, 2010.  We recorded the full value of the derivative of $2,372,837 as a liability at issuance with an offset to valuation discount. As the fair value of the liability of $2,372,837 exceeded the note value of $1,243,625, the excess of the liability over the note amount of $1,129,212 was considered to be cost of the private placement and was recorded upon issuance.  The fair value of the warrant liability as of March 31, 2011 was $2,070,915 (see Note 8).





As of March 31, 2011, investors have converted $1,578,125 of the Convertible Notes plus interest of $11,502 into 6,358,507 shares of our common stock.  The outstanding balance at March 31, 2011 is $10,872 which includes $872 in accrued interest.




2010 Winter Offering.From February 15, 2010 to March 31, 2010, we conducted a private offering (the “Winter 2010 Offering”) consisting of an aggregate of $885,863 face amount of its Convertible Promissory Notes (the “Winter 2010  Notes”) have been sold for an aggregate purchase price of $805,330.  While the stated interest rate on the Winter 2010 Notes is 0%, the implied interest rate on the Winter 2010 Notes is 10% per annum. The Winter 2010 Notes mature on the first anniversary of their date of issuance. The Winter 2010 Notes are convertible, at the option of the note holder, into 2,214,657 shares of our common stock (the “Conversion Shares”) at an initial conversion price of $0.40 per share (the “Conversion Price”).




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Each of the investors in the Winter 2010 Offering received, for no additional consideration, a warrant (the “Winter 2010 Warrants”), entitling the holder to purchase a number of shares of our common stock equal to 100% of the number of shares of common stock into which the Winter 2010 Notes are convertible (the “Warrant Shares”).  Each Winter 2010 Warrant is exercisable on a cash basis only at an initial price of $0.40 per share, and is exercisable immediately upon issuance and for a period of two (2) years from the date of issuance. Up to 2,214,657 Warrant Shares are initially issuable to date on exercise of the Winter 2010 Warrants.





We received $805,330 in net proceeds in the Winter 2010 Offering which was used for general corporate purposes and working capital. The aggregate value of the Winter 2010 Offering Warrants issued were valued at $476,268 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of 1.02; dividend yield of 0%; volatility factors of the expected market price of common stock of 135%; and an expected life of two years (statutory term) and vest immediately upon issuance.  We also determined that the notes contained a beneficial conversion feature of $329,062.  As of March 31,2011, the aggregate value of the Winter 2010 Offering Warrants, the beneficial conversion feature and the transaction fees of $80,533 are considered as debt discount and were fully amortized in conjunction with the conversion of the notes.





As of March 31, 2011, investors have converted $885,863 of the Convertible Notes into 2,214,657 shares of our common stock.  There was no outstanding balance at March 31, 2011.




2010 Spring Offering. From April 15, 2010 to April 30, 2010, we conducted a private offering (the “Spring 2010 Offering”) consisting of an aggregate of $143,000 face amount of its Convertible Promissory Notes (the “Spring 2010  Notes”) have been sold for an aggregate purchase price of $130,000.  While the stated interest rate on the Spring 2010 Notes is 0%, the actual interest rate on the Spring 2010 Notes is 10% per annum. The Spring 2010 Notes mature on the first anniversary of their date of issuance. The Spring 2010 Notes are convertible, at the option of the note holder, into 357,500 shares of our common stock (the “Conversion Shares”) at an initial conversion price of $0.40 per share (the “Conversion Price”).





Each of the investors in the Spring 2010 Offering received, for no additional consideration, a warrant (the “Spring 2010 Warrants”), entitling the holder to purchase a number of shares of our common stock equal to 100% of the number of shares of common stock into which the Spring 2010 Notes are convertible (the “Warrant Shares”).  Each Spring 2010 Warrant is exercisable on a cash basis only at an initial price of $0.40 per share, and is exercisable immediately upon issuance and for a period of two (2) years from the date of issuance. Up to 357,500 Warrant Shares are initially issuable to date on exercise of the Spring 2010 Warrants.





We received $130,000 in net proceeds in the Spring 2010 Offering which was used for general corporate purposes and working capital. The aggregate value of the Spring 2010 Offering Warrants issued were valued at $62,730 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of .41; dividend yield of 0%; volatility factors of the expected market price of common stock of 110%; and an expected life of two years (statutory term) and vest immediately upon issuance.  We also determined that the notes contained a beneficial conversion feature of $67,270.  As of March 31, 2011, the aggregate value of the Spring 2010 Offering Warrants, the beneficial conversion feature and the transaction fees of $13,000 are considered as debt discount and were fully amortized in conjunction with the conversion of the notes.





As of March 31, 2011, investors have converted $143,000 of the Convertible Notes into 357,000 shares of our common stock.  There was no outstanding balance at March 31, 2011.




2010 Summer Offering. From June 14, 2010 to July 31, 2010, we conducted and concluded a private offering (the “Summer 2010 Offering”) consisting of up to $500,000 aggregate face amount of out convertible notes (the “ Summer 1010 Notes). A total of $392,150 Summer 2010 Notes were sold to twenty six accredited investors for an aggregate purchase price of $356,500.  While the stated interest rate on the Summer 2010 Notes is 0%, the actual interest rate on the Summer 2010 Notes is 10% per annum. The Summer 2010 Notes mature on the first anniversary of of the closing of this offering and will be convertible, at the option of the note holder, into up to 1,568,600 shares of our common stock at a conversion price of $0.25 per share (the “Conversion Price”).





Each of the investors in the Summer 2010 Offering will receive, for no additional consideration, a warrant (the “Summer 2010 Warrants”), entitling the holder to purchase a number of shares of our common stock equal to 100% of the number of shares of common stock into which the Summer 2010 Notes are convertible (the “Warrant Shares”).  Each Summer 2010 Warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable  for a period of twenty four months.  Up to 1,568,600 Warrant Shares are initially issuable on exercise of the Summer 2010 Warrants.




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We received $356,500 in net proceeds in the Summer 2010 Offering which was used for general corporate purposes and working capital. The aggregate value of the Summer 2010 Offering Warrants issued were valued at $209,512 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of .55; dividend yield of 0%; volatility factors of the expected market price of common stock of 132%; and an expected life of two years (statutory term) and vest immediately upon issuance.  We also determined that the notes contained a beneficial conversion feature of $146,988.  As of March 31, 2011, the aggregate value of the Summer 2010 Offering Warrants, the beneficial conversion feature and the transaction fees of $35,650 are considered as debt discount and were fully amortized in conjunction with the conversion of the notes.





As of March 31, 2011, investors have converted $392,150 of the Convertible Notes into 1,568,600 shares of the Company’s common stock.  There was no outstanding balance at March 31, 2011.





2010 Fall Offering. From August 10, 2010 to September 30, 2010, we conducted and concluded a private offering (the “Fall 2010 Offering”) consisting of up to $600,000 aggregate face amount of out convertible notes (the “Fall 1010 Notes). A total of $174,482 Fall 2010 Notes were sold to ten accredited investors for an aggregate purchase price of $158,620.  While the stated interest rate on the Fall 2010 Notes is 0%, the actual interest rate on the Fall 2010 Notes is 10% per annum. The Fall 2010 Notes mature on the first anniversary of of the closing of this offering and will be convertible, at the option of the note holder, into up to 697,928 shares of our common stock at a conversion price of $0.25 per share (the “Conversion Price”).





Each of the investors in the Fall 2010 Offering will receive, for no additional consideration, a warrant (the “Fall 2010 Warrants”), entitling the holder to purchase a number of shares of our common stock equal to 100% of the number of shares of common stock into which the Fall 2010 Notes are convertible (the “Warrant Shares”).  Each Fall 2010 Warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable  for a period of twenty four months.  Up to 697,928 Warrant Shares are initially issuable on exercise of the Fall 2010 Warrants.





We received $158,620 in net proceeds in the Fall 2010 Offering which was used for general corporate purposes and working capital. The aggregate value of the Fall 2010 Offering Warrants issued were valued at $88,113 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of .42; dividend yield of 0%; volatility factors of the expected market price of common stock of 135%; and an expected life of two years (statutory term) and vest immediately upon issuance.  We also determined that the notes contained a beneficial conversion feature of $70,507.  As of March 31, 2011, the aggregate value of the Summer 2010 Offering Warrants, the beneficial conversion feature and the transaction fees of $15,862 are considered as debt discount and will be amortized over the life of the notes.





As of March 31, 2011, investors have converted $174,482 of the Convertible Notes into 697,928 shares of the Company’s common stock.  There was no outstanding balance at March 31, 2011.




2010 Fall Offering #2





From October 4, 2010 to November 30, 2010, the Company conducted and concluded a private offering (the “Fall 2010 Offering #2”) consisting of up to $3,000,000 aggregate face amount of its convertible notes (the “ Fall 2010 Notes). A total of $940,347 Fall 2010 #2 Notes were sold to ten accredited investors for an aggregate purchase price of $849,861.  While the stated interest rate on the Fall 2010 #2 Notes is 0%, the actual interest rate on the Fall 2010 #2 Notes is 10% per annum. The Fall 2010 #2 Notes mature on the first anniversary of the closing of this offering and will be convertible, at the option of the noteholder into 3,761,386 shares of the Company’s common stock at a conversion price of $0.25 per share (the “Conversion Price”).





Each of the investors in the Fall 2010 #2 Offering will receive, for no additional consideration, a warrant (the “Fall 2010 #2 Warrants”), entitling the holder to purchase a number of shares of our common stock equal to 100% of the number of shares of common stock into which the Fall 2010 #2 Notes are convertible (the “Warrant Shares”).  Each Fall 2010 Warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable for a period of twenty four months.  Up to 3,761,386 Warrant Shares are initially issuable on exercise of the Fall 2010 #2 Warrants.




The Company received $849,861 in net proceeds in the Fall 2010 #2 Offering which was used for general corporate purposes and working capital. The aggregate value of the Fall 2010 #2 Offering Warrants issued were valued at $436,986 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of .27; dividend yield of 0%; volatility factors of the expected market price of common stock of 121%; and an expected life of two years (statutory term) and vest immediately upon issuance.  The Company also determined that the notes contained a beneficial conversion feature of $417,875.  As of March 31, 2011, the aggregate value of the Fall 2010 #2 Offering Warrants, the beneficial conversion feature and the transaction fees of $85,486 are considered as debt discount and will be amortized over the life of the notes.





As of March 31, 2011, investors have converted $929,347 of the Convertible Notes into 3,717,386 shares of the Company’s common stock.  The outstanding balance at March 31, 2011 was $11,000.





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2011 Winter Offering





From December 13, 2010 through February 28, 2011, the Company  conducted a private offering (the “Winter 2011 Offering”) of up to $3,000,000 aggregate face amount of its convertible notes (the “Winter 2011  Notes”). A total of $2,588,422 aggregate face amount of the Winter 2011  Notes were sold for an aggregate purchase price of $2,353,111.  While the stated interest rate on the Winter 2011 Notes is 0%, the actual interest rate on the Winter 2011 Notes is 10% per annum. The Winter 2011 Notes mature on the first anniversary of their date of issuance. The Winter 2011 Notes are convertible, at the option of the note holder, into 10,353,688 shares of common stock of the Company (the “Conversion Shares”) at an initial conversion price of $0.25 per share (the “Conversion Price”).




Each of the investors in the Winter 2011 Offering received, for no additional consideration, a warrant (the “Winter 2011 Warrants”), entitling the holder to purchase a number of shares of the Company’s common stock equal to 100% of the number of shares of common stock into which the Winter 2011 Notes are convertible (the “Warrant Shares”).  Each Winter 2011 Warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable immediately upon issuance and for a period of two (2) years from the date of issuance. Up to 10,353,688 Warrant Shares are initially issuable to date on exercise of the Winter 2011 Warrants.





The Company received $2,353,111 in net proceeds in the 2011 Winter Offering which was used for general corporate purposes and working capital. The aggregate value of the 2011 Offering Warrants issued were valued at $1,368,888 using the Black-Scholes-Merton option valuation model with the following assumptions; risk-free interest rate of .25; dividend yield of 0%; volatility factors of the expected market price of common stock of 130%; and an expected life of two years (statutory term) and vest immediately upon issuance.  The Company also determined that the notes contained a beneficial conversion feature of $984,223.  As of March 31, 2011, the aggregate value of the 2011 Winter Offering Warrants, the beneficial conversion feature and the transaction fees of $235,311 are considered as debt discount and will be amortized over the life of the notes.





As of March 31, 2011, the outstanding balance of the 2011 Winter Offering was $2,588.422.





Critical Accounting Policies and Estimates





Our discussion and analysis of our condensed consolidated financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated financial statements and related disclosures requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, expenses, and related disclosure of contingent assets and liabilities. We evaluate, on an on-going basis, our estimates and judgments, including those related to the useful life of the assets. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.





The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the condensed consolidated results that we report in our financial statements. The SEC considers an entity’s most critical accounting policies to be those policies that are both most important to the portrayal of a company’s financial condition and results of operations and those that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about matters that are inherently uncertain at the time of estimation.. For a more detailed discussion of the accounting policies of the Company, see Note 2 of Notes to the condensed consolidated financial statements.




We believe the following critical accounting policies, among others, require significant judgments and estimates used in the preparation of our condensed consolidated financial statements:





The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Certain significant estimates were made in connection with preparing our condensed consolidated financial statements as described in Note 1 to Notes to condensed consolidated financial statements. Actual results could differ from those estimates.





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Revenue Recognition





The Company recognizes revenue based upon meeting the four criteria pursuant to the authoritative guidance issued by the FASB:





●
Persuasive evidence of an arrangement exists;●
Delivery has occurred or services rendered;●
The seller’s price to the buyer is fixed or determinable; and●
Collectability is reasonably assured.





We contract with manufactures of fixed magnetic field products and sell them to various original equipment manufacturers in the motor vehicle and small utility motor markets. We negotiate an initial contract with the customer fixing the terms of the sale and then receives a letter of credit or full payment in advance of shipment. Upon shipment, we recognize the revenue associated with the sale of the products to the customer.




Stock-Based Compensation





The Company periodically issues stock options and warrants to employees and non-employees in non-capital raising transactions for services and for financing costs. The Company accounts for stock option and warrant grants issued and vesting to employees based on the authoritative guidance provided by the Financial Accounting Standards Board whereas the value of the award is measured on the date of grant and recognized over the vesting period. The Company accounts for stock option and warrant grants issued and vesting to non-employees in accordance with the authoritative guidance of the Financial Accounting Standards Board whereas the value of the stock compensation is based upon the measurement date as determined at either a) the date at which a performance commitment is reached, or b) at the date at which the necessary performance to earn the equity instruments is complete. Non-employee stock-based compensation charges generally are amortized over the vesting period on a straight-line basis. In certain circumstances where there are no future performance requirements by the non-employee, option grants are immediately vested and the total stock-based compensation charge is recorded in the period of the measurement date.





The fair value of the Company's common stock option grant is estimated using the Black-Scholes option pricing model, which uses certain assumptions related to risk-free interest rates, expected volatility, expected life of the common stock options, and future dividends. Compensation expense is recorded based upon the value derived from the Black-Scholes option pricing model, and based on actual experience. The assumptions used in the Black-Scholes option pricing model could materially affect compensation expense recorded in future periods.




Recent Accounting Pronouncements




Recent accounting pronouncements did not or are not believed to have a material impact on the Company’s present or future consolidated financial statements.


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Item 3. Quantitative and Qualitative Disclosure about Market Risk





Not applicable.





Item 4. Controls and Procedures





Evaluation of Disclosure Controls and Procedures





Our management evaluated, with the participation of our Chief Executive Officer and Interim Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Interim Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)  were ineffective as of March 31, 2011 due to the material weaknesses in our internal control over financial reporting described below.





Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.  Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including our Chief Executive Officer and Interim Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.  Internal control consists of procedures which are designed with the objective of providing reasonable assurance that our transactions are properly authorized, recorded and reported and our assets are safeguarded against unauthorized or improper use, to permit the preparation of our financial statements in conformity with generally accepted accounting principles.





We identified certain matters that constitute material weakness (as defined under the Public Company Accounting Oversight Board Auditing Standard No. 2) in our internal control over financial reporting as discussed on Management’s Annual Report on Internal Control Over Financial Reporting below.





In light of the material weaknesses in internal control over financial reporting described below, we performed additional analysis and other post-closing procedures to ensure that our financial statements were prepared in accordance with generally accepted accounting principles.  Despite material weaknesses in our internal control over financial reporting, we believe that the financial statements included in our Form 10-Q for the period ended March 31, 2011 fairly present, in all material respects, our financial condition, results of operations, changes in shareholder’s equity and cash flows for the periods presented.





Management’s Annual Report on Internal Control over Financial Reporting.





Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transaction and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.





Because of its inherent limitation, internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives.





Our Chief Executive Officer, Interim Chief Financial Officer and Controller conducted an assessment of the effectiveness of our internal control over financial reporting as of March 31, 2011 based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).  A material weakness is a deficiency or a combination of deficiencies in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis.





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Based on that assessment, we have identified the following material weaknesses and have implemented the following remediation of material weaknesses in internal control over financial reporting:




Lack of segregation of duties




We have limited staff in our corporate offices and, as such, there is a lack of segregation of duties.  In December 2006 our Controller retired and in January 2007 our Chief Financial Officer retired due to medical problems.  We have subsequently hired an Interim Chief Financial Officer and a full-time Controller and our former Controller provides certain financial consulting services.




Lack of documented and reviewed system of internal control




We have an internal control weakness due to the lack of a documented and reviewed system of internal control.  We have determined that to perform the processes and remediate this internal control deficiency, we will either need to engage an internal control consultant or reassign existing personnel.  We have started to enhance some of our key internal control systems surrounding inventory purchasing and control, and to document those changes; however, this process is on-going and the implementation of policies and procedures may take several quarters.





As a result of the material weaknesses described above, management concluded that, as of March 31, 2011, we did not maintain effective internal control over financial reporting based on the criteria established in Internal Control – Integrated Framework, issued by COSO.





We have retained a consulting firm and are conducting an evaluation to design and implement adequate systems of accounting and financial statement disclosure controls. We expect to complete areview during 2011 to comply with the requirements of the SEC, which as required by SEC rules, may include an opinion from our auditors regarding management’s report on internal control over financial reporting for our fiscal year ending 2011.  We believe that the ultimate success of our plan to improve our internal control over financial reporting will require a combination of additional financial resources, outside consulting services, legal advice, additional personnel, further reallocation of responsibility among various persons, and substantial additional training of those of our officers, personnel and others, including certain of our directors such as our Chairman of the Board and committee chairs, who are charged with implementing and/or carrying out our plan.  It should also be noted that the design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.





In addition, our management with the participation of our Chief Executive Officer and Interim Chief Financial Officer have determined that no change in our internal control over financial reporting (as that term is defined in Rules 13(a)-15(f) and 15(d)-15(f) of the Securities Exchange Act of 1934) occurred during or subsequent to the quarter ended September 30, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.





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PART II





Item 1. Legal Proceedings





We have concluded our litigation in previous matters involving the Company’s prior Chairman and Chief Executive, Jeffrey Muller and all related matters and are of the current opinion that the Company no longer faces litigation liability in connection with those cases. We are continuing to ensure the Company’s obligations are fully in compliance with a previous injunction order entered by a Federal District Court over six years ago to timely file all of the Company’s financial and related reports.  The Company will shortly be petitioning the Federal District Court to dissolve the compliance injunction on the basis that for more than a six-year period, under the Company’s new administrative and executive leadership, it has been in full compliance with the Company’s SEC financial and reporting obligations. We can provide no assurance that such action to dissolve the injunction would be successful.





There is no other litigation of any significance with the exception of the matters that have arisen under, and are being handled in, the normal course of business.




Litigation Involving Former Executive Officer





As previously reported, on April 7, 2010, Bruce McKinnon, the former CEO of the Company, and the Company entered into an Agreement Re: Collection on Judgment (“Judgment”) (the “Settlement Agreement”),  wherein McKinnon, among other things, agreed to cease further collection efforts on the Judgment, and the Company, among other things, agreed to satisfy the Judgment for, and McKinnon agreed to accept as full and final satisfaction of the Judgment, subject to certain payment waivers described below, a total amount of $360,000, plus interest of ten percent (10%) per annum from March 15, 2010, on the unpaid balance until paid, payable as follows:  $30,000 on April 7, 2010; $85,000 on or before April 15, 2010; and, $15,000 per month commencing on June 1, 2010, until paid.   As of March 31, 2011, all payments have been made on time and the balance due is $116,355.  The Settlement Agreement also provides that if the Company makes all payments thereunder, on a timely basis, McKinnon will waive final payments due him in the amount of $35,000.




There is no other litigation of any significance with the exception of the matters that have arisen under, and are being handled in, the normal course of business.





Item 1A.  Risk Factors





There have been no material changes in the risk factors previously disclosed in Form 10-K for the period ended December 31, 2010, which we filed with the SEC on March 31, 2011.





Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds





2009  Fall Offering.From October 2, through January 15, 2010, the Company conducted a private offering (the “2009 Fall Offering”) consisting of an aggregate of $1,588,125 of Convertible Promissory Notes. The Notes were sold for  $1,186,875 net proceeds, and the Company converted existing liabilities of $401,250 to these notes.  The Notes are convertible into 6,352,500 shares of our common stock and in addition investors received warrants to purchase up to 6,352,500 shares of our common stock.  (See “Details of Recent Financing Transactions”).





2010 Winter Offering.From February 15, 2010 through June 30, 2010, we conducted a private offering (the “2010 Winter Offering”) and issued Convertible Notes in the aggregate face amount of $885,863.  These Notes were sold for an aggregate purchase price of $805,330 net proceeds.  The Notes are convertible into 2,214,657 shares of our common stock and in addition, investors received warrants entitling the holders to purchase up to 2,214,657 shares of our common stock.  (See “Details of Recent Financing Transactions”).





2010 Spring Offering.From April 15, 2010 through April 30, 2010, we conducted a private offering (the “2010 Spring Offering”) and issued Convertible Notes in the aggregate face amount of $143,000.  These Notes were sold for an aggregate purchase price of $130,000 net proceeds.  The Notes are convertible into 357,000 shares of our common stock and in addition, investors received warrants entitling the holders to purchase up to 357,000 shares of our common stock.  (See “Details of Recent Financing Transactions”).





2010 Summer Offering.From June 14, 2010 through July 31, 2010, we conducted a private offering (the “2010 Summer Offering”) and issued Convertible Notes in the aggregate face amount of $392,150.  These Notes were sold for an aggregate purchase price of $356,500 net proceeds.  The Notes are convertible into 1,568,600 shares of our common stock and in addition, investors received warrants entitling the holders to purchase up to 1,568,600 shares of our common stock.  (See “Details of Recent Financing Transactions”).




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2010 Fall Offering.From August 10, 2010 through September 30, 2010, we conducted a private offering (the “2010 Fall Offering”) and issued Convertible Notes in the aggregate face amount of $174,482.  These Notes were sold for an aggregate purchase price of $158,620 net proceeds.  The Notes are convertible into 697,928 shares of our common stock and in addition, investors received warrants entitling the holders to purchase up to 697,928 shares of our common stock.  (See “Details of Recent Financing Transactions”).





2010 Fall#2 Offering.From October 4, 2010 through November 30, 2010, we conducted a private offering (the “2010 Fall#2 Offering”) and issued Convertible Notes in the aggregate face amount of $940,347.  These Notes were sold for an aggregate purchase price of $849,861 net proceeds.  The Notes are convertible into 3,761,386 shares of our common stock and in addition, investors received warrants entitling the holders to purchase up to 3,761,386 shares of our common stock.  (See “Details of Recent Financing Transactions”).




2011 Winter Offering.From December 13, 2010  through February 28, 2011, we conducted a private offering (the “2011 Winter Offering”) and issued Convertible Notes in the aggregate face amount of $2,588,422.  These Notes were sold for an aggregate purchase price of $2,353,111 net proceeds.  The Notes are convertible into 10,353,688 shares of our common stock and in addition, investors received warrants entitling the holders to purchase up to 10,353,699 shares of our common stock.  (See “Details of Recent Financing Transactions”).




The sales of the securities described above were made in reliance on the exemptions from registration set forth in Section 4(2) of the Securities Act of 1933, as amended (the “Act”), or Regulations D or S promulgated thereunder.




Other Issuances.





During the three months ended March 31, 2011, the Company issued 1,609,924 shares of common stock in exchange for conversion of $402,481 of Convertible Notes.





During the three months ended March 31, 2011, the Company issued 81,020 shares of common stock upon cashless exercise of warrants.





During the three months ended March 31, 2011, the Company issued 77,778 shares of common stock upon exercise of options at $0.27 per share and valued at $21,000.


Item 3. Defaults Upon Senior Securities





None





Item 4. Submission of Matters to a Vote of Security Holders





None





Item 5. Other Information





On January 29, 2011, the Company issued 17,600,000 options to Cecil Bond Kyte, its chairman and chief executive officer. The options have an exercise price of $.25 per share, vest over a five year period, and expire ten years from date of grant.   Twenty percent of the options shall vest on each of the first five anniversary dates.  In the event of a change of control of the Company, all unvested options shall vest on the date of the change of control.  During the three months ended March 31, 2011, the Company amortized $254,326 of compensation cost based on the vesting of the options.  Future unamortized compensation expense on the outstanding options at March 31, 2011 is $6,587,938.  As of March 31, 2011, the market price  of the Company’s stock was $0.43 per share and the aggregate intrinsic value of the options outstanding and exercisable was $396,267.


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Stock Issuance





From April 1, 2011 through May 10, 2011, we issued 9,009,486 additional shares of our common stock in exchange for the conversion of $2,252,372 Convertible Notes.  The outstanding  balance of  Convertible Notes at  May 10, 2011 is $398,849.




2011 Spring Offering





Since March 14, 2011 we have been conducting a private offering (the “Spring 2011 Offering”) of up to $1,100,000 aggregate face amount of its convertible notes (the “Spring 2011  Notes”). The Spring 2011 Offering will close on or before May 31, 2011. As of May 6, 2011 a total aggregate face amount of $401,720 the Spring 2011 Notes have been sold for an aggregate purchase price of $365,200.  While the stated interest rate on the Spring 2011 Notes is 0%, the actual interest rate on the Spring 2011 Notes is 10% per annum. The Spring 2011 Notes mature on the first anniversary of their date of issuance. The Spring 2011 Notes are convertible, at the option of the note holder, into 1,606,880 shares of our common stock  (the “Conversion Shares”) at an initial conversion price of $0.25 per share (the “Conversion Price”).





Each of the investors in the Spring 2011 Offering will receive, for no additional consideration, a warrant (the “Spring 2011 Warrants”), entitling the holder to purchase a number of shares of our common stock equal to 100% of the number of shares of common stock into which the Spring 2011 Notes are convertible (the “Warrant Shares”).  Each Spring 2011 Warrant is exercisable on a cash basis only at an initial price of $0.30 per share, and is exercisable immediately upon issuance and for a period of two (2) years from the date of issuance. Up to 1,606,880 Warrant Shares are initially issuable to date on exercise of the Spring 2011 Warrants.





Item 6. Exhibits





Exhibit No.

Description31.1

Certification of Chief Executive Officer of Quarterly Report Pursuant to Rule 13(a)-15(e) or Rule 15(d)-15(e)31.2

Certification of Interim Chief Financial Officer of Quarterly Report pursuant to Rule 13(a)-15(e) or Rule 15(d)-15(e)32

Certification of Chief Executive Officer and Interim Chief Financial Officer of Quarterly Report Pursuant to 18 U.S.C. Section 1350





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SIGNATURES





In accordance with Section 13 or 15(d) of the Exchange Act, the Registrant has caused this Report to be signed on its behalf by the undersigned, hereunto duly authorized.





SAVE THE WORLD AIR, INC.Date: May 10, 2011
By:
/s/ EUGENE E. EICHLEREugene E. EichlerInterim Chief Financial Officer











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EXHIBIT INDEX





Exhibit No.

Description31.1

Certification of Chief Executive Officer of Quarterly Report Pursuant to Rule 13(a)-15(e) or Rule 15(d)-15(e)31.2

Certification of Interim Chief Financial Officer of Quarterly Report Pursuant to Rule 13(a)-15(e) or Rule 15(d)-15(e)32

Certification of Chief Executive Officer and Interim Chief Financial Officer of Quarterly Report Pursuant to 18 U.S.C. Section 1350