** **

**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

**Form 10-K****/A****Amendment No. 1**

 
| **ý** | ** ** | **ANNUAL REPORT PURSUANT TO SECTION  13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|------------|------------|-----------------------------------------------------------------------------------------------------|
|       |       |                                                                                                |
| ** ** | ** ** | **For the fiscal year ended September  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**   |

** **

**Commissionfile number: 000-30819**

 

**ParticleDrilling Technologies, Inc.**

(Exact name of registrantas specified in its charter)

 

| **Nevada**                                        | ** ** | **20-1563395**                       |
|---------------------------------------------------|------------|--------------------------------------|
| (State of incorporation)                          |       | (I.R.S. Employer Identification No.) |
|                                              |       |                                 |
| **1021  Main Street, Suite 2650  Houston, Texas** |       | **77002**                            |
| (Address of principal executive offices)          |       | (Zip Code)                           |

** **

Registrant’s telephone number, including area code:

**713-223-3031**

 

Securities registeredPursuant to Section 12(b) of the Act:

**None**

 

Securities registeredPursuant to Section 12(g) of the Act:

**Common Stock, par value $0.001 pershare**

 

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

 

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act..     Yes o No ý

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.     Yes ý No o

 

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.     o

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Exchange ActRule 12b-2).  Yes ý          No o

 

Indicate by checkmark if the registrant is a shell company (as defined in Rule 12b-2 of theAct).     Yes o No ý

 

The aggregatemarket value of the voting and non-voting common equity held by non-affiliatesof the registrant was approximately $103,970,000 as of March 31, 2005 (based onthe last sale price of such stock as quoted on the OTCBB).

 

As of December 9,2005, there were 24,441,472 shares of the registrant’s common stock, parvalue $0.001 per share, outstanding.

 

Documents incorporatedby reference: Definitive Proxy Statement for the 2006 Annual Meeting of Shareholdersof Particle Drilling Technologies, Inc. filed January 25, 2006, which isincorporated by reference into Part III of this Form 10-K/A AmendmentNo. 1.

 

 

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**TABLEOF CONTENTS**

 
| Explanatory  Note | 1                                                                                                                    |
|-------------------|----------------------------------------------------------------------------------------------------------------------|
| **PART I**        |
| Item 1.           | Business                                                                                                             | 2 |
| Item 1A.          | Risk Factors                                                                                                         | 7 |
| Item 1B.          | Unresolved Staff Comments                                                                                            | 10 |
| Item 2.           | Properties                                                                                                           | 10 |
| Item 3.           | Legal Proceedings                                                                                                    | 10 |
| Item 4.           | Submission of Matters to a  Vote of Security Holders                                                                 | 11 |
|              |                                                                                                                 |   |
| **PART II**       |
| Item 5.           | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchasers  of Equity Securities | 11 |
| Item 6.           | Selected Financial Data                                                                                              | 12 |
| Item 7.           | Management’s Discussion and  Analysis of Financial Condition and Results of Operation                           | 13 |
| Item 7A.          | Quantitative and Qualitative  Disclosures About Market Risk                                                          | 19 |
| Item 8.           | Financial Statements and  Supplementary Data                                                                         | 20 |
| Item 9.           | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                                | 47 |
| Item 9A.          | Controls and  Procedures                                                                                             | 47 |
| Item 9B.          | Other Information                                                                                                    | 47 |
|              |                                                                                                                 |   |
| **PART III**      |
| Item 10.          | Directors  and Executive Officers of the Registrant                                                                  | 48 |
| Item 11.          | Executive  Compensation                                                                                              | 48 |
| Item 12.          | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                     | 48 |
| Item 13.          | Certain  Relationships and Related Transactions                                                                      | 48 |
| Item 14.          | Principal  Accounting Fees and Services                                                                              | 48 |
|              |                                                                                                                 |   |
| **PART IV**       |
| Item 15.          | Exhibits and  Financial Statement Schedules                                                                          | 48 |

 

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**EXPLANATORY NOTE**

 

ThisAmendment No. 1 on Form 10-K/A amends and restates certain disclosure items inour annual report on Form 10-K for the year ended September 30, 2005, which weoriginally filed on December 14, 2005.  

 

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 original quarterly reporton Form 10-Q for the period ended June 30, 2005.

 

Accordingly, this Form10-K/A includes our restated financial statements for the year ended September30, 2005, and for the period from June 9, 2003 (date of inception) to September30, 2005 with accompanying notes.  ThisForm 10-K/A also updates disclosure in Item 7. “Management’s Discussion andAnalysis of Financial Condition and Results of Operation” to reflect therestated financial statements described above and in Item 9A. “Controlsand Procedures” to reflect the re-evaluation of our disclosure controls andprocedures and our internal control over financial reporting by our management,including our Chief Executive Officer and our Chief Financial Officer, inconnection with the filing of this Form 10-K/A.

 

Except for the foregoing restatedinformation, the Form 10-K/A continues to describe conditions as of the date ofthe original filing and we have not updated the disclosures contained herein toreflect events that occurred at a later date. Other events occurring after the original filing or other disclosuresnecessary to reflect subsequent events have been addressed in reports filedwith the SEC subsequent to the date of the original filing.  In addition, we have included as exhibits tothis amendment new certifications of our Chief Executive Officer and ChiefFinancial Officer.  

 

We are also correctingunintentional typographical errors that appeared on our Consolidated Statementsof Cash Flows covering the periods from June 9, 2003 (date of inception) toSeptember 30, 2003 and June 9, 2003 (date of inception) to September 30,2005.  Specifically, the column headingsfor those periods are being changed from “June 30, 2003” and “June 30, 2005” to“September 30, 2003” and “September 30, 2005”, respectively.  We have also added additional disclosure toNote 5 to the consolidated financial statements describing the intangibleassets we acquired in connection with our acquisition of the PID technology inJanuary 2004. Lastly, we are adding additional disclosure to the footnotes ofour financial statements regarding certain pending litigation against theCompany that was previously disclosed in Item 3. “Legal Proceedings” in ouroriginal annual report on Form 10-K. While we believe the described litigation is without merit and that thelikelihood of an adverse judgment against the Company is remote, an adversejudgment would severely impair our ability to continue as a going concern.

 

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*Unless the context otherwise requires, allreferences in this report of the “Company,” “we,” “us,” or “our” are toParticle Drilling Technologies, Inc. and its subsidiary.*

 

**PART I**

 

**Item 1.  Business**

 

**General**

 

Particle Drilling Technologies, Inc., a Nevadacorporation, is a holding company organized on June 14, 2002 and wasformerly known as MedXLink Corp. We changed our name to Particle DrillingTechnologies, Inc. on January 25, 2005, following the merger onJanuary 14, 2005 of our wholly-owned subsidiary with and into ParticleDrilling Technologies, Inc., a Delaware corporation ("PDTI").  Prior to our acquisition of PDTI, we were ashell company. Currently our business consists of one segment and onegeographic area, and information about our net loss and total assets is locatedunder “Item 8. Financial Statements and Supplementary Data.”

 

PDTI was formed in March 2004 for the purpose ofraising capital and to acquire Particle Drilling, Inc., a Texascorporation. Particle Drilling, Inc. (formerly known as ProDrilAcquisition Corp.) was formed in June 2003 for the purpose of acquiringcertain of the assets, patents and other intellectual property, and certainliabilities related to the Particle Impact Drilling technology, which we referto as the “PID technology” or the “PID System.” Particle Drilling, Inc.was merged with and into PDTI in June 2004.

 

The patented PID System utilizes a specially-designed “fitfor purpose” drill bit fitted with jetting nozzles and polycrystalline diamondcompact cutting structures. We refer to this bit as the “PID bit.” The nozzlesin the PID bit serve to accelerate hardened steel shot entrained with ordinarydrilling mud to fracture and remove the formation ahead of the bit. The shotflows back up the wellbore annulus along with the drilling fluid and formationcuttings to the surface where the PID System separates and re-circulates theshot. The PID System is primarily operated utilizing hydraulic energy that is commonlyavailable on drilling rigs used today in combination with the PID Systemequipment. Each particle is driven into the rock formation at a high velocityand delivers a force many times greater than the compressional strength of therock, even in formations that exist in the subsurface at elevated hardness andstress. Depending on the volume of shot introduced into the drilling mud, thenumber of shot strikes on the formation is in excess of four million perminute, thereby yielding a higher rate of penetration than conventional rollercone rock bits.

 

By comparison, conventional drilling methods usingroller cone rock bits rely on mechanical energy created by the weight andtorque applied to a bit, and the amount of total rotational mechanical energy availableon drilling rigs is limited. The result is that the bit gouges out smallervolumes of rock as the compressional strength of the rock increases with depthand pressure; whereas we believe the volume of rock excavated by the PID Systemis less affected by rock hardness or depth.

 

The PID System is designed to entrain, circulate, andrecover shot in the mud system without allowing the shot to circulate throughthe rig pumps. The PID System is designed as a mobile service that will beprovided to the oil and gas operator as part of the normal drilling process andis configured to service a well in progress with minimal interference. We arecontinuing the development of our PID bit and latest shot injector tocomplement the PID System.

 

The PID System is expected to result in higher ratesof penetration than current conventional drilling methods. The rate ofpenetration gains generated by the PID System are expected to result inoperators paying less variable drilling costs (e.g., rig time, labor, fuel, bits,rentals), which are purchased as part of the ordinary drilling cycle. As aresult, we believe the PID System can reduce drilling costs and lower findingcosts, thus improving the overall economics to the oil and gas drillingindustry in certain geologic basins.

 

**Business Strategy andPlan of Operation**

 

We believe the PID System development has advancedsignificantly and should be available for commercial trials in the firstcalendar quarter of 2006.  Our operationsplan for the remainder of fiscal year 2006 is expected to include: (1) beginnegotiations of commercial contracts with potential customers; (2) implementationof the PID System on a

 

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drilling oil or gas well; (3) hiring and training additional fieldand technical personnel; and (4) assembly of additional PID Systems.

 

Our initial target customers will be oil and gasoperators drilling onshore wells in geologic basins of the U.S. known to havehard rock and/or highly abrasive formations. We will initially focus ourmarketing and sales efforts on operators with multi-well drilling programscentered in a single U.S. basin. Additionally, we will target customers thatexhibit a willingness to embrace emerging technologies and have the financialresources to tolerate the perceived risk associated with utilizing new drillingtechnologies. Currently we have not entered into any contracts or agreementswith potential customers.

 

We expect to deliver value to our customers as aspecialty service provider using patented technology and high quality fieldpersonnel. Based on the experience of our management team in the oilfieldservices industry and the exploration and production industry, we believe thatcurrently no other company attempts to deliver a comparable drilling serviceutilizing technology that is similar to the PID System and that is targeted toserve the hard rock drilling market. Instead, we believe drill bit and drillingmud manufacturers generally design and sell products for hard rock environmentsthat are based on conventional drilling technology.

 

We expect to operate in a fashion more comparable to adirectional drilling or well stimulation service provider in which we willprovide our system and field personnel who will work with the rig crews tooperate our system as an integral component of the drilling operation, and wewill offer our services on a gain sharing basis whereby the cost saved as aresult of using the PID System will be shared between us and the operator. ThePID System is expected to result in higher rates of penetration, therebyreducing drilling costs and lowering finding costs to improve the overalleconomics of the oil and gas drilling industry in certain geologic basins.While this gain sharing model will initially be the preferred way to gainmarket share, we believe that equal or greater returns can be achieved througha more traditional dayrate or fixed fee structure. Initially, we intend toutilize the revenue model most preferred by our potential customer base so longas satisfactory returns are realized.

 

In order to attain market acceptance, we expect toeventually offer operating contracts that will charge a fixed hourly rate andfees based on consumables such as the drill bits and the steel shot. Werecognize that some oil and gas companies will only accept fixed pricing,especially in international operations dealing with tenders and governmentpartners. Additionally, this contracting strategy will facilitate working whereexploration wells and development wells do not have ample offset drilling dataon which to establish a performance baseline. We expect that this contracting strategy will produce margins that aresimilar to the gain sharing model.

 

**Industry**

 

Both oil and natural gasmarkets have seen a robust pricing environment since 2002.  According to the November 8, 2005 *Energy Outlook* release published by the Energy InformationAdministration (EIA), many of the same factors that drove world oil markets in2005, such as low OPEC spare production capacity and rapid growth of demand,will continue to affect markets in 2006. The EIA Annual Energy Outlook 2005 estimates strong economic growth willcontinue through 2025 with an average 3.1% growth per year.  The energy-intensive manufacturing component ofthe U.S. economy is expected to grow at 1.5% per year.  As of December 2, 2005, the Baker Hughes U.S.land rig count was at 1,360, a 21% increase from a year earlier.

 

We believe that economicgrowth and the projected oil and gas commodity pricing environment willcontinue to drive increased drilling and activities of the oilfield service andsupply sector over the next two years, and likely beyond.  We believe that the capacity constrained U.S.land rig market will continue to experience dayrate price increases overutilization.  As a result, we believeNorth American land drillers and related service providers will continue to besome of the biggest beneficiaries of the oil and gas price environment andeconomic growth.

 

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*TheDrilling Industry*—We do not believe the current conventionaldrilling process using traditional rotary rig equipment and roller cone drillbits has fundamentally changed in a significant manner since the firstcommercial applications of the equipment by the Hughes Tool Company in the1920s. Although horizontal drilling and other innovations in the way thesedrilling systems are used have greatly increased well productivity, gains inrates of penetration and absolute drilling efficiency were limited until 1989.At that time, fixed cutter polycrystalline diamond compact bits, or “PDC bits,”became a functional alternative to roller cone bits for a limited but growingsegment of the drilling market. This technology was focused on wells drilled insofter formations as PDC bits could achieve higher rates of penetration andlonger run times, both of which achieved appreciable cost savings by reducingdrilling time. The industry has adopted PDC bits for these specificapplications, although a PDC bit can cost several times as much as a comparableroller cone bit.  Despite the increasedeffectiveness of the PDC bit and other technologies, we believe that operatorsand drilling engineers continue to actively seek ways to improve rates ofpenetration, particularly in hard rock and abrasive formations, and are veryreceptive to using promising new technologies.

 

**The PID System**

* *

*ParticleRecovery System*—The PID System utilizes a mobile shotdelivery and recovery system capable of operating with most conventionaldrilling rigs used in our target markets. Our system is designed to entrain,circulate, and recover the shot without allowing the material to pass throughthe rig pumps. Previous particle abrasive drilling systems did not have theability to circulate, separate, and re-circulate the abrasive or abradingparticles and the material passed through the normal rig pumps. An example isthe system known as “Abrasive-Jet Drilling” used by Gulf Research andDevelopment Co., a division of Gulf Oil Corporation (“Gulf”), in the 1960’s and1970’s. Gulf made a number of significant advances in the technology ofdelivering particles under pressure for the purpose of increasing rate ofpenetration, which aided us in the development of the PID System. Basically,the Gulf system used fine particle abrasives to scrape, scour, gouge or abradethe formations in order to remove it. This technology requires very highsurface pressures up to 11,000 psi in order to give the small particle thevelocity to abrade the formation ahead of the drill bit.  The PID System utilizes larger particles atnormal rig pressures to fracture the formation ahead of the drill bit.

 

*RigIntegration*—The PID System is designed to connect to andservice an operational well in progress with minimal interference to normaldrilling operations. All PID System equipment is either mounted on trucks ortrailers, and we expect that the system can be installed on a rig during ascheduled bit trip. A good portion of the PID System may be mobilized andrigged up offline so as not to interfere with the drilling operation inprogress. Once the operator is finished with the PID System, we expect that itcan be taken offline in one to two hours and demobilized with no furtherinterference with the drilling operation. We believe this operationaltransparency is extremely important for industry acceptance of the PID System.

 

*PID Bit*—Weare continuing the development of our fit-for-purpose PID bit. The PID bit is afixed-cutter bit designed with a PDC cutting structure.  Eight series of full scale tests wereconducted at TerraTek Drilling Laboratory (“TerraTek”), an independent drillingresearch and testing facility located in Salt Lake City, Utah during the periodfrom July 2002 through February 2003. These tests indicated that thePID bit and PID System are capable of achieving penetration rates ranging fromtwo to four times faster than current conventional methods in hard rockconditions similar to our target market. Our target markets are drillingintervals where hard and/or abrasive formations result in penetration ratesaveraging ten feet per hour or less.

 

**Recent Testing of the PID System**

 

Testing of the PID Systems was conducted at TerraTekin March and June of this year.  In March2005, we conducted a series of 11 full scale tests on two versions of the PIDbit designed with four jetting nozzles: (1) a high volume PID bit and(2) a low volume PID bit. The high volume PID bit is designed to operatewith 600 or more gallons per minute (“GPM”) of total fluid, including up to 16.5GPM of shot. The low volume PID bit is aimed at reducing horsepowerrequirements during drilling operations, and is designed to operate with 400 to450 GPM of total fluid, including up to 16.5 GPM of shot. Test results of thehigh volume PID bit during March performed in-line with our expectations. Inparticular, this PID bit demonstrated improved rate of penetration performanceand bit/cutter durability versus the previously tested 3-nozzle PID bit. Testsof the low volume PID bit indicated that the center nozzle of the bit wasundersized. This resulted in lack of shot to the center hole and large-sizedcuttings from the rock ring which caused the testing to end prematurely.

 

In June 2005, we conducted another series of 11 fullscale tests at TerraTek on three versions of the PID bit: (1) a modifiedversion of the high volume PID bit, (2) a modified version of the lowvolume PID bit, and (3) a next generation high

 

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volume PID bit. Design changes were made based on data collected duringthe March tests in order to improve shot distribution by modifying nozzlediameters and placement. All three bits exhibited consistent drillingperformance throughout a number of separate tests, including shot rates of 12,14 and 16.5 GPM, with bit weights varying at 5,000, 10,000 and 15,000 pounds.During this testing phase, we were able to determine that overall penetrationrates for all three bits met or exceeded our expectations. In general,penetration rates for the modified high volume PID bit and the next generationhigh volume PID bit demonstrated a greater than 10% improvement over the highvolume PID bit we tested in March. Further, we tested the modified low volumePID bit that we were unable to test reliably in March. The penetration rate ofthe modified low volume PID bit consistently performed as well as or betterthan the next generation high volume PID bit, and consistently exceededperformance of the original high volume PID bit and the modified high volumePID bit.

 

In July 2005, we completed a two week testprogram at the Gas Technology Institute’s Catoosa test drilling facility (“Catoosa”)near Tulsa, Oklahoma.  At Catoosa, wewere able to adapt the PID System to an actual well, run the system under fulloperating conditions and further test and refine procedures and processes foroperating the PID System.  During thistest sequence, we observed drilling penetration rates at or above expectedrates through very hard limestone intervals, but also through softer sandstonesand shale formations.  We also identifiedareas for improvement including the shot injector system, maintenance ofdesired mud properties and system procedures to improve connection time, shothandling at surface and some test site related improvements related to the testwell surface casing and rig flow line. Modifications and improvements were made in order to continue testingand to log more hours on the PID system at Catoosa in October and November2005.

 

In November 2005, we completed another three weeks oftesting at Catoosa and were able to log more continuous hours on the PID Systemunder various operating conditions.  Thevarious operating conditions tested include two PID bit designs; two PID bitsizes; both low and high flow rates of drilling fluid ranging from 425 to over600 GPM, and different shot injection rates. All conditions tested were effective at delivering target level rates ofpenetration through very hard and abrasive intervals.  We also developed and tested procedures foritems that did not perform satisfactorily in our prior tests at Catoosa in Julyof this year, including enhancing the shot injection system, reducing theconnection time and developing improvements in the handling of shot in thewellbore and at the surface.  The shotinjection system was improved, and it functioned and performed reliably duringthis test.  Based on this test, someadditional improvements will be made to the PID bit and also the shot recoverysystem at surface.  We believe these improvementsare rather straightforward and will not necessitate a return trip to Catoosa orTerraTek prior to deploying the PID system on a commercial trial.

 

Our primary products still need to demonstratesatisfactory performance in the commercial market. Our operations plan callsfor further research and development, including the development of differentbit sizes and a newer and more efficient injector system. Poor performance ofthe PID bit or other components of the PID System while conducting commercialtrials could further extend the shop and laboratory testing phase, which woulddelay the full commercialization of the PID System and increase the fundsneeded to complete our research and development. This would have the effect ofslowing our advancement as funds otherwise intended to build new PID Systemsand expand our operations may be needed to conduct additional research.

 

**Competition**

 

Based on theexperience of our management team in the oilfield services industry and theexploration and production industry, we believe that currently no other companyattempts to deliver a comparable drilling service utilizing technology that issimilar to the PID System and that is targeted to serve the hard rock drillingmarket.  The oilfield services industryin which we compete, however, is highly competitive, and most of our potentialcompetitors will have greater financial resources than we do. Many of ourpotential competitors have been in the oilfield drilling business for manyyears and have well-established business contacts with exploration andproduction companies. Competitors may enter markets served or proposed to beserved by us, and we may not be able to compete successfully against suchcompanies or have adequate funds to compete effectively.  Recent developments in PDC bits have madethem more durable and capable of drilling in certain hard rock environments;however, many customers operating in our target markets continue to utilizeroller cone rock bits.

 

**Patents**

 

*Acquisitionof Patents and Licenses.*    Ourpredecessor company acquired the intellectual property and certain assets andassumed certain liabilities underlying the PID technology in January 2004pursuant to certain acquisition agreements in which we agreed to(1) purchase certain of the assets and assume certain of the liabilitiesof ProDril Services Inc. (“PSI”) and

 

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ProDril Services International, Ltd. (“PSIL”) related to the PIDtechnology, (2) purchase certain patents related to the PID technologyfrom Curlett Family Limited Partnership, Ltd. (“CFLP”), (3) acquirecertain technology licenses from CCORE Technology and Licensing, Ltd. (“CTL”),(4) continue the funding of initial research and development expenses withrespect to the technology acquired, and (5) take steps towards thecommercialization of the PID technology.

 

Pursuant to such acquisition agreements with CFLP, we acquiredfrom CFLP their entire right, title and interest throughout the world in and topatents related to the PID technology, including all CFLP inventions and thefollowing patents:

 

•U.S. Patent No. 6,386,300, issued May 14, 2002, entitled “Formationcutting method and system.”

•U.S. Patent No. 6,581,700, issued June 24, 2003, entitled “Formationcutting method and system.”

 

In addition to the inventions embodied in the CFLPpatents described above, we also acquired from CFLP, among other things, otherpatent applications that are pending and certain proprietary know-howpertaining specifically to the PID technology.

 

The patent assignment from CFLP is subject to anexclusive license to CFLP to make and sell or otherwise commercially exploit,for non-oil and gas industry applications, products developed by CFLP thatembody the patents or inventions assigned to us by CFLP, or our improvementsthereto.  

 

In connection with the acquisition of such technology,we are required to pay to certain of the aforementioned entities a royaltyequal to, in the aggregate, four percent of our quarterly gross revenuereceived as a result of the patents, inventions and know-how received fromCFLP.

 

***Acquisitionof Patents and Licenses***

 

We have continued to enhance and improve upon the PIDtechnology and to develop additional technology and know-how in the applicationof the PID technology.  The PIDtechnology and related technologies remain core to our business, and we havecontinued to seek patent protection in the United States and other countries inwhich we expect there to be a significant market for application of ourtechnology.

 

**Research and Development**

 

We are in the development stage focused primarily onresearch and development.  We maintain anactive research and development program. The program improves existing products and processes, develops newproducts and processes, and improves engineering standards and practices thatwill serve the changing needs of our customers. Our expenditures for research and development activities were $2,802,155in 2005, $621,752 in 2004, and $39,626 from June 9, 2003 (date of inception) toSeptember 30, 2003.

 

In our continuing effort toenhance the PID technology, we have retained Beeken TechQuest, Ltd. (Beeken) todevelop a more efficient and cost effective shot injector system.  Beeken is led by Dr. B.N. Murali, formerlythe Vice President of Technology for Halliburton Energy Services.  During his last nine years at Halliburton,Dr. Murali was in charge of developing new technology for all product servicelines.  Beeken is designing a system toreplace the existing shot injection system with a simpler, less expensiveapproach.  This system has the potentialto reduce the cost of the PID System while providing redundant injectioncapability.

 

**Environmental Regulations**

 

We are subject to numerous and changing local, state, andfederal laws and regulations concerning the use, storage, treatment, disposaland general handling of materials, some of which may be considered to behazardous substances and wastes, and restrictions concerning the release ofpollutants and contaminants into the environment. These laws and regulationsmay require us to obtain and maintain certain permits and other authorizationsmandating procedures under which we must operate and restrict emissions anddischarges. Many of these laws and regulations provide for strict joint andseveral liabilities for the costs of cleaning up contamination resulting fromreleases of regulated materials, substances and wastes into the environment.Violation of these laws and regulations as well as terms and conditions ofoperating permits issued to us may result in the imposition of administrative,civil, and criminal penalties and fines, remedial actions or, in more serioussituations, shutdowns or revocation of permits or authorizations. We believethat future compliance by our operating businesses with existing laws andregulations will not have a material adverse effect on us and that futurecapital expenditures for environmental remediation will not be material.

 

We regularly monitor and review our operations,procedures and policies for compliance with environmental laws and regulationsand our operating permits. There can be no assurance that a review of our past,present or future operations by courts or federal, state, local or foreignregulatory authorities will not result in determinations that could have amaterial adverse effect on us.  Inaddition, the revocation of any of our material operating permits, the denialof any material permit application or the failure to renew any interim permit,could have a material adverse effect on us. In addition, compliance with

 

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more stringent environmental laws and regulations, more vigorousenforcement policies, or stricter interpretations of current laws andregulations, or the occurrence of an industrial accident, could have a materialadverse effect us.

 

**Employees**

 

As of November 30,2005, we had 15 employees.  None of ouremployees are covered by collective bargaining agreements.  We believe that relationships with ouremployees are satisfactory.

 

**Website**

 

Our website is located at www.particledrilling.com.  The filings we make with the Securities andExchange Commission (“SEC”), such as Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, andamendments to those reports, are available free of charge through our websiteas soon as reasonably practicable after they have been filed with or furnishedto the SEC pursuant to Section 13(a) or 15(d) of the Securities and ExchangeAct of 1934 (the “1934 Act”).  Forms 3, 4 and 5 filed with respect toequity securities under Section 16(a) of the 1934 Act are also availableon the website.  All of these materials are located at the “InvestorRelations” link.

 

Our website also includes the following corporategovernance materials, at the link “Corporate Governance:” the Code of BusinessConduct & Ethics, and charters of each Board committee, including the AuditCommittee, the Compensation Committee, and the Nominating and CorporateGovernance Committee. You may also obtain a printed copy of any of thematerials referenced above by contacting us through the website or at thefollowing address: Particle Drilling Technologies, Inc., 1021 Main Street,Suite 2650, Houston, Texas 77002.

 

**Item 1A. Risk Factors**

 

***We have a limitedoperating history and no revenues and are subject to risks inherent in a newbusiness enterprise. As a result, we have not demonstrated to date that we cansuccessfully implement our business plan or that the PID technology will besuccessful in a commercial application.***

 

We have recently acquired PDTI, which had a limitedoperating history and, accordingly, is subject to substantial risks inherent inthe commencement of a new business enterprise. Prior to our acquisition of PDTIin January 2005, we had no material operations. The business of PDTI wasoriginally established in June 2003 to: (1) purchase certain of theassets and assume certain of the liabilities of ProDril Services, Incorporated(“PSI”) and ProDril Services International, Ltd. (“PSIL”), related to thePID technology; (2) purchase certain patents underlying the PID technologyfrom the Curlett Family Limited Partnership, Ltd. (“CFLP”);(3) acquire certain technology licenses related to the PID technology fromCCORE Technology and Licensing, Ltd. (“CTL”); (4) continue thefunding of initial research and development expenses with respect to thetechnology acquired; and (5) take steps towards the commercialization ofthe PID technology. To date, the business has not generated any revenue from itsoperations. We may not be able to successfully develop, commercialize or marketour products, generate revenues, or operate profitably. Additionally, we andour business have a very limited operating history that investors can analyzeto aid them in making an informed judgment as to the merits of an investment inus. Any investment in us should be considered a high risk investment because youwill be investing in a development stage company with unforeseen costs,expenses, competition, and other problems to which new ventures are oftensubject. In addition, the technology we acquired is still in the developmentstage and has not yet been applied in a commercial setting. Currently we havenot entered into any contracts or agreements with potential customers. Becausewe are a development stage company, our prospects must be considered in lightof the risks, expenses, and difficulties encountered in establishing a newbusiness in a highly competitive industry.

 

***We have limitedsources of liquidity and may not be able to obtain sufficient funding torealize positive cash flows.***

 

We require substantial capital to pursue our operatingstrategy and execute our business plan. As we have no internal sources ofliquidity, we will continue to rely on external sources for liquidity, and forthe foreseeable future, our principal source of working capital will be fromcapital we have raised through private placements of our securities and otherexternal sources.

 

Our current monthly operating overhead isapproximately $275,000,excluding research and development costs, and we expect that such amount willincrease as we expand our operations. Should we require additional capital, we may not be able to obtain fundsfrom external sources in sufficient amounts to fund our business plan.

 

7

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Even if we are able to demonstrate the commercialapplication of our products, we may require additional capital in the future toproduce our products in sufficient commercial quantities in order for us torealize positive cash flows. Any such additional capital may lead to additionaldilution of our shareholders. Additionally, it may be difficult for us to raiseadditional capital in sufficient quantities or at all.

 

***The PID System is anew technology and it may never be accepted in the marketplace.***

 

Certain aspects of the PID technology have not beenused or deployed in a commercial oil and gas well. Market acceptance of ourproducts will largely depend upon our ability to demonstrate the PID System’sefficiency, cost effectiveness, safety features and ease of use. We may not beable to demonstrate that the PID System can effectively be deployed on acommercial oil and gas well in a safe and cost-effective manner. The use of thePID technology will also depend upon concerted sales efforts by us and ourmarketing team. The PID System may never be accepted in the market inpreference to other competing technologies that currently exist or that maysubsequently be developed. If our products are not generally accepted by themarketplace, we may not realize sufficient revenues or cash flow to execute ouroperations plan and we may be forced to pursue a different strategy orliquidate our company.

 

***In order to enterthe oilfield services market on a full scale basis, we must successfullycomplete additional research and development, the cost of which may exceed theamounts we have budgeted in our operations plan. Any such cost overruns couldexhaust our available capital and force us to raise additional capital, whichcapital may not be available or may lead to additional dilution of ourshareholders.***

 

Our primary products must demonstrate satisfactoryperformance in the commercial market. Our operations plan calls for furtherresearch and development, including the development of different bit sizes anda newer and more efficient injector system. Poor performance of the PID bit orother components of the PID System while conducting commercial trials couldfurther extend the shop and laboratory testing phase, which would delay thefull commercialization of the PID System and increase the funds needed tocomplete our research and development. This would have the effect of slowingour advancement as funds otherwise intended to build new PID Systems and expandour operations may be needed to conduct additional research.

 

Regardless of the success of the initial research anddevelopment, we will require additional research and development and capitalspending to continuously improve our service capabilities and expand ouroperations. We presently intend to finance a portion of our expansion throughthe use of bank or lease financing. As such, our inability to obtain suchfinancing on favorable terms, or at all, could delay or prevent us from fullycommercializing our technology. In addition, regardless of the amount ofresearch and development completed by us, our products may never be successfulin commercial operations.

*** ***

***We are obligated tomake certain royalty payments that will limit our profitability.***

 

In connection with our acquisition of the PIDtechnology, we agreed to make certain royalty payments to PSI and PSIL. Underour agreement with PSI, we are obligated to pay PSI a royalty on a quarterlybasis equal to 18.0% of our earnings before interest, income taxes,depreciation and amortization (“EBITDA”) derived from the use of the PIDtechnology for such quarter until an aggregate of $67,500,000 has been paid toPSI. Under our agreement with PSIL, we are obligated to pay PSIL a royalty on aquarterly basis equal to 2.0% of our EBITDA derived from the use of the PIDtechnology for such quarter until an aggregate of $7,500,000 has been paid. Wehave also entered into additional royalty agreements that require us to pay atotal of 4.0% of our quarterly gross revenue derived from the use of the PIDtechnology to certain entities from which we acquired the PID technology. Theseroyalty obligations will have the effect of limiting our liquidity and ourprofitability.

 

***We rely on theintellectual property rights we acquired to the PID technology and we may notbe able to successfully protect or defend our intellectual property rights. Ourcompetitive position depends to a significant extent on our ability to assertand defend our intellectual property rights in order to restrict othercompetitors from offering similar services.***

 

Our success depends on certain patents and patentapplications that we purchased from CFLP, CTL, PSI and PSIL, along with otherproprietary intellectual property rights we intend to develop. We rely on acombination of nondisclosure and other contractual arrangements and tradesecret, patent, copyright, and trademark laws to protect our proprietary rightsand the proprietary rights of third parties from whom we license intellectualproperty. The steps we have taken to protect our rights may not be adequate todeter misappropriation of our proprietary information. We also may not be ableto detect unauthorized use of and take appropriate steps to enforce ourintellectual property rights. In addition, the laws of some foreign countriesmay not protect our proprietary rights as fully or in the same manner as do thelaws of the United States. Also, despite the

 

8

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steps taken by us to protect our proprietary rights, others may developtechnologies similar or superior to the PID technology or design around theproprietary rights we own.

 

We are also subject to the risk of litigation alleginginfringement of third-party intellectual property rights. Any such claims couldrequire us to spend significant sums in litigation, pay damages, developnon-infringing intellectual property or acquire licenses to the intellectualproperty which is the subject of the asserted infringement. If we are unable tosuccessfully enforce our intellectual property rights, or if claims aresuccessfully brought against us for infringing the intellectual property rightsof others, such events could cause us to pay substantial damages, cause us tolose a key competitive advantage, force us to conduct additional research todevelop non-infringing technology or cause us to have to pursue a differentbusiness strategy.

 

***We are currentlyengaged in litigation that could have a material adverse effect on ourliquidity and results of operations.***

 

PDTI filed a lawsuit in District Court in HarrisCounty, Texas in November 2004 styled *ParticleDrilling Technologies, Inc. vs. PSI Distribution Incorporated, Harry B.Curlett, Curlett Family Limited Partnership, Ltd., CCore Technology andLicensing, Ltd., Deep Heat Energy Corporation, and Energeo, LP*to recover certain tangible and intangible assets that PDTI believes shouldhave been transferred as part of the Acquisition Agreement among PSI, theCurlett Group (as defined below) and the successor company of PDTI. It waspursuant to this acquisition that PDTI acquired its intellectual propertyrights to the PID technology. In January 2005, PDTI reached a settlementwith one of the defendants, PSI Distribution Incorporated (“PSID”), which isthe successor entity to PSI, whereby PDTI agreed to hold PSID harmless withregard to this lawsuit in exchange for PSID’s agreement to re-affirm and ratifythe Acquisition Agreement. Further, PDTI obtained in this settlement anyrights, claims and causes of action that PSID may have to pursue damages or torecover assets from the other parties named in the lawsuit.

 

On December 6, 2004, PDTI received a response tothe above-referenced lawsuit from certain of the defendants, namely Harry B.Curlett, CFLP, CTL and Deep Heat Energy Corporation, which we refer to as the “CurlettGroup,” in which the Curlett Group asserted a counterclaim against PDTIclaiming, among other things, that PDTI (1) owes Mr. Curlett $40,000plus default interest at 18% per annum under a promissory note and certain feesincurred in connection with collection under the note; (2) committed abreach of contract in connection with the Acquisition Agreement referenced inthe preceding paragraph and the closing of that agreement in January 2004;(3) engaged in economic duress and fraud in the inducement in connectionwith the negotiation and closing of the Acquisition Agreement; and(4) committed fraud in connection with that transaction. The counterclaimrequests damages of, among other things, judgment on the $40,000 principalamount of the promissory note plus accrued default interest and costs ofcollection, actual damages of not less than $10 million for breach ofcontract and fraud, exemplary damages of not less than $20 million and adeclaratory judgment rescinding the Acquisition Agreement.

 

By filing this lawsuit, we seek to recover theintellectual property related to the PID technology as it applies to non-oiland gas applications. We believe the counterclaim made by the Curlett Group iswithout merit. We intend to vigorously pursue our claims in this case and shallvigorously defend the alleged counterclaims by the Curlett Group. Discovery inthis litigation is ongoing, however, and our position with regard to the meritsof the various claims and defenses may change as additional information isadduced through the discovery process. The outcome of all litigation isinherently uncertain; as a result, we do not know at this time whether or notwe will recover any of the intellectual property that we seek to recover in ouroriginal petition or if any or all of the remedies requested by the CurlettGroup in their counter-claim will be awarded. If the monetary damages requestedin this counterclaim were granted in a judgment against us, such damages wouldseverely impair our ability to continue as a going concern. Furthermore, if therequest for rescission of the Acquisition Agreement that closed inJanuary 2004 is granted as requested by the counterclaim, such a judgmentcould have the effect of causing us to lose all intellectual property ownershiprights to the PID technology.

 

***We may face intensecompetition in our industry from companies with a more established reputationand greater financial resources than us.***

 

The oilfield services industry in which we compete ishighly competitive, and most of our potential competitors will have greaterfinancial resources than we do. Many of our potential competitors have been inthe oilfield drilling business for many years and have well-establishedbusiness contacts with exploration and production companies. Competitors mayenter markets served or proposed to be served by us, and we may not be able tocompete successfully against such companies or have adequate funds to competeeffectively.

 

9

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***Our stockholdersmay experience substantial dilution as a result of the exercise of outstandingoptions and warrants to purchase our common stock.***

 

In connection with our acquisition of PDTI, we assumedwarrants to purchase 228,000 shares of common stock and options issued underPDTI’s 2004 Incentive Stock Plan to purchase 3,205,000 shares of common stock.In connection with the private placement of our common stock inFebruary 2005, we granted the placement agent warrants to purchase1,500,000 shares of our common stock. Since our acquisition of PDTI, we haveissued options to purchase an additional 720,000******shares of our common stock. Thecommon stock issuable upon exercise of these options and warrants representsapproximately 19%of our outstanding shares of common stock on a fully-diluted basis. Theexercise of these options and warrants would result in substantial dilution toour existing stockholders and any sales of these shares of common stock, or theperception that these sales might occur, could lower the market price of ourcommon stock.

 

***We presently do notintend to pay cash dividends on our common stock.***

 

We currently anticipate that no cash dividends will bepaid on our common stock in the foreseeable future. While our dividend policywill be based on the operating results and capital needs of the business, weanticipate that all earnings, if any, will be retained to finance the futureexpansion of our company.

 

**Item 1B.  Unresolved Staff Comments**

 

None Applicable

 

**Item2.  Properties**

 

Our principal executive and administrative officefacility is leased in downtown Houston, Texas at One City Centre, 1021 MainStreet, Suite 2650, Houston, Texas 77002. We also lease an 11,000 square footoperating facility at 7407 Wright Road, Houston, Texas 77041.

 

We believe that our properties are generally in goodcondition, are well maintained, and are generally suitable and adequate tocarry on our business.

 

**Item 3. Legal Proceedings**

 

PDTI filed alawsuit in District Court in Harris County, Texas in November 2004 styled *Particle Drilling Technologies, Inc. vs. PSIDistribution Incorporated, Harry B. Curlett, Curlett Family LimitedPartnership, Ltd., CCore Technology and Licensing, Ltd., Deep HeatEnergy Corporation, and Energeo, LP* to recover certain tangible andintangible assets that PDTI believes should have been transferred as part ofthe Acquisition Agreement among PSI, the Curlett Group (as defined below) and thesuccessor company of PDTI. It was pursuant to this acquisition that PDTIacquired its intellectual property rights to the PID technology. InJanuary 2005, PDTI reached a settlement with one of the defendants, PSID,whereby PDTI agreed to hold PSID harmless with regard to this lawsuit inexchange for PSID’s agreement to re-affirm and ratify the AcquisitionAgreement. Further, PDTI obtained in this settlement any rights, claims andcauses of action that PSID may have to pursue damages or to recover assets fromthe other parties named in the lawsuit.

 

OnDecember 6, 2004, PDTI received a response to the above-referenced lawsuitfrom certain of the defendants, namely Harry B. Curlett, CFLP, CTL and DeepHeat Energy Corporation, which we refer to as the “Curlett Group,” in which theCurlett Group asserted a counterclaim against PDTI claiming, among otherthings, that PDTI (1) owes Mr. Curlett $40,000 plus default interestat 18% per annum under a promissory note and certain fees incurred inconnection with collection under the note; (2) committed a breach ofcontract in connection with the Acquisition Agreement referenced in thepreceding paragraph and the closing of that agreement in January 2004;(3) engaged in economic duress and fraud in the inducement in connectionwith the negotiation and closing of the Acquisition Agreement; and(4) committed fraud in connection with that transaction. The counterclaimrequests damages of, among other things, judgment on the $40,000 principalamount of the promissory note plus accrued default interest and costs ofcollection, actual damages of not less than $10 million for breach ofcontract and fraud, exemplary damages of not less than $20 million and adeclaratory judgment rescinding the Acquisition Agreement.

 

By filing thislawsuit, we seek to recover the intellectual property related to the PIDtechnology as it applies to non-oil and gas applications. We believe thecounterclaim made by the Curlett Group is without merit. We intend tovigorously pursue our claims in this case and shall vigorously defend thealleged counterclaims by the Curlett Group. Discovery in this litigation isongoing, however, and our position with regard to the merits of the various claimsand defenses may change as

 

10

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additional information is adduced through the discovery process. Theoutcome of all litigation is inherently uncertain; as a result, we do not knowat this time whether or not we will recover any of the intellectual propertythat we seek to recover in our original petition or if any or all of the remediesrequested by the Curlett Group in their counter-claim will be awarded. If themonetary damages requested in this counterclaim were granted in a judgmentagainst us, such damages would severely impair our ability to continue as agoing concern. Furthermore, if the request for rescission of the AcquisitionAgreement that closed in January 2004 is granted as requested by thecounterclaim, such a judgment could have the effect of causing us to lose allintellectual property ownership rights to the PID technology.

 

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

 

No matters weresubmitted during the fourth quarter of 2005 to a vote of the holders of ourcommon stock, through the solicitation of proxies or otherwise.

 

**PART II**

 

**Item 5.  Market for Registrant’s Common Equity, RelatedStockholder Matters and Issuer Purchases of Equity Securities**

 

**Market Information**

 

Our common stock trades on the NASDAQ Capital Marketunder the symbol PDRT.  Prior toJune 28, 2005, shares of our common stock were traded on the OTC BulletinBoard.  Prior to the announcement of ouragreement to acquire PDTI on July 14, 2004, there was limited trading in ourcommon stock and therefore the prices quoted for periods prior to such dateshould not be considered to be based on an established public tradingmarket.  The following table sets forththe high and low bid prices per share of our common stock for the fiscal yearsended September 30, 2005 and 2004.  Allprices quoted from the time when our common stock was traded on the OTCBulletin Board reflect inter-dealer prices, without retail mark-up, mark-downor commission and may not necessarily represent actual transactions.

 
| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2004**       |       |     |       |    |       |
| First Quarter  |       | $        | 0.10       |    | $          | 0.10 |   |
| Second Quarter |       | $        | 0.10       |    | $          | 0.10 |   |
| Third Quarter  |       | $        | 0.10       |    | $          | 0.10 |   |
| Fourth Quarter |       | $        | 3.75       |    | $          | 0.10 |   |
|           |       |     |       |    |       |
| **2005**       |       |     |       |    |       |
| First Quarter  |       | $        | 3.57       |    | $          | 3.39 |   |
| Second Quarter |       | $        | 6.09       |    | $          | 5.69 |   |
| Third Quarter  |       | $        | 6.15       |    | $          | 5.91 |   |
| Fourth Quarter |       | $        | 4.59       |    | $          | 4.22 |   |

 

**Holders**

 

The approximate number of holders of record of theshares of our common stock was 290 as of November 30, 2005.

 

**Use of Proceeds**

 

On June 29, 2005, the Securities and ExchangeCommission declared effective our registration statement of Form S-1(Registration No. 333-123925).  Theregistration statement registers for resale from time to time 14,131,538 sharesof our common stock previously issued to the selling stockholders named thereinfor an aggregate offering amount of $66,135,598.  We have not and will not receive any proceedsfrom the sale of the shares of common stock that are subject to theregistration statement.  The offering iscontinuing and ongoing and is not managed by an underwriter.  We have incurred expenses of approximately$105,000 in connection with the filing of the registration statement for legaland accounting fees and associated costs.

 

**Dividends**

 

Holders of shares of common stock will be entitled toreceive cash dividends when, as and if declared by our Board of Directors, outof funds legally available for payment thereof. However, if dividends are notdeclared by our Board of Directors, no dividends shall be paid. We have notpaid any dividends on our common stock since our inception.

 

We do not anticipate that any cash dividends will bepaid in the foreseeable future. While our dividend policy will be based on theoperating results and capital needs of the business, we anticipate that allearnings, if any, will be retained to finance our future expansion. Therefore,prospective investors who anticipate the need for immediate income by way ofcash dividends from their investment should not purchase our securities.

 

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**Securities Authorized for Issuance Under EquityCompensation Plans**

 

The following table summarizes as of September 30,2005, certain information regarding equity compensation to our employees,officers, directors and other persons under our equity compensation plans:

 
| **Plan category**                                            | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-  average exercise  price of  outstanding  options,  warrants and  rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  column (a))** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **(a)**                                                                                             | ** ** | **(b)**                                                                                | ** ** | **(c)**                                                                                                                                               | ** ** |
| Equity  compensation plans approved by security holders      |       | —                                                                                              |       | n/a                                                                                    |       | n/a                                                                                                                                                   |       |
| Equity  compensation plans not approved by security holders* |       | 5,593,000                                                                                           |       | $                                                                                      | 1.44       |                                                                                                                                                  | 1,230,000  |   |
|                                                         |       |                                                                                                |       |                                                                                   |       |                                                                                                                                                  |       |
| Total                                                        |       | 5,593,000                                                                                           |       | $                                                                                      | 1.44       |                                                                                                                                                  | 1,230,000  |   |

 

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*      The following equitycompensation plans have not been approved by security holders:

 

·        In April 2004, the Board of Directors of ParticleDrilling, Inc. approved and adopted the 2004 Stock Plan.  The stockholders of PDTI adopted this plan inAugust 2004.  This plan provides for theissuance of incentive stock options, non-statutory stock options and restrictedstock grants to our directors, employees and consultants.  This plan provides for the issuance ofoptions and restricted stock awards to purchase or issue up to 3,500,000 sharesof common stock.  Awards may be grantedat not less than the fair market value (as defined in this plan) on the datesuch awards are granted.  The optionsexpire ten years from the date granted unless otherwise specified in the awardagreement.

·        In March 2005, our Board of Directors approved andadopted the Particle Drilling Technologies, Inc. 2005 Stock IncentivePlan.  This plan provides for theissuance of incentive stock options, non-statutory stock options and restrictedstock grants to our directors, employees and consultants.  This plan provides for the issuance ofoptions and restricted stock awards to purchase or issue up to 2,000,000 sharesof common stock.  Awards may be grantedat not less than the fair market value (as defined in this plan) on the datethe awards are granted.  The optionsexpire ten years after date of grant unless otherwise specified in the awardagreement.  

·        On April 30, 2004, ParticleDrilling, Inc. granted warrants to ten consultants as consideration forservices provided to Particle Drilling, Inc. Pursuant to these warrants, the ten consultants have the right topurchase up to an aggregate of 90,000 shares of common stock of ParticleDrilling, Inc. (consisting of warrants to purchase 30,000 shares, 25,000shares, 6,000 shares, 6,000 shares, 5,000 shares, 5,000 shares, 5,000 shares,4,000 shares, 2,000 shares and 2,000 shares). On June 17, 2004, Particle Drilling, Inc. granted warrants to anadditional consultant for services provided to Particle Drilling, Inc., pursuantto which such consultant has the right to purchase up to 10,000 shares ofcommon stock of Particle Drilling, Inc. The warrants described in this paragraph have an exercise price of $0.12and a maximum term of five years from the date granted.  All of these warrants were converted intowarrants to purchase common stock of PDTI in connection with the merger ofParticle Drilling, Inc. into PDTI, and were then assumed by our company inconnection with our acquisition of PDTI.

·        On November 1, 2004, PDTIgranted warrants to two consultants as consideration for services provided toPDTI, pursuant to which such consultants have the right to purchase up to10,000 shares and 2,500 shares, respectively, of common stock of PDTI.  The warrants described in this paragraph havean exercise price of $3.00 per share and maximum term of five years from thedate granted.  In connection with ouracquisition of PDTI, we assumed these warrants.

·        On January 11, 2005, PDTIgranted warrants to eight parties affiliated with the placement agent ascompensation for their services in connection with the private placement ofPDTI Series A preferred stock in January 2005. Pursuant to these warrants, the parties affiliated with the placementagent have the right to purchase up to an aggregate of 65,500 shares of ourcommon stock (consisting of warrants to purchase 32,641 shares, 10,000 shares,6,667 shares, 5,000 shares, 5,000 shares, 2,192 shares, 2,000 shares and 2,000shares).  The warrants described in thisparagraph have an exercise price of $2.00 and a maximum term of five years fromthe date granted.  In connection with ouracquisition of PDTI, we assumed these warrants.

·        On February 9, 2005, wegranted warrants to seven parties affiliated with the placement agent inconnection with the private placement of our common stock in February 2005 asconsideration for services provided to us. Pursuant to these warrants, the parties affiliated with the placementagent have the right to purchase up to an aggregate of 1,500,000 shares of ourcommon stock (consisting of warrants to purchase 800,000 shares, 360,000shares, 135,000 shares, 135,500 shares, 30,000 shares, 25,000 shares and 15,000shares).  The warrants described in thisparagraph have an exercise price of $2.00 per share and a maximum term of tenyears from the date granted.

 

**Item 6.  Selected Financial Data**

 

The following table sets forth selected financial dataof the Company derived from our consolidated financial statements. The selectedfinancial data should be read in conjunction with the Company’s consolidatedfinancial statements and notes thereto, included elsewhere in this report.

 

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| ** **                                  | ** ** | ** **                   | ** ** | ** **        | ** ** | **Period from  June 9, 2003  (date of  inception) to** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-------------------|------------|--------------------------------------------------------|------------|
| ** **                                  | ** ** | **Year Ended September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                  | ** ** | **2005**                     | ** ** | **2004**          | ** ** | **2003**                                               | ** ** |
| ** **                                  | ** ** | **(Restated)**               | ** ** | ** **        | ** ** | ** **                                             | ** ** |
| **Statement  of Operations Data:**          |       |                         |       |              |       |                                                   |       |
| Revenues                                    |       | $                            | —     |              | $          | —                                                 |       | $ | — |   |
| Operating  expenses:                        |       | —                       |       | —            |       | —                                                 |       |
| Research and  development                   |       | 2,802,155                    |       | 621,752           |       | 39,626                                                 |       |
| General and  administrative                 |       | 3,182,313                    |       | 2,683,024         |       | 503,158                                                |       |
| Loss from  operations                       |       | (5,984,468                   | )          | (3,304,776        | )          | (542,784                                               | )          |
| Other income  (expenses)                    |       | 260,050                      |       | (26,224           | )          | —                                                 |       |
| Net loss                                    |       | $                            | (5,724,418 | )                 | $          | (3,331,000                                             | )          | $ | (542,784 | ) |
|                                        |       |                         |       |              |       |                                                   |       |
| **Basic  and Diluted Net Loss Per Share:**  |       |                         |       |              |       |                                                   |       |
| Loss from operations                        |       | $                            | (0.27      | )                 | $          | (0.25                                                  | )          | $ | (0.07 | ) |
| Net loss                                    |       | $                            | (0.26      | )                 | $          | (0.25                                                  | )          | $ | (0.07 | ) |
| Weighted average  shares outstanding        |       | 22,150,365                   |       | 13,364,183        |       | 7,741,646                                              |       |
|                                        |       |                         |       |              |       |                                                   |       |
| **Cash  Flow Data:**                        |       |                         |       |              |       |                                                   |       |
| Net cash used in  operating activities      |       | $                            | (4,625,184 | )                 | $          | (1,714,691                                             | )          | $ | (250,566 | ) |
| Net cash used in  investing activities      |       | (1,723,254                   | )          | (267,546          | )          | (351,031                                               | )          |
| Net cash  provided by financing activities  |       | 16,832,721                   |       | 1,999,098         |       | 605,099                                                |       |
|                                        |       |                         |       |              |       |                                                   |       |
| **Balance  Sheet Data (at end of period):** |       |                         |       |              |       |                                                   |       |
| Cash and cash  equivalents                  |       | $                            | 10,504,646 |              | $          | 20,363                                                 |       | $ | 3,502 |   |
| Working capital  surplus (deficiency)       |       | 9,386,096                    |       | (1,301,027        | )          | (5,575                                                 | )          |
| Total assets                                |       | 13,548,413                   |       | 1,570,585         |       | 362,033                                                |       |
| Long-term debt                              |       | 9,463                        |       | 20,201            |       | —                                                 |       |
| Total  stockholders’ equity            |       | 12,148,107                   |       | 118,459           |       | 69,120                                                 |       |

 

**Item 7.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

The followingdiscussion of our financial condition and results of operations should be readtogether with the unaudited consolidated financial statements and related notesthat are included elsewhere in this report.

 

**Restatementof Financial Statements**

** **

Thehistorical information for the year ended September 30, 2005, and for theperiod from June 9, 2003 (date of inception) to September 30, 2005, have beenrestated after determining that the Company’s policy of recording stock-basedemployee compensation upon vesting of the underlying equity award wasinconsistent with the guidelines set forth under Statements of FinancialAccounting 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 consolidatedfinancial statements, the Audit Committee of the Company’s Board of Directorsdetermined that it was necessary to restate the consolidated financialstatements contained in the Company’s original annual report on Form 10-K forthe year ended September 30, 2005 and the Company’s original quarterly reporton Form 10-Q for the period ended June 30, 2005.

 

As a result of therestatement, net loss for the year ended September 30, 2005 and for the periodfrom June 9, 2003 (date of inception) to September 30, 2005 was increased by$437,350.

 

The following is asummary of the effect of the restatement on the consolidated financialstatements and net loss per share amounts affected on our previously reportedconsolidated financial statements:

 
| ** **                                        | ** ** | **Increase from Previously Reported Amounts for the:** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                        | ** ** | ** **                                             | ** ** | ** ** | ** ** | **Period from** | ** ** |
| ** **                                        | ** ** | ** **                                             | ** ** | ** ** | ** ** | **June 9, 2003** | ** ** |
| ** **                                        | ** ** | ** **                                             | ** ** | ** ** | ** ** | **(date of** | ** ** |
| ** **                                        | ** ** | ** **                                             | ** ** | ** ** | ** ** | **inception) to** | ** ** |
| ** **                                        | ** ** | **Year Ended September 30,**                           | ** ** | **September 30,** | ** ** |
| ** **                                        | ** ** | **2005**                                               | ** ** | **Before 2005** | ** ** | **2005** | ** ** |
|                                              |       |                                                   |       |   |   |   |   |
| **Statement of Operations Data:**                 |       |                                                   |       |   |   |   |   |
| Operating expenses:                               |       |                                                   |       |   |   |   |   |
| General and  administrative                       |       | $                                                      | 437,350    |   | $ | — |   | $ | 437,350 |   |
| Loss from operations                              |       | 437,350                                                |       | — |   | 437,350 |   |
| Net loss                                          |       | 437,350                                                |       | — |   | 437,350 |   |
|                                              |       |                                                   |       |   |   |   |   |
| Net loss per common share - basic and diluted     |       | $                                                      | 0.02       |   | $ | — |   | $ | 0.02 |   |
|                                              |       |                                                   |       |   |   |   |   |
| **Cash Flow Data:**                               |       |                                                   |       |   |   |   |   |
| Cash flows from operating activitities:           |       |                                                   |       |   |   |   |   |
| Net loss                                          |       | $                                                      | 437,350    |   | $ | — |   | $ | 437,350 |   |
| Stock-based  compensation                         |       | 437,350                                                |       | — |   | 437,350 |   |
| Net cash used in operating activities             |       | —                                                 |       | — |   | — |   |
|                                              |       |                                                   |       |   |   |   |   |
| **Balance Sheet Data (at end of period):**        |       |                                                   |       |   |   |   |   |
| Stockholders' equity                              |       |                                                   |       |   |   |   |   |
| Additional  paid-in-capital                       |       | $                                                      | 437,350    |   | $ | — |   | $ | 437,350 |   |
| Deficit  accumulated during the development stage |       | 437,350                                                |       | — |   | 437,350 |   |
| Total Stockholders' equity                        |       | —                                                 |       | — |   | — |   |

 

**Overview**

 

On January 14, 2005, we acquired ParticleDrilling Technologies, Inc., a privately-held Delaware corporation (“PDTI”).As a result of this acquisition, our company, which previously was a shellcompany that had no material operations, acquired the business of PDTI and weare now engaged in the development of the PID System (the "PIDSystem"), 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.

 

We are a development-stage company and have a limitedoperating history.  Our predecessorcompany for financial reporting purposes was formed on June 9, 2003 toacquire the technology related to the PID System (the “PID technology”). We arestill developing this technology, and to date, we have not generated anyrevenues from our operations.  As wecontinue to execute our operations plan, we expect our development andoperating expenses to increase.

 

In June 2005, we completed the second phase of atwo phase test on the patented PID bit at the TerraTek Drilling Laboratory (“TerraTek”),an independent drilling research and testing facility located in Salt Lake City,Utah.  In July 2005, we completed atwo week test program at the GTI Catoosa drilling facility (“Catoosa”) outsideof Tulsa,

 

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Oklahoma.  At Catoosa, we wereable to run the PID System in an actual well, and also test and refine theoperating procedures and processes to better prepare for actual fieldwork.  Overall, we were pleased with the PID System’sdrilling performance and identified areas for operational improvement.

 

In November 2005, wecompleted our testing program at Catoosa and were able to run the PID Systemwhile drilling multiple hard and abrasive intervals.  Additionally, we were able to evaluateperformance and further develop operating procedures for the PID System.  We also developed and tested procedures foritems that did not perform satisfactorily in our prior tests at Catoosa in Julyof this year, including enhancing the shot injection system, reducing theconnection time and developing improvements in the handling of shot in thewellbore and at the surface.  The shotinjection system was improved and functioned and performed reliably during thetest.

 

The various operatingconditions tested include two drill bit (PID bit) designs; two PID bit sizes;both low and high flow rates of drilling fluid ranging from 425 to over 600GPM, and different shot injection rates. All conditions tested were effective at delivering target level rates ofpenetration through very hard and abrasive intervals.  During testing we identified certainengineering and design improvements that will be implemented to make the systemmore robust.  In some instances, the highflow PID bits suffered fracturing and washout erosion problems associated withthe nozzles.  We are confident that withsome adjustments to material and design in specific areas of the PID bit, thisissue will be overcome, as it was not a prevalent problem with all PID bitstested.  The modifications needed toimprove performance can be fully evaluated in our research facility in Houston,Texas, thus avoiding the need to return to Catoosa or TerraTek prior todeploying the PID System on a commercial trial.

 

During the test program,representatives from potential customers visited the test site and witnessedtesting.  We believe the PID System willbe available for commercial trials in target application areas in the first calendarquarter of 2006.  The immediate marketfor this drilling system will focus on wells that are drilling less than 100feet per day in a normal pressure environment utilizing a 7 7/8” or 8 1/2” bit.

 

*Researchand development.*    We have made andexpect to continue to make substantial investments in research and developmentactivities in order to develop and market our PID technology. Research anddevelopment costs consist primarily of general and administrative and operatingexpenses related to research and development activities. We expense researchand development costs as incurred except for property, plant and equipmentrelated to research and development activity that have an alternative futureuse. Property, plant and equipment for research and development activity thathave an alternative future use are capitalized and the related depreciation isexpensed as research and development costs.

 

In our continuing effort toenhance the PID technology, we have retained Beeken TechQuest, Ltd. (Beeken) todevelop a more efficient and cost effective shot injector system.  Beeken is led by Dr. B.N. Murali, formerlythe Vice President of Technology for Halliburton Energy Services.  During his last nine years at Halliburton,Dr. Murali was in charge of developing new technology for all product servicelines.  Beeken is designing a system toreplace the existing shot injection system with a simpler, less expensiveapproach.  This system has the potentialto reduce the cost of the PID System while providing redundant injectioncapability.

 

*Generaland administrative.*    General andadministrative expenses consist primarily of salaries and benefits, officeexpense, professional services, and other corporate overhead costs. We haveexperienced and expect to continue to experience increases in general andadministrative expenses as a result of: (1) becoming subject to reporting andcompliance obligations applicable to publicly-held companies inJanuary 2005; (2) stock-based compensation accounted for under Statementsof Financial Accounting Standards (“SFAS”) No. 123(R), *Share-BasedPayment*; and (3) as we continue to develop, test and prepare the PIDtechnology for commercialization.

 

***Comparison of YearEnded September 30, 2005 with Year Ended September 30, 2004***

 

*Researchand development.*    Research anddevelopment expenses were $2,802,155 and $621,752 for the years endedSeptember 30, 2005 and 2004, respectively, representing an increase of$2,180,403.  We had only a limitedability to develop the PID technology due to our lack of funds available duringthe year ended September 30, 2004.  As aresult of the completion of our private placement in February 2005, we havecontinued to use substantial resources during fiscal 2005 to develop and testthe PID technology, including a test program conducted at TerraTek during Marchand June 2005 and a test program

 

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conducted at Catoosa during July and November 2005.  In fiscal 2005, research and developmentexpenses also increased due to direct costs associated with the development ofthe injector system and PID bits of $1,508,430 while no such comparable costswere incurred in fiscal 2004.  Indirectcost, or overhead, relating to research and development increased $671,973during fiscal 2005 compared to fiscal 2004. We hired additional employees, made certain modifications to ourresearch facility and had an increase in depreciation expense as a result ofadditional property purchased during fiscal 2005.

 

*Generaland administrative.*    General andadministrative expenses were $3,182,313 and $2,683,024 for the years endedSeptember 30, 2005 and 2004, respectively, representing an increase of $499,289.  The increase is primarily related toreporting and compliance obligations applicable to publicly-held companies andstock-based compensation.

 

*Otherincome (expenses).*    Other income(expenses) were $260,050 and ($26,224) for the years ended September 30,2005 and 2004, respectively, representing an increase in other income of$286,274.  The increase was primarilyattributable to interest income, rental income and the gains on debtextinguishment during fiscal 2005. Interest income was due to the interest earned on the investment offunds received in our private placement in February 2005.  In addition, we record $7,761 each month inrental income due from Energy XXI, an affiliate of John D. Schiller (our formerinterim President and Chief Executive Officer until November 15, 2005, andcurrently one of our directors).  Such monthlyrental payments do not begin until December 2005.  Gains on debt extinguishment were due tosettlements on a note payable and certain accounts payable that were related tothe liabilities we assumed in connection with our acquisition of the PIDtechnology.

 

***Comparison of YearEnded September 30, 2004 with Period from June 9, 2003 (date ofinception) to September 30, 2003***

 

*Researchand development.*    Research anddevelopment expenses were $621,752 and $39,626 for the year endedSeptember 30, 2004 and for the period from June 9, 2003 toSeptember 30, 2003, respectively, representing an increase of$582,126.  The increase was principallydue to:  (1) the short term of ourexistence during fiscal year 2003; (2) the acquisition of our core technologyduring fiscal year 2004; and (3) depreciation expense related to researchand development equipment of $109,376 during fiscal year 2004.  In January 2004, we acquired the PIDtechnology and began design work on the PID bit and the PID System.  During fiscal year 2004, we also moved ouroperating facility from Cody, Wyoming to Houston, Texas.

 

*Generaland administrative.*    General andadministrative expenses were $2,683,024 and $503,158 for the year endedSeptember 30, 2004 and for the period from June 9, 2003 to September 30,2003, respectively, representing an increase of $2,179,866.  The increase was primarily due to the shortterm of our existence during fiscal year 2003. During fiscal year 2004, we issued common stock valued at approximately$974,000 for services primarily connected with placement agent and advisoryservices.

 

**Liquidity and Capital Resources**

 

Our principal sources of liquidity are cash and cashequivalents.  Cash requirements throughthe end of the fiscal year 2006 are primarily to fund research and developmentactivities, to continuously improve service capabilities, expand operations,general and administrative costs and capital expenditures.  We believe we have sufficient resources tomeet our working capital and capital expenditure requirements for at least thenext 12 months; however, our continued existence depends on the successfuldevelopment of the PID technology and our ability to successfully commercializethis technology.

 

Since inception on June 9, 2003 throughSeptember 30, 2005, we have financed our operations through private salesof our equity and the issuance of convertible notes payable, totaling netproceeds of $19,436,918.  As ofSeptember 30, 2005, we had $10,504,646 in cash and cash equivalents.

 

On February 9, 2005, we sold 9,000,000 shares ofour common stock at $2.00 per share in a private placement and received grossproceeds of $18,000,000.  We paidcommissions 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 thisprivate placement, we issued ten year warrants to persons associated with theplacement agent to purchase 1,500,000 shares of our common stock in theaggregate at $2.00 per share.  Inaddition, we used $1,500,000 of these proceeds to repurchase 3,000,000 sharesof our common stock from Prentis B. Tomlinson (PDTI’s former President andChief Executive Officer until December 2, 2004). These shares werepurchased as treasury stock and recorded at cost.

 

*CashFlows from Operations. *Cash flow used for operations is primarily affected by ourresearch and development progress and business development.  Net cash flows used for operations during theyear ended September 30, 2005 were $4,625,184 compared to $1,714,691 and$250,566 for fiscal 2004 and fiscal 2003, respectively.  The increase from fiscal 2004 to fiscal 2005was the result of our successful fundraising efforts in February 2005 allowingus more cash resources to

 

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increase the planned development expenditures for the PIDtechnology.  In addition, we becamesubject to the reporting requirements of the Securities Exchange Act of 1934 inJanuary 2005, thus resulting in increased general and administrative costs.  The increase from fiscal 2003 to fiscal 2004was primarily due to our being in operation for only four months for the periodended September 30, 2003.  Duringfiscal year 2004, we began developing the PID technology that we acquired inJanuary 2004.  Our working capitalsince inception (June 9, 2003) has been fully funded from cash flows fromfinancing activities.

 

*CashFlows from Investing Activities. *Our capital spendingfor the year ended September 30, 2005 was $1,723,254 compared to $267,546 and$351,031 for fiscal 2004 and fiscal 2003, respectively.  During the year ended September 30,2005, we increased capital spending for our research and development activitiesin accordance with our 2005 capital budget. Our capital spending sinceinception (June 9, 2003) has been fully funded from cash flows fromfinancing activities.  We anticipate that our capital expenditures for thenext several months will continue to be fully funded from our available cashand cash equivalents.

 

*CashFlows from Financing Activities.  *Net cash provided byfinancing activities for year ended September 30, 2005 was $16,832,721compared to $1,999,098 and $605,099 for fiscal 2004 and fiscal 2003,respectively.  During each of the yearsended September 30, 2005 and 2004, and during the period from June 9, 2003(date of inception) to September 30, 2003, we received net proceeds of$18,647,666, $2,299,696, and $581,904, respectively, from the issuance of ourcommon stock and convertible notes. During the year ended September 30, 2005, we used $1,500,000 torepurchase 3,000,000 shares of common stock from a shareholder.  We used$314,945, $277,403 and $0 to repay notes payable during the years endedSeptember 30, 2005 and 2004, and during the period from June 9, 2003 (dateof inception) to September 30, 2003, respectively.  During the year ended September 30,2004, a $553,500 note was converted to common stock, and we used $23,195 torepay borrowings under a loan agreement with related parties, Prentis B.Tomlinson (PDTI’s former President and Chief Executive Officer untilDecember 2, 2004), and an affiliate of Prentis B. Tomlinson.

 

*ContractualObligations.*    Our contractualobligations at September 30, 2005 are set forth in the table below.  Our long-term debt obligation (including currentportion of long-term debt) is related to equipment that was financed for athree year period, beginning July 2004, and is secured by the sameequipment.  Our operating leaseobligations consist of our office and commercial operating facility that are bothlocated in Houston, Texas.

 

In March 2005, we entered into a five year leaseagreement for new corporate offices that commenced in June 2005.  We moved our previous corporate offices thatwere located at 808 Travis Street, Suite 850, Houston, Texas 77002 to 1021 MainStreet, Suite 2650, Houston, Texas 77002. In March 2005, we delivered to the lessor a security deposit 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 $18,758.

 

In June 2005, we extended the commercialoperating lease that expired June 30, 2005 for one additional year.  The commercial operating lease will expireJune 30, 2006. The future minimum lease payments under this lease are$43,200.

 
| ** **                                              | ** ** | **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) |       | $                          | 21,060     |   | $ | 11,597 |   | $ | 9,463 |   | $ | — |   | $ | — |   |
| Operating Lease  Obligations                            |       | 1,020,199                  |       | 248,214 |   | 615,042 |   | 156,943 |   | — |   |
|                                                    |       |                       |       |   |   |   |   |   |   |   |   |
| Total                                                   |       | $                          | 1,041,259  |   | $ | 259,811 |   | $ | 624,505 |   | $ | 156,943 |   | $ | — |   |

 

**Off-Balance Sheet Arrangements**

 

In connection with the acquisition of the PIDtechnology in January 2004, PDTI entered into a Royalty Agreement withProDril Services, Incorporated (“PSI”) pursuant to which we are obligated topay PSI a royalty on a quarterly basis equal to 18% of our earnings beforeinterest, income taxes, depreciation and amortization (“EBITDA”) derived fromthe use of the PID technology, until an aggregate of $67,500,000 has been paid.PDTI also entered into a Royalty Agreement in

 

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January 2004 with ProDril Services, International, Ltd. (“PSIL”)pursuant to which we are obligated to pay PSIL a royalty on a quarterly basisequal to 2% of our EBITDA derived from the use of the PID technology, 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, derived fromthe use of the PID technology.  As ofSeptember 30, 2005, we had no revenues or EBITDA; therefore no royaltieshave been paid or accrued.

 

**Related Party Transactions**

 

In March 2005, we entered into a five yearsublease agreement with an affiliate of John D. Schiller, our former interimPresident and Chief Executive Officer until November 15, 2005, and currentlyone of our directors pursuant to which this affiliate subleased from usapproximately 5,200 square feet of our corporate office space, beginning inJune 2005.  Future annual minimum rental income associated with thesublease is $93,128.  Total futureminimum rental income associated with the sublease for the full term of thelease is $442,358.

 

We believe that the transaction described above wasnegotiated on an arm’s length basis and that the terms of the transaction wasat least as favorable to us as those that could have been obtained from anunaffiliated third party.

 

**Critical Accounting Policies**

 

The discussion and analysis of our financial conditionand results of operations is based on our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these consolidated financial statements requires usto make estimates and judgments that affect the reported amounts of assets,liabilities and expenses.  We base ourestimates on historical experience and on various other assumptions that we believeto be reasonable under the circumstances, the results of which form the basisfor making judgments about the carrying values of assets and liabilities thatare not readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.  We believethe following critical accounting policies affect our most significantjudgments and estimates used in the preparation of our consolidated financialstatements.

 

*ReverseAcquisition. *The acquisition of PDTI was accounted foras a reverse acquisition.  Pursuant tothe guidance in Appendix B of SEC Accounting Disclosure Rules andPractices Official Text, we believe the acquisition of PDTI was a merger of a privateoperating company into a non-operating public shell corporation with nominalnet assets which typically results in the owners and management of the privatecompany having actual or effective operating control of the combined companyafter the transaction, with the shareholders of the former public shellcontinuing only as passive investors. These transactions are considered by the staff of the Securities andExchange Commission to be capital transactions in substance, rather thanbusiness 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, thereverse acquisition has been accounted for as a recapitalization. Foraccounting purposes, PDTI is considered the acquirer in the reverseacquisition.  The historical financialstatements are those of PDTI.  Net lossper share for periods prior to the merger in January 2005 are restated toreflect the number of equivalent shares received by the acquiring company.

 

*Impairmentof Long-Lived Assets. *We evaluate our long-lived assetsfor indicators of possible impairment by comparison of the carrying amounts tofuture net undiscounted cash flows expected to be generated by such assets whenevents or changes in circumstances indicate the carrying amount of an asset maynot be recoverable.  Should an impairmentexist, the impairment loss would be measured based on the excess carrying valueof the asset over the asset’s fair value or discounted estimates of future cashflows.  We also evaluate the capitalizedcosts for patents and patent applications filed but not issued for possibleimpairments.  We have not identified anysuch impairment losses to date.

 

*Stock-BasedCompensation. *In December 2004, the Financial AccountingStandards Board (“FASB”) issued a revision to SFAS No. 123, *Share-Based Payment*.  This statement establishes standards for theaccounting for transactions in which an entity exchanges its equity instrumentsfor goods or services.  It also addressestransactions in which an entity incurs liabilities in exchange for goods orservices that are based on the fair value of the entity’s equity instruments orthat may be settled by the issuance of those equity instruments.  This statement focuses primarily onaccounting for transactions in which an entity obtains employee services inshare-based payment transactions.  Thisstatement does not change the accounting guidance for share-based paymenttransactions with parties other than employees provided in SFAS No. 123 asoriginally issued.  This statement iseffective for new awards and those modified, repurchased or cancelled ininterim or annual reporting periods beginning after June 15, 2005.  We early adopted this standard uponinception.

 

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*Researchand Development. *The costs of materials and equipmentor facilities that are acquired or constructed for research and developmentactivities and that have alternative future uses are capitalized as tangibleassets when acquired or constructed.  Thecost of such materials consumed in research and development activities and thedepreciation of such equipment or facilities used in those activities areresearch and development costs.  However,the costs of materials, equipment, or facilities acquired or constructed forresearch and development activities that have no alternative future uses areconsidered research and development costs and are expensed at the time thecosts are incurred.

 

*IncomeTaxes.*  The Company reports its income taxes inaccordance with SFAS 109, *Accounting for IncomeTaxes*, which calls for the utilization of the asset and liabilitymethod of accounting for income taxes. Under this method, deferred taxes are determined based on differencesbetween financial reporting and tax bases of assets and liabilities and aremeasured using the enacted marginal tax rates and laws that will be in effectwhen the differences reverse.  Temporarydifferences have been created for all stock option plans and are included inour SFAS 109 computation.  AtSeptember 30, 2005, we had cumulative net operating loss carryforwards ofapproximately $7,001,000, which expire in years 2006 through 2024.  No effect has been shown in the consolidatedfinancial statements for the net operating loss carryforwards as the likelihoodof future tax benefit from such net operating loss carryforwards is notdeterminable at this time.  Accordingly,the potential tax benefits of the net operating loss carryforwards, estimatedbased upon tax rates at September 30, 2005, have been offset by valuationreserves of the same amount.

 

*NetLoss per Share.*** **The Company has presented basicand diluted net loss per share pursuant to SFAS No. 128, *Earnings Per Share*.  In accordance with SFAS No. 128, basicand diluted net loss per share has been computed using the weighted-averagenumber of shares of common stock outstanding during the period.  Dilutive net loss per share would give affectto the dilutive effect of common stock equivalents consisting of options andwarrants.  Potentially dilutivesecurities have been excluded from the net loss per common share calculation asthe effects would be antidilutive. Potentially dilutive securities for the years ended September 30, 2005and 2004 and for the period from June 9, 2003 (date of inception) toSeptember 30, 2003 that have been excluded are 991,711, 98,771 and 0,respectively.

 

**Recent Accounting Pronouncements**

 

In May 2005, the Financial Accounting StandardsBoard issued SFAS No. 154, *Accounting Changes andError Corrections*.  This newstandard replaces Accounting Principals Board Opinion (“APB”) No. 20, *Accounting Changes,* and SFAS No. 3, *Reporting Accounting Changes in Interim Financial Statements*.  This statement changes the requirements forthe accounting for and reporting of a change in accounting principle andapplies to all voluntary changes in accounting principle.  It also applies to changes required by anaccounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. When a pronouncement includes specific transition provisions, thoseprovisions should be followed.  APBNo. 20 required that most voluntary changes in accounting principle berecognized by including in net income of the period of the change thecumulative effect of changing 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 SFAS No. 154 are effective for fiscal years beginningafter December 15, 2005.  As such we are required to adopt SFAS No. 154by October 1, 2006.  We do not expect this statement to have amaterial impact on our consolidated financial statements.

 

**Forward-Looking Statements**

 

Statements in this annual report on Form 10-Kthat are not historical facts (including any statements concerning plans andobjectives of management for future operations or economic performance, orassumptions or forecasts related thereto) are forward-looking statementssubject to Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. These statements can be identified bythe use of forward-looking terminology including “forecast,” “may,” “believe,”“expect,” “anticipate,” “estimate,” “continue” or other similar words. Thesestatements discuss future expectations, contain projections of results ofoperations or of financial condition or state other “forward-looking”information.  We and our representativesmay from time to time make other oral or written statements that are alsoforward-looking statements.

 

These forward-looking statements are made based uponour management’s current plans, expectations, estimates, assumptions andbeliefs concerning future events impacting us and therefore involve a number ofrisks and uncertainties.  We caution thatforward-looking statements are not guarantees and that actual results coulddiffer materially from those expressed or implied in the forward-lookingstatements as a result of certain factors, including but not limited todependence upon energy industry spending, the volatility of oil and gas prices,weather interruptions, the results of testing of our products, the

 

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availability of capital resources and the other factors described under“Item 1A. Risk Factors”.  We undertake noobligation to update any forward-looking statements except as required by law.

 

**Item 7A.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

We believe that wedo not have any material exposure to financial market risk and we do not enterinto foreign currency or interest rate transactions.

 

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**Item 8.  Financial Statements and Supplementary Data**

 

**PARTICLE DRILLING TECHNOLOGIES,INC.**

**(a development stage enterprise)**

 

**Index to Consolidated FinancialStatements**

 
| Management’s Report on Internal Control over Financial  Reporting                                                                                                                                                                               | 21     |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                                                                 |   |
| Reports of Independent Registered Public Accounting  Firm                                                                                                                                                                                            | 22     |
|                                                                                                                                                                                                                                                 |   |
| Consolidated Balance Sheets as of September 30, 2005  and 2004                                                                                                                                                                                       | 24     |
|                                                                                                                                                                                                                                                 |   |
| Consolidated Statements of Operations for the years  ended September 30, 2005 and 2004,  and for the periods from June 9, 2003 (date of inception) to September 30,  2003 and June 9,  2003 (date of inception) to September 30, 2005                | 25     |
|                                                                                                                                                                                                                                                 |   |
| Consolidated Statements of Stockholders’ Equity for  the years ended September 30, 2005  and 2004, and for the periods from June 9, 2003 (date of inception) to  September 30, 2003  and June 9, 2003 (date of inception) to September 30, 2005 | 26     |
|                                                                                                                                                                                                                                                 |   |
| Consolidated Statements of Cash Flows for the years  ended September 30, 2005 and 2004,  and for the periods from June 9, 2003 (date of inception) to September 30,  2003 and June 9,  2003 (date of inception) to September 30, 2005                | 27     |
|                                                                                                                                                                                                                                                 |   |
| Notes to Consolidated Financial Statements                                                                                                                                                                                                           | 28     |

 

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**MANAGEMENT’S REPORT ON INTERNALCONTROL OVER FINANCIAL REPORTING**

 

Our company’s managementis responsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange ActRule 13a-15(f).  Internal controlover financial reporting is a process designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation of ourconsolidated financial statements for external purposes in accordance withgenerally accepted accounting principles. Under the supervision and with the participation of our company’smanagement, including the Chief Executive Officer and the Chief FinancialOfficer, we conducted an evaluation of the effectiveness of our internalcontrol over financial reporting based on the framework in *Internal Control — Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission.

 

Our internal control overfinancial reporting includes those policies and procedures that:(1) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of our assets;(2) provide reasonable assurance that transactions are recorded asnecessary to permit preparation of our consolidated financial statements inaccordance with generally accepted accounting principles, and that our receiptsand expenditures are being made only in accordance with authorizations of ourmanagement and directors; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use or dispositionof our assets that could have a material effect on our consolidated financialstatements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements.  Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

 

Based on our evaluationunder the framework in *InternalControl — Integrated Framework,*the management of our companyconcluded that our internal control over financial reporting was effective asof September 30, 2005. We have considered the restatement of our financialresults for the year ended September 30, 2005 and have concluded that suchrestatement does not represent a material weakness in our internal control overfinancial reporting.

 

The assessment by the management of our company of theeffectiveness of our internal control over financial reporting as of September30, 2005 has been audited by UHY Mann Frankfort Stein & Lipp CPAs, LLP, anindependent registered public accounting firm, as stated in their report thatfollows.

 

 
| /s/ J. CHRIS BOSWELL                                                                                                 |   |   |
|----------------------------------------------------------------------------------------------------------------------|--------|--------|
| Chief Financial Officer                                                                                              |   |
|                                                                                                                 |   |
| Houston, Texas                                                                                                       |   |
| December 14, 2005, except for the second sentence of the fourth paragraph  as to which the date is February 14, 2006 |

 

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**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

 

The Board of Directors andStockholders of Particle Drilling Technologies, Inc.:

 

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting appearing on page 21, that Particle Drilling Technologies, Inc. andsubsidiaries (the “Company”) maintained effective internal control overfinancial reporting as of September 30, 2005, based on criteria established in *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission (COSO).The Company’s management is responsible for maintaining effective internalcontrol over financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of theCompany’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

 

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of consolidated financial statementsfor external purposes in accordance with generally accepted accountingprinciples. A company’s internal control over financial reporting includesthose policies and procedures that (1) pertain to the maintenance of recordsthat, in reasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonable assurancethat transactions are recorded as necessary to permit preparation ofconsolidated financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the consolidated financialstatements.

 

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

 

In our opinion, management’s assessment that ParticleDrilling Technologies, Inc. and subsidiaries maintained effective internal controlover financial reporting as of September 30, 2005, is fairly stated, in allmaterial respects, based on criteria established in *Internal Control—Integrated Framework*issued by COSO. Also,in our opinion, Particle Drilling Technologies, Inc. and subsidiariesmaintained, in all material respects, effective internal control over financialreporting as of September 30, 2005, based on criteria established in *Internal Control—Integrated Framework*issuedby COSO.  We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Particle DrillingTechnologies, Inc. as of September 30, 2005 and 2004, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows foreach of the years ended September 30, 2005 and 2004,  and periods from June 9, 2003 (date ofinception) to September 30, 2003 and June 9, 2003 (date of inception) toSeptember 30, 2005, and our report dated December 14, 2005 expressed anunqualified opinion on those consolidated financial statements.

 

 
| /s/ UHY Mann Frankfort Stein & Lipp CPAs, LLP                                                                                                                                                         |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                      |
| Houston, Texas                                                                                                                                                                                            |
| December 14, 2005, except as to the effect of the  restatement described in Management’s Report on Internal Control Over  Financial Reporting (As Revised) as to which the date is February 14, 2006 |

 

22

----

 

**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

 

To the Board of Directorsand StockholdersParticle Drilling Technologies, Inc.Houston, Texas

 

We haveaudited the accompanying consolidated balance sheets of Particle DrillingTechnologies, Inc. and subsidiaries (the “Company”) (a development stagecompany) as of September 30, 2005 and 2004, and the related consolidatedstatements of operations, stockholders’ equity, and cash flows for the yearsended September 30, 2005 and 2004, and for the periods from June 9, 2003 (dateof inception) to September 30, 2003 and June 9, 2003 (date of inception) toSeptember 30, 2005.  These consolidated financialstatements are the responsibility of the Company’s management.  Our responsibility is to express an opinion onthese consolidated financial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States).  Those standards require that we plan andperform the audits to obtain reasonable assurance about whether the consolidatedfinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe consolidated financial statements.  Anaudit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall consolidated financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofParticle Drilling Technologies, Inc. as of September 30, 2005 and 2004, and theconsolidated results of their operations and their cash flows for the years endedSeptember 30, 2005 and 2004, and for the periods from June 9, 2003 (date ofinception) to September 30, 2003 and June 9, 2003 (date of inception) toSeptember 30, 2005, in conformity with accounting principles generally acceptedin the United States of America.

 

Asdiscussed in Note 2 to the consolidated financial statements, the accompanyingconsolidated financial statements have been restated.

 

We have also audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theeffectiveness of the Company’s internal control over financial reporting as ofSeptember 30, 2005, based on the criteria established in *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission and ourreport dated December 14, 2005 expressed an unqualified opinion on management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting and an unqualified opinion on the effectiveness of theCompany’s internal control over financial reporting.

 

 
| /s/ UHY Mann Frankfort Stein & Lipp CPAs, LLP                                |   |
|----------------------------------------------------------------------------------|--------|
|                                                                             |
| Houston,  Texas                                                                  |
| December  14, 2005, except for Note 2 as to  which the date is February 14, 2006 |

 

 

23

----

 

**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                             | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                                             | ** ** | **(Restated)**          | ** ** | ** **              | ** ** |
| **ASSETS**                                                                                                                                                                                                             |       |                    |       |                    |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Current assets:                                                                                                                                                                                                        |       |                    |       |                    |       |
| Cash and cash  equivalents                                                                                                                                                                                             |       | $                       | 10,504,646 |                    | $          | 20,363 |   |
| Accounts  receivable - related party                                                                                                                                                                                   |       | 42,330                  |       | —                  |       |
| Prepaid expenses                                                                                                                                                                                                       |       | 229,963                 |       | 110,535                 |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Total current  assets                                                                                                                                                                                                  |       | 10,776,939              |       | 130,898                 |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Property, plant  & equipment, net                                                                                                                                                                                  |       | 1,277,982               |       | 451,825                 |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Intangibles, net                                                                                                                                                                                                       |       | 1,102,403               |       | 982,612                 |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Other assets                                                                                                                                                                                                           |       | 391,089                 |       | 5,250                   |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Total assets                                                                                                                                                                                                           |       | $                       | 13,548,413 |                    | $          | 1,570,585 |   |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                          |       |                    |       |                    |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Current  liabilities:                                                                                                                                                                                                  |       |                    |       |                    |       |
| Accounts payable                                                                                                                                                                                                       |       | $                       | 1,056,733  |                    | $          | 864,177 |   |
| Short-term notes  payable                                                                                                                                                                                              |       | 79,880                  |       | 340,304                 |       |
| Current portion  of long-term debt                                                                                                                                                                                     |       | 11,597                  |       | 10,891                  |       |
| Accrued  liabilities                                                                                                                                                                                                   |       | 242,633                 |       | 216,553                 |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Total current  liabilities                                                                                                                                                                                             |       | 1,390,843               |       | 1,431,925               |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Long-term debt                                                                                                                                                                                                         |       | 9,463                   |       | 20,201                  |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Commitments and  Contingencies - See Note 16                                                                                                                                                                           |       |                    |       |                    |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Stockholders’  equity:                                                                                                                                                                                            |       |                    |       |                    |       |
| Common stock,  $.001 par value, 100,000,000 shares authorized,  27,441,472 shares issued and 24,441,472 shares outstanding at September 30,  2005,  and 18,095,447 shares issued and outstanding at September 30, 2004 |       | 27,441                  |       | 18,095                  |       |
| Additional  paid-in capital                                                                                                                                                                                            |       | 23,218,868              |       | 3,974,148               |       |
| Treasury stock  at cost, 3,000,000 shares and -0- shares at September 30, 2005  and September 30, 2004, respectively                                                                                                   |       | (1,500,000              | )          | —                  |       |
| Deficit  accumulated during the development stage                                                                                                                                                                      |       | (9,598,202              | )          | (3,873,784              | )          |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Total  stockholders’ equity                                                                                                                                                                                       |       | 12,148,107              |       | 118,459                 |       |
|                                                                                                                                                                                                                   |       |                    |       |                    |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                       |       | $                       | 13,548,413 |                    | $          | 1,570,585 |   |

 

The accompanying notes are an integral part of these statements.

 

24

----

 

**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                | ** ** | ** **                   | ** ** | ** **        | ** ** | **Period from  June 9, 2003  (date of  inception) to** | ** ** | **Period from  June 9, 2003  (date of  inception) to** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------|------------|-------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                | ** ** | **Year Ended September 30,** | ** ** | **September 30,** | ** ** | **September 30,**                                      | ** ** |
| ** **                                                                | ** ** | **2005**                     | ** ** | **2004**          | ** ** | **2003**                                               | ** ** | **2005**                                               | ** ** |
|                                                                      |       | **(Restated)**               |       |              |       |                                                   |       | **(Restated)**                                         |       |
| Revenues                                                                  |       | $                            | —     |              | $          | —                                                 |       | $                                                      | —     |   | $ | — |   |
|                                                                      |       |                         |       |              |       |                                                   |       |                                                   |       |
| Operating  expenses:                                                      |       |                         |       |              |       |                                                   |       |                                                   |       |
| Research and  development                                                 |       | 2,802,155                    |       | 621,752           |       | 39,626                                                 |       | 3,463,533                                              |       |
| General and  administrative                                               |       | 3,182,313                    |       | 2,683,024         |       | 503,158                                                |       | 6,368,495                                              |       |
|                                                                      |       |                         |       |              |       |                                                   |       |                                                   |       |
| Total operating  expenses                                                 |       | 5,984,468                    |       | 3,304,776         |       | 542,784                                                |       | 9,832,028                                              |       |
|                                                                      |       |                         |       |              |       |                                                   |       |                                                   |       |
| Loss from  operations                                                     |       | (5,984,468                   | )          | (3,304,776        | )          | (542,784                                               | )          | (9,832,028                                             | )          |
|                                                                      |       |                         |       |              |       |                                                   |       |                                                   |       |
| Other income  (expenses)                                                  |       |                         |       |              |       |                                                   |       |                                                   |       |
| Interest income                                                           |       | 209,305                      |       | —            |       | —                                                 |       | 209,305                                                |       |
| Rental income -  related party                                            |       | 27,162                       |       | —            |       | —                                                 |       | 27,162                                                 |       |
| Gain on debt  extinguishment                                              |       | 35,283                       |       | —            |       | —                                                 |       | 35,283                                                 |       |
| Interest expense                                                          |       | (11,700                      | )          | (26,224           | )          | —                                                 |       | (37,924                                                | )          |
|                                                                      |       |                         |       |              |       |                                                   |       |                                                   |       |
| Total other  income (expenses)                                            |       | 260,050                      |       | (26,224           | )          | —                                                 |       | 233,826                                                |       |
|                                                                      |       |                         |       |              |       |                                                   |       |                                                   |       |
| Net loss                                                                  |       | $                            | (5,724,418 | )                 | $          | (3,331,000                                             | )          | $                                                      | (542,784   | ) | $ | (9,598,202 | ) |
|                                                                      |       |                         |       |              |       |                                                   |       |                                                   |       |
| Net loss per  common share, basic and diluted                             |       | $                            | (0.26      | )                 | $          | (0.25                                                  | )          | $                                                      | (0.07      | ) | $ | (0.58 | ) |
|                                                                      |       |                         |       |              |       |                                                   |       |                                                   |       |
| Weighted average  number of common shares outstanding - basic and diluted |       | 22,150,365                   |       | 13,364,183        |       | 7,741,646                                              |       | 16,408,395                                             |       |

 

The accompanying notes are an integral part of these statements.

 

25

----

 

**PARTICLEDRILLING TECHNOLOGIES, INC.**

**(adevelopment stage enterprise)**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**Forthe Period from June 9, 2003 (date of inception)**

**toSeptember 30, 2005**

**(Restated)**

 
| ** **                                                                                                                                   | ** ** | ** **        | ** ** | ** **          | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | **Deficit**     | ** ** | ** **             | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|---------------------|------------|-------------|------------|-----------------|------------|----------------|------------|-----------------|------------|------------------------|------------|
| ** **                                                                                                                                   | ** ** | ** **        | ** ** | ** **          | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | **Accumulated** | ** ** | **Total**              | ** ** |
| ** **                                                                                                                                   | ** ** | ** **        | ** ** | ** **          | ** ** | ** **  | ** ** | ** **      | ** ** | **Additional** | ** ** | **During**      | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                                                                   | ** ** | **Common  Stock** | ** ** | **Treasury  Stock** | ** ** | **Paid-in** | ** ** | **Development** | ** ** | **Equity**     | ** ** |
| ** **                                                                                                                                   | ** ** | **Shares**        | ** ** | **Amount**          | ** ** | **Shares**  | ** ** | **Amount**      | ** ** | **Capital**    | ** ** | **Stage**       | ** ** | **(Deficit)**          | ** ** |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Retroactive  restatement of stockholders’ equity prior to merger for recapitalization                                                   |       | 1,550,000         |       | $                   | 1,550      |        |       | —          |       | $              | —     |            | $          | (1,550                 | )          | $ | — |   | $ | — |   |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued to founders at $0.001 per share in June 2003                                                                            |       | 9,000,000         |       | 9,000               |       | —      |       | —          |       | —         |       | —          |       | 9,000                  |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued in private placement for cash at $2.00 per share from June 2003 to  September 2003, less offering expense of $436,096   |       | 504,500           |       | 505                 |       | —      |       | —          |       | 572,399        |       | —          |       | 572,904                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for services provided at $2.00 per share in July 2003                                                                   |       | 15,000            |       | 15                  |       | —      |       | —          |       | 29,985         |       | —          |       | 30,000                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Net loss                                                                                                                                     |       | —            |       | —              |       | —      |       | —          |       | —         |       | (542,784        | )          | (542,784               | )          |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Balance,  September 30, 2003                                                                                                                 |       | 11,069,500        |       | 11,070              |       | —      |       | —          |       | 600,834        |       | (542,784        | )          | 69,120                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued in private placement for cash at $2.00 per share from October 2003 to  February 2004, less offering expense of $166,322 |       | 196,800           |       | 197                 |       | —      |       | —          |       | 227,080        |       | —          |       | 227,277                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for services provided at $2.00 per share in October 2003                                                                |       | 27,000            |       | 27                  |       | —      |       | —          |       | 53,973         |       | —          |       | 54,000                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for cash at $2.00 per share from October 2003 to March 2004                                                             |       | 325,000           |       | 325                 |       | —      |       | —          |       | 649,675        |       | —          |       | 650,000                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for cash at $1.82 per share in October 2003                                                                             |       | 2,750             |       | 2                   |       | —      |       | —          |       | 4,998          |       | —          |       | 5,000                  |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued in exchange for note payable at $2.00 per share in January 2004                                                         |       | 25,000            |       | 25                  |       | —      |       | —          |       | 49,975         |       | —          |       | 50,000                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for services provided at $2.00 per share in January 2004                                                                |       | 12,000            |       | 12                  |       | —      |       | —          |       | 23,988         |       | —          |       | 24,000                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for cash at $0.72 per share in March 2004                                                                               |       | 69,508            |       | 70                  |       | —      |       | —          |       | 49,930         |       | —          |       | 50,000                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for cash at $0.97 per share in March 2004                                                                               |       | 15,480            |       | 15                  |       | —      |       | —          |       | 14,985         |       | —          |       | 15,000                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for cash at $0.75 per share in March 2004                                                                               |       | 35,000            |       | 35                  |       | —      |       | —          |       | 26,215         |       | —          |       | 26,250                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for services provided at $2.00 per share in March 2004                                                                  |       | 70,000            |       | 70                  |       | —      |       | —          |       | 139,930        |       | —          |       | 140,000                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for services provided at $2.00 per share in March 2004                                                                  |       | 75,000            |       | 75                  |       | —      |       | —          |       | 149,925        |       | —          |       | 150,000                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for cash at $0.74 per share in April 2004                                                                               |       | 23,500            |       | 23                  |       | —      |       | —          |       | 17,477         |       | —          |       | 17,500                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued in exchange of accounts payable at $0.12 per share upon exercise of  warrants in April 2004                             |       | 50,000            |       | 50                  |       | —      |       | —          |       | 6,850          |       | —          |       | 6,900                  |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for cash at $0.12 per share upon exercise of warrants from April 2004  to June 2004                                     |       | 113,909           |       | 114                 |       | —      |       | —          |       | 15,605         |       | —          |       | 15,719                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for cash at $0.12 per share upon exercise of employee stock options in  June 2004                                       |       | 200,000           |       | 200                 |       | —      |       | —          |       | 32,062         |       | —          |       | 32,262                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued in connection with advisory agreement at $0.12 per share in June 2004                                                   |       | 5,000,000         |       | 5,000               |       | —      |       | —          |       | 595,000        |       | —          |       | 600,000                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued at $1.50 per share upon conversion of note payable in June 2004, less  offering expense                                 |       | 410,000           |       | 410                 |       | —      |       | —          |       | 553,090        |       | —          |       | 553,500                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued in private placement for cash at $2.00 per share from July 2004 to  September 2004, less offering expense               |       | 375,000           |       | 375                 |       | —      |       | —          |       | 717,125        |       | —          |       | 717,500                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Fair value of  common stock warrants issued for services                                                                                     |       | —            |       | —              |       | —      |       | —          |       | 2,880          |       | —          |       | 2,880                  |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Stock-based  employee compensation                                                                                                           |       | —            |       | —              |       | —      |       | —          |       | 42,551         |       | —          |       | 42,551                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Net loss                                                                                                                                     |       | —            |       | —              |       | —      |       | —          |       | —         |       | (3,331,000      | )          | (3,331,000             | )          |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Balance,  September 30, 2004                                                                                                                 |       | 18,095,447        |       | 18,095              |       | —      |       | —          |       | 3,974,148      |       | (3,873,784      | )          | 118,459                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued in private placement for cash at $2.00 per share from October 2004 to  February 2005, less offering expense             |       | 850,000           |       | 850                 |       | —      |       | —          |       | 1,581,585      |       | —          |       | 1,582,435              |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for services provided at $1.75 per share in October 2004                                                                |       | 10,000            |       | 10                  |       | —      |       | —          |       | 17,490         |       | —          |       | 17,500                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued upon cashless exercise of warrants at $0.12 per share in December 2004                                                  |       | 9,314             |       | 10                  |       | —      |       | —          |       | (10            | )          | —          |       | —                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued for cash at $0.01 per share upon exercise of warrants in December 2004                                                  |       | 33,333            |       | 33                  |       | —      |       | —          |       | 302            |       | —          |       | 335                    |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  cancelled at $0.12 per share in January 2005                                                                                   |       | (700,000          | )          | (700                | )          | —      |       | —          |       | (83,300        | )          | —          |       | (84,000                | )          |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  cancelled at $0.001 per share in January 2005                                                                                  |       | (50,000           | )          | (50                 | )          | —      |       | —          |       | 50             |       | —          |       | —                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued in private placement for cash at $2.00 per share in February 2005,  less offering expense                               |       | 9,000,000         |       | 9,000               |       | —      |       | —          |       | 14,605,332     |       | —          |       | 14,614,332             |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Repurchase of  common stock at $0.50 per share in February 2005                                                                              |       | —            |       | —              |       | (3,000,000  | )          | (1,500,000      | )          | —         |       | —          |       | (1,500,000             | )          |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Restricted stock  issued to employees at $4.90 per share in May 2005                                                                         |       | 140,000           |       | 140                 |       | —      |       | —          |       | (140           | )          | —          |       | —                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Restricted stock  issued to employees at $5.45 per share in May 2005                                                                         |       | 5,000             |       | 5                   |       | —      |       | —          |       | (5             | )          | —          |       | —                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Common stock  issued upon cashless exercise of warrants at $0.12 per share in August 2005                                                    |       | 48,378            |       | 48                  |       | —      |       | —          |       | (48            | )          | —          |       | —                 |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Fair value of  common stock warrants issued for services                                                                                     |       | —            |       | —              |       | —      |       | —          |       | 2,508,564      |       | —          |       | 2,508,564              |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Stock-based  employee compensation                                                                                                           |       | —            |       | —              |       | —      |       | —          |       | 614,900        |       | —          |       | 614,900                |       |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Net loss                                                                                                                                     |       | —            |       | —              |       | —      |       | —          |       | —         |       | (5,724,418      | )          | (5,724,418             | )          |
|                                                                                                                                         |       |              |       |                |       |        |       |            |       |           |       |            |       |                   |       |
| Balance,  September 30, 2005                                                                                                                 |       | 27,441,472        |       | $                   | 27,441     |        | (3,000,000 | )               | $          | (1,500,000     | )          | $               | 23,218,868 |                   | $          | (9,598,202 | ) | $ | 12,148,107 |   |
|                                                                                                                                              |            |                   |            |                     |            |             |            |                 |            |                |            |                 |            |                        |            |  |  |  |  |  |  |

 

The accompanyingnotes are an integral part of these statements.

 

26

----

 

**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                   | ** ** | ** **                   | ** ** | ** **        | ** ** | **Period from  June 9, 2003  (date of  inception) to** | ** ** | **Period from  June 9, 2003  (date of  inception) to** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------|------------|-------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **Year Ended September 30,** | ** ** | **September 30,** | ** ** | **September 30,**                                      | ** ** |
| ** **                                                                   | ** ** | **2005**                     | ** ** | **2004**          | ** ** | **2003**                                               | ** ** | **2005**                                               | ** ** |
|                                                                         |       | **(Restated)**               |       |              |       |                                                   |       | **(Restated)**                                         |       |
| Cash flows from  operating activities:                                       |       |                         |       |              |       |                                                   |       |                                                   |       |
| Net loss                                                                     |       | $                            | (5,724,418 | )                 | $          | (3,331,000                                             | )          | $                                                      | (542,784   | ) | $ | (9,598,202 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                         |       |              |       |                                                   |       |                                                   |       |
| Gain on debt  extinguishment                                                 |       | (35,283                      | )          | —            |       | —                                                 |       | (35,283                                                | )          |
| Depreciation and  amortization expense                                       |       | 391,467                      |       | 147,409           |       | —                                                 |       | 538,876                                                |       |
| Short-term note  issued for services                                         |       | —                       |       | 44,000            |       | —                                                 |       | 44,000                                                 |       |
| Common stock  issued for services                                            |       | (66,500                      | )          | 968,000           |       | 30,000                                                 |       | 931,500                                                |       |
| Warrants issued  for services                                                |       | 57,999                       |       | 5,830             |       | —                                                 |       | 63,829                                                 |       |
| Stock-based  employee compensation                                           |       | 614,900                      |       | 50,814            |       | —                                                 |       | 665,714                                                |       |
| Changes in  operating assets and liabilities:                                |       |                         |       |              |       |                                                   |       |                                                   |       |
| Increase in  accounts receivable - related party                             |       | (42,330                      | )          | —            |       | —                                                 |       | (42,330                                                | )          |
| Increase in  prepaid expenses                                                |       | (68,428                      | )          | (49,545           | )          | —                                                 |       | (117,973                                               | )          |
| (Increase)  decrease in other current assets                                 |       | —                       |       | 7,500             |       | (7,500                                                 | )          | —                                                 |       |
| Increase in  accounts payable                                                |       | 221,329                      |       | 362,527           |       | 132,939                                                |       | 716,795                                                |       |
| Increase in  accrued liabilities                                             |       | 26,080                       |       | 79,774            |       | 136,779                                                |       | 242,633                                                |       |
|                                                                         |       |                         |       |              |       |                                                   |       |                                                   |       |
| Net cash used in  operating activities                                       |       | (4,625,184                   | )          | (1,714,691        | )          | (250,566                                               | )          | (6,590,441                                             | )          |
|                                                                         |       |                         |       |              |       |                                                   |       |                                                   |       |
| Cash flows from  investing activities:                                       |       |                         |       |              |       |                                                   |       |                                                   |       |
| Payments to purchase  property and equipment                                 |       | (1,167,134                   | )          | (16,555           | )          | —                                                 |       | (1,183,689                                             | )          |
| Proceeds from  sale of property and equipment                                |       | —                       |       | 20,957            |       | —                                                 |       | 20,957                                                 |       |
| Payments to  purchase intangibles                                            |       | (170,281                     | )          | (185,468          | )          | (74,695                                                | )          | (430,444                                               | )          |
| Payments to  purchase other assets                                           |       | (385,839                     | )          | (5,250            | )          | —                                                 |       | (391,089                                               | )          |
| Payments issued  for note receivable                                         |       | —                       |       | (24,447           | )          | (276,336                                               | )          | (300,783                                               | )          |
| Payments issued  for note receivable - related party                         |       | —                       |       | (56,783           | )          | —                                                 |       | (56,783                                                | )          |
|                                                                         |       |                         |       |              |       |                                                   |       |                                                   |       |
| Net cash used in  investing activities                                       |       | (1,723,254                   | )          | (267,546          | )          | (351,031                                               | )          | (2,341,831                                             | )          |
|                                                                         |       |                         |       |              |       |                                                   |       |                                                   |       |
| Cash flows from  financing activities:                                       |       |                         |       |              |       |                                                   |       |                                                   |       |
| Proceeds from  issuance of common stock                                      |       | 18,647,666                   |       | 1,746,196         |       | 581,904                                                |       | 20,975,766                                             |       |
| Repurchase of common  stock                                                  |       | (1,500,000                   | )          | —            |       | —                                                 |       | (1,500,000                                             | )          |
| Proceeds from  issuance of convertible notes                                 |       | —                       |       | 553,500           |       | —                                                 |       | 553,500                                                |       |
| Repayments of  notes payable                                                 |       | (314,945                     | )          | (277,403          | )          | —                                                 |       | (592,348                                               | )          |
| 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                                   |       | 16,832,721                   |       | 1,999,098         |       | 605,099                                                |       | 19,436,918                                             |       |
|                                                                         |       |                         |       |              |       |                                                   |       |                                                   |       |
| Net increase in  cash and cash equivalents                                   |       | 10,484,283                   |       | 16,861            |       | 3,502                                                  |       | 10,504,646                                             |       |
|                                                                         |       |                         |       |              |       |                                                   |       |                                                   |       |
| Cash and cash  equivalents - beginning of period                             |       | 20,363                       |       | 3,502             |       | —                                                 |       | —                                                 |       |
|                                                                         |       |                         |       |              |       |                                                   |       |                                                   |       |
| Cash and cash  equivalents - end of period                                   |       | $                            | 10,504,646 |              | $          | 20,363                                                 |       | $                                                      | 3,502      |   | $ | 10,504,646 |   |
|                                                                         |       |                         |       |              |       |                                                   |       |                                                   |       |
| Supplemental  disclosures of cash flow information:                          |       |                         |       |              |       |                                                   |       |                                                   |       |
| Cash paid for  interest                                                      |       | $                            | 14,004     |              | $          | 24,697                                                 |       | $                                                      | —     |   | $ | 38,701 |   |
|                                                                         |       |                         |       |              |       |                                                   |       |                                                   |       |
| Non-cash  investing and financing activities:                                |       |                         |       |              |       |                                                   |       |                                                   |       |
| Prepaid  insurance acquired with note payable                                |       | $                            | 51,000     |              | $          | 60,990                                                 |       | —                                                 |       | $ | 111,990 |   |
| 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                                                |       |

 

The accompanying notes are an integral part of these statements.

 

27

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**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. ORGANIZATION AND NATURE OFBUSINESS**

 

Particle DrillingTechnologies, Inc. (“PDTI”or the “Company”) is a Nevada corporation, formerlynamed MedXLink, Corp. (“MXLK”).  OnJanuary 14, 2005, Particle Drilling Technologies, Inc., a Delaware corporation(“PDTI-DE ”) merged with a subsidiary of MXLK in a stock-for-stock transactionas a result of a merger and plan of reorganization agreement between MXLK and PDTI-DE.  Pursuant to the above merger, MXLK assumedPDTI-DE’s operations and business plan and changed its name to ParticleDrilling Technologies, Inc.

 

PDTI is a development stage company engaged in thedevelopment of a proprietary drilling system technology (“Particle ImpactDrilling” or “PID”).  The PID technologyis designed to increase the rate-of-penetration in the drilling process,particularly in hard rock drilling environments.  PDTI intends to develop and exploit thistechnology by commercializing the PID system in the oil and gas industry.

 

PDTI is devoting substantially all of its efforts toproduct development, commercializing the technology and recruiting personnel.PDTI has substantially funded its operations with proceeds from the issuance ofcommon stock.  In the course of thedevelopment activities, PDTI has sustained operating losses and expects suchlosses to continue into fiscal 2006.  PDTI will finance its operations primarilythrough cash and cash equivalents on hand, future financing from the issuanceof debt or equity instruments and through the generation of revenues once commercialoperations get underway.  However, theCompany has yet to generate any revenues, and has no assurance of futurerevenues.  To management’s knowledge, nocompany has yet marketed a salable product using the technology that is beingdeveloped by the Company.  Even ifmarketing efforts are successful, substantial time may pass before revenues arerealized.  In management’s opinion, basedon available cash and cash equivalents on hand, PDTI has sufficient liquidityto meet its working capital and capital expenditure requirements for at leastthe next twelve months.

 

**2. RESTATEMENT OF FINANCIALSTATEMENTS**

 

The historical information for the year endedSeptember 30, 2005, and for the period from June 9, 2003 (date of inception) toSeptember 30, 2005, have been restated after determining that the Company’spolicy of recording stock-based employee compensation upon vesting of theunderlying equity award was inconsistent with the guidelines set forth underStatements of Financial Accounting Standards (“SFAS”) No. 123(R), *Share-Based Payment*.

** **

On February 7, 2006, the Company received commentsfrom the Staff of the Securities and Exchange Commission (“SEC”) to its annualreport 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 SFAS No.123(R).  Historically, the Company hascalculated 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 consolidated financial statements, the Audit Committee ofthe Company’s Board of Directors determined that it was necessary to restatethe consolidated financial statements contained in the Company’s originalannual report on Form 10-K for the year ended September 30, 2005 that was filedon December 14, 2005.

 

As a result of the restatement, net loss for the yearended September 30, 2005 and for the period from June 9, 2003 (date ofinception) to September 30, 2005 was increased by $437,350.

 

The following are the restated consolidated financialstatements for the year ended September 30, 2005 compared to the previouslyreported amounts:

 

28

----

 

**RESTATEDCONSOLIDATED BALANCE SHEETAS OF SEPTEMBER 30, 2005**

 
| ** **                                                                                                                                                                                                            | ** ** | **As Reported** | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                                                                                                                                                                                                            | ** ** | ** **      | ** ** | ** **      | ** ** | ** **   | ** ** |
| **ASSETS**                                                                                                                                                                                                            |       |            |       |            |       |         |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Current assets:                                                                                                                                                                                                       |       |            |       |            |       |         |       |
| Cash and cash  equivalents                                                                                                                                                                                            |       | $               | 10,504,646 |            | $          | —       |       | $ | 10,504,646 |   |
| Accounts  receivable - related party                                                                                                                                                                                  |       | 42,330          |       | —          |       | 42,330       |       |
| Prepaid expenses                                                                                                                                                                                                      |       | 229,963         |       | —          |       | 229,963      |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Total current  assets                                                                                                                                                                                                 |       | 10,776,939      |       | —          |       | 10,776,939   |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Property, plant & equipment, net                                                                                                                                                                                  |       | 1,277,982       |       | —          |       | 1,277,982    |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Intangibles, net                                                                                                                                                                                                      |       | 1,102,403       |       | —          |       | 1,102,403    |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Other assets                                                                                                                                                                                                          |       | 391,089         |       | —          |       | 391,089      |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Total assets                                                                                                                                                                                                          |       | $               | 13,548,413 |            | $          | —       |       | $ | 13,548,413 |   |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| **LIABILITIES  AND STOCKHOLDERS' EQUITY**                                                                                                                                                                             |       |            |       |            |       |         |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Current liabilities:                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Accounts payable                                                                                                                                                                                                      |       | $               | 1,056,733  |            | $          | —       |       | $ | 1,056,733 |   |
| Short-term notes  payable                                                                                                                                                                                             |       | 79,880          |       | —          |       | 79,880       |       |
| Current portion  of long-term debt                                                                                                                                                                                    |       | 11,597          |       | —          |       | 11,597       |       |
| Accrued  liabilities                                                                                                                                                                                                  |       | 242,633         |       | —          |       | 242,633      |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Total current  liabilities                                                                                                                                                                                            |       | 1,390,843       |       | —          |       | 1,390,843    |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Long-term debt                                                                                                                                                                                                        |       | 9,463           |       | —          |       | 9,463        |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Commitments and Contingencies                                                                                                                                                                                         |       |            |       |            |       |         |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Stockholders' equity:                                                                                                                                                                                                 |       |            |       |            |       |         |       |
| Common stock,  $.001 par value, 100,000,000 shares authorized, 27,441,472 shares issued and  24,441,472 shares outstanding at September 30, 2005, and 18,095,447 shares  issued and outstanding at September 30, 2004 |       | 27,441          |       | —          |       | 27,441       |       |
| Additional  paid-in capital                                                                                                                                                                                           |       | 22,781,518      |       | 437,350         |       | 23,218,868   |       |
| Treasury stock  at cost, 3,000,000 shares and -0- shares at September 30, 2005                                                                                                                                        |       |            |       |            |       |         |       |
| and September  30, 2004, respectively                                                                                                                                                                                 |       | (1,500,000      | )          | —          |       | (1,500,000   | )          |
| Deficit  accumulated during the development stage                                                                                                                                                                     |       | (9,160,852      | )          | (437,350        | )          | (9,598,202   | )          |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Total  stockholders' equity                                                                                                                                                                                           |       | 12,148,107      |       | —          |       | 12,148,107   |       |
|                                                                                                                                                                                                                  |       |            |       |            |       |         |       |
| Total  liabilities and stockholders' equity                                                                                                                                                                           |       | $               | 13,548,413 |            | $          | —       |       | $ | 13,548,413 |   |

 

 

29

----

 

**RESTATEDCONSOLIDATED STATEMENT OF OPERATIONSFOR THE YEAR ENDED SEPTEMBER 30, 2005**

 
| ** **                                                                | ** ** | **As Reported** | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                                                                | ** ** | ** **      | ** ** | ** **      | ** ** | ** **   | ** ** |
| Revenues                                                                  |       | $               | —     |            | $          | —       |       | $ | — |   |
|                                                                      |       |            |       |            |       |         |       |
| Operating expenses:                                                       |       |            |       |            |       |         |       |
| Research and  development                                                 |       | 2,802,155       |       | —          |       | 2,802,155    |       |
| General and  administrative                                               |       | 2,744,963       |       | 437,350         |       | 3,182,313    |       |
|                                                                      |       |            |       |            |       |         |       |
| Total operating  expenses                                                 |       | 5,547,118       |       | 437,350         |       | 5,984,468    |       |
|                                                                      |       |            |       |            |       |         |       |
| Loss from  operations                                                     |       | (5,547,118      | )          | (437,350        | )          | (5,984,468   | )          |
|                                                                      |       |            |       |            |       |         |       |
| Other income (expenses)                                                   |       |            |       |            |       |         |       |
| Interest income                                                           |       | 209,305         |       | —          |       | 209,305      |       |
| Rental income -  related party                                            |       | 27,162          |       | —          |       | 27,162       |       |
| Gain on debt  extinguishment                                              |       | 35,283          |       | —          |       | 35,283       |       |
| Interest expense                                                          |       | (11,700         | )          | —          |       | (11,700      | )          |
|                                                                      |       |            |       |            |       |         |       |
| Total other  income (expenses)                                            |       | 260,050         |       | —          |       | 260,050      |       |
|                                                                      |       |            |       |            |       |         |       |
| Net loss                                                                  |       | $               | (5,287,068 | )               | $          | (437,350     | )          | $ | (5,724,418 | ) |
|                                                                      |       |            |       |            |       |         |       |
| Net loss per  common share, basic and diluted                             |       | $               | (0.24      | )               | $          | (0.02        | )          | $ | (0.26 | ) |
|                                                                      |       |            |       |            |       |         |       |
| Weighted average  number of common shares outstanding - basic and diluted |       | 22,150,365      |       | —          |       | 22,150,365   |       |

 

 

30

----

 

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

 
| ** **                                                                | ** ** | **As Reported** | ** ** | **Adjustments** | ** ** | **Restated** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                                                                | ** ** | ** **      | ** ** | ** **      | ** ** | ** **   | ** ** |
| Revenues                                                                  |       | $               | —     |            | $          | —       |       | $ | — |   |
|                                                                      |       |            |       |            |       |         |       |
| Operating expenses:                                                       |       |            |       |            |       |         |       |
| Research and  development                                                 |       | 3,463,533       |       | —          |       | 3,463,533    |       |
| General and  administrative                                               |       | 5,931,145       |       | 437,350         |       | 6,368,495    |       |
|                                                                      |       |            |       |            |       |         |       |
| Total operating  expenses                                                 |       | 9,394,678       |       | 437,350         |       | 9,832,028    |       |
|                                                                      |       |            |       |            |       |         |       |
| Loss from  operations                                                     |       | (9,394,678      | )          | (437,350        | )          | (9,832,028   | )          |
|                                                                      |       |            |       |            |       |         |       |
| Other income (expenses)                                                   |       |            |       |            |       |         |       |
| Interest income                                                           |       | 209,305         |       | —          |       | 209,305      |       |
| Rental income -  related party                                            |       | 27,162          |       | —          |       | 27,162       |       |
| Gain on debt  extinguishment                                              |       | 35,283          |       | —          |       | 35,283       |       |
| Interest expense                                                          |       | (37,924         | )          | —          |       | (37,924      | )          |
|                                                                      |       |            |       |            |       |         |       |
| Total other  income (expenses)                                            |       | 233,826         |       | —          |       | 233,826      |       |
|                                                                      |       |            |       |            |       |         |       |
| Net loss                                                                  |       | $               | (9,160,852 | )               | $          | (437,350     | )          | $ | (9,598,202 | ) |
|                                                                      |       |            |       |            |       |         |       |
| Net loss per common share, basic and diluted                              |       | $               | (0.56      | )               | $          | (0.02        | )          | $ | (0.58 | ) |
|                                                                      |       |            |       |            |       |         |       |
| Weighted average  number of common shares outstanding - basic and diluted |       | 16,408,395      |       | —          |       | 16,408,395   |       |

 

 

31

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**RESTATEDCONSOLIDATED STATEMENT OF CASH FLOWSFOR THE YEAR ENDED SEPTEMBER 30, 2005**

 
| ** **                                                                   | ** ** | **As Reported** | ** ** | **Adustments** | ** ** | **Restated** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|------------|----------------|------------|--------------|------------|
|                                                                         |       |            |       |           |       |         |       |
| Cash flows from operating activities:                                        |       |            |       |           |       |         |       |
| Net loss                                                                     |       | $               | (5,287,068 | )              | $          | (437,350     | )          | $ | (5,724,418 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |            |       |           |       |         |       |
| Gain on debt  extinguishment                                                 |       | (35,283         | )          | —         |       | (35,283      | )          |
| Depreciation and  amortization expense                                       |       | 391,467         |       | —         |       | 391,467      |       |
| 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         |       | 437,350        |       | 614,900      |       |
| Changes in  operating assets and liabilities:                                |       |            |       |           |       |         |       |
| Increase in  accounts receivable - related party                             |       | (42,330         | )          | —         |       | (42,330      | )          |
| Increase in  prepaid expenses                                                |       | (68,428         | )          | —         |       | (68,428      | )          |
| (Increase)  decrease in other current assets                                 |       | —          |       | —         |       | —       |       |
| Increase in  accounts payable                                                |       | 221,329         |       | —         |       | 221,329      |       |
| Increase in  accrued liabilities                                             |       | 26,080          |       | —         |       | 26,080       |       |
|                                                                         |       |            |       |           |       |         |       |
| Net cash used in  operating activities                                       |       | (4,625,184      | )          | —         |       | (4,625,184   | )          |
|                                                                         |       |            |       |           |       |         |       |
| Cash flows from investing activities:                                        |       |            |       |           |       |         |       |
| Payments to  purchase property and equipment                                 |       | (1,167,134      | )          | —         |       | (1,167,134   | )          |
| Proceeds from  sale of property and equipment                                |       | —          |       | —         |       | —       |       |
| Payments to  purchase intangibles                                            |       | (170,281        | )          | —         |       | (170,281     | )          |
| 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                                       |       | (1,723,254      | )          | —         |       | (1,723,254   | )          |
|                                                                         |       |            |       |           |       |         |       |
| 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                                                 |       | (314,945        | )          | —         |       | (314,945     | )          |
| Proceeds from  borrowings under loan agreements - related parties            |       | —          |       | —         |       | —       |       |
| Repayment of  borrowings under loan agreements - related parties             |       | —          |       | —         |       | —       |       |
|                                                                         |       |            |       |           |       |         |       |
| Net cash  provided by financing activities                                   |       | 16,832,721      |       | —         |       | 16,832,721   |       |
|                                                                         |       |            |       |           |       |         |       |
| Net increase in cash and cash equivalents                                    |       | 10,484,283      |       | —         |       | 10,484,283   |       |
|                                                                         |       |            |       |           |       |         |       |
| Cash and cash equivalents - beginning of period                              |       | 20,363          |       | —         |       | 20,363       |       |
|                                                                         |       |            |       |           |       |         |       |
| Cash and cash equivalents - end of period                                    |       | $               | 10,504,646 |           | $          | —       |       | $ | 10,504,646 |   |
|                                                                         |       |            |       |           |       |         |       |
| Supplemental disclosures of cash flow information:                           |       |            |       |           |       |         |       |
| Cash paid for  interest                                                      |       | $               | 14,004     |           | $          | —       |       | $ | 14,004 |   |
|                                                                         |       |            |       |           |       |         |       |
| Non-cash investing and financing activities:                                 |       |            |       |           |       |         |       |
| Prepaid  insurance acquired with note payable                                |       | $               | 51,000     |           | $          | —       |       | $ | 51,000 |   |
| 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                               |       | —          |       | —         |       | —       |       |

 

 

32

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

 
| ** **                                                                   | ** ** | **As Reported** | ** ** | **Adustments** | ** ** | **Restated** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|------------|----------------|------------|--------------|------------|
|                                                                         |       |            |       |           |       |         |       |
| Cash flows from operating activities:                                        |       |            |       |           |       |         |       |
| Net loss                                                                     |       | $               | (9,160,852 | )              | $          | (437,350     | )          | $ | (9,598,202 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |            |       |           |       |         |       |
| Gain on debt  extinguishment                                                 |       | (35,283         | )          | —         |       | (35,283      | )          |
| Depreciation and  amortization expense                                       |       | 538,876         |       | —         |       | 538,876      |       |
| 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         |       | 437,350        |       | 665,714      |       |
| Changes in  operating assets and liabilities:                                |       |            |       |           |       |         |       |
| Increase in  accounts receivable - related party                             |       | (42,330         | )          | —         |       | (42,330      | )          |
| Increase in  prepaid expenses                                                |       | (117,973        | )          | —         |       | (117,973     | )          |
| (Increase)  decrease in other current assets                                 |       | —          |       | —         |       | -            |       |
| Increase in  accounts payable                                                |       | 716,795         |       | —         |       | 716,795      |       |
| Increase in  accrued liabilities                                             |       | 242,633         |       | —         |       | 242,633      |       |
|                                                                         |       |            |       |           |       |         |       |
| Net cash used in  operating activities                                       |       | (6,590,441      | )          | —         |       | (6,590,441   | )          |
|                                                                         |       |            |       |           |       |         |       |
| Cash flows from investing activities:                                        |       |            |       |           |       |         |       |
| Payments to  purchase property and equipment                                 |       | (1,183,689      | )          | —         |       | (1,183,689   | )          |
| Proceeds from  sale of property and equipment                                |       | 20,957          |       | —         |       | 20,957       |       |
| Payments to  purchase intangibles                                            |       | (430,444        | )          | —         |       | (430,444     | )          |
| 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                                       |       | (2,341,831      | )          | —         |       | (2,341,831   | )          |
|                                                                         |       |            |       |           |       |         |       |
| 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                                                 |       | (592,348        | )          | —         |       | (592,348     | )          |
| 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                                   |       | 19,436,918      |       | —         |       | 19,436,918   |       |
|                                                                         |       |            |       |           |       |         |       |
| Net increase in cash and cash equivalents                                    |       | 10,504,646      |       | —         |       | 10,504,646   |       |
|                                                                         |       |            |       |           |       |         |       |
| Cash and cash equivalents - beginning of period                              |       | —          |       | —         |       | —       |       |
|                                                                         |       |            |       |           |       |         |       |
| Cash and cash equivalents - end of period                                    |       | $               | 10,504,646 |           | $          | —       |       | $ | 10,504,646 |   |
|                                                                         |       |            |       |           |       |         |       |
| Supplemental disclosures of cash flow information:                           |       |            |       |           |       |         |       |
| Cash paid for  interest                                                      |       | $               | 38,701     |           | $          | —       |       | $ | 38,701 |   |
|                                                                         |       |            |       |           |       |         |       |
| Non-cash investing and financing activities:                                 |       |            |       |           |       |         |       |
| Prepaid  insurance acquired with note payable                                |       | $               | 111,990    |           | $          | —       |       | $ | 111,990 |   |
| 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      |       |

 

 

33

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**3. SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

**Basis of Presentation**

 

The accompanying consolidated financial statementshave been prepared in conformity with accounting principles generally acceptedin the United States of America.  Certainreclassifications have been made to conform prior period amounts to the currentperiod presentation.  Thesereclassifications had no effect on net loss, net loss per share or stockholders’equity.

 

**Reverse Acquisition**

 

For the purposes of these consolidated financialstatements, the merger of PDTI-DE into MXLK was treated as a reverseacquisition.  Pursuant to the guidance inAppendix B of SEC Accounting Disclosure Rules and Practices Official Text,the merger of a private operating company into a non-operating public shellcorporation with nominal net assets typically results in the owners andmanagement of the private company having actual or effective operating controlof the combined company after the transaction, with the shareholders of theformer public shell continuing only as passive investors.  These transactions are considered by thestaff of the Securities and Exchange Commission to be capital transactions insubstance, rather than business combinations.  That is, the transaction is equivalent to theissuance of stock by the private company for the net monetary assets of theshell corporation, accompanied by a recapitalization.  Accordingly, the reverse acquisition has beenaccounted for as a recapitalization.  Foraccounting purposes, PDTI is considered the acquirer in the reverseacquisition.  The historical consolidatedfinancial statements are those of PDTI.  Netloss per share for periods prior to the merger are restated to reflect the numberof equivalent shares received by the acquiring company.

 

**Principles of Consolidation**

 

The accompanying consolidated financial statementsinclude the accounts of the Company and its subsidiary.  All significant intercompany balances andtransactions have been eliminated.

 

34

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**Use of Estimates**

 

The preparation of consolidated financial statementsin conformity with accounting principles generally accepted in the UnitedStates of America requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities, disclosure of contingentassets and liabilities at the date of the consolidated financial statements andthe reported amounts of revenues and expenses during the reportingperiods.  Actual results could differfrom these estimates.

 

**Cash Equivalents**

 

Cash equivalents include highly liquid investmentswith a maturity of three months or less when acquired.

 

**Fair Value of Financial Instruments**

 

We invest cash in excess of operating requirements in U.S.Money Market Funds.  The carrying amountsreported in the consolidated balance sheets for current assets and currentliabilities approximate fair value due to the short maturity of these items.

 

**Concentration of Credit Risk**

 

Financial instruments that potentially subject PDTI toa concentration of credit risk consist of cash and cash equivalents. Cash andcash equivalents are deposited in demand in one financial institution in theUnited States.  Deposits held with financialinstitutions may exceed the amount of insurance provided on such deposits.  PDTI has not experienced any material losseson its deposits of cash and cash equivalents.

 

**Property and Equipment**

 

Property and equipment are stated at cost.  Depreciation is calculated using thestraight-line method over the estimated useful lives of the assets, whichranges from three to five years.  Leaseholdimprovements are amortized using the straight-line method over the estimateduseful lives of the assets or the term of the lease, whichever is shorter.  Whenever assets are retired or otherwisedisposed of, the cost and related accumulated depreciation are removed from theaccounts, and any resulting gain or loss is recognized in income for theperiod.  The cost of maintenance andrepairs is expensed as incurred and any significant improvements that extendthe useful life of the assets are capitalized.

 

**Intangible Assets**

 

An intangible asset that is acquired eitherindividually or with a group of other assets (but not those acquired in abusiness combination) is initially recognized and measured based on its fairvalue.  The costs of a group of assetsacquired in a transaction other than a business combination are allocated tothe individual assets acquired based on their relative fair values and are notconsidered goodwill.  The cost ismeasured based on the fair value of the consideration given or the fair valueof the net assets acquired, whichever is more reliably measurable.  Intangible assets are amortized on a straight-linebasis over the best estimate of their useful lives.  The amortization period and amortizationmethod are reviewed annually at each financial year-end.  Additional patent and application costs arecapitalized, and amortized over their useful lives once the patents are issued.

 

**Impairment of Long-Lived Assets**

 

PDTI evaluates its long-lived assets for indicators ofpossible impairment by comparison of the carrying amounts to future netundiscounted cash flows expected to be generated by such assets when events orchanges in circumstances indicate the carrying amount of an asset may not berecoverable.  Should an impairment exist,the impairment loss would be measured based on the excess carrying value of theasset over the asset’s fair value or discounted estimates of future cashflows.  PDTI also evaluates the capitalizedcosts for patents and patent applications filed but not issued for possibleimpairments. PDTI has not identified any such impairment losses to date.

 

35

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**Offering Expense**

 

Offering expenses consist primarily of placement feesand expenses, professional fees and printing costs.  These expenses are charged against the relatedproceeds from the sale of Company stock in the periods in which they occur orcharged to expense in the event of a terminated offering.

 

**Income Taxes**

 

The Company follows Statements of Financial AccountingStandards (“SFAS”) No. 109 *Accountingfor Income Taxes*. This statement requires an asset and liabilityapproach for financial accounting and reporting for income tax purposes.  This statement recognizes the amount of taxespayable or refundable for the current year and deferred tax liabilities andassets for future tax consequences of events that have been recognized in the consolidatedfinancial statements or tax returns.  Provisions(benefits) for income taxes result from permanent and temporary differences inthe recognition of accounting transactions for tax and financial reportingpurposes.  Valuation allowances areestablished when necessary to reduce deferred tax assets to the amount expectedto be realized.

 

**Stock-Based Compensation**

 

The Company follows SFAS No. 123(R), *Share-Based Payment.*  This statement establishes standards for theaccounting for transactions in which an entity exchanges its equity instrumentsfor goods or services.  It also addressestransactions in which an entity incurs liabilities in exchange for goods orservices that are based on the fair value of the entities equity instruments orthat may be settled by the issuance of those equity instruments.  This statement focuses primarily on accountingfor transactions in which an entity obtains employee services in share-basedpayment transactions.  This statementdoes not change the accounting guidance for share-based payment transactionswith parties other than employees provided in SFAS No. 123 as originallyissued.

 

**Research and Development**

 

The costs of materials and equipment or facilitiesthat are acquired or constructed for research and development activities andthat have alternative future uses are capitalized as tangible assets whenacquired or constructed.  The cost ofsuch materials consumed in research and development activities and thedepreciation of such equipment or facilities used in those activities areresearch and development costs.  However,the costs of materials, equipment, or facilities acquired or constructed forresearch and development activities that have no alternative future uses areconsidered research and development costs and are expensed at the time thecosts are incurred.

 

**Net Loss Per Share**

 

The Company has presented basic and diluted net lossper share pursuant SFAS No. 128, *EarningsPer Share*.  In accordance withSFAS No. 128, basic and diluted net loss per share has been computed usingthe weighted-average number of shares of common stock outstanding during theperiod.  Dilutive net loss per sharewould give affect to the dilutive effect of common stock equivalents consistingof options and warrants.  Potentially dilutivesecurities have been excluded from the net loss per common share calculation asthe effects would be antidilutive.  Potentiallydilutive securities for the years ended September 30, 2005 and 2004 andfor the period from June 9, 2003 (date of inception) to September 30,2003 that have been excluded are 991,711, 98,771 and 0 respectively.

 

The following is the calculation of basic and dilutedweighted average shares outstanding and net loss per share for each of theyears and periods ending September 30:

 
| ** **                                   | ** ** | ** **                   | ** ** | ** **        | ** ** | **Period from**   | ** ** | **Period from**   | ** ** |
|----------------------------------------------|------------|------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                   | ** ** | ** **                   | ** ** | ** **        | ** ** | **June 9, 2003**  | ** ** | **June 9, 2003**  | ** ** |
| ** **                                   | ** ** | ** **                   | ** ** | ** **        | ** ** | **(date of**      | ** ** | **(date of**      | ** ** |
| ** **                                   | ** ** | **Year Ended September 30,** | ** ** | **inception) to** | ** ** | **inception) to** | ** ** |
| ** **                                   | ** ** | ** **                   | ** ** | ** **        | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                   | ** ** | **2005**                     | ** ** | **2004**          | ** ** | **2003**          | ** ** | **2005**          | ** ** |
|                                         |       | **(Restated)**               |       |              |       |              |       | **(Restated)**    |       |
| Net loss (numerator):                        |       |                         |       |              |       |              |       |              |       |
| Net loss - basic  and diluted                |       | $                            | (5,724,418 | )                 | $          | (3,331,000        | )          | $                 | (542,784   | ) | $ | (9,598,202 | ) |
|                                         |       |                         |       |              |       |              |       |              |       |
| Weighted average shares (denominator):       |       |                         |       |              |       |              |       |              |       |
| Weighted average  shares - basic and diluted |       | 22,150,365                   |       | 13,364,183        |       | 7,741,646         |       | 16,408,395        |       |
|                                         |       |                         |       |              |       |              |       |              |       |
| Net loss per share:                          |       |                         |       |              |       |              |       |              |       |
| Basic and  diluted                           |       | $                            | (0.26      | )                 | $          | (0.25             | )          | $                 | (0.07      | ) | $ | (0.58 | ) |

 

 

**Recent Accounting Pronouncements**

 

In May 2005, the Financial Accounting StandardsBoard issued SFAS No. 154, *Accounting Changes andError Corrections*.  This newstandard replaces Accounting Principals Board Opinion (“APB”) No. 20, *Accounting Changes,* and SFAS No. 3, *Reporting Accounting Changes in Interim Financial Statements*.  This statement changes the requirements forthe accounting for and reporting of a change in accounting principle andapplies to all voluntary changes in accounting principle.  It also applies to changes required by anaccounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. When a pronouncement includes specific transition provisions, thoseprovisions should be followed.  APBNo. 20 required that most voluntary changes in accounting principle berecognized by including in net income of the period of the change thecumulative effect of changing to the new accounting principle.  This statement requires retrospectiveapplication to prior period financial statements of changes in accounting principle,unless it is impracticable to determine either the period-specific effects orthe cumulative effect of the change.  Theprovisions of SFAS No. 154 are effective for fiscal years beginning afterDecember 15, 2005.  As such we are required to adopt SFAS No. 154 byOctober 1, 2006.  We do not expect this statement to have a materialimpact on our consolidated financial statements.

 

36

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**4. PROPERTY AND EQUIPMENT**

 

The following is a summary of property and equipment,at cost less accumulated depreciation, at September 30:

** **
| ** **                            | ** ** | **2005**  | ** ** | **2004** | ** ** |
|---------------------------------------|------------|-----------|------------|----------|------------|
|                                  |       |      |       |     |       |
| Office furniture  and equipment       |       | $         | 200,360    |     | $          | 66,070 |   |
| Machines and  equipment               |       | 1,530,665 |       | 497,821  |       |
|                                  |       |      |       |     |       |
| Total cost of  property and equipment |       | 1,731,025 |       | 563,891  |       |
|                                  |       |      |       |     |       |
| Less:  accumulated depreciation  |       | 453,043   |       | 112,066  |       |
|                                  |       |      |       |     |       |
| Total property  and equipment, net    |       | $         | 1,277,982  |     | $          | 451,825 |   |

 

For the years ended September 30, 2005 and 2004and the period from June 9, 2003 (date of inception) to September 30, 2003, depreciationexpense totaled $340,977, $112,066 and $0, respectively.

 

**5. INTANGIBLE ASSETS**

 

The following is a summary of intangibles, at costless accumulated amortization, at September 30:

** **
| ** **                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
|                                 |       |     |       |     |       |
| Intangibles, at  cost                |       | $        | 1,188,236  |     | $          | 1,017,955 |   |
| Less:  accumulated amortization |       | 85,833   |       | 35,343   |       |
|                                 |       |     |       |     |       |
| Total  intangibles, net              |       | $        | 1,102,403  |     | $          | 982,612 |   |

 

During fiscal years 2005 and 2004, the Companyincurred direct cost of $170,281 and $88,192, respectively, for patents filedbut not issued.

 

The estimated amortization expense for each of thefive succeeding years following September 30, 2005 is $50,500.

 

In January 2004, as consideration for theCompany’s acquisition from ProDril Services Inc. (“PSI”) of equipment with afair value of $479,610 and all intellectual property associated with PSI’s PIDtechnology, the Company assumed liabilities in the amount of $945,980 from PSIand exchanged a note receivable from PSI in the amount of $300,783.  The note receivable from PSI originated undera revolving credit facility between PSI and the Company which was signed in May2003.  In order to induce the Company toenter into the revolving credit facility, PSI, and certain affiliates of PSI,assigned the patents underlying the PID technology and related intellectual propertyto the Company.  Under the terms of thisagreement, PSI had the right to recover the patents if the note receivable waspaid in full prior to the signing of a purchase and sale agreement between theparties.  A purchase and sale agreementwas signed among the parties on September 10, 2003. The Company recorded anintangible asset of $767,153 for the difference in the fair value of total considerationgiven under the purchase and sale agreement and the fair value of the net tangibleassets acquired.  The Company believes that the $767,153 attributed to theintangible assets represents the best estimate of the fair value of such assetsat the date of the acquisition.  All ofthe intangible assets relate to the patents and the intellectual property relatedto the patents underlying the PID technology. In connection with the acquisition, the Company incurred direct legalfees of $87,915 and $74,695 during the fiscal year ended underlying the PIDtechnology September 30, 2004 and the period ending September 30,2003, respectively.  Since all of the intangible assets acquired wererelated to the patents, PDTI determined the useful life of the intangibles tobe 18.3 years at the date of acquisition.

 

For the years ended September 30, 2005 and 2004and the period from June 9, 2003 (date of inception) to September 30, 2003,amortization expense totaled $50,490, $35,343 and $0, respectively.

 

37

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**6. SHORT-TERM NOTES**

 

The following is a table of PDTI’s short-term obligationsat September 30:

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Short-term note  payable at prime plus 2% interest, secured by a certain license agreement  related to the Dual Jet Technology.   The Company was in default on this note agreement as of September 30,  2004.  PDTI was also in default on the  first payment which caused the interest rate to increase from 2% to 18% as of  February 21, 2004.  During fiscal year  2005 the principal and accrued interest was settled for $95,000. |       | $        | —     |     | $          | 114,778 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Short-term note  at prime plus 5% imputed interest, unsecured with monthly principal and  interest payments of $10,000.                                                                                                                                                                                                                                                                                                                                 |       | —   |       | 74,878   |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Short-term note  at 5.5% interest, unsecured with monthly principal and interest payments of  $6,933.                                                                                                                                                                                                                                                                                                                                                   |       | —   |       | 47,436   |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Short-term note  at prime plus 2% interest, unsecured with monthly principal payments of  $5,000 plus interest.  As of September  30, 2005, the amount due on this note is in dispute pending a lawsuit that  was filed in November 2004.                                                                                                                                                                                                          |       | 40,000   |       | 40,000   |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Short-term note,  unsecured with quarterly principal payments of $5,000, or due on demand with  receipt of net $5,000,000 from sale of securities.                                                                                                                                                                                                                                                                                                      |       | —   |       | 29,782   |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Short-term note,  unsecured due December 31, 2004, or upon receipt of net $5,000,000 from sale  of securities.                                                                                                                                                                                                                                                                                                                                          |       | —   |       | 21,030   |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Short-term note,  unsecured with principal payments of $3,667 per month.                                                                                                                                                                                                                                                                                                                                                                                |       | —   |       | 11,000   |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Short-term note  at 6.5% interest, unsecured with monthly principal and interest payments of  $5,821.                                                                                                                                                                                                                                                                                                                                                   |       | 39,880   |       | —   |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Other                                                                                                                                                                                                                                                                                                                                                                                                                                                   |       | —   |       | 1,400    |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |     |       |     |       |
| Total short-term  notes payable                                                                                                                                                                                                                                                                                                                                                                                                                         |       | $        | 79,880     |     | $          | 340,304 |   |

 

38

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**7. ACCRUEDLIABILITIES**

 

Accruedliabilities consist of the following at September 30:

 
| ** **                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
|                              |       |     |       |     |       |
| Payroll and  related expenses     |       | $        | 4,449      |     | $          | 132,067 |   |
| General and  administrative       |       | 21,846   |       | —   |       |
| Rent                              |       | 57,450   |       | —   |       |
| Professional  fees                |       | 2,154    |       | 80,000   |       |
| Audit fees                        |       | 112,000  |       | —   |       |
| Research and  development expense |       | 33,243   |       | —   |       |
| Accrued capital  costs            |       | 11,491   |       | —   |       |
| Accrued interest                  |       | —   |       | 4,486    |       |
|                              |       |     |       |     |       |
| Total accrued  liabilities        |       | $        | 242,633    |     | $          | 216,553 |   |

 

**8. LONG-TERM DEBT**

 

Long-termdebt consists of the following at September 30:

 
| ** **                                                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                          |       |     |       |     |       |
| Note payable to  a bank in monthly installments of $927, including interest at 6.25%, due in  July 2007, secured by a vehicle |       | $        | 21,060     |     | $          | 31,092 |   |
|                                                                                                                          |       |     |       |     |       |
| Less:  current portion classified as current on  the balance sheet                                                       |       | 11,597   |       | 10,891   |       |
|                                                                                                                          |       |     |       |     |       |
| Total long-term  debt                                                                                                         |       | $        | 9,463      |     | $          | 20,201 |   |

 

**9. COMMON STOCK**

 

All common stock sold or issued in exchange forservices included an anti-dilution provision with the exception of the founders’shares, the 5,000,000 shares of common stock issued in June 2004 to PDTI’sfinancial advisors, and shares of common stock issued in exchange forwarrants.  In June 2004, all shareholderswhose shares included an anti-dilution provision agreed to exchange theanti-dilution provision for registration rights, thereby eliminating the anti-dilutionprovision.

 

At September 30, 2005 and2004, the Company had 24,441,472 and 18,095,447 shares of common stock outstanding,respectively.  Common stock reserved forissuance consists of the following at September 30:

 
| ** **                                           | ** ** | **2005**  | ** ** | **2004**  | ** ** |
|------------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                                 |       |      |       |      |       |
| Exercise of  stock options                           |       | 3,915,000 |       | 2,655,000 |       |
| Exercise of  warrants                                |       | 1,678,000 |       | 160,000   |       |
| Future grants of  stock options and restricted stock |       | 1,230,000 |       | 645,000   |       |
|                                                 |       |      |       |      |       |
| Total common  stock reserved for issuance            |       | 6,823,000 |       | 3,460,000 |       |

 

39

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**10. TREASURY STOCK**

 

In February 2005, the Board ofDirectors authorized the repurchase of 3,000,000 shares of the Company’s commonstock at $0.50 per share from Prentis B. Tomlinson, PDTI’s formerPresident and Chief Executive Officer and a director of PDTI untilDecember 2, 2004.  In February 2005,PDTI used $1.5 million of the $18 million gross proceeds received from theFebruary 9, 2005 private placement to repurchase 3,000,000 shares at $0.50 pershare from Mr. Tomlinson.

 

**11. STOCK OPTIONS AND WARRANTS**

 

**Stock Options**

 

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 September 30, 2005, theCompany had 1,200,000 shares of common stock available for issuance pursuant toawards under the 2005 Plan.  Under the2005 Plan, the exercise price of each option equals the market value of theCompany’s common stock on the date of grant and the maximum term for theoptions is ten years.

 

In April 2004, the Board of Directors adopted the2004 Stock Incentive Plan (the “2004 Plan”). The 2004 Plan provides the issuance of incentive stock options,non-statutory stock options and restricted stock to directors, employees andconsultants of PDTI. Provisions under the 2004 Plan allow for the issuance of upto 3,500,000 shares of common stock pursuant to awards under this plan.  As of September 30, 2005, the Companyhad 30,000 awards available for grant under the 2004 Plan. Under the 2004 Plan,the exercise price of each option equals the market value of the Company’scommon stock on the date of grant and the maximum term for the options is tenyears.

 

Stock-based employee compensation expense recorded forawards issued under the 2004 Plan and the 2005 Plan for the years endedSeptember 20, 2005 and 2004 was $614,900 and $50,814, respectively.  Stock-based employee compensation expense forawards issued under the 2004 Plan and the 2005 Plan since inception (June 9,2003) to September 30, 2005 was $665,714.

 

**Warrants**

 

In October 2004, PDTI issued warrants to purchase33,333 shares of the Company’s common stock at $0.01 per share.  Thewarrants were issued to a financial advisor for services provided.  TheCompany recorded an expense of $58,000 using the Black-Scholes option pricingmodel.

 

In connection with a private placement that commencedin April 2004 and completed in January 2005, PDTI issued warrants, inJanuary 2005, to purchase 65,500 shares of the Company’s common stock tocertain persons associated with the Placement Agent of this privateplacement.  Offering expense recorded for these warrants was$80,565.  The related expense was a direct cost of the associatedfinancing and was therefore charged directly to stockholders’ equity. Each warrant has an exercise price of $2.00 per share with a maximum term offive years.  The fair value of each warrant granted is estimated as of thegrant date using the Black-Scholes option pricing model.

 

In connection with a private placement that wascompleted February 9, 2005, PDTI issued warrants, in February 2005,to purchase 1,500,000 shares of the Company’s common stock to certain personsassociated with the Placement Agent of this private placement.  Offeringexpense recorded for these warrants was $2,370,000.  The related expensewas a direct cost of the associated financing and was therefore chargeddirectly to stockholders’ equity.  Each warrant has an exercise price of$2.00 per share with a maximum term of ten years.  The fair value of eachwarrant granted is estimated as of the grant date using the Black-Scholesoption pricing model.

 

During fiscal year 2004, PDTI issued warrants topurchase 323,909 of the Company’s common stock to consultants. The exerciseprice of each warrant equals the market value of the Company’s common stock onthe date of grant and the maximum term for the warrants is five years. For thefiscal year ended September 30, 2004, compensation expense recorded forthese warrants was $5,830.

 

The Company did not have any stock option or stockwarrant activity for the period from June 9, 2003 (date of inception) toSeptember 30, 2003; therefore, no compensation expense was recorded forthis period.

 

40

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**Summarized Information for Stock Options andWarrants**

 

The following is a summary of all stock option andwarrant activity for fiscal years 2005 and 2004:

 
| ** **                         | ** ** | **Number of  Shares  Underlying  Options** | ** ** | **Weighted  Average  Exercise**

**Price** | ** ** | **Number of  Shares  Underlying  Warrants** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|
|                               |       |                                       |       |                                       |       |                                        |       |                                   |       |
| Outstanding at  October 1, 2003    |       | —                                     |       | $                                          | —     |                                        | —     |                                   | $          | — |   |
|                               |       |                                       |       |                                       |       |                                        |       |                                   |       |
| Granted                            |       | 2,855,000                                  |       | 0.12                                       |       | 323,909                                     |       | 0.12                                   |       |
| Exercised                          |       | (200,000                                   | )          | 0.12                                       |       | (163,909                                    | )          | 0.12                                   |       |
| Forfeited                          |       | —                                     |       | —                                     |       | —                                      |       | —                                 |       |
|                               |       |                                       |       |                                       |       |                                        |       |                                   |       |
| Outstanding at  September 30, 2004 |       | 2,655,000                                  |       | $                                          | 0.12       |                                        | 160,000    |                                   | $          | 0.12 |   |
|                               |       |                                       |       |                                       |       |                                        |       |                                   |       |
| Granted                            |       | 1,270,000                                  |       | 3.60                                       |       | 1,611,333                                   |       | 1.97                                   |       |
| Exercised                          |       | —                                     |       | —                                     |       | (91,025                                     | )          | 0.08                                   |       |
| Forfeited                          |       | (10,000                                    | )          | 4.90                                       |       | (2,308                                      | )          | 0.12                                   |       |
|                               |       |                                       |       |                                       |       |                                        |       |                                   |       |
| Outstanding at  September 30, 2005 |       | 3,915,000                                  |       | $                                          | 1.24       |                                        | 1,678,000  |                                   | $          | 1.90 |   |
|                               |       |                                       |       |                                       |       |                                        |       |                                   |       |
| Exercisable at  September 30, 2005 |       | 2,211,250                                  |       | $                                          | 0.49       |                                        | 1,678,000  |                                   | $          | 1.90 |   |
|                               |       |                                       |       |                                       |       |                                        |       |                                   |       |
| Exercisable at  September 30, 2004 |       | 1,030,000                                  |       | $                                          | 0.12       |                                        | 160,000    |                                   | $          | 0.12 |   |

 

The weighted average fair value of an option to purchaseone share of common stock granted during fiscal years 2005 and 2004 was $2.37and $0.04, respectively.  The weightedaverage fair value of a warrant to purchase one share of common stock grantedduring fiscal years 2005 and 2004 was $1.56 and $0.02, respectively.  The fair value of each stock option andwarrant granted is estimated as of the date of grant using the Black-Scholesoption pricing model with the following weighted average assumptions:

 
| ** **               | ** ** | **Weighted Average  Assumption for  Options Granted** | ** ** | **Weighted Average  Assumption for  Warrants Granted** | ** ** |
|--------------------------|------------|-------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **               | ** ** | **2005**                                              | ** ** | **2004**                                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                     |       |                                                  |       |                                                   |       |   |   |   |   |
| Risk-free  interest rate |       | 4.0                                                   | %          | 4.2                                                    | %          | 3.9 | % | 3.3 | % |
|                     |       |                                                  |       |                                                   |       |   |   |   |   |
| Expected  volatility     |       | 40.4                                                  | %          | None                                                   |       | 69.8 | % | None |   |
|                     |       |                                                  |       |                                                   |       |   |   |   |   |
| Dividend yield           |       | None                                                  |       | None                                                   |       | None |   | None |   |
|                     |       |                                                  |       |                                                   |       |   |   |   |   |
| Expected life            |       | 7.8 years                                             |       | 10 years                                               |       | 9.6 years |   | 5 years |   |

 

41

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Thefollowing table summarizes information about stock options outstanding andexercisable at September 30, 2005:

 
| **Options Outstanding**      | ** ** | **Options Exercisable**                    | ** ** |
|------------------------------|------------|--------------------------------------------|------------|
| **Range of  Exercise Price** | ** ** | **Number of  Shares  Underlying  Options** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares  Underlying  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                         |       |                                       |       |   |   |   |   |   |   |   |   |
| $0.12 to $1.75               |       | 3,205,000                                  |       | 8.6 years |   | $ | 0.40 |   | 2,211,250 |   | $ | 0.49 |   |
| $4.90 to $6.65               |       | 710,000                                    |       | 9.6 years |   | $ | 5.02 |   | — |   | — |   |
|                         |       | 3,915,000                                  |       | 8.8 years |   | $ | 1.24 |   | 2,211,250 |   | $ | 0.49 |   |

 

Thefollowing table summarizes information about warrants outstanding andexercisable at September 30, 2005:

 
| **Warrants Outstanding**     | ** ** | **Warrants Exercisable**                    | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| **Range of  Exercise Price** | ** ** | **Number of  Shares  Underlying  Warrants** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares  Underlying  Warrants** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                         |       |                                        |       |   |   |   |   |   |   |   |   |
| $0.12 to $3.00               |       | 1,678,000                                   |       | 8.8 years |   | $ | 1.90 |   | 1,678,000 |   | $ | 1.90 |   |
|                              |            |                                             |            |  |  |  |  |  |  |  |  |  |  |

 

Thefollowing table presents information about stock options and warrants grantedduring the year where the exercise price of some stock options and warrantsdiffered from the market price of the Company’s stock on the grant date:

 
| ** **                                | ** ** | **Number of  Shares  Underlying  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares  Underlying  Warrants** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|
|                                      |       |                                       |       |                                   |       |                                        |       |                                   |       |
| Year ended  September 30, 2005            |       |                                       |       |                                   |       |                                        |       |                                   |       |
|                                      |       |                                       |       |                                   |       |                                        |       |                                   |       |
| Exercise price  equals market value       |       | 1,270,000                                  |       | $                                      | 3.60       |                                        | 1,565,500  |                                   | $          | 2.00 |   |
| Exercise price  greater than market value |       | —                                     |       | —                                 |       | 12,500                                      |       | 3.00                                   |       |
| Exercise price  less than market value    |       | —                                     |       | —                                 |       | 33,333                                      |       | 0.01                                   |       |
|                                      |       |                                       |       |                                   |       |                                        |       |                                   |       |
|                                      |       | 1,270,000                                  |       | $                                      | 3.60       |                                        | 1,611,333  |                                   | $          | 1.97 |   |
|                                      |       |                                       |       |                                   |       |                                        |       |                                   |       |
| Year ended  September 30, 2004            |       |                                       |       |                                   |       |                                        |       |                                   |       |
|                                      |       |                                       |       |                                   |       |                                        |       |                                   |       |
| Exercise price  equals market value       |       | 2,855,000                                  |       | $                                      | 0.12       |                                        | 323,909    |                                   | $          | 0.12 |   |
| Exercise price  greater than market value |       | —                                     |       | —                                 |       | —                                      |       | —                                 |       |
| Exercise price  less than market value    |       | —                                     |       | —                                 |       | —                                      |       | —                                 |       |
|                                      |       |                                       |       |                                   |       |                                        |       |                                   |       |
|                                      |       | 2,855,000                                  |       | $                                      | 0.12       |                                        | 323,909    |                                   | $          | 0.12 |   |

 

**12. INCOME TAXES**

 

For the period ended September 30, 2005, there werepermanent and temporary differences of approximately $74,000 and $2,561,000,respectively, which decreased the tax loss for the current year.

 

At September 30, 2005, the Company has cumulative netoperating loss carryforwards of approximately $7,001,000 which expire in years2006 through 2024.  No effect has beenshown in the consolidated financial statements for the net

 

42

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operating loss carryforwards as the likelihood of future tax benefitfrom such net operating loss carryforwards is not determinable at this time.  Accordingly, the potential tax benefits of thenet operating loss carryforwards, estimated based upon current tax rates atSeptember 30, 2005, have been offset by valuation reserves of the same amount.  The valuation allowance increased $1,462,178from September 30, 2004 to September 30, 2005.

 

Deferred tax assets consisted of the following atSeptember 30:

 
| ** **                       | ** ** | **2005**       | ** ** | **2004**   | ** ** | **Total**      | ** ** |
|----------------------------------|------------|----------------|------------|------------|------------|----------------|------------|
|                             |       | **(Restated)** |       |       |       | **(Restated)** |       |
| Deferred tax  asset:             |       |           |       |       |       |           |       |
| Net operating  loss carryforward |       | $              | 1,921,222  |       | $          | 1,304,022      |       | $ | 3,225,244 |   |
| Intangibles                      |       | —         |       | 31,296     |       | 31,296         |       |
| Stock warrants  exercised        |       | 834,807        |       | —     |       | 834,807        |       |
| Stock-based  compensation        |       | 190,401        |       | —     |       | 190,401        |       |
| Deferred tax  liability:         |       |           |       |       |       |           |       |
| Intangibles                      |       | (55,002        | )          | —     |       | (55,002        | )          |
| Property and  equipment          |       | (99,424        | )          | (5,492     | )          | (104,916       | )          |
|                             |       |           |       |       |       |           |       |
| Deferred tax  asset              |       | 2,792,004      |       | 1,329,826  |       | 4,121,830      |       |
|                             |       |           |       |       |       |           |       |
| Valuation  allowance             |       | (2,792,004     | )          | (1,329,826 | )          | (4,121,830     | )          |
|                             |       |           |       |       |       |           |       |
| Net deferred tax  asset          |       | $              | —     |       | $          | —         |       | $ | — |   |

 

Due to thelosses that have occurred since the Company’s inception, and that the effect ofany permanent or temporary differences on taxable income have been deemedimmaterial, no statutory rate reconciliation of the Company’s tax rate isdisclosed nor discussed within this footnote.

 

**13. RELATED PARTY TRANSACTIONS**

 

In March 2005, the Company entered into a fiveyear sublease agreement with an affiliate of John D. Schiller, PDTI’s interimPresident and Chief Executive Officer of PDTI until November 15, 2005, andcurrently one of PDTI’s directors 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.  Futureannual minimum rental income associated with the sublease is $93,128.

 

In April 2004, the Company entered into anadvisory agreement with Cagan McAfee Capital Partners, LLC (“CMCP”) to assistin providing investment banking and other financial advisory services.  One of the principal’s of CMCP was a directorof the Company until February 8, 2005.  Inconnection with the advisory agreement, the Company issued 5,000,000 shares ofits common stock to CMCP and various affiliates of CMCP.  CMCP cancelled 700,000 of these shares inconnection with the merger with MedXLink Corp. in January 2005.  The Company is also required to pay CMCP amonthly advisory fee of $9,500 commencing on the date of signing a mergeragreement with a public company and continuing for two years following themerger.  The Company signed a mergeragreement with MedXLink, Corp, a public company, on July 14, 2004 andmerged with MedXLink, Corp on January 14, 2005.

 

In 2003, the Company entered into a revolving loanagreement with an affiliate of Prentis B. Tomlinson, PDTI’s former Presidentand Chief Executive Officer and a director of PDTI until December 2,2004.  The agreement was createdinitially to provide PDTI access to funds to carry out daily managementactivities in the normal course of business and to provide financial support toPSI until such time as the acquisition of certain assets and liabilities of PSIcould be completed (See Note 14 below for a complete description of theacquisition referred to above).  Theterms of the agreement allow for the right to offset.  At September 30, 2003, the affiliate ofMr. Tomlinson owed PDTI $318,744 and PDTI owed the affiliate ofMr. Tomlinson $322,172 for a net amount due to the affiliate of $3,428.  In July 2004, the affiliate ofMr. Tomlinson owed PDTI $381,789 and PDTI owed the affiliate ofMr. Tomlinson $325,006 for a net amount due from the affiliate of $56,783.During July 2004, PDTI purchased various office furniture, fixtures andequipment with a fair market value of $63,356 from the affiliate ofMr. Tomlinson by offsetting the balance owed to PDTI under this revolvingloan agreement.  In addition to theoffice furniture, fixtures and equipment, PDTI assumed the property taxliability of $6,573.

 

43

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During the period from June 9, 2003 (date ofinception) to September 30, 2003, Prentis B. Tomlinson advanced PDTI$19,767.  During fiscal year 2004, theCompany paid Mr. Tomlinson the entire balance owed.

 

**14. MERGERS**

 

On July 14, 2004, MedXLink, Corp. (“MXLK”, or the“Parent”), a Nevada corporation and an inactive publicly-traded company,entered into an Agreement and Plan of Reorganization with Particle DrillingTechnologies, Inc., a Delaware corporation (“PDTI-DE”), whereby MXLK agreed toacquire PDTI-DE through PDTI Acquisition Corp. (“Merger Sub”), a newly formedDelaware corporation and wholly owned subsidiary of MXLK, by issuing commonstock in exchange for all the outstanding shares of PDTI-DE.  On January 14, 2005, MXLK closed themerger with PDTI-DE and issued 16,698,094 shares of common stock (including3,381,538 shares of common stock issued upon conversion of the same number ofshares of Series A Convertible Preferred Stock of PDTI-DE) to holders ofcommon stock of PDTI-DE and reserved for issuance (1) 228,000 shares ofcommon stock pursuant to outstanding warrants to purchase common stock ofPDTI-DE, and (2) 3,205,000 shares of common stock pursuant to outstandingoptions to purchase common stock of PDTI-DE. In addition, 1,342,404 issued and outstanding shares of common stock ofPDTI-DE were cancelled for no consideration in connection with the merger.  As a result of the merger, the Parent had18,248,094 shares of common stock issued and outstanding (including 3,381,538shares of common stock issued upon conversion of the same number of shares ofSeries A Convertible Preferred Stock of PDTI-DE) and an additional 3,433,000shares of common stock reserved for issuance as described above. Following themerger, PDTI-DE continued as the surviving corporation under the name of ParticleDrilling Technologies, Inc. as a subsidiary of Parent.

 

**15. ACQUISITIONS**

 

In June 2003, PDTI entered into an Assignment andAssumption Agreement with the Curlett Family Limited Partnership, Ltd (“CFLP”)whereby PDTI acquired from CFLP its entire right, title and interest in the PIDpatent and patent application.

 

In June 2003, PDTI entered into an ExclusiveLicense Agreement with CCORE Technology and Licensing, Ltd. (“CCORE”),PSI, Harry B. Curlett, Curlett Family Limited Partnership, Ltd., and ProDrilServices International, Ltd. (“PSIL”) whereby PDTI was granted a worldwideand irrevocable exclusive license for the dual jet nozzle and its attendantsystem apparatus.  This technology is anon-core asset with respect to PDTI’s business plan.

 

In September 2003, PDTI entered into anAcquisition Agreement with ProDril Partners, LLC, PSI, Mr. Harry B.Curlett, CCORE Technology and Licensing, Ltd., and CFLP whereby PDTIagreed to acquire substantially all of the assets of PSI and agreed to assumecertain PSI liabilities.  Also inSeptember 2003, PDTI entered into a separate Acquisition Agreement withProDril Partners, LLC, ProDril Services International, Ltd.,Mr. Harry B. Curlett, CCORE Technology and Licensing, Ltd., and CFLPwhereby PDTI acquired substantially all of the assets of PSIL and agreed toassume certain PSIL liabilities.  Theclosing date of the two mentioned Acquisition Agreements was effectiveJanuary 20, 2004.

 

**16. COMMITMENTS AND CONTINGENCIES**

 

**Lease Commitments**

 

Rent expense with respect toour lease commitments for the years ended September 30, 2005, 2004 and periodfrom June 9, 2003 (date of inception) to September 30, 2003 was $155,424,$63,999 and $18,658, respectively.  TheCompany is obligated under non-cancellable operating leases for PDTI’s officespace and commercial operating facility in Houston, Texas.  Future minimum payments required under theseleases as of September 30, 2005 are as follows:

 

44

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**YearEnding September 30:**

 
| 2006                          |   | $       | 248,214   |   |
|-------------------------------|--------|---------|-----------|--------|
| 2007                          |   | 205,014 |      |
| 2008                          |   | 205,014 |      |
| 2009                          |   | 205,014 |      |
| 2010                          |   | 150,690 |      |
|                          |   |    |      |
| Total minimum  lease payments |   | $       | 1,013,946 |   |

 

**Royalty Agreements**

 

In January 2004, PDTI entered into a RoyaltyAgreement with PSI whereby PDTI will be required to pay PSI a royalty on aquarterly basis equal to 18% of the earnings before interest, income taxes,depreciation and amortization (“EBITDA”) derived from the use of the PIDtechnology, until an aggregate of $67,500,000 has been paid.  PDTI also entered into a Royalty Agreement inJanuary 2004 with PSIL whereby PDTI will be required to pay PSIL a royaltyon a quarterly basis equal to 2% of EBITDA derived from the use of the PIDtechnology, until an aggregate of $7,500,000 has been paid.  In addition, PDTI will be required to payCCORE, PSI and PSIL a royalty equal to 1.6%, 1.2% and 1.2%, respectively, ofPDTI’s quarterly gross revenue derived from the use of the PID technology.  PDTI has no revenues or EBITDA; therefore noroyalties have been paid or accrued as of September 30, 2005.

 

**Litigation**

 

The Company is currently engaged in litigationregarding the acquisition of its PID technology.  While the outcome ofthis litigation cannot be predicted with certainty, the Company believes thatthe probability of an adverse judgment in this litigation is remote.  However, should the Company receive anadverse judgment in this litigation, it would severely impair the Company’sability to continue as a going concern.  SeeItem 3. “Legal Proceedings” for more information concerning this litigation.

 

**17. SUBSEQUENT EVENTS**

 

On November 15, 2005, John D. Schiller, PDTI’s formerinterim President and Chief Executive Officer, resigned as PDTI’s interimPresident and Chief Executive Officer and J. Chris Boswell, PDTI’s Senior VicePresident and Chief Financial Officer, assumed the position as interim ChiefExecutive Officer.  Mr. Boswell willremain PDTI’s Chief Financial Officer while assuming the interim ChiefExecutive Officer position with the Company.

 

45

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**PARTICLEDRILLING TECHNOLOGIES, INC.**

**(adevelopment stage enterprise)**

**SUPPLEMENTALINFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS**

**SUMMARIZEDQUARTERLY FINANCIAL DATA**

**(Unaudited)**

 

 
| ** **                                    | ** ** | **Fiscal 2005 Quarter Ended** | ** ** |
|-----------------------------------------------|------------|-------------------------------|------------|
| ** **                                    | ** ** | **December 31**               | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** |
| ** **                                    | ** ** | ** **                    | ** ** | ** ** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                          |       |                          |       |   |   |   |   |   |   |
| Revenues                                      |       | $                             | —     |   | $ | — |   | $ | — |   | $ | — |   |
| Gross profit                                  |       | —                        |       | — |   | — |   | — |   |
| Loss from operations                          |       | (876,193                      | )          | (1,228,197 | ) | (1,715,917 | ) | (2,164,161 | ) |
| Net loss                                      |       | (882,745                      | )          | (1,159,730 | ) | (1,631,673 | ) | (2,050,270 | ) |
| Net loss per common share - basic and diluted |       | $                             | (0.05      | ) | $ | (0.05 | ) | $ | (0.07 | ) | $ | (0.08 | ) |

 
| ** **                                    | ** ** | **Fiscal 2004 Quarter Ended** | ** ** |
|-----------------------------------------------|------------|-------------------------------|------------|
| ** **                                    | ** ** | **December 31**               | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** |
|                                          |       |                          |       |   |   |   |   |   |   |
| Revenues                                      |       | $                             | —     |   | $ | — |   | $ | — |   | $ | — |   |
| Gross profit                                  |       | —                        |       | — |   | — |   | — |   |
| Loss from operations                          |       | (387,716                      | )          | (838,987 | ) | (1,244,413 | ) | (833,660 | ) |
| Net loss                                      |       | (387,716                      | )          | (846,449 | ) | (1,254,643 | ) | (842,192 | ) |
| Net loss per common share - basic and diluted |       | $                             | (0.03      | ) | $ | (0.07 | ) | $ | (0.10 | ) | $ | (0.05 | ) |

 

Restated Summarized Quarterly Financial Data:

The consolidated financial statements for the quarters ended June 30,2005 and September 30, 2005 were restated to recognize additional stock-basedcompensation for those periods as described in Note 2.  As a result, the loss from operations and thenet loss for the three months ended June 30, 2005 and September 30, 2005increased $125,033 and $312,317, respectively. The net loss per common share (basic and diluted) for each of the threemonths ended June 30, 2005 and September 30, 2005 increased $0.01.

 

46

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**Item 9.  Changes in and Disagreements with Accountantson Accounting and Financial Disclosure**

 

On March 29, 2005, the Audit Committee of the Board ofDirectors of the Company approved the dismissal of Chisholm, Bierwolf &Nilson, LLC (“CBN”) as the Company’s independent registered public accountingfirm.

 

CBN’s reports on the Company’s financial statementsfor the fiscal years ended September 30, 2003 and 2004 did not contain anadverse opinion or disclaimer of opinion, nor have they contained anyqualification or modification as to uncertainty, audit scope or accountingprinciples.  During the fiscal yearsended September 30, 2003 and 2004, and through March 29, 2005, the Company hashad no disagreements with CBN on any matters of accounting principles orpractice, financial statement disclosure, or auditing scope or procedure, whichif not resolved to CBN’s satisfaction, would have caused CBN to address suchdisagreement in connection with its report.

 

On March 29, 2005 the Company engaged UHY MannFrankfort Stein & Lipp CPAs, LLP (“Mann Frankfort”) to serve as the Company’sindependent registered public accounting firm. During the fiscal years ended September 30, 2003 and 2004, and throughMarch 29, 2005, the Company did not consult with Mann Frankfort regarding anyof the matters or events set forth in Item 304(a)(2)(i) or (ii) of RegulationS-K.  Mann Frankfort served as theindependent registered public accounting firm of Particle DrillingTechnologies, Inc., a Delaware corporation, which was acquired by the Companyon January 14, 2005.

 

**Item 9A.  Controls and Procedures**

 

**Disclosure Controls andProcedures**

 

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in our reportsunder the Securities and Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the rules andforms promulgated by the Securities and Exchange Commission’s (“SEC”), and thatsuch information is accumulated and communicated to management, including ourchief executive officer and chief financial officer, to allow timely decisionsregarding required disclosure. The design of any system of control is based inpart upon certain assumptions about the likelihood of future events, and therecan be no assurance that any design will succeed in achieving our statedpurpose under all potential future conditions. As required by Rule 13a-15(b) ofthe Securities Exchange Act of 1934, an evaluation was performed under thesupervision and with the participation of our chief executive officer and ourchief financial officer of the effectiveness of the 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 the period covered by this annual reporton Form 10-K/A filed with the SEC. Based upon that evaluation and in connectionwith their determination that the matters described immediately below relatingto the restatement of our historical financial information, our chief executiveofficer and our chief financial officer concluded that our disclosure controlsand procedures, as of September 30, 2005, were effective in timely alertingthem to material company information required to be included in our periodicfilings with the SEC.

 

Our chief executive officer and our chief financialofficer reviewed with members of our Audit Committee whether the restatementour financial results for the fiscal quarter ended June 30, 2005 and year endedSeptember 30, 2005 affected their conclusions that our disclosure controls andprocedures, as of September 30, 2005, were effective in timely alerting them tomaterial company information required to be included in our periodic filingswith the SEC. In connection with their review, our chief executive officer andchief financial officer noted that our decision to restate our financialresults did not call into question whether the relevant information wasrecorded, processed, summarized or reported within the time periods specifiedin the SEC's rules and forms. It also did not involve any issue about whetherinformation required to be disclosed was accumulated and communicated to ourchief executive officer and chief financial officer to allow timely decisionsregarding required disclosure. Rather, the restatements resulted fromreconsideration of our policy for recording stock-based employee compensationexpense in connection with preparing responses to a comment letter that wereceived from the Staff of the SEC on our annual report on Form 10-K for theyear ended September 30, 2005.  Our chiefexecutive officer and chief financial officer did not find that management'sultimate determination that its prior policy of recording stock-basedcompensation expense was inconsistent with generally accepted accountingprinciples raised any question about whether our disclosure controls andprocedures were effective to ensure that required information was disclosed tothem as appropriate to allow timely decisions regarding required disclosure.Therefore, based on that review, our chief executive officer and our chieffinancial officer determined that their prior conclusions, that our disclosurecontrols and procedures were effective as of September 30, 2005, had notchanged.

 

**Management’s Report on InternalControl over Financial Reporting and Report of Independent Registered PublicAccounting Firm**

 

The informationrequired to be furnished pursuant to this item is set forth under the captions “Management’sReport on Internal Control over Financial Reporting” (As Revised) and “Reportof Independent Registered Public Accounting Firm” in Item 8 of this report.

 

**Changes in Internal Control overFinancial Reporting**

 

As of the end ofthe period covered by this report, we carried out an evaluation, under thesupervision and with the participation of our principal executive and principalfinancial officers, of our internal control over financial reporting todetermine whether any changes occurred during the fourth quarter of fiscal 2005that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting. Based on that evaluation, there were no changes in our internal controlover financial reporting or in other factors that have materially affected orare reasonably likely to materially affect our internal control over financialreporting.

 

**Item 9B. Other Information**

 

None Applicable

 

47

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**PART III**

 

**Item 10.  Directors and Executive Officers of theRegistrant**

 

Pursuant to General Instructions G(3) to Form 10-K,the information required to be disclosed by this Item is incorporated herein byreference from our Definitive Proxy Statement pursuant to Regulation 14A filedJanuary 25, 2006.

 

**Item 11.  Executive Compensation**

** **

Pursuant to General Instructions G(3) to Form 10-K,the information required to be disclosed by this Item is incorporated herein byreference from our Definitive Proxy Statement pursuant to Regulation 14A filedJanuary 25, 2006.

 

**Item 12.  Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

 

Pursuant to General Instructions G(3) to Form 10-K,the information required to be disclosed by this Item is incorporated herein byreference from our Definitive Proxy Statement pursuant to Regulation 14A filedJanuary 25, 2006.

 

**Item 13.  Certain Relationships and RelatedTransactions**

 

Pursuant to General Instructions G(3) to Form 10-K,the information required to be disclosed by this Item is incorporated herein byreference from our Definitive Proxy Statement pursuant to Regulation 14A filedJanuary 25, 2006.

 

**Item 14.  Principal Accountant Fees and Services**

 

Pursuant to General Instructions G(3) to Form 10-K,the information required to be disclosed by this Item is incorporated herein byreference from our Definitive Proxy Statement pursuant to Regulation 14A filedJanuary 25, 2006.

 

**PART IV**

 

**Item 15.  Exhibits and Financial Statement Schedules**

 

(a) List of documents filed as part of this Annual Report

 

(1) Consolidate Financial Statements

 

All of our consolidated financialstatements are set forth under Item 8 of this Annual Report onForm 10-K.

 

(2) FinancialStatement Schedules: 

 

Financial statement scheduleslisted under SEC rules but not included in this report are omitted because theyare not applicable or the required information is provided in the notes to ourconsolidated financial statements.

 

(3) Exhibits

 

See Exhibit Index

 

48

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the Registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized, on the fourteenth day of February, 2006.

** **

** **
|   | PARTICLE DRILLING  TECHNOLOGIES, INC |
|--------|--------------------------------------|
|   |                                 |   |
|   | By                                   | /s/ J. CHRIS BOSWELL |   |
|   |                                 | J. Chris Boswell |
|   |                                 | Senior Vice President  and Chief Financial Officer |

 

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant and in the capacities indicated and on thefourteenth day of February, 2006.

 
| **Signature**           | ** ** | **Title**                                                                                                                   |
|-------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                        |
|                    |       | Chairman of the Board  and Director                                                                                         |
| Kenneth R.  LeSuer      |       |                                                                                                                        |
|                    |       |                                                                                                                        |
| /s/ JIM B. TERRY        |       | President and Chief Executive Officer (principal  executive officer)                                                        |
| Jim B. Terry            |       |
|                    |       |                                                                                                                        |
| /s/ J. CHRIS  BOSWELL   |       | Senior Vice President, Chief Financial Officer and  Director (principal financial officer and principal accounting officer) |
| J. Chris Boswell        |       |
|                    |       |                                                                                                                        |
|                    |       |                                                                                                                        |
| /s/ THOMAS E.  HARDISTY |       | Senior Vice President of Corporate Development and  Director                                                                |
| Thomas E.  Hardisty     |       |
|                    |       |                                                                                                                        |
| /s/ JOHN D.  SCHILLER   |       | Director                                                                                                                    |
| John. D.  Schiller      |       |                                                                                                                        |
|                    |       |                                                                                                                        |
|                    |       | Director                                                                                                                    |
| Michael S.  Mathews     |       |                                                                                                                        |
|                    |       |                                                                                                                        |
| /s/ HUGH A.  MENOWN     |       | Director                                                                                                                    |
| Hugh A. Menown          |       |                                                                                                                        |
|                    |       |                                                                                                                        |
| /s/ STEVE A.  WEYEL     |       | Director                                                                                                                    |
| Steve A. Weyel          |       |                                                                                                                        |

 

49

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**EXHIBITINDEX**
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **       | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 2.1              |       | Acquisition Agreement dated as of January 20,  2004 among Particle Drilling, Inc., ProDril Partners L.L.C.,  ProDril Services Incorporated, Mr. Harry B. Curlett, CCORE  Technology and Licensing,  Ltd. and Curlett Family Limited  Partnership, Ltd. (Incorporated herein by reference to Exhibit 10.3  to our current report filed on Form 8-K dated January 20, 2005.)                                                                                                     |
| 2.2              |       | Acquisition Agreement dated as of January 20,  2004 among Particle Drilling, Inc., ProDril Partners L.L.C., ProDril  Services International Limited, Mr. Harry B. Curlett, CCORE  Technology and Licensing, Ltd. and Curlett Family Limited Partnership, Ltd.  (Incorporated herein by reference to Exhibit 10.4 to our current report  on Form 8-K dated January 20, 2005).                                                                                                                  |
| 2.3              |       | Agreement and Plan of Reorganization dated  July 14, 2004 by and among MedXLink Corp., a Nevada corporation,  PDTI Acquisition Corp., a Delaware corporation, Dean Becker, Particle  Drilling Technologies,  Inc., a Delaware corporation, ProDril  Partners L.L.C., a Texas limited liability company, and Thomas E.  Hardisty. (Incorporated herein by reference to Exhibit 2.1 to our  current report filed on Form 8-K dated July 14, 2004.)                                    |
| 2.4              |       | Amendment No. 1 to the Agreement and Plan of  Reorganization dated January 10, 2005 by and among MedXLink Corp.,  a Nevada corporation, PDTI Acquisition Corp., a Delaware corporation,  Dean Becker, Particle Drilling Technologies, Inc., a Delaware  corporation, ProDril Partners L.L.C., a Texas limited liability company,  and Thomas E. Hardisty. (Incorporated herein by reference to  Exhibit 99.1 to our current report filed on Form 8-K dated  January 12, 2005.) |
| 2.5              |       | Plan of Merger and Merger Agreement, dated  January 19, 2005, between Particle Drilling Technologies, Inc. and  MedXLink Corp. (Incorporated herein by reference to Exhibit 2.3 to our  current report filed on Form 8-K dated January 31, 2005.)                                                                                                                                                                                                                                                       |
| 3.1              |       | Articles of Incorporation of MedePort, Inc.  (Incorporated herein by reference to Exhibit 3.1 to our current report  filed on Form 8-K dated January 20, 2005.)                                                                                                                                                                                                                                                                                                                                              |
| 3.2              |       | Articles of Amendment to the Articles of  Incorporation of MedePort, Inc. (Incorporated herein by reference to  Exhibit 3.2 to our current report filed on Form 8-K dated  January 20, 2005.)                                                                                                                                                                                                                                                                                                                |
| 3.3              |       | Articles of Merger dated January 25, 2005  changing the name of the Company to Particle Drilling Technologies, Inc.  (Incorporated herein by reference to Exhibit 3.3 to our Registration  Statement on Form S-1 (Registration No. 333-123925 filed on April 7, 2005.)                                                                                                                                                                                                                                                 |
| 3.4              |       | Bylaws of the Company (Incorporated herein by  reference to Exhibit 3.3 to our current report filed on Form 8-K  dated January 20, 2005.)                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1             | †     | Particle Drilling, Inc. 2004 Stock Incentive  Plan. (Incorporated herein by reference to Exhibit 10.5 to our current  report filed on Form 8-K dated January 20, 2005.)                                                                                                                                                                                                                                                                                                                                      |
| 10.2             | †     | 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.)                                                                                                                                                                                                                                                                                                                            |
| 10.3             | †     | Form of Incentive Stock Option Agreement.  (Incorporated herein by reference to Exhibit 10.6 to our current report  filed on Form 8-K dated January 20, 2005.)                                                                                                                                                                                                                                                                                                                                                    |
| 10.4             | †     | Form of Non-Statutory Stock Option Agreement.  (Incorporated herein by reference to Exhibit 10.7 to our current report  filed on Form 8-K dated January 20, 2005.)                                                                                                                                                                                                                                                                                                                                                |
| 10.5             | †     | Employment Agreement dated August 18, 2003  between ProDril Acquisition Company, Inc. and Jon Christopher Boswell,  as amended on April 8, 2004. (Incorporated herein by reference to  Exhibit 10.8 to our current report filed on Form 8-K dated  January 20, 2005.)                                                                                                                                                                                                                              |
| 10.6             | †     | Employment Agreement dated August 1, 2003  between ProDril Acquisition Company, Inc. and Thomas E. Hardisty,  as amended on April 8, 2004. (Incorporated herein by reference to  Exhibit 10.9 to our current report filed on Form 8-K dated  January 20, 2005.)                                                                                                                                                                                                                               |
| 10.7             | †     | Employment Agreement dated August 1, 2003  between ProDril Acquisition Company and Gordon Tibbitts. (Incorporated herein  by reference to Exhibit 10.10 to our current report filed on  Form 8-K dated January 20, 2005.)                                                                                                                                                                                                                                                                                    |
| 10.8             | †     | Letter agreement dated December 2, 2004 between  Particle Drilling Technologies, Inc. and Prentis Tomlinson, Jr.  (Incorporated herein by reference to Exhibit 10.11 to our current report  filed on Form 8-K dated January 20, 2005.)                                                                                                                                                                                                                                                             |
| 10.9             |       | Securities Purchase Agreement, dated as of  February 9, 2005, by and among Particle Drilling Technologies, Inc.  and the Purchasers listed on Schedule I thereto. (Incorporated herein by  reference to Exhibit 10.1 to our current report filed on Form 8-K  dated February 10, 2005.)                                                                                                                                                                                                            |
| 10.10            |       | Registration Rights Agreement, dated as of  February 9, 2005, by and among Particle Drilling Technologies, Inc.  and each of the Purchasers. (Incorporated herein by reference to  Exhibit 10.2 to our current report filed on Form 8-K dated  February 10, 2005.)                                                                                                                                                                                                                                      |
| 10.11            |       | Common Stock Purchase Warrant issued by Particle  Drilling Technologies, Inc. to Rita Barr (with attached schedule of  substantially identical Common Stock Purchase Warrants not filed with the  Securities and Exchange Commission). (Incorporated herein by reference to  Exhibit 10.3 to our current report filed on Form 8-K dated February 10,  2005.)                                                                                                                                                 |
| 10.12            |       | Stock Purchase Agreement, dated as of  February 8, 2005, by and between Particle Drilling  Technologies, Inc. and Prentis B. Tomlinson, Jr. (Incorporated  herein by reference to Exhibit 10.4 to our current report filed on  Form 8-K dated February 10, 2005.)                                                                                                                                                                                                                             |
| 10.13            |       | Form of Common Stock Purchase Warrant issued by  Particle Drilling Technologies, Inc. to Tejas Securities  Group, Inc. (Incorporated herein by reference to Exhibit 10.5 to  our current report filed on Form 8-K dated February 10, 2005.)                                                                                                                                                                                                                                                             |
| 10.14            |       | Assignment and Assumption Agreement dated  January 20, 2004 among Curlett Family Limited Partnership, Ltd., ProDril  Services Incorporated, Harry B. Curlett, CCORE Technology and Licensing,  Ltd. ProDril Services International Limited and Particle Drilling, Inc.  (Incorporated by reference to Exhibit 10.14 to Amendment No. 1 to our  Registration Statement on Form S-1 (Registration No. 333-123925) filed on May  20, 2005.)                                                                               |
| 10.15            |       | Royalty Agreement dated January 20, 2004  between Particle Drilling, Inc. and ProDril Services Incorporated.  (Incorporated by reference to Exhibit 10.15 to Amendment No. 1 to our  Registration Statement on Form S-1 (Registration No. 333-123925) filed on May  20, 2005.)                                                                                                                                                                                                                                              |
| 10.16            |       | Royalty Agreement dated January 20, 2004  between Particle Drilling, Inc. and ProDril Services International Limited.  (Incorporated by reference to Exhibit 10.16 to Amendment No. 1 to our  Registration Statement on Form S-1 (Registration No. 333-123925) filed on May  20, 2005.)                                                                                                                                                                                                                                     |
| 10.17            |       | Sublease Agreement dated March 21, 2005 between  Particle Drilling Technologies, Inc. and The Exploitation Company, LLP.  (Incorporated by reference to Exhibit 10.17 to Amendment No. 2 to our  Registration Statement on Form S-1 (Registration No. 333-123925) filed on  June 27, 2005.)                                                                                                                                                                                                                                 |
| 14.1             |       | Particle Drilling Technologies, Inc. Code of  Business Conduct and Ethics. (Incorporated herein by reference to Exhibit  14.1 to our current report filed on Form 8-K dated February 9, 2005.)                                                                                                                                                                                                                                                                                                                                   |
| 16.1             |       | Letter of Chisholm, Bierwolf &  Nilson, LLC. (Incorporated herein by reference to Exhibit 16.1 to  our current report filed on Form 8-K dated April 4, 2005.)                                                                                                                                                                                                                                                                                                                                       |
| 21.1*            |       | Subsidiaries of Particle Drilling Technologies, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 23.1*            |       | Consent of UHY Mann Frankfort Stein & Lipp  CPAs, LLP.                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| 31.1*            |       | Certification of the Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 31.2*            |       | Certification of the Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 32.1*            |       | Certification of the Chief Executive Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 32.2*            |       | Certification of the Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                                                                                          |

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*   Filed herewith

†   Managementcontract or compensatory plan or arrangement

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