**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q/AAmendment No. 1**

 

**(Mark One)**

 
| **ý** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|--------------------------------------------------------------------------------------------------------|

 

**For the quarterly period ended June 30,2005**

 

**OR**

 
| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|---------------------------------------------------------------------------------------------------------|

 

**For the transition period from                    to                    **

 

**Commission File Number 000-30819**

 

**Particle DrillingTechnologies, Inc.**

(Exact name of registrant asspecified in its charter)

 
| **Nevada**(State or other  jurisdiction of incorporation or   organization) | ** ** | **20-1563395**   (I.R.S. Employer Identification No.) |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------------|

 

**1021 Main Street, Suite 2650**

**Houston, Texas 77002**(Address of principal executive offices)(Zip Code)

 

**713-223-3031**

(Registrant’s telephone number, includingarea code)

 

**808 Travis, Suite 850**

**Houston, Texas 77002**

(Former name, former address and formerfiscal year, if changed since last report)

 

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

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes  o  No  ý

 

Thenumber of shares of the registrant’s common stock, $.001 par value, outstandingas of August 12, 2005 was 24,393,094.

 

 

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**PARTICLE DRILLINGTECHNOLOGIES, INC.**

**(adevelopment stage enterprise)**

 

**FORM 10-Q/AFOR THE QUARTER ENDED JUNE 30, 2005**

 

**INDEX**

 
| **Explanatory  Note**                    | ** **                                                                                        |
|------------------------------------------|---------------------------------------------------------------------------------------------------|
| ** **                               | ** **                                                                                        |
| **Part I  - Financial Information** | ** **                                                                                        |
|                                     |                                                                                              |   |
| Item 1.                                  | Financial Statements  (Unaudited)                                                                 | 3 |
|                                     |                                                                                              |   |
|                                     | Consolidated Balance Sheets at June 30,  2005 (Unaudited) and September 30, 2004        | 3 |
|                                     |                                                                                              |   |
|                                     | Consolidated Statements of  Operations (Unaudited) - Three Months and Nine Months Ended           | 4 |
|                                     | June 30, 2005 and 2004  and from June 9, 2003 (date of inception) to June 30, 2005 |   |
|                                     |                                                                                              |   |
|                                     | Consolidated Statements of  Cash Flows (Unaudited) - Nine Months Ended                            | 5 |
|                                     | June 30, 2005 and 2004  and from June 9, 2003 (date of inception) to June 30, 2005 |   |
|                                     |                                                                                              |   |
|                                     | Notes to Consolidated  Financial Statements (Unaudited)                                           | 6 |
|                                     |                                                                                              |   |
| Item  2.                                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations       | 16 |
|                                     |                                                                                              |   |
| Item  3.                                 | Quantitative  and Qualitative Disclosures about Market Risk                                       | 23 |
|                                     |                                                                                              |   |
| Item  4.                                 | Controls  and Procedures                                                                          | 23 |
|                                     |                                                                                              |   |
| **Part II - Other Information**     | **24**                                                                                            |
|                                     |                                                                                              |   |
| Item 6.                                  | Exhibits                                                                                          | 24 |
|                                     |                                                                                              |   |
|                                     | Signatures                                                                                        | 25 |

 

1

----

 

 

**EXPLANATORY NOTE**

 

ThisAmendment No. 1 on Form 10-Q/A amends and restates certain disclosure items inour quarterly report on Form 10-Q for the quarter ended June 30, 2005, which weoriginally filed on August 15, 2005.  

 

On February 7, 2006, the Company receivedcomments from the Staff of the Securities and Exchange Commission (“SEC”) toits annual report on Form 10-K for the year ended September 30, 2005.  In connection with the receipt of thesecomments, the Company determined that its policy for recording equitycompensation was inconsistent with the guidance set forth under Statements ofFinancial Accounting Standards (“SFAS”) No. 123(R).  Historically, the Company has calculated thecompensation expense associated with equity awards using the Black-Scholesmodel and amortized that expense over the service period as the equity awardsvest, commencing with the first vesting dates of the awards.  To fully comply with the guidance set forthin SFAS No. 123(R), the Company is now recording such expense on a straightline basis over the relevant service periods, commencing with the dates ofgrant of the awards.  On February 9,2006, following an analysis of the impact of this error on the Company’spreviously released financial statements, the Audit Committee of the Company’sBoard of Directors determined that it was necessary to restate the financialstatements contained in the Company’s original annual report on Form 10-K forthe year ended September 30, 2005 and the Company’s quarterly report on Form10-Q for the period ended June 30, 2005.

Accordingly,this quarterly report on form 10-Q/A includes our restated financial statementsfor the three months and nine months ended June 30, 2005, and for the periodfrom June 9, 2003 (date of inception) to June 30, 2005 with accompanying notes.

 

Exceptfor the foregoing restated information, this quarterly report on form 10-Q/Acontinues to describe conditions as of the date of the original filing and wehave not updated the disclosures contained herein to reflect events thatoccurred at a later date.  Other eventsoccurring after the original filing or other disclosures necessary to reflectsubsequent events have been addressed in reports filed with the SEC subsequentto the date of the original filing.

 

Thisquarterly report on Form 10-Q/A sets forth the original filing in its entirety;however, as a result of the restatement of the Company’s financial statementsdescribed above, this quarterly report on Form 10-Q/A only amends or restatesthe unaudited consolidated financial statements and accompanying notes in Item1 of Part I of the original filing, the disclosures in Items 2 and 4 of Part Iof the original filing to reflect the restatement described above.  In each case, the amendment or restatementwas made solely as a result of the items discussed in Note 2 of the unauditedconsolidated financial statements, and no other information in the originalfiling is amended hereby.  In addition,we have included as exhibits to this amendment new certifications of our ChiefExecutive Officer and Chief Financial Officer. 

 

 

2

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**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                            | ** ** | **(Restated)  June 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **2005**                      | ** ** | **2004**               | ** ** |
| ** **                                                                                                                                                                                            | ** ** | **(Unaudited)**               | ** ** | ** **             | ** ** |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| **ASSETS**                                                                                                                                                                                            |       |                          |       |                   |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Current  assets:                                                                                                                                                                                      |       |                          |       |                   |       |
| Cash and  cash equivalents                                                                                                                                                                            |       | $                             | 11,786,046 |                   | $          | 20,363 |   |
| Accounts  receivable - related party                                                                                                                                                                  |       | 9,316                         |       | —                 |       |
| Prepaid  expenses                                                                                                                                                                                     |       | 89,929                        |       | 110,535                |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Total  current assets                                                                                                                                                                                 |       | 11,885,291                    |       | 130,898                |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Property,  plant & equipment, net                                                                                                                                                            |       | 1,244,745                     |       | 451,825                |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Intangibles,  net                                                                                                                                                                                     |       | 980,435                       |       | 982,612                |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Other assets                                                                                                                                                                                          |       | 391,089                       |       | 5,250                  |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Total assets                                                                                                                                                                                          |       | $                             | 14,501,560 |                   | $          | 1,570,585 |   |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                        |       |                          |       |                   |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Current  liabilities:                                                                                                                                                                                 |       |                          |       |                   |       |
| Accounts  payable                                                                                                                                                                                     |       | $                             | 326,829    |                   | $          | 864,177 |   |
| Short-term  notes payable                                                                                                                                                                             |       | 40,000                        |       | 340,304                |       |
| Current  portion of long-term debt                                                                                                                                                                    |       | 10,566                        |       | 10,891                 |       |
| Accrued  expenses                                                                                                                                                                                     |       | 225,918                       |       | 216,553                |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Total  current liabilities                                                                                                                                                                            |       | 603,313                       |       | 1,431,925              |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Long-term  debt                                                                                                                                                                                       |       | 12,187                        |       | 20,201                 |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Commitments  and Contingencies - Note 9                                                                                                                                                               |       |                          |       |                   |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Stockholders’  equity:                                                                                                                                                                           |       |                          |       |                   |       |
| Common  stock, $.001 par value, 100,000,000 shares authorized, 27,393,094 issued and  24,393,094 outstanding at June 30, 2005, and 18,095,447 issued and  outstanding at September 30, 2004 |       | 27,393                        |       | 18,095                 |       |
| Additional  paid-in capital                                                                                                                                                                           |       | 22,906,599                    |       | 3,974,148              |       |
| Treasury  stock at cost, 3,000,000 shares and -0- shares at June 30, 2005 and September 30,  2004, respectively                                                                             |       | (1,500,000                    | )          | —                 |       |
| Deficit  accumulated during the development stage                                                                                                                                                     |       | (7,547,932                    | )          | (3,873,784             | )          |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Total  stockholders’ equity                                                                                                                                                                      |       | 13,886,060                    |       | 118,459                |       |
|                                                                                                                                                                                                  |       |                          |       |                   |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                      |       | $                             | 14,501,560 |                   | $          | 1,570,585 |   |

 

The accompanying notes are anintegral part of these statements.

 

3

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**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                               | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** **        | ** ** | ** ** | ** ** | **Period from**       | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|-------------------|------------|------------|------------|-----------------------|------------|
| ** **                                                               | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** **        | ** ** | ** ** | ** ** | **June 9, 2003** | ** ** |
| ** **                                                               | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** **        | ** ** | ** ** | ** ** | **(date of**          | ** ** |
| ** **                                                               | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** **        | ** ** | ** ** | ** ** | **inception) to**     | ** ** |
| ** **                                                               | ** ** | **Three Months Ended June 30,** | ** ** | **Nine Months Ended June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                               | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005**          | ** ** | **2004**   | ** ** | **2005**              | ** ** |
| ** **                                                               | ** ** | **(Restated)**                       | ** ** | ** **                          | ** ** | **(Restated)**    | ** ** | ** ** | ** ** | **(Restated)**        | ** ** |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Revenues                                                                 |       | $                                    | —     |                                | $          | —            |       | $          | —     |                  | $          | — |   | $ | — |   |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Operating  expenses:                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Research and  development                                                |       | 731,054                              |       | 152,444                             |       | 1,721,457         |       | 276,865    |       | 2,382,835             |       |
| General and  administrative                                              |       | 984,863                              |       | 1,091,969                           |       | 2,098,850         |       | 2,194,251  |       | 5,285,032             |       |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Total  operating expenses                                                |       | 1,715,917                            |       | 1,244,413                           |       | 3,820,307         |       | 2,471,116  |       | 7,667,867             |       |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Loss from  operations                                                    |       | (1,715,917                           | )          | (1,244,413                          | )          | (3,820,307        | )          | (2,471,116 | )          | (7,667,867            | )          |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Other income  (expenses)                                                 |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Interest  income                                                         |       | 80,725                               |       | —                              |       | 126,102           |       | —     |       | 126,102               |       |
| Rental  income                                                           |       | 3,880                                |       | —                              |       | 3,880             |       | —     |       | 3,880                 |       |
| Gain on debt  extinguishment                                             |       | —                               |       | —                              |       | 26,990            |       | —     |       | 26,990                |       |
| Interest  expense                                                        |       | (361                                 | )          | (10,230                             | )          | (10,813           | )          | (17,692    | )          | (37,037               | )          |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Total other  income (expenses)                                           |       | 84,244                               |       | (10,230                             | )          | 146,159           |       | (17,692    | )          | 119,935               |       |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Net loss                                                                 |       | $                                    | (1,631,673 | )                                   | $          | (1,254,643        | )          | $          | (3,674,148 | )                     | $          | (2,488,808 | ) | $ | (7,547,932 | ) |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Net loss per  common share,  basic and diluted                           |       | $                                    | (0.07      | )                                   | $          | (0.10             | )          | $          | (0.17      | )                     | $          | (0.21 | ) | $ | (1.04 | ) |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
|                                                                     |       |                                 |       |                                |       |              |       |       |       |                  |       |
| Weighted  average number of common shares outstanding, basic and diluted |       | 24,312,819                           |       | 12,563,072                          |       | 21,385,891        |       | 11,808,866 |       | 7,226,995             |       |

 

Theaccompanying notes are an integral part of these statements.

 

4

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**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                   | ** ** | ** **                          | ** ** | ** **        | ** ** | **Period from**       | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                   | ** ** | ** **                          | ** ** | ** **        | ** ** | **June 9, 2003** | ** ** |
| ** **                                                                   | ** ** | ** **                          | ** ** | ** **        | ** ** | **(date of**          | ** ** |
| ** **                                                                   | ** ** | ** **                          | ** ** | ** **        | ** ** | **inception) to**     | ** ** |
| ** **                                                                   | ** ** | **Nine Months Ended June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                   | ** ** | **2005**                            | ** ** | **2004**          | ** ** | **2005**              | ** ** |
| ** **                                                                   | ** ** | **(Restated)**                      | ** ** | ** **        | ** ** | **(Restated)**        | ** ** |
| ** **                                                                   | ** ** | ** **                          | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash flows  from operating activities:                                       |       |                                |       |              |       |                  |       |
| Net loss                                                                     |       | $                                   | (3,674,148 | )                 | $          | (2,488,808            | )          | $ | (7,547,932 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                |       |              |       |                  |       |
| Gain on debt  extinguishment                                                 |       | (26,990                             | )          | —            |       | (26,990               | )          |
| Depreciation  and amortization expense                                       |       | 244,598                             |       | 90,427            |       | 392,009               |       |
| Short-term  note issued for services                                         |       | —                              |       | 44,000            |       | 44,000                |       |
| Common stock  issued for services                                            |       | (66,500                             | )          | 968,000           |       | 931,500               |       |
| Warrants  issued for services                                                |       | 57,999                              |       | 5,830             |       | 63,829                |       |
| Stock-based  employee compensation                                           |       | 302,583                             |       | 50,814            |       | 353,397               |       |
| Changes in  operating assets and liabilities:                                |       |                                |       |              |       |                  |       |
| Increase in  accounts receivable                                             |       | —                              |       | (6,410            | )          | —                |       |
| Increase in  accounts receivable - related party                             |       | (9,316                              | )          | —            |       | (9,316                | )          |
| (Increase)  decrease in prepaid expenses                                     |       | 20,606                              |       | —            |       | (28,939               | )          |
| Decrease in  other current assets                                            |       | —                              |       | 7,500             |       | —                |       |
| Increase  (decrease) in accounts payable                                     |       | (516,868                            | )          | 133,250           |       | (21,402               | )          |
| Increase  (decrease) in accrued liabilities                                  |       | 9,365                               |       | (10,261           | )          | 225,918               |       |
|                                                                         |       |                                |       |              |       |                  |       |
| Net cash  used in operating activities                                       |       | (3,658,671                          | )          | (1,205,658        | )          | (5,623,926            | )          |
|                                                                         |       |                                |       |              |       |                  |       |
| Cash flows  from investing activities:                                       |       |                                |       |              |       |                  |       |
| Payments to  purchase property and equipment                                 |       | (999,651                            | )          | (1,983            | )          | (1,016,206            | )          |
| Proceeds  from sale of property and equipment                                |       | —                              |       | 6,982             |       | 20,957                |       |
| Payments to  purchase intangibles                                            |       | (35,690                             | )          | (154,192          | )          | (295,853              | )          |
| Payments to  purchase other assets                                           |       | (385,839                            | )          | —            |       | (391,089              | )          |
| Payments  issued for note receivable                                         |       | —                              |       | (24,447           | )          | (300,783              | )          |
| Payments  issued for note receivable - related party                         |       | —                              |       | (56,783           | )          | (56,783               | )          |
|                                                                         |       |                                |       |              |       |                  |       |
| Net cash  used in investing activities                                       |       | (1,421,180                          | )          | (230,423          | )          | (2,039,757            | )          |
|                                                                         |       |                                |       |              |       |                  |       |
| Cash flows  from financing activities:                                       |       |                                |       |              |       |                  |       |
| Proceeds  from issuance of common stock                                      |       | 18,647,666                          |       | 1,028,697         |       | 20,975,766            |       |
| Purchases of  treasury stock                                                 |       | (1,500,000                          | )          | —            |       | (1,500,000            | )          |
| Proceeds  from issuance of convertible notes                                 |       | —                              |       | 553,500           |       | 553,500               |       |
| Repayments  of notes payable                                                 |       | (302,132                            | )          | (123,013          | )          | (579,537              | )          |
| Proceeds  from borrowings under loan agreements - related parties            |       | —                              |       | —            |       | 23,195                |       |
| Repayment of  borrowings under loan agreements - related parties             |       | —                              |       | (23,195           | )          | (23,195               | )          |
|                                                                         |       |                                |       |              |       |                  |       |
| Net cash  provided by financing activities                                   |       | 16,845,534                          |       | 1,435,989         |       | 19,449,729            |       |
|                                                                         |       |                                |       |              |       |                  |       |
| Net increase  in cash and cash equivalents                                   |       | 11,765,683                          |       | (92               | )          | 11,786,046            |       |
|                                                                         |       |                                |       |              |       |                  |       |
| Cash and  cash equivalents - beginning of period                             |       | 20,363                              |       | 3,502             |       | —                |       |
|                                                                         |       |                                |       |              |       |                  |       |
| Cash and  cash equivalents - end of period                                   |       | $                                   | 11,786,046 |              | $          | 3,410                 |       | $ | 11,786,046 |   |
|                                                                         |       |                                |       |              |       |                  |       |
| Supplemental  disclosures of cash flow information:                          |       |                                |       |              |       |                  |       |
| Cash paid  for interest                                                      |       | $                                   | 12,339     |              | $          | 16,023                |       | $ | 37,037 |   |
|                                                                         |       |                                |       |              |       |                  |       |
| Non-cash  investing and financing activities:                                |       |                                |       |              |       |                  |       |
| Prepaid  insurance acquired with note payable                                |       | $                                   | —     |              | $          | —                |       | $ | 60,990 |   |
| Common stock  issued as consideration for account payable                    |       | —                              |       | 6,000             |       | 6,000                 |       |
| Common stock  issued as consideration for note payable                       |       | —                              |       | 50,000            |       | 50,000                |       |
| Related  party note receivable exchanged for property and equipment          |       | —                              |       | —            |       | 56,783                |       |
| Note payable  converted into common stock                                    |       | —                              |       | 553,500           |       | 553,500               |       |
| Property and  equipment acquired with assumed liabilities                    |       | —                              |       | 479,610           |       | 479,610               |       |
| Intangibles  acquired with assumed liabilities                               |       | —                              |       | 757,792           |       | 757,792               |       |

 

Theaccompanying notes are an integral part of these statements.

 

5

----

 

**PARTICLE DRILLINGTECHNOLOGIES, INC.**

**(a development stage enterprise)**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

**1. BASIS OF PRESENTATION**

 

Theaccompanying unaudited consolidated financial statements, which include the accountsof Particle Drilling Technologies, Inc. (the “Company” or “PDTI”) andits subsidiary, have been prepared in accordance with generally acceptedaccounting principles in the United States of America (“US GAAP”) and pursuantto the rules and regulations of the Securities and ExchangeCommission.  Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with US GAAP have beencondensed or omitted in accordance with such rules and regulations. The information furnished in the interim condensed consolidated financialstatements includes normal recurring adjustments and reflects all adjustments,which in the opinion of management are necessary for a fair presentation ofsuch financial statements.  Although management believes the disclosuresand information presented are adequate to make the information not misleading,these interim condensed consolidated financial statements should be read inconjunction with the Company’s September 30, 2004 audited consolidatedfinancial statements and notes thereto.  Operating results for the threemonths and nine months ended June 30, 2005 are not necessarily indicativeof the results that may be expected for the year ending September 30,2005.

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting periods.  Actual results could differ from these estimates.

 

Certainreclassifications have been made to conform prior period amounts to the currentperiod presentation.  Thesereclassifications had no effect on net loss, earnings per share, orstockholders’ equity.

 

**2.****RESTATEMENT OF FINANCIALSTATEMENTS**

** **

The historical information for the three months andnine months ended June 30, 2005, and for the period from June 9, 2003 (date ofinception) to June 30, 2005, have been restated after determining that theCompany’s policy of recording stock-based employee compensation upon vesting ofthe underlying equity award was inconsistent with the guidelines set forthunder Statements of Financial Accounting Standards (“SFAS”) No. 123(R), *Share-Based Payment*. 

 

OnFebruary 7, 2006, the Company received comments from the Staff of theSecurities and Exchange Commission (“SEC”) to its annual report on Form 10-Kfor the year ended September 30, 2005. In connection with the receipt of these comments, the Company determinedthat its policy for recording equity compensation was inconsistent with theguidance set forth under SFAS No. 123(R). Historically, the Company has calculated the compensation expenseassociated with equity awards using the Black-Scholes model and amortized thatexpense over the service period as the equity awards vest, commencing with thefirst vesting dates of the awards.  Tofully comply with the guidance set forth in SFAS No. 123(R), the Company is nowrecording such expense on a straight line basis over the relevant serviceperiods, commencing with the dates of grant of the awards.  On February 9, 2006, following an analysis ofthe impact of this error on the Company’s previously released financialstatements, the Audit Committee of the Company’s Board of Directors determinedthat it was necessary to restate the financial statements contained in theCompany’s original annual report on Form 10-K for the year ended September 30,2005 and the Company’s quarterly report on Form 10-Q for the period ended June30, 2005.

 

As aresult of the restatement, net loss for the three and nine month periods endedJune 30, 2005, and for the period from June 9, 2003 (date of inception) to June30, 2005 was increased by $125,033.

 

6

----

 

Thefollowing are the restated financial statements for the third quarter of fiscal2005 compared to the previously reported amounts:

 

**RESTATEDCONSOLIDATED BALANCE SHEETAS OF JUNE 30, 2005(UNAUDITED)**

 
| ** **                                                                                                                                                                                                       | ** ** | **As Reported** | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| **ASSETS**                                                                                                                                                                                                       |       |            |       |            |       |         |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Current assets:                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Cash and cash equivalents                                                                                                                                                                                        |       | $               | 11,786,046 |            | $          | —       |       | $ | 11,786,046 |   |
| Accounts receivable—related party                                                                                                                                                                           |       | 9,316           |       | —          |       | 9,316        |       |
| Prepaid expenses                                                                                                                                                                                                 |       | 89,929          |       | —          |       | 89,929       |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Total current assets                                                                                                                                                                                             |       | 11,885,291      |       | —          |       | 11,885,291   |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Property,  plant & equipment, net                                                                                                                                                                            |       | 1,244,745       |       | —          |       | 1,244,745    |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Intangibles,  net                                                                                                                                                                                                |       | 980,435         |       | —          |       | 980,435      |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Other assets                                                                                                                                                                                                     |       | 391,089         |       | —          |       | 391,089      |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Total assets                                                                                                                                                                                                     |       | $               | 14,501,560 |            | $          | —       |       | $ | 14,501,560 |   |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| **LIABILITIES AND STOCKHOLDERS' EQUITY**                                                                                                                                                                         |       |            |       |            |       |         |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Current  liabilities:                                                                                                                                                                                            |       |            |       |            |       |         |       |
| Accounts payable                                                                                                                                                                                                 |       | $               | 326,829    |            | $          | —       |       | $ | 326,829 |   |
| Short-term notes payable                                                                                                                                                                                         |       | 40,000          |       | —          |       | 40,000       |       |
| Current portion of long-term debt                                                                                                                                                                                |       | 10,566          |       | —          |       | 10,566       |       |
| Accrued expenses                                                                                                                                                                                                 |       | 225,918         |       | —          |       | 225,918      |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Total current liabilities                                                                                                                                                                                        |       | 603,313         |       | —          |       | 603,313      |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Long-term  debt                                                                                                                                                                                                  |       | 12,187          |       | —          |       | 12,187       |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Commitments  and Contingencies                                                                                                                                                                                   |       |            |       |            |       |         |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Stockholders'  equity:                                                                                                                                                                                           |       |            |       |            |       |         |       |
| Common stock, $.001 par value, 100,000,000  shares authorized, 27,393,094 shares issued and 24,393,094 shares outstanding  at June 30, 2005, and 18,095,447 shares issued and outstanding at September  30, 2004 |       | 27,393          |       | —          |       | 27,393       |       |
| Additional paid-in capital                                                                                                                                                                                       |       | 22,781,566      |       | 125,033         |       | 22,906,599   |       |
| Treasury stock at cost, 3,000,000 shares  and -0- shares at June 30, 2005 and September 30, 2004, respectively                                                                                                   |       | (1,500,000      | )          | —          |       | (1,500,000   | )          |
| Deficit accumulated during the development  stage                                                                                                                                                                |       | (7,422,899      | )          | (125,033        | )          | (7,547,932   | )          |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Total stockholders' equity                                                                                                                                                                                       |       | 13,886,060      |       | —          |       | 13,886,060   |       |
|                                                                                                                                                                                                             |       |            |       |            |       |         |       |
| Total liabilities and stockholders' equity                                                                                                                                                                       |       | $               | 14,501,560 |            | $          | —       |       | $ | 14,501,560 |   |

 

 

7

----

 

**RESTATEDCONSOLIDATED STATEMENT OF OPERATIONSFOR THE THREE MONTHS ENDED JUNE 30, 2005(UNAUDITED)**

 
| ** **                                                                   | ** ** | **As Reported** | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| Revenues                                                                     |       | $               | —     |            | $          | —       |       | $ | — |   |
|                                                                         |       |            |       |            |       |         |       |
| Operating  expenses:                                                         |       |            |       |            |       |         |       |
| Research and development                                                     |       | 731,054         |       | —          |       | 731,054      |       |
| General and administrative                                                   |       | 859,830         |       | 125,033         |       | 984,863      |       |
|                                                                         |       |            |       |            |       |         |       |
| Total operating expenses                                                     |       | 1,590,884       |       | 125,033         |       | 1,715,917    |       |
|                                                                         |       |            |       |            |       |         |       |
| Loss from operations                                                         |       | (1,590,884      | )          | (125,033        | )          | (1,715,917   | )          |
|                                                                         |       |            |       |            |       |         |       |
| Other income  (expenses)                                                     |       |            |       |            |       |         |       |
| Interest income                                                              |       | 80,725          |       | —          |       | 80,725       |       |
| Rental income—related party                                             |       | 3,880           |       | —          |       | 3,880        |       |
| Gain on debt extinguishment                                                  |       | -               |       | —          |       | —       |       |
| Interest expense                                                             |       | (361            | )          | —          |       | (361         | )          |
|                                                                         |       |            |       |            |       |         |       |
| Total other income (expenses)                                                |       | 84,244          |       | —          |       | 84,244       |       |
|                                                                         |       |            |       |            |       |         |       |
| Net loss                                                                     |       | $               | (1,506,640 | )               | $          | (125,033     | )          | $ | (1,631,673 | ) |
|                                                                         |       |            |       |            |       |         |       |
| Net loss per common share, basic and  diluted                                |       | $               | (0.06      | )               | $          | (0.01        | )          | $ | (0.07 | ) |
|                                                                         |       |            |       |            |       |         |       |
| Weighted average number of common shares  outstanding—basic and diluted |       | 24,312,819      |       | —          |       | 24,312,819   |       |

 

 

8

----

 

**RESTATEDCONSOLIDATED STATEMENT OF OPERATIONSFOR THE NINE MONTHS ENDED JUNE 30, 2005(UNAUDITED)**

** **
| ** **                                                                   | ** ** | **As Reported** | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| Revenues                                                                     |       | $               | —     |            | $          | —       |       | $ | — |   |
|                                                                         |       |            |       |            |       |         |       |
| Operating  expenses:                                                         |       |            |       |            |       |         |       |
| Research and development                                                     |       | 1,721,457       |       | -               |       | 1,721,457    |       |
| General and administrative                                                   |       | 1,973,817       |       | 125,033         |       | 2,098,850    |       |
|                                                                         |       |            |       |            |       |         |       |
| Total operating expenses                                                     |       | 3,695,274       |       | 125,033         |       | 3,820,307    |       |
|                                                                         |       |            |       |            |       |         |       |
| Loss from operations                                                         |       | (3,695,274      | )          | (125,033        | )          | (3,820,307   | )          |
|                                                                         |       |            |       |            |       |         |       |
| Other income  (expenses)                                                     |       |            |       |            |       |         |       |
| Interest income                                                              |       | 126,102         |       | —          |       | 126,102      |       |
| Rental income—related party                                             |       | 3,880           |       | —          |       | 3,880        |       |
| Gain on debt extinguishment                                                  |       | 26,990          |       | —          |       | 26,990       |       |
| Interest expense                                                             |       | (10,813         | )          | —          |       | (10,813      | )          |
|                                                                         |       |            |       |            |       |         |       |
| Total other income (expenses)                                                |       | 146,159         |       | —          |       | 146,159      |       |
|                                                                         |       |            |       |            |       |         |       |
| Net loss                                                                     |       | $               | (3,549,115 | )               | $          | (125,033     | )          | $ | (3,674,148 | ) |
|                                                                         |       |            |       |            |       |         |       |
| Net loss per common share, basic and  diluted                                |       | $               | (0.17      | )               | $          | —       |       | $ | (0.17 | ) |
|                                                                         |       |            |       |            |       |         |       |
| Weighted average number of common shares  outstanding—basic and diluted |       | 21,385,891      |       | —          |       | 21,385,891   |       |

** **

 

9

----

 

**RESTATEDCONSOLIDATED STATEMENT OF OPERATIONSFOR THE PERIOD FROM JUNE 9, 2003 (DATE OF INCEPTION)TO JUNE 30, 2005(UNAUDITED)**

 
| ** **                                                                   | ** ** | **As Reported** | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| Revenues                                                                     |       | $               | —     |            | $          | —       |       | $ | — |   |
|                                                                         |       |            |       |            |       |         |       |
| Operating  expenses:                                                         |       |            |       |            |       |         |       |
| Research and development                                                     |       | 2,382,835       |       | —          |       | 2,382,835    |       |
| General and administrative                                                   |       | 5,159,999       |       | 125,033         |       | 5,285,032    |       |
|                                                                         |       |            |       |            |       |         |       |
| Total operating expenses                                                     |       | 7,542,834       |       | 125,033         |       | 7,667,867    |       |
|                                                                         |       |            |       |            |       |         |       |
| Loss from operations                                                         |       | (7,542,834      | )          | (125,033        | )          | (7,667,867   | )          |
|                                                                         |       |            |       |            |       |         |       |
| Other income  (expenses)                                                     |       |            |       |            |       |         |       |
| Interest income                                                              |       | 126,102         |       | —          |       | 126,102      |       |
| Rental income—related party                                             |       | 3,880           |       | —          |       | 3,880        |       |
| Gain on debt extinguishment                                                  |       | 26,990          |       | —          |       | 26,990       |       |
| Interest expense                                                             |       | (37,037         | )          | —          |       | (37,037      | )          |
|                                                                         |       |            |       |            |       |         |       |
| Total other income (expenses)                                                |       | 119,935         |       | —          |       | 119,935      |       |
|                                                                         |       |            |       |            |       |         |       |
| Net loss                                                                     |       | $               | (7,422,899 | )               | $          | (125,033     | )          | $ | (7,547,932 | ) |
|                                                                         |       |            |       |            |       |         |       |
| Net loss per common share, basic and  diluted                                |       | $               | (1.03      | )               | $          | (0.01        | )          | $ | (1.04 | ) |
|                                                                         |       |            |       |            |       |         |       |
| Weighted average number of common shares  outstanding—basic and diluted |       | 7,226,995       |       | —          |       | 7,226,995    |       |

 

 

10

----

 

**RESTATEDCONSOLIDATED STATEMENT OF CASH FLOWSFOR THE NINE MONTHS ENDED JUNE 30, 2005(UNAUDITED)**

 
| ** **                                                                   | ** ** | **As Reported** | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| Cash flows  from operating activities:                                       |       |            |       |            |       |         |       |
| Net loss                                                                     |       | $               | (3,549,115 | )               | $          | (125,033     | )          | $ | (3,674,148 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |            |       |            |       |         |       |
| Gain on debt extinguishment                                                  |       | (26,990         | )          | —          |       | (26,990      | )          |
| Depreciation and amortization expense                                        |       | 244,598         |       | —          |       | 244,598      |       |
| Short-term note issued for services                                          |       | —          |       | —          |       | —       |       |
| Common stock issued for services                                             |       | (66,500         | )          | —          |       | (66,500      | )          |
| Warrants issued for services                                                 |       | 57,999          |       | —          |       | 57,999       |       |
| Stock-based employee compensation                                            |       | 177,550         |       | 125,033         |       | 302,583      |       |
| Changes in operating assets and  liabilities:                                |       |            |       |            |       |         |       |
| Increase in accounts receivable                                              |       | —          |       | —          |       | —       |       |
| Increase in accounts receivable—related  party                          |       | (9,316          | )          | —          |       | (9,316       | )          |
| (Increase) decrease in prepaid expenses                                      |       | 20,606          |       | —          |       | 20,606       |       |
| Decrease in other current assets                                             |       | —          |       | —          |       | —       |       |
| Increase (decrease) in accounts payable                                      |       | (516,868        | )          | —          |       | (516,868     | )          |
| Increase (decrease) in accrued liabilities                                   |       | 9,365           |       | —          |       | 9,365        |       |
|                                                                         |       |            |       |            |       |         |       |
| Net cash used in operating activities                                        |       | (3,658,671      | )          | —          |       | (3,658,671   | )          |
|                                                                         |       |            |       |            |       |         |       |
| Cash flows  from investing activities:                                       |       |            |       |            |       |         |       |
| Payments to purchase property and equipment                                  |       | (999,651        | )          | —          |       | (999,651     | )          |
| Proceeds from sale of property and  equipment                                |       | —          |       | —          |       | —       |       |
| Payments to purchase intangibles                                             |       | (35,690         | )          | —          |       | (35,690      | )          |
| Payments to purchase other assets                                            |       | (385,839        | )          | —          |       | (385,839     | )          |
| Payments issued for note receivable                                          |       | —          |       | —          |       | —       |       |
| Payments issued for note receivable—related  party                      |       | —          |       | —          |       | —       |       |
|                                                                         |       |            |       |            |       |         |       |
| Net cash used in investing activities                                        |       | (1,421,180      | )          | —          |       | (1,421,180   | )          |
|                                                                         |       |            |       |            |       |         |       |
| Cash flows  from financing activities:                                       |       |            |       |            |       |         |       |
| Proceeds from issuance of common stock                                       |       | 18,647,666      |       | —          |       | 18,647,666   |       |
| Purchases of common stock                                                    |       | (1,500,000      | )          | —          |       | (1,500,000   | )          |
| Proceeds from issuance of convertible notes                                  |       | —          |       | —          |       | —       |       |
| Repayments of notes payable                                                  |       | (302,132        | )          | —          |       | (302,132     | )          |
| Proceeds from borrowings under loan  agreements—related parties         |       | —          |       | —          |       | —       |       |
| Repayment of borrowings under loan  agreements—related parties          |       | —          |       | —          |       | —       |       |
|                                                                         |       |            |       |            |       |         |       |
| Net cash provided by financing activities                                    |       | 16,845,534      |       | —          |       | 16,845,534   |       |
|                                                                         |       |            |       |            |       |         |       |
| Net increase  in cash and cash equivalents                                   |       | 11,765,683      |       | —          |       | 11,765,683   |       |
|                                                                         |       |            |       |            |       |         |       |
| Cash and  cash equivalents—beginning of period                          |       | 20,363          |       | —          |       | 20,363       |       |
|                                                                         |       |            |       |            |       |         |       |
| Cash and  cash equivalents—end of period                                |       | $               | 11,786,046 |            | $          | —       |       | $ | 11,786,046 |   |
|                                                                         |       |            |       |            |       |         |       |
| Supplemental  disclosures of cash flow information:                          |       |            |       |            |       |         |       |
| Cash paid for interest                                                       |       | $               | 12,339     |            | $          | —       |       | $ | 12,339 |   |
|                                                                         |       |            |       |            |       |         |       |
| Non-cash  investing and financing activities:                                |       |            |       |            |       |         |       |
| Prepaid insurance acquired with note  payable                                |       | $               | —     |            | $          | —       |       | $ | — |   |
| Common stock issued as consideration for  account payable                    |       | —          |       | —          |       | —       |       |
| Common stock issued as consideration for  note payable                       |       | —          |       | —          |       | —       |       |
| Related party note receivable exchanged for  property and equipment          |       | —          |       | —          |       | —       |       |
| Note payable converted into common stock                                     |       | —          |       | —          |       | —       |       |
| Property and equipment acquired with  assumed liabilities                    |       | —          |       | —          |       | —       |       |
| Intangibles acquired with assumed  liabilities                               |       | —          |       | —          |       | —       |       |

 

 

11

----

 

**RESTATEDCONSOLIDATED STATEMENT OF CASH FLOWSFOR THE PERIOD FROM JUNE 9, 2003 (DATE OF INCEPTION) TO JUNE 30, 2005(UNAUDITED)**

 
| ** **                                                                   | ** ** | **As Reported** | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| Cash flows  from operating activities:                                       |       |            |       |            |       |         |       |
| Net loss                                                                     |       | $               | (7,422,899 | )               | $          | (125,033     | )          | $ | (7,547,932 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |            |       |            |       |         |       |
| Gain on debt extinguishment                                                  |       | (26,990         | )          | —          |       | (26,990      | )          |
| Depreciation and amortization expense                                        |       | 392,009         |       | —          |       | 392,009      |       |
| Short-term note issued for services                                          |       | 44,000          |       | —          |       | 44,000       |       |
| Common stock issued for services                                             |       | 931,500         |       | —          |       | 931,500      |       |
| Warrants issued for services                                                 |       | 63,829          |       | —          |       | 63,829       |       |
| Stock-based employee compensation                                            |       | 228,364         |       | 125,033         |       | 353,397      |       |
| Changes in operating assets and  liabilities:                                |       |            |       |            |       |         |       |
| Increase in accounts receivable                                              |       | —          |       | —          |       | —       |       |
| Increase in accounts receivable—related  party                          |       | (9,316          | )          | —          |       | (9,316       | )          |
| (Increase) decrease in prepaid expenses                                      |       | (28,939         | )          | —          |       | (28,939      | )          |
| Decrease in other current assets                                             |       | —          |       | —          |       | —       |       |
| Increase (decrease) in accounts payable                                      |       | (21,402         | )          | —          |       | (21,402      | )          |
| Increase (decrease) in accrued liabilities                                   |       | 225,918         |       | —          |       | 225,918      |       |
|                                                                         |       |            |       |            |       |         |       |
| Net cash used in operating activities                                        |       | (5,623,926      | )          | —          |       | (5,623,926   | )          |
|                                                                         |       |            |       |            |       |         |       |
| Cash flows  from investing activities:                                       |       |            |       |            |       |         |       |
| Payments to purchase property and equipment                                  |       | (1,016,206      | )          | —          |       | (1,016,206   | )          |
| Proceeds from sale of property and  equipment                                |       | 20,957          |       | —          |       | 20,957       |       |
| Payments to purchase intangibles                                             |       | (295,853        | )          | —          |       | (295,853     | )          |
| Payments to purchase other assets                                            |       | (391,089        | )          | —          |       | (391,089     | )          |
| Payments issued for note receivable                                          |       | (300,783        | )          | —          |       | (300,783     | )          |
| Payments issued for note receivable—related  party                      |       | (56,783         | )          | —          |       | (56,783      | )          |
|                                                                         |       |            |       |            |       |         |       |
| Net cash used in investing activities                                        |       | (2,039,757      | )          | —          |       | (2,039,757   | )          |
|                                                                         |       |            |       |            |       |         |       |
| Cash flows  from financing activities:                                       |       |            |       |            |       |         |       |
| Proceeds from issuance of common stock                                       |       | 20,975,766      |       | —          |       | 20,975,766   |       |
| Purchases of common stock                                                    |       | (1,500,000      | )          | —          |       | (1,500,000   | )          |
| Proceeds from issuance of convertible notes                                  |       | 553,500         |       | —          |       | 553,500      |       |
| Repayments of notes payable                                                  |       | (579,537        | )          | —          |       | (579,537     | )          |
| Proceeds from borrowings under loan  agreements—related parties         |       | 23,195          |       | —          |       | 23,195       |       |
| Repayment of borrowings under loan  agreements—related parties          |       | (23,195         | )          | —          |       | (23,195      | )          |
|                                                                         |       |            |       |            |       |         |       |
| Net cash provided by financing activities                                    |       | 19,449,729      |       | —          |       | 19,449,729   |       |
|                                                                         |       |            |       |            |       |         |       |
| Net increase  in cash and cash equivalents                                   |       | 11,786,046      |       | —          |       | 11,786,046   |       |
|                                                                         |       |            |       |            |       |         |       |
| Cash and  cash equivalents—beginning of period                          |       | —          |       | —          |       | —       |       |
|                                                                         |       |            |       |            |       |         |       |
| Cash and  cash equivalents—end of period                                |       | $               | 11,786,046 |            | $          | —       |       | $ | 11,786,046 |   |
|                                                                         |       |            |       |            |       |         |       |
| Supplemental  disclosures of cash flow information:                          |       |            |       |            |       |         |       |
| Cash paid for interest                                                       |       | $               | 37,037     |            | $          | —       |       | $ | 37,037 |   |
|                                                                         |       |            |       |            |       |         |       |
| Non-cash  investing and financing activities:                                |       |            |       |            |       |         |       |
| Prepaid insurance acquired with note  payable                                |       | $               | 60,990     |            | $          | —       |       | $ | 60,990 |   |
| Common stock issued as consideration for  account payable                    |       | 6,000           |       | —          |       | 6,000        |       |
| Common stock issued as consideration for  note payable                       |       | 50,000          |       | —          |       | 50,000       |       |
| Related party note receivable exchanged for  property and equipment          |       | 56,783          |       | —          |       | 56,783       |       |
| Note payable converted into common stock                                     |       | 553,500         |       | —          |       | 553,500      |       |
| Property and equipment acquired with  assumed liabilities                    |       | 479,610         |       | —          |       | 479,610      |       |
| Intangibles acquired with assumed  liabilities                               |       | 757,792         |       | —          |       | 757,792      |       |

 

 

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**3.****RECENT ACCOUNTING PRONOUNCEMENTS**

 

InMay 2005, the FASB issued SFAS 154, “Accounting Changes and ErrorCorrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3.”This statement changes the requirements for the accounting for and reporting ofa change in accounting principle and applies to all voluntary changes inaccounting principle. It also applies to changes required by an accountingpronouncement in the unusual instance that the pronouncement does not includespecific transition provisions. When a pronouncement includes specifictransition provisions, those provisions should be followed. APB No. 20required that most voluntary changes in accounting principle be recognized byincluding in net income of the period of the change the cumulative effect ofchanging to the new accounting principle. This statement requires retrospectiveapplication to prior period financial statements of changes in accountingprinciple, unless it is impracticable to determine either the period-specificeffects or the cumulative effect of the change.  The provisions of SFAS154 are effective for fiscal years beginning after December 15,2005.  As such we are required to adopt SFAS 154 by October 1,2006.  We do not expect this statement to have a material impact on our consolidated financial statements.

 

**4. REVERSE ACQUISITION WITH MEDXLINK, CORP**

 

OnJuly 14, 2004, MedXLink, Corp. (“MXLK”, or the “Parent”), a Nevadacorporation and an inactive publicly-traded company, entered into an Agreementand Plan of Reorganization with Particle Drilling Technologies, Inc.,a Delaware corporation, (“PDTI-DE”), whereby MXLK agreed to acquire PDTI-DE bymerging PDTI Acquisition Corp. (“Merger Sub”), a newly formed Delawarecorporation and wholly owned subsidiary of MXLK, with and into 

 

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PDTI-DEand issuing common stock of MXLK in exchange for all the outstanding shares ofPDTI-DE.  On January 14, 2005, MXLK closed its acquisition of PDTI-DEand issued 16,698,094 shares of common stock (including 3,381,538 shares ofcommon stock issued upon conversion of the same number of shares of Series AConvertible Preferred Stock of PDTI-DE) to holders of common stock of PDTI-DEand reserved for issuance (1) 228,000 shares of common stock pursuant tooutstanding warrants to purchase common stock of PDTI-DE, and (2) 3,205,000shares of common stock pursuant to outstanding options to purchase common stockof PDTI-DE.  In addition, 1,342,404 issued and outstanding shares ofcommon stock of the Parent were cancelled for no consideration in connectionwith the Merger.  Following the merger, the Parent had 18,248,094 sharesof common stock issued and outstanding (which included 3,381,538 shares ofcommon stock issued upon conversion of the same number of shares of Series AConvertible Preferred Stock of PDTI-DE) and an additional 3,433,000 shares ofcommon stock reserved for issuance upon exercise of warrants and options asdescribed above.  Following the merger, PDTI-DE continued as the survivingcorporation under the name of Particle Drilling Technologies, Inc. asa subsidiary of Parent, the Parent changed its name to Particle DrillingTechnologies, Inc., and its stock trading symbol changed from MXLK.OB toPDRT.OB.  On June 28, 2005, theCompany’s shares began trading on the Nasdaq SmallCap Market under the symbolPDRT.

 

**5. NET LOSS PER COMMON SHARE**

 

TheCompany has presented basic and diluted net loss per share pursuant toStatement of Financial Accounting Standards (SFAS) No. 128, *Earnings Per Share*.  In accordancewith SFAS No. 128, basic and diluted net loss per share has been computedusing the weighted average number of shares of common stock outstanding duringthe period.  Dilutive net loss per share would give effect to the dilutiveeffect of common stock equivalents consisting of options and warrants. Potentially dilutive securities have been excluded from the net loss per commonshare calculation as the effects would be antidilutive.  Potentiallydilutive securities totaling 5,653,000 and 2,815,000 for the periods ended June 30,2005 and 2004, respectively, were not included in the computation of weightedaverage diluted common shares because the impact of these potentially dilutivesecurities were antidilutive.

 

**6. COMMON STOCK**

 

FromOctober 2004 to December 2004, PDTI issued 285,000 shares of itscommon stock for cash in a private placement at $2.00 per share.  PDTIreceived net proceeds of $533,000 after deducting the offering expenses of$37,000.

 

InOctober 2004, PDTI issued 10,000 shares of common stock to a financialadvisor for consulting services rendered.  PDTI recorded a charge of$17,500 for the fair value of common stock on the date of issuance.

 

InDecember 2004, PDTI issued 9,314 shares of its common stock upon a netcashless exercise of 10,000 warrants at $0.12 per share.

 

InDecember 2004, PDTI issued upon exercise of warrants, 33,333 shares of theCompany’s common stock for cash at $0.01 per share.

 

InJanuary 2005, PDTI issued 565,000 shares of its common stock for cash in aprivate placement at $2.00 per share.  PDTI received proceeds of$1,130,000.  These shares related to a private placement which began in April 2004and was completed in January 2005.  The Company issued a total of1,635,000 shares of its common stock under this private placement from April 2004to January 2005 and received net proceeds of $2,934,000.

 

InJanuary 2005, Cagan McAfee Capital Partners, LLC (“CMCP”) and variousgroups associated with CMCP agreed to and cancelled 700,000 shares of theCompany’s common stock that had been valued at $0.12 per share when the Companyoriginally issued such shares of common stock in June 2004.  Thiscancellation was conducted in an effort to facilitate the reverse acquisitionbetween PDTI and MedXLink, Corp.  PDTI recorded a credit to compensationexpense of $84,000 in January 2005 for the cancellation of these shares,an amount equal to the compensation expense recorded when these shares wereissued in 2004.

 

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InJanuary 2005, Prentis B. Tomlinson (PDTI’s former President and CEO until December 2,2004) and Thomas E. Hardisty, Senior Vice President of Corporate Development ofPDTI, cancelled 45,000 and 5,000 shares, respectively, of the Company’s commonstock that was valued at $0.001 per share.  Mr. Tomlinson and Mr. Hardistyagreed to cancel these shares of the Company’s common stock in an effort tofacilitate the reverse acquisition between PDTI and MedXLink, Corp.

 

InFebruary 2005, the Company sold 9,000,000 shares of its common stock at$2.00 per share in a private placement that closed February 9, 2005. The Company received gross proceeds of $18,000,000.  The Company paid 3.0%commissions on the first $15,000,000 and 5.0% commissions on the remaining$3,000,000 gross proceeds received, $100,000 for reimbursable expenses, andlegal fees of $315,767 related to the offering.  In addition, PDTI used$1,500,000 of these proceed to repurchase 3,000,000 shares of common stock fromMr. Tomlinson.  These shares were purchased as treasury stock andrecorded at cost.

 

InMay 2005, the Company issued 140,000 shares of restricted common stock to Directorsand employees at $4.90 per share, which will vest over two and three yearperiods, respectively.

 

InMay 2005, the Company issued 5,000 shares of restricted common stock to aDirector at $5.43 per share, which will vest over a two year period.

 

AtJune 30, 2005, the Company had 24,393,094 shares of common stockoutstanding and has issued options and warrants to purchase up to 5,653,000additional shares of the Company’s common stock.

 

**7. STOCK-BASED EMPLOYEE COMPENSATION**

 

InApril 2004, the Board of Directors adopted the 2004 Stock Incentive Plan(the “2004 Plan”).  The 2004 Plan provides for the issuance of incentivestock options, non-statutory stock options and restricted stock grants todirectors, employees and consultants of PDTI.  Provisions under the 2004Plan allowed for the issuance of up to 3,500,000 shares of common stockpursuant to awards under this Plan.  As of June 30, 2005, the Companyhad 30,000 shares of common stock available for issuance pursuant to awardsunder the 2004 Plan.

 

InMarch 2005, the Board of Directors adopted the 2005 Stock Incentive Plan(the “2005 Plan”).  The 2005 Plan provides the issuance of incentive stockoptions, non-statutory stock options and restricted stock grants to directors,employees and consultants of PDTI.  Provisions under the 2005 Plan allowfor the issuance of options and restricted stock awards to purchase or issue upto 2,000,000 shares of common stock.  As of June 30, 2005, theCompany had 1,200,000 shares of common stock available for issuance pursuant toawards under the 2005 Plan.

 

Stock-basedemployee compensation expense recorded for awards issued under the 2004 Planand the 2005 Plan for the three and nine months ended June 30, 2005 was$140,783 and $302,583, respectively.  Stock-based employee compensation expense recorded for awards issuedunder the 2004 Plan and the 2005 Plan for the three and nine months ended June30, 2004 was $50,814.  Stock-basedemployee compensation expense recorded for awards issued under the 2004 Planand the 2005 Plan since inception (June 9, 2003) to June 30, 2005 was $353,397.

 

**8. WARRANTS**

 

InOctober 2004, PDTI issued warrants to purchase 33,333 shares of theCompany’s common stock at $0.01 per share.  The warrants were issued to afinancial advisor for services provided.  The Company recorded an expense of$58,000 using the Black-Scholes option pricing model under the followingassumptions: dividend yield of 0%; expected volatility of 0%; risk-freeinterest rate of 3.34%; and expected life of 0 years.

 

Inconnection with a private placement that commenced in April 2004 and completedin January 2005, PDTI issued warrants, in January 2005, to purchase65,500 shares of the Company’s common stock to certain persons associated withthe Placement Agent of this private placement.  Offering expense recordedfor these warrants was $80,565.  The related expense was a direct cost ofthe associated financing and was therefore charged directly to stockholders’equity.  Each warrant has an exercise price of $2.00 per share with amaximum term of five years.  The fair value of each warrant granted isestimated as of the grant date using the Black-Scholes option pricing modelwith the following weighted average assumptions: dividend yield of 0%; expectedvolatility of 71.86%; risk-free interest rate of 3.73%; and expected life of fiveyears.

 

Inconnection with a private placement that was completed February 9, 2005,PDTI issued warrants, in February 2005, to purchase 1,500,000 shares ofthe Company’s common stock to certain persons associated with the 

 

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PlacementAgent of this private placement.  Offering expense recorded for thesewarrants was $2,370,000.  The related expense was a direct cost of theassociated financing and was therefore charged directly to stockholders’equity.  Each warrant has an exercise price of $2.00 per share with a maximumterm of ten years.  The fair value of each warrant granted is estimated asof the grant date using the Black-Scholes option pricing model with thefollowing weighted average assumptions: dividend yield of 0%; expectedvolatility of 71.86%; risk-free interest rate of 4.00%; and expected life of tenyears.

 

**9. COMMITMENTS AND CONTINGINCIES**

 

In March 2005, theCompany entered into a five year lease agreement for a new corporate office anddelivered to the lessor a security deposit of $350,000 in the form of anirrevocable letter of credit, and is included in other assets on the balancesheet.  In June 2005, the Companymoved its corporate offices from 808 Travis Street, Suite 850, Houston,Texas, 77002 to 1021 Main Street, Suite 2650, Houston, Texas, 77002.  The future annual minimum lease payments are$186,256.

 

The Company renewed theoperating lease for its commercial operation facility that expired June 30,2005.  The lease was renewed for twelvemonths beginning July 1, 2005, with future annual minimum lease paymentsat July 1, 2005 of $57,600.

 

**10. RELATED PARTY TRANSACTIONS**

 

In March 2005, theCompany entered into a five year sublease agreement with an affiliate of JohnD. Schiller, interim President and CEO of PDTI, pursuant to which PDTI will subleaseapproximately 50% of the Company’s 10,310 square foot new corporate office tothe affiliate of Mr. Schiller, effective June 2005.  Future annual minimum rental incomeassociated with the sublease is $93,128.

 

**11. INCOME TAXES**

 

TheCompany reports its income taxes in accordance with SFAS 109, “Accounting forIncome Taxes,” which calls for the utilization of the asset and liabilitymethod of accounting for income taxes. Under this method, deferred taxes aredetermined based on differences between financial reporting and tax bases ofassets and liabilities and are measured using the enacted marginal tax ratesand laws that will be in effect when the differences reverse.  Temporary differences have been created forall stock option plans and are included in the Company’s SFAS 109computation.  At June 30, 2005, theCompany had cumulative net operating loss carryforwards of $7,580,219, whichexpire in years 2005 through 2023. No effect has been shown in the financialstatements for the net operating loss carryforwards as the likelihood of futuretax benefit from such net operating loss carryforwards is not determinable atthis time. Accordingly, the potential tax benefits of the net operating losscarryforwards, estimated based upon tax rates at June 30, 2005, have beenoffset by valuation reserves of the same amount.

 

**12. SUBSEQUENT EVENTS**

 

InAugust 2005, the Company amended the lease agreement related to its corporateoffices to expand the leased premises an additional 1,086 square feet for atotal of 11,396 square feet.  The amendedlease agreement became effective August 1, 2005.  With respect to the expanded premises only, thefuture annual minimum lease payments under the amended lease will be anadditional $18,756 and will expire January 31, 2011.

 

**Item 2: Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.**

 

Thefollowing discussion of our financial condition and results of operationsshould be read together with the unaudited consolidated financial statementsand related notes that are included elsewhere in this report. This discussionmay contain forward-looking statements based upon current expectations thatinvolve risks and 

 

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uncertaintiesthat could cause actual results to differ materially from the forward-lookingstatements.  We undertake no obligation to update any forward-lookingstatements except as required by law.

 

**Restatement ofFinancial Statements**

** **

The historical information for the three months andnine months ended June 30, 2005, and for the period from June 9, 2003 (date ofinception) to June 30, 2005, have been restated after determining that theCompany’s policy of recording stock-based employee compensation upon vesting ofthe underlying equity award was inconsistent with the guidelines set forthunder Statements of Financial Accounting Standards (“SFAS”) No. 123(R), *Share-Based Payment*. 

 

OnFebruary 7, 2006, the Company received comments from the Staff of theSecurities and Exchange Commission (“SEC”) to its annual report on Form 10-Kfor the year ended September 30, 2005. In connection with the receipt of these comments, the Company determinedthat its policy for recording equity compensation was inconsistent with theguidance set forth under Statements of Financial Accounting Standards (“SFAS”)No. 123(R).  Historically, the Companyhas calculated the compensation expense associated with equity awards using theBlack-Scholes model and amortized that expense over the service period as theequity awards vest, commencing with the first vesting dates of the awards.  To fully comply with the guidance set forthin SFAS No. 123(R), the Company is now recording such expense on a straightline basis over the relevant service periods, commencing with the dates ofgrant of the awards.  On February 9,2006, following an analysis of the impact of this error on the Company’spreviously released financial statements, the Audit Committee of the Company’sBoard of Directors determined that it was necessary to restate the financialstatements contained in the Company’s original annual report on Form 10-K forthe year ended September 30, 2005 and the Company’s quarterly report on Form10-Q for the period ended June 30, 2005.

 

As aresult of the restatement, net loss for the three and nine month periods endedJune 30, 2005, and for the period from June 9, 2003 (date of inception) to June30, 2005 was increased by $125,033.

 

Thefollowing is a summary of the effect of the restatement on the financialstatements and net loss per share amounts affected on our previously reportedfinancial statements:

 
| ** **                                        | ** ** | **Increase from Previously Reported Amounts for the** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                        | ** ** | **Three Months  Ended June 30,  2005**                | ** ** | **Nine Months  Ended June 30,   2005** | ** ** | **Period from   June 9, 2003   (date of  inception) to   June 30, 2005** | ** ** |
| **Statement  of Operations Data:**                |       |                                                  |       |   |   |   |   |
| Operating  expenses:                              |       |                                                  |       |   |   |   |   |
| General and administrative                        |       | $                                                     | 125,033    |   | $ | 125,033 |   | $ | 125,033 |   |
| Loss from  operations                             |       | 125,033                                               |       | 125,033 |   | 125,033 |   |
| Net loss                                          |       | 125,033                                               |       | 125,033 |   | 125,033 |   |
|                                              |       |                                                  |       |   |   |   |   |
| Net loss per  common share—basic and diluted |       | 0.01                                                  |       | — |   | 0.01 |   |
|                                              |       |                                                  |       |   |   |   |   |
| **Cash  Flow Data:**                              |       |                                                  |       |   |   |   |   |
| Cash flows  from operating activitities:          |       |                                                  |       |   |   |   |   |
| Net loss                                          |       | $                                                     | 125,033    |   | $ | 125,033 |   | $ | 125,033 |   |
| Stock-based compensation                          |       | 125,033                                               |       | 125,033 |   | 125,033 |   |
| Net cash  used in operating activities            |       | —                                                |       | — |   | — |   |
|                                              |       |                                                  |       |   |   |   |   |
| **Balance  Sheet Data (at end of period):**       |       |                                                  |       |   |   |   |   |
| Stockholders'  equity                             |       |                                                  |       |   |   |   |   |
| Additional paid-in-capital                        |       | $                                                     | 125,033    |   | $ | 125,033 |   | $ | 125,033 |   |
| Deficit accumulated during the development  stage |       | 125,033                                               |       | 125,033 |   | 125,033 |   |
| Total  Stockholders' equity                       |       | —                                                |       | — |   | — |   |

 

 

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**Overview**

 

OnJanuary 14, 2005, we acquired Particle Drilling Technologies, Inc.,a privately-held Delaware corporation (“PDTI”).  As a result of thisacquisition, our company, which previously had no material operations, acquiredthe business of PDTI and we are now engaged in the development of the Particle ImpactDrilling System, a patented system utilizing a specially designed “fit forpurpose” drill bit fitted with jetting nozzles and polycrystalline diamondcompact cutting structures for use in the oil and gas drilling industry.

 

Weare a development-stage company and have a limited operating history. Ourpredecessor company for financial reporting purposes was formed on June 9,2003 to acquire the technology related to the Particle Impact DrillingSystem (the “PID technology”). We are still developing this technology, and todate, we have not generated any revenues from our operations. As we continue toexecute our operations plan, we expect our development and operating expensesto increase.

 

InJune 2005, we successfully completed the second phase of a two phase teston the patented PID bit at the Terratek Drilling Research Laboratory in SaltLake City.  In July 2005, wecompleted a two week test program at the GTI Catoosa facility outside of Tulsa,Oklahoma.  At the Catoosa facility, wewere able to run the PID system in an actual well, as well as test and refinethe operating procedures and processes to better prepare for actualfieldwork.  Overall, we were pleased withthe PID system’s drilling performance and identified areas for operationalimprovement.  We will continue to refinethe system and develop operational protocols that should allow us to move thesystem reliably into the commercial market. In that connection, we are planning a second test at the Catoosafacility in late October or early November 2005.

 

*Research and development. *We have made and expect to continueto make substantial investments in research and development activities in orderto develop and market our PID technology. Research and development costsconsist primarily of general and administrative and operating expenses relatedto research and development activities. We expense research and developmentcosts as incurred except for property, plant and equipment related to researchand development activity that have an alternative future use. Property, plantand equipment for research and development that have an alternative future useare capitalized and the related depreciation is expensed as research anddevelopment costs.

 

*General and administrative. *General and administrativeexpenses consist primarily of salaries and benefits, office expense, professionalservices, and other corporate overhead costs. We anticipate increases ingeneral and administrative expenses as a result of becoming subject toreporting obligations applicable to publicly-held companies in January 2005,and as we continue to develop, test and prepare the PID technology forcommercialization.

 

**Results of Operations**

 

***Quarter Ended June 30,2005 Compared to Quarter Ended June 30, 2004***

 

*Research and development. *Research and developmentexpenses were $731,054 and $152,444 for the three months ended June 30,2005 and 2004, respectively, representing an increase of $578,610.  We had only a limited ability to develop thetechnology due to our lack of funds available during the three months ended June 30,2004.  As a result of the successful completion of our private placement inFebruary 2005, we have continued to use substantial resources during the threemonths ended June 30, 2005 to develop and test the PID technology,including a test program conducted at the Terratek drill test facility in SaltLake City (“Terratek”) during June 2005. Depreciation expense, included in research and development expense, forthe three months ended June 30, 2005 and 2004 was $104,769 and $38,646,respectively, representing an increase of $66,123.  The increase primarily related to thepurchase of a key component of the PID System during the three months endedJune 30, 2005.

 

*General and administrative. *General and administrativeexpenses were $984,863 and $1,091,969 for the three months ended June 30,2005 and 2004, respectively, representing a decrease of $107,106. The decreasewas primarily attributed to a higher level of stock-based compensation issuedto non-employees during the three months ended June 30, 2004.  Theseissuances were necessary because we had limited liquidity during the earlystages of 

 

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ourdevelopment that resulted in us issuing more stock-based compensation duringthe three months ended June 30, 2004. Depreciation and amortization expense, included in general andadministrative expense, for the three months ended June 30, 2005 and 2004 was$19,363 and $12,801, respectively, representing an increase of $6,562.  The increase primarily related to thepurchase of office furniture and equipment following the period ended June 30,2004.

 

*Other income. *Other income was $84,605 and $0for the three months ended June 30, 2005 and 2004, respectively.  The increase is due to $80,725 of interestearned on the investment of funds secured in the private placement in February 2005,and $3,880 in rental income from a sublease with an affiliate of John D.Schiller, our interim President and CEO.

 

*Interest expense*.  Interest expense was $361and $10,230 for the three months ended June 30, 2005 and 2004,respectively, representing a decrease of $9,869.  The decrease in interestexpense was primarily due to the repayment after the three months ended June 30,2004 of certain notes payable that were assumed in connection with ouracquisition of the PID technology.

 

***Nine Months Ended June 30,2005 Compared to Nine Months Ended June 30, 2004***

 

*Research and development. *Research and developmentexpenses were $1,721,457 and $276,865 for the nine months ended June 30,2005 and 2004, respectively, representing an increase of $1,444,592.  Wehad limited liquidity to fund the development of the PID technology during the ninemonths ended June 30, 2004.  As aresult of the successful completion of our private placement in February 2005,we have used substantial resources during the second and third quarters of fiscal2005 to develop and test the PID technology, including two test programsconducted at Terratek in March and June 2005, respectively.  Depreciation expense, included in researchand development expense, for the nine months ended June 30, 2005 and 2004 was$190,816 and $67,949, respectively, representing an increase of $122,867.  The increase primarily related to thepurchase of equipment related to the PID System during the nine months endedJune 30, 2005.

 

*General and administrative. *General and administrativeexpenses were $2,098,850 and $2,194,251 for the nine months ended June 30,2005 and 2004, respectively, representing a decrease of $95,401.  Thedecrease was primarily attributed to a higher level of stock-based compensationissued to non-employees during the nine months ended June 30, 2004. These issuances were necessary because we had limited liquidity during theearly stages of our development that resulted in us issuing more stock-basedcompensation during the nine months ended June 30, 2004.  Depreciation and amortization expense,included in general and administrative expense, for the nine months ended June30, 2005 and 2004 was $53,782 and $22,478, respectively, representing anincrease of $31,304.  The increaseprimarily related to the purchase of office furniture and equipment during thenine months ended June 30, 2005.

 

*Other Income. *Other income was $156,972 and $0 for the nine months ended June 30,2005 and 2004, respectively.  The increaseis due to $126,102 of interest earned on the investment of funds secured in theprivate placement in February 2005, and $3,880 in rental income from asublease with an affiliate of John D. Schiller, our interim President and CEO. Wealso recorded a gain on debt extinguishments of $26,990 during the nine monthsended June 30, 2005 due to settlements on a note payable and an accountpayable that were related to the liabilities we assumed in connection with ouracquisition of the PID technology.

 

*Interest expense*.  Interest expense was $10,813and $17,692 for the nine months ended June 30, 2005 and 2004,respectively, representing a decrease of $6,879.  The decrease in interestexpense was primarily due to the payment of certain notes payable that were assumedin connection with our acquisition of the PID technology.  This decrease was partially offset by higherinterest expense associated with certain equipment we purchased in July 2004that was financed with bank debt.  Weincurred an additional $1,243 of interest expense related to this equipmentnote during the nine month period ended June 30, 2005.

 

**Liquidity and Capital Resources**

 

Ourprincipal sources of liquidity are cash and cash equivalents.  Cash requirements through the end of thefiscal year 2005 are primarily to fund research and development activities andto continuously improve service capabilities and expand operations. We believewe have sufficient resources to meet our working capital and capitalexpenditure requirements for at least the next 12 months; however, ourcontinued existence depends on the successful development of the PID technologyand our ability to successfully commercialize this technology.

 

Sinceinception on June 9, 2003 through June 30, 2005, we have financed ouroperations through private sales of our equity and the issuance of convertiblenotes payable, totaling net proceeds of $19,449,729.  As of June 30,2005, we had $11,786,046 in cash and cash equivalents.

 

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OnFebruary 9, 2005, we sold 9,000,000 shares of our common stock at $2.00per share in a private placement and received gross proceeds of $18,000,000. Wepaid commissions to the placement agent in the amount of $600,000, $100,000 forreimbursable expenses, and legal fees related to this offering of$315,767.  In connection with this private placement, we issued ten yearwarrants to persons associated with the placement agent to purchase 1,500,000shares of our common stock in the aggregate at $2.00 per share. In addition, weused $1,500,000 of these proceeds to repurchase 3,000,000 shares of our commonstock from Prentis B. Tomlinson (PDTI’s former President and Chief ExecutiveOfficer until December 2, 2004). These shares were purchased as treasurystock and recorded at cost.

 

*Cash Flows from Operations. *Net**cashflow used for operations is primarily affected by our research and developmentprogress and business development.  Ourcash flow used for operations is also impacted by changes in working capital.  Our net cash flow used for operations was$3,658,671 and $1,205,658 for the nine months ended June 30, 2005 and2004, respectively, representing an increase of $2,453,013.  The increase is primarily due to oursuccessful fundraising efforts in February 2005 allowing us more cashresources to increase the planned development of the PID technology.  As a result, net loss increased from$2,488,808 to $3,674,148 for the nine month periods ended June 30, 2004and 2005, respectively, an increase of $1,185,340.  Our changes in operating assets andliabilities, excluding cash and cash equivalents, decreased $620,292 for thenine months ended June 30, 2005 compared to the nine months ended June 30,2004.  The decrease is primarily due tous making our credit obligation payments on-time during the nine months ended June 30,2005.  We did not have the cash resourcesto make all timely payments for our credit arrangements during the nine monthsended June 30, 2004.  Net cash usedin operating activities from June 9, 2003 (date of inception) to June 30,2005 was $5,623,926.  Net loss duringthis period was $7,547,932 of which $1,924,006 related to non-cash activitiesthat were added back to reconcile net loss to net cash used in operatingactivities.  The non-cash activities primarilyrelated to stock-based compensation.  Wehad limited liquidity during the early stages of development and as a result weissued more stock-based compensation to employees and non-employees.

 

*Cash Flows from Investing Activities. *Ourcapital spending for the nine months ended June 30, 2005 and 2004 was$1,421,180 and $230,423, respectively, representing an increase of $1,190,757.  During the nine months ended June 30,2005, we increased capital spending for our research and development activitiesin accordance with our 2005 capital budget. Our capital spending since inception (June 9, 2003) has been fullyfunded from cash flows from financing activities.  We anticipate that our capital expendituresfor the remaining of fiscal year 2005 will continue to be fully funded from ouravailable cash and cash equivalents.

 

*Cash Flows from Financing Activities. *Netcash provided by financing activities for the nine months ended June 30,2005 and 2004 was $16,845,534 and $1,435,989, respectively. During the ninemonths ended June 30, 2005 and 2004, we received net proceeds of$18,647,666 and $1,582,197, respectively, from the issuance of our common stockand convertible notes. During the nine months ended June 30, 2005, we used$1,500,000 to repurchase 3,000,000 shares of common stock from ashareholder.  We used $302,132 and $123,013 to repay notes payable duringthe nine months ended June 30, 2005 and 2004, respectively.  Duringthe nine months ended June 30, 2004, we used $23,195 to repay borrowingsunder a loan agreement with related parties, Prentis B. Tomlinson (PDTI’sformer CEO and President until December 2, 2004), and an affiliate ofPrentis B. Tomlinson.  During the ninemonths ended June 30, 2004, a $553,500 note was converted to common stock.

 

*Contractual Obligations. *Our contractual obligations at June 30,2005 are set forth in the table below. Our long-term debt obligation (includingcurrent portion of long-term debt) is related to equipment that was financedfor a three year period, beginning July 2004, and is secured by the sameequipment. Our operating lease obligations consist of our office and commercialoperating facility that are both located in Houston, Texas.

 

InMarch 2005, we entered into a five year lease agreement for new corporateoffices that commenced in June 2005. We moved our previous corporate offices that were located at 808 TravisStreet, Suite 850, Houston, TX 77002 to 1021 Main Street, Suite 2650,Houston, TX 77002. In March 2005, we delivered to the lessor a securitydeposit of $350,000 in the form of an irrevocable letter of credit.  Our future annual minimum lease payments are$186,256.  In August 2005, weexpanded the corporate office facility an additional 1,086 square feet for atotal of 11,396 square feet.  The futureannual minimum lease payments for the additional space will be $18,756.

 

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InJune 2005, we extended the commercial operating lease that expired June 30,2005 for one additional year.  Thecommercial operating lease will expire June 30, 2006.  The future minimum lease payments under thislease are $57,600

 
| ** **                                               | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------------------|------------|----------------------------|------------|
| **Contractual Obligations**                              | ** ** | **Total**                  | ** ** | **Less than 1  year** | ** ** | **1 - 3 years** | ** ** | **3 - 5 years** | ** ** | **More than 5  years** | ** ** |
|                                                     |       |                       |       |   |   |   |   |   |   |   |   |
| Long-Term  Debt Obligation   (including current portion) |       | $                          | 22,753     |   | $ | 10,566 |   | $ | 12,187 |   | $ | — |   | $ | — |   |
| Operating  Lease Obligations                             |       | 988,882                    |       | 243,856 |   | 558,770 |   | 186,256 |   | — |   |
|                                                     |       |                       |       |   |   |   |   |   |   |   |   |
| Total                                                    |       | $                          | 1,011,635  |   | $ | 254,422 |   | $ | 570,957 |   | $ | 186,256 |   | $ | — |   |

 

**Off-Balance Sheet Arrangements**

 

Inconnection with the acquisition of the PID technology in January 2004,PDTI entered into a Royalty Agreement with ProDril Services, Incorporated (“PSI”)pursuant to which we are obligated to pay PSI a royalty on a quarterly basisequal to 18% of our earnings before interest, income taxes, depreciation andamortization (“EBITDA”) until an aggregate of $67,500,000 has been paid. PDTIalso entered into a Royalty Agreement in January 2004 with ProDrilServices, International, Ltd. (“PSIL”) pursuant to which we are obligated topay PSIL a royalty on a quarterly basis equal to 2% of our EBITDA until anaggregate of $7,500,000 has been paid. In addition, we are obligated to payCCORE Technology and Licensing, Ltd. (“CTL”), PSI and PSIL a royalty equal to1.6%, 1.2% and 1.2%, respectively, of our quarterly gross revenue. As of June 30,2005, PDTI had no revenues or EBITDA; therefore no royalties have been paid oraccrued.

 

**Related Party Transactions**

 

In March 2005, we entered into a five year sublease agreement withan affiliate of John D. Schiller, our interim President and CEO, pursuant towhich this affiliate will sublease from us approximately 5,200 square feet ofour corporate office space, effective June 2005.  Future annual minimum rental incomeassociated with the sublease is $93,128.

 

We believe that the transaction described above was negotiated on anarm’s length basis and that the terms of the transaction was at least asfavorable to us as those that could have been obtained from an unaffiliatedthird party.

 

**Critical Accounting Policies**

 

Ourdiscussion and analysis of our financial condition and results of operations isbased on our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The preparation of these consolidated financial statements requiresus to make estimates and judgments that affect the reported amounts of assets,liabilities and expenses. We base our estimates on historical experience and onvarious other assumptions that we believe to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions. We believe the following criticalaccounting policies affect our most significant judgments and estimates used inthe preparation of our consolidated financial statements.

 

*Reverse Acquisition. *The acquisition of PDTI wasaccounted for as a reverse acquisition. Pursuant to the guidance inAppendix B of SEC Accounting Disclosure Rules and Practices OfficialText, we believe the acquisition of PDTI was a “merger of a private operatingcompany into a non-operating public shell corporation with nominal net assets 

 

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typicallyresults in the owners and management of the private company having actual oreffective operating control of the combined company after the transaction, withthe shareholders of the former public shell continuing only as passiveinvestors. These transactions are considered by the staff to be capitaltransactions in substance, rather than business combinations. That is, thetransaction is equivalent to the issuance of stock by the private company forthe net monetary assets of the shell corporation, accompanied by arecapitalization.” Accordingly, the reverse acquisition has been accounted foras a recapitalization. For accounting purposes, PDTI is considered the acquirerin the reverse acquisition. The historical financial statements are those ofPDTI. Earnings per share for periods prior to the merger in January 2005are restated to reflect the number of equivalent shares received by theacquiring company.

 

*Impairment of Long-Lived Assets. *We review long-lived assets andcertain identifiable assets for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. If the sum of the expected future undiscounted cash flows is lessthan the carrying amount of the asset, further impairment analysis isperformed. An impairment loss is measured as the amount by which the carryingamount exceeds the fair value of assets.

 

*Stock-Based Compensation. *In December 2004, the FASBissued a revision to SFAS No. 123, *Share-BasedPayment*. This statement establishes standards for the accounting fortransactions in which an entity exchanges its equity instruments for goods orservices. It also addresses transactions in which an entity incurs liabilitiesin exchange for goods or services that are based on the fair value of theentity’s equity instruments or that may be settled by the issuance of thoseequity instruments. This statement focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. This statement does not change the accounting guidancefor share-based payment transactions with parties other than employees providedin SFAS No. 123 as originally issued. This statement is effective for newawards and those modified, repurchased or cancelled in interim or annualreporting periods beginning after June 15, 2005. We early adopted thisstandard upon inception.

 

*Research and Development. *The costs of materials andequipment or facilities that are acquired or constructed for research anddevelopment activities and that have alternative future uses are capitalized astangible assets when acquired or constructed. The cost of such materialsconsumed in research and development activities and the depreciation of suchequipment or facilities used in those activities are research and developmentcosts. However, the costs of materials, equipment, or facilities acquired orconstructed for research and development activities that have no alternativefuture uses are considered research and development costs and are expensed atthe time the costs are incurred.

 

*Income Taxes.*  The Company reports its income taxesin accordance with SFAS 109, “Accounting for Income Taxes,” which calls for theutilization of the asset and liability method of accounting for income taxes.Under this method, deferred taxes are determined based on differences betweenfinancial reporting and tax bases of assets and liabilities and are measuredusing the enacted marginal tax rates and laws that will be in effect when thedifferences reverse.  Temporarydifferences have been created for all stock option plans and are included in ourSFAS 109 computation.  At June 30,2005, we had cumulative net operating loss carryforwards of $7,580,219, whichexpire in years 2005 through 2023. No effect has been shown in the financialstatements for the net operating loss carryforwards as the likelihood of futuretax benefit from such net operating loss carryforwards is not determinable atthis time. Accordingly, the potential tax benefits of the net operating losscarryforwards, estimated based upon tax rates at June 30, 2005, have beenoffset by valuation reserves of the same amount.

 

**Recent Accounting Pronouncements**

 

InMay 2005, the FASB issued SFAS 154, “Accounting Changes and ErrorCorrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3.”This statement changes the requirements for the accounting for and reporting ofa change in accounting principle and applies to all voluntary changes inaccounting principle. It also applies to changes required by an accountingpronouncement in the unusual instance that the pronouncement does not includespecific transition provisions. When a pronouncement includes specifictransition provisions, those provisions should be followed. APB No. 20required that most voluntary changes in accounting principle be recognized byincluding in net income of the period of the change the cumulative effect ofchanging to the new accounting principle. This statement requires 

 

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retrospectiveapplication to prior period financial statements of changes in accountingprinciple, unless it is impracticable to determine either the period-specificeffects or the cumulative effect of the change.  The provisions of SFAS154 are effective for fiscal years beginning after December 15,2005.  As such we are required to adopt SFAS 154 by October 1,2006.  We do not expect this statement to have a material impact on our Consolidated Financial Statements.

 

**Forward-Looking Statements**

 

Statementsin this quarterly report on Form 10-Q that are not historical facts(including any statements concerning plans and objectives of management forfuture operations or economic performance, or assumptions or forecasts relatedthereto) are forward-looking statements subject to Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934. These statements can be identified by the use of forward-lookingterminology including “forecast,” “may,” “believe,” “expect,” “anticipate,” “estimate,”“continue” or other similar words. These statements discuss future expectations,contain projections of results of operations or of financial condition or stateother “forward-looking” information. We and our representatives may from timeto time make other oral or written statements that are also forward-lookingstatements.

 

Theseforward-looking statements are made based upon our management’s current plans,expectations, estimates, assumptions and beliefs concerning future eventsimpacting us and therefore involve a number of risks and uncertainties. Wecaution that forward-looking statements are not guarantees and that actualresults could differ materially from those expressed or implied in theforward-looking statements as a result of certain factors, including but notlimited to dependence upon energy industry spending, the volatility of oil andgas prices, weather interruptions, the results of testing of our products andthe availability of capital resources.

 

Becausethese forward-looking statements involve risks and uncertainties, actualresults could differ materially from those expressed or implied by theseforward-looking statements for a number of important reasons, including thosediscussed under “Risk Factors” in our prospectus filed pursuant to Rule 424on June 30, 2005. We undertake no obligation to update any forward-lookingstatements except as required by law.

 

**Item 3.Quantitative and Qualitative Disclosures about Market Risk**

 

Webelieve that we do not have any material exposure to financial market risk andwe do not enter into foreign currency or interest rate transactions.

 

**Item 4.Controls and Procedures**

 

We maintaindisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in our reports under the Securities Exchange Act of1934 is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms promulgated by the Securities and ExchangeCommission (“SEC”), and that such information is accumulated and communicatedto management, including our Chief Executive Officer and Chief FinancialOfficer, to allow timely decisions regarding required disclosure. The design ofany system of control is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving our stated purpose under all potential future conditions.As required by Rule 13a-15(b) of the Securities Exchange Act of 1934, anevaluation was performed under the supervision and with the participation ofour Chief Executive Officer and Chief Financial Officer of the effectiveness ofthe design and operation of our "disclosure controls and procedures"(as defined under Rule 13a-15(e) and Rule 15d-15(e)) as of the end of theperiod covered by this quarterly report on Form 10-Q/A filed with the SEC.Based upon that evaluation and in connection with their determination that thematters described immediately below relating to the restatement of ourhistorical financial information, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures, as ofJune 30, 2005, were effective in timely alerting them to material companyinformation required to be included in our periodic filings with the SEC.

 

Our ChiefExecutive Officer and Chief Financial Officer reviewed with members of ourAudit Committee whether the restatement of our financial results for our fiscalquarter ended June 30, 2005 and year ended September 30, 2005 affected theirconclusions that our disclosure controls and procedures, as of June 30, 2005,were effective in timely alerting them to material company information requiredto be included in our periodic filings with the SEC. In connection with theirreview, our Chief Executive Officer and Chief Financial Officer noted that ourdecision to restate our fiscal quarter ended June 30, 2005 and year endedSeptember 30, 2005 financial results did not call into question whether therelevant information was recorded, processed, summarized or reported within thetime periods specified in the SEC's rules and forms. It also did not involveany issue about whether information required to be disclosed in this quarterlyreport on Form 10-Q/A was accumulated and communicated to our Chief ExecutiveOfficer and Chief Financial Officer to allow timely decisions regardingrequired disclosure. Rather, the restatements resulted from reconsideration ofour policy for recording stock-based employee compensation expense inconnection with preparing responses to a comment letter that we received fromthe Staff of the SEC on our annual report on Form 10-K for the year endedSeptember 30, 2005.  Our Chief ExecutiveOfficer and Chief Financial Officer did not find that management's ultimatedetermination that its prior policy of recording stock-based compensationexpense was inconsistent with generally accepted accounting principles raisedany question about whether our disclosure controls and procedures wereeffective to ensure that required information was disclosed to them asappropriate to allow timely decisions regarding required disclosure. Therefore,based on that review, our Chief Executive Officer and Chief Financial Officer determinedthat their prior conclusions, that our disclosure controls and procedures wereeffective as of June 30, 2005, had not changed.

 

There was no change in our internal control over financialreporting during our third quarter of fiscal 2005 that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

 

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**Part II – Other Information**

 

**Item 6. Exhibits**

 

Exhibits:

 
| **Exhibit ****No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                         |
|--------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                     |       |                                                                                                                                                                                                                                                                                                    |
| 10.1                     |       | Particle Drilling  Technologies, Inc. 2005 Stock Incentive Plan. (Incorporated herein by  reference to Exhibit 99.1 to our current report filed on Form 8-K  dated April 4, 2005.)                                                                                             |
|                     |       |                                                                                                                                                                                                                                                                                                    |
| 10.2                     |       | Sublease  Agreement dated March 21, 2005 between Particle Drilling  Technologies, Inc. and The Exploitation Company, LLP. (Incorporated  herein by reference to Exhibit 10.17 to Amendment No. 2 to our  Registration Statement on Form S-1 filed on June 27, 2005). |
|                     |       |                                                                                                                                                                                                                                                                                                    |
| 31.1                     |       | Certification  of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of  the Securities Exchange Act of 1934. *                                                                                                                                                                 |
|                     |       |                                                                                                                                                                                                                                                                                                    |
| 31.2                     |       | Certification  of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of  the Securities Exchange Act of 1934. *                                                                                                                                                                 |
|                     |       |                                                                                                                                                                                                                                                                                                    |
| 32.1                     |       | Certification  of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. **                                                                                                                                   |
|                     |       |                                                                                                                                                                                                                                                                                                    |
| 32.2                     |       | Certification  of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. **                                                                                                                                   |
|                     |       |                                                                                                                                                                                                                                                                                                    |
|                          |
| *                        |       | Filed  herewith                                                                                                                                                                                                                                                                                         |
| **                       |       | Furnished  herewith                                                                                                                                                                                                                                                                                     |

 

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SIGNATURES

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                          | PARTICLE DRILLING TECHNOLOGIES, INC.         |   |
|-------------------------------|---------------------------------------------------|--------|
|                          | (Registrant)                                      |   |
|                          |                                              |   |
| Date:  February 14, 2006 | /s/ J. Chris Boswell                              |   |
|                          | J. Chris Boswell                                  |
|                          | Senior Vice President and Chief Financial Officer |

 

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**EXHIBIT INDEX**

 
| **Exhibit   No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                         |
|------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                   |       |                                                                                                                                                                                                                                                                                                    |
| 10.1                   |       | Particle Drilling  Technologies, Inc. 2005 Stock Incentive Plan. (Incorporated herein by  reference to Exhibit 99.1 to our current report filed on Form 8-K  dated April 4, 2005.)                                                                                             |
|                   |       |                                                                                                                                                                                                                                                                                                    |
| 10.2                   |       | Sublease Agreement dated March 21,  2005 between Particle Drilling Technologies, Inc. and The  Exploitation Company, LLP. (Incorporated herein by reference to Exhibit 10.17  to Amendment No. 2 to our Registration Statement on Form S-1 filed  on June 27, 2005). |
|                   |       |                                                                                                                                                                                                                                                                                                    |
| 31.1                   |       | Certification of the Chief  Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the  Securities Exchange Act of 1934. *                                                                                                                                                                 |
|                   |       |                                                                                                                                                                                                                                                                                                    |
| 31.2                   |       | Certification of the Chief  Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the  Securities Exchange Act of 1934. *                                                                                                                                                                 |
|                   |       |                                                                                                                                                                                                                                                                                                    |
| 32.1                   |       | Certification of the Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. **                                                                                                                                   |
|                   |       |                                                                                                                                                                                                                                                                                                    |
| 32.2                   |       | Certification of the Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. **                                                                                                                                   |
|                   |       |                                                                                                                                                                                                                                                                                                    |
|                        |
| *                      |       | Filed herewith                                                                                                                                                                                                                                                                                          |
| **                     |       | Furnished herewith                                                                                                                                                                                                                                                                                      |

 

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