UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington D.C.,
20549





FORM
10-K





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


For
the fiscal year ended December 31, 2008





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





Commission
File No. 0-30351





DEEP
DOWN, INC.


(Exact
name of registrant as specified in its charter)




Nevada
            
            75-2263732(State
      of other jurisdiction of incorporation)
            
            (I.R.S.
      Employer Identification No.)8827 W. Sam Houston Pkwy N., Suite 100, Houston,
      Texas
            
            77040(Address
      of Principal Executive Office)
            
            (Zip
      Code)




Registrant’s
telephone number, including area code: (281) 517-5000





Securities
registered pursuant to Section 12(b) of the Act: NONE





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





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.     
Yes o   No þ





Indicate
by check mark whether the issuer is not required to file reports pursuant to
Section 13 or 15(d) of the Exchange Act.     Yes o   No þ





Indicate
by check mark whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirement for the past 90 days. Yes þ No £





Indicate
by check mark if disclosures of delinquent filers in response to Item 405 of
Regulations S-K is not contained in this form, and will not be contained, to the
best of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.   £





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
definition of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.





Large
accelerated filer o         
Accelerated filer þ        
Non-accelerated filer o      
Smaller reporting company þ





Indicate
by checkmark whether the registrant is a shell company (as defined in Rule 12b-2
of the Exchange Act). Yes £   No
þ





The
aggregate market value of the voting stock and non-voting common equity held by
non-affiliates, computed by reference to the price at which the common equity
was sold, or the average bid and asked price of such common equity, as of June
30, 2008, the last business day of our most recently completed second quarter,
was approximately $98,131,000.





At March
13, 2009, the issuer had outstanding 177,350,630 shares of Common Stock, par
value $0.001 per share.





Explanatory
Note





Pursuant
to subsection (3) of “Accelerated Filer and Large
Accelerated Filer” as defined under Rule 12(b)-2 of the Exchange Act,
Deep Down, Inc. is filing this Annual Report on Form 10-K for its fiscal year
ended December 31, 2008 with a determination that we have become an “accelerated
filer” after having been a “smaller reporting company” for Exchange Act
reporting purposes.  However, in accordance with subsection (4) of
“Smaller Reporting
Company”, Deep Down, Inc. is continuing to reflect its status as a
smaller reporting company in the disclosure we provide in this Annual Report (as
such subsection (4) requires us to reflect the determination that we are no
longer a “smaller reporting company” in the information we provide in our
quarterly report on Form 10-Q for the first fiscal quarter of
2009).








TABLE
OF CONTENTS






PART
      IItem
      1
              Description
      of Business
              3Item
      1A
              Risk
      Factors
              13Item
      1B
              Unresolved
      Staff Comments
              13Item
      2
              Description
      of Property
              13Item
      3
              Legal
      Proceedings
              14Item
      4
              Submission
      of Matters to a Vote of Security Holders
              14PART
      IIItem
      5
              Market
      for the Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
              15Item
      6
              Selected
      Financial Data
              16Item
      7
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              16Item
      7A
              Quantitative
      and Qualitative Disclosures About Market Risk
              27Item
      8
              Financial
      Statements
              27Item
      9
              Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
              27Item
      9A
              Controls
      and Procedures
              27Item
      9B
              Other
      Information
              28PART
      IIIItem
      10
              Directors,
      Executive Officers, Promoters, Control Persons and Corporate Governance;
      Compliance with Section 16(a) of the Exchange Act
              29Item
      11
              Executive
      Compensation
              31Item
      12
              Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
              34Item
      13
              Certain
      Relationships and Related Transactions, and Director
      Independence
              35Item
      14
              Principal
      Accountant Fees and Services
              35Item
      15
              Exhibits,
      Financial Statement Schedules
              36Signatures
              37





-1-


Forward-Looking
Information





Unless
otherwise indicated, the terms “Deep Down, Inc.”, “Deep Down”, “Company,” “we,”
“our” and “us” are used in this report to refer to Deep Down, Inc., a Nevada
corporation, and its wholly-owned subsidiaries.





In this
Annual Report on Form 10-K, we may make certain forward-looking statements,
including statements regarding our plans, strategies, objectives, expectations,
intentions and resources that are made pursuant to the safe harbor provisions of
the Private Securities Litigation Reform Act of 1995. We do not undertake to
update, revise or correct any of the forward-looking information. The following
discussion should also be read in conjunction with the audited consolidated
financial statements and the notes thereto.





The
statements contained in this Annual Report on Form 10-K that are not historical
fact are forward-looking statements (as such term is defined in the Private
Securities Litigation Reform Act of 1995), within the meaning of Section 27A of
the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. The forward-looking statements contained
herein are based on current expectations that involve a number of risks and
uncertainties. These statements can be identified by the use of forward-looking
terminology such as “believes,” “expects,” “may,” “will,” “should,” “intend,”
“plan,” “could,” “is likely,” or “anticipates,” or the negative thereof or other
variations thereon or comparable terminology, or by discussions of strategy that
involve risks and uncertainties. The Company wishes to caution the reader that
these forward-looking statements that are not historical facts are only
predictions. No assurances can be given that the future results indicated,
whether expressed or implied, will be achieved. While sometimes presented with
numerical specificity, these projections and other forward-looking statements
are based upon a variety of assumptions relating to the business of the Company,
which, although considered reasonable by the Company, may not be realized.
Because of the number and range of assumptions underlying the Company’s
projections and forward-looking statements, many of which are subject to
significant uncertainties and contingencies that are beyond the reasonable
control of the Company, some of the assumptions inevitably will not materialize,
and unanticipated events and circumstances may occur subsequent to the date of
this report. These forward-looking statements are based on current expectations
and the Company assumes no obligation to update this information. Therefore, the
actual experience of the Company and the results achieved during the period
covered by any particular projections or forward-looking statements may differ
substantially from those projected. Consequently, the inclusion of projections
and other forward-looking statements should not be regarded as a representation
by the Company or any other person that these estimates and projections will be
realized, and actual results may vary materially. There can be no assurance that
any of these expectations will be realized or that any of the forward-looking
statements contained herein will prove to be accurate.






-2-


PART
I




Item
1.          DESCRIPTION OF BUSINESS.





History





Deep
Down, Inc. (OTCBB:DPDW), a publicly traded Nevada corporation, originated on
December 14, 2006, through a reverse merger with Mediquip Holdings, Inc.
(“Mediquip”), a publicly traded Nevada corporation.  Deep Down, Inc.,
the operating company, was originally a Delaware corporation founded in 1997,
but had been acquired in a series of transactions on November 21, 2006, by
Subsea Acquisition Corporation (“Subsea”).





On June
29, 2006, Subsea, a Texas corporation, was formed by three shareholders with the
intent to acquire offshore energy service providers. On November 21, 2006,
Subsea acquired all the common stock of Strategic Offshore Services Corporation
(“SOS”), a Texas corporation, for 3,000 shares of Subsea’s Series F preferred
stock and 1,000 shares of Series G preferred stock from two common shareholders
(who were also shareholders of Subsea).  Since the entities were under
common control, and SOS did not constitute a business, the Company was charged
compensation expense to shareholders for the fair value of both series of
preferred stock totaling $3.3 million.





Additionally,
on November 21, 2006, Subsea acquired Deep Down, Inc., a Delaware corporation
founded in 1997. Under the terms of this transaction, all of Deep Down, Inc.’s
shareholders transferred ownership of all of Deep Down Inc.’s common stock to
Subsea in exchange for 5,000 shares of Subsea’s Series D preferred stock and
5,000 shares of Subsea’s Series E preferred stock resulting in Deep Down Inc.
becoming a wholly-owned subsidiary of Subsea. On the same day, Subsea then
merged with Deep Down, Inc., with the surviving company operating as Deep Down,
Inc. This transaction was accounted for as a purchase, with Subsea being the
accounting acquirer based on a change in voting control.





On
December 14, 2006, after divesting its Westmeria Healthcare Limited subsidiary,
MediQuip acquired all 9,999,999 outstanding shares of Deep Down common stock and
all 14,000 outstanding shares of Deep Down preferred stock in exchange for
75,000,000 shares of common stock and 14,000 shares of preferred stock of
MediQuip.  The shares of preferred stock of MediQuip were issued with
the same designations, rights and privileges as the Deep Down preferred stock
existing immediately prior to such transaction.  As a result of the
acquisition, the shareholders of Deep Down obtained ownership of a majority of
the outstanding voting stock of MediQuip.  MediQuip changed its name
to Deep Down, Inc. as part of the transaction, and Deep Down, Inc. continued as
a Nevada corporation following consummation of the acquisition. The merger was
accounted for as a reverse merger whereby Deep Down was the accounting acquirer
resulting in a recapitalization of Deep Down’s equity.





On April
2, 2007, Deep Down acquired substantially all of the assets of ElectroWave USA,
Inc., a Texas corporation for a total purchase price of $0.2 million. Deep Down
formed a wholly-owned subsidiary, ElectroWave USA, Inc. (“ElectroWave”), a
Nevada corporation, to complete the acquisition.  Located in
Channelview, Texas, ElectroWave offers design, assembly, installation and
commissioning of electronic monitoring and control systems for the energy,
military, and commercial business markets. This was not a "significant"
acquisition; therefore, no pro forma results are included for this acquisition
in this Form 10-K.





Effective
December 1, 2007, Deep Down acquired all of the common stock of Mako
Technologies, Inc. for a total purchase price of $11.3 million including
transaction fees.  Deep Down formed a wholly-owned subsidiary, Mako
Technologies, LLC (“Mako”) to complete the acquisition.  Located in
Morgan City, Louisiana, Mako serves the offshore petroleum and marine industries
with technical support services, and equipment vital to offshore petroleum
production, through rentals of its remotely operated vehicles (“ROV”), topside
and subsea equipment and support systems used in diving operations, maintenance
and repair operations, offshore construction and environmental and marine
surveys.





On June
5, 2008, Deep Down completed the acquisition of Flotation Technologies, Inc.
(“Flotation”), for a total purchase price of $23.9 million. Deep Down also
purchased related technology from an entity affiliated with the selling
shareholders. Deep Down effectively dated the acquisition for accounting
purposes as of May 1, 2008 and consummated the closing on June 6, 2008.
Flotation engineers, designs and manufactures deepwater buoyancy systems using
high-strength FlotecTM
syntactic foam and polyurethane elastomers from its facilities in Biddeford,
Maine.





In
February 2009, we formed Deep Down International Holdings, LLC, a Nevada limited
liability company and wholly owned subsidiary of the Company, for the purpose of
holding securities for foreign companies organized or acquired by Deep Down.
Deep Down International Holdings, LLC currently has no material assets or
operations.


-3-


Our
current operations are the result of the acquisitions of Deep Down, ElectroWave,
Mako and Flotation.  In addition to our strategy of continuing to grow
and strengthen our operations, including by expanding our services and products
in accordance with our customers’ demands, we intend to continue to seek
strategic acquisitions of complementary service providers, product manufacturers
and technologies that are focused primarily on supporting offshore deepwater
exploration, development and production of oil and gas reserves and other
maritime operations.





Business
Overview





We
provide services to the offshore energy industry to support deepwater
exploration, development and production of oil and gas and other maritime
operations.  We are primarily a service company and produce custom
engineered products that assist us in fulfilling service objectives for specific
projects on a contractual basis.  We design and manufacture a broad
line of deep water equipment, surface equipment and offshore rig equipment that
are used by major integrated, large independent and foreign national oil and gas
companies in offshore areas throughout the world.  We also manufacture
monitoring and control systems used by offshore energy and other maritime
operations.  Our products are often initially developed in direct
response to customer requests for solutions to critical problems in the
field.  We also serve the growing offshore petroleum and maritime
industries with technical management and support services.  Set forth
below is a more detailed description of important services and products we
provide.





Our goal
is to provide superior products and services designed to provide safer, more
cost-effective solutions in a quicker timeframe for our clients.  We
believe there is significant demand for, and brand name recognition of, our
established products due to the technological capabilities, reliability, cost
effectiveness, timely delivery and operational timesaving features of these
products. Since our formation, we have introduced many new products that
continue to broaden the market currently served by us.





We market
our products and services primarily through our offices in Houston, Texas,
Biddeford, Maine and Morgan City, Louisana. Our sales representatives
travel worldwide to the major international energy and maritime
markets.  We generally manufacture and fabricate our products at our
facilities, although we also work with third parties who provide manufacturing
and fabrication support through their own facilities in the Houston, Texas
metroplex.





Segments





For the
fiscal years ended December 31, 2008 and 2007, the operations of Deep Down’s
subsidiaries have been aggregated into a single reporting segment under the
provisions of SFAS 131 “Disclosures about Segments of an Enterprise and Related
Information” (“SFAS 131”). We determined that the operating segments of
Delaware, ElectroWave, Mako and Flotation (as of their respective acquisition
dates) may be aggregated into a single reporting segment because
aggregation is consistent with the objective and basic principles of paragraph
17 of SFAS 131. While the operating segments have different product lines, they
are very similar with regards to the five criteria for aggregation. They are all
service-based operations revolving around our personnel’s expertise in the deep
water industry, and any equipment is produced to a customer specified design and
engineered using Deep Down personnel’s expertise, with installation as part of
our service revenue to the customer. Additionally, the segments have similar
customers and distribution methods, and their economic characteristics were
similar with regard to their gross margin percentages for the fiscal years ended
December 31, 2008 and 2007.





Services
and Products




Services. We provide a wide
variety of project engineering and management services, including the design,
installation and retrieval of subsea equipment and systems, connection and
termination operations, well commissioning services as well as construction
support and ROV equipment rentals.  We pride ourselves on the ability
to collaborate with the engineering departments of oil and gas operators,
installation contractors and subsea equipment manufacturers to find the
quickest, safest, and most cost-effective solutions to address all manner of
issues in the subsea world.  We also provide various products in
connection with the use of our installation, retrieval, storage and management
services.




Offshore Project
Management.  Our installation management team specializes in
deepwater subsea developments. We are often contracted by our customers to
assist with the preparation and evaluation of subsea development bids and
requests for quotes.  Our experience comes from working with
installation contractors, oil and gas operators, controls suppliers, umbilical
manufacturers and other subsea equipment manufacturers, who often hire us to
help ensure that a project progresses smoothly, on time and on
budget.


-4-




Project
Engineering.  Our engineers have experience ranging from the
initial conceptual design phases through manufacturing and installation, and
concluding with topside connections and commissioning.  Our experience
provides us with a level of “hands on” and practical understanding that has
proven to be indispensable in enabling us to offer customer solutions to the
many problems encountered both subsea and topside.  Because of our
wide knowledge base, our engineering team is often hired by oil and gas
operators, installation contractors and subsea equipment manufacturers to
provide installation management and engineering support services.  Our
engineering team has been involved in most of the innovative solutions used
today in deepwater subsea systems.  We specialize in offshore
installation engineering and the writing of practical installation
procedures.  We deal with issues involving flying leads, compliant
umbilical splices, bend stiffener latchers, umbilical hardware, hold-back
clamps, and the development of distribution system components.  We are
heavily involved in the fabrication of installation aids to simplify offshore
executions, and offer hydraulic, fiber optic, and electrical testing services
and various contingency testing tools.




Installation Support and
Management.  Our installation management services are centered
on the utilization of standardized hardware, proven, well-tested installation
techniques, and an experienced, consistent team that has proven to be safe and
skilled in all aspects of the installation process.  We pride
ourselves on supporting installation contractors through our installation
management and engineering services, installation aids and equipment, and our
offshore installation support services, including spooling operations, offshore
testing, and flying lead installation support. Many installation contractors
find it beneficial to utilize our services to help reduce on-board personnel
since our specialized technicians can perform multiple tasks. We have
designed and fabricated many different installation tools and equipment over the
years.  We have been involved in the design of the following equipment
to help make installations run as smoothly as possible:  steel flying
leads, steel flying lead deployment systems, umbilical hardware and termination
systems, umbilical bell mouths, lay chutes, rapid deployment cartridges,
horizontal drive units, mud mats, flying lead installation and parking frames,
umbilical termination assembly stab & hinge over systems, and numerous other
pieces of offshore equipment.  Our team has vast experience with the
installation of flexible and rigid risers and flowlines, umbilicals, flexible
and rigid jumpers, steel tube and thermoplastic hose flying leads, pipeline end
terminations (“PLETs”) and manifolds.  In addition, we provide an
extensive array of installation aids, including steel flying lead installation
systems, a 5-ton Caterpillar®
tensioner, a 10-foot radius lay chute with work platform, many varieties of
buoyancy, clump weights, VIV strakes, mud mats, dual tank skids, gang
boxes, work vans, pumping and testing skids, control booths, fluid drum
carriers, crimping systems, load cells,  300 and 340-ton under-rollers, a
200-ton carousel, UTA running and parking deployment
frames, termination shelters, pipe straightners, ROV hooks and
shackles, stackable SeaStax®tanks,
baskets, and boxes, and ballgrab rental rigging.




Spooling
Services.  Our experienced personnel are involved in the
operation of spooling equipment on many projects, including operations for other
companies to run their spooling equipment.  We have developed a very
efficient (in both time and cost) system for spooling, utilizing our horizontal
drive units, under-rollers, tensioners, carousels and rapid deployment
cartridges.




Pull-In
Operations.  We are involved in the pull-in operations for most
of the major umbilical projects in the Gulf of Mexico.  Our
familiarity with offshore systems is important, and our pull-ins run smoothly
because the same engineers who plan the pull-in operations are also involved in
supervising the offshore operations.  Our offshore servicemen comprise
the topside umbilical support team and are familiar with the umbilical
termination hardware.  These same servicemen are often involved in
terminating the umbilicals at the manufacturers’ yard several weeks prior to the
installation.  Everything is thoroughly tested prior to installation,
including winches at the rental contractor’s yard and after set-up on the
platform. Load cells are tested onshore, and the same load cells are used to
test the system offshore. This eliminates variables and validates the condition
of the pull-in system.  We then perform pull-ins under more controlled
conditions with increased confidence, resulting in safer
operations.




Terminations.  Deep
Down and members of its team have been involved in umbilical terminations since
1988.  The Company’s team was involved with the designs for the
armored thermo plastic umbilicals at Multiflex, the first steel tube umbilical
in the Gulf of Mexico for the Shell Popeye®
umbilical, and the standardization of many steel tube umbilical
terminations.  We have also pioneered the concept of the compliant
Moray® section
that enables a traditional helically wound umbilical to be used for direct well
step outs, or long field flying leads.  Our management believes we are
the only company that can terminate umbilicals provided by any manufacturer with
the same termination system.


-5-




Testing
Services.  Umbilical manufacturers, control suppliers,
installation contractors, and oil and gas operators utilize our services to
perform all aspects of testing, including initial Factory Acceptance Testing
(“FAT”), Extended Factory Acceptance Testing (“EFAT”) and System Integration
Testing (“SIT”), relating to the connecting of the umbilical termination
assemblies, the performing of installations, and the completion of the
commissioning of the system thereafter.  To execute these services, we
have assembled a variety of personnel and equipment to ensure that all testing
operations are done in the safest and time-efficient manner, ensuring a reduced
overall project cost.  We also work hard to utilize the most detailed
digital testing and monitoring equipment to ensure that the most accurate data
is provided to our clients.  We have been hired to perform coiled
tubing flushing, cleaning, and hydro testing, umbilical filling, flushing,
pressure, flow rate, and cleanliness testing, load out monitoring and testing,
installation monitoring, post installation testing, system commissioning,
umbilical intermediate testing, and umbilical termination assembly cleanliness,
flow, and leak testing.  We believe we have one of the best filling,
flushing and testing teams in the business. Deep Down employs a variety of
different pumping systems to meet industry needs and offers maximum
flexibility.  Our philosophy is to flush through the maximum number of
lines at the highest flow rate possible to maximize efficiency.  We
have assembled a comprehensive list of offshore pumping units and an assortment
of chemical pumping skids.  Our equipment can be used to pump all of
the standard offshore water-based chemicals as well as all offshore
commissioning fluids such as Methanol and diesel.  The Company has
been involved in the design, procurement, testing, installation, and operation
of the testing equipment.  Deep Down’s engineers and service
technicians can also assist in writing the testing procedures and sequences from
simple FAT to very extensive multiple pressures and fluids testing up to full
system SIT procedures.




System Integration
Testing.  We have led the offshore industry move into the
digital age with our use of digital transducers to provide much greater levels
of accuracy compared to information gathered from conventional chart recorders.
We have a wide variety of digital pressure transducers, flow meters, and
temperature gauges. We have two wire data systems (4 port and one 16 port) as
well as 25 individual digital pressure and temperature recorders that are often
employed for installation monitoring activities. In addition to these units, the
Company also has three desks set up with data systems that are capable of
tracking from 4 to 15 individual sensors simultaneously. These capabilities, in
combination with subsea handling equipment, experienced personnel, and a
fully-equipped facility, render Deep Down ideal for managing SIT
operations.




Commissioning.  We
have been involved in most of the topside connections and commissioning (the
removal of inert fluids used during the umbilicals’ transportation and
installation) projects in the Gulf of Mexico since its formation in
1997.  Our commissioning team is often identified early in the project
and participates in all aspects of planning and risk assessment for the
project.  Due to the limited time associated with project
commissioning, it is extremely important to perform detailed planning and
engineering prior to arrival at the offshore production platform location to
reduce any possible shut in or down time.  Our engineers and
technicians work closely with the project managers and production platform
engineers to help ensure that all aspects of the installation or retrieval
project, including potential risks and dangers, are identified, planned for, and
eliminated prior to arrival on the production platform.  Due to the
different requirements for testing and commissioning of subsea systems, we have
an assortment of pumps and equipment to deploy to ensure a safe and efficient
commissioning program.  We have experience handling all types of
commissioning fluids, including asphaltine dispersants, diesel, methanol,
xylene, corrosion inhibitors, water-based control fluids, oil-based control
fluids, 100% glycol, paraffin inhibitors, and alcohol.




Storage
Management.  Our facility in Channelview covers more than
50,000 square feet of internal high quality warehousing capacity and 300,000
square feet of external storage and is strategically located in Houston's Ship
Channel area.  Our warehouse is designed to provide clients with
flexible and cost effective warehousing and storage management
alternatives.  Our professional and experienced warehouse staff,
combined with the very latest in information technology, results in a fully
integrated warehousing package designed to deliver effective solutions to client
needs. Among other capabilities, we are capable of providing long-term
specialized contract warehousing; long and short-term storage; modern materials
handling equipment; undercover loading areas; quality security systems;
integrated inventory management; packing and repacking; computerized stock
controls; and labeling.




Products.  We
provide installation support equipment and component parts and assemblies for
subsea distribution systems.  We believe the key to successful
installations of hardware is to design the subsea system by considering
installation issues first, working backwards to the design of the hardware
itself.  This is why we have been instrumental in the development of
hardware and techniques to simplify deepwater installations.  We
design, manufacture, fabricate, inspect, assemble, test and market subsea
equipment, surface equipment and offshore rig equipment that are used by major
integrated, large independent and foreign national oil and gas companies in
offshore areas throughout the world.  Our products are used during oil
and gas exploration, development and production operations on offshore drilling
rigs, such as floating rigs and jack-ups, and for drilling and production of oil
and gas wells on offshore platforms, tension leg platforms and moored vessels
such as floating production storage and offloading vessels
(“FPSO”).  We have significant involvement in umbilical and steel
flying lead installations in the Gulf of Mexico and throughout the
world.  A few of our major product lines are highlighted
below.


-6-




Flying Leads.  We
have developed a method to pull individual steel tubes, hoses, or electrical
cables to create a loose steel tube flying lead or short
umbilical.  We can manufacture steel flying leads up to 10,000 feet in
length with any J-plate desired, with or without electrical cables
included.  We have built flying leads with up to 14
tubes.  Additional electrical lines and fiber optic cables can be
added to produce any combination required for the transportation of various
fluids, chemicals or data.  The flying leads are then fitted with our
terminations and Morays® that are
attached to the multiple quick connection plate, and finished off with our
elastomeric bend limiters.  The non-helix wound design allows for our
flying leads to be very installation friendly with minimal-bending
stiffness.  A Moray® is the
termination head on the flying lead and connects the tubing assembly to the
junction plate.  A compliant Moray® consists
of a 20-foot flexible flying lead with an electro-hydraulic Moray® that is
connected to a full-sized umbilical with the installation tension being applied
through an armor pot and slings extending by the compliant
section.




Umbilical
Hardware.  Our operational team has been involved in more
umbilical installations than probably any other team in the
industry.  Our blend of experiences with drilling contractors,
umbilical manufacturers, subsea engineers and installation contractors has been
effective in positioning us to act on behalf of oil and gas operators to ensure
key hardware installation is performed in the most efficient and safe
manner.  This breadth of experiences gives us a unique perspective
when fabricating and designing terminations for umbilical
manufacturers.  Our designs are often much lighter in weight and
smaller than the typical hardware that has been created and used in the past by
our competitors.  Our engineering team has designed and fabricated
bending restrictors, armor pots, split barrels, tubing fittings and unions,
hinging umbilical splices and topsides terminations with our unique threaded
welded fittings, the compliant umbilical splice, and the bend stiffener
latcher.  Our umbilical hardware has enabled our clients to use
installation friendly techniques for deploying hardware on the ocean
floor.




Bend Limiters.  We
offer both electrometric and steel bend limiters.  Steel bend limiters
are typically utilized for steel tube umbilicals and have been designed with a
simple and reliable hinged attachment system which significantly decreases
installation time.  Electrometric bend limiters are typically provided
for small diameter umbilicals or flying leads, as well as for their compliant
umbilical section, which turns a traditional umbilical into a ROV-friendly,
installable flying lead.  Due to our ability to design and manufacture
bend limiters in-house, delivery time is greatly
reduced.




Compliant
Splice.  We have created a unique method of converting spare
umbilicals into actual production umbilicals by splicing spare umbilicals
together to produce any length required.  This methodology is achieved
through our Compliant Splice, which is a patent-pending termination system that
eliminates the burdens of dealing with umbilical splices during
installation.  This design is capable of housing both electrical and
fiber optic Fiber Termination Assemblies while still allowing for the splice to
be spooled up onto a reel or carousel. This allows oil and gas operators to save
significant costs through utilization of existing capital investments in spare
umbilicals, which reduces field development costs and delivery time.   An
optional mud mat is used to assist in carrying the splice over the chute and
functions to keep the splice out of the mud for easy inspection.




SeaStax®.  SeaStax®embodies
our concept for offshore storage and space management to help optimize available
deck space on offshore installation vessels, drilling rigs and production
platforms.  The key philosophy behind SeaStax® is to
take common offshore items and store them in a standard-sized container to allow
for the storage system to be stackable and interchangeable in subsurface
conditions.  The current system utilizes newly-designed 550 gallon
tote tanks, baskets, and tool boxes that are all inter-changeable and
stackable.  Using common dimensions and designs allows a variety of
different items to all be commonly stored and stacked, to minimize required
storage area.  The stacking philosophy can be applied to other custom
applications if required. In order to maximize accessibility and to reduce
maintenance, a variety of options are available such as galvanizing, ladders,
and drip pans.




Installation
Aids.  To help our clients and to meet our own internal needs,
we have developed an extensive array of installation aids, including steel
flying lead installation systems, a 5-ton Caterpillar®
tensioner, a 10-foot radius lay chute with work platform, many varieties of
buoyancy, clump weights, VIV strakes, mud mats, dual tank skids, gang
boxes, work vans, pumping and testing skids, control booths, fluid drum
carriers, crimping systems, load cells,  300 and 340-ton under-rollers, a
200-ton carousel, UTA running and parking deployment
frames, termination shelters, pipe straightners, ROV hooks and
shackles, stackable SeaStax®tanks,
baskets, and boxes, and ballgrab rental rigging.


-7-


Services
and Products from Acquisitions





Through
our acquisitions of Flotation, Mako and ElectroWave, we have further increased
our service and product offerings.  Several of such increased
offerings are described below.





Flotation




Flotation
engineers, designs and manufactures deepwater buoyancy systems using
high-strength FlotecTMsyntactic foam and polyurethane
elastomers.  Flotation’s  product offerings include
distributed buoyancy for flexible pipes and umbilicals, drilling riser buoyance
modules, CoreTecTM
drilling riser buoyancy modules, ROVitsTM
buoyancy, Hydro-Float mooring buoys, StablemoorTM
low-drag ADCP deployment solution, Quick-LocTM cable floats, HardballTM
umbilical floats, FlotecTM cable and pipeline protection, InflexTM polymer
bend restrictors, and installation buoyancy of any size and depth
rating.




The
majority of Flotation’s product offerings are made with FlotecTMsyntactic
foam, a product composed of hollow glass microballoons, combined with epoxy
resin and a catalyst. These microballoons or microspheres are very small, 20-120
microns in diameter, and provide the buoyancy to syntactic foam.  The
microballoons give syntactic foam its light weight, low thermal conductivity and
resistance to compressive stress that far exceeds other types of
foams.  The microballoons come in different densities and strengths
which are required for greater depth applications. In some applications, the
liquid syntactic foam resulting from the combination of ingredients is poured
into high-density polyethylene shells that form the flotation device and encase
and protect the syntactic foam from damage.




Because
of historic purchaser dissatisfaction with Flotation’s principal competitor,
Flotation was asked by oil companies to provide buoyancy products to the oil and
gas exploration and production sector.  The most significant step for
Flotation to take in order to get into the oil business was to secure an ISO
9001:2000 registration for its manufacturing operation.  Receipt of
those certificates allowed oil and gas clients to place their first orders with
Flotation Technologies.




Flotation’s
drilling riser product is marketed under the name CoreTecTM. Flotation also
manufactures polyurethane products, including bend restrictors, impact
protection, drill riser auxiliary clamps and other custom-designed products,
including some buoyancy products with macrospheres.  While the
overwhelming majority of Flotation‘s revenue comes from buoyancy products for
the petroleum production sector, Flotation also serves the oceanographic and
military markets.




Mako





Located
in Morgan City, Louisiana, Mako serves the growing offshore petroleum and marine
industries with technical support services and products vital to offshore
petroleum production.  Mako’s offerings are primarily, through rentals
of its remotely operated vehicles ("ROV"), topside and subsea equipment, and
support systems used in diving operations, maintenance and repair operations,
offshore construction, and environmental/marine surveys.





Diving and Offshore
Constuction Equipment Rental.  We employ a permanent staff of
highly qualified technicians and mechanics to maintain and refurbish Mako's
equipment in between rentals. We carry a wide array of equipment to service
the diving industry, including water blasting equipment, breathing air dive
compressors, hot water units with feed pumps, man rider winches, hydraulic
tools and hose reels, underwater video units, sonar units, magnetic
gradiometers, dive radios, lift bags, volume tanks, decompression
chambers, hot water pressure washers, and saturation systems.





ROV Equipment
Rental.  We provide the latest ROV tooling technology as part
of Mako’s rental fleet.  Mako's ROV tooling rental fleet is constantly
growing, with the addition of tools as they are requested by our
customers.  We have, as part of Mako’s rental inventory, a 2,000-foot
depth-rated inspection / light work class remotely-operated vehicle (ROV)
complete with a control van and launch / recovery system.  We also
have, as part of Mako’s inventory, a 300-meter depth-rated Seaeye Falcon and a
1,500-meter depth rated Seaeye Lynx observation class ROV.  Our
services include platform inspection (Level I, II and III, jack-up and
template), platform installation and abandonment, surveys (environmental,
pipeline existing and as built, oceanographic, nuclear and hydroelectric),
search and recovery, salvage, subsea intervention (hot stab operations, torque
tool, well, pipeline commissioning, and stack landings), telecommunication cable
inspections (existing and as built), research (fisheries, scientific and marine
archeology), anchor handling (mooring and anchor chain monitoring), ROV
consulting and project management, ROV pilots and technicians, and underwater
cinematography.  We provide an extensive line of ROV tools, ROV clamps
and ROV-friendly hooks and shackles that are state-of-the-art in
design.


-8-




Marine
Surveys.  Mako provides the offshore industry with a responsive
marine survey service.  Mako’s surveyors have extensive experience in
the marine industry, and provide a reliable and timely service, encompassing
on-and-off hire surveys, damage surveys, engine surveys, loading / securing of
cargo (warranty), trip and tow, suitability surveys, valuation surveys, hull
audio gauging, owner representatives, and regulatory vessel
compliance.





ElectroWave





We offer
products and services in the fields of electronic monitoring and control systems
for the energy, military, and commercial business sectors.  We design,
manufacture, install, and commission integrated Programmable Logic Controller
(“PLC”) and Supervisory Control and Data Acquisition (“SCADA”) based
instrumentation and control systems, including ballast control and monitoring,
drilling instrumentation, vessel management systems, marine advisory systems,
machinery plant control and monitoring systems, and closed circuit television
systems.  We can take projects from conceptual/system design through
installation, commissioning, and support. Our understanding of system
requirements and our ability to quickly understand our customer’s needs allows
us to produce quality products and services on time and on budget.





We have
supplied equipment on drilling production rigs operating throughout the world,
including Abu Dhabi, Angola, Australia, Azerbaijan, Brazil, Congo, Dubai, Egypt,
Equatorial Guinea, India, Indonesia, Kuwait, Mexico, Nigeria, Norway, Russia,
the United Kingdom, United States, Vietnam, and other areas. ElectroWave is
also a supplier of integrated marine systems for ships with design, manufacture,
and delivery of machinery plant control and monitoring systems and/or alarm
monitoring systems for 3 Molinari Class Staten Island ferries, a United States
Coast Guard ice breaker, one of the world’s largest hopper dredges, and other
vessels.





Below are
some of ElectroWave’s major services:





Drillers Display
System.  We have two proprietary drillers display
systems.  One of the proprietary systems was provided by one of our
customers and is installed only on that customer’s rigs.  The other
proprietary drillers display system was developed internally and is installed in
rigs worldwide. Drillers display systems allow the driller to keep an eye
on all the important parameters required for monitoring activity. Viewing of mud
pits, trip pits, flow rates, weight on bit, hook load, and other activities are
available to the driller at a glance. Logging software provides data analysis at
a whole new level, bringing more efficient drilling operations and increased
production from each working rig.  Our two largest customers for
ElectroWave’s drillers display systems are Transocean Offshore and Diamond
Offshore Drilling.





Machinery Plant Control
System.  The Machinery Plant Control and Monitoring Systems
(MPCMS) allow the operators of a vessel to reduce manning requirements by
integrating all of the machinery controls and monitoring systems into one. The
MPCMS can reduce the number of crew on one vessel by more than 50%, allowing the
vessel owner to save personnel expenses or allocate personnel to more critical
areas.  ElectroWave's largest MPCMS system consists of over 5,000
points, consisting of hard wired sensors, contacts, and data over industrial
protocols such as Ethernet, Modbus, and Profibus.  We have integrated
systems such as fire, flooding, ballast, fueling, bridge, propulsion, engines,
HVAC, deck machinery, air systems, emergency generators, lighting, and more,
into one system.  An entire vessel can now almost be operated from one
station by a very minimal crew.  Our MPCMS is currently in use on the
United States Coast Guard Ice Breaker Mackinaw.





Ballast
Console.  ElectroWave designs replacement ballast control
consoles for a number of customers. The consoles they are replacing have fallen
out of service and are typically only partially functioning. ElectroWave first
sends out a technician to perform a "site survey" during which our technician
will take copious notes about the existing installation, all of the wiring, and
any manuals that exist for the system. Our team then brings this information
back to our facility where we design replacement consoles that fit exactly where
the old console was, reducing hot work and re-wiring.  After designing
a new console, drawings are sent to the rig managers, electricians, and company
electricians for verification. After drawings are verified, the console is
released for production. Upon receiving the console at our factory, our
electricians (some of which are ex-rig electricians) wire the console to match
the old system wiring. After through testing at our factory, the console is
shipped to the customer where it is installed by our field service personnel.
The new console is wired to operate exactly like the old system to reduce
re-training of ballast control officers and rig hands. After the console is
commissioned, our technicians will provide any support and training necessary
before leaving the site.  We have installed ballast control systems
that are full touch screen capable, operating over 80 valves and more than 30
tanks.


-9-


CCTV
System.  ElectroWave has tackled some very difficult
Closed-circuit Television (“CCTV”) security and monitoring
requirements.  Post-911, the New York Department of Transportation
(NYDOT) wanted cameras to watch every available compartment of their three new
ferries. ElectroWave stepped up to the challenge and provided NYDOT one of the
most sophisticated CCTV systems available on passenger transportation ferries. A
system of cameras, coupled with digital video recording, allow post-event
tracing and security on one of the most-used transportation devices in New
York.  CCTV is more than just security, many (if not all) oil rigs
have CCTV systems installed to keep an eye on the safety of those working on the
rig.  Cameras watch unmanned spaces, machinery spaces, and potential
hazard zones for trouble. This helps to keep the manning requirement on the rigs
to a minimum while allowing for a safer working
environment.  ElectroWave typically provides Pelco camera systems, but
is capable of integrating existing camera systems into new CCTV installations.
ElectroWave has also developed hardware and software in-house to allow the use
of Pan/Tilt/Zoom (“P/T/Z”) cameras from hazardous locations where PTZ keyboards
cannot be installed.





Manufacturing





Our
manufacturing facilities are in Channelview, Texas, a suburb of Houston, where
we conduct a broad variety of processes, including machining, fabrication,
inspection, assembly and testing. Our Manufactured Systems Division is devoted
to the design, manufacturing, testing, and commissioning of heavy equipment used
in both on- and offshore operations in a variety of markets and
industries.





Our manufacturing plant is ISO 9001 and
American Petroleum Institute certified.  We maintain our high standards of
product quality through the use of quality assurance specialists who work with
product manufacturing personnel throughout the manufacturing process and inspect
and document equipment as it is processed through the Company's manufacturing
facility.  We have the capability to manufacture various products from
each of our product lines at our major manufacturing facility and believe that
this localized manufacturing capability is essential in order to compete with
our major competitors.  We maintain valuable relationships with
several other companies that own additional fabrication facilities in and around
Houston, Texas.  These other companies provide excellent subcontract
manufacturing support on an as-needed basis.  Our manufacturing
process includes heat treatment, machining, fabrication, inspection, assembly
and testing.





We have
designed, developed, and assembled our own continuous liquid syntactic foam
production machine.  This machine allows Flotation to produce the
large volume of foam required to make the 7-14 foot long drilling pipe flotation
risers that appear to be in high demand for offshore drilling in very deep
waters such as those in Brazil.  These drill pipe risers will operate
effectively in water depths of up to 4,000 meters (13,000
feet).   Flotation has foam that is capable of operating in water
depths of up to 7,000 meters (23,000 feet).  Flotation’s drilling
riser buoyancy design is unique in the industry, and a patent application has
been filed.





Customers





Demand
for our deep water services, surface equipment and offshore rig equipment is
substantially dependent on the condition of the oil and gas industry to invest
in substantial capital expenditures as well as continual maintenance and
improvements on its offshore exploration, drilling and production operations.
The level of these expenditures is generally dependent upon various factors such
as expected prices of oil and gas, exploration and production costs of oil and
gas, the level of offshore drilling and production activity.  The
prevailing view of future oil and gas prices are influenced by numerous factors
affecting the supply and demand for oil and gas.  These factors
include worldwide economic activity, interest rates, cost of capital,
environmental regulation, tax policies, and production levels and prices set and
maintained by producing nations and OPEC.  Capital expenditures are
also dependent on the cost of exploring for and producing oil and gas, the sale
and expiration dates of domestic and international offshore leases, the
discovery rate of new oil and gas reserves in offshore areas and technological
advances. Oil and gas prices and the level of offshore drilling and production
activity have historically been characterized by significant
volatility.





Our
principal customers are major integrated oil and gas companies, large
independent oil and gas companies, foreign national oil and gas companies,
subsea equipment manufacturers and subsea equipment installation contractors
involved in offshore exploration, development and
production.  Offshore drilling contractors, engineering and
construction companies, the military and other companies involved in maritime
operations represent a smaller customer base.





We are
not dependent on any one customer or group of customers. The number and variety
of our products required in a given period by a customer depends upon their
capital expenditure budget as well as the results of competitive bids.
Consequently, a customer may account for a material portion of revenues in one
period and may represent an immaterial portion of revenues in a subsequent
period. While we are not dependent on any one customer or group of customers,
the loss of one or more of our significant customers could, at least on a
short-term basis, have an adverse effect on the results of
our operations.


-10-


Marketing
and Sales





We market
our products and services throughout the world directly through our sales
personnel in our Houston, Texas, Biddeford, Maine and Morgan City, Louisiana
offices. We periodically advertise in trade and technical publications of our
customer base.  We also participate in industry conferences and trade
shows to enhance industry awareness of our products and services.  Our
customers generally order products and services after consultation with us on
their project.  Orders are typically completed within two weeks to
three months depending on the type of product or service.  Larger and
more complex products may require four to six months to complete.  Our
customers select our products and services based on the quality, reliability and
reputation of the product or service, price, timely delivery and advance
technology.  For large drilling and production system orders, we
engage our project management team to coordinate customer needs with
engineering, manufacturing and service organizations, as well as with
subcontractors and vendors.  Our profitability on projects is
dependent on performing accurate and cost-effective bids as well as performing
efficiently in accordance with bid specifications.  Various factors
can adversely affect our performance on individual projects that could
potentially adversely affect the profitability of a project.




Product
Development and Engineering





The
technological demands of the oil and gas industry continue to increase as
offshore exploration and drilling operations expand into deeper and more hostile
environments.  Conditions encountered in these environments include
well pressures of up to 15,000 psi, mixed flows of oil and gas under high
pressure that may also be highly corrosive, and water depths in excess of 5,000
feet.  We are continually engaged in product development activities to
generate new products and to improve existing products and services to meet our
customers’ specific needs.  We also focus our activities on reducing
the overall cost to the customer, which includes not only the initial capital
cost but also operating costs associated with its products.





We have
an established track record of introducing new products and product
enhancements.  Our product development work is conducted at our
facilities in Channelview, Texas and in the field.  Our application
engineering staff also provides engineering services to customers in connection
with the design and sales of our products.  Our ability to develop new
products and maintain technological advantages is important to our future
success.





We
believe that the success of our business depends more on the technical
competence, creativity and marketing abilities of our employees than on any
individual patent, trademark or copyright.  Nevertheless, as part of
our ongoing product development and manufacturing activities, our policy is to
seek patents when appropriate on inventions concerning new products and product
improvements.  All patent rights for products developed by employees
are assigned to us.





Competition





The
principal competitive factors in the petroleum drilling and production and
maritime equipment markets are quality, reliability and reputation of the
product, price, technology, the ability to provide quality service and timely
delivery.  We face significant competition from other manufacturers of
exploration, production and maritime equipment.  Several of our
primary competitors are diversified multinational companies with substantially
larger operating staffs and greater capital resources and have a longer history
in the manufacturing of these types of equipment.  We compete
principally with Dynacon, FMC, Halliburton Product Pipeline Services, Kvaerner,
Norson, Ocean Works, Oceaneering, VFL, and Halliburton Product Pipeline Services
on our umbilical services; Dynacon, Ocean Works and Odem on our Launch and
Recovery Systems; and Entech, Technip, Manatec and Pegasus on our installation
management services.





Flotation’s
principal competitors in the polyurethane area are Trelleborg AB, Balmoral
Group, Dunlaw Engineering Ltd., ABCO Industries Limited, and Whitefield Plastics
Corporation.  Flotation’s principal competitor in the syntactic foam
is Trelleborg AB. CRP Group was acquired by Trelleborg AB in January 2006 and
now operates worldwide as Trelleborg Offshore, with North American operations
under the name Trelleborg Offshore, Inc.  Other competitors include
Cumming Corp., located in Massachusetts; Matrix Composites & Engineering
Ltd., located in Australia; Balmoral Group, located in Scotland; Syntech
Materials, Inc., located in Virginia; and Marine Subsea Group, located in
Norway.


-11-


Employees





We had
169 employees as of March 13, 2009.  Our employees are not covered by
collective bargaining agreements and we consider our employee relations to be
good.  Our operations depend in part on our ability to attract a
skilled labor force.  While we believe that our wage rates are
competitive and that our relationship with our skilled labor force is good, a
significant increase in the wages paid by competing employers could result in a
reduction of our skilled labor force, increases in the wage rates that we pay or
both.





Governmental
Regulations





A
significant portion of our business activities are subject to federal, state,
local and foreign laws and regulations and similar agencies of foreign
governments.  The technical requirements of these laws and regulations are
becoming increasingly expensive, complex and stringent.  These regulations
are administered by various federal, state and local health and safety and
environmental agencies and authorities, including the Occupational Safety and
Health Administration of the U.S. Department of Labor and the U.S. Environmental
Protection Agency.  From time to time, we are also subject to a wide range
of reporting requirements, certifications and compliance as prescribed by
various federal and state governmental agencies.  Expenditures relating to
such regulations are made in the normal course of our business and are neither
material nor place us at any competitive disadvantage. We do not currently
expect compliance with such laws will require us to make material
expenditures.





We are
also affected by tax policies, price controls and other laws and regulations
generally relating to the oil and gas industry, including those specifically
directed to offshore operations.  Adoption of laws and regulations
that curtail exploration and development drilling for oil and gas could
adversely affect our operations by limiting demand for our services or
products.





Increased
concerns about the environment have resulted in offshore drilling in certain
areas being opposed by environmental groups, and certain areas have been
restricted.  To the extent that new or additional environmental
protection laws that prohibit or restrict offshore drilling are enacted and
result in increased costs to the oil and gas industry in general, our business
could be materially affected.  In addition, these laws may provide for
"strict liability" for damages to natural resources or threats to public health
and safety, rendering a party liable for the environmental damage without regard
to negligence or fault on the part of such party.  Sanctions for
noncompliance may include revocation of permits, corrective action orders,
administrative or civil penalties and criminal prosecution.  Certain
environmental laws provide for joint and several strict liabilities for
remediation of spills and releases of hazardous substances.  In addition,
companies may be subject to claims alleging personal injury or property damage
as a result of alleged exposure to hazardous substances, as well as damage to
natural resources.  Such laws and regulations may also expose us to
liability for the conduct of or conditions caused by others, or for our acts
that were in compliance with all applicable laws at the time such acts were
performed.  Compliance with environmental laws and regulations may require
us to obtain permits or other authorizations for certain activities and to
comply with various standards or procedural requirements.





We cannot
determine to what extent our future operations and earnings may be affected by
new legislation, new regulations or changes in existing
regulations.  We believe that our facilities are in substantial
compliance with current regulatory standards.  Based on our experience
to date, we do not currently anticipate any material adverse effect on our
business or consolidated financial position as a result of future compliance
with existing environmental laws and regulations controlling the discharge of
materials into the environment.  However, future events, such as
changes in existing laws and regulations or their interpretation, more vigorous
enforcement policies of regulatory agencies, or stricter or different
interpretations of existing laws and regulations, may require additional
expenditures which may be material.


-12-


Patents,
Trademarks and Copyrights




The
Company currently holds one patent covering riser tensioner sensor
assembly.  An additional five patents have been applied for and are in
process.  Trademarked names of the Company include DRILSYS TM,
ELECTROWAVE TM, MUDSYS
TM ,
AQUASOX TM , MORAY
TM
and SEASTAX TM ,
QUICK-LOC®,
FLOTEC®, and
PROTEUSTM.




We also
obtained all the rights to the following inventions, including all provisional
applications in connection with the acquisition of Flotation:




·
            Drilling
      Riser Buoyancy Produced with Plastic Shell (inventors Timothy H. Cook,
      Fred Maguire and David Capotosto);




·
            Drilling
      Riser Auxiliary Claim with Integral Mux Clamp (inventors Timothy H. Cook,
      Fred Maguire and David Capotosto);




·
            Clam
      for Holding Distributed Buoyancy Modules (inventors David Capotosto and
      William Stewart); and




·
            Hinged
      Distributed Buoyancy Module (inventors Timothy H. Cook and David
      Capotosto).





Item
1A.         RISK FACTORS





This item
is not applicable for smaller reporting companies.





Item
1B.         UNRESOLVED STAFF COMMENTS





On August
27, 2008, Deep Down received a letter from the SEC whereby the SEC requested
additional information related to issues disclosed in our Form 10-KSB for the
year ended December 31, 2007, filed April 1, 2008, regarding the following
topics: corporate history, segment disclosures, critical accounting policies,
non-GAAP presentation of financial information, predecessor financial statements
and the Mako purchase disclosures. We responded to the SEC in a comment
response letter dated October 7, 2008 filed as correspondence with the SEC with
the information requested on all topics.





On
December 4, 2008, Deep Down received a response letter from the SEC whereby the
SEC requested additional information related to our response letter dated
October 7, 2008. The SEC comments in the December 4 letter requested further
clarification to our responses regarding the following topics: corporate
history, segment disclosures, predecessor financial statements and the Mako
purchase disclosures. We responded to the SEC in a comment response letter dated
January 28, 2009 filed as correspondence with the SEC with the information
requested on all topics.





On
February 26, 2009, Deep Down received a response letter from the SEC stating
that they require that we amend the Form 10-KSB for December 31, 2007 to present
supplemental audited predecessor financial statements for Deep Down, Inc. for
the period January 1, 2006 through November 20, 2006, in accordance with Rule
310(a) of Regulation S-B. There were no further questions regarding the other
issues in our response dated January 28, 2009. We are working to complete the
predecessor financial statements along with the additional disclosure items and
footnotes that would be necessary to explain the predecessor statements and to
appropriately disclose the predecessor operating results for Deep Down, Inc. for
the noted accounting period. We anticipate completing the noted financial
statements and required audit procedures shortly after this Form 10-K is filed.
We replied to the SEC with this same information on March 11, 2009.





Item
2.           DESCRIPTION OF PROPERTY





Our
principal corporate offices were relocated to 8827 W. Sam Houston Parkway N.,
Suite 100, Houston, TX  77040 on February 21, 2009. The lease term
began on that date and includes an allowance for leasehold improvements by the
landlord, plus a charge for monthly common area expenses (“CAM charges”) on a
pro-rata basis of the total building expenses (including insurance, security,
maintenance, property taxes and utilities) beginning on the sixth month of the
lease term. Monthly lease cost ranges from $12,177 to $14,391 plus CAM charges,
due to a rent escalation clause over the term of the 89-month
lease.


-13-


Our
operating facilities for Deep Down and ElectroWave continue to be located at
15473 East Freeway, Channelview, Texas 77530.  We lease the
Channelview property, which consists of approximately 8 acres of land that
houses 60,000 square feet of manufacturing space and 7,000 square feet of office
space.  We lease all buildings, structures, fixtures and other
improvements from JUMA, LLC, a related party. See Item 13 “Certain Relationships and Related
Transactions, and Director Independence” included in this
report. The base rate of $15,000 per month is payable to JUMA, LLC through
August 31, 2013, together with all costs of maintaining, servicing, repairing
and operating the premises, including insurance, utilities and property
taxes.





Mako
leases its property and buildings from Sutton Industries at a base rate of
$7,300 per month.  Mako is located at 125 Mako Lane, Morgan City, LA
70380.  The 5-year lease term commenced on June 1, 2006, and includes
an additional 5-year renewal option at the end of the initial
term.





In
connection with the purchase of Flotation, Deep Down acquired the operating
facilities and administrative offices located at 20 Morin Street, Biddeford,
Maine 04005 for a fair market value of $3.3 million. The facility consists of
3.61 acres of land, including a 46,925 square-foot light industrial
manufacturing facility and administrative offices. Additionally, in October
2008, Flotation entered into a 60-month lease for 18,000 square feet of
warehouse space within a 107,000 square foot warehouse located at 26 Morin
Street, Biddeford, Maine and purchased a three-quarter acre parcel, which are
both adjacent to Flotation’s operating facility.





We
believe that our current space is suitable, adequate and of sufficient capacity
to support our current operations.





Item
3.          LEGAL PROCEEDINGS





We are
from time to time involved in legal proceedings arising in the normal course of
business. As of the date of this Annual Report on Form 10-K, we are currently
not involved in any pending, material legal proceedings except as noted
below.





Deep Down
is currently in arbitration with the former stockholders of Flotation
Technologies, Inc. regarding the proper calculation of the “Cash Price
Adjustment” pursuant to the Stock Purchase Agreement by and between Deep Down,
Flotation Technologies, Inc. and its stockholders dated April 17,
2008.





In
connection with the private placement of our common stock in June 2008 (the
“Private Placement”), Deep Down entered into a registration rights agreement
with the purchasers in the Private Placement (the “Registration Rights
Agreement”) pursuant to which the purchasers have certain demand registration
rights. Deep Down filed a Registration Statement on Form S-1 on July 21, 2008.
Pursuant to the Registration Rights Agreement, Deep Down was obligated to have
the Registration Statement declared effective by September 3, 2008 (the
“Required Effective Date”), or the Company would be required to pay damages to
the purchasers in the Private Placement for each day following the Required
Effective Date, until but excluding the date the Commission declares the
Registration Statement effective. Deep Down has evaluated this obligation under
the Registration Rights Agreement for liability treatment under FASB
Statement No. 5,“Accounting for
Contingencies” (“SFAS 5”) and Financial Statement Staff Position (FSP) EITF
00-19(2) “Accounting for Registration Payment Arrangements” and determined that
the registration rights meet the definition of a liability under the
authoritative guidance and has reserved $1.2 million in potential damages under
the terms of the Private Placement for the 90-day period September 4 to December
4, 2008, when we obtained a legal opinion allowing the removal of the related
stock’s restrictive legends.





Item
4.          SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS





There
were no matters submitted to a vote of our security holders during the period
covered by this Annual Report on Form 10-K.


-14-


PART
II





Item
5.          MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES





Market
for Common Stock





Our
common stock trades publicly on the OTC Bulletin Board under the symbol “DPDW.”
The OTCBB is a regulated quotation service that displays real-time quotes,
last-sale prices and volume information in over-the-counter equity securities.
The OTCBB securities are traded by a community of market makers that enter
quotes and trade reports. This market is extremely limited and any prices quoted
may not be a reliable indication of the value of our common stock.





Prior to
the reverse merger with MediQuip on December 14, 2006, no public market in our
common stock existed. Beginning December 14, 2006, our common stock was quoted
on the OTC Bulletin Board. These quotes represent inter-dealer quotations,
without adjustment for retail mark-up, markdown or commission and may not
represent actual transactions.  The following table sets, for the
periods indicated, the high and low sales prices for our common stock as
reported by the OTC Bulletin Board.





High
            
            
            LowFiscal
      Year 2008:December
      31, 2008
            
            $
            0.62
            
            
            $
            0.11September
      30, 2008
            
            $
            0.95
            
            
            $
            0.44June
      30, 2008
            
            $
            1.27
            
            
            $
            0.68March
      31, 2008
            
            $
            1.24
            
            
            $
            0.35Fiscal
      Year 2007:December
      31, 2007
            
            $
            2.35
            
            
            $
            0.76September
      30, 2007
            
            $
            0.94
            
            
            $
            0.51June
      30, 2007
            
            $
            0.78
            
            
            $
            0.27March
      31, 2007
            
            $
            0.42
            
            
            $
            0.16




Holders





As of
March 13, 2009, there were 1,081 holders of record of our common stock and we
believe there were 1,081 beneficial owners.




Dividend
Policy




To date,
we have not paid any cash dividends and our present policy is to retain earnings
for working capital use.  Under the terms of our credit agreement with
Whitney Bank, we are restricted from paying cash dividends on our common stock,
unless no default under the credit agreement exists at the time of or would
arise after giving effect to any such distribution. We intend to retain
operating capital for the growth of the company operations.


-15-


Equity
Compensation Plan Information




The
following table sets forth the outstanding equity instruments as of December 31,
2008:




Number
      of securities
                to
      be issued
                upon
      exercise of
                outstanding
      options,
              
              Weighted-average
                exercise
      price of
                outstanding
      options,
              
              Number
      of securities
                remaining
      available
                for
      future issuance under
                equity
      compensation plans
                (excluding
      securities reflectedPlan Category
              warrants and rights
              
              warrants and rights
              
              in first column)Equity
      compensation plans approved by securityholders
              8,066,667 (1)
              
              $0.96
              
              17,336,000 (1)Equity
      compensation plans not approved by securityholders
              638,812 (2)
              
              $0.78
              
              N/ATOTAL
              8,705,479
              
              $0.95
              
              17,336,000


____________





(1)       Represents 8,066,667 shares of common
stock that may be issued pursuant to options granted as of December 31, 2008 and
approximately 17,336,000 additional available for future grant under the 2003
Directors, Officers and Consultants Stock Option, Stock Warrant and Stock Award
Plan (the “Plan”). Shares available for grant include 1,200,000 restricted
shares that were granted under the Plan to executives and employees on February
14, 2008 which vest on February 14, 2010, provided such respective recipient
remains employed with the Company on such date. These restricted shares are
included in the shares outstanding as of December 31, 2008.  Under the
Plan, the total number of shares subject to grants and awards is 15% of issued
and outstanding shares of common stock.





(2)       Represents
638,812 shares of common stock underlying warrants approved by the Company’s
Board of Directors, including 320,000 warrants granted to a consultant as part
of our prior $6.5 million borrowing facility entered into on August 6, 2007,
plus an additional 118,812 warrants granted to a consultant as part of the
additional $6.0 million advanced under the amendment to that same borrowing
facility effective December 31, 2007, plus an additional 200,000 warrants issued
on June 5, 2008 in connection with the purchase of Flotation.  See
Note 11 to our consolidated financial statements included in this report with
regard to material terms of such warrants.




Recent
Sales of Unregistered Securities





None





Item
6.          SELECTED FINANCIAL DATA





This item
is not applicable for smaller reporting companies.





Item
7.          MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS





History





Deep
Down, Inc., a publicly traded Nevada corporation, originated on December 14,
2006, through a reverse merger with Mediquip, a publicly traded Nevada
corporation.  Deep Down, Inc., the operating company, was originally a
Delaware corporation founded in 1997, but had been acquired in a series of
transactions on November 21, 2006, by Subsea.





On June
29, 2006, Subsea, a Texas corporation, was formed by three shareholders with the
intent to acquire offshore energy service providers. On November 21, 2006,
Subsea acquired all the common stock of SOS, a Texas corporation, for 3,000
shares of Subsea’s Series F preferred stock and 1,000 shares of Series G
preferred stock from two common shareholders (who were also shareholders of
Subsea).  Since the entities were under common control, and SOS did
not constitute a business, the Company charged compensation expense to
shareholders for the fair value of both series of preferred stock totaling $3.3
million.


-16-


Additionally,
on November 21, 2006, Subsea acquired Deep Down, Inc., a Delaware corporation
founded in 1997. Under the terms of this transaction, all of Deep Down, Inc.’s
shareholders transferred ownership of all of Deep Down Inc.’s common stock to
Subsea in exchange for 5,000 shares of Subsea’s Series D preferred stock and
5,000 shares of Subsea’s Series E preferred stock resulting in Deep Down Inc.
becoming a wholly-owned subsidiary of Subsea. On the same day, Subsea then
merged with Deep Down, Inc., with the surviving company operating as Deep Down,
Inc. This transaction was accounted for as a purchase, with Subsea being the
acquirer based on a change in voting control.





On
December 14, 2006, after divesting its Westmeria Healthcare Limited subsidiary,
MediQuip acquired all 9,999,999 outstanding shares of Deep Down common stock and
all 14,000 outstanding shares of Deep Down preferred stock in exchange for
75,000,000 shares of common stock and 14,000 shares of preferred stock of
MediQuip.  The shares of preferred stock of MediQuip were issued with
the same designations, rights and privileges as the Deep Down preferred stock
existing immediately prior to such transaction.  As a result of the
acquisition, the shareholders of Deep Down obtained ownership of a majority of
the outstanding voting stock of MediQuip.  MediQuip changed its name
to Deep Down, Inc. as part of the transaction, and Deep Down, Inc. continued as
a Nevada corporation following consummation of the acquisition. The transaction
was accounted for as a reverse merger, whereby Deep Down was considered to be
the accounting acquirer resulting in a recapitalization of Deep Down’s
equity.





On April
2, 2007, Deep Down acquired substantially all of the assets of ElectroWave USA,
Inc., a Texas corporation for a total purchase price of $0.2 million. Deep Down
formed a wholly-owned subsidiary, ElectroWave, a Nevada corporation, to complete
the acquisition.  Located in Channelview, Texas, ElectroWave offers
design, assembly, installation and commissioning of electronic monitoring and
control systems for the energy, military, and commercial business markets. This
was not a "significant" acquisition; therefore, no pro forma results are
included for this acquisition in this Form 10-K.





Effective
December 1, 2007, Deep Down acquired all of the common stock of Mako
Technologies, Inc. for a total purchase price of $11.3 million including
transaction fees.  Deep Down formed a wholly-owned subsidiary, Mako,
to complete the acquisition.  Located in Morgan City, Louisiana, Mako
serves the offshore petroleum and marine industries with technical support
services, and equipment vital to offshore petroleum production, through rentals
of its ROV, topside and subsea equipment and support systems used in diving
operations, maintenance and repair operations, offshore construction and
environmental and marine surveys.





On June
5, 2008, Deep Down completed the acquisition of Flotation, for a total purchase
price of $23.9 million. Deep Down also purchased related technology from an
entity affiliated with the selling shareholders. Deep Down effectively dated the
acquisition for accounting purposes as of May 1, 2008 and consummated the
closing on June 6, 2008. Flotation engineers, designs and manufactures deepwater
buoyancy systems using high-strength FlotecTM
syntactic foam and polyurethane elastomers from its facilities in Biddeford,
Maine.





In
February 2009, we formed Deep Down International Holdings, LLC, a Nevada limited
liability company and wholly owned subsidiary of the Company, for the purpose of
holding securities for foreign companies organized or acquired by Deep Down.
Deep Down International Holdings, LLC currently has no material assets or
operations.





Our
current operations are the result of the acquisitions of Deep Down, ElectroWave,
Mako and Flotation.  In addition to our strategy of continuing to grow
and strengthen our operations, including by expanding our services and products
in accordance with our customers’ demands, we intend to continue to seek
strategic acquisitions of complementary service providers, product manufacturers
and technologies that are focused primarily on supporting offshore deepwater
exploration, development and production of oil and gas reserves and other
maritime operations.





Critical
Accounting Policies





The
accompanying discussion and analysis of our financial condition and results of
operations is based upon our audited consolidated financial statements, which
have been prepared in accordance with accounting principles generally accepted
in the United States of America. See Note 1 “Nature of Business and Summary of
Significant Accounting Policies” of our consolidated financial statements
included in this report for additional details. The following discussion
addresses our most critical accounting policies, which are those that require
significant judgment and use of assumptions.


-17-


Accounts
Receivable





Trade
accounts receivable are recorded at the invoiced amount and do not bear
interest.  The allowance for doubtful accounts on trade receivables is
our best estimate of the probable amount of credit losses in our existing
accounts receivables.  A considerable amount of judgment is required
in assessing the realization of receivables.  Relevant assessment
factors include the credit worthiness of the customers and prior collection
history.  Account balances are charged off against the allowance after
all reasonable means are exhausted and the potential for recovery is considered
remote.  The allowance requirements are based on the most current
facts available and are re-evaluated and adjusted on a regular basis and as
additional information is received.  We do not expect to have any
off-balance sheet credit exposure related to our customers.





Consolidation





The
accompanying audited financial statements include the results of Deep Down and
all of its wholly-owned subsidiaries, including Deep Down Delaware since its
inception on June 29, 2006, ElectroWave since its acquisition on April 2, 2007,
Mako since its acquisition on December 1, 2007 and Flotation since its
acquisition on May 1, 2008.  All significant intercompany balances and
transactions have been eliminated.





Long-Lived
Assets




We
evaluate long-lived assets for impairment whenever changes in circumstances
indicate that the carrying amount of the asset may not be
recoverable.  Recoverability of assets to be held and used is measured
by a comparison of the carrying amount of an asset to future undiscounted cash
flows expected to be generated by the asset.  If assets are considered
to be impaired, the impairment to be recognized is measured by the amount by
which the carrying amounts exceed the fair values of the
assets.  Assets to be disposed are reported at the lower of carrying
values or fair values, less costs of disposal. We found no significant
adjustments during our review of fixed assets.





Stock-Based
Compensation





We
account for stock-based compensation issued to employees and non-employees as
required by SFAS No. 123(R) “Share-based Payment”.Under
these provisions, we record expense ratably over the requisite service period
based on the fair value of the awards determined at the grant date utilizing the
Black-Scholes pricing model for options and warrants.  We first
granted stock options in April 2007, and thus do not have extensive history upon
which to evaluate our estimates. For the year ended 2008, we estimated
forfeitures to be 0%. We expect to increase our forfeiture estimate in future
periods as we accumulate our history with regard to forfeitures.





Key
assumptions used in the Black-Scholes model for both stock options and warrant
valuations include (1) expected volatility (2) expected term (3) discount
rate and (4) expected dividend yield. Since we do not have a sufficient trading
history to determine the volatility of our own stock, we based our estimates of
volatility on a representative peer group consisting of companies in the same
industry, with similar market capitalizations and similar stage of development.
Additionally, Deep Down continues to use the simplified method related to
employee option grants as allowed by Staff Accounting Bulletin ("SAB") 110,
Share-Based Payment.





The fair
value of each stock option or warrant grant is estimated on the date of the
grant using the Black-Scholes model and is based on the following key
assumptions for the year ended December 31, 2008:





Dividend
      yield
            
            0%Risk
      free interest rate
            
            2.52%
      - 2.84%Expected
      life of options
            2-3
      yearsExpected
      volatility
            
            51.7%
      - 61.3%





Revenue
Recognition




We
generally recognize revenue once the following four criterion are
met:  (i) persuasive evidence of an arrangement exists, (ii) delivery
of the equipment has occurred or services have been rendered, (iii) the price of
the equipment or service is fixed and determinable and (iv) collectability is
reasonably assured.  For certain fabrication projects, revenue is
recognized upon shipment or when customer-specific contract elements
(“milestone(s)”) are met.   Fabrication and sale of equipment
billings are contingent upon satisfaction of a significant condition of sale
milestone, including but not limited to, factory acceptance testing and customer
approval, and recognized upon transfer of title to the
customer.  Service revenue is recognized as the service is
provided.


-18-


From time
to time, we enter into large fixed price contracts which we determine that
recognizing revenues for these types of contracts is appropriate using the
percentage-of-completion method under Statement of Position 81-1, “Accounting
for Performance of Construction-Type and Certain Production-Type Contracts”
(“SOP 81-1”), which compares the percentage of costs incurred to date to the
estimated total costs for the contract.  This method is preferred because
management considers total costs the best available measure of
progress.





Total
costs include all direct material and labor costs plus all indirect costs
related to contract performance, such as supplies, equipment repairs, employee
travel and supervisor time. Selling, general and administrative costs are
charged to expense as incurred.  Provisions for estimated losses on
uncompleted contracts (if any) are made in the period in which such losses are
determined.  Changes in job performance, job conditions, and total contract
values may result in revisions to costs and income and are recognized in the
period in which the revisions are determined.  Unapproved change orders are
accounted for in revenue and cost when it is probable that the costs will be
recovered through a change in the contract price. In circumstances where
recovery is considered probable but the revenues cannot be reliably estimated,
costs attributable to change orders are deferred pending determination of
contract price.





Costs and
estimated earnings in excess of billings on uncompleted contracts arise when
revenues are recorded on a percentage-of-completion basis but cannot be invoiced
under the terms of the contract. Such amounts are invoiced upon completion of
contractual milestones. Billings in excess of costs and estimated earnings on
uncompleted contracts arise when milestone billings are permissible under the
contract, but the related costs have not yet been incurred. All contract costs
are recognized currently on jobs formally approved by the customer and contracts
are not shown as complete until virtually all anticipated costs have been
incurred and the items are shipped to the customer.





In
accordance with industry practice, assets and liabilities related to costs and
estimated earnings in excess of billings on uncompleted contracts, as well as
billings in excess of costs and estimated earnings on uncompleted contracts,
have been classified as current. The contract cycle for certain long-term
contracts may extend beyond one year, thus collection of amounts related to
these contracts may extend beyond one year.





All
intercompany revenue balances and transactions were eliminated in
consolidation.





Goodwill
and Intangible Assets





Goodwill
represents the cost in excess of the fair value of net assets acquired in
business combinations. SFAS No. 142, “Goodwill and Other Intangible Assets”
(SFAS 142), prescribes the process for impairment testing of goodwill on an
annual basis or more often if a triggering event occurs. Goodwill is not
amortized, and there were no indicators of impairment at December 31,
2008.





We
evaluated the carrying value of goodwill during the fourth quarter of each year
and between annual evaluations if events occur or circumstances change that
would more likely than not reduce the fair value of the reporting unit below its
carrying amount. Such circumstances could include a significant adverse change
in legal factors or in business or the business climate or unanticipated
competition. When evaluating whether goodwill is impaired, we compare the fair
value of the business to its carrying amount, including goodwill. The fair value
of the reporting unit is estimated using the income or discounted cash flows
method. If the carrying amount of the business exceeds its fair value, then the
amount of the impairment loss must be measured. The impairment loss would be
calculated by comparing the implied fair value of the reporting unit’s goodwill
to its carrying amount.





Our
intangible assets consist of assets acquired in the purchases of the Mako and
Flotation subsidiaries and is comprised of customer lists, non-compete covenants
with key employees and trademarks related to Mako’s ROVs and to Flotation’s
processes, materials and technology.  We amortize the intangible
assets over their useful lives ranging from three to forty years on a
straight-line basis.


-19-


Income
Taxes





We have
adopted the provisions of SFAS No. 109, “Accounting for Income Taxes" which
requires recognition of deferred tax liabilities and assets for the expected
future tax consequences of events that have been included in the consolidated
financial statements or tax returns. Under this method, deferred tax liabilities
and assets are determined based on the difference between the financial
statement and tax basis of assets and liabilities using enacted tax rates in
effect for the year in which the differences are expected to
reverse.





In June
2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48
clarifies the accounting for uncertainty in income taxes recognized in an
enterprise’s financial statements in accordance with FASB Statement No. 109,
“Accounting for Income Taxes,” by prescribing a recognition threshold and
measurement attribute for the financial statement recognition and measurement of
a tax position taken or expected to be taken in a tax return. If a tax position
is more likely than not to be sustained upon examination, then an enterprise
would be required to recognize in its financial statements the largest amount of
benefit that is greater than 50% likely of being realized upon ultimate
settlement. We have determined that there was no FIN 48 tax liability at
December 31, 2008.





Executive
Overview





2008 has
been a very difficult year economically and on Wall Street, however it has been
a very good year for Deep Down in continuing our dramatic growth operationally.
We are continuing to mature and develop into an elite deepwater offshore energy
service provider. We acquired Flotation in May 2008, which significantly
expanded our operations in the buoyancy products and services area. We announced
a major contract of $11.0 million for our riser buoyancy products and services
which will be used in a deepwater project off the coast of Brazil. We also
expanded our fleet of ROVs in Louisiana by five ROVs during the
year.





In June
2008, we completed a Private Placement sale of stock which allowed us to
acquire Flotation, as well as retire the very expensive Prospect Capital
Corporation (“Prospect”) debt of over $12.0 million. The sale of this stock
required the Company to file a registration statement with the Securities and
Exchange Commission in order to register the shares. The registration statement
has taken much longer and is significantly more costly than expected, however,
the acquisition of Flotation has allowed us to become an essential service
company to the offshore deepwater energy industry, which is the best market
place, and we are expanding rapidly with new technology during a major down turn
in the industry.





Deep
Down’s balance sheet is very strong with healthy liquidity ratios. During the
year, we incurred a significant number of one-time cash expenses along with a
significant number of non-cash expenses. Deep Down expensed over $2.9 million in
amortization of debt discounts and deferred financing costs and costs related to
the extinguishment of the $12.0 million Prospect debt. Our bad debt expense
increased by $1.4 million as a result of substantially increasing our reserves
as well as expensing a receivable for a large customer in Louisiana that filed
for bankruptcy during the year. Our general and administrative expenses are up
by almost $1.2 million for professional fees in connection with the acquisition
of Flotation and the registration statement. General and administrative expense
is also increased by $1.2 million in accrual of penalty fees associated with not
having the registration statement declared effective by the SEC. These one-time
expenses total over $6.7 million. We look forward to 2009 when most of these
expenses will not be a part of our operations.





Recent
developments





On March
5, 2009, the Company’s wholly owned subsidiary, Flotation, obtained loan
proceeds in the principal amount of approximately $1.8 million pursuant to a
loan agreement Flotation and the Company entered into with TD Bank, N.A. (“TD
Bank”) as of February 13, 2009.  This loan agreement provides a
further commitment to Flotation for advancement of principal in the amount of
$0.3 million.  Loans under the loan agreement are generally secured by
Flotation’s operational premises in Biddeford, Maine under a mortgage and
security agreement and a collateral assignment of leases and
rents.  In connection with the loan agreement, TD Bank required that
the Company enter into a debt subordination agreement that subordinated any debt
Flotation owes to the Company other than accounts payable between them arising
in the ordinary course of business.  Furthermore, as part of the loan
agreement, TD Bank required a “negative pledge” that prohibits Flotation and the
Company from granting security interests in Flotation’s personal property, other
than such security interests granted in respect of the Company’s primary
facility for borrowed money (as currently held with Whitney National Bank
(“Whitney Bank”)).  The Company is obligated to repay proceeds funded
on March 5, 2009 based on a schedule of monthly installments of approximately
$13,000, with an initial payment on March 13, 2009 and a final payment of all
remaining outstanding and unpaid principal and accrued interest in February
2016. However, upon advancement of additional principal amounts available under
the loan agreement, TD Bank will recalculate the monthly installments to an
amount that will fully amortize the then outstanding principal balance over a
20-year amortization schedule.


-20-


In
connection with such loan for Flotation, the Company entered into a second
amendment of its existing credit facility with Whitney Bank to permit such loan
and the security and other arrangements relating to Flotation’s loan
agreement.  The terms of the second amendment also included a
guarantor’s consent and agreement, to be signed by each of the Company’s
subsidiaries as guarantors of the obligations of the Company under such existing
credit facility, that Whitney required as a condition to the effectiveness of
the second amendment.  Additionally, Whitney Bank required that Deep
Down International Holdings, LLC, a Nevada limited liability company and wholly
owned subsidiary of the Company formed in February 2009, enter into joinder
agreements for the guaranty and security agreement arrangements generally
required of the Company’s subsidiaries under the existing credit
facility.  Deep Down International Holdings, LLC currently has no
material assets or operations.





The
following discussion of our financial condition and results of operations should
be read in conjunction with our consolidated financial statements and the notes
to those financial statements appearing elsewhere in this Form 10-K. This
discussion contains forward-looking statements that involve significant risks
and uncertainties. As a result of many factors, our actual results may
differ materially from those anticipated in our forward-looking
statements.




Results
of Operations





Revenues





2008
            
            
            2007
            
            
            Change
            
            
            %Revenues
            
            $
            35,769,705
            
            
            $
            19,389,730
            
            
            $
            16,379,975
            
            
            
            84.5%







Revenues
increased by approximately $16.4 million, or 84.5% to $35.8 million for the year
ended December 31, 2008 from approximately $19.4 million for the previous year.
This increase in revenue was primarily attributable to strong demand for our
services and equipment from our customers in the oil and gas industry and the
impact of the inclusion of our acquisitions of Mako and Flotation, which
accounted for $17.3 million of the increase. The remainder of the change in
revenue is due to not repeating some large construction projects that we billed
in fiscal 2007, since they had low gross margins and did not meet our criteria
for continuing orders.





Cost of
sales




2008
            
            
            2007
            
            
            Change
            
            
            %Cost
      of sales
            
            $
            21,686,033
            
            
            $
            13,306,086
            
            
            $
            8,379,947
            
            
            
            63.0%Gross
      Margin
            
            $
            14,083,672
            
            
            $
            6,083,644
            
            
            $
            8,000,028
            
            
            
            131.5%Gross
      Margin %
            
            
            39%
            
            
            
            31%
            
            
            
            49%








Gross
profit was $14.1 million for the year ended December 31, 2008 compared to $6.1
million for the previous year, reflecting an overall improvement in gross profit
margin from 31% to 39%. Gross margins were positively impacted by the inclusion
of our acquisitions of Flotation and Mako, which had slightly better margins
than the rest of the Company operations.





Selling, general and
administrative expenses





Selling,
general and administrative expenses (“SG&A”) included rent, utilities,
general office expenses, insurance, personnel and other costs necessary to
conduct business operations.  SG&A for the year ended December 31,
2008 was $14.3 million compared to $4.3 million for the same period last year
for an increase of $10.0 million. The acquisitions of Mako and Flotation
represented $3.8 million of the increase. Bad debt increased by $1.4 million due
to the write off of certain accounts, one of which filed for bankruptcy
protection. Personnel and related costs (not included in the Mako and Flotation
amount) increased by $2.3 million due to expansion of our businesses requiring
more personnel and the related requirements to administer a public company and
comply with reporting requirements. Additionally, we paid approximately $2.0
million more than the prior year in professional, accounting and legal fees to
support our various initiatives during fiscal 2008 relating to the filing of a
registration statement and to support the referenced acquisitions. Stock-based
compensation related to employee stock options and restricted stock was
approximately $0.6 million in the current fiscal year compared to approximately
$0.2 million for the comparable prior year period.


-21-


Depreciation and
amortization expense





2008
            
            
            2007
            
            
            Change
            
            
            %Depreciation
            
            $
            1,314,138
            
            
            $
            398,611
            
            
            $
            915,527
            
            
            
            229.7%Amortization
            
            
            1,048,968
            
            
            
            28,353
            
            
            
            1,020,615
            
            
            
            3599.7%Depreciation
      and amortization
            
            $
            2,363,106
            
            
            $
            426,964
            
            
            $
            1,936,142
            
            
            
            453.5%




Depreciation
and amortization expense for the year ended December 31, 2008 was $2.4 million
compared to $0.4 million for the year ended 2007 due mainly to the acquisitions
of Mako and Flotation, though Flotation has only eight months of depreciation
expense since it was acquired May 1, 2008. Fixed assets acquired in the Mako and
Flotation subsidiaries totaled $7.9 million. A total of $1.1 million of the
depreciation expense is recorded as cost of sales related to revenue-producing
assets, compared to $0.3 million for the previous year. In addition,
amortization of intangible assets for the year ended December 31, 2008 was $1.0
million compared to approximately $28,000 for the year ended 2007. For the year
ended December 31, 2008 we recorded eight months of amortization for Flotation
intangible assets plus a full year of Mako intangible assets, whereas only one
month of Mako amortization was included for 2007.





We
depreciate our assets using the straight-line method over the estimated useful
lives of the respective assets. Buildings are depreciated between 10 and 36
years, and leasehold improvements are amortized over the shorter of the assets'
useful lives or lease terms. We depreciate equipment from two to seven years,
computers and electronics from two to four years, and furniture and fixtures
from two to seven years.  Deep Down’s intangible assets consist of
$19.2 million in specifically identified intangible assets acquired in the
purchase of the Flotation and Mako subsidiaries, including customer
relationships, non-compete covenants, trademarks and various technology
rights. We are amortizing the intangible assets over their estimated useful
lives on the straight-line basis between three and forty years.





Interest
expense





Interest
expense for the year ended December 31, 2008 was $3.5 million compared to $2.4
million for the prior year.  In connection with the early payoff of
our credit agreement with Prospect in June 2008, we accelerated the remaining
deferred financing costs totaling $0.7 million and recorded this charge to
interest expense. Additionally, $1.5 million in debt discounts were accelerated
and recorded as interest expense. We paid cash interest related to such credit
agreement totaling $0.9 million for the year ended December 31, 2008 compared to
$0.5 million in the prior year. During the year ended December 31, 2008, we
recognized $0.1 million of interest related to accretion on the redemption of
Series E Preferred Stock. For the prior year, $1.6 million of the total
interest related to accretion on the redemption of Series G and Series E
Preferred Stock.





Gain/(loss) on debt
extinguishment





In
connection with the early payoff of our credit agreement with Prospect in June
2008, early termination fees of approximately $0.4 million were recognized as a
loss on early extinguishment of debt. During the year ended December, 31, 2007,
we executed a Securities Redemption Agreement with our former chief financial
officer to redeem 4,000 shares of Series E exchangeable preferred stock at a
discounted price of $500 per share for a total of $2.0 million.  The
discount of $500 per share from the face value of $1,000 was accounted for as a
substantial modification of debt, thereby generating a gain on extinguishment of
debt of $2.0 million.





Net Income
(loss)





Net loss
was $4.3 million for the year ended December 31, 2008 as compared to net income
of approximately $1.0 million for the prior year. This is due primarily to the
costs incurred with private placement of stock and the related registration
statement penalty costs of $1.2 million, the costs associated with the
acquisition of Flotation, and a $1.4 million increase to bad debt expense to
increase reserves and write off a large receivable from a customer in Louisiana
that filed for bankruptcy.


-22-


EBITDA





Earnings
before interest, taxes, depreciation and amortization (“EBITDA”) is a non-GAAP
financial measure. We use EBITDA as an unaudited supplemental financial
measure to assess the financial performance of our assets without regard to
financing methods, capital structures, taxes or historical cost basis; our
liquidity and operating performance over time in relation to other companies
that own similar assets and that we believe calculate EBITDA in a similar
manner; and the ability of our assets to generate cash sufficient for us to pay
potential interest costs. We also understand that such data are used by
investors to assess our performance. However, the term EBITDA is not defined
under generally accepted accounting principles and EBITDA is not a measure of
operating income, operating performance or liquidity presented in accordance
with generally accepted accounting principles. When assessing our operating
performance or liquidity, investors should not consider this data in isolation
or as a substitute for net income, cash flow from operating activities, or other
cash flow data calculated in accordance with generally accepted accounting
principles.





EBITDA
decreased by approximately $3.7 million to $0.4 million for the year ended
December 31, 2008 from approximately $4.1 million for the previous year. This
decrease includes one-time charges of $1.4 million for increased bad debt
expense, and in connection with the acquisition of Flotation and the
registration statement, approximately $1.2 million in professional fees plus
$1.2 million in accrued penalties associated with the delay in the approval
of the registration statement.





The
following is a reconciliation of net income (loss) to EBITDA for the years ended
December 31, 2008 and 2007:





2008
            
            
            2007
            
            
            Change
            
            
            %Net
      income (loss)
            
            $
            (4,322,893
            )
            
            $
            952,509
            
            
            $
            (5,275,402
            )
            
            
            -553.8%Add
      back interest expense
            
            
            3,511,177
            
            
            
            2,430,149
            
            
            
            1,081,028
            
            
            
            44.5%Deduct
      interest income
            
            
            (110,504
            )
            
            
            (92,664
            )
            
            
            (17,840
            )
            
            
            19.3%Add
      back depreciation and amortization
            
            
            2,363,106
            
            
            
            426,964
            
            
            
            1,936,142
            
            
            
            453.5%Add
      back tax expense (benefit)
            
            
            (1,042,372
            )
            
            
            369,673
            
            
            
            (1,412,045
            )
            
            
            -382.0%EBITDA
            
            $
            398,514
            
            
            $
            4,086,631
            
            
            $
            (3,688,117
            )
            
            
            (90.2)%





Capital
Resources and Liquidity





We
believe that the liquidity we derived from the Private Placement and cash
flows attributable to our operations is sufficient to fund our capital
expenditures, debt maturities and other business needs. We generated our
liquidity and capital resources primarily through operations and available
capital markets. At December 31, 2008, long-term debt was $2.1 million, of which
$0.4 million was current.





Notwithstanding
the foregoing, on November 11, 2008, we entered into a $2.0 million revolving
credit agreement (the “Revolver”) with Whitney Bank as
lender.  On December 18, 2008, we amended the Revolver and added an
additional $1.2 million to the credit agreement as a term loan.  We
expect that such financing will sufficiently support our working capital needs.
At December 31, 2008, we have not drawn any amounts available under the
Revolver. The $1.2 million term loan was used to pay 75% of the new Super Mohawk
21 ROV which was delivered in January 2009. See Note 7 to the consolidated
financial statements included in this report.





Our
credit agreement with Whitney Bank provides for letters of credit, which we
executed an irrevocable transferrable standby letter of credit with a customer
for $1.1 million on February 10, 2009. The letter of credit was executed as a
guarantee of performance by Deep Down and its subsidiaries on a long-term
contract, allows partial and multiple drawings, and expires August 31, 2009 with
an automatic one-year extension period unless cancelled 90 days in advance of
the expiration date.


-23-


On March
5, 2009, Flotation, obtained loan proceeds in the principal amount of
approximately $1.8 million pursuant to a loan agreement Flotation and the
Company entered into with TD Bank as of February 13, 2009. This loan agreement
provides a further commitment to Flotation for advancement of principal in the
amount of $0.3 million. In connection with the loan agreement, TD Bank required
that the Company enter into a debt subordination agreement that subordinated any
debt Flotation owes to the Company other than accounts payable between them
arising in the ordinary course of business.  Furthermore, as part of
the loan agreement TD Bank required a “negative pledge” that prohibits Flotation
and the Company from granting security interests in Flotation’s personal
property, other than such security interests granted in respect of the Company’s
primary facility for borrowed money (as currently held with Whitney
Bank).  See Note 15 to the consolidated financial statements included
in this report for further information on this loan agreement.





In
connection with such loan for Flotation, the Company entered into a second
amendment of its existing credit facility with Whitney Bank.  The
terms of the second amendment included a guarantor’s consent and agreement, to
be signed by each of the Company’s subsidiaries as guarantors of the obligations
of the Company under such existing credit facility, that Whitney Bank required
as a condition to the effectiveness of the second amendment. Additionally,
Whitney Bank required that Deep Down International Holdings, LLC enter into
joinder agreements for the guaranty and security agreement arrangements
generally required of the Company’s subsidiaries under the existing credit
facility.





As of
December 31, 2008, our cash and cash equivalents were $2.6 million, which
includes restricted cash of $0.1 million.  Cash and cash equivalents
were $2.6 million including restricted cash of $0.4 million as of December 31,
2007.  Management believes that we have adequate capital resources
when combined with our cash position and cash flow from operations to meet
current operating requirements for the 12 months ending December 31,
2009.





On June
5, 2008, we sold 57,142,857 shares of Deep Down’s common stock in the Private
Placement at a price of $0.70 per share, for a total purchase price of $40.0
million and net proceeds to us of approximately $37.1 million. We used
$22.1 million of the net proceeds to fund the cash portion of the Flotation
purchase, and used approximately $12.5 million to repay outstanding debt,
interest and early termination fees on June 12, 2008. We retained the balance
from the Private Placement to be used for working capital purposes. In
connection with the Registration Rights Agreement associated with
the Private Placement and under guidance of SFAS 5, we have reserved $1.2
million in potential damages for the 90-day period September 4 to December 4,
2008. See Item 3. Legal Proceedings included in this report with regard to the
Registration Rights Agreement.





On
January 4, 2008, in accordance with the terms of the purchase of Mako, the
original shareholders of Mako received the first cash installment of $2.9
million, and on April 11, 2008 they received the final cash installment of
$1.2 million pursuant to the securities redemption and shareholder payable
agreement.





Cash
Flow from Operating Activities





For the
year ended December 31, 2008, cash used in operating activities was $0.2 million
as compared to $3.0 million for the prior year. Our working capital balances
vary due to delivery terms and payments on key contracts, costs and estimated
earnings in excess of billings on uncompleted contracts, and outstanding
receivables and payables. We used some of the operating cash flow to reduce
accounts payable and accrued liabilities by $0.3 million compared to an increase
of $1.0 million in 2007. Billings in excess of costs on uncompleted contracts
increased by $2.1 million for 2008 mostly related to a large job that will be
completed during 2009. Additionally, we recorded the following non-cash charges
during 2008: amortization of deferred financing costs and debt discount related
to the extinguishment of long-term debt totaling $2.6 million, share-based
compensation of $0.6 million, bad debt expense of $1.5 million and depreciation
and amortization of $2.4 million. In fiscal 2007, we had a gain on
extinguishment of debt of $2.0 million related to the redemption of preferred
stock at a discount, recognition of a sales type lease receivable of $0.9
million, an increase of finished goods of $0.5 million, depreciation and
amortization of $0.4 million and amortization of deferred financing costs, debt
discounts and accretion on preferred stock totaling $1.8
million.


-24-


Cash
Flow from Investing Activities





For the
year ended December 31, 2008, cash used in investing activities was $31.0
million as compared to $1.4 million for the prior year. The majority of the
2008 activity related to the cash paid to Flotation shareholders totaling $22.1
million offset by cash acquired of $0.2 million, which was funded by the net
proceeds of the Private Placement as discussed above. Additionally, in
accordance with the terms of the purchase of Mako, we made the cash
payments to the original Mako shareholders in the amount of $4.2 million plus
some adjustments to purchase price expenses. The restricted cash balance of
$0.37 million as of December 31, 2007 was released in connection with the payoff
of the Credit Agreement, offset by the increase in restricted cash of $0.1
million required under a letter of credit entered into during fiscal
year 2008. We used $4.8 million for equipment purchases for the year
ended December 31, 2008 as compared to $0.8 million for the prior year
period.





Cash
Flow from Financing Activities





For the
year ended December 31, 2008, cash provided by financing activities
was $31.5 million compared to $6.6 million for the prior year
period.  During the year ended December 31, 2008, we completed the
foregoing described Private Placement for net proceeds of $37.1 million. In June
2008, we paid approximately $12.5 million to Prospect to pay the balance
due under its Credit Agreement and related interest and early termination fees.
In January 2008, in accordance with the terms of the purchase of Mako, we paid
$0.9 million of notes payable plus accrued interest of $2,664, and received
proceeds from Prospect totaling $5.6 million. During the third quarter of 2008,
we received the balance due under the sales lease receivable, bringing the
annual receipts to $0.6 million.





For the
year ended December 31, 2007, net cash provided from financing activities was
$6.6 million.  This was primarily due to long-term debt issuances totaling
$6.2 million, which was offset by payments on long term debt of $2.8 million.
Additionally, we received proceeds from the issuance of common stock net of
expenses of $4.0 million.




Off-Balance
Sheet Arrangements





We have
no off-balance sheet arrangements that have or are reasonably likely to have a
current or future effect on our financial condition, changes in financial
condition, revenues or expenses, results of operations, liquidity, capital
expenditures or capital resources that is material to investors.





Inflation
and Seasonality





We do not
believe that our operations are significantly impacted by inflation. Our
business is not seasonal in nature.




-25-


Recent Accounting Pronouncements





In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No.
157”). SFAS No. 157 establishes a framework for measuring fair value under
generally accepted accounting procedures and expands disclosures on fair value
measurements. This statement applies under previously established valuation
pronouncements and does not require the changing of any fair value measurements,
though it may cause some valuation procedures to change. Under SFAS No. 157,
fair value is established by the price that would be received to sell the item
or the amount to be paid to transfer the liability of the asset as opposed to
the price to be paid for the asset or received to transfer the liability.
Further, it defines fair value as a market specific valuation as opposed to an
entity specific valuation, though the statement does recognize that there may be
instances when the low amount of market activity for a particular item or
liability may challenge an entity’s ability to establish a market amount. In the
instances that the item is restricted, this pronouncement states that the owner
of the asset or liability should take into consideration what effects the
restriction would have if viewed from the perspective of the buyer or assumer of
the liability. This statement is effective for all assets valued in financial
statements for fiscal years beginning after November 15, 2007.  Deep
Down adopted SFAS 157 for financial assets and liabilities in 2008 with no
material impact to the consolidated financial statements but with additional
required consolidated financial statement footnote disclosures. We do not
anticipate the application of SFAS 157 to nonfinancial assets and
nonfinancial liabilities will have a material impact on our consolidated
financial statements.





In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business
Combinations (“SFAS No. 141(R)”) and No. 160, Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB No. 51 (“SFAS No. 160”).
SFAS No. 141(R) and SFAS No. 160 are products of a joint project between the
FASB and the International Accounting Standards Board.  The revised
standards continue the movement toward the greater use of fair values in
financial reporting. SFAS No. 141(R) will significantly change how business
acquisitions are accounted for and will impact financial statements both on the
acquisition date and in subsequent periods. These changes include the expensing
of acquisition related costs and restructuring costs when incurred, the
recognition of all assets, liabilities and noncontrolling interests at fair
value during a step-acquisition, and the recognition of contingent consideration
as of the acquisition date if it is more likely than not to be
incurred.  SFAS No. 160 will change the accounting and reporting for
minority interests, which will be recharacterized as noncontrolling interests
and classified as a component of equity.  SFAS No. 141(R) and SFAS No.
160 are effective for both public and private companies for fiscal years
beginning on or after December 15, 2008 (January 1, 2009 for companies with
calendar year-ends). SFAS No. 141(R) will be applied prospectively. SFAS No. 160
requires retroactive adoption of the presentation and disclosure requirements
for existing minority interests. All other requirements of SFAS No. 160 shall be
applied prospectively. Early adoption is prohibited for both
standards.  We will apply the requirements of SFAS No. 141(R) to all
business combinations after January 1, 2009; SFAS No. 160 will have no impact on
our consolidated financial statements as we have no minority
interests.





In
December 2007, the SEC staff issued Staff Accounting Bulletin (“SAB”) 110,
Share-Based Payment, which amends SAB 107, Share-Based Payment, to permit public
companies, under certain circumstances, to use the simplified method in SAB 107
for employee option grants after December 31, 2007. Use of the simplified method
after December 2007 is permitted only for companies whose historical data about
their employees’ exercise behavior does not provide a reasonable basis for
estimating the expected term of the options. Deep Down did not have stock
options outstanding until 2007, and thus does not have adequate historical
data to determine expected option lives. Therefore, we will continue to use the
simplified method as allowed under the provision of SAB 110.





In June
2008, EITF 07-5, “Determining whether an Instrument (or Embedded Feature) is
indexed to an Entity’s Own Stock” was issued. This standard triggers liability
accounting on all options and warrants exercisable at strike prices denominated
in any currency other than the Company’s functional currency or where
instruments’ exercise prices is reset under certain future events. This Issue is
effective for financial statements issued for fiscal years beginning after
December 15, 2008, and interim periods within those fiscal years. Early
application is not permitted. We are currently evaluating the impact that EITF
07-5 will have on our consolidated financial position or result of
operations.





In June
2008, FASB issued EITF Issue No. 08-4, “Transition Guidance for Conforming
Changes to Issue No. 98-5 (“EITF No. 08-4”)”. The objective of EITF No.08-4 is
to provide transition guidance for conforming changes made to EITF No. 98-5,
“Accounting for Convertible Securities with Beneficial Conversion Features or
Contingently Adjustable Conversion Ratios”, that result from EITF No. 00-27
“Application of Issue No. 98-5 to Certain Convertible Instruments”, and SFAS No.
150, “Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity”. This Issue is effective for financial statements issued
for fiscal years ending after December 15, 2008. Early application is permitted.
Management is currently evaluating the impact of adoption of EITF No.
08-4.


-26-




Item 7A.          QUANTITATIVE AND
QUALITATIVE DISCLOSURES ABOUT MARKET RISK





This item
is not applicable for smaller reporting companies.








Item
8.             FINANCIAL STATEMENTS




The
financial statements and schedules are included herewith commencing on page
F-1.




Reports
      of Independent Registered Public Accounting Firm
            F-2Consolidated
      Balance Sheets
            F-5Consolidated
      Statements of Operations
            F-6Consolidated
      Statements of Changes in Stockholders’ Equity
            F-7Consolidated
      Statements of Cash Flows
            F-8Notes
      to Consolidated Financial Statements
            F-10






Item
9.             CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE





None.







Item
9A.          CONTROLS
AND PROCEDURES





Evaluation
of Disclosure Controls and Procedures





We
carried out an evaluation, under the supervision and with the participation of
our management, including our principal executive officer and principal
financial officer, of the effectiveness of our disclosure controls and
procedures (as defined in Exchange Act Rules 13a-15(e) and
15d-15(e)).  Based upon that evaluation, our principal executive
officer and principal financial officer concluded that, as of the end of the
period covered in this report, our disclosure controls and procedures were not
effective to ensure that information required to be disclosed in reports filed
under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the required time periods and is accumulated and communicated to
our management, including our principal executive officer and principal
financial officer, as appropriate to allow timely decisions regarding required
disclosure. This determination was in response to the SEC comment letter
received February 26, 2009, in which the SEC stated that they require that we
present the audited predecessor financial statements for Deep Down, Inc. for the
period January 1, 2006 through November 20, 2006, in accordance with Rule 310(a)
of Regulation S-B. Management will remediate this as soon as practicable by
supplementing the amounts reported in Form 10-KSB for December 31, 2007 with the
predecessor audited financial information for Deep Down from January 1, 2006 to
November 20, 2006. See Item 1B. Unresolved Staff Comments, included in this
report on Form 10-K for further information on the SEC response.





Our
management, including our principal executive officer and principal financial
officer, does not expect that our disclosure controls and procedures or our
internal controls will prevent all error or fraud. A control system, no matter
how well conceived and operated, can provide only reasonable, not absolute,
assurance that the objectives of the control system are met.  Further,
the design of a control system must reflect the fact that there are resource
constraints and the benefits of controls must be considered relative to their
costs.  Due to the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, have been detected.


-27-


Management’s
Report on Internal Control Over Financial Reporting.





Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting as defined in Rule 13a-15(f) under the
Securities Exchange Act, as amended.  Our management assessed the
effectiveness of our internal control over financial reporting as of December
31, 2008. In making this assessment, our management used the criteria set forth
by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”)
in Internal Control-Integrated Framework.  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.  We have identified the
following material weaknesses.





1.
            As
      of December 31, 2008, we did not maintain effective controls over the
      control environment.  Specifically, we have not formally adopted
      a written code of business conduct and ethics that governs the Company’s
      employees, officers and directors.  Further, the Board of
      Directors does not currently have any independent members and no director
      qualifies as an audit committee financial expert as defined in Item
      407(d)(5)(ii) of Regulation S-B.  We did not maintain the
      following controls: sufficient policies and procedures over the
      administration of an accounting and fraud risk policy, sufficient
      documentation on the review and follow-up on the remediation of
      deficiencies, and a sufficient segregation of duties to decrease the risk
      of inappropriate accounting. Since these entity level programs have a
      pervasive effect across the organization, management has determined that
      these circumstances constitute a material weakness.2.
            Management
      has determined that we did not maintain effective controls over the
      accuracy of revenue recognition. Specifically, there was not sufficient
      review, supervision, and monitoring in regards to projects accounted for
      under the percentage-of-completion
method.





Because
of these material weaknesses, management has concluded that the Company did not
maintain effective internal control over financial reporting as of December 31,
2008, based on the criteria established in "Internal Control-Integrated
Framework" issued by the COSO.





Changes
in Internal Control Over Financial Reporting.





In our
efforts to continuously improve our internal controls, management has taken
steps to enhance the following controls and procedures subsequent to December
31, 2008 as part of our remediation efforts in addressing the material
weaknesses above:








·
            Management
      is in the process of implementing a new system-wide accounting and
      management software program to address the revenue recognition and gross
      margin analysis of projects accounted for under the
      percentage-of-completion method.





·
            Management
      has prepared an Employee Handbook and Code of Conduct and plans to
      circulate these documents throughout the organization and obtain signed
      acknowledgements from employees.





·
            Management
      plans to document its accounting policies and procedures to increase
      consistency among divisions.





·
            Management
      has increased documentation around certain authorization and review
      controls.





This
annual report includes an attestation report of the Company’s independent
registered public accounting firm regarding internal control over financial
reporting.





Item
9B.                
OTHER INFORMATION





None.





-28-


PART
III




Item
      10.
            DIRECTORS,
      EXECUTIVE OFFICERS, PROMOTERS, CONTROL PERSONS AND CORPORATE GOVERNANCE;
      COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE
  ACT





The
following table sets forth the names, ages and positions of all of our directors
and executive officers.





Name
            
            Age
            
            Position Held With The
    CompanyRobert
      E. Chamberlain, Jr.
            
            50
            
            Chairman
      of the Board, Chief Acquisitions Officer and DirectorRonald
      E. Smith*
            
            50
            
            President,
      Chief Executive Officer and DirectorEugene
      L. Butler
            
            67
            
            Chief
      Financial Officer and DirectorMary
      L. Budrunas*
            
            57
            
            Vice-President,
      Corporate Secretary and DirectorBradley
      M. Parro
            
            51
            
            Vice-President


_________________________





*  Ronald
E. Smith and Mary L. Budrunas are married to each other.





Robert
E. Chamberlain, Jr., Chairman of the Board, Chief Acquisitions Officer, and
Director. Mr. Chamberlain has served as Chairman and Director of the
Company since December 2006.  Mr. Chamberlain has a B.S. in Chemical
Engineering and a B.S. in Biomedical Engineering from Northwestern University's
Technological Institute and an MBA from Northwestern University's Kellogg
Graduate School of Management. Mr. Chamberlain served as Vice President with
Solomon Brothers Inc. (1986 to 1992), where his responsibilities included
mergers, acquisitions, leveraged buyouts, merchant banking, divestitures,
corporate finance, capital raises, restructurings and new product development in
both the private and public markets. From 1992 through 1995, Mr. Chamberlain
served as Vice President for Laidlaw Securities and Dickinson & Co. where he
was responsible for generating public and private equity transactions. Since
1995, Mr. Chamberlain has assisted small emerging growth companies gain access
to the capital markets and develop well articulated strategic objectives through
consulting companies he controlled. Previously, Mr. Chamberlain served as
Chairman, CEO, CFO and Director of a publicly-traded energy company involved in
the development of oil and gas opportunities, primarily in the Barnett Shale of
Texas.





Ronald
E. Smith, President, Chief Executive Officer and Director . Mr. Smith
co-founded Deep Down in 1997 and has served as President and Director of the
Company since December 2006. Mr. Smith graduated from Texas A&M University
with a Bachelor of Science degree in Ocean Engineering in 1981. Mr. Smith worked
both onshore and offshore in management positions for Ocean Drilling and
Exploration Company (ODECO), Oceaneering Multiflex, Mustang Engineering and
Kvaerner before founding Deep Down. Mr. Smith’s interests include all types of
offshore technology, nautical innovations, state of the art communications,
diving technology, hydromechanics, naval architecture, dynamics of offshore
structures, diving technology and marketing of new or innovative concepts. Mr.
Smith is directly responsible for the invention or development of many
innovative solutions for the offshore industry, including the first steel tube
flying lead installation system.





Eugene
L. Butler, Chief Financial Officer and Director.   Mr. Butler
has served as Chief Financial Officer and Director with Deep Down since
June 2007. Mr. Butler was Managing Director of CapSources, Inc., an
investment banking firm specializing in mergers, acquisitions and
restructurings, from 2002 until 2007. Prior to this, he has served in various
capacities as a director, president, chief executive officer, chief financial
officer and chief operating officer for Weatherford International, Inc., a $2
billion multinational service and equipment corporation serving the worldwide
energy market, from 1974 to 1991.  He was elected to Weatherford’s
Board of Directors in May of 1978, elected president and chief operating officer
in 1979, and president and chief executive officer in 1984.  He
successfully developed and implemented a turnaround strategy eliminating debt
and returning the company to profitability during a severe energy
recession.  Mr. Butler also expanded operations into international
markets allowing Weatherford to become a major worldwide force with its offshore
petroleum products and services.  Mr. Butler graduated from
Texas A&M University in 1963, and served as an officer in the U.S. Navy
until 1969 when he joined Arthur Andersen & Co.  Mr.
Butler is distinguished by numerous medals and decorations, including the Bronze
Star with combat “V” and the Presidential Unit Citation for his service
with the river patrol force in Vietnam.


-29-


Mary L.
Budrunas, Vice-President,  Corporate Secretary and
Director.
Ms. Budrunas, co-founder of Deep Down, Inc. along with current chief executive
officer Ronald E. Smith, has served as Vice-President and Director of the
Company since December 2006.  Ms. Budrunas is responsible for the
Company’s administrative functions, including human resources and
accounting.  Ms. Budrunas has more than 30 years of logistical
management experience in manufacturing, fabrication, and industrial sourcing in
the oil and gas industry. Prior to Ms. Budrunas co-founding Deep Down in 1997,
she managed the purchasing efforts of many projects over a 10-year period for
Mustang Engineering, and previously directed procurement for a large petroleum
drilling and production facility project in Ulsan, Korea.





Bradley
M. Parro, Vice President.  Mr. Parro has served as Vice
President since May 2008.  Prior to this, he was the Managing Director
for Continental Shelf Associates where he was responsible for business
development for that company’s Houston, Texas office.  From 1998
through 2004, he served in various executive capacities, including chief
financial officer, chief operating officer and chief executive officer of
PetroCom, LLC, a $30 million wireless communications company serving the
offshore oil and gas industry.  He also held the position of chief
financial officer for oilfield service providers Ceanic Corporation and Perry
Tritech, Inc.  His experience includes mergers and acquisitions,
corporate restructuring, equity and sub-debt placement, strategic planning and
execution and executive financial and operational management. Mr. Parro has a
Bachelor of Science degree in finance from the University of Illinois at
Champaign-Urbana and a Master of Business Administration degree from Loyola
University of Chicago.





Corporate
Governance




The
Company promotes accountability for adherence to honest and ethical conduct;
endeavors to provide full, fair, accurate, timely and understandable disclosure
in reports and documents that the Company files with the SEC and in other public
communications made by the Company and strives to be compliant with applicable
governmental laws, rules and regulations. The Company has not formally adopted a
written code of business conduct and ethics that governs the Company’s
employees, officers and directors as the Company is not required to do
so.





In lieu
of an Audit Committee, the Company’s Board of Directors is responsible for
reviewing and making recommendations concerning the selection of outside
auditors, reviewing the scope, results and effectiveness of the annual audit of
the Company's financial statements and other services provided by the Company’s
independent public accountants. The Board of Directors reviews the Company's
internal accounting controls, practices and policies. Our Board of Directors has
determined that no director qualifies as an independent audit committee
financial expert as defined in Item 407(d) (5) (ii) of Regulation
S-K.





Changes
to the Procedures for Stockholder’s Nomination of Directors





By action
approved by the Company’s stockholders during fiscal year 2008 and under
provisions of amendments to the Company’s Articles of Incorporation filed with
the Secretary of State of the State of Nevada on September 29, 2008, the Company
established the following rules for stockholder nominations for directors to
serve on the Company’s Board of Directors:





·
            In
      order to make a nomination, a stockholder must give notice of such
      nomination to the Secretary of the Company in writing, delivered or mailed
      by first class United States mail, postage prepaid, not less than 30 days
      or more than 60 days prior to the meeting at which directors are to be
      elected; provided, however, that if the Company gives less than 40-days’
      notice of such meeting of stockholders, such written notice shall be
      delivered or mailed to the Secretary of the Company no later than the
      close of the tenth day following the day on which notice of the meeting
      was mailed to the stockholders.




·
            Each
      notice given by a stockholder with respect to any nomination of directors
      shall set forth (1) the name, age, business address and, if known,
      residence address of each nominee proposed in the notice, (2) the
      principal occupation or employment of each such nominee, and (3) the
      number of shares of stock of the Company which are beneficially owned by
      each such nominee.




·
            The
      stockholder making any such nomination shall promptly provide any other
      information reasonably requested by the
Company.




-30-


Section
16(a) Beneficial Ownership Reporting Compliance




Section 16(a)
of the Exchange Act requires the Company’s officers and directors, and persons
who own more than ten percent of a registered class of the Company’s equity
securities, to file reports of securities ownership and changes in such
ownership with the SEC. Officers, directors and greater than ten percent
shareholders also are required by rules promulgated by the SEC to furnish the
Company with copies of all Section 16(a) forms they file.




Based
solely upon a review of the copies of such forms furnished to the Company or
written representations that no Forms 5 were required, the Company believes that
all Section 16(a) filing requirements were not met during fiscal year
2008.  There were two Form 4 filings due on April 1, 2008, required by Mary
Budrunas and Ron Smith for conversions of Series D Preferred Stock into common
stock on March 28, 2008, representing 16,627,005 and 6,652,871 shares of common
stock, respectively. These Form 4 filings have not been completed. Additionally,
there were two Form 3 filings that were filed late during the year ended
December 31, 2008. The first was required by Bradley M. Parro, to report the
issuance of 350,000 stock options granted on May 1, 2008.  The second was
required by Jacob Marcell, to report the issuance of 7,032,781 shares of common
stock granted on January 22, 2008. A total of three Form 4 filings were filed
late for the reporting of issuance of 1,000,000 stock options and 350,000 shares
of restricted common stock to each of Ron Smith, Robert Chamberlain and Eugene
Butler. These Form 4 filings were due on February 19, 2008 and filed on February
28, 2008.


Item
11.          EXECUTIVE COMPENSATION




The
following table sets forth information concerning the total compensation earned
in the years ended December 31, 2008 and 2007 by our Chief Executive Officer and
our two highest compensated executive officers other than our CEO (collectively,
our “Named Executive Officers” or “NEOs”).





Summary
Compensation Table





Name
      and
                  Principal
      Position
                Year
                
                Salary
      ($)
                
                
                Bonus ($)
                
                
                Stock
                  Awards
                  ($)
      (1)
                
                
                Option
                  Awards
                  ($)
      (1)
                
                
                All
      Other
                  Compensation
                  ($)
      (2)
                
                
                TotalRonald
      E. Smith
                2008
                
                $
                250,000
                
                
                $
                175,000
                
                
                $
                64,313
                
                
                $
                14,172
                
                
                $
                12,000
                
                
                $
                515,485President,
      Chief Executive Officer and Director
                2007
                
                $
                250,000
                
                
                $
                19,231
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                269,231Robert
      E. Chamberlain, Jr.
                2008
                
                $
                225,000
                
                
                $
                175,000
                
                
                $
                64,313
                
                
                $
                14,172
                
                
                $
                32,440
                
                
                $
                510,925Chairman
      of the Board, Chief Acquisitions Officer and Director
                2007
                
                $
                180,000
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                20,265
                
                
                $
                200,265Eugene
      L. Butler
                2008
                
                $
                225,000
                
                
                $
                175,000
                
                
                $
                64,313
                
                
                $
                220,272
                
                
                $
                28,204
                
                
                $
                712,789Chief
      Financial Officer and Director
                2007
                
                $
                105,000
                
                
                $
                -
                
                
                $
                -
                
                
                $
                120,225
                
                
                $
                14,568
                
                
                $
                239,793




(1)           “Stock
Awards” and “Option Awards” are quantified in the table according to the amount
included in 2008 and 2007 share-based compensation expense for the equity awards
granted to each NEO through the end of 2008 as determined in accordance with
SFAS 123(R). No stock awards or option awards granted to NEOs were forfeited
during 2008 and 2007. For a discussion of the assumptions and methodologies used
to value the stock and option awards reported in the table above, see Note 10
“Stock-Based Compensation” to our consolidated financial statements included in
this report. All options are for the purchase of our common stock. Stock awards
are grants of restricted stock representing time-vesting shares.





(2)           The
amounts in the “All Other Compensation” column for 2008 were attributed to the
following:


·
            Mr.
      Smith: Amounts included for the year ended 2008 consisted of a vehicle
      allowance ($1,000 per month).


·
            Mr.
      Chamberlain: Amounts included for the year ended 2008 consisted of a
      vehicle allowance ($1,000 per month) and $20,440 for reimbursement for
      federal and state payroll withholdings customarily withheld for an
      employee.


·
            Mr.
      Butler: Amounts included for the year ended 2008 consisted of a vehicle
      allowance ($1,000 per month) and $16,204 for reimbursement for federal and
      state payroll withholdings customarily withheld for an
      employee.




-31-


Narrative
Disclosure to Summary Compensation Table





All of
the compensation described in the foregoing table, other than those amounts
shown in the “Bonus”, “Stock Awards” and “Option Awards” columns, was paid to
the NEOs pursuant to agreements with Deep Down.




Mr. Smith
has an employment agreement to serve as our President and Chief Executive
Officer.  Mr. Smith’s employment agreement provides for an annual base
salary of $250,000, which was increased to $345,000 effective January 1, 2009,
plus a vehicle allowance of $1,000 per month.  The term of Mr. Smith’s
employment agreement is through August 6, 2010, and is subject to further
automatic renewals for annual periods up to an additional two
years.




Mr.
Chamberlain serves as our Chairman of the Board and Chief Acquisitions Officer
pursuant to a consulting agreement we have with Strategic Capital Services, Inc.
(“Strategic”).  The consulting agreement with Strategic provides that
we pay Mr. Chamberlain an annual base salary of $180,000, which was increased to
$225,000 effective as of January 1, 2008 and to $310,000 effective as of January
1, 2009. Additionally, Mr. Chamberlain receives a vehicle allowance of $1,000
per month and reimbursement for federal and state payroll withholdings
customarily withheld for an employee, which are included in the “All Other
Compensation” column. The consulting agreement with Strategic for Mr.
Chamberlain’s services has an initial term through August 6, 2010, and is
subject to further automatic renewals for annual periods up to an additional two
years.





Effective
May 31, 2007, we hired Mr. Butler as our Chief Financial Officer and provided
for his compensation under an employment agreement.  This employment
agreement provided that Mr. Butler receive an annual base salary of
$180,000.  The agreement also provided that he receive an aggregate of
options to purchase 3,000,000 shares of our common stock. These options will
vest over three years, with substantially one-third vesting on the first, second
and third anniversary of the date of grant. The per share exercise price of
$0.515 for such options was determined by the closing market price of the common
stock on the date of grant.  Effective August 6, 2007, Mr. Butler’s
employment agreement was replaced by a consulting agreement between Deep Down
and Eugene L. Butler & Associates.  We increased compensation
payable to Mr. Butler to $225,000 effective as of January 1, 2008 and to
$310,000 effective as of January 1, 2009. Additionally, Mr. Butler receives a
vehicle allowance of $1,000 per month and reimbursement for federal and state
payroll withholdings customarily withheld for an employee, which are included in
the “All Other Compensation” column. The consulting agreement for Mr. Butler’s
services has an initial term through August 6, 2010, and is subject to automatic
renewals for annual periods up to an additional two years.





The
amounts included in the “Bonus” column of the foregoing table represent specific
cash bonuses paid to the NEOs.  In June 2008, Messrs. Smith,
Chamberlain and Butler were each awarded and paid a cash performance bonus in
the amount of $100,000. Additionally, Deep Down awarded Messrs. Smith,
Chamberlain and Butler with cash performance bonuses of $75,000 relating to
fiscal year 2008 (the amounts were paid in January 2009). The amount included in
the 2007 “Bonus” column of $19,168 for Mr. Smith represents offshore bonuses
that are paid by the Company in respect of time the Company requires of its
employees to spend offshore.





The
amounts included for 2008 in the “Stock Awards” and the “Option Awards” columns
above reflect awards to purchase 1,000,000 shares of our common stock and grants
of 350,000 restricted shares of our common stock provided to each of Messrs.
Smith, Chamberlain and Butler on February 14, 2008. In each case, the awards and
grants were made under our 2003 Directors, Officers and Consultants Stock
Option, Stock Warrant and Stock Award Plan. The options vest over three years
and have an exercise price of $1.50. Each of the grants of restricted shares of
our common stock is scheduled to vest in its entirety on February 14, 2010,
provided that the officer continues to be employed with Deep Down through the
vesting date.


-32-


Outstanding
Equity Awards at December 31, 2008





The
following tables present information regarding the outstanding equity awards
held by each of the NEOs as of December 31, 2008.





Option
Awards





Option
              Grant
            
            Number
      of Securities Underlying
              Unexercised
      Options
            
            
            Number
      of Securities Underlying
              Unexercised
      Options
            
            
            Option
              Exercise
      Price
            
            Option
              ExpirationName
            Date
            
            Exercisable
      (#)
            
            
            Unexercisable
      (#)
            
            
            ($/Sh)
            
            DateRonald
      E. Smith
            2/14/2008
            
            
            -
            
            
            
            1,000,000
            (1)
            
            
            1.50
            
            2/14/2013Robert
      W. Chamberlain
            2/14/2008
            
            
            -
            
            
            
            1,000,000
            (1)
            
            
            1.50
            
            2/14/2013Eugene
      L. Butler
            2/14/2008
            
            
            -
            
            
            
            1,000,000
            (1)
            
            
            1.50
            
            2/14/20135/31/2007
            
            
            1,000,000
            (2)
            
            
            2,000,000
            (2)
            
            
            0.52
            
            8/31/2010




(1)
            These
      options will vest over three years, with substantially one-third vesting
      on the first, second and third anniversary of the date of grant, provided
      that the officer continues to be employed with Deep Down through each
      vesting date.


(2)
            The
      remaining unvested portion of this option award is scheduled to vest in
      equal installments on May 31, 2009 and May 31, 2010, provided that Mr.
      Butler continues to be employed with Deep Down through each vesting
      date.





Stock
Awards





Award
            
            Number
      of Shares or Units of Stock That Have Not Vested
            
            Market
      Value of Shares or Units of Stock that Have Not VestedName
            
            
            
            
            
            Grant
      Date
            
            (#)
      (2)
            
            ($)
      (1)Ronald
      E. Smith
            
            
            
            
            
            2/14/2008
            
            350,000
            
            56,000Robert
      W. Chamberlain
            
            
            
            
            
            2/14/2008
            
            350,000
            
            56,000Eugene
      L. Butler
            
            
            
            
            
            2/14/2008
            
            350,000
            
            56,000




(1)
            The
      market value is calculated by multiplying the number of shares by the
      closing price of our common stock of $ 0.16 on December 31,
      2008.


(2)
            This
      restricted stock award is scheduled to vest in its entirety on February
      14, 2010, provided that the officer continues to be employed with Deep
      Down through the vesting date.





Option
Exercises and Stock Vested During the Year Ended December 31, 2008





There
were no options exercised by NEOs during the year ended December 31, 2008. All
of the restricted stock issued on February 14, 2008 becomes fully vested on
February 14, 2010.




Compensation
of Directors





The
directors of the Company are all also executive officers of the Company and as
directors do not receive any additional compensation for their performance of
services as directors.  The Company may agree to provide compensation
to directors in the future.


-33-


Item
      12.
            SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS




The
following table sets forth certain information, as of March 13, 2009, concerning
the beneficial ownership of shares of Common Stock of the Company by (i) each
person known by the Company to beneficially own more than 5% of
the  outstanding shares of the Company’s common stock; (ii) each
Director; (iii) the Company’s “Named Executive Officers” (as determined under
Item 402(m) of Regulation S-K); and (iv) all directors and executive officers of
the Company as a group. To the knowledge of the Company, all persons listed in
the table have sole voting and investment power with respect to their shares,
except to the extent that authority is shared with their respective spouse under
applicable law. In addition, unless otherwise indicated, all persons named below
can be reached at Deep Down, Inc., 8827 W. Sam Houston Pkwy N., Suite 100,
Houston, Texas 77040.




Name of Beneficial Owner
            
            Shares
      of Common Stock Beneficially Owned (1)
            
            Percent
      of
              Common
      Stock OutstandingRonald
      E. Smith (2)
            
            44,963,209
            
            25.3%Mary
      L. Budrunas (2)
            
            44,963,209
            
            25.3%Robert
      E. Chamberlain, Jr.(3)
            
            25,691,708
            
            14.5%Eugene
      L. Butler (4)
            
            1,683,333
            
            *All
      directors and officers as a group (4 persons)
            72,338,250  
      (5)
            
            40.3%* -
      Less than 1%




(1)
            A
      person is deemed to be the beneficial owner of securities that can be
      acquired within 60 days from the date set forth above through the exercise
      of any option, warrant or right. Shares of common stock subject to
      options, warrants or rights that are currently exercisable or exercisable
      within 60 days are deemed outstanding for computing the percentage of the
      person holding such options, warrants or rights, but are not deemed
      outstanding for computing the percentage of any other person. The amounts
      and percentages are based upon 177,350,630 shares of common stock
      outstanding as of March 13, 2009.


(2)
            Mr.
      Smith and Ms. Budrunas are husband and wife. Shares include 26,216,871
      shares owned directly by Mr. Smith and 18,413,005 shares owned directly by
      Ms. Budrunas. Shares also include 350,000 shares of restricted stock
      issued to Mr. Smith on February 14, 2008 which become fully vested on the
      second anniversary of the grant, February 14, 2010, plus 333,333 shares of
      Deep Down’s common stock that Mr. Smith has the right to acquire by
      exercise of stock options which vested on February 14,
    2009.


(3)
            Shares
      include 350,000 shares of restricted stock issued to Mr. Chamberlain on
      February 14, 2008 which become fully vested on the second anniversary of
      the grant, February 14, 2010, plus 333,333 shares of Deep Down’s common
      stock that Mr. Chamberlain has the right to acquire by exercise of stock
      options which vested on February 14,
2009.


(4)
            Shares
      include 350,000 shares of restricted stock issued to Mr. Butler on
      February 14, 2008 which become fully vested on the second anniversary of
      the grant, February 14, 2010, plus 333,333 and 1,000,000 shares of Deep
      Down’s common stock that Mr. Butler has the right to acquire by exercise
      of stock options which vested on February 14, 2009 and which vested on May
      31, 2008, respectively.


(5)
            Shares
      include 1,999,999 shares of Deep Down’s common stock that executive
      officers and directors have the right to acquire by exercise of stock
      options.





Disclosure
regarding our equity compensation plans as required by this item is incorporated
by reference to the information set forth under Item 5 “Market for the
Registrant’s Common Equity, and Related Stockholder Matters and Issuer Purchases
of Equity Securities” in Part II of this report.


-34-


Item
13.          CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE




We lease
all buildings, structures, fixtures and other improvements at our Channelview,
Texas location from JUMA, LLC, a company owned by Ronald E. Smith, CEO and a
director of Deep Down and Mary L. Budrunas, a vice president and a director of
Deep Down. The base rate of $15,000 per month is payable to JUMA, LLC
through August 31, 2013, together with all costs of maintaining, servicing,
repairing and operating the premises, including insurance, utilities and
property taxes.





On March
28, 2008, Deep Down redeemed 4,500 shares of Series D preferred stock owned by
Ronald Smith and Mary Budrunas.  The Series D preferred shares were
redeemed for 23,279,876 shares of common stock.





None of
the Company’s Directors are independent. Under the NASDAQ® standards for
“independence”, none of our directors would qualify as independent generally or
with respect to any specific independence requirements for any committee member.
However, as the Company is not traded on the NASDAQ®, the Company is not
required to comply with NASDAQ® independence requirements at this
time.  At such time, if ever, as the Company is traded on NASDAQ® or
any alternative exchange, which requires director independence, the Company
plans to take steps at that time to comply with such independence
requirements.





Item
14.          PRINCIPAL ACCOUNTANT FEES AND SERVICES




The
following table sets forth the aggregate fees paid to Malone & Bailey, PC
for audit services rendered in connection with the Company's consolidated
financial statements and reports for the years ended December 31, 2008 and 2007,
respectively, and for other services rendered during those years on behalf of
Deep Down and its subsidiaries:




December
      31, 2008
            December
      31, 2007(i)
      Audit Fees
            $             503,714
            $           205,967(ii)
      Audit Related Fees
            86,634
            165,931(iii)
      Tax Fees
            49,130
            16,260(iv)
      All Other Fees
            -
            -




Audit Fees: Consists of fees
billed for professional services rendered for the audit of Deep Down’s
consolidated financial statements, the review of interim condensed consolidated
financial statements included in quarterly reports, registration statements and
other offering documentation, services that are normally provided by Malone
& Bailey, PC in connection with statutory and regulatory filings or
engagements and attest services, except those not required by statute or
regulation.





Audit-Related Fees: Consists
of fees billed for assurance and related services that are reasonably related to
the performance of the audit and review of Deep Down’s consolidated financial
statements and are not reported under "Audit Fees." These services include
auditing work on proposed transactions, including the audit of Mako
Technologies, Inc., and Flotation Technologies, Inc., attest services that are
not required by statute or regulation, and consultations concerning financial
accounting and reporting standards.





Tax Fees: Consists of tax
compliance, tax preparation and other tax services. Tax compliance and tax
preparation consists of fees billed for professional services related to
assistance with tax returns. Other tax services consist of fees billed for other
miscellaneous tax consulting.





All Other
Fees:  None.





Pre-Approval
of Audit and Permissible Non-Audit Services of Independent Auditors





The Board
of Directors pre-approves all audit and permissible non-audit services provided
by Malone & Bailey, PC. These services may include audit services,
audit-related services, tax services and other services. The Board of Directors
may also pre-approve particular services on a case-by-case basis and may
delegate pre-approval authority to one or more directors. If so delegated, the
director must report any pre-approval decision to the Board of Directors at its
first meeting after the pre-approval was obtained.


35


PART
IV





Item
15. Exhibits,
Financial Statement Schedules





(a)
            Financial
      Statements and Schedules.  See the consolidated financial
      statements and related schedules commencing on page F-1 of this
      report.





(b)
            Exhibits.




Exhibit
                Number
              Description
      of Exhibit2.1
              Agreement
      and Plan of Reorganization among MediQuip Holdings, Inc., Deep Down, Inc.,
      and the majority shareholders of Deep Down, Inc. (incorporated by
      reference from Exhibit 2.1 to our Form 10-KSB/A filed with the Commission
      on May 1, 2008).3.1
              Articles
      of Incorporation of Deep Down, Inc. (conformed to include the amendment of
      the Articles of Incorporation filed with the Secretary of State of the
      State of Nevada on September 29, 2008) (incorporated by reference from
      Exhibit A to our Schedule 14C filed on August 15, 2008).3.2
              Amended
      and Restated ByLaws of Deep Down, Inc. (incorporated by reference from
      Exhibit B to our Schedule 14C filed on August 15, 2008).3.3
              Form
      of Certificate of Designations of Series D Redeemable Convertible
      Preferred Stock (incorporated herein by reference from Exhibit 3.4 to our
      Form 10-KSB/A filed with the Commission on May 1, 2008).3.4
              Form
      of Certificate of Designations of Series E Redeemable Exchangeable
      Preferred Stock (incorporated herein by reference from Exhibit 3.5 to our
      Form 10-KSB/A filed with the Commission on May 1, 2008).3.5
              Form
      of Certificate of Designations of Series F Redeemable Convertible
      Preferred Stock (incorporated herein by reference from Exhibit 3.6 to our
      Form 10-KSB/A filed with the Commission on May 1, 2008).3.6
              Form
      of Certificate of Designations of Series G Redeemable Exchangeable
      Preferred Stock (incorporated herein by reference from Exhibit 3.7 to our
      Form 10-KSB/A filed with the Commission on May 1, 2008).4.1
              Common
      Stock Purchase Warrant for 320,000 shares of common stock of Deep Down,
      Inc. issued to Dragonfly Capital Partners, LLC dated August 6, 2007
      (incorporated herein by reference from Exhibit 4.2 to our Form 10-KSB
      filed with the Commission on April 1, 2008).4.2
              Common
      Stock Purchase Warrant for 118,812 shares of common stock of Deep Down,
      Inc. issued to Dragonfly Capital Partners, LLC dated January 4, 2008
      (incorporated herein by reference from Exhibit 4.3 to our Form 10-KSB
      filed with the Commission on April 1, 2008).4.3
              Common
      Stock Purchase Warrant for 200,000 shares of common stock of Deep Down,
      Inc. issued to Subsea, LLC dated June 6, 2008 (incorporated herein by
      reference from Exhibit 4.1 to our Form 8-K/A (Amendment No. 2) filed with
      the Commission on June 9, 2008).4.4
              Registration
      Rights Agreement, dated August 6, 2007, among Deep Down, Inc. and Prospect
      Capital Corporation (incorporated herein by reference from Exhibit 4.4 to
      our Form 10-KSB/A filed with the Commission on May 1, 2008).4.5
              Private
      Placement Memorandum dated May 16, 2008 (incorporated herein by reference
      from Exhibit 20.1 to our Form 8-K/A (Amendment No. 2) filed with the
      Commission on June 9, 2008).4.6
              Amended
      and Restated Supplement No. 1 to Private Placement Memorandum, dated June
      2, 2008 (incorporated herein by reference from Exhibit 4.6 to our Form S-1
      Registration Statement (file no. 333-152435) filed with the Commission on
      July 21, 2008).4.7
              Purchase
      Agreement, dated June 2, 2008, among Deep Down, Inc., and the Purchasers
      named therein (incorporated herein by reference from Exhibit 10.1 to our
      Form 8-K/A (Amendment No. 2) filed with the Commission on June 9,
      2008)4.8
              6%
      Subordinated Debenture of Deep Down, Inc. dated March 31, 2008
      (incorporated herein by reference from Exhibit 4.1 to our Form 10-Q filed
      with the Commission on May 16, 2008)4.9†
              Stock
      Option, Stock Warrant and Stock Award Plan (incorporated herein by
      reference from Exhibit 4.10 to our Form S-1 Registration Statement (file
      no. 333-152435) filed with the Commission on July 21, 2008).10.1
              Credit
      Agreement, dated as of November 11, 2008, among Deep Down, Inc. as
      borrower and Whitney National Bank, as lender (incorporated herein by
      reference from Exhibit 10.1 to our Form 10-Q filed with the Commission on
      November 14, 2008).10.2
              First
      Amendment to Credit Agreement entered into as of December 18, 2008, among
      Deep Down, Inc. as borrower and Whitney National Bank, including the
      Guarantor’s Consent and Agreement as signed on behalf of Electrowave USA,
      Inc., Flotation Technologies, Inc., Mako Technologies, LLC and Deep Down,
      Inc. (incorporated herein by reference from Exhibit 10.1 to our Form 8-K
      filed with the Commission on December 19,
2008).
 36
  10.3*
              Second
      Amendment to Credit Agreement entered into as of February 13, 2009, among
      Deep Down, Inc., as borrower, and Whitney National Bank, including the
      Guarantor’s Consent and Agreement as signed on behalf of Electrowave USA,
      Inc., Flotation Technologies, Inc., Mako Technologies, LLC and Deep Down,
      Inc.10.4
              Guaranty,
      dated as of November 11, 2008, by ElectroWave USA, Inc., Flotation
      Technologies, Inc., Mako Technologies, LLC and Deep Down, Inc. for the
      benefit of Whitney National Bank (incorporated herein by reference from
      Exhibit 10.2 to our Form 10-Q filed with the Commission on November 14,
      2008).10.5*
              Joinder
      to Guaranty, dated as of February 13, 2009, by Deep Down International
      Holdings, LLC.10.6
              Security
      Agreement, dated as of November 11, 2008, among Deep Down, Inc.,
      ElectroWave USA, Inc., Flotation Technologies, Inc., Mako Technologies,
      LLC and Deep Down, Inc. for the benefit of Whitney National Bank
      (incorporated herein by reference from Exhibit 10.3 to our Form 10-Q filed
      with the Commission on November 14, 2008).10.7*
              Joinder
      to Security Agreement, dated as of February 13, 2009, by Deep Down
      International Holdings, LLC.10.8
              Second
      Amendment to Security Agreement, dated as of February 13, 2009, by Deep
      Down, Inc., ElectroWave USA, Inc., Flotation Technologies, Inc., Mako
      Technologies, LLC and Deep Down, Inc. for the benefit of Whitney National
      Bank (incorporated herein by reference from Exhibit 10.3 to our Form 8-K
      filed with the Commission on December 19, 2008).10.9
              Term
      Note, dated December 18, 2008, executed by Deep Down, Inc. and paid to
      order to Whitney National Bank (incorporated herein by reference from
      Exhibit 10.2 to our Form 8-K filed with the Commission on December 19,
      2008).10.10†
              Consulting
      Agreement, dated as of August 6, 2007, between Deep Down, Inc. and
      Strategic Capital Services, Inc. regarding the services of Robert
      Chamberlain (incorporated herein by reference from Exhibit 10.1 to our
      Form 10-KSB filed with the Commission on April 1, 2008).10.11†
              Employment
      Agreement, dated as of August 6, 2007, between Deep Down, Inc. and Ronald
      E. Smith (incorporated herein by reference from Exhibit 10.2 to our Form
      10-KSB filed with the Commission on April 1, 2008).10.12†
              Consulting
      Agreement, dated effective as of August 6, 2007, between Deep Down, Inc.
      and Eugene L. Butler & Associates regarding the services of Eugene L.
      Butler (incorporated herein by reference from Exhibit 10.3 to our
      Form 10-KSB filed with the Commission on April 1, 2008).10.13
              Agreement
      and Plan of Merger among Deep Down, Inc., Mako Technologies, LLC, Mako
      Technologies, Inc. and the shareholders of Mako Technologies, Inc. dated
      December 17, 2007 (incorporated herein by reference from Exhibit 2.1
      to our Form 10-KSB filed with the Commission on April 1,
      2008).10.14
              Agreement
      and Plan of Reorganization among Deep Down, Inc., ElectroWave (USA), Inc.,
      a Nevada corporation, ElectroWave (USA) Inc., a Texas corporation,
      Pinemont IV, Martin L. Kershman and Ronald W. Nance (incorporated herein
      by reference from Exhibit 10.10 to our Form 10-KSB/A filed with the
      Commission on May 1, 2008).10.15
              Lease
      Agreement, dated September 1, 2006, between Deep Down, Inc., a Delaware
      corporation, as tenant, and JUMA, L.L.C. (incorporated herein by
      reference from Exhibit 10.4 to our Form 10-KSB filed with the Commission
      on April 1, 2008).10.16
              Lease
      Amendment and Extension Agreement, dated as of May 1, 2008, between Deep
      Down, Inc. a Delaware corporation, and JUMA, L.L.C. (incorporated herein
      by reference from Exhibit 10.8 to our Form 10-Q filed with the Commission
      on August 15, 2008).10.17
              Lease
      Agreement dated June 1, 2006, between Mako Technologies, Inc., as Lessee
      and Sutton Industries, as Lessor (incorporated herein by reference from
      Exhibit 10.12 to our Form 10-KSB/A filed with the Commission on May 1,
      2008).10.18*
              Office
      Building Lease, dated November 24, 2008, between Deep Down, Inc. and
      A-K-S-L 49 Beltway 8, L.P.10.19
              Stock
      Purchase Agreement, dated April 17, 2008, among Deep Down, Inc., Flotation
      Technologies, Inc. and the selling stockholders named
      therein (incorporated herein by reference from Exhibit 10.1 to our
      Form 8-K filed with the Commission on April 21, 2008).10.20†
              Employment
      Agreement with David A. Capotosto, dated June 5, 2008 (incorporated
      herein by reference from Exhibit 10.12 to our Form S-1 Registration
      Statement (file no. 333-152435) filed with the Commission on July 21,
      2008).
  37
  10.21†
              Employment
      Agreement with Bradley M. Parro, dated May 1, 2008 (incorporated
      herein by reference from Exhibit 10.13 to our Form S-1 Registration
      Statement (file no. 333-152435) filed with the Commission on July 21,
      2008).10.22*
              Loan
      Agreement entered into as of February 13, 2009, by and among Flotation
      Technologies, Inc., Deep Down, Inc., and TD Bank, N.A.10.23*
              Mortgage
      and Security Agreement entered into as of February 13, 2009, by Flotation
      Technologies, Inc. in favor of TD Bank, N.A.10.24*
              Collateral
      Assignment of Leases and Rents entered into as of February 13, 2009, by
      Flotation Technologies, Inc. in favor of TD Bank, N.A.10.25*
              Commercial
      Note entered into as of February 13, 2009, by Flotation Technologies, Inc.
      in favor of TD Bank, N.A.10.26*
              Debt
      Subordination Agreement entered into as of February 13, 2009, by and among
      Flotation Technologies, Inc., Deep Down, Inc., and TD Bank,
      N.A.10.27*
              Environmental
      Indemnity Agreement entered as of February 13, 2009 in favor of TD Bank,
      N.A.21.1*
              Subsidiary
      list24.1*
              Power
      of Attorney (set forth immediately following the registrant’s signatures
      to this report).31.1*
              Rule
      13a-14(a)/15d-14(a) Certification of the President and Chief Executive
      Officer of Deep Down, Inc.31.2*
              Rule
      13a-14(a)/15d-14(a) Certification of the Chief Financial Officer of Deep
      Down, Inc.32.1*
              Section
      1350 Certification of the President and Chief Executive Officer of Deep
      Down, Inc.32.2*
              Section
      1350 Certification of the Chief Financial Officer of Deep Down,
      Inc.
 
 * Filed
or furnished herewith.
 
 † Exhibit
constitutes a management contract or compensatory plan or
arrangement.








38


SIGNATURES




In
accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.





DEEP
DOWN, INC.


(Registrant)








/s/ RONALD E.
SMITH





President
and Chief Executive Officer


Dated:
March 16, 2009








/s/ EUGENE L.
BUTLER





Chief
Financial Officer


Dated:
March 16, 2009




POWER
OF ATTORNEY





KNOWN ALL
MEN BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints RONALD E. SMITH and EUGENE L. BUTLER, and each of them,
his or her true and lawful attorneys-in-fact and agents, with full power of
substitution and re-substitution for him or her and in his or her name, place
and stead, in any and all capacities, to sign any and all amendments to this
Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and
other documents in connection therewith with the Securities and Exchange
Commission, granting unto said attorneys-in-fact and agents, and each of them,
full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully and to
all intents and purposes as he might or could do in person hereby ratifying and
confirming all that said attorneys-in-fact and agents, or his substitute or
substitutes, may lawfully do or cause to be done by virtue hereof.





Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.




Signatures
            
            Title
            Date/s/ RONALD E.
      SMITH
            
            President,
      Chief Executive Officer and Director
            March
      16, 2009Ronald
      E. Smith
            
            (Principal
      Executive Officer)/s/ EUGENE L.
      BUTLER
            
            Chief
      Financial Officer and Director
            March
      16, 2009Eugene
      L. Butler
            
            (Principal
      Financial Officer and Principal Accounting Officer)/s/ ROBERT E. CHAMBERLAIN,
      JR.
            
            Chairman,
      Chief Acquisitions Officer and Director
            March
      16, 2009Robert
      E. Chamberlain, Jr./s/ MARY L.
      BUDRUNAS
            
            Vice-President,
      Corporate Secretary and Director
            March
      16, 2009Mary
      L. Budrunas




39


EXHIBIT
INDEX




Exhibit
              Number
            Description
      of Exhibit2.1
            Agreement
      and Plan of Reorganization among MediQuip Holdings, Inc., Deep Down, Inc.,
      and the majority shareholders of Deep Down, Inc. (incorporated by
      reference from Exhibit 2.1 to our Form 10-KSB/A filed with the Commission
      on May 1, 2008).3.1
            Articles
      of Incorporation of Deep Down, Inc. (conformed to include the amendment of
      the Articles of Incorporation filed with the Secretary of State of the
      State of Nevada on September 29, 2008) (incorporated by reference from
      Exhibit A to our Schedule 14C filed on August 15, 2008).3.2
            Amended
      and Restated ByLaws of Deep Down, Inc. (incorporated by reference from
      Exhibit B to our Schedule 14C filed on August 15, 2008).3.3
            Form
      of Certificate of Designations of Series D Redeemable Convertible
      Preferred Stock (incorporated herein by reference from Exhibit 3.4 to our
      Form 10-KSB/A filed with the Commission on May 1, 2008).3.4
            Form
      of Certificate of Designations of Series E Redeemable Exchangeable
      Preferred Stock (incorporated herein by reference from Exhibit 3.5 to our
      Form 10-KSB/A filed with the Commission on May 1, 2008).3.5
            Form
      of Certificate of Designations of Series F Redeemable Convertible
      Preferred Stock (incorporated herein by reference from Exhibit 3.6 to our
      Form 10-KSB/A filed with the Commission on May 1, 2008).3.6
            Form
      of Certificate of Designations of Series G Redeemable Exchangeable
      Preferred Stock (incorporated herein by reference from Exhibit 3.7 to our
      Form 10-KSB/A filed with the Commission on May 1, 2008).4.1
            Common
      Stock Purchase Warrant for 320,000 shares of common stock of Deep Down,
      Inc. issued to Dragonfly Capital Partners, LLC dated August 6, 2007
      (incorporated herein by reference from Exhibit 4.2 to our Form 10-KSB
      filed with the Commission on April 1, 2008).4.2
            Common
      Stock Purchase Warrant for 118,812 shares of common stock of Deep Down,
      Inc. issued to Dragonfly Capital Partners, LLC dated January 4, 2008
      (incorporated herein by reference from Exhibit 4.3 to our Form 10-KSB
      filed with the Commission on April 1, 2008).4.3
            Common
      Stock Purchase Warrant for 200,000 shares of common stock of Deep Down,
      Inc. issued to Subsea, LLC dated June 6, 2008 (incorporated herein by
      reference from Exhibit 4.1 to our Form 8-K/A (Amendment No. 2) filed with
      the Commission on June 9, 2008).4.4
            Registration
      Rights Agreement, dated August 6, 2007, among Deep Down, Inc. and Prospect
      Capital Corporation (incorporated herein by reference from Exhibit 4.4 to
      our Form 10-KSB/A filed with the Commission on May 1, 2008).4.5
            Private
      Placement Memorandum dated May 16, 2008 (incorporated herein by reference
      from Exhibit 20.1 to our Form 8-K/A (Amendment No. 2) filed with the
      Commission on June 9, 2008).4.6
            Amended
      and Restated Supplement No. 1 to Private Placement Memorandum, dated June
      2, 2008 (incorporated herein by reference from Exhibit 4.6 to our Form S-1
      Registration Statement (file no. 333-152435) filed with the Commission on
      July 21, 2008).4.7
            Purchase
      Agreement, dated June 2, 2008, among Deep Down, Inc., and the Purchasers
      named therein (incorporated herein by reference from Exhibit 10.1 to our
      Form 8-K/A (Amendment No. 2) filed with the Commission on June 9,
      2008)4.8
            6%
      Subordinated Debenture of Deep Down, Inc. dated March 31, 2008
      (incorporated herein by reference from Exhibit 4.1 to our Form 10-Q filed
      with the Commission on May 16, 2008)4.9†
            Stock
      Option, Stock Warrant and Stock Award Plan (incorporated herein by
      reference from Exhibit 4.10 to our Form S-1 Registration Statement (file
      no. 333-152435) filed with the Commission on July 21, 2008).10.1
            Credit
      Agreement, dated as of November 11, 2008, among Deep Down, Inc. as
      borrower and Whitney National Bank, as lender (incorporated herein by
      reference from Exhibit 10.1 to our Form 10-Q filed with the Commission on
      November 14, 2008).10.2
            First
      Amendment to Credit Agreement entered into as of December 18, 2008, among
      Deep Down, Inc. as borrower and Whitney National Bank, including the
      Guarantor’s Consent and Agreement as signed on behalf of Electrowave USA,
      Inc., Flotation Technologies, Inc., Mako Technologies, LLC and Deep Down,
      Inc. (incorporated herein by reference from Exhibit 10.1 to our Form 8-K
      filed with the Commission on December 19,
2008).


40




10.3*
            Second
      Amendment to Credit Agreement entered into as of February 13, 2009, among
      Deep Down, Inc., as borrower, and Whitney National Bank, including the
      Guarantor’s Consent and Agreement as signed on behalf of Electrowave USA,
      Inc., Flotation Technologies, Inc., Mako Technologies, LLC and Deep Down,
      Inc.10.4
            Guaranty,
      dated as of November 11, 2008, by ElectroWave USA, Inc., Flotation
      Technologies, Inc., Mako Technologies, LLC and Deep Down, Inc. for the
      benefit of Whitney National Bank (incorporated herein by reference from
      Exhibit 10.2 to our Form 10-Q filed with the Commission on November 14,
      2008).10.5*
            Joinder
      to Guaranty, dated as of February 13, 2009, by Deep Down International
      Holdings, LLC.10.6
            Security
      Agreement, dated as of November 11, 2008, among Deep Down, Inc.,
      ElectroWave USA, Inc., Flotation Technologies, Inc., Mako Technologies,
      LLC and Deep Down, Inc. for the benefit of Whitney National Bank
      (incorporated herein by reference from Exhibit 10.3 to our Form 10-Q filed
      with the Commission on November 14, 2008).10.7*
            Joinder
      to Security Agreement, dated as of February 13, 2009, by Deep Down
      International Holdings, LLC.10.8
            Second
      Amendment to Security Agreement, dated as of February 13, 2009, by Deep
      Down, Inc., ElectroWave USA, Inc., Flotation Technologies, Inc., Mako
      Technologies, LLC and Deep Down, Inc. for the benefit of Whitney National
      Bank (incorporated herein by reference from Exhibit 10.3 to our Form 8-K
      filed with the Commission on December 19, 2008).10.9
            Term
      Note, dated December 18, 2008, executed by Deep Down, Inc. and paid to
      order to Whitney National Bank (incorporated herein by reference from
      Exhibit 10.2 to our Form 8-K filed with the Commission on December 19,
      2008).10.10†
            Consulting
      Agreement, dated as of August 6, 2007, between Deep Down, Inc. and
      Strategic Capital Services, Inc. regarding the services of Robert
      Chamberlain (incorporated herein by reference from Exhibit 10.1 to our
      Form 10-KSB filed with the Commission on April 1, 2008).10.11†
            Employment
      Agreement, dated as of August 6, 2007, between Deep Down, Inc. and Ronald
      E. Smith (incorporated herein by reference from Exhibit 10.2 to our Form
      10-KSB filed with the Commission on April 1, 2008).10.12†
            Consulting
      Agreement, dated effective as of August 6, 2007, between Deep Down, Inc.
      and Eugene L. Butler & Associates regarding the services of Eugene L.
      Butler (incorporated herein by reference from Exhibit 10.3 to our
      Form 10-KSB filed with the Commission on April 1, 2008).10.13
            Agreement
      and Plan of Merger among Deep Down, Inc., Mako Technologies, LLC, Mako
      Technologies, Inc. and the shareholders of Mako Technologies, Inc. dated
      December 17, 2007 (incorporated herein by reference from Exhibit 2.1
      to our Form 10-KSB filed with the Commission on April 1,
      2008).10.14
            Agreement
      and Plan of Reorganization among Deep Down, Inc., ElectroWave (USA), Inc.,
      a Nevada corporation, ElectroWave (USA) Inc., a Texas corporation,
      Pinemont IV, Martin L. Kershman and Ronald W. Nance (incorporated herein
      by reference from Exhibit 10.10 to our Form 10-KSB/A filed with the
      Commission on May 1, 2008).10.15
            Lease
      Agreement, dated September 1, 2006, between Deep Down, Inc., a Delaware
      corporation, as tenant, and JUMA, L.L.C. (incorporated herein by
      reference from Exhibit 10.4 to our Form 10-KSB filed with the Commission
      on April 1, 2008).10.16
            Lease
      Amendment and Extension Agreement, dated as of May 1, 2008, between Deep
      Down, Inc. a Delaware corporation, and JUMA, L.L.C. (incorporated herein
      by reference from Exhibit 10.8 to our Form 10-Q filed with the Commission
      on August 15, 2008).10.17
            Lease
      Agreement dated June 1, 2006, between Mako Technologies, Inc., as Lessee
      and Sutton Industries, as Lessor (incorporated herein by reference from
      Exhibit 10.12 to our Form 10-KSB/A filed with the Commission on May 1,
      2008).10.18*
            Office
      Building Lease, dated November 24, 2008, between Deep Down, Inc. and
      A-K-S-L 49 Beltway 8, L.P.10.19
            Stock
      Purchase Agreement, dated April 17, 2008, among Deep Down, Inc., Flotation
      Technologies, Inc. and the selling stockholders named
      therein (incorporated herein by reference from Exhibit 10.1 to our
      Form 8-K filed with the Commission on April 21, 2008).10.20†
            Employment
      Agreement with David A. Capotosto, dated June 5, 2008 (incorporated
      herein by reference from Exhibit 10.12 to our Form S-1 Registration
      Statement (file no. 333-152435) filed with the Commission on July 21,
      2008).




41




10.21†
            Employment
      Agreement with Bradley M. Parro, dated May 1, 2008 (incorporated
      herein by reference from Exhibit 10.13 to our Form S-1 Registration
      Statement (file no. 333-152435) filed with the Commission on July 21,
      2008).10.22*
            Loan
      Agreement entered into as of February 13, 2009, by and among Flotation
      Technologies, Inc., Deep Down, Inc., and TD Bank, N.A.10.23*
            Mortgage
      and Security Agreement entered into as of February 13, 2009, by Flotation
      Technologies, Inc. in favor of TD Bank, N.A.10.24*
            Collateral
      Assignment of Leases and Rents entered into as of February 13, 2009, by
      Flotation Technologies, Inc. in favor of TD Bank, N.A.10.25*
            Commercial
      Note entered into as of February 13, 2009, by Flotation Technologies, Inc.
      in favor of TD Bank, N.A.10.26*
            Debt
      Subordination Agreement entered into as of February 13, 2009, by and among
      Flotation Technologies, Inc., Deep Down, Inc., and TD Bank,
      N.A.10.27*
            Environmental
      Indemnity Agreement entered as of February 13, 2009 in favor of TD Bank,
      N.A.21.1*
            Subsidiary
      list24.1*
            Power
      of Attorney (set forth immediately following the registrant’s signatures
      to this report).31.1*
            Rule
      13a-14(a)/15d-14(a) Certification of the President and Chief Executive
      Officer of Deep Down, Inc.31.2*
            Rule
      13a-14(a)/15d-14(a) Certification of the Chief Financial Officer of Deep
      Down, Inc.32.1*
            Section
      1350 Certification of the President and Chief Executive Officer of Deep
      Down, Inc.32.2*
            Section
      1350 Certification of the Chief Financial Officer of Deep Down,
      Inc.





* Filed
or furnished herewith.





† Exhibit
constitutes a management contract or compensatory plan or
arrangement.


42


INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS








Reports
      of Independent Registered Public Accounting Firm
            F-2Consolidated
      Balance Sheets
            F-5Consolidated
      Statements of Operations
            F-6Consolidated
      Statements of Changes in Stockholders’ Equity
            F-7Consolidated
      Statements of Cash Flows
            F-8Notes
      to the Consolidated Financial Statements
            F-10









F-1


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and Stockholders of Deep Down, Inc.


Houston,
Texas




We have
audited the accompanying consolidated balance sheets of Deep Down, Inc. (the
"Company") as of December 31, 2008 and 2007 and the related consolidated
statements of operations, changes in stockholders' equity and cash flows for the
years ended December 31, 2008 and 2007.  These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.





We
conducted our audits in accordance with standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of the Company, as of December
31, 2008 and 2007, and the results of its operations and its cash flows
for the years ended December 31, 2008 and 2007 in conformity
with accounting principles generally accepted in the United States of
America.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the Company’s internal control over financial
reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated
Frameworkissued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), and our report dated March 12, 2009, expressed an
adverse opinion.





/s/  MALONE
& BAILEY, PC


www.malone-bailey.com


Houston,
Texas





March 12,
2009


F-2





REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER
FINANCIAL REPORTING







To the
Board of Directors and Shareholders of Deep Down, Inc., Houston,
Texas





We have
audited Deep Down, Inc.’s (“the Company”)  internal control over
financial reporting as of December 31, 2008, based on criteria established in
Internal Control—Integrated
Frameworkissued by the Committee of Sponsoring Organizations of the
Treadway Commission (the COSO criteria). Deep Down, Inc.’s management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on the Company’s internal
control over financial reporting based on our audit.





Management
excluded from its assessment of the effectiveness of the Company’s disclosure
controls and procedures and internal control over financial reporting, the
disclosure controls and procedures and internal controls of the Flotation
business. Management was unable to assess the effectiveness of the disclosure
controls and procedures and internal control over financial reporting of the
Flotation businesses because of the integration of the business. Management
expects to update its assessment of the effectiveness of the disclosure controls
and procedures and internal control over financial reporting to include the
Flotation businesses as soon as practicable. The business accounts for
approximately 32% of the consolidated revenue of Deep Down, and approximately
43% of consolidated assets.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk. Our audit also included performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.





A
company’s 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. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





A
material weakness is a deficiency, or 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. The following
material weaknesses have been identified and included in management’s
assessment:





·
            Management
      has determined that the Company did not maintain an effective entity level
      control
environment.  Specifically:


o
            The
      Company has not yet implemented all the necessary policies and procedures
      to ensure that they have an effective control environment based on
      criteria established in the COSO framework. Specifically, the Company
      needs to fully implement controls to help prevent or detect the
      circumvention of controls by employees or management. The Company also
      needs to perform a formal risk profile and analysis of the
      Company.


o
            The
      Company did not maintain sufficient policies and procedures over the
      administration of an accounting and fraud risk
  policy.


o
            The
      Company did not maintain sufficient documentation on the review and follow
      up on the remediation of
deficiencies.


o
            The
      Company did not maintain a sufficient segregation of duties to decrease
      the risk of inappropriate
accounting.


F-3


·
            Management
      has determined that the Company did not maintain effective controls over
      the accuracy of revenue recognition. Specifically, there was not
      sufficient review, supervision, and monitoring in regards to projects
      accounted for under the percentage-of-completion
  method.





These
material weaknesses were considered in determining the nature, timing and extent
of audit tests applied in our audit of the fiscal year 2008 consolidated
financial statements and this report does not affect our report dated March 12,
2009 on those financial statements.





In our
opinion, because of the effect of the material weaknesses described above on the
achievement of the objectives of the control criteria, Deep Down, Inc. has not
maintained effective internal control over financial reporting as of December
31, 2008, based on the COSO criteria.





We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets of Deep Down,
Inc. as of December 31, 2008 and 2007, and the related consolidated statements
of income, changes in stockholders’ equity, and cash flows for the years ended
December 31, 2008 and 2007 and our report dated March 12, 2009 expressed an
unqualified opinion thereon.





/s/
Malone & Bailey, PC


www.malone-bailey.com


Houston,
Texas





March 12,
2009


F-4


Deep Down, Inc.Consolidated
      Balance Sheets




December
      31, 2008
            
            
            December
      31, 2007ASSETSCash
      and cash equivalents
            
            $
            2,495,464
            
            
            $
            2,206,220Restricted
      cash
            
            
            135,855
            
            
            
            375,000Accounts
      receivable, net
            
            
            10,772,097
            
            
            
            7,190,466Prepaid
      expenses and other current assets
            
            
            633,868
            
            
            
            720,886Inventory
            
            
            1,224,170
            
            
            
            502,253Costs
      and estimated earnings in excess of billings on uncompleted
      contracts
            
            
            707,737
            
            
            
            -Work
      in progress
            
            
            137,940
            
            
            
            749,455Deferred
      tax asset
            
            
            216,900
            
            
            
            75,810Receivable
      from Prospect, net
            
            
            -
            
            
            
            2,687,333Total
      current assets
            
            
            16,324,031
            
            
            
            14,507,423Property
      and equipment, net
            
            
            13,799,196
            
            
            
            5,368,961Other
      assets, net
            
            
            457,836
            
            
            
            1,211,514Intangibles,
      net
            
            
            18,090,680
            
            
            
            4,369,647Goodwill
            
            
            15,024,300
            
            
            
            10,594,144Total
      assets
            
            $
            63,696,043
            
            
            $
            36,051,689LIABILITIES
      AND STOCKHOLDERS' EQUITYAccounts
      payable and accrued liabilities
            
            $
            4,318,394
            
            
            $
            3,569,826Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
            
            
            2,315,043
            
            
            
            188,030Payable
      to Mako shareholders
            
            
            -
            
            
            
            3,205,667Current
      portion of long-term debt
            
            
            382,912
            
            
            
            995,177Total
      current liabilities
            
            
            7,016,349
            
            
            
            7,958,700Long-term
      debt, net of accumulated discount of $0 and $1,703,258
      respectively
            
            
            1,718,475
            
            
            
            10,698,818Deferred
      tax liabilities
            
            
            1,125,945
            
            
            
            -Series
      E redeemable exchangeable preferred stock, par value $0.01, face value and
      liquidationpreference
      of $1,000 per share, no dividend preference, authorized 10,000,000
      aggregate
              shares
      of all series of preferred stock, -0- and 500 issued and outstanding,
      respectively
            
            
            -
            
            
            
            386,411Total
      liabilities
            
            
            9,860,769
            
            
            
            19,043,929Temporary
      equity:Series
      D redeemable convertible preferred stock, $0.01 par value, face value and
      liquidationpreference
      of $1,000 per share, no dividend preference, authorized 10,000,000
      aggregate shares of all series of preferred stock, -0- and 5,000
      issued and outstanding, respectively
            
            
            -
            
            
            
            4,419,244Total
      temporary equity
            
            
            -
            
            
            
            4,419,244Stockholders'
      equity:Common
      stock, $0.001 par value, 490,000,000 shares authorized,
      177,350,630and
      85,976,532 shares issued and outstanding, respectively
            
            
            177,351
            
            
            
            85,977Additional
      paid-in capital
            
            
            60,328,124
            
            
            
            14,849,847Accumulated
      deficit
            
            
            (6,670,201
            )
            
            
            (2,347,308
            )Total
      stockholders' equity
            
            
            53,835,274
            
            
            
            12,588,516Total
      liabilities and stockholders' equity
            
            $
            63,696,043
            
            
            $
            36,051,689




See
accompanying notes to consolidated financial statements.


F-5





Deep
      Down, Inc.Consolidated Statements of OperationsFor
      the Years Ended December 31, 2008 and 2007







For
      the Twelve Months EndedDecember
      31,2008
            
            
            2007Revenues
            
            $
            35,769,705
            
            
            $
            19,389,730Cost
      of sales
            
            
            21,686,033
            
            
            
            13,306,086Gross
      profit
            
            
            14,083,672
            
            
            
            6,083,644Operating
      expenses:Selling,
      general & administrative
            
            
            14,290,440
            
            
            
            4,284,553Depreciation
      and amortization
            
            
            1,285,079
            
            
            
            141,247Total
      operating expenses
            
            
            15,575,519
            
            
            
            4,425,800Operating
      income (loss)
            
            
            (1,491,847
            )
            
            
            1,657,844Other
      income (expense):Gain
      (loss) on debt extinguishment
            
            
            (446,412
            )
            
            
            2,000,000Interest
      income
            
            
            110,504
            
            
            
            92,664Interest
      expense
            
            
            (3,511,177
            )
            
            
            (2,430,149
            )Other
      (expense) income
            
            
            (26,333
            )
            
            
            1,823Total
      other expense
            
            
            (3,873,418
            )
            
            
            (335,662
            )Income
      (loss) before income taxes
            
            
            (5,365,265
            )
            
            
            1,322,182Benefit
      from (provision for) income taxes
            
            
            1,042,372
            
            
            
            (369,673
            )Net
      income (loss)
            
            $
            (4,322,893
            )
            
            $
            952,509Earnings
      (loss) per share:Basic
            
            $
            (0.03
            )
            
            $
            0.01Weighted-average
      common shares outstanding
            
            
            142,906,616
            
            
            
            73,917,190Diluted
            
            $
            (0.03
            )
            
            $
            0.01Weighted-average
      common shares outstanding
            
            
            142,906,616
            
            
            
            104,349,455




See
accompanying notes to consolidated financial statements.


F-6





Deep
      Down, Inc.Statements
      of Changes in Stockholders'
    EquityFor
      the Years Ended December 31, 2008 and
2007








AdditionalCommon
      Stock
            
            
            Series
      C Preferred Stock
            
            
            Paid-in
            
            
            AccumulatedShares
      (#)
            
            
            Amount
      ($)
            
            
            Shares
      (#)
            
            
            Amount
      ($)
            
            
            Capital
            
            
            Deficit
            
            
            TotalBalance
      at December 31, 2006
            
            
            82,870,177
            
            
            $
            82,870
            
            
            
            22,000
            
            
            $
            22
            
            
            $
            (82,792
            )
            
            $
            (3,299,817
            )
            
            $
            (3,299,717
            )Net
      income
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            952,509
            
            
            
            952,509Shares
      repurchased
            
            
            (25,000,000
            )
            
            
            (25,000
            )
            
            
            
            
            
            
            
            
            
            
            (225,000
            )
            
            
            
            
            
            
            (250,000
            )Redemption
      of Series E Preferred Stock
            
            
            3,463,592
            
            
            
            3,464
            
            
            
            
            
            
            
            
            
            
            
            3,840,314
            
            
            
            
            
            
            
            3,843,778Redemption
      of Series C Preferred Stock
            
            
            4,400,000
            
            
            
            4,400
            
            
            
            (22,000
            )
            
            
            (22
            )
            
            
            (4,378
            )
            
            
            
            
            
            
            -Stock
      issued for debt payment
            
            
            543,689
            
            
            
            544
            
            
            
            
            
            
            
            
            
            
            
            559,456
            
            
            
            
            
            
            
            560,000Stock
      issued for acquisition of a business
            
            
            6,574,074
            
            
            
            6,574
            
            
            
            
            
            
            
            
            
            
            
            4,989,723
            
            
            
            
            
            
            
            4,996,297Private
      Placement offering
            
            
            13,125,000
            
            
            
            13,125
            
            
            
            
            
            
            
            
            
            
            
            3,946,875
            
            
            
            
            
            
            
            3,960,000Stock
      based compensation
            
            
            -
            
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            187,394
            
            
            
            
            
            
            
            187,394Warrants
      issued to lender
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,479,189
            
            
            
            
            
            
            
            1,479,189Warrants
      issued to third party for deferred financing costs
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            159,066
            
            
            
            
            
            
            
            159,066Balance
      at December 31, 2007
            
            
            85,976,532
            
            
            $
            85,977
            
            
            
            -
            
            
            
            -
            
            
            $
            14,849,847
            
            
            $
            (2,347,308
            )
            
            $
            12,588,516Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (4,322,893
            )
            
            
            (4,322,893
            )Exchange
      of Series D preferred stock
            
            
            25,866,518
            
            
            
            25,867
            
            
            
            
            
            
            
            
            
            
            
            4,393,377
            
            
            
            
            
            
            
            4,419,244Stock
      issued for acquisition of Mako
            
            
            2,802,969
            
            
            
            2,803
            
            
            
            
            
            
            
            
            
            
            
            1,959,275
            
            
            
            
            
            
            
            1,962,078Stock
      issued for acquisition of Flotation
            
            
            1,714,286
            
            
            
            1,714
            
            
            
            
            
            
            
            
            
            
            
            1,421,143
            
            
            
            
            
            
            
            1,422,857Warrants
      issued for acquisition of Flotation
            
            
            
            
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            121,793
            
            
            
            
            
            
            
            121,793Restricted
      stock issued for service
            
            
            1,200,000
            
            
            
            1,200
            
            
            
            
            
            
            
            
            
            
            
            (1,200
            )
            
            
            
            
            
            
            -Stock
      issued in private placement, net of $2,940,331 fees
            
            
            57,142,857
            
            
            
            57,143
            
            
            
            
            
            
            
            
            
            
            
            37,002,527
            
            
            
            
            
            
            
            37,059,670Cashless
      exercise of stock options
            
            
            29,339
            
            
            
            29
            
            
            
            
            
            
            
            
            
            
            
            (29
            )
            
            
            
            
            
            
            -Stock
      issued for exercise of warrants
            
            
            2,618,129
            
            
            
            2,618
            
            
            
            
            
            
            
            
            
            
            
            (2,618
            )
            
            
            
            
            
            
            -Stock
      based compensation
            
            
            -
            
            
            
            -
            
            
            
            
            
            
            
            
            
            
            
            584,009
            
            
            
            
            
            
            
            584,009Balance
      at December 31, 2008
            
            
            177,350,630
            
            
            $
            177,351
            
            
            
            -
            
            
            
            -
            
            
            $
            60,328,124
            
            
            $
            (6,670,201
            )
            
            $
            53,835,274






See
accompanying notes to consolidated financial statements.


F-7




Deep
      Down, Inc.Consolidated Statement of Cash FlowsFor
      the Years Ended December 31, 2008 and 2007




2008
                
                
                2007Cash
      flows from operating activities:Net
      income (loss)
                
                $
                (4,322,893
                )
                
                $
                952,509Adjustments
      to reconcile net income to net cash used in operating
      activities:Gain
      on extinguishment of debt
                
                
                -
                
                
                
                (2,000,000
                )Interest
      income
                
                
                (54,975
                )
                
                
                -Non-cash
      amortization of debt discount
                
                
                1,816,847
                
                
                
                1,780,922Non-cash
      amortization of deferred financing costs
                
                
                762,700
                
                
                
                54,016Share-based
      compensation
                
                
                584,009
                
                
                
                187,394Bad
      debt expense
                
                
                1,507,494
                
                
                
                108,398Depreciation
      and amortization
                
                
                2,363,106
                
                
                
                426,964Loss
      on disposal of equipment
                
                
                228,352
                
                
                
                24,336Deferred
      taxes payable
                
                
                (855,708
                )
                
                
                -Changes
      in assets and liabilities:Lease
      receivable
                
                
                -
                
                
                
                (863,000
                )Accounts
      receivable
                
                
                (3,087,260
                )
                
                
                (4,388,146
                )Prepaid
      expenses and other current assets
                
                
                (493,100
                )
                
                
                (54,310
                )Inventory
                
                
                (1,224,170
                )
                
                
                -Finished
      goods
                
                
                -
                
                
                
                (502,253
                )Costs
      and estimated earnings in excess of billings on uncompleted
      contracts
                
                
                1,482,698
                
                
                
                -Work
      in progress
                
                
                (707,737
                )
                
                
                246,278Accounts
      payable and accrued liabilities
                
                
                (328,788
                )
                
                
                1,022,726Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
                
                
                2,127,013
                
                
                
                (1,970
                )Net
      cash used in operating activities
                
                $
                (202,412
                )
                
                $
                (3,006,136
                )Cash
      flows used in investing activities:Cash
      paid for acquisition of Flotation, net of cash acquired of
      $235,040
                
                
                (22,161,864
                )
                
                
                -Cash
      paid for acquisition of Mako, net of cash acquired of
    $280,841
                
                
                (4,236,634
                )
                
                
                280,841Cash
      deficit acquired in ElectroWave acquisition
                
                
                -
                
                
                
                (18,974
                )Cash
      paid for third party debt
                
                
                -
                
                
                
                (432,475
                )Cash
      received from sale of ElectroWave receivables
                
                
                -
                
                
                
                261,068Cash
      paid for final acquisition costs
                
                
                -
                
                
                
                (242,924
                )Purchases
      of equipment
                
                
                (4,803,795
                )
                
                
                (830,965
                )Restricted
      cash
                
                
                239,145
                
                
                
                (375,000
                )Net
      cash used in investing activities
                
                $
                (30,963,148
                )
                
                $
                (1,358,429
                )Cash
      flows from financing activities:Payment
      for cancellation of common stock
                
                
                -
                
                
                
                (250,000
                )Redemption
      of preferred stock
                
                
                -
                
                
                
                (250,000
                )Proceeds
      from sale of common stock, net of expenses
                
                
                37,059,670
                
                
                
                3,960,000Proceeds
      from sales-type lease
                
                
                587,000
                
                
                
                276,000Borrowings
      on debt - related party
                
                
                -
                
                
                
                150,000Payments
      on debt - related party
                
                
                -
                
                
                
                (150,000
                )Borrowings
      on long-term debt
                
                
                6,769,087
                
                
                
                6,204,779Increase
      in deferred financing fees
                
                
                -
                
                
                
                (442,198
                )Creation
      of debt discount due to lender's fees
                
                
                -
                
                
                
                (180,000
                )Payments
      of long-term debt
                
                
                (12,960,953
                )
                
                
                (2,760,258
                )Net
      cash provided by financing activities
                
                $
                31,454,804
                
                
                $
                6,558,323Change
      in cash and equivalents
                
                
                289,244
                
                
                
                2,193,758Cash
      and cash equivalents, beginning of period
                
                
                2,206,220
                
                
                
                12,462Cash
      and cash equivalents, end of period
                
                $
                2,495,464
                
                
                $
                2,206,220




See
accompanying notes to consolidated financial statements.


F-8





Deep
      Down, Inc.Consolidated
      Statements of Cash FlowsFor
      the Years Ended December 31, 2008 and
2007







2008
                        
                        
                        2007Supplemental
      schedule of noncash investing and financing activities:Warrants
      issued for acquisition of Flotation
                        
                        $
                        121,793
                        
                        
                        $
                        -Stock
      issued for acquisition of Flotation
                        
                        $
                        1,422,857
                        
                        
                        $
                        -Stock
      issued for acquisition of Mako
                        
                        $
                        1,962,078
                        
                        
                        $
                        4,996,297Receivable
      from lender - Prospect Capital Corporation
                        
                        $
                        -
                        
                        
                        $
                        5,604,000Payable
      to Mako Shareholders
                        
                        $
                        -
                        
                        
                        $
                        (2,916,667
                        )Non-cash
      increases to Mako Goodwill
                        
                        $
                        (371,728
                        )
                        
                        $
                        -Deferred
      tax adjustment to Mako Goodwill
                        
                        $
                        (1,840,563
                        )
                        
                        $
                        -Correction
      of common stock par value to paid in capital
                        
                        $
                        -
                        
                        
                        $
                        114,750Fixed
      assets purchased with capital lease
                        
                        $
                        -
                        
                        
                        $
                        525,000Fixed
      assets transferred from Inventory
                        
                        $
                        502,253
                        
                        
                        $
                        110,181Exchange
      of Series D preferred stock
                        
                        $
                        4,419,244
                        
                        
                        $
                        -Exchange
      of Series E preferred stock
                        
                        $
                        -
                        
                        
                        $
                        3,366,778Redemption
      of Series E preferred stock
                        
                        $
                        -
                        
                        
                        $
                        4,935,463Common
      stock issued for notes payable
                        
                        $
                        -
                        
                        
                        $
                        560,000Exchange
      of Series E preferred stock for subordinated debenture
                        
                        $
                        500,000
                        
                        
                        $
                        -Common
      shares issued as restricted stock
                        
                        $
                        1,200
                        
                        
                        $
                        -Creation
      of debt discount due to warrants issued to lender
                        
                        $
                        -
                        
                        
                        $
                        1,479,189Creation
      of deferred financing fee due to warrants issued to third
      party
                        
                        $
                        -
                        
                        
                        $
                        159,066Supplemental
      Disclosures:Cash
      paid for interest
                        
                        $
                        909,027
                        
                        
                        $
                        594,667Cash
      paid for pre-payment penalties
                        
                        $
                        446,413
                        
                        
                        $
                        -Cash
      paid for taxes
                        
                        $
                        332,009
                        
                        
                        $
                        114,970







See
accompanying notes to consolidated financial statements.


F-9
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Note
1:          Nature of Business and Summary of Significant Accounting
Policies





Nature
of Business


Deep
Down, Inc., a Nevada corporation (“Deep Down”), is the parent company to its
wholly-owned subsidiaries: Deep Down, Inc., a Delaware corporation (“Deep Down
Delaware”), ElectroWave USA, Inc., a Nevada corporation (“ElectroWave”), since
its acquisition effective April 2, 2007, Mako Technologies, LLC, a Nevada
limited liability company (“Mako”), since its acquisition effective December 1,
2007, and Flotation Technologies, Inc., a Maine corporation (“Flotation”), since
its acquisition effective May 1, 2008.




Deep Down
Delaware provides installation management, engineering services, support
services and storage management services for the subsea controls, umbilicals and
offshore pipeline industries. Deep Down Delaware also fabricates component
parts for subsea distribution systems and assemblies.





ElectroWave
offers products and services in the fields of electronic monitoring and control
systems for the energy, military, marine and commercial business
sectors.





Mako
serves the growing offshore petroleum and marine industries with technical
support services and products vital to offshore petroleum production, through
rentals of its remotely operated vehicles (“ROV”), topside and subsea equipment
and diving support systems used in diving operations, maintenance and repair
operations, offshore construction, and environmental/marine
surveys.





Flotation
engineers, designs and manufactures deepwater buoyancy systems using
high-strength FlotecTM
syntactic foam and polyurethane
elastomers.  Flotation’s  product offerings include
distributed buoyancy for flexible pipes and umbilicals, drilling riser buoyance
modules, CoreTecTM
drilling riser buoyancy modules, ROVitsTM
buoyancy, Hydro-Float mooring buoys, StablemoorTM
low-drag ADCP deployment solution, Quick-LocTM cable floats, HardballTM
umbilical floats, FlotecTM cable and pipeline protection, InflexTM polymer
bend restrictors, and installation buoyancy of any size and depth
rating.




Summary
of Significant Accounting Policies





Principles
of consolidation:





The
consolidated financial statements include the accounts of Deep Down and its
wholly-owned subsidiaries for the years ended December 31, 2008 and
2007.





All
significant inter-company transactions and balances have been eliminated in
consolidation.





Use
of 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
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.





Reclassifications





Prior
period information presented in these financial statements includes
reclassifications which were made to conform to the current period
presentation.  These reclassifications had no effect on our previously
reported net income (loss) or stockholders' equity. For example, Deep Down
reclassified a portion of total depreciation expense, $1,078,027 and $285,717,
into Cost of sales from Operating expenses for the years ended December 31, 2008
and 2007, respectively. The remainder of depreciation expense for each
respective year is reported in the Operating expenses section of the Statements
of Operations.


F-10
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Cash
and Cash Equivalents and Restricted Cash





Deep Down
considers all highly liquid investments with maturities from date of purchase of
three months or less to be cash equivalents. Cash and equivalents consist of
cash on deposit with foreign and domestic banks and, at times, may exceed
federally insured limits.





Per the
terms of its secured credit agreement with Prospect Capital Corporation, Deep
Down was required to keep cash on hand equal to the previous six months interest
payment on the debt arising under such credit agreement. At December 31, 2007,
this amount approximated $375,000 which is reflected on the balance sheet as
restricted cash. When the credit agreement was paid in June 2008, this amount
was released from all restrictions.





At
December 31, 2008, Deep Down has restricted cash of $135,855 related to a letter
of credit for a vendor. See further details at Note 14 Commitments and
Contingencies.





Fair
Value of Financial Instruments





The
estimated fair value of Deep Down’s financial instruments is as follows at
December 31, 2008:





·
            Cash
      and equivalents, accounts receivable and accounts payable - the carrying
      amounts approximated fair value due to the short-term maturity of these
      instruments.·
            Long-term
      debt - the carrying value of Deep Down’s debt instruments closely
      approximates the fair value due to the recent date of the debt and that
      the line of credit portion has a LIBOR-based
  rate.





Accounts
Receivable





Deep Down
provides an allowance for doubtful accounts on trade receivables based on
historical collection experience, the level of past due accounts and a specific
review of each customer’s trade receivable balance with respect to their ability
to make payments and expectations of future conditions that could impact the
collectability of accounts receivable. When specific accounts are determined to
be uncollectable, they are expensed as bad debt expense in that period. At
December 31, 2008 and 2007, Deep Down estimated its allowance for doubtful
accounts to be $574,975 and $139,787, respectively. Bad debt expense totaled
$1,507,494 and $110,569 for the years ended December 31, 2008 and 2007,
respectively.





Concentration
of Credit Risk





Deep Down
maintains cash balances at several banks. Accounts at the institution are
insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. Deep
Down had approximately $932,000 of uninsured cash balances at December 31,
2008.





As of
December 31, 2008, four of Deep Down’s customers accounted for 20%, 11%, 9% and
4% of total accounts receivable, respectively. For the year ended December 31,
2008, Deep Down’s five largest customers accounted for 20%, 7%, 7%, 4% and 3% of
total revenues, respectively.





As of
December 31, 2007, four of Deep Down’s customers accounted for 11%, 9%, 7% and
7% of total accounts receivable, respectively.  For the year ended
December 31, 2007, Deep Down’s four largest customers accounted for 7%, 7%, 6%
and 6% of total revenues, respectively.


F-11
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Inventory
and Work in Progress





Inventory
is stated at lower of cost (first-in, first out) or net realizable
value.





December
      31, 2008
            
            
            December
      31, 2007Raw
      materials
            
            $
            789,815
            
            
            $
            -Finished
      goods
            
            
            145,928
            
            
            
            502,253Work
      in progress
            
            
            288,427
            
            
            
            -Total
      Inventory
            
            $
            1,224,170
            
            
            $
            502,253





Work in
progress at December 31, 2008 and 2007 not presented in inventory above,
represents costs that have been incurred for time and materials that are not
appropriate to be billed to customers at such date, according to the contractual
terms.  Some of our billings are contingent upon satisfaction of a
significant condition of sale (“milestone”), including but not limited to, FAT
and customer approval. Amounts at December 31, 2008 and 2007 were $137,940 and
$749,455, respectively.





Property
and Equipment





Property
and equipment are stated at cost, net of accumulated depreciation. Depreciation
and amortization is computed using the straight-line method over the estimated
useful lives of the respective assets. Buildings are depreciated between 10 and
36 years, and leasehold improvements are amortized over the shorter of the
assets' useful lives or lease terms. Equipment lives range from two to seven
years, computers and electronic lives are generally from two to four years, and
furniture and fixtures are two to seven years. Replacements and betterments
are capitalized, while maintenance and repairs are expensed as incurred. It is
Deep Down’s policy to include depreciation expense on assets acquired under
capital leases with depreciation expense on owned assets.





Goodwill
and Intangible Assets





Goodwill
represents the cost in excess of the fair value of net assets acquired in
business combinations. SFAS No. 142, “Goodwill and Other Intangible Assets”
(SFAS 142), prescribes the process for impairment testing of goodwill on an
annual basis or more often if a triggering event occurs. Goodwill is not
amortized, and there were no indicators of impairment at December 31,
2008.





Deep Down
evaluates the carrying value of goodwill during the fourth quarter of each year
and between annual evaluations if events occur or circumstances change that
would more likely than not reduce the fair value of the reporting unit below its
carrying amount. Such circumstances could include a significant adverse change
in legal factors or in business or the business climate or unanticipated
competition. When evaluating whether goodwill is impaired, Deep Down compares
the fair value of the business to its carrying amount, including goodwill. The
fair value of the reporting unit is estimated using an income, or discounted
cash flow approach. If the carrying amount of the business exceeds its fair
value, then the amount of the impairment loss must be measured. The impairment
loss would be calculated by comparing the implied fair value of reporting unit
goodwill to its carrying amount.





Deep
Down’s intangible assets, net of accumulated amortization consist of $18.1
million in specifically identified intangible assets acquired in the purchase of
the Flotation and Mako subsidiaries, including customer relationships,
non-compete covenants, trademarks and various technology rights.  We are
amortizing the intangible assets over their estimated useful lives on the
straight line basis between three and forty years.





Long-Lived
Assets





SFAS No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets," requires
that Deep Down periodically review the carrying amounts of its property and
equipment and its finite-lived intangible assets to determine whether current
events or circumstances indicate that such carrying amounts may not be
recoverable. The carrying amount of a long-lived asset is not recoverable if it
exceeds the sum of the undiscounted cash flows expected to result from the use
and eventual disposition of the asset. If it is determined that an impairment
loss has occurred, the loss is measured as the amount by which the carrying
amount of the long-lived asset exceeds its fair value.


F-12
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Lease
Obligations





Deep Down
leases land and buildings under noncancelable operating leases.  Deep
Down leases its Channelview, Texas, operating location for Delaware and
ElectroWave from an entity owned by the CEO and his wife, a Vice President and
Director, in addition to several vehicles, modular office buildings and
office equipment which are also recorded as operating leases and are
expensed.  Additionally, beginning in February 2009, Deep Down leases
its office headquarters in Houston, Texas, under a noncancellable operating
lease. Mako leases office, warehouse and operating space in Morgan City,
Louisana, under a noncancellable operating lease. Flotation entered into a
noncancellable operating lease for warehouse facilities in Biddeford, Maine, in
October 2008. Deep Down also leases a 100-ton mobile gantry crane under a
capital lease, which is included with Property and Equipment on the consolidated
balance sheet.





At the
inception of a lease, Deep Down evaluates each agreement to determine whether
the lease will be accounted for as an operating or capital lease. The term of
the lease used for such an evaluation includes renewal option periods only in
instances in which the exercise of the renewal option can be reasonably assured
and failure to exercise such option would result in an economic
penalty.





Deep Down
accounts for tenant incentives received from its landlords in connection with
certain of its operating leases as a deferred rent liability within lease
obligations and amortizes such amounts over the relevant lease term. For leases
that contain rent escalations, Deep Down records the total rent payable during
the lease term, as determined above, on a straight-line basis over the term of
the lease (including any “rent abatement” period beginning upon possession of
the premises), and records the difference between the minimum rents paid and the
straight-line rent as a lease obligation.





Revenue
Recognition





Deep
Down’s contract revenue is made up of customized product and service
revenue.  Revenue from fabrication and sale of equipment is recognized
upon transfer of title to the customer which is upon shipment or when
customer-specific acceptance requirements are met. Service revenue is recognized
as the service is provided.  Rental revenue is recognized pro-rata
over the rental period based on daily or monthly rates.  Shipping and
handling charges paid by Deep Down are included in cost of goods
sold.





From time
to time, Deep Down enters into large fixed price contracts which Deep Down
determines that recognizing revenues for these contracts were appropriate using
the percentage-of-completion method under Statement of Position 81-1,
“Accounting for Performance of Construction-Type and Certain Production-Type
Contracts” (“SOP 81-1”), measured by the percentage of costs incurred-to-date to
estimated total costs for the contract.  This method is preferred because
management considers the total cost to be the best available measure of progress
on the contracts.





Contract
costs include all direct material and labor costs and those indirect costs
related to contract performance, such as supplies, equipment repairs, employee
travel and supervisor time. Selling, general and administrative costs are
expensed as incurred.  Provisions for estimated losses on uncompleted
contracts (if any) are accrued in the same period as the estimated loss is
determined.  Changes in job performance, job conditions, and total contract
values may result in revisions to costs and income and are recognized in the
period in which the revisions are determined.  Change orders are accounted
for in revenue and cost when it is probable that the costs will be recovered. In
such circumstances where recovery is considered probable but the revenues cannot
be reliably estimated, costs attributable to change orders are deferred pending
re-negotiation of contract terms.





Costs and
estimated earnings in excess of billings on uncompleted contracts arise when
revenues are recorded on a percentage-of-completion basis but cannot be invoiced
under the terms of the contract. Such amounts are subsequently invoiced upon
satisfaction of contractual requirements or “milestones”. Billings in excess of
costs and estimated earnings on uncompleted contracts arise when milestone
billings are permissible under the contract, but the related costs have not yet
been incurred. All contract costs are recognized currently on jobs formally
approved by the customer and contracts are not shown as complete until
substantially all of the anticipated costs have been incurred and the items have
been shipped to the customer.





In
accordance with industry practice, assets and liabilities related to costs and
estimated earnings in excess of billings on uncompleted contracts, as well as
billings in excess of costs and estimated earnings on uncompleted contracts,
have been classified as current. The contract cycle for certain long-term
contracts may extend beyond one year, thus collection of amounts related to
these contracts may extend beyond one year.


F-13
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Income
Taxes





In
accordance with SFAS No. 109, Accounting for Income Taxes, the provision
for income taxes is computed using the asset and liability method, under which
deferred tax assets and liabilities are recognized for the expected future tax
consequences of temporary differences between the financial reporting and tax
bases of assets and liabilities, and for operating losses and tax credit
carryforwards. Deferred tax assets and liabilities are measured using the
currently enacted tax rates that apply to taxable income in effect for the years
in which those tax assets are expected to be realized or settled. The Company
records a valuation allowance to reduce deferred tax assets to the amount that
is believed more likely than not to be realized.





During
2008, Deep Down adopted the Financial Accounting Standards Board’s (“FASB”)
Financial Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income
Taxes—an interpretation of FASB Statement No. 109. FIN 48 changes the
accounting for uncertainty in income taxes by creating a new framework for how
companies should recognize, measure, present, and disclose uncertain tax
positions in their financial statements. Under FIN 48, Deep Down may recognize
the tax benefit from an uncertain tax position only if it is more likely than
not the tax position will be sustained on examination by the taxing authorities,
based on the technical merits of the position. The tax benefits recognized in
the financial statements from such positions are then measured based on the
largest benefit that has a greater than 50% likelihood of being realized upon
settlement. FIN 48 also provides guidance on the reversal of previously
recognized tax positions, balance sheet classifications, accounting for interest
and penalties associated with tax positions, and income tax disclosures. See
Note 12, “Income Taxes” for additional information, including the effects of
adoption on Deep Down’s consolidated financial statements.





Stock-Based
Compensation





Deep Down
accounts for stock-based compensation issued to employees and non-employees as
required by SFAS No. 123(R) “Share-based Payment” (“SFAS No. 123(R)”). Under
these provisions, Deep Down records an expense based on the fair value of the
awards utilizing the Black-Scholes pricing model for options and warrants. 
Additionally, Deep Down continues to use the simplified method related to
employee option grants as allowed by Staff Accounting Bulletin ("SAB") 110,
Share-Based Payment.





SFAS
No. 123(R) prohibits recognition of a deferred tax asset for an excess tax
benefit that has not been realized. The Company will recognize a benefit from
stock-based compensation in equity if an incremental tax benefit is realized by
following the ordering provisions of the tax law.





Earnings
(Loss) per Common Share




SFAS No. 128,
Earnings (Loss) Per Share(“EPS”) requires earnings (loss) per share to be calculated and
reported as both basic EPS and diluted EPS. Basic EPS is calculated by dividing
net income (loss) by the weighted average number of common shares outstanding
for the period. Diluted EPS is calculated by dividing net income by the weighted
average number of common shares and dilutive common stock equivalents
(convertible notes and interest on the notes, stock awards and stock options)
outstanding during the period. Dilutive EPS reflects the potential dilution that
could occur if options to purchase common stock were exercised for shares of
common stock. The following is a reconciliation of the number of shares
(denominator) used in the basic and diluted EPS computations:





For
      the Twelve Months EndedDecember
      31,2008
            
            
            2007Numerator:Net
      income (loss)
            
            $
            (4,322,893
            )
            
            $
            952,509Denominator:Weighted
      average shares outstanding
            
            
            142,906,616
            
            
            
            73,917,190Effect
      of dilutive securities
            
            
            -
            
            
            
            30,432,265Denominator
      for diluted earnings per share
            
            
            142,906,616
            
            
            
            104,349,455Basic
      earnings per share
            
            $
            (0.03
            )
            
            $
            0.01Diluted
      earnings per share
            
            $
            (0.03
            )
            
            $
            0.01





Potentially
dilutive securities representing 501,615 shares of common stock for the year
ended December 31, 2008 were excluded from the computation of diluted earnings
per share for this year because their effect would have been
anti-dilutive.


F-14
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Dividends





Deep Down
has no formal dividend policy or obligations. Under the terms of a $2 million
borrowing facility from Whitney National Bank signed on November 11, 2008, we
are restricted from paying cash dividends on our common stock, though the terms
do allow that we may from time to time make cash distributions to our
shareholders if no default exists prior to or after giving effect to any such
distribution. Deep Down intends to retain operating capital for the growth of
the company operations.





Advertising
costs:




Advertising
and promotion costs, which totaled $412,202 and $114,209 during the year ended
December 31, 2008 and 2007, respectively, are expensed as incurred.





Segment
information





For the
fiscal year ended December 31, 2008, the operations of Deep Down’s subsidiaries
have been aggregated into a single reporting segment under the provisions of
SFAS 131 “Disclosures about Segments of an Enterprise and Related Information”
(“SFAS 131”). We determined that the operating segments of Delaware,
ElectroWave, Mako and Flotation may be aggregated into a single reporting
segment because aggregation is consistent with the objective and basic
principles of paragraph 17 of SFAS 131. While the operating segments have
different product lines, they are very similar with regards to the five criteria
for aggregation. They are all service-based operations revolving around our
personnel’s expertise in the deep water industry, and any equipment is produced
to a customer specified design and engineered using Deep Down personnel’s
expertise, with installation as part of our service revenue to the customer.
Additionally, the segments have similar customers and distribution methods, and
their economic characteristics were similar with regard to their gross margin
percentages for the fiscal year ended December 31, 2008.





Recent
Accounting Pronouncements




In
September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No.
157”). SFAS No. 157 establishes a framework for measuring fair value under
generally accepted accounting procedures and expands disclosures on fair value
measurements. This statement applies under previously established valuation
pronouncements and does not require the changing of any fair value measurements,
though it may cause some valuation procedures to change. Under SFAS No. 157,
fair value is established by the price that would be received to sell the item
or the amount to be paid to transfer the liability of the asset as opposed to
the price to be paid for the asset or received to transfer the liability.
Further, it defines fair value as a market specific valuation as opposed to an
entity specific valuation, though the statement does recognize that there may be
instances when the low amount of market activity for a particular item or
liability may challenge an entity’s ability to establish a market amount. In the
instances that the item is restricted, this pronouncement states that the owner
of the asset or liability should take into consideration what affects the
restriction would have if viewed from the perspective of the buyer or assumer of
the liability. This statement is effective for all assets valued in financial
statements for fiscal years beginning after November 15, 2007. Deep Down adopted
SFAS 157 for financial assets and liabilities in 2008 with no material
impact to the consolidated financial statements but with additional required
consolidated financial statement footnote disclosures. Deep Down does not
anticipate the application of SFAS 157 to nonfinancial assets and
nonfinancial liabilities will have a material impact on its consolidated
financial statements.




In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business
Combinations (“SFAS No. 141(R)”) and No. 160, Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB No. 51 (“SFAS No. 160”).
SFAS No. 141(R) and SFAS No. 160 are products of a joint project between the
FASB and the International Accounting Standards Board.  The revised
standards continue the movement toward the greater use of fair values in
financial reporting. SFAS No. 141(R) will significantly change how business
acquisitions are accounted for and will impact financial statements both on the
acquisition date and in subsequent periods. These changes include the expensing
of acquisition related costs and restructuring costs when incurred, the
recognition of all assets, liabilities and noncontrolling interests at fair
value during a step-acquisition, and the recognition of contingent consideration
as of the acquisition date if it is more likely than not to be
incurred.  SFAS No. 160 will change the accounting and reporting for
minority interests, which will be recharacterized as noncontrolling interests
and classified as a component of equity.  SFAS No. 141(R) and SFAS No.
160 are effective for both public and private companies for fiscal years
beginning on or after December 15, 2008 (January 1, 2009 for companies with
calendar year-ends). SFAS No. 141(R) will be applied prospectively. SFAS No. 160
requires retroactive adoption of the presentation and disclosure requirements
for existing minority interests. All other requirements of SFAS No. 160 shall be
applied prospectively. Early adoption is prohibited for both
standards.  Deep Down will apply the requirements of SFAS No. 141(R)
to all business combinations after January 1, 2009. SFAS No. 160 will have no
impact on Deep Down’s financial statements as the Company has no minority
interests.


F-15
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


In
December 2007, the SEC staff issued SAB 110, Share-Based Payment, which
amends SAB 107, Share-Based Payment, to permit public companies, under certain
circumstances, to use the simplified method in SAB 107 for employee option
grants after December 31, 2007. Use of the simplified method after December 2007
is permitted only for companies whose historical data about their employees’
exercise behavior does not provide a reasonable basis for estimating the
expected term of the options. Deep Down did not have stock options outstanding
until 2007, thus does not have adequate historical data to determine option
lives. Therefore, Deep Down will continue to use the simplified method as
allowed under the provision of SAB 110.





In June
2008, EITF 07-5, “Determining whether an Instrument (or Embedded Feature) is
indexed to an Entity’s Own Stock” was issued. This standard triggers liability
accounting on all options and warrants exercisable at strike prices denominated
in any currency other than the Company’s functional currency. This Issue is
effective for financial statements issued for fiscal years beginning after
December 15, 2008, and interim periods within those fiscal years. Early
application is not permitted. Deep Down is currently evaluating the impact that
EITF 07-5 will have on its consolidated financial position or result of
operations.





In June
2008, FASB issued EITF Issue No. 08-4, “Transition Guidance for Conforming
Changes to Issue No. 98-5 (“EITF No. 08-4”)”. The objective of EITF No.08-4 is
to provide transition guidance for conforming changes made to EITF No. 98-5,
“Accounting for Convertible Securities with Beneficial Conversion Features or
Contingently Adjustable Conversion Ratios”, that result from EITF No. 00-27
“Application of Issue No. 98-5 to Certain Convertible Instruments”, and SFAS No.
150, “Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity”. This Issue is effective for financial statements issued
for fiscal years ending after December 15, 2008. Early application is permitted.
Management is currently evaluating the impact of adoption of EITF No.
08-4.





Note
2:          Costs and Estimated
Earnings in Excess of Billings on Uncompleted Contracts





The
components of costs and estimated earnings in excess of billings on
uncompleted contracts are summarized below:





December
      31, 2008
            
            
            December
      31, 2007Costs
      incurred on uncompleted contracts
            
            $
            2,114,714
            
            
            $
            -Estimated
      earnings
            
            
            4,969,444
            
            
            
            -7,084,158
            
            
            
            -Less:
      Billings to date
            
            
            8,691,464
            
            
            
            188,030$
            (1,607,306
            )
            
            $
            (188,030
            )Included
      in the accompanying consolidated balance sheets under the following
      captions:Costs
      and estimated earnings in excess of billings on uncompleted
      contracts
            
            
            707,737
            
            
            
            -Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
            
            
            (2,315,043
            )
            
            
            (188,030
            )$
            (1,607,306
            )
            
            $
            (188,030
            )





The asset
balance of $707,737 at December 31, 2008 is related to a large contract that was
completed during December 2008 except for the final documentation. This
retention amount is in accordance with applicable provisions of engineering and
construction contracts and became due upon completion of contractual
requirements in January 2009. Deep Down has recognized approximately 90% of the
related revenue based on the percentage-of-completion method. The billings in
excess of costs and estimated earnings on uncompleted contracts of $2,315,043 at
December 31, 2008 consists mainly of a deposit on a large job that will be
completed in fiscal year 2009.


F-16
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Note
3:          Acquisitions





Purchase
of Mako Technologies, Inc.




Effective
December 1, 2007, Deep Down purchased 100% of the common stock of Mako
Technologies, Inc. for $11,307,000.  Pursuant to the agreement and
plan of merger, two installments were paid to the Mako shareholders. The first
installment of $2,916,667 in cash and 6,574,074 restricted shares of common
stock of Deep Down, valued at $0.76 per share ($4,996,297), were paid on January
4, 2008. The second installment of 2,802,969 restricted shares of common stock
of Deep Down, valued at $0.70 per share ($1,962,090), was issued on March 28,
2008. The final cash payment of $1,243,571 which was paid on April 11, 2008, was
included in the “Payable to Mako shareholders” on the historical consolidated
balance sheets at December 31, 2007. The total purchase price of $11,307,000
included $188,369 of transaction expenses.




The first
payment to the shareholders of Mako was reflected on the accompanying
consolidated balance sheet as of December 31, 2007 due to the certainty of
payment and the intention of all the parties to complete this payment prior to
fiscal year end.  The second payment of $3,205,667 was reflected as a
payable to shareholders due to the timing of payments in the subsequent fiscal
year. The financing with Prospect was also reflected as of December 31, 2007
since the funds were generally used to pay the shareholders of Mako. The net
proceeds from Prospect of $5,604,000 are offset by the first cash payment to
shareholders of Mako of $2,916,667 resulting in a balance of $2,687,333
reflected as “Receivable from Prospect,” on the consolidated balance sheet at
December 31, 2007.




The
acquisition of Mako was accounted for using the purchase method of accounting in
accordance with SFAS 141, “Business Combinations” (“SFAS 141”) since Deep Down
acquired substantially all of the assets, certain liabilities, employees, and
business of Mako.




The
following table summarizes the estimated fair values of the assets acquired and
liabilities assumed at the date of acquisition:





Purchase
      of Mako:Cash
      and cash equivalents
            
            $
            280,841Accounts
      receivable
            
            
            1,411,420Construction
      in progress
            
            
            279,590Prepaid
      expenses
            
            
            179,583Property,
      plant and equipment, net
            
            
            2,994,382Intangibles
            
            
            4,371,000Goodwill
            
            
            5,354,840Total
      assets acquired
            
            $
            14,871,656Accounts
      payable and accrued expenses
            
            
            904,709Deferred
      tax liability
            
            
            1,840,563Long
      term debt
            
            
            819,384Total
      liabilities assumed
            
            $
            3,564,656Net
      assets acquired
            
            $
            11,307,000





Upon
finalization of final tax returns, Deep Down determined that $1,840,563 of the
purchase price was to be allocated to a deferred tax liability due to the
difference in the tax balance sheet and book balance sheet related to the
intangible and fixed assets.




The
allocation of the purchase price has been finalized upon the receipt of
management’s review of final amounts and final tax returns.


F-17
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Purchase of Flotation
Technologies, Inc.





On June
5, 2008, Deep Down completed the acquisition of Flotation, pursuant to the Stock
Purchase Agreement entered into on April 17, 2008. Deep Down purchased Flotation
from three individual shareholder members of the same family and purchased
related technology from an entity affiliated with the selling shareholders. Deep
Down assumed effective control and dated the acquisition for accounting purposes
on May 1, 2008. As such, the consolidated statement of operations include the
operating results of Flotation from May 1, 2008 to December 31,
2008.





The
acquisition of Flotation has been accounted for using the purchase method of
accounting in accordance with SFAS 141 since Deep Down acquired substantially
all of the assets, certain liabilities, employees, and business of
Flotation.





The
purchase price of Flotation was $23,941,554 and consisted of
$22,100,000 cash and 1,714,286 shares of common stock valued at $0.83 per
common share plus transaction costs of $296,904. In addition, warrants to
purchase 200,000 shares of common stock at $0.70 per share were issued to an
entity affiliated with the selling shareholders for the acquisition of the
related technology. The warrants are exercisable at any time from June 3, 2009
through September 3, 2011 and include piggyback registration rights with respect
to the underlying shares of common stock. Deep Down valued the warrants at
$121,793 based on the Black-Scholes option pricing model. The purchase price may
be adjusted upward or downward, dependant on certain working capital targets.
Both parties are in preliminary negotiations concerning this adjustment and as
of the current date, there has been no agreement as to the
adjustment.




Deep Down
sold 57,142,857 shares to accredited investors on June 5, 2008, for
approximately $37,000,000 in net proceeds, at a price of $0.70 per share. Deep
Down used $22,100,000 in proceeds from this private placement to fund the cash
requirement of the Flotation acquisition.




Deep Down
also issued 600,000 incentive common stock purchase options to employees of
Flotation for their continued services with an exercise price of $1.15 per
share. The employee options vest one-third of the original amount each year and
may be exercised in whole or in part after vesting. Deep Down valued the options
at $264,335 based on the Black-Scholes option pricing model, and will recognize
the related compensation cost ratably over the requisite service period and not
in the purchase price of the transaction.




The table
below reflects the composition of the purchase price as noted
above:




Summary of purchase price:Cash
            
            $
            22,100,000Certain
      transaction costs
            
            
            296,904Fair
      market value of common stock
            
            
            1,422,857Fair
      market value of warrants issued
            
            
            121,793Total
      purchase price
            
            $
            23,941,554




The
purchase price of $23,941,554 was in exchange for all of the outstanding capital
stock of Flotation. The acquisition price was allocated to the assets acquired
and liabilities assumed based upon their estimated fair values with the excess
being recorded in goodwill.  The following table summarizes the
estimated fair values of the assets acquired and liabilities assumed at the date
of acquisition on May 1, 2008:




Summary of net assets
      acquired:Cash
      and cash equivalents
            
            $
            235,040Accounts
      receivable
            
            
            2,105,519Construction
      in progress
            
            
            871,183Prepaid
      expenses
            
            
            15,904Property,
      plant and equipment, net
            
            
            4,907,752Intangibles
            
            
            14,797,000Goodwill
            
            
            2,141,469Total
      assets acquired
            
            $
            25,073,867Accounts
      payable and accrued liabilities
            
            
            1,132,313Total
      liabilities assumed
            
            $
            1,132,313Net
      assets acquired
            
            $
            23,941,554




F-18
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Deep Down
obtained an independent valuation of the assets and liabilities as of the
purchase date of May 1, 2008. Based on the independent valuation, the fair value
of the property, plant and equipment was increased by approximately $1,258,000
and will be depreciated over estimated useful lives of 3 to 40 years using the
straight-line method.




Deep Down
has estimated the fair value of Flotation’s identifiable intangible assets as
follows:





Estimated
      Fair Value
            
            Useful
      LifeTrademarks
            
            $                   2,039,000
            
            40Technology
            
            11,209,000
            
            25Non-compete
      covenant
            
            879,000
            
            3Customer
      relationship
            
            670,000
            
            25$                 14,797,000




The table
below reflects the assumptions used for warrant and option grants related to
Flotation during the year ended December 31, 2008:




Dividend
      yield
            
            0%Risk
      free interest rate
            
            2.52%
      - 2.84%Expected
      life of options
            2-3
      yearsExpected
      volatility
            
            51.7%
      - 61.3%




The
allocation of the purchase price was based on preliminary unaudited
estimates.  Estimates and assumptions are subject to change upon the
receipt of management’s review of audited final amounts and final tax returns.
This final evaluation of net assets acquired will be offset by a corresponding
change in goodwill and is expected to be complete within one year of the
purchase date.





Unaudited pro forma
condensed combined financial statements




The
unaudited pro forma combined condensed financial statements are presented for
informational purposes only and are not necessarily indicative of the results of
operations that actually would have been achieved had each acquisition been
consummated as of that time, nor are they intended to be a projection of future
results.




The
unaudited condensed combined pro forma results were as follows:


F-19
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007




Unaudited Pro Forma Combined Condensed Statements of
      OperationsFor
      the Year Ended December 31, 2008HistoricalFour
      Months
            
            
            
            
            
            
            
            
            CombinedApril
      30,
            
            
            Flotation
            
            
            
            
            
            Condensed2008
            
            
            Pro
      Forma
            
            
            
            
            
            Pro
      FormaDeep
      Down
            
            
            Flotation
            
            
            Entries
            
            
            
            
            
            ResultsRevenues
            
            $
            35,769,705
            
            
            $
            5,941,472
            
            
            $
            -
            
            
            
            
            
            $
            41,711,177Cost
      of sales
            
            
            21,686,033
            
            
            
            4,005,179
            
            
            
            -
            
            
            
            
            
            
            25,691,212Gross
      profit
            
            
            14,083,672
            
            
            
            1,936,293
            
            
            
            -
            
            
            
            
            
            
            16,019,965Total
      operating expenses
            
            
            15,575,519
            
            
            
            968,179
            
            
            
            302,416
            
            
            (d/e)
            
            
            
            16,846,114Operating
      income (loss)
            
            
            (1,491,847
            )
            
            
            968,114
            
            
            
            (302,416
            )
            
            
            
            
            
            
            (826,149
            )Total
      other expense
            
            
            (3,873,418
            )
            
            
            (57,335
            )
            
            
            -
            
            
            
            
            
            
            
            (3,930,753
            )Income
      (loss) fromcontinuing
      operations
            
            
            (5,365,265
            )
            
            
            910,779
            
            
            
            (302,416
            )
            
            
            
            
            
            
            (4,756,902
            )Benefit
      from (provision for) income taxes
            
            
            1,042,372
            
            
            
            -
            
            
            
            (225,094
            )
            
            (f)
            
            
            
            817,278Net
      income (loss)
            
            $
            (4,322,893
            )
            
            $
            910,779
            
            
            $
            (527,510
            )
            
            
            
            
            
            $
            (3,939,624
            )Basic
      earnings (loss) per share
            
            $
            (0.03
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            (0.02
            )Shares
      used in computingbasic
      per share amounts
            
            
            142,906,616
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            168,682,522Diluted
      earnings (loss) per share
            
            $
            (0.03
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            (0.02
            )Shares
      used in computingdiluted
      per share amounts
            
            
            142,906,616
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            168,682,522See
      accompanying notes to unaudited pro forma combined condensed financial
      statements.






The
historical results of Deep Down for the year ended December 31, 2008 contain
eight months of results for Flotation operations since its acquisition was
effective May 1, 2008, thus the four months ending April 30, 2008 are presented
as pro forma. The weighted-average shares of stock used in computing basic and
diluted per share amounts give effect to the 2,802,969 Mako shares issued on
March 28, 2008 and the total of 58,857,143 common shares of Deep Down issued in
June 2008, of which such amount 57,142,857 were issued in connection with the
Private Placement and 1,714,286 were issued to Flotation’s prior shareholders,
as if all these shares were issued January 1, 2008. Taxes are calculated on the
pro forma entries at Deep Down’s estimated combined effective rate of
37%.


F-20
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007




Unaudited Pro Forma Combined Condensed Statement of
      OperationsFor
      the Year Ended December 31, 2007HistoricalMakoDeep
      Down
            
            
            Eleven
            
            
            Flotation
            
            
            
            
            
            
            
            
            
            
            
            
            CombinedYear
      Ended
            
            
            Months
      Ended
            
            
            Year
      Ended
            
            
            Mako
            
            
            
            Flotation
            
            
            
            
            
            CondensedDecember
      31,
            
            
            November
      30,
            
            
            December
      31,
            
            
            Pro
      Forma
            
            
            
            Pro
      Forma
            
            
            
            
            
            Pro
      Forma2007
            
            
            2007
            
            
            2007
            
            
            Entries
            
            
            
            Entries
            
            
            
            
            
            ResultsRevenues
            
            $
            19,389,730
            
            
            $
            5,494,388
            
            
            $
            13,410,002
            
            
            $
            -
            
            
            
            $
            -
            
            
            
            
            
            $
            38,294,120Cost
      of sales
            
            
            13,306,086
            
            
            
            2,298,597
            
            
            
            8,117,600
            
            
            
            -
            
            
            
            
            -
            
            
            
            
            
            
            23,722,283Gross
      profit
            
            
            6,083,644
            
            
            
            3,195,791
            
            
            
            5,292,402
            
            
            
            -
            
            
            
            
            -
            
            
            
            
            
            
            14,571,837Total
      operating expenses
            
            
            4,425,800
            
            
            
            2,455,728
            
            
            
            2,001,047
            
            
            
            448,679
            
            (a)
            
            
            907,247
            
            
            (d/e)
            
            
            
            10,238,501Operating
      income (loss)
            
            
            1,657,844
            
            
            
            740,063
            
            
            
            3,291,355
            
            
            
            (448,679
            )
            
            
            
            (907,247
            )
            
            
            
            
            
            
            4,333,336Total
      other income (expense)
            
            
            (335,662
            )
            
            
            (65,702
            )
            
            
            766,477
            
            
            
            (1,059,573
            )
            (b)
            
            
            -
            
            
            
            
            
            
            
            (694,460
            )Income
      (loss) from continuing operations
            
            
            1,322,182
            
            
            
            674,361
            
            
            
            4,057,832
            
            
            
            (1,508,252
            )
            
            
            
            (907,247
            )
            
            
            
            
            
            
            3,638,876Benefit
      from (provision for) income taxes
            
            
            (369,673
            )
            
            
            (319,432
            )
            
            
            -
            
            
            
            558,053
            
            
            
            
            (1,165,716
            )
            
            (f)
            
            
            
            (1,296,768
            )Net
      income (loss)
            
            $
            952,509
            
            
            $
            354,929
            
            
            $
            4,057,832
            
            
            $
            (950,199
            )
            
            
            $
            (2,072,963
            )
            
            
            
            
            
            $
            2,342,108Basic
      earnings per share
            
            $
            0.01
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            0.02Shares
      used in computing basic per share amounts
            
            
            73,917,190
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (c/g)
            
            
            
            142,133,381Diluted
      earnings per share
            
            $
            0.01
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            0.01Shares
      used in computing diluted per share amounts
            
            
            104,349,455
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (c/g)
            
            
            
            172,565,646See
      accompanying notes to unaudited pro forma combined condensed financial
      statements.




The
Unaudited Pro Forma Combined Condensed Statements include the following pro
forma assumptions and entries for Mako (net of estimated taxes at Deep Down’s
estimated combined effective rate of 37%):




(a)
            Amortization
      of the intangible assets at a rate of $40,789 per month for the eleven
      months ended November 30, 2007. One month is included in the historical
      Deep Down total for the year ended December 31,
  2007.


(b)
            Represents
      cash interest plus amortization of deferred financing costs and debt
      discounts for the Credit Agreement.  Interest was payable at
      15.5% on the outstanding principal, and the related fees were amortized
      using the effective interest method over the four-year life of the
      loan.


(c)
            A
      total of 9,377,043 shares were issued for the total transaction. These pro
      forma amounts give effect as if shares were issued January 1,
      2007.




The
Unaudited Pro Forma Combined Condensed Statements include the following pro
forma assumptions and entries for Flotation:




(d)
            Recognition
      of stock based compensation from employee stock options issued in
      connection with the acquisition of Flotation. Deep Down estimated $7,343
      per month for the respective time
periods.


(e)
            Amortization
      of the intangible assets at a rate of $68,261 per month based on the
      remaining useful lives in the table
above.


(f)
            Represents
      estimated income tax accruals for the historical income plus all pro forma
      adjustments for the respective periods at Deep Down’s estimated combined
      effective rate of 37%. Flotation was an S-Corp, and as such did not accrue
      income taxes in its historical financial
  statements.


(g)
            A
      total of 58,857,143 common shares of Deep Down were issued; 57,142,857 in
      connection with the Private Placement, and 1,714,286 to Flotation
      shareholders. These pro forma amounts give effect as if shares were issued
      January 1, 2007.


F-21
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Note
4:          Property and
Equipment





Property
and equipment consisted of the following as of December 31, 2008 and
2007:





December
      31, 2008
            
            
            December
      31, 2007
            
            
            Useful
      LifeLand
            
            $
            461,955
            
            
            $
            -
            
            
            
            -Building
            
            
            3,201,301
            
            
            
            195,305
            
            
            7 -
      36 yearsLeasehold
      improvements
            
            
            344,485
            
            
            
            75,149
            
            
            2 -
      5 yearsFurniture
      and fixtures
            
            
            160,443
            
            
            
            63,777
            
            
            2 -
      7 yearsVehicles
      and trailers
            
            
            120,847
            
            
            
            112,161
            
            
            3 -
      5 yearsEquipment
            
            
            3,897,475
            
            
            
            1,809,474
            
            
            2 -
      10 yearsRental
      Equipment
            
            
            4,694,681
            
            
            
            3,144,559
            
            
            7 -
      10 yearsComputer
      and office equipment
            
            
            473,518
            
            
            
            194,693
            
            
            2 -
      5 yearsConstruction
      in progress
            
            
            2,130,068
            
            
            
            196,157Total
            
            
            15,484,773
            
            
            
            5,791,275Less:
      Accumulated depreciation
            
            
            (1,685,577
            )
            
            
            (422,314
            )Property
      and equipment, net
            
            $
            13,799,196
            
            
            $
            5,368,961





Depreciation
expense for the years ended December 31, 2008 and 2007 was $1,314,138 and
$398,611, respectively. Deep Down recorded $1,078,027 and $285,717,
respectively, of the total depreciation as Cost of Sales on the accompanying
statements of operations. Accumulated depreciation on equipment under capital
lease is $137,500 and $62,500 at December 31, 2008 and 2007,
respectively.





During
the year ended December 31, 2008, we leased additional property from JUMA, LLC,
a related party, and incurred $342,430 in leasehold improvements. See additional
discussion in Note 13 regarding the nature of the related party.





In
connection with the purchase of Flotation, Deep Down acquired land along with a
building and improvements with a fair market value of approximately $3,300,000.
This 3.61 acre site in Maine houses a 46,925 square foot light industrial
manufacturing facility.





On June
30, 2008, Deep Down transferred equipment with a cost basis of $502,253 from
inventory to its rental equipment fleet.





At
December 31, 2008, construction in progress represents assets that are not ready
for service or are in the construction stage. The balance includes
approximately $1,509,000 for a new ROV which was completed in January 2009. Deep
Down will begin depreciating these assets once they are put into
use.





Note
5:          Other
Assets





Other
assets consisted of the following as of December 31, 2008 and 2007:





December
      31, 2008
            
            
            December
      31, 2007Patents
            
            $
            174,434
            
            
            $
            5,172Capitalized
      R&D
            
            
            270,097
            
            
            
            270,097Deferred
      financing costs, net of amortization of $0 and $54,560
            
            
            -
            
            
            
            762,700Lease
      receivable, long term
            
            
            
            
            
            
            173,000Other
            
            
            13,305
            
            
            
            545Total
      other assets
            
            $
            457,836
            
            
            $
            1,211,514





See
further discussion of the deferred financing costs in Note 7 under the heading
Secured Credit Agreement.


F-22
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Note
6:          Intangible Assets
and Goodwill





Amounts
allocated to intangible assets are amortized on a straight-line basis over their
estimated useful lives. Deep Down is in the process of finalizing the valuations
of certain intangible assets related to the Flotation acquisition; consequently,
the initial allocations of the respective purchase price amounts are preliminary
and subject to change for a period of one year following the acquisition,
although management believes amounts are materially accurate as of December 31,
2008. Estimated intangible asset values, net of recognized amortization expense
include the following:





December
      31, 2008
            
            
            December
      31, 2007Estimated
            
            Gross
      Carrying
            
            
            Accumulated
            
            
            Net
      Carrying
            
            
            Gross
      Carrying
            
            
            Accumulated
            
            
            Net
      CarryingUseful
      Life
            
            Value
            
            
            Amortization
            
            
            Amount
            
            
            Value
            
            
            Amortization
            
            
            AmountCustomer
      relationship
            8-25
      Years
            
            $
            3,515,000
            
            
            $
            (403,131
            )
            
            $
            3,111,869
            
            
            $
            2,869,000
            
            
            $
            (11,157
            )
            
            $
            2,857,843Non-Compete
      Covenant
            3-5
      Years
            
            
            1,334,000
            
            
            
            (293,916
            )
            
            
            1,040,084
            
            
            
            458,000
            
            
            
            (7,633
            )
            
            
            450,367Trademarks
            25-40
      Years
            
            
            3,110,000
            
            
            
            (80,393
            )
            
            
            3,029,607
            
            
            
            1,071,000
            
            
            
            (9,563
            )
            
            
            1,061,437Technology
            25
      Years
            
            
            11,209,000
            
            
            
            (299,880
            )
            
            
            10,909,120
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            
            $
            19,168,000
            
            
            $
            (1,077,320
            )
            
            $
            18,090,680
            
            
            $
            4,398,000
            
            
            $
            (28,353
            )
            
            $
            4,369,647





Estimated
amortization expense for each of the five subsequent fiscal years is expected to
be:





Years
      ended December 31,:2009
            
            $
            1,308,5882010
            
            
            1,308,5882011
            
            
            1,113,2432012
            
            
            1,008,0172013
            
            
            924,588Thereafter
            
            
            12,427,656$
            18,090,680





The
following table presents goodwill as of the dates indicated, as well as changes
in the account during the period shown:





AmountCarrying
      amount as of December 31, 2007
            
            $
            10,594,144Goodwill
      acquired during the year
            
            
            4,430,156Carrying
      amount as of December 31, 2008
            
            $
            15,024,300





The
increases to goodwill include the adjustment to the Mako purchase price due to
the finalization of tax returns as discussed in Note 3 above. Deep Down
determined that approximately $1,840,000 of the purchase price was to be
allocated to a deferred tax liability due to the difference in the tax balance
sheet and book balance sheet related to the intangible and fixed
assets.


F-23
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Note
7:          Long-Term
Debt





At
December 31, 2008 and 2007 long-term debt consisted of the
following:




December
      31, 2008
            
            
            December
      31, 2007Bank
      term loan
            
            $
            1,150,000
            
            
            $
            -Secured
      credit agreement
            
            
            -
            
            
            
            12,000,000Debt
      discount, net of amortization of $0 and $135,931
    respectively
            
            
            -
            
            
            
            (1,703,258
            )Other
      bank loans
            
            
            15,087
            
            
            
            916,044Total
      secured credit agreements and bank debt
            
            
            1,165,087
            
            
            
            11,212,7866%
      Subordinated Debenture
            
            
            500,000
            
            
            
            -Capital
      lease obligation
            
            
            436,300
            
            
            
            481,209Total
      long-term debt
            
            
            2,101,387
            
            
            
            11,693,995Current
      portion of long-term debt
            
            
            (382,912
            )
            
            
            (995,177
            )Long-term
      debt, net of current portion
            
            $
            1,718,475
            
            
            $
            10,698,818





Revolving
Credit Line and Term Loan





On
November 11, 2008, Deep Down entered into a new Credit Agreement (the
“Revolver”) with Whitney National Bank (“Whitney Bank”) as lender. The Revolver
provides a commitment to lend to Deep Down of the lesser of $2,000,000 and 80%
of eligible receivables (generally defined as current due accounts receivables
in which the lender has a first priority security interest).  All of
the commitment under the Revolver is also available in commitments for the
lender to issue letters of credit for the benefit of Deep Down. Outstanding
amounts under the Revolver generally will bear interest at rates based on the
British Bankers Association LIBOR Rate for dollar deposits with a term of one
month plus an applicable rate of 2.00% to 3.00% based on the leverage ratio of
Deep Down.  Accrued interest under the Revolver is payable monthly.
Unused portions of the commitment generally accrue a commitment fee of 0.25% to
0.50% based on the leverage ratio of Deep Down and such fee is due and payable
by Deep Down quarterly.  The Revolver has a termination date of
November 11, 2010. At December 31, 2008, Deep Down has not drawn on any amounts
available under the Revolver.





On
December 18, 2008, Deep Down entered into an amendment to the Revolver, (the
“Term Loan”) with Whitney Bank and received an advance of $1,150,000 on that
date.  The Term Loan provides for a 3-year term loan with an annual
interest rate of 6.5%, and monthly principal and interest payments paid in
arrears of $35,246 per month beginning February 1, 2009, with a maturity of
December 18, 2011 (unless accelerated by default under terms of the Revolver).
Funds were used towards the purchase price of a new Super Mohawk 21 ROV for use
in Deep Down's operations, which was delivered in January 2009. This
Term Loan replaces the provision in the Revolver for a five-year term loan, and
is subject to the terms and conditions of the Revolver.





Each of
Deep Down’s subsidiaries has guaranteed the obligations of Deep Down under the
Revolver and as such, Deep Down’s obligations in connection with the Revolver
are secured by a first priority lien generally on all of their non real property
assets. The terms of the Revolver and the related loan documents subject Deep
Down to several covenants, including requirements to: provide security generally
on all of Deep Down's non real property assets, cause Deep Down’s
subsidiaries to provide guarantees, provide certain financial information to the
lender, give inspection rights to the lender, and apply insurance and eminent
domain proceeds to repayment of amounts outstanding under the
Revolver.  Furthermore, the terms of the Revolver impose restrictions
on the ability of Deep Down and its subsidiaries to incur further indebtedness
or liens, to make investments in other businesses, to pay dividends, to engage
in mergers, acquisitions or dispositions or other lines of businesses, to enter
into transactions with their affiliates, to prepay other indebtedness or to make
any change in their respective fiscal year or method of accounting (other than
changes as required by generally accepted accounting principles in the
U.S.).


F-24
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Under the
Revolver, Deep Down is required to meet certain covenants and
restrictions.  The financial covenants are reportable each quarter,
beginning with the quarter ending March 31, 2009.  Financial covenants
include maintaining total debt to consolidated EBITDA below 2.5
to 1, consolidated EBITDA to consolidated net interest expense and principal
payments on the total debt greater than 1.5 to 1, and tangible net worth in
excess of $20,000,000 as each term is defined in the Credit
Agreement. Other covenants include limitations on issuance of common stock,
liens, transactions with affiliates, additional indebtedness and permitted
investments, among others.





Secured
Credit Agreement




On August
6, 2007, Deep Down entered into a $6,500,000 secured credit agreement, (the
“Credit Agreement”) with Prospect Capital Corporation (“Prospect”) and received
an advance of $6,000,000 on that date.  The Credit Agreement provided
for a 4-year term, an annual interest rate of 15.5%, with the ability to defer
up to 3.0% of interest through a PIK (paid-in-kind) feature and principal
payments of $75,000 per quarter beginning September 30, 2008, with the remaining
balance outstanding due August 6, 2011. Interest payments were payable monthly,
in arrears, on each month-end commencing on August 31, 2007.





On
December 21, 2007, Deep Down entered into an amendment to the Credit
Agreement (the “Amendment”) to provide the funding for the cash portion of the
purchase of Mako. The total commitment available under the Amendment was
increased to $13,000,000. Amounts borrowed were $6,000,000 on the increased
line for a total of $12,000,000 outstanding. Quarterly principal payments
increased to $250,000 beginning September 30, 2008.





Terms of
the Credit Agreement also included a detachable warrant to purchase up to
4,960,585 shares of common stock at an exercise price of $0.507 per
share.  The warrant had a five-year term and became exercisable on the
earlier of the two-year anniversary of the original financing, or upon payment
in full of the outstanding balance. The relative fair value of the warrant
was estimated to be $1,479,189 based on the Black Scholes pricing model and was
recorded as a discount to the note. The assumptions used in the model
included (1) expected volatility of 52.7%, (2) expected term of 3.5 years, (3)
discount rate of 5% and (4) zero expected dividends.





Additionally,
in connection with the initial advance in August 2007 and the additional advance
under the Amendment, Deep Down pre-paid $180,000, respectively, in points to the
lender which were each treated as discounts to the note.





The
discounts associated with the value of the warrants and the cash-based expenses
were amortized into interest expense over the life of the Credit Agreement using
the effective interest rate method. A total of $1,703,258 and $135,931 of
debt discount was amortized into interest expense for the years ended December
31, 2008 and 2007, respectively. The fiscal year 2008 amount included
acceleration of the remaining balance due to early payoff of the debt as
discussed below.




Deep Down
capitalized a total of $555,314 in deferred financing costs related to the
original amounts borrowed under the Credit Agreement.  Of this amount,
$442,194 was paid in cash to various third parties related to the financing, and
the remainder of $113,120 represents the Black Scholes valuation of warrants
issued to one of these third party vendors.  The warrant is a
detachable warrant to purchase up to 320,000 shares of common stock at an
exercise price of $0.75 per share. The warrant has a five-year term and becomes
exercisable on the earlier of the two-year anniversary of the original
financing, or upon payment in full of the outstanding balance. The
assumptions used in the Black Scholes model included (1) expected volatility of
52.7%, (2) expected term of 3.5 years, (3) discount rate of 5% and (4) zero
expected dividends.





In
connection with the second advance under the Credit Agreement on January 4,
2008, Deep Down capitalized an additional $261,946 in deferred financing
costs. Of this amount, $216,000 was paid in cash to various third parties
related to the financing, and the remainder of $45,946 represents the
Black-Scholes valuation of warrants issued to one of these third party vendors.
The detachable warrant was granted to purchase up to 118,812 shares of common
stock at an exercise price of $1.01 per share.  The warrant had a
five-year term and is immediately exercisable. The fair value of the
warrant was estimated to be $45,946 based on the Black Scholes pricing model,
using the following assumptions: (1) expected volatility of 61.3%, (2) expected
term of 2.5 years, (3) discount rate of 3.2% and (4) zero expected
dividends.





The
deferred financing costs associated with the value of the warrants and the
cash-based expenses were amortized into interest expense over the life of the
Credit Agreement using the effective interest rate method.  A total of
$762,700 and $54,560 of deferred financing cost was amortized into interest
expense for the years ended December 31, 2008 and 2007, respectively. The fiscal
year 2008 amount included acceleration due to early payoff of the debt as
discussed below.


F-25
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Cash
interest paid for the years ended December 31, 2008 and 2007 was $821,500 and
$377,167, respectively. Deep Down paid the full 15.5% and did not exercise the
PIK feature for the monthly periods through June 2008 when the debt was paid in
full, see details below. Under the Credit Agreement, Deep Down
was required to meet certain covenants and restrictions as well as maintain
a debt service reserve account.  As of December 31, 2007, $375,000 was
classified as “Restricted cash” on the accompanying consolidated balance
sheets.





On June
12, 2008, Deep Down paid $12,492,912 to Prospect to pay off the balance
outstanding under the Credit Agreement and related interest and early
termination fees. In connection with the early payoff, Deep Down accelerated the
remaining deferred financing costs totaling $661,149 and recorded this charge as
interest expense. Additionally, $1,490,955 in debt discounts were accelerated
and recorded as interest expense. Early termination fees of $446,412 were
recognized as a loss on early extinguishment of debt. Since the warrants issued
in connection with the original Credit Agreement and the Amendment dated January
4, 2008 were detachable, there was no change to these equity instruments. On
July 3, 2008, Prospect exercised their outstanding 4,960,585 warrants in a
cashless exercise for a total of 2,618,129 shares of Deep Down common
stock.





Other
Bank Loans





In
December 2008, Deep Down entered into an auto loan with 36 monthly payments of
$454, including interest at 5.5%, beginning January 22, 2009 through December
22, 2011. The loan is collateralized by the vehicle purchased.





In
January 2008, in accordance with the terms of the purchase of Mako, Deep Down
paid $916,044 of notes payable plus accrued interest of $2,664. These notes were
payable to various banks, with interest rates between 7.85% and 8.3% and were
collateralized by Mako assets and life insurance policy.





Exchange
of Series E Redeemable Exchangeable Preferred Stock to 6% Subordinated
Debenture





On March
31, 2008, 500 shares of the Series E Redeemable Exchangeable Preferred Stock
were exchanged into a 6% Subordinated Debenture (the “Debenture”) in an
outstanding principal amount of $500,000.  The Debenture has a fixed
interest rate of 6% interest per annum to be paid annually on March 31st through
maturity on March 31, 2011. See the additional discussion of the terms of
the Series E preferred stock at Note 8. Interest expense on the Debenture of
$22,603 has been recognized and recorded as an accrued liability for the year
ended December 31, 2008.





Capital
lease





In
February 2007, Deep Down purchased under a seller-financed capital lease, a
100-ton mobile gantry crane and related equipment.  The equipment was
delivered and placed into service in March 2007.  In accordance with
SFAS 13 “Accounting for Leases” as amended, the lease was capitalized and the
lease obligation and related assets recognized on Deep Down’s consolidated
balance sheet.  The total value of the lease payments discounted at
an 11.2% interest rate, or $525,000, was capitalized.  The off-setting
lease obligation is $436,300 at December 31, 2008. See Note 14 regarding the
future minimum payments due on the capital lease.





Payment
table





Aggregate
principal maturities of long-term debt, excluding capital leases which are
detailed in Note 14, were as follows for years ended December 31:





Years
      ended December 31,:2009
            
            $
            332,7202010
            
            
            385,7472011
            
            
            911,5642012
            
            
            35,056$
            1,665,087




F-26
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Note
8:          Preferred
Stock





Series
D Redeemable Convertible Preferred Stock Classified as Temporary Equity
Instruments





During
the first quarter of fiscal year 2008, the outstanding 5,000 shares of
Series D redeemable convertible preferred stock (“Series D”) were converted into
25,866,518 shares of common stock.  The Series D had a face value and
liquidation preference of $1,000 per share, no dividend preference, and were
convertible into shares of common stock determined by dividing the face amount
by a conversion price of $0.1933.  The Series D had been valued at
inception at $4,419,244 based on the Black-Scholes fair value of the Series
D.





Series
E and G Classified as Liabilities





The
Series E and G redeemable exchangeable preferred stock (“Series E” and “Series
G”) had a face value and liquidation preference of $1,000 per share, no dividend
preference, and were exchangeable at the holder’s option into 6% Subordinated
Notes due three years from the date of the exchange. These shares carried voting
rights equal to 690 votes per share. The Series E and G preferred stock were
valued based on the discounted value of their expected future cash flows, using
a discount rate of 20%.  Deep Down evaluated the Series E and G
preferred stock and classified them as debt instruments from the date of
issuance due to the fact that they were exchangeable at the option of the holder
thereof into Notes.  The difference between the face value of the
Series E and G preferred stock and the discounted book value recorded on the
balance sheet, or original issue discount, was deemed to be non-cash interest
expense from the date of issuance through the term of the Stock.





Deep Down
was accreting this original issue discount using the effective interest
rate method.  Interest expense related to the accretion of the
original issue discount totaled $113,589 and $1,644,990 for the years ended
December 31, 2008 and 2007, respectively.





On March
31, 2008, 500 shares of the Series E preferred stock were exchanged into a 6%
Subordinated Debenture in an outstanding principal amount of
$500,000.  The Series E had a face value and liquidation preference of
$1,000 per share, no dividend preference, and were exchangeable at the holder’s
option into a 6% debenture due three years from the date of the exchange. Upon
exchange into the Debenture, Deep Down recorded $113,589 in interest expense for
the accretion of the Series E up to face value. See additional discussion of the
Subordinated Debenture in Note 7.





In
February 2007, Deep Down redeemed 250 shares of Series E preferred stock
held by its CEO at the face value of $1,000 per share for a total of
$250,000.  Deep Down accreted the remaining discount of $72,799
attributable to such shares on the date of redemption as interest
expense.





In May
2007, Deep Down executed a Securities Redemption Agreement with the former CFO
of Deep Down to redeem 4,000 shares of Series E preferred stock at a discounted
price of $500 per share for a total of $2,000,000.  The discount of
$500 per share from the face value of $1,000 was accounted for as a substantial
modification of debt, thereby generating a gain on extinguishment of debt which
is reflected in other income.  Deep Down accreted the remaining
discount of $1,017,707 attributable to such shares on the date of redemption as
interest expense.





On
September 13, 2007, Deep Down redeemed 2,250 shares of Series E preferred stock
owned by the CEO and director, and his wife, a Vice-President and director of
Deep Down.  The Series E preferred stock was redeemed for 2,250,000
shares of common stock at the closing price of $0.66 totaling
$1,473,750.  Since the shareholders are related parties, no accretion
interest was recorded related to the redemption.  The difference
between the carrying value of the Series E shares of $1,685,463 and the common
stock market value was recorded to Paid in Capital.





Additionally,
in October 2007, Deep Down redeemed 1,250 shares of Series E preferred
stock at the face value of $1,000 per share for a total of $1,250,000. The
Series E preferred shares were redeemed for 1,213,592 shares of common stock at
the closing price of $1.03.  Deep Down accreted the remaining discount of
$260,520 attributable to such shares on the date of redemption and recorded it
as interest expense.





All
Series G preferred shares were cancelled and exchanged during the first quarter
of 2007. Accordingly, there is no future discount accretion relating to the
Series G preferred shares.  See “Series F and G Cancellation and
Issuance of Additional Series E” below.


F-27
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Series
F and G Cancellation and Issuance of Additional Series E





On March
20, 2007, Deep Down finalized the terms of an agreement with a former
non-employee director who surrendered 25,000,000 shares of common stock for
$250,000 in cash. The market value of those shares was $7,250,000. Additionally,
he surrendered 1,500 shares of Series F convertible preferred stock with a value
of $1,325,773 and 500 shares of Series G exchangeable preferred stock with a
value of $357,615 to Deep Down for cancellation in exchange for 1,250 shares of
Series E exchangeable preferred stock valued at $945,563. The Series E Preferred
Stock was valued based on the discounted value of its expected future cash
flows, using a discount rate of 20%.  The difference between the
values of the preferred shares surrendered and the newly issued shares was
$737,826 which is reflected in paid in capital on the accompanying consolidated
balance sheet. In addition, he also kept 500 shares of Series E exchangeable
preferred stock he previously owned and agreed to tender his resignation from
the Board.




On March
20, 2007, Deep Down issued 2,000 shares of Series E exchangeable preferred stock
to John C. Siedhoff, then Chief Financial Officer, and director, valued at
$1,512,901 for the surrender of his ownership of 1,500 shares of Series F
convertible preferred stock valued at $1,325,773 and 500 shares of Series G
exchangeable preferred stock valued at $357,616, which were returned to the
transfer agent for cancellation.  The Series E Preferred Stock was
valued based on the discounted value of its expected future cash flows, using a
discount rate of 20%.  The difference between the values of the surrendered
shares and the newly issued shares was $170,489 which is reflected in paid in
capital on the accompanying consolidated balance sheet. Deep Down has treated
this as a modification of a share-based payment in accordance with the
provisions of SFAS No. 123R, “Share-Based Payments”.





Series
C Preferred Stock





The
Series C shares had a face value and a liquidation preference of $12.50 per
share, a cumulative dividend of 7% payable at the conversion date, and were
convertible into shares of common stock determined by dividing the face amount
by a conversion price of $0.0625. These shares carried no voting
rights.  All of the Series C shares were converted in the fourth
quarter of fiscal year 2007 to 4,400,000 shares of Deep Down’s common
stock.





Note
9:          Common
Stock





Private
Placement, fiscal year 2008




On June
5, 2008, Deep Down sold 57,142,857 shares of its common stock in a private
placement to accredited investors, for $40,000,000 at a per-share price of $0.70
(the “Private Placement”). After transaction costs, Deep Down had net proceeds
of $37,059,670. Dahlman Rose & Company, LLC acted as exclusive placement
agent for the equity financing.





Deep Down
used $22,100,000 of the net proceeds to fund the cash portion of the Flotation
purchase, and used $12,492,912 to repay outstanding debt, along with early
termination fees, to Prospect on June 12, 2008. Deep Down retained the remaining
net proceeds for working capital purposes.





Private
Placements, fiscal year 2007




On March
20, 2007, Deep Down completed the sale of 10,000,000 shares of common stock in a
private placement for $1,000,000. A total of 1,025,000 shares were purchased by
the CEO and director, and his wife, a Vice-President and director of
Deep Down. The shares are restricted securities as defined in Rule 144 of the
Securities Act of 1933 and contain a restrictive legend, which restricts the
ability of the holders to sell these shares for a period of no less than six
months. Funds from such private placement sale were used to redeem certain
outstanding exchangeable preferred stock and for working capital.





On
October 12, 2007, Deep Down closed an agreement with Ironman Energy Capital,
L.P. for a private placement of 3,125,000 shares of common stock at $0.96 per
share, or $3,000,000 in the aggregate, pursuant to an agreement reached on
October 2, 2007 when the closing price was $1.03 per share. In connection with
this private placement, the Deep Down entered into registration rights
agreement, under which, upon demand registration by the holder after December
31, 2008, Deep Down could be subject to liquidating damages in the amount of 1%
of the proceeds for every 30 days a registration statement is not declared
effective. Deep Down is currently evaluating the probability of incurring these
liquidated damages as a contingent liability and not yet determined the
potential impact on the financial statements.


F-28
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Other
stock issuances





On
September 13, 2007, Deep Down redeemed 2,250 shares of Series E preferred stock
owned by the Chief Executive Officer and director, and his wife, a
Vice-President of Deep Down.  The Series E preferred shares were
redeemed for 2,250,000 shares of common stock at the closing price of
$0.66.





During
the year ended December 31, 2007, we executed a Securities Redemption Agreement
with our former chief financial officer to redeem 4,000 shares of Series E
exchangeable preferred stock at a discounted price of $500 per share for a total
of $2,000,000.  In October 2007, Deep Down made the final payment of
$560,000 under the terms of this Securities Redemption Agreement by issuing
543,689 shares of common stock valued at the closing price of $1.03 on the same
day.





Note
10:         Stock-Based
Compensation





Deep Down
has a stock-based compensation plan - the 2003 Directors, Officers and
Consultants Stock Option, Stock Warrant and Stock Award Plan (the “Plan”). Deep
Down accounts for stock-based compensation expense under SFAS No. 123 (Revised
2004), “Share-based Payment,” (“SFAS No. 123(R)”). The exercise price of the
options, as well as the vesting period, is established by Deep Down’s Board of
Directors. The options granted under the Plan have vesting periods that range
from immediate vesting to vesting over five years, and the contract terms of the
options granted are up to ten years. Under the Plan, the total number of options
permitted is 15% of issued and outstanding common shares. During the year ended
December 31, 2008, Deep Down granted 4,200,000 options and 1,200,000 shares of
restricted stock, and cancelled 875,000 options subject to forfeitures under the
Plan. Based on the shares of common stock outstanding at December 31, 2008,
there were approximately 17,336,000 options available for grant under the Plan
as of that date.





In
December 2007, the SEC staff issued Staff Accounting Bulletin (“SAB”) 110,
Share-Based Payment, which amends SAB 107, Share-Based Payment, to permit public
companies, under certain circumstances, to use the simplified method in SAB 107
for employee option grants after December 31, 2007. Use of the simplified method
after December 2007 is permitted only for companies whose historical data about
their employees’ exercise behavior does not provide a reasonable basis for
estimating the expected term of the options. Deep Down did not have stock
options outstanding until fiscal year 2007, and has exercised a relatively small
amount of shares, and thus does not have adequate historical data to determine
option lives. Therefore, Deep Down will continue to use the simplified method as
allowed under the provision of SAB 110.





Shares
issued for Service





On
February 14, 2008, Deep Down issued 1,200,000 restricted shares to executives
and employees on February 14, 2008 which vest on February 14, 2010, provided
such respective recipient remains employed with Deep Down on such date. The
shares were valued at a price of $0.42 based on the closing price of common
stock on that date. The shares vest on the second anniversary of the grant date,
and Deep Down is amortizing the related stock-based compensation of $504,000
over the 2 year period. For the year ended December 31, 2008, Deep Down
recognized a total of $220,500 in stock-based compensation related to these
issued shares of restricted stock; the unamortized portion of the estimated fair
value of restricted stock is $283,500 at December 31, 2008.





The
following table summarizes Deep Down’s restricted stock activity for the year
ended December 31, 2008. The aggregate intrinsic value is based upon the closing
price of $0.16 of Deep Down’s common stock on December 31, 2008.





Restricted
              Shares
            
            
            Weighted-
      Average
              Grant
      Price
            
            
            Aggregate
              Intrinsic
      ValueOutstanding
      at December 31, 2007
            
            
            -Grants
            
            
            1,200,000
            
            
            $
            0.42Outstanding
      at December 31, 2008
            
            
            1,200,000
            
            
            $
            0.42
            
            
            $
            -




F-29
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Stock
Option Activity During 2008





During
the year ended December 31, 2008, Deep Down granted 4,200,000 options under the
Plan as detailed below. On June 17, 2008, Deep Down effected a cashless exercise
of 50,000 employee stock options for 29,339 net shares of common stock issued in
accordance with terms of the Plan.





During
the year ended December 31, 2008, Deep Down granted an aggregate of 350,000
stock options to various employees with exercise prices between $0.71 and $0.88,
reflecting the respective closing price on the applicable date of grant. The
fair value of such options was $114,737 based on the Black-Scholes option
pricing model. Additionally, Deep Down issued 600,000 stock options to employees
of Flotation in connection with that acquisition.





On
February 14, 2008, Deep Down issued an aggregate of 3,000,000 stock options to
Ronald E. Smith, Robert E. Chamberlain, and Eugene L. Butler, with an exercise
price per share of $1.50, which was in excess of the day’s closing price of
$0.42. The fair value of such options was $145,764 based on the Black-Scholes
option pricing model.





Additionally,
on January 22, 2008, Deep Down issued 250,000 stock options to an officer with
an exercise price of $0.70, the closing price of Deep Down’s common stock on
that date.  These options have since been forfeited due to the
officer’s departure in May 2008.





All of
the options issued during 2008 have terms for vesting at the rate of one third
of the total grant annually on the anniversary of their respective grant dates.
Since Deep Down does not have a sufficient trading history to determine the
volatility of its own stock, it based its estimates of volatility on a
representative peer group consisting of companies in the same industry, with
similar market capitalizations and similar stage of development.





Stock
Options Granted During 2007





During
the year ended December 31, 2007, Deep Down granted 5,500,000 options under
the Plan.  Deep Down issued an aggregate of 1,500,000 stock options to
various consultants, of which 300,000 were issued with an exercise price of
$0.30, $0.50, $0.75, $1.00, and $1.25, respectively.  Additionally,
Deep Down issued an aggregate of 1,000,000 stock options to various
employees with an exercise price of $0.50 and 3,000,000 stock options to an
officer and director with an exercise price of $0.515.





Summary
of Stock Options





Deep Down
is expensing all stock options on a straight line basis over the requisite
expected service periods. The total stock-based compensation expense
for stock options for the years ended December 31, 2008 and 2007, respectively,
was $584,009 and $187,394, respectively. The unamortized portion of the
estimated fair value of outstanding stock options is $718,912 at December 31,
2008.


F-30
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007
 The
following table summarizes Deep Down’s stock option activity for the year ended
December 31, 2008. The aggregate intrinsic value is based on the closing price
of $0.16 on December 31, 2008.





Shares
              Underlying
              Options
            
            
            Weighted-
              Average
              Exercise
      Price
            
            
            Weighted-
              Average
              Remaining
      Contractual Term
              (in
      years)
            
            
            Aggregate
              Intrinsic
      Value
              (In-The-Money)Outstanding
      at December 31, 2006
            
            
            -
            
            
            $
            -Grants
            
            
            5,500,000
            
            
            $
            0.58Outstanding
      at December 31, 2007
            
            
            5,500,000
            
            
            $
            0.58Grants
            
            
            4,200,000
            
            
            
            1.35Exercises
            
            
            (50,000
            )
            
            
            0.50Cancellations
      & Forfeitures
            
            
            (1,583,333
            )
            
            
            0.70Outstanding
      at December 31, 2008
            
            
            8,066,667
            
            
            $
            0.96
            
            
            
            2.3
            
            
            $
            -Exerciseable
      at December 31, 2008
            
            
            1,720,834
            
            
            $
            0.57
            
            
            
            1.6
            
            
            $
            -





The
following summarizes Deep Down’s outstanding options and their respective
exercise prices at December 31, 2008:




ExercisePrice
            
            
            Shares
              UnderlyingOptions$ 
      0.30 - 0.49
            
            
            
            100,000$ 
      0.50 - 0.69
            
            
            
            3,716,667$ 
      0.70 - 0.99
            
            
            
            450,000$ 
      1.00 - 1.29
            
            
            
            800,000$ 
      1.30 - 1.50
            
            
            
            3,000,0008,066,667





The fair
value of each stock option grant is estimated on the date of the grant using the
Black-Scholes model and is based on the following key assumptions for the year
ended December 31, 2008:





Dividend yield
            
            0%Risk
      free interest rate
            2.64%
      - 2.84%Expected
      life of options
            3
      yearsExpected
      volatility
            53.3%
      - 63.3%




Note
11:         Warrants





In
connection with the purchase of Flotation, Deep Down issued warrants to purchase
200,000 common shares at $0.70 per share to an entity affiliated with the
selling shareholders in consideration for the acquisition of related technology.
The warrants are exercisable at any time from June 3, 2009 through September 3,
2011 and include piggyback registration rights with respect to the underlying
shares of common stock.  Deep Down valued the warrants at $121,793
based on the Black Scholes option pricing model and included this value in the
purchase price allocation relating to Flotation.





On August
6, 2007, as part of the Credit Agreement with Prospect, described above in Note
7, Deep Down issued detachable warrants to purchase up to 4,960,585 shares
of common stock with an exercise price of $0.51, for a term of five years, with
vesting occurring on the earlier of the second anniversary of the agreement or
upon payment in full of the debt. On July 3, 2008, the holder of these warrants
exercised the warrants for a total of 2,618,129 shares of Deep Down’s common
stock in a cashless exercise.





Additionally,
as part of the Credit Agreement with Prospect, described above in Note 7, Deep
Down issued a detachable warrant to purchase up to 320,000 shares of common
stock at an exercise price of $0.75, for a term of five years, with vesting
occurring on the earlier of the second anniversary of the agreement or upon
payment in full of the debt. In connection with the second advance under the
Credit Agreement with Prospect, Deep Down granted a detachable warrant to
purchase up to 118,812 shares of common stock at an exercise price of $1.01 per
share.  This warrant has a five-year term and is immediately
exercisable.


F-31
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


A summary
of warrant transactions follows. The aggregate intrinsic value is based on the
closing price of $0.16 on December 31, 2008.





Shares
              Underlying
              Warrants
            
            
            Weighted-
              Average
              Exercise
      Price
            
            
            Weighted-
              Average
      Remaining
              Contractual
      Term
              (in
      years)
            
            
            Aggregate
              Intrinsic
      Value
              (In-The-Money)Outstanding
      at December 31, 2006
            
            
            -
            
            
            $
            -Grants
            
            
            5,399,397
            
            
            
            0.53Outstanding
      at December 31, 2007
            
            
            5,399,397
            
            
            
            0.53Grants
            
            
            200,000
            
            
            
            0.70Exercised
            
            
            (4,960,585
            )
            
            
            0.51Outstanding
      at December 31, 2008
            
            
            638,812
            
            
            $
            0.78
            
            
            
            4.0
            
            
            $
            -Exerciseable
      at December 31, 2008
            
            
            438,812
            
            
            $
            0.82
            
            
            
            4.0
            
            
            $
            -





The
following summarizes Deep Down’s outstanding warrants and their respective
exercise prices at December 31, 2008:





Exercise
      Price
            
            Shares
              Underlying
              Warrants$   0.70
      - 0.99
            
            520,000$             1.01
            
            118,812638,812





The fair
value of each warrant grant is estimated on the date of the grant using the
Black-Scholes model and is based on the following key assumptions for the years
ended December 31, 2008 and 2007:





December
      31, 2008
            
            December
      31, 2007Dividend yield
            
            0%
            
            0%Risk
      free interest rate
            2.52%
            
            3.18%
      - 5.0%Expected
      life of options
            2
      years
            
            2.5
      - 3.5 yearsExpected
      volatility
            51.70%
            
            52.7%
      - 61.3%





Note
12:         Income
Taxes





The
provision for income taxes on income from continuing operations is comprised of
the following for the years ended December 31, 2008 and 2007.  The
provision for income taxes differs from the amount computed by applying the U.S.
statutory income tax rate to income from continuing operations before income
taxes for the reasons set forth below for the years ended December 31, 2008 and
2007.




December
      31, 2008
            
            
            December
      31, 2007Federal:Current
            
            $
            (453,602
            )
            
            $
            402,619Deferred
            
            
            (855,703
            )
            
            
            (75,810
            )Total
      Federal
            
            $
            (1,309,305
            )
            
            $
            326,809State:Current
            
            $
            266,933
            
            
            $
            42,864Deferred
            
            
            -
            
            
            
            -Total
      State
            
            $
            266,933
            
            
            $
            42,864Total
      income tax expense (benefit)
            
            $
            (1,042,372
            )
            
            $
            369,673




F-32
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007





Year
      endedDecember
      31, 2008
            
            December
      31, 2007Income
      tax expense at federal statutory rate
            34.0%
            
            34.0%State
      taxes, net of federal expense
            
            -3.3%
            
            0.0%Deferred
      financing
            
            -7.6%
            
            0.0%Accretion
            
            -2.1%
            
            3.2%Other,
      net
            
            -1.4%
            
            -9.2%Total
      effective rate
            
            19.6%
            
            28.0%





Income
tax benefit was $1,042,372 for the year ended December 31, 2008 compared to
income tax expense of $369,673 for the previous year.





Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and
the amounts used for income tax purposes, as well as operating loss and tax
credit carry forwards.  The tax effects of the temporary differences and
carry forwards are as follows at December 31, 2008 and 2007:




December
      31, 2008
            
            
            December
      31, 2007Deferred
      tax assets:Allowance
      For Bad Debt
            
            $
            195,492
            
            
            $
            47,528Net
      Operating Loss
            
            
            1,060,998
            
            
            
            -Stock
      Compensation
            
            
            315,827
            
            
            
            117,264Section
      263 (a) Adjustment
            
            
            21,354
            
            
            
            -Depreciation
      on property and equipment
            
            
            -
            
            
            
            32,577Charitable
      Contributions
            
            
            54
            
            
            
            54Other
            
            
            -
            
            
            
            1,616Total
      deferred tax assets
            
            $
            1,593,725
            
            
            $
            199,039Deferred
      tax liabilities:Depreciation
      on property and equipment
            
            $
            (797,224
            )
            
            $
            -Intangible
      Amortization
            
            
            (1,389,720
            )
            
            $
            (5,965
            )Total
      deferred tax liabilities
            
            $
            (2,186,944
            )
            
            $
            (5,965
            )Less:
      valuation allowance
            
            
            (315,826
            )
            
            $
            (117,264
            )Net
      deferred tax assets (liabilities)
            
            $
            (909,045
            )
            
            $
            75,810




Deep Down
has $3,120,583 in net operating loss (“NOL”) carry forwards available to offset
future or prior taxable income.  These federal NOL’s will expire in 2028.
As of December 31, 2008, these NOL’s are not limited under Section
382.





Deep Down
has recorded a deferred tax liability of $1,840,563 for the temporary difference
arising from the intangible assets acquired in the Mako
transaction.





A
valuation allowance is established when it is more likely than not that some of
the deferred tax assets will not be realized.  Management analyzed its
current operating results and future projections and determined that a valuation
allowance was needed to the extent it applied to the future benefits related to
the stock based compensation.  A valuation allowance for the NOL and
other deferred tax assets was not needed at December 31, 2008, based on the more
likely than not threshold of the NOL’s being realized.





Note
13:         Related Party
Transactions




Deep Down
leases all buildings, structures, fixtures and other improvements at the
Channelview, Texas location from JUMA, LLC, a company owned by Ronald E. Smith,
President and CEO and a director of Deep Down and Mary L. Budrunas, a Vice
President and director of Deep Down. The base rate of $15,000 per month is
payable to JUMA, LLC through August 31, 2013, together with all costs of
maintaining, servicing, repairing and operating the premises, including
insurance, utilities and property taxes.





On March
28, 2008, Deep Down redeemed 4,500 shares of Series D preferred stock owned by
Ronald Smith and Mary Budrunas.  The Series D preferred shares were
redeemed for 23,279,876 shares of common stock.


F-33
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Note
14:         Commitments and
Contingencies





Litigation





Deep Down
is from time to time involved in legal proceedings arising from the normal
course of business. As of the date of this report, Deep Down is not currently
involved in any material legal proceedings except as noted below.





Deep Down
is currently in arbitration with the former stockholders of Flotation
Technologies, Inc. regarding the proper calculation of the “Cash Price
Adjustment” pursuant to the Stock Purchase Agreement by and between Deep Down,
Flotation Technologies, Inc. and its stockholders dated April 17, 2008. Any
purchase price adjustment will be allocated to the goodwill balance once the
preliminary estimates are finalized within the one year time frame.





In
connection with the Private Placement in June 2008, Deep Down filed an initial
Registration Statement on Form S-1 on July 21, 2008 to register the shares
issued. Pursuant to the Registration Rights Agreement, Deep Down was obligated
to have the Registration Statement declared effective by September 3, 2008, the
Required Effective Date, or the Company would be required to pay damages to the
purchasers in the Private Placement for each day following the Required
Effective Date, until but excluding the date the Commission declares the
Registration Statement effective. The Registration statement has not been
declared effective by the SEC. Deep Down has evaluated this obligation under the
Registration Rights Agreement for liability treatment under FASB
Statement No. 5,“Accounting for
Contingencies” (“SFAS 5”) and Financial Statement Staff Position (FSP) EITF
00-19(2) “Accounting for Registration Payment Arrangements” and determined that
the registration rights met the definition of a liability under the
authoritative guidance and has reserved $1,212,120 in potential damages under
terms of the Private Placement for the 90-day period September 4 to December 4,
2008. Deep Down obtained an opinion from legal counsel allowing removal of the
related stock’s restrictive legends, which was deemed to be equivalent and thus
satisfying the registration rights requirements.





Leases





Deep Down
leases certain offices, facilities, equipment and vehicles under noncancelable
operating and capital leases expiring at various dates through
2016.





At
December 31, 2008, future minimum contractual obligations were as
follows:





Years
      ended December 31,:
            
            Capital Leases
            
            
            Operating Leases2009
            
            $
            96,428
            
            
            $
            738,2642010
            
            
            96,428
            
            
            
            646,8712011
            
            
            96,428
            
            
            
            531,0332012
            
            
            96,428
            
            
            
            481,5312013
            
            
            96,428
            
            
            
            384,080Thereafter
            
            
            16,072
            
            
            
            376,131Total
      minimum lease payments
            
            $
            498,212
            
            
            $
            3,157,910Residual
      principal balance
            
            
            105,000Amount
      representing interest
            
            
            (166,912
            )Present
      value of minimum lease payments
            
            $
            436,300Less
      current maturities of capital lease obligations
            
            
            50,192Long-term
      contractal obligations
            
            $
            386,108




Rent
expense totaled $525,627 and $186,866 for the years ended December 31, 2008 and
2007, respectively.


F-34
 Notes
to Consolidated Financial Statements for the Years ended December 31, 2008 and
2007


Letters
of Credit





Certain
customers require us to post a bank letter of credit guarantee. These letters of
credit assure our creditors that we will perform under terms of our contract and
with associated vendors and subcontractors. In the event of default, the
creditor may demand payment from the bank under a letter of credit. To date,
there have been no significant expenses related to letters of credit for the
periods reported. We were contingently liable for secured and unsecured letters
of credit of $135,000 as of December 31, 2008, which is offset by restricted
cash in the same amount.





In
December 2008, Deep Down amended the credit agreement with Whitney Bank as more
fully described in Note 7. The credit agreement provides for letters of credit,
which Deep Down executed a letter of credit with a customer for $1,107,456
subsequent to December 31, 2008. See further discussion at Note 15.





Additionally,
Deep Down has a letter of credit in the amount of $135,855 representing a
performance guarantee that was filed with the planning office of the City of
Biddeford, Maine related to improvements planned to the Flotation site. The
offsetting restricted cash is reflected on the balance sheet.





Note
15:         Subsequent
Events





Deep
Down’s credit agreement with Whitney Bank provides for letters of credit, which
Deep Down executed an irrevocable transferrable standby letter of credit with a
customer for $1,107,456 on February 10, 2009. The letter of credit was executed
as a guarantee of performance by Deep Down and its subsidiaries on a contract,
allows partial and multiple drawings, and expires August 31, 2009 with an
automatic one-year extension period unless cancelled 90 days in advance of the
expiration date.





Amendment
to credit agreement and new loan agreement





On March
5, 2009, Deep Down’s wholly owned subsidiary, Flotation, obtained loan proceeds
in the principal amount of approximately $1,840,000 pursuant to a loan agreement
Flotation and Deep Down entered into with TD Bank, N.A. (“TD Bank”) as of
February 13, 2009.  This loan agreement provides a further commitment
to Flotation for advancement of principal in the amount of $320,000. Loans under
the loan agreement are generally secured by Flotation’s operational premises in
Biddeford, Maine under a mortgage and security agreement and a collateral
assignment of leases and rents.  In connection with the loan
agreement, TD Bank required that Deep Down enter into a debt subordination
agreement that subordinated any debt Flotation owes to Deep Down other than
accounts payable between them arising in the ordinary course of
business.  Furthermore, as part of the loan agreement TD Bank required
a “negative pledge” that prohibits Flotation and Deep Down from granting
security interests in Flotation’s personal property, other than such security
interests granted in respect of Deep Down’s primary facility for borrowed money
(as currently held with Whitney Bank). Deep Down is obligated to repay proceeds
funded on March 5, 2009 based on a schedule of monthly installments of
approximately $13,000, with an initial payment on March 13, 2009 and a final
payment of all remaining outstanding and unpaid principal and accrued interest
in February 2016.  However, upon advancement of any portion of the
$320,000 additional principal amount available under the loan agreement, TD Bank
will recalculate the monthly installments to an amount that will fully amortize
the then outstanding principal balance over a 20-year amortization
schedule.





In
connection with such loan for Flotation, Deep Down entered into a second
amendment of its existing credit facility with Whitney Bank to permit such loan
and the security and other arrangements relating to Flotation’s loan
agreement.  The terms of the second amendment also included a
guarantor’s consent and agreement, to be signed by each of Deep Down’s
subsidiaries as guarantors of the obligations of Deep Down under such existing
credit facility, that Whitney Bank required as a condition to the effectiveness
of the second amendment. Additionally, Whitney Bank required that Deep Down
International Holdings, LLC, a Nevada limited liability company and wholly owned
subsidiary of Deep Down formed in February 2009, enter into joinder agreements
for the guaranty and security agreement arrangements generally required of Deep
Down’s subsidiaries under the existing credit facility. Deep Down International
Holdings, LLC currently has no material assets or operations.








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