UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





x
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended March 31, 2011



ORo
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACTFor the transition period from _________________ to _________________




logo
Commission file number 000-33155



COATES INTERNATIONAL, LTD.

(Exact Name of Registrant as Specified in its Charter)





Delaware

22-2925432(State or other Jurisdiction of

(I.R.S. EmployerIncorporation or Organization)

Identification No.)





Highway 34 & Ridgewood Road, Wall Township, New Jersey 07719


(Address of Principal Executive Office) (Zip Code)





(732) 449-7717


(Registrant's telephone number including area code)





Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.





Yes x No o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every


Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).


Yes o No o





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)





Yes o No x





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




Large accelerated filer ‚o

Accelerated filer Non-accelerated filer ‚oNon-accelerated filer ‚o

Smaller reporting company x


(Do not check if a smaller reporting company)





As of May 12, 2011, 281,379,275 shares of the Registrant’s common stock were issued and outstanding.


























COATES INTERNATIONAL, LTD.


QUARTERLY REPORT ON FORM 10-Q





CONTENTS





MARCH 31, 2011





PagePART 1 -
FINANCIAL INFORMATIONItem 1.
Financial Statements:Balance Sheets
3Statements of Operations
4Condensed Statements of Cash Flows
5Notes to Financial Statements
6-20Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
21-29Item 3.
Quantitative and Qualitative Disclosures About Market Risk
29Item 4.
Controls and Procedures
29PART II -
OTHER INFORMATIONItem 1.
Legal Proceedings
30Item 1A.
Risk Factors
30Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
30Item 3.
Defaults Upon Senior Securities
30Item 4.
(Removed and Reserved)
30Item 5.
Other Information
30Item 6.
Exhibits
30SIGNATURES
31








2




Coates International, Ltd.


Balance Sheets


March 31,


December 31,2011


2010(Unaudited)AssetsCurrent AssetsCash

$
25,500


$
53,360Restricted cash


31,718



61,643Other receivables


-



11,440Inventory, net


462,366



431,999Total Current Assets


519,584



558,442Property, plant and equipment, net


2,357,887



2,368,680Deferred licensing costs, net


62,795



63,866Total Assets

$
2,940,266


$
2,990,988Liabilities and Stockholders' DeficiencyCurrent LiabilitiesAccounts payable and accrued liabilities

$
1,349,458


$
1,242,842Unearned revenue


154,124



144,124Promissory notes to related parties


298,682



463,537Mortgage loan payable


1,680,000



1,710,000Convertible promissory notes, net of unamortized discount


95,573



84,700Derivative liability related to convertible promissory notes


77,366



84,80010% Convertible note


10,000



10,000Total Current Liabilities


3,665,203



3,740,003License deposits


375,000



375,000Total Liabilities


4,040,203



4,115,003Commitments and ContingenciesStockholders' DeficiencyPreferred Stock, $0.001 par value, 100,000,000 shares authorized, 14,001 shares issued and outstanding at March 31, 2011 and December 31, 2010


14



14Common Stock, $0.0001 par value, 1,000,000,000 shares authorized, 278,755,194  and 275,906,253 shares issued and outstanding at March 31, 2011 and December 31, 2010, respectively


27,876



27,591Additional paid-in capital


23,120,915



22,553,853Accumulated deficit


(24,248,742
)


(23,705,473
)Total Stockholders' Deficiency


(1,099,937
)


(1,124,015
)Total Liabilities and Stockholders' Deficiency

$
2,940,266


$
2,990,988
  The accompanying notes are an integral part of these financial statements.







3




Coates International, Ltd.


Statements of Operations Unaudited


For the Three Month Ended March 31,2011


2010Revenue from research and development

$
-


$
850,000Expenses:Research and development costs


20,858



-General and administrative expenses


349,265



320,680Depreciation and amortization


16,654



15,120386,777



335,800(386,777
)


514,200Other Operating Expense:Increase in estimated fair value of embedded derivative liabilities


17,160



-(Loss) Income from Operations


(403,937
)


514,200Interest  expense, net


139,332



61,636(Loss) Income Before Income Taxes


(543,269
)


452,564Provision for income taxes


-



-Net (Loss) Income

$
(543,269
)

$
452,564Basic net (loss) income per share

$
-


$
-Basic weighted average shares outstanding


276,531,131



275,505,697Diluted net (loss) income per share

$
-


$
-Diluted weighted average shares outstanding


276,531,131



275,616,172


The accompanying notes are an integral part of these financial statements.





4





Coates International Ltd.


Condensed Statements of Cash Flows


Unaudited




For the the Three Months Ended March 31,2011


2010Net Cash Flows (Used in) Provided by Operating Activities

$
(280,570
)

$
433,330Cash Flows Used in Investing Activities:Acquisition of property, plant and equipment


(4,790
)


-Net Cash Used in Investing Activities


(4,790
)


-Cash Flows Provided by (Used in) Financing Activities:Issuance of convertible promissory note


32,500



-Issuance of promissory notes to related parties


37,000



-Repayment of promissory notes to related party


(12,000
)


(100,000
)Repayment of 10% convertible note


-



(10,000
)Issuance of common stock and warrants


200,000



3,645Release from Interest reserve


30,000



-Repayment of Mortgage Loan


(30,000
)


-Net Cash Provided by Provided by (Used in) Financing Activities


257,500



(106,355
)Net (Decrease) Increase in Cash


(27,860
)


326,975Cash, beginning of yearperiod


53,360



252,902Cash, end of period

$
25,500


$
579,877Supplemental Disclosure of Cash Flow Information:Cash paid during the period for interest

$
31,885


$
45,036


Supplemental Disclosure of Non-cash Financing Activities:Conversion of convertible promissory notes

$
93,500



-Conversion of promissory notes to related party


180,000


$
-$
273,500


$
-
 The accompanying notes are an integral part of these financial statements.




5






Coates International, Ltd.


Notes to Financial Statements


(All amounts rounded to thousands of dollars)


(Unaudited)





1. BASIS OF PRESENTATION





The accompanying unaudited financial statements of Coates International, Ltd. (the “Company”) have been prepared in accordance with accounting principles generally accepted for interim financial information and rules and regulations of the Securities and Exchange Commission (the “SEC”). Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the three month periods ended March 31, 2011 and 2010 are not necessarily indicative of the results that may be expected for any other interim period or for the full year.  The unaudited financial statements should be read in conjunction with the financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2010.





The Company incurred a net loss for the three months ended March 31, 2011 of ($543,000), and has incurred substantial net losses since inception while engaging primarily in research and development. As of March 31, 2011, the Company had accumulated losses of ($24,249,000) and had negative working capital of ($3,146,000). In addition, the current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty in the Company’s challenge to secure needed additional working capital. These factors raise substantial doubt about the Company’s ability to continue as a going concern.





The Company has been actively undertaking efforts to secure new sources of working capital.  On May 3, 2011, the Company received a firm commitment letter from Black Swan Capital Group, Inc. for a proposed term loan of $10 million (the “Loan”) which is expected to close and fund the Company before the end of May 2011.The proposed Loan may be drawn down in two tranches consisting of $5 million at the closing and $5 million at any time thereafter within 9 months after the closing date, upon 30 days’ prior notice. During the three months ended March 31, 2011, the Company raised new working capital of $270,000 consisting of proceeds from issuance of stock and warrants amounting to $200,000, proceeds from issuance of promissory notes to related parties of $37,000 and proceeds from issuance of a convertible promissory note amounting to $33,000. The Company continues to actively seek out new sources of working capital; however, there can be no assurance that it will be successful in these efforts. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty.





The doubt about the Company’s ability to continue to operate as a going concern has existed for a number of years. Management has been successful in raising sufficient new working capital throughout that time to enable the Company to continue as a going concern and, although management cannot provide assurances that it can be successful, management believes that it can continue to do so in the future. Management has instituted a cost control program intended to cut variable costs to only those expenses that are necessary to complete its activities related to research and development and manufacturing an initial shipment of natural gas fueled industrial electric power Coates Spherical Rotary Valve (“CSRV”) engine generators, enter the production phase of operations, develop additional commercially feasible applications of the CSRV system technology, seek additional sources of working capital and cover the general and administrative expenses in support of such activities.








6







2.
ACCOUNTING POLICIES





Net Loss per Share





Basic net income (loss) per share is based on the weighted average number of common shares outstanding without consideration of potentially dilutive shares of common stock. Diluted net income (loss) per share is based on the weighted average number of common and potentially dilutive common shares outstanding, when applicable.





Use of Estimates





The preparation of the Company’s financial statements in conformity with accounting principles generally accepted for interim financial information and rules and regulations of the SEC requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These significant estimates include determining a value for the Series A Preferred Stock issued and certain limited anti-dilution rights granted to George J. Coates, determining the amount of discount on convertible promissory notes, measuring the estimated fair value of embedded derivative liabilities related to convertible promissory notes outstanding, assigning useful lives to property, plant and equipment, determining an appropriate amount to reserve for obsolete and slow moving inventory, determining the amount of the allowance for deferred tax assets, assigning expected lives to and estimating the rate of forfeitures of stock options granted and selecting a volatility factor for stock options in order to estimate the fair value of the Company’s stock options on the date of grant.





3.
CONCENTRATIONS OF CREDIT AND BUSINESS RISK





At March 31, 2011, the Company maintained cash balances with two financial institutions. Accounts at these institutions are currently fully insured by the Federal Deposit Insurance Corporation.





The Company’s operations are devoted to the development, application and marketing of the CSRV system technology which was invented by George J. Coates, the Company’s founder and his son Gregory Coates. George J. Coates is the Chairman, Chief Executive Officer, President and controlling stockholder of the Company. From July 1982 through May 1993, seven U.S. patents as well as a number of foreign patents were issued with respect to the CSRV system technology.  Since the inception of the Company in 1988, all aspects of the business have been completely dependent upon the activities of George J. Coates.  The loss of George J. Coates’ availability or service due to death, incapacity or otherwise would have a material adverse effect on the Company's business and operations. The Company does not presently have any key-man life insurance in force for Mr. Coates.





The Company is highly dependent on Almont Energy, Inc. (“Almont”) for cash flows, revenues and profits from a research and development agreement and exclusive sub-licensing agreements covering sale and distribution of natural gas fueled, industrial electric power CSRV engine generators within the territories of Canada and the United States. As discussed in more detail in Note 4, at March 31, 2011, Almont owed the Company approximately $6 million dollars due under the research and development, sublicensing and escrow agreements.  Payment of this balance is dependent on Almont’s continuing effort to raise new equity capital.





4.
AGREEMENTS ASSIGNED TO ALMONT ENERGY INC.





In 1999, the Company granted a sublicense to Well to Wire Energy, Inc. ("WWE"), Canadian-based company that provided services to the oil and gas industry.  This sublicense provided for a $5,000,000 license fee to be paid to the Company and covers the use of the CSRV system technology in the territory of Canada (the “Canadian License”). A separate research and development agreement (“R&D Agreement”) provided for WWE to pay an additional $5,000,000 fee to the Company in consideration for the development and delivery of certain prototype engines. The Company satisfactorily completed development of the prototypes in accordance with this agreement. The research and development agreement has not been reduced to the form of a signed, written agreement.








7





In 2008, the Company also entered into an escrow agreement with WWE that provided conditional rights to a second sublicense agreement between the Company and WWE for the territory of the United States (the “US License”). The US license has been deposited into an escrow account and the grant of the license will not become effective until the conditions for release from escrow are satisfied. The US License provides for a license fee to be paid to the Company of $50 million.





The escrow agreement required that WWE make payment (the “Release Payment”) to the Company equal to the remaining unpaid balance of licensing fee for the Canadian License, the R&D Agreement fee and the down payment of $1,000,000 required under the US License. WWE had been making periodic nonrefundable payments to the Company toward satisfaction of the Release Payment.





During the first quarter of 2010, with the prior consent of the Company, WWE assigned the Canadian License and the rights to the US License, subject to the terms and conditions of the escrow agreement, to Almont Energy, Inc. (“Almont”), a privately held, independent third party entity based in Alberta, Canada. In connection with the assignment, the Company waived all events of default by WWE under the escrow agreement. The Company also waived the provisions of the escrow agreement requiring the payment of interest on the unpaid balance of the Release Payment. Almont made two payments to the Company in February 2010 totaling $700,000 as a prerequisite condition to the Company consenting to the assignment.





In connection with the assignment of the Canadian License and the rights to the US License, Almont has also assumed all of the obligations set forth in the escrow agreement between the Company and WWE, with the following modifications:





●
The Release Payment Date as defined in the escrow agreement has been extended to March 19, 2012. At the time of the assignment, the remaining unpaid balance of the Release Payment was $5,997,000. Provided that Almont remits this entire unpaid balance to the Company on or before the Release Payment Date, the US License will be released from escrow and granted to Almont. Almont is required to remit to the Company 60% of all monies it raises from future equity or debt transactions, exclusive of proceeds from equipment purchase financing transactions, until the Release Payment is paid in full.





●
After payment of the Release Payment which includes the $ 1 million deposit towards the US License, Almont has also become obligated to pay the $49 million remaining balance of the US License Fee to the Company. Payment shall be made quarterly in an amount equal to 5% of Almont’s quarterly net profits. In addition, Almont is required to remit a portion of the proceeds it receives from equity or debt transactions, exclusive of equipment financing transactions to the Company until the entire balance of the US License fee is paid in full. However, in any event, the entire $49 million licensing fee is required to be paid on or before February 19, 2015.





To the extent that Almont is not successful or experiences delays in remitting the balance of the Release Payment, the Company’s cash flow, results of operations and financial condition could be adversely affected.





The Canadian License





The Canadian License exclusively licenses within Canada the use of the CSRV system technology for industrial engines fueled by natural gas to generate electrical power. Additional provisions of the Canadian License agreement are as follows:





●
Licensee shall have the exclusive right to use, lease and sell electric power generators designed with the CSRV system technology within Canada.●
Licensee shall have a specified right of first refusal to market the CSRV electric power generators worldwide.








8





Ÿ
Upon commencement of the production and distribution of the CSRV electric power generators, the minimum annual number of generators to be purchased by Licensee in order to maintain exclusivity is 120.  Until otherwise agreed between the parties, the price per generator shall be $159,000.  In the event Licensee fails to purchase the minimum 120 Coates generator engines during any year, Licensee will automatically lose its exclusivity. In such a case, Licensee would retain non-exclusive rights to continue to use and sell the CSRV generator engine in the territory of Canada.Ÿ
Licensee is required to pay a royalty to the Company equal to 5% of the sum of its annual gross profits and $400,000.





Ÿ
All licensed rights under this license agreement related to the CSRV system technology will remain with the Company.





The US License





The US License will, upon Almont satisfying the Release Payment, grant to Almont the right to use, sell and lease Licensed Products manufactured by the Company, as the power source for the generation of electrical energy.  Licensed Products consist of CSRV Engines, CSRV Valve Systems, CSRV Valve Seals, CSRV Rotary Valve Spheres and CSRV Valve Components for use in electric power generation applications.





The manufacture of any Licensed Products by Licensee is prohibited.  Licensee is required to procure all internal combustion engines incorporating the CSRV system technology from the Company or its designee. The license granted to Licensee is exclusive within the Territory, provided that Licensee satisfies the minimum annual purchase commitment of 120 internal combustion engines incorporating the CSRV system technology, the Coates Engines and all component parts. The agreement also grants Licensee a right of first refusal in the event that the Company negotiates an offer with another third party for a worldwide license to use the Licensed Product.





The business plan of Almont assumes the purchase of a substantial number of CSRV units over a 5-year period. Almont’s purchase of CSRV units from the Company will be made by way of standard purchase orders, issued based on market and customer demand. Over the 5-year period, Almont anticipates that the volume of total purchases from the Company will be similar to, or potentially exceed the 7,400 CSRV units contemplated in the Company’s previous arrangement with WWE. Almont plans to finance its purchases from cash flow and by way of project and/or equipment financing, proceeds from issuance of equity or corporate debt instruments and conventional bank financing.





5.
COOPERATION AGREEMENT WITH TONGJI UNIVERSITY OF CHINA





In June 2010, the Company and the Coates Trust (collectively “Coates”) entered into a Cooperation Agreement with Tongji University of China (the “University”) for the purpose of enabling the University to undertake an evaluation and testing of the CSRV engine technology. The results of the evaluation and testing will be used to determine if, and to what extent, the engine technology could be applied in the manufacture and distribution of products in China. Coates is required to deliver to the University a 1600cc, 4-cylinder CSRV engine and a 1600cc, 4-cylinder poppet valve engine to facilitate comparison. The University is responsible for obtaining any required regulatory approvals in connection with the evaluation and testing activities. The costs and expenses of testing and evaluation of the engine shall be the responsibility of the University. Coates is required to provide technical assistance, as needed, to optimize the success of the evaluation and testing.





The University is to promptly furnish Coates with a copy of its findings. Provided the results of the evaluation and testing of the CSRV engines are deemed satisfactory, Coates has agreed that it will sub-license the CSRV technology to Chinese engine manufacturers. The parties also entered into a Confidentiality and Non-Disclosure Agreement which provides for protection of the CSRV technical information and patents. The Coates Trust has expressed its intention to license the CSRV system technology rights to the Company for the territory to be defined in connection with any such licenses granted to Chinese manufacturers. At this time, the parties are not actively working on this cooperation agreement, but may agree to do so at some point in the future.








9





6.
INVESTMENT IN COATES FINANCE MANAGEMENT, LTD.





In October 2009, the Company entered into a joint venture (“JV”) arrangement with an independent third party for the purpose of undertaking a private offering of collateralized zero coupon bonds to institutional investors. A new entity, Coates Finance Management, LLC (“CFM”) was formed to carry out the objectives of the joint venture. The Company owned 90% of CFM; however, 100% of the JV entity’s profits and losses were to be allocated to the Company. This entity was being accounted for as a consolidated subsidiary.





In March 2010, after careful consideration of this proposed undertaking, the Company’s board of directors (the “Board”) concluded that the bond offering should not be further pursued and the Company terminated the joint venture arrangement. The Company was not obligated to incur any additional costs, and there are no provisions for any penalties in connection with termination of the JV Agreement. As of the effectiveness of the termination of this Joint Venture, the accounting for CFM as a consolidated subsidiary ceased.





7.
INVENTORY





Inventory was comprised of the following:





March 31, 2011


December 31, 2010Raw materials

$
449,000


$
447,000Work-in-process


164,000



136,000Finished goods


-



-Reserve for obsolescence


(151,000
)


(151,000
)Total

$
462,000


$
432,000





8.
PROPERTY, PLANT AND EQUIPMENT





Property, plant and equipment were comprised of the following:





March 31, 2011


December 31, 2010Land

$
1,235,000


$
1,235,000Building


964,000



964,000Building improvements


83,000



83,000Machinery and equipment


662,000



658,000Furniture and fixtures


39,000



39,0002,983,000



2,979,000Less: Accumulated depreciation


(625,000
)


(610,000
)Total

$
2,358,000


$
2,369,000





9.
MORTGAGE LOAN PAYABLE





The Company has a mortgage loan on the land and building that serves as its headquarters, warehouse and research and development facility with an outstanding balance of $1,680,000 at March 31, 2011. The mortgage loan bears interest at the rate of 7.5% per annum and matures July 2011. The Company intends to either negotiate a refinancing of the mortgage loan or repay it with the proceeds of a proposed $10 million term loan for which it received a firm commitment letter in May 2011, if the term loan is successfully funded. Commencing September 2010, the Company became obligated to make principal payments of $10,000 per month, which are being automatically deducted from monies in an interest-bearing restricted cash account on deposit with the lender. The Company is also required to make monthly interest-only payments. The Company incurred $35,000 of expenses in connection with initially securing this mortgage loan, which was amortized to interest expense over the initial one year term of the loan. The loan is collateralized by a security interest in all of the Company’s assets, the pledge of 5 million shares of common stock of the Company owned by George J. Coates, which were deposited into escrow for the benefit of the lender and the personal guarantee of George J. Coates. The Company is not permitted to create or permit any secondary mortgage or similar liens on the property or improvements thereon without prior consent of the lender. Up to $500,000 of the principal balance of the mortgage loan may be prepaid each year without penalty. A prepayment penalty of 2% of the outstanding loan amount would be imposed if the loan is repaid in full at or before maturity unless such prepayment funds are obtained from a permanent mortgage loan obtained from the lender.








10





10.
PROMISSORY NOTES TO RELATED PARTIES





The Company received $100,000 from The Coates Trust, a trust owned and controlled by George J. Coates and $200,000 from two of its directors and issued promissory notes payable on demand. All three promissory notes provide for interest at the rate of 17% per annum, compounded monthly and a transaction fee of $7,500. For accounting purposes, the transaction fees were amortized to interest expense over the initial term of the promissory notes before the holders agreed to restructure these notes to be payable on demand. In March 2010, the promissory note to The Coates Trust was repaid in full, including accrued interest and the transaction fee totaling $10,000.





In July 2010, the Company received $100,000 from The Coates Trust and issued a promissory note that is due on demand. In October 2010, the Company received an additional $80,000 from the Coates Trust and issued a promissory note that is due on demand. The promissory notes provided for interest at 17% per annum, compounded monthly. On March 31, 3011, by mutual agreement between the Company and The Coates Trust, these notes, amounting to $180,000, plus accrued interest thereon of $18,000 were converted into 1,165,507 shares of the Company’s common stock at a conversion rate of $0.17 per share.





In a series of transactions between the Company and George J. Coates between September 2010 and March 2011, the Company received aggregate proceeds of $73,000 from George J. Coates and issued promissory notes that are due on demand. These notes bears interest at the rate of 17% per annum, compounded monthly. During this period, a total of $43,000 of the promissory notes was repaid. In November 2010, the Company received $6,000 from Bernadette Coates, spouse of George J. Coates and issued a promissory note that is due on demand. The promissory note provides for interest at 17% per annum, compounded monthly.





In November 2010, the Company received an additional $50,000 from one of its directors and issued a promissory note that is due on demand. The promissory note provides for interest at 17% per annum, compounded monthly.





For the three month periods ended March 31, 2011 and 2010, interest expense on these promissory notes amounted to $22,000 and $16,000, respectively. At March 31, 2011, unpaid accrued interest on these promissory notes amounting to $66,000 is included in accounts payable and accrued liabilities in the accompanying balance sheet.





11.
CONVERTIBLE PROMISSORY NOTES AND EMBEDDED DERIVATIVE LIABILITIES





The Company entered into a series of securities purchase agreements (the “Purchase Agreements”) with an investor and issued convertible promissory notes, as follows:





Issued

Principal Amount


Nominal Interest Rate

Maturity

Balance,

March 31, 2011August 2010

$
78,500



8.00
%
May 2011

$
-September 2010


67,500



8.00
%
July 2011


52,500December 2010


58,000



8.00
%
September 2011


58,000February 2011


32,500



8.00
%
November 2011


32,500$
236,500







$
143,000








The Notes may be converted into unregistered shares of the Company’s common stock, par value $0.0001 per share (the “Common Stock”), at the Conversion Price, as defined below, in whole, or in part, at any time beginning 180 days after the date of issuance of the Notes, at the option of the holder. The Conversion Price shall be equal to 61% multiplied by the Variable Conversion Rate which is equal to the average of the three (3) lowest closing bid prices of the Common Stock during the ten (10) trading day period prior to the date of conversion. The Notes also contains a prepayment option whereby the Company may make a payment to the holder equal to 150% of the then outstanding unpaid principal, interest and any other amounts that might be due for penalties or any event of a default under the Notes during the 179-day period following the date of issuance of the Notes, upon three (3) trading days’ prior written notice to the holder.





The 61% discounted Conversion Price establishes a beneficial conversion feature (“BCF”) which is required to be valued and accreted to interest expense over the six month minimum conversion period of the Convertible Notes. The Company is also required to record additional unamortized discount to recognize the estimated value of the derivative liabilities arising from the convertible promissory notes. Accordingly, the Company recorded a total initial amount of unamortized discount on these Convertible Notes of $182,000. For the three month period ended March 31, 2011, the amount of interest expense resulting from accretion of the unamortized discount on the convertible promissory notes amounted to $82,000.





The total unamortized discount represented by the value of the BCF is being accreted over the six month period until the conversion of the convertible promissory notes into common stock is permitted. This resulted in an overall effective interest rate of 106%, 129%, 135% and 147% on the $78,500, $67,500, $58,000 and $32,500 convertible notes, respectively. The remaining unamortized balance of this discount, which amounted to $47,000, has been netted against the face amount of the convertible promissory notes resulting in a net carrying amount of $96,000. This net amount is presented in the accompanying balance sheet at March 31, 2011.





In accordance with GAAP, the conversion features associated with the convertible promissory notes represent derivatives. The Company initially recorded the estimated value of the embedded derivative liabilities amounting to $37,000 arising from the series of convertible promissory notes. The estimated fair value of the embedded derivative liability is required to be remeasured at each balance sheet date. The estimated fair value of the embedded derivative liabilities, which were measured at their aggregate estimated fair value, based on Level 2 inputs, amounted to $77,000, at March 31, 2011. The change in the estimated fair value of the embedded derivative liabilities amounted to $17,000 for the three months ended March 31, 2011. This amount is included in the accompanying statements of operations as increase in estimated fair value of embedded derivative liabilities.









11




The embedded derivative liabilities arise because, based on historical trading patterns of the Company’s stock, the formula for determining the Conversion Rate is expected to result in a lower Conversion Rate than the closing price of the stock on the actual date of conversion (hereinafter referred to as the “Variable Conversion Rate Differential”. The estimated fair value of the derivative liabilities have been calculated based on a Black-Scholes option pricing model.





The Company made the private placement of these securities in reliance upon Section 4(2) of the Securities Act of 1933, as amended (the “Act”), Rule 506 of Regulation D, and the rules and regulations promulgated thereunder, and/or upon any other exemption from the registration requirements of the Act, as applicable.





12.
10% CONVERTIBLE NOTE TO RELATED PARTY





The 10% Convertible Note, which is held by one of the Company’s directors is convertible, at the option of the holder, into shares of the Company’s common stock at an initial conversion rate that is determined by dividing the principal amount of the note being converted by $0.45. This convertible note is payable on demand. Interest shall accrue at the rate of 10% per annum and shall be payable at the time of repayment of principal. All interest shall be forfeited upon conversion, in which case the holder would be entitled to dividends declared, if any, on the Company’s common stock during the time the convertible note was outstanding. In March 2010, $10,000 principal amount of this convertible note was repaid along with accrued interest thereon of $3,000. The Company has reserved 22,222 shares of its common stock for conversion of the remaining $10,000 balance of this note.





13.
CONTRACTUAL OBLIGATIONS





The following table summarizes the Company’s contractual obligations at March 31, 2011:




Amount Due WithinTotal


2011Mortgage loan payable

$
1,680,000


$
1,680,000Promissory notes to related parties(1)


299,000



299,000Employment agreements(2)


233,000



233,000Convertible promissory notes(3)


143,000



143,00010% promissory note


10,000



10,000Total

$
2,365,000


$
2,365,000





(1)
In April 2011, promissory notes to related parties with an aggregate principal amount of $250,000, plus accrued interest thereon of $70,000, were converted into 1,869,570 shares of the Company’s common stock at a conversion rate of $0.171 per share, there by reducing this commitment to $49,000.





(2)
Our obligation under employment agreements would increase to $550,000, upon achieving an adequate level of Working Capital, as defined.





(3)
In April 2011, an aggregate of $52,000 principal amount of convertible promissory notes, including interest thereon amounting to $3,000, was converted by the holder into 554,511 unregistered shares of the Company’s common stock, thereby reducing this commitment to $90,500.





14.          CAPITAL STOCK





Common Stock





The Company’s common stock is traded on the Over the Counter Bulletin Board (“OTCBB”) market system and Pink Sheets under the ticker symbol COTE. The Company is authorized to issue up to 1,000,000,000 shares of common stock, par value, $0.0001 per share (the “Common Stock”).





During the three months ended March 31, 2011 and 2010, the Company sold -0- and 10,000 registered shares of its common stock, respectively, under an equity line of credit with Dutchess Private Equities Fund, Ltd. and received proceeds of $-0- and $4,000, respectively. There were no offering costs related to the sale of these shares.





During the three months ended March 31, 2011, the Company sold 600,000 shares of its common stock and 600,000 warrants to purchase one share of its common stock at an exercise price of $0.25 per share in consideration for $150,000 received from the son of a director. This transaction was a private sale of unregistered, restricted securities pursuant to a stock purchase agreement.





During the three months ended March 31, 2011, the Company sold 200,000 shares of its common stock in consideration for $50,000 to one of its directors. This transaction was a private sale of unregistered, restricted securities pursuant to a stock purchase agreement.






12







During the three months ended March 31, 2011, convertible promissory notes with a total principal amount of $94,000, plus accrued interest thereon totaling $3,000 were convertible by the holder into 883,434 unregistered shares of the Company’s common stock.





There were no sales or conversions of common stock during the three months ended March 31, 2010.





At March 31, 2011, Company had reserved 10,292,606 shares of its common stock to cover the potential conversion of convertible securities and exercise of stock options and warrants.





Preferred Stock and anti-dilution rights





The Company is authorized to issue 100,000,000 new shares of preferred stock, par value, $0.001 per share (the “Preferred Stock”).  The Company may issue any class of the Preferred Stock in any series. The board of directors shall have authority to establish and designate series, and to fix the number of shares included in each such series and the relative rights, preferences and limitations as between series, provided that, if the stated dividends and amounts payable on liquidation are not paid in full, the shares of all series of the same class shall share ratably in the payment of dividends including accumulations, if any, in accordance with the sums which would be payable on such shares if all dividends were declared and paid in full, and in any distribution of assets other than by way of dividends in accordance with the sums which would be payable on such distribution if all sums payable were discharged in full. Shares of each such series when issued shall be designated to distinguish the shares of each series from shares of all other series.





The board of directors has designated 25,000 shares of Preferred Stock as Series A Preferred Stock, $0.001 par value per share. Each share of Series A Preferred Stock entitles the holder of record to the right to vote 10,000 shares of common stock with respect to all matters that are submitted to a vote of shareholders. The Series A Preferred Stock does not provide the holder any rights to share in dividends or any distribution of assets to any other shareholders of any other class of the Company’s securities in a liquidation or for any other purpose.





No shares of Preferred Stock were issued during the three months ended March 31, 2011. During the three months ended March 31, 2010, the Board agreed to the issuance of 4,001 shares of Series A Preferred Stock of the Company (representing 40,010,000 voting shares) to George J. Coates in order to restore the original percentage of all votes originally held by the Coates family at January 1, 2007. The Coates family shareholdings had been diluted as a result of various issuances of new shares of stock in connection with raises of new equity capital during the period from January 1, 2007 through the date of issuance of the shares of Series A Preferred Stock. As a result, the Coates family requested that as a prerequisite condition to issuing any further shares to new investors and/or lenders, that George J. Coates be awarded the Company’s super-majority voting shares of Series A Preferred Stock, $0.001 par value per share in order to restore its original percentage of all votes that it held at January 1, 2007.





In order to enable the Company to raise needed working capital, the Board deemed it advisable and consented to authorize the issuance of additional shares of Series A Preferred Stock to George J. Coates to restore the Coates family’s voting percentage upon any future issuance of new shares of the Company’s common stock as a result of a sale or conversion of securities into common stock (except that no Series A Preferred Stock shall be issued to George J. Coates to restore the Coates Family voting percentage in connection with any new shares of common stock issued upon sale or conversion of the Company’s securities issued pursuant to public offerings by the Company).





Each issuance of shares of Series A Preferred Stock to George J. Coates does not have any effect on the share of dividends or liquidation value of the holders of the Company’s common stock. However, the voting rights of the holders of the Company’s common stock are diluted with each issuance.









13




The Company arranged for an independent professional services firm to determine the estimated fair value of the shares of Series A Preferred Stock provided to Mr. Coates. The estimated aggregate fair value of the Series A Preferred Stock provided to Mr. Coates in 2010 amounted to $10,000. This amount, which was recorded as compensation expense, is included in general and administrative expenses in the accompanying statement of operations for the three months ended March 31, 2010.





16.          INVESTMENT AGREEMENTS WITH DUTCHESS FUNDS





In 2007, the Company entered into an Investment Agreement with Dutchess Private Equities Fund, Ltd. which expired in June 2010. Pursuant to this Agreement, the Investor committed to purchase up to $10,000,000 of the Company’s common stock.





During the three months ended March 31, 2010, the Company sold 10,000 shares of its common stock under this equity line of credit and received proceeds of $4,000.





In August 2010, the Company entered into a new investment agreement (the “Investment Agreement”) with Dutchess Opportunity Fund, II, LP, a Delaware limited partnership (“Dutchess”). Pursuant to the terms of the Investment Agreement, Dutchess shall commit to purchase up to Ten Million ($10,000,000) Dollars of the Company’s Common Stock over the course of thirty-six (36) months.





The Company also entered into a registration rights agreement (the “Registration Rights Agreement”) with Dutchess. Pursuant to the terms of the Registration Rights Agreement, the Company was obligated to file a registration statement with the Securities and Exchange Commission (“SEC”) covering 17,000,000 shares of the Common Stock underlying the Investment Agreement. By mutual agreement activities on this financing opportunity have been temporarily suspended to enable the Company to focus on commencing production and raising working capital to cover the costs of the registration of the securities.





17.          UNEARNED REVENUE





The Company has received non-refundable deposits aggregating $144,000 from Almont in connection with its order for the shipment of natural gas fueled electric power CSRV engine generators and a $10,000 refundable deposit related to the future potential issuance of a license for the CSRV technology. Recognition of these amounts as revenue is being deferred until shipment of the generators and execution of the related license agreement, respectively. The total amount of $154,000 is included in unearned revenue in the accompanying balance sheet at March 31, 2011.





18.           INCOME (LOSS) PER SHARE





At March 31, 2011, the Company had 10,292,606 shares of common stock potentially issuable upon assumed conversion of (i) $10,000 principal amount of a 10% convertible note into 22,222 shares of common stock, (ii) 42 outstanding warrants to purchase 210,000 shares of common stock at a price per share of $1.10, (iii) warrants to purchase 1,000,000 shares of common stock at a price per share of $0.25, (iv) warrants to purchase 333,333 shares of common stock at a price per share of $0.30, (v)  warrants to purchase 885,713 shares of common stock at a price per share of $0.35, (vi) 1,725,000 vested stock options and 25,000 non-vested stock options to purchase shares of common stock at a price per share of $0.44, (vii) 100,000 vested stock options to purchase shares of common stock at a price per share of $0.43, (viii) 50,000 vested stock options to purchase shares of common stock at a price per share of $0.39, (ix) 30,000 vested stock options to purchase shares of common stock at a price per share of $1.00, (x) 360,000 non-vested stock options to purchase shares of common stock at a price per share of $0.40, (xi) 200,000 non-vested stock options purchase shares of common stock at a price per share of $0.25; and, (xii) 5,351,338 shares potentially issuable upon conversion of the outstanding principal balance of convertible promissory notes which were not eligible for conversion at March 31, 2011.  For the three months ended March 31, 2011, none of the potentially issuable shares of common stock were assumed to be converted because the Company incurred a net loss in that year and the effect of including them in the calculation would have been anti-dilutive.








14





At March 31, 2010, the Company had 3,351,268 shares of common stock potentially issuable upon assumed conversion of (i) $10,000 principal amount of a 10% convertible note into 22,222 shares of common stock, (ii) 42 outstanding warrants to purchase 210,000 shares of common stock at a price per share of $1.10, (iii) warrants to purchase 333,333 shares of common stock at a price per share of $0.30 and warrants to purchase 885,713 shares of common stock at a price per share of $0.35 and (iv) 1,700,000 vested stock options to purchase shares of common stock at a price per share of $0.44, 50,000 non-vested stock options to purchase shares of common stock at a price per share of $0.44, 100,000 non-vested stock options to purchase shares of common stock at a price per share of $0.43 and 50,000 non-vested stock options to purchase shares of common stock at a price per share of $0.39.





For the three months ended March 31, 2010, the following presents the adjustments made to net income and the weighted average number of shares outstanding in determining diluted earnings per share presented in the statement of operations:





Basic Net Income

$
453,000Interest on 10% Convertible Note


-Diluted Net Income

$
453,000Basic Weighted Average Number of Shares Outstanding


275,505,697Assumed conversion of 10% Convertible Note


22,222Assumed conversion of Warrants


88,253Diluted Weighted Average Number of Shares Outstanding


275,616,172





19.          STOCK OPTIONS




The Company’s 2006 Stock Option and Incentive Plan (the “Stock Plan”) was adopted by the Board in October 2006. In September 2007, the Stock Plan, by consent of George J. Coates, majority shareholder, was adopted by the Company’s shareholders. The Stock Plan provides for the grant of stock-based awards to employees, officers and directors of, and consultants or advisors to, the Company and its subsidiaries, if any.  Under the Stock Plan, the Company may grant options that are intended to qualify as incentive stock options (“incentive stock options”) within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the “Code”), options not intended to qualify as incentive stock options (“non-statutory options”), restricted stock and other stock-based awards. Incentive stock options may be granted only to employees of the Company.  A total of 12,500,000 shares of common stock may be issued upon the exercise of options or other awards granted under the Stock Plan.  The maximum number of shares with respect to which awards may be granted to any employee under the Stock Plan shall not exceed 25% of the 12,500,000 total number of shares of common stock permitted to be granted under the Stock Plan.





The Stock Plan is administered by the Board and the Compensation Committee.  Subject to the provisions of the Stock Plan, the Board and the Compensation Committee each has the authority to select the persons to whom awards are granted and determine the terms of each award, including the number of shares of common stock subject to the award. Payment of the exercise price of an award may be made in cash, in a “cashless exercise” through a broker, or if the applicable stock option agreement permits, shares of common stock or by any other method approved by the Board or Compensation Committee.  Unless otherwise permitted by the Company, awards are not assignable or transferable except by will or the laws of descent and distribution.








15





Upon the consummation of an acquisition of the business of the Company, by merger or otherwise, the Board shall, as to outstanding awards (on the same basis or on different bases as the Board shall specify), make appropriate provision for the continuation of such awards by the Company or the assumption of such awards by the surviving or acquiring entity and by substituting on an equitable basis for the shares then subject to such awards either (a) the consideration payable with respect to the outstanding shares of common stock in connection with the acquisition, (b) shares of stock of the surviving or acquiring corporation or (c) such other securities or other consideration as the Board deems appropriate, the fair market value of which (as determined by the Board in its sole discretion) shall not materially differ from the fair market value of the shares of common stock subject to such awards immediately preceding the acquisition. In addition to or in lieu of the foregoing, with respect to outstanding stock options, the Board may, on the same basis or on different bases as the Board shall specify, upon written notice to the affected optionees, provide that one or more options then outstanding must be exercised, in whole or in part, within a specified number of days of the date of such notice, at the end of which period such options shall terminate, or provide that one or more options then outstanding, in whole or in part, shall be terminated in exchange for a cash payment equal to the excess of the fair market value (as determined by the Board in its sole discretion) for the shares subject to such stock options over the exercise price thereof.  Unless otherwise determined by the Board (on the same basis or on different bases as the Board shall specify), any repurchase rights or other rights of the Company that relate to a stock option or other award shall continue to apply to consideration, including cash, that has been substituted, assumed or amended for a stock option or other award pursuant to these provisions. The Company may hold in escrow all or any portion of any such consideration in order to effectuate any continuing restrictions.





The Board may at any time provide that any stock options shall become immediately exercisable in full or in part, that any restricted stock awards shall be free of some or all restrictions, or that any other stock-based awards may become exercisable in full or in part or free of some or all restrictions or conditions, or otherwise realizable in full or in part, as the case may be.





The Board or Compensation Committee may, in its sole discretion, amend, modify or terminate any award granted or made under the Stock Plan, so long as such amendment, modification or termination would not materially and adversely affect the participant.





In February 2011, stock options to purchase 200,000 shares of the Company’s common stock at an exercise price of $0.25 per share were granted to one of the Company’s directors. These stock options vest over a one year period and expire in 2026. No stock options were granted during the three months ended March 31, 2010.





During the three month ended March 31, 2011 and 2010, no stock options became vested. The weighted-average fair value of 585,000 nonvested stock options at March 31, 2011 was $120,000. Total compensation cost related to nonvested stock options at March 31, 2011 that had not been recognized was $108,000. This non-cash compensation expense will be recognized in the future over a remaining weighted average period of approximately six months.





For the three months ended March 31, 2011 and 2010, the Company recorded non-cash stock-based compensation expense amounting to $38,000 and $13,000, respectively, relating to stock options. For the three months ended March 31, 2011 and 2010, $3,000 and $-0-, respectively, of this amount is included in research and development expenses and $33,000 and $13,000, respectively, of this amount is included in general and administrative expenses in the accompanying statements of operations. For the three months ended March 31, 2011 and 2010, $2,000 and $-0-, respectively, of this amount was allocated to work in process inventory.





A summary of the activity in the Company’s Stock Option Plan is as follows:





Exercise Price Per Share


Number Outstanding


Weighted Average Remaining Contractual Life


Number Exercisable


Weighted Average Exercise Price


Weighted Average Fair Value Per Stock Option at Date of GrantBalance, 1/1/10

$
0.39 -1.00



2,290,000



12



1,905,000


$
0.44


$
0.36Granted

$
0.25



200,000



15



-


$
0.25


$
0.17Balance, 3/31/11

$
0.25 -1.00



2,490,000



12



1,905,000


$
0.42


$
0.34








16








No stock options were exercised, forfeited or expired during the three months ended March 31, 2011. The weighted average fair value of the Company's stock options was estimated using the Black-Scholes option pricing model which requires highly subjective assumptions including the expected stock price volatility. These assumptions were as follows:





·
Historical stock price volatility


139-180
%·
Risk-free interest rate


1.11%-4.64
%·
Expected life (in years)


4·
Dividend yield


0.00
%





The valuation assumptions were determined as follows:





●
Historical stock price volatility: The Company obtained the volatility factor of other publicly traded engine manufacturers that were also in the research and development stage.●
Risk-free interest rate: The Company bases the risk-free interest rate on the interest rate payable on U.S. Treasury securities in effect at the time of the grant for a period that is commensurate with the assumed expected option life.●
Expected life: The expected life of the options represents the period of time options are expected to be outstanding. The Company has no historical data on which to base this estimate. Accordingly, the Company estimated the expected life based on its assumption that the executives will be subject to frequent black out periods during the time that the stock options will be exercisable and based on the Company’s expectation that it will complete its research and development phase and commence its initial production phase. The vesting period of these options was also considered in the determination of the expected life of each stock option grant.●
No expected dividends.





The same methodology and assumptions were utilized in estimating the fair value of non-employee stock options granted to the Company’s general corporate counsel, as discussed above.





20.          INCOME TAXES





Deferred income taxes are determined using the liability method for the temporary differences between the financial reporting basis and income tax basis of the Company’s assets and liabilities. Deferred income taxes are measured based on the tax rates expected to be in effect when the temporary differences are included in the Company’s tax return. Deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases.





Deferred tax assets decreased by $442,000 and $190,000 for the three months ended March 31, 2011 and 2010, respectively. These amounts were fully offset by a corresponding decrease in the tax valuation allowance resulting in no net change in deferred tax assets, respectively during these periods.




No liability for unrecognized tax benefits was required to be reported at March 31, 2011 and 2010.  Based on the Company's evaluation, it has concluded that there are no significant uncertain tax positions requiring recognition in the Company's financial statements.  The Company's evaluation was performed for tax years ended 2005 through 2010, the only periods subject to examination.  The Company believes that its income tax positions and deductions will be sustained on audit and does not anticipate that adjustments, if any, will result in a material change to its financial position. For the three months ended March 31, 2011 and 2010, there were no penalties or interest related to the Company’s income tax returns.






17







21.          RELATED PARTY TRANSACTIONS





Compensation and Benefits Paid





The approximate amount of compensation and benefits paid to George J. Coates, Gregory Coates and Bernadette Coates, exclusive of non-cash stock-based compensation for employee stock options granted to George J. Coates, Gregory Coates and Bernadette Coates is summarized as follows:





For the Three Months

Ended March 31,2011


2010George J. Coates

$
65,000


$
104,000Gregory Coates


42,000



52,000Bernadette Coates


20,000



18,000





Included in the above amounts for the three months ended March 31, 2010 is compensation paid to George J. Coates and Gregory Coates for vacation earned but not taken during the prior calendar year. Also included in compensation paid to George J. Coates during the three months ended March 31, 2010 is $10,000 representing the estimated fair value of 4,001 shares of Series A Preferred Stock awarded, as more fully discussed in Note 14.





In addition to the above compensation, stock-based compensation expense related to stock option granted to George J. Coates amounted to $14,000 and $3,400 for the three months ended March 31, 2011 and 2010, respectively.





Promissory Notes to Related Parties





During the three months ended March 31, 2011, in a series of transactions, the Company received aggregate proceeds of $37,000 from George J. Coates and issued promissory notes that are due on demand. These notes bears interest at the rate of 17% per annum, compounded monthly. During this period, a total of $22,000 of promissory notes was repaid.





During the three months ended March 31, 2011, by mutual agreement between the Company and The Coates Trust, a trust owned and controlled by George J. Coates, promissory notes issued to The Coates Trust amounting to $180,000, plus accrued interest thereon of $18,000 were converted into 1,165,507 shares of the Company’s common stock at a conversion rate of $0.17 per share.





Other





Barry C. Kaye, Treasurer and Chief Financial Officer was paid compensation of $16,500 and $22,000 during the three months ended March 31, 2011 and 2010, respectively.





As discussed in Note 14, during the three months ended March 31, 2011, the Company sold 600,000 shares of its common stock and 600,000 warrants to purchase one share of its common stock at an exercise price of $0.25 per share in consideration for $150,000 received from the son of a director. The Company also sold 200,000 shares of its common stock in consideration for $50,000 to one of its directors. These transactions were private sales of unregistered, restricted securities pursuant to a stock purchase agreement.






18







22.           LITIGATION AND CONTINGENCIES





Mark D. Goldsmith, a former executive of the Company, filed a lawsuit in January 2008 in which he asserts that the Company is liable to him for breach of an employment contract that never became effective. In the opinion of management, Mr. Goldsmith’s performance was unsatisfactory and, accordingly, he was offered the opportunity to resign. Further, management is of the opinion that the claim of Mr. Goldsmith is baseless because the Company had cause to terminate its relationship with Mr. Goldsmith. The Company intends to vigorously defend this lawsuit and has instituted a counterclaim against Mr. Goldsmith. The Company believes that Mr. Goldsmith misrepresented his background and capabilities in order to induce it and/or Coates Motorcycle Company, Ltd. ("CMC") to hire him. The Company is also contending that certain of Mr. Goldsmith's business decisions were made to further his self interest rather than the interests of the Company. The Company believes that Mr. Goldsmith's claims have no basis in fact and, accordingly, that the outcome of this legal action will not be material to its financial condition or results of operations. Efforts by the court to settle this matter have been unsuccessful. Trial is currently scheduled for August 23, 2011. The Company intends to vigorously defend against Mr. Goldsmith’s claims and pursue its counterclaims.





The Company has without prejudice to its position, accrued compensation under his employment agreement for accounting purposes only, of $96,000 of his salary. Although the Company does not intend to make any payments to Mr. Goldsmith in connection with this employment agreement, this amount is included in accounts payable and accrued liabilities in the accompanying balance sheets.





In March 2010, one of the Company’s vendors notified the Company of its contention that it is owed $160,000, plus accrued interest, for services rendered in 2007. At a meeting with the vendor in the second quarter of 2010, the vendor acknowledged that it did not have documentation to support its claim. Since that meeting, the Company has not received any further communications from this vendor. The Company believes there is no basis in fact to support the vendor’s contention and it is not likely that the vendor can prevail with its position. Accordingly, no amount has been recorded for this unasserted claim.





The Company is not a party to any other litigation that is material to its business.





23.           RECENTLY ISSUED ACCOUNTING STANDARD





In April 2010, the Financial Accounting Standards Board issued Accounting Standards Update No. 2010-17, “Milestone Method of Revenue Recognition, a consensus of the FASB Emerging Issues Task Force”. This standard provides guidance on defining a milestone and when it is appropriate to apply this standard in recognizing revenue from research and development transactions. In general, this standard permits recognition of revenue from research and development that is contingent upon achievement of one or more specified milestones defined in the research and development arrangements which meet specified criteria for such revenue recognition. This standard becomes effective for fiscal periods beginning after June 15, 2010. Adoption of this standard did not have a material effect on the Company's financial statements.





24.           SUBSEQUENT EVENTS





Conversion of Promissory Notes to Related Parties





In April 2011, by mutual agreement between the Company and two of the Company’s directors holding promissory notes issued by the Company, promissory notes, with an aggregate principal amount of $250,000, plus accrued interest thereon of $70,000, were converted into 1,869,570 shares of the Company’s common stock at a conversion rate of $0.171 per share.





Conversion and Issuance of Convertible Promissory Notes





In April 2011, an aggregate of $52,000 principal amount of convertible promissory notes, including interest thereon amounting to $3,000, was converted by the holder into 554,511 unregistered shares of the Company’s common stock.






19







In May 2011, the Company entered into a securities purchase agreement with an investor and issued an 8% convertible promissory note which matures in February 2012 and received cash proceeds of $96,500, net of financing costs of $3,500. This note contains the same terms and conditions as the previous convertible promissory notes more fully discussed in Note 12.





Issuance of Promissory Notes to Related Parties





In a series of transactions between the Company and George J. Coates during April and May 2011, the Company received aggregate proceeds of $73,000 from George J. Coates and issued promissory notes that are due on demand. These notes bear interest at the rate of 17% per annum, compounded monthly. The funds for these promissory notes were obtained from the net proceeds of sales by Mr. Coates of 803,405 of his shares of common stock of the Company pursuant to Rule 144 of the Securities Act of 1934. In April 2011, the Company received $12,000 from Bernadette Coates, spouse of George J. Coates and issued a promissory note that is due upon demand. The promissory note provides for interest at 17% per annum, compounded monthly.





Private Sales of Shares of Common Stock





Subsequent to March 31, 2011, the Company sold in two transactions, 200,000 shares of its common stock and 200,000 warrants to purchase one share of its common stock at an exercise price of $0.25 per share in consideration for $50,000 received from the son of a director. These transactions were private sales of unregistered, restricted securities pursuant to a stock purchase agreement.





Funding Commitment





On May 3, 2011, the Company received a firm commitment letter from Black Swan Capital Group, Inc. (“Black Swan”) for a proposed term loan of $10 million (the “Loan”). The commitment is subject to standard conditions for closing and is expected to close before the end of May 2011. As such, the Loan has not yet been provided and at this time the Company is not yet under a contractual obligation to repay the Loan. The terms of the proposed Loan, which would mature two years after the closing date, provide for interest at 10% per annum. The Loan may be drawn down in two tranches consisting of $5 million at the closing and $5 million at any time thereafter within 9 months after the closing date upon 30 days’ prior notice. The Loan will be secured by all of the Company’s assets and will contain covenants requiring the maintenance of certain financial ratios and financial calculations to be defined. The Company would also be required to deposit unregistered, restricted shares of its common stock with a value equal to the amount of the Loan into an escrow account for the benefit of the lender as collateral for the Loan. The Company is also required to pay a closing fee of 3.5% at the time of the closing. The Company’s existing $1,660,000 mortgage loan is expected to be repaid from the proceeds at the closing.





The new working capital that would be provided from funding of the Loan would enable the Company to ramp up production and fulfill orders for the Coates CSRV Natural Gas Industrial Electric Power Generator Sets for Almont Energy, Inc.





Issuance of Shares of Preferred Stock





Subsequent to March 31, 2011, the Company issued 4,328 shares of Series A Preferred Stock (representing 43,280,000 voting shares) to George J. Coates pursuant to anti-dilution provisions in effect with respect to the Coates family.





The issuance of shares of Series A Preferred Stock to George J. Coates dilutes the voting percentage of all other shareholders with respect to matters brought before the shareholders for a vote, but does not have any effect on their share of dividends or liquidation value of the other holders of the Company’s common stock.






20







Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS





Forward-Looking Statements





This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Federal securities laws, and is subject to the safe-harbor created by such Act and laws. Forward-looking statements may include our statements regarding our goals, beliefs, strategies, objectives and plans, including product and service developments, current dependence on our agreements with Almont Energy, Inc., future financial conditions, results or projections or current expectations. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of such terms, or other comparable terminology. These statements are subject to known and unknown risks, uncertainties, assumptions and other factors that may cause actual results to be materially different from those contemplated by the forward-looking statements. The business and operations of Coates International, Ltd. are subject to substantial risks, which increase the uncertainty inherent in the forward-looking statements contained in this report. Except as required by law, we undertake no obligation to release publicly the result of any revision to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Further information on potential factors that could affect our business is described in our various periodic reports filed with the SEC. Readers are also urged to carefully review and consider the various disclosures we have made in this and such previously filed reports.





Background





We have completed development of the Coates spherical rotary valve (“CSRV”) system technology for use in internal combustion engines of all types. In November 2010, we shipped the first industrial CSRV natural gas fueled electric power engine generator set (“CSRV Gen Set”) to Almont Energy, Inc. (“Almont”). At the end of April 2011, we shipped a second CSRV Gen Set to Almont and recognized sales of $125,000. This unit had been prepaid by Almont, the proceeds of which were included in unearned revenue at March 31, 2011. Additional CSRV Gen Sets are currently in production to fulfill orders from Almont.





We believe that the CSRV system technology delivers significant competitive advantages over technology currently applied in conventional internal combustion engines, including substantial improvement in fuel efficiency, a substantial reduction in harmful emissions, adaptability to almost any type of engine fuel and longer intervals between scheduled engine maintenance. This technology has been successfully applied to CSRV Gen Sets, automobile engines, a 35 KW synchronous residential generator and a high performance racing car engine.  We are beginning to ramp up production to fulfill additional orders from Almont and will continue to transaction to larger scale manufacturing operations in order to be properly positioned to take advantage of this technology as it achieves acceptance in the marketplace.  This includes searching for the optimal manufacturing facility based on location, shipping logistics and availability of a skilled labor pool suitable for large scale manufacturing of the CSRV system technology.  We continue to actively seek out new sources of working capital to fund our plans for the commencement of manufacturing activities.





We may also conduct new research and development activities in connection with applying this technology to other commercially feasible internal combustion engine applications and are planning to manufacture engines and/or license the technology to third party Original Equipment Manufacturers (“OEMs”) for multiple other applications and uses. We believe the CSRV system technology has wide applicability to products of all types powered by internal combustion engines.





Initially, we intend to sell the CSRV Gen Sets to Almont, the successor in interest to Well to Wire Energy, Inc. (“WWE”) with respect to (i) a license agreement covering the territory of Canada; and, (ii) certain rights to a license covering the territory of the United States. Almont is a privately held, independent third party entity based in Alberta, Canada. The business plan of Almont assumes the purchase of a substantial number of CSRV Gen Sets over a 5-year period commencing upon our ramp up of production to fulfill their orders. Almont’s purchase of CSRV Gen Sets from us will be made by way of standard purchase orders, issued based on market and customer demand. Over the 5-year period, Almont anticipates that the volume of total purchases from us will be similar to, or potentially exceed the 7,400 CSRV Gen Sets contemplated in our previous arrangement with WWE. Almont plans to finance its purchases from cash flow and by way of project and/or equipment financing, proceeds from issuance of equity or corporate debt instruments and conventional bank financing.








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Our ability to establish large scale manufacturing operations, recruit plant workers, finance initial manufacturing inventories and fund capital expenditures is highly dependent on our ability to successfully raise substantial new working capital in an amount and at a pace which matches our business plans. On May 3, 2011, the Company received a firm commitment letter from Black Swan Capital Group, Inc. for a proposed term loan of $10 million (the “Loan”) which is expected to close and fund the Company before the end of May 2011. The proposed Loan may be drawn down in two tranches consisting of $5 million at the closing and $5 million at any time thereafter within 9 months after the closing date upon 30 days’ prior notice.





Other potential sources of such new working capital include sales of our equity and/or debt securities through private placement and/or secondary public offerings, issuances of promissory notes to related parties, issuances of convertible promissory notes, pursuing and entering into additional sublicensing agreements with OEM’s and/or distributors, additional payments from Almont towards the escrow agreement Release Payment and US Licensing fees and positive working capital generated from sales of our CSRV products to Almont and others. There can be no assurance that we will be successful in raising adequate new working capital or even any new working capital to carry out our business plans.  The current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty to our challenge to secure such additional working capital.





We are actively engaged in efforts to raise working capital to fund our ongoing operations and the ramp up of production of our products incorporating the CSRV system technology.





Non-binding Preliminary Letter of Intent to Merge with Heavy Equipment Manufacturer in China





In December 2010, we entered into a non-binding letter of intent with an established heavy equipment manufacturer in China and The Coates Trust. The letter expresses the mutual intent of the parties for a merger, between the Company and this Chinese entity through an exchange of shares of stock. We are prevented by confidentiality provisions from disclosing the name of the Chinese entity. The merger would be subject to required governmental approvals and also requires that we undertake a secondary public offering of our securities to raise between $220 million and $500 million to fund both our U.S. operations and operations in China. Management believes such a merger would provide us with ready access to substantial existing manufacturing capacity and a trained labor force in China. Management further believes that, based on current economic factors and conditions, manufacturing in China would provide us with lower manufacturing costs than we would incur in the United States. Should the merger plans go forward, we would expect to distribute products manufactured in China to Asia, Africa and Europe. We would continue to pursue our plans to manufacture products in the United States for distribution to customers in Western Hemisphere countries.





The terms of the merger provide that if the merger is consummated, we would receive a controlling 60% ownership interest in the Chinese entity and the Chinese entity would receive 50 million shares of our common stock and $100 million from the net proceeds of the public offering, if successful.  The balance of the proceeds would be retained by us to provide for working capital to commence large scale manufacturing in the United States for distribution in our licensed territories. In the event the secondary public offering is successful, we would issue 50 million shares of our common stock to The Coates Trust in consideration for a world-wide license of the CSRV system technology. We would then grant a world-wide (with the exception of the US and Canada) non-exclusive license for the manufacturing, sale and distribution of the CSRV system technology to this Chinese entity.





We believe that this merger is conditioned upon, and will only be able to achieve the mutual objectives of the parties if, (i) either the Company and/or the Chinese entity enter into one or more substantial long-term, high volume, contracts to supply CSRV system technology products to one or more customers in the territories outside of the Western Hemisphere; and (ii) the satisfactory observation by representatives of the Chinese entity of the performance of CSRV Gen Sets in the field.








22





There are no assurances that (i) the necessary governmental approvals can be obtained, (ii) the Company can be successful in raising the minimum amount of funds from a secondary public offering of its securities, (iii) such long-term, high volume contracts can be secured; and, (iv) the Chinese entity will be satisfied with the performance of the CSRV Gen Sets in the field.





Cooperation Agreement with Tongji University of China





We have also entered into a Cooperation Agreement with Tongji University of China (the “University”) for the purpose of enabling the University to undertake evaluation and testing of the CSRV engine technology. The results of the evaluation and testing will be used to determine if, and to what extent, the engine technology could be applied in the manufacture of products in China. We are required to deliver to the University a CSRV 1600cc 4-cylinder engine and a 1600cc 4-cylinder poppet valve engine to facilitate comparison. We are also required to provide technical assistance, as needed, to optimize the success of the evaluation and testing. The University is to promptly furnish us with a copy of its findings. Provided the results of the evaluation and testing of the CSRV engines are deemed satisfactory, we have agreed to sub-license the CSRV Technology to Chinese engine manufacturers. The parties also entered into a Confidentiality and Non-Disclosure Agreement at the same time, which provides for protection of the CSRV technical information and patents. The Coates Trust has expressed its intention to license the rights to the CSRV technology to the Company for the territory to be defined in connection with any such licenses granted to Chinese manufacturers. At this time, the parties are not actively working on this cooperation agreement, but may agree to do so at some point in the future.





Agreements with Well to Wire Energy, Inc. Assigned to Almont Energy, Inc.





In 1999, we granted a sublicense to Well to Wire Energy, Inc. ("WWE"), a Canadian-based company that provided services in the oil and gas industry.  This sublicense provides for a $5,000,000 license fee to be paid to us and covers the use of the CSRV system technology in the territory of Canada (the “Canadian License”). A separate research and development agreement (“R&D Agreement”) provided for WWE to pay us an additional $5,000,000 fee in consideration for the development and delivery of certain prototype engines. We completed development of the prototypes in accordance with this agreement at the end of 2007. The research and development agreement has not been reduced to the form of a signed, written agreement.





In 2008, we also entered into an escrow agreement with WWE that provides conditional rights to a second sublicense agreement to WWE for the territory of the United States (the “US License”). The US license has been deposited into an escrow account and the grant of the license will not become effective until the conditions for release from escrow are satisfied. The US License provides for a license fee of $50 million.





The escrow agreement requires that WWE make a payment (“Release Payment”) to us equal to the remaining unpaid balance of the licensing fee for the Canadian License, the R&D Agreement fee and the down payment of $1,000,000 required under the US License.





During the first quarter of 2010, with our prior consent, WWE assigned the Canadian License and the rights to the US License, subject to the terms and conditions of the escrow agreement, to Almont Energy Inc. (“Almont”), a privately held, independent third party entity based in Alberta, Canada. In connection with the assignment, we waived all events of default by WWE under the escrow agreement. We also waived the provisions of the escrow agreement requiring the payment of interest on the unpaid balance of the Release Payment. Almont made two payments to us in February 2010 totaling $700,000 as a prerequisite condition to our consent to the assignment. During the three months ending March 31, 2011 and 2010 Almont and WWE made Release Payments to us totaling $-0- and $850,000, respectively.








23





In connection with the assignment of the Canadian License and the rights to the US License, Almont has also assumed all of the obligations set forth in the escrow agreement with the following modifications:





Ÿ
The Release Payment Date as defined in the escrow agreement has been extended to March 19, 2012. At the time of the assignment, the remaining unpaid balance of the Release Payment was approximately $5,997,000. Provided that Almont remits this entire unpaid balance to us on or before the Release Payment Date, the US License will be released from escrow and granted to Almont. Almont is required to remit to us 60% of all monies it raises from future equity or debt transactions, exclusive of proceeds from equipment purchase financing transactions, until the Release Payment is paid in full.





Ÿ
After payment of the Release Payment which includes the $ 1 million deposit towards the US License, Almont has also become obligated to pay the $49 million balance of the US License Fee to us. Payment shall be made quarterly in an amount equal to 5% of Almont’s quarterly net profits. In addition, Almont is required to remit to us a portion of the proceeds it receives from equity or debt transactions, exclusive of equipment financing transactions until the entire balance of the US License fee is paid in full. However, in any event, the entire $49 million licensing fee is required to be paid on or before February 19, 2015.





To the extent that Almont is not successful or experiences delays in remitting the balance of the Release Payment, our cash flow, results of operations and financial condition could be adversely affected.





The Canadian License





The Canadian License exclusively licenses within Canada the use of the CSRV system technology for industrial engine generators to be fueled by natural gas to generate electrical power. Additional provisions of the Canadian License agreement are as follows:





Ÿ
Licensee shall have the exclusive right to use, lease and sell electric power generators that are based on the CSRV system technology within Canada.Ÿ
Licensee shall have a specified right of first refusal to market the electric power generators worldwide.





Ÿ
Upon commencement of the production and distribution of the electric power generators, the minimum annual number of generators to be purchased by Licensee in order to maintain exclusivity is 120.  Until otherwise agreed between the parties, the price per generator shall be $159,000.  In the event Licensee fails to purchase the minimum 120 CSRV engines during any year, Licensee will automatically lose its exclusivity. In such a case, Licensee would retain non-exclusive rights to continue to use and sell the CSRV engines in the territory of Canada.Ÿ
Licensee is required to pay a royalty to us equal to 5% of the sum of its annual gross profits and $400,000.





Ÿ
All licensed rights under this license agreement related to the CSRV system technology will remain with us.





The US License





The US License will, upon Almont satisfying the Release Payment, grant to WWE the right to use, sell and lease Licensed Products manufactured by us, as the power source for the generation of electrical energy.  Licensed Products consist of CSRV Engines, CSRV Valve Systems, CSRV Valve Seals, CSRV Rotary Valve Spheres and CSRV Valve Components for use in electric power generation applications.






24





The manufacture of any Licensed Products by Licensee is prohibited.  Licensee is required to procure all internal combustion engines incorporating the CSRV Valve System from us or our designee. The license granted to Licensee is exclusive within the Territory, provided that Licensee satisfies the minimum annual purchase commitment of 120 internal combustion engines incorporating the CSRV system technology, the Coates engines and all component parts. The agreement also grants Licensee a right of first refusal in the event that we negotiate an offer with another third party for a worldwide license to use the Licensed Product.





The business plan of Almont assumes the purchase of a substantial number of CSRV units over a 5-year period. Almont’s purchase of CSRV units from us will be made by way of standard purchase orders, issued based on market and customer demand. Over the 5-year period, Almont anticipates that the volume of total purchases from us will be similar to, or potentially exceed the 7,400 CSRV units contemplated in our previous arrangement with WWE. Almont plans to finance its purchases from cash flow and by way of project and/or equipment financing, proceeds from issuance of equity or corporate debt instruments and conventional bank financing.





We do not currently have the production capacity to fulfill orders for this number of engine generators over the next five years.  Management believes that we could be successful in entering into a procurement contract with one or more major engine suppliers in the United States to deliver engine blocks incorporating our proprietary pistons and heads.  Under this approach, we would complete the production of the engines by incorporating the CSRV system technology into these engine blocks.




There are a number of inherent risks associated with achieving this level of revenues over the next five years, including:




Although we intend to pursue numerous other opportunities to generate revenues from production of internal combustion engines incorporating the CSRV system technology and/or licensing of this technology to original equipment manufacturers, until we are able to enter into definitive agreements with new customers, our revenues will be concentrated with a single customer, Almont.  Almont will be required to remit periodic installments of the Release Payment due us under the escrow agreement and make timely payments for its purchases of CSRV system technology-based products from us.




There can be no assurances that we will have adequate capital resources to acquire an appropriate manufacturing plant and procure a sufficient number of engine blocks, inventory and parts on a timely basis, as well as cover the payroll costs for an increased labor force and overhead that would be required in order to fulfill orders for this volume of engine generators over the next five years. In the event that we are unable to fulfill this volume of orders, our revenues and profitability would be negatively impacted to the extent of any such shortfall.





Significant Estimates





The preparation of our financial statements in conformity with accounting principles generally accepted for interim financial information and rules and regulations of the SEC requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These significant estimates include determining a value for the Series A Preferred Stock issued and certain limited anti-dilution rights granted to George J. Coates, determining the amount of discount on convertible promissory notes,  measuring the estimated fair value of embedded derivative liabilities related to our convertible promissory notes outstanding, assigning useful lives to our property, plant and equipment, determining an appropriate amount to reserve for obsolete and slow moving inventory, determining the amount of the allowance for deferred tax assets, assigning expected lives to and estimating the rate of forfeitures of stock options granted and selecting a volatility factor for our stock options in order to estimate the fair value of our stock options on the date of grant.






25




Results of Operations – Three Months EndedMarch 31, 2011 Compared to Three Months Ended March 31, 2010 (All amounts rounded to thousands of dollars)





No revenues from sales or research and development were generated during the three month period ended March 31, 2011. For the three months ended March 31, 2010, revenues from research and development amounted to $850,000.




Research and development expenses were $21,000 and $-0- for the three months ended March 31, 2011 and 2010, respectively. Included in research and development expenses for the three months ended March 31, 2011 and 2010 were $18,000 and $-0-, respectively, of allocated compensation and benefits and $3,000 and $-0-, respectively and of allocated stock-based compensation expense.




General and administrative expenses increased to $349,000 for the three months ended March 31, 2011 from $321,000 in the corresponding period in 2010. This net increase of $28,000 primarily resulted from the following: An increase in legal and professional fees of $141,000, an increase in stock-based compensation charged to general and administrative expenses of $20,000 and an increase in marketing expenses of $3,000, offset by a decrease in compensation and benefits of $68,000, a decrease in patent maintenance costs of $31,000, a decrease in printing costs of $13,000, a decrease in office expenses of $7,000, a decrease in investor relations costs of $6,000, a decrease in building expenses of $5,000, a decrease in shop supplies and tools of $5,000 and a net decrease in other expenses of $1,000.




Depreciation and amortization increased by $2,000 to $17,000 for the three months ended March 31, 2011 from $15,000 for the three months ended March 31, 2010.




Other operating expense for the three months ended March 31, 2011, consisted of an increase in the fair value of embedded derivative liabilities amounting to ($17,000) in connection with convertible promissory notes outstanding. In accordance with GAAP, the fair value of these embedded liabilities is required to be remeasured at each balance sheet reporting date.




Interest expense, net, amounted to $139,000 for the three months ended March 31, 2011, an increase of $77,000 from interest expense, net incurred in the comparable 2010 period. This increase was primarily related to interest expense on convertible promissory notes which were not outstanding in the 2010 period, offset by the discontinuance of the amortization of deferred financing costs.




The change in deferred tax assets for the three months ended March 31, 2011 and 2010 was fully offset by a valuation allowance, resulting in a $-0- net income tax provision.




We incurred a net loss of ($543,000) and earned a net profit of $453,000 for the three months ended March 31, 2011 and 2010, respectively.





Liquidity and Capital Resources (All amounts rounded to thousands of dollars)





Our cash position at March 31, 2011 was $26,000, a decrease of $28,000 from the cash position of $53,000 at December 31, 2010. We had negative working capital of ($3,146,000) at March 31, 2011 which represents a $35,000 increase from the ($3,182,000) of negative working capital at December 31, 2010. Current liabilities of $3,665,000 at March 31, 2011, decreased by $75,000 from the $3,740,000 balance at December 31, 2010. Current liabilities are primarily comprised of unearned revenue of $154,000, a mortgage loan in the amount of $1,680,000 which matures in July 2011, accounts payable and accrued liabilities of $1,349,000, promissory notes to related parties totaling $309,000, unamortized carrying value of convertible promissory notes of $96,000 and embedded derivative liabilities related to convertible promissory notes of $77,000.





Operating activities utilized cash of ($281,000) during the three months ended March 31, 2011 which primarily consisted of a net loss for the period of ($543,000), decreased by non-cash interest expense of $107,000, non-cash stock-based compensation expense of $38,000, depreciation and amortization of $17,000, a non-cash increase of $17,000 in the fair value of the embedded liabilities related to convertible promissory notes and increased by other changes of ($10,000). In addition, we realized additional operating cash from a net increase in accounts payable and accrued liabilities of $102,000, collection of accounts receivable of $11,000 and unearned revenue received of $10,000. Operating cash was utilized for inventory purchases of ($30,000).






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Investing activities utilized cash of ($5,000) for the acquisition of property, plant and equipment during the three months ended March 31, 2011. There were no investing activities for the three months ended March 31, 2010.





Financing activities generated cash of approximately $258,000 for the three months ended March 31, 2011, consisting of proceeds from issuance of stock and warrants of $200,000, issuance of promissory notes to related parties of $37,000, issuance of convertible notes amounting to $33,000 and the release from a restricted bank account of cash amounting to $30,000, offset by a $30,000 partial repayment of the principal amount of a mortgage loan and partial repayment of promissory notes to related parties in the amount of $12,000.





Subsequent to March 31, 2011, we raised additional working capital consisting of net proceeds of $96,500 from the issuance of a convertible promissory note, proceeds of $50,000 from the sale of common stock and common stock warrants to the son of a director, proceeds of promissory notes issued to George J. Coates of $38,000, proceeds of $12,000 from a promissory note issued to Bernadette Coates, the spouse of George J. Coates. On May 3, 2011, the Company received a firm commitment letter from Black Swan Capital Group, Inc. (“Black Swan”) for a proposed term loan of $10 million (the “Loan”) which is expected to close and fund the Company before the end of May 2011. The proposed Loan may be drawn down in two tranches consisting of $5 million at the closing and $5 million at any time thereafter within 9 months after the closing date, upon 30 days’ prior notice.





In the opinion of management, we will be required to continue to raise additional working capital to fully achieve our objectives as we are entering the production phase of our operations and continue research and development activities in connection with developing other commercially viable applications of our CSRV system technology to internal combustion engines. Various potential sources of such additional working capital is anticipated to come from one or more of the following: the commitment received from Black Swan to fund a $10 million term loan in May 2011, sales and shipments of natural gas fueled industrial electric power CSRV engine generators to Almont, cash flows from payments by Almont under the escrow agreement, additional issuances of convertible promissory notes and private sales of common stock and common stock warrants. The current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty in our challenge to secure needed additional working capital. There can be no assurance that we will be able to obtain the necessary working capital for our production phase on a time frame that will enable us to optimize our production capacity.





Contractual Obligations and Commitments





The following table summarizes our contractual obligations and commitments at March 31, 2011 (rounded to thousands of dollars):





Amount Due WithinTotal


2011Mortgage loan payable

$
1,680,000


$
1,680,000Promissory notes to related parties(1)


299,000



299,000Employment agreements(2)


233,000



233,000Convertible promissory notes(3)


143,000



143,000Maturity of 10% promissory notes


10,000



10,000Total

$
2,365,000


$
2,365,000








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(1)
In April 2011, promissory notes to related parties with an aggregate principal amount of $250,000, plus accrued interest thereon of $70,000, were converted into 1,869,570 shares of the Company’s common stock at a conversion rate of $0.171 per share, there by reducing this commitment to $49,000.





(2)
Our obligation under employment agreements would increase to $550,000, upon achieving an adequate level of Working Capital, as defined.





(3)
In April 2011, an aggregate of $52,000 principal amount of convertible promissory notes, including interest thereon amounting to $3,000, was converted by the holder into 554,511 unregistered shares of the Company’s common stock, thereby reducing this commitment to $90,500.





Total non-cash compensation cost related to nonvested stock options at March 31, 2011 that has not been recognized was approximately $108,000. This compensation expense will be recognized in the future over a remaining weighted average period of approximately 6 months.





Plan of Operation





We have completed development of the natural gas fueled industrial electric power CSRV engine generator sets (“CSRV Gen Sets”) and have commenced production on a limited basis. We are constrained by a limited availability of working capital needed to manufacture CSRV products. We intend to sell our CSRV Gen Sets to Almont and other prospective customers as arrangements to supply our products are finalized. In November 2010, we shipped the first industrial CSRV Gen Set to Almont. At the end of April 2011, we shipped a second CSRV Gen Set to Almont generating sales of $125,000. This unit had been prepaid by Almont, the proceeds of which were included in unearned revenue at March 31, 2011. Additional CSRV Gen Sets are currently in production to fulfill orders from Almont.





We intend to ramp up manufacturing to be able to fulfill orders based on Almont’s five-year business plan, which anticipates that it will require a volume of CSRV Gen Set similar to or greater than the 7,400 units previously planned by WWE. Fulfillment is expected to occur over a five-year period. We intend to take advantage of the fact that essentially all the components of the engine generators may be sourced and acquired from subcontractors and, accordingly, expect to manufacture the engine generators in the two following ways:





Ÿ
Assembly – to develop assembly lines at a new manufacturing facility to be constructed or acquired in the future in order to increase our manufacturing capacity. When the demand for our products justifies it, we will take the required steps in order to increase our work force.  We anticipate that we will recruit a significant number of new employees and make substantial capital expenditures in connection with establishing such large scale operations.Ÿ
Licensing our CSRV system technology to Original Equipment Manufacturers (“OEM's”) – to take advantage of third party manufacturers’ production capacity by signing OEM agreements.





Our ability to establish such manufacturing operations, recruit plant workers, finance initial manufacturing inventories and fund capital expenditures is highly dependent on our ability to successfully raise substantial new working capital in an amount and at a pace which matches our business plans. Anticipated potential sources of such new working capital include: the commitment received from Black Swan to fund a $10 million term loan in May 2011, positive working capital generated from sales of our CSRV products to Almont and others, additional payments from Almont for the Release Payment, additional issuances of convertible promissory notes, issuances of promissory notes to related parties, private sales of common stock and common stock warrants, sales of our equity and/or debt securities through private placements and/or secondary public offerings and pursuing and entering into additional sublicensing agreements with OEM's and/or distributors. There can be no assurance that we will be successful in raising adequate new working capital or even any new working capital to carry out our business plans.  The current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty in our challenge to secure such additional working capital.





Once we transition to production and delivery of our products, we intend to increase our expenditures for marketing and branding activities with the objective of increasing market awareness and acceptance of the CSRV system technology.






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The extent to which we can carry out this plan of operation will be highly dependent on our success in raising new sources of capital and generating cash flows from operations in the production phase.





Going Concern (All amounts rounded to thousands of dollars)





As shown in the accompanying financial statements, we incurred a net loss for the three month period ended March 31, 2011 of ($543,000), and have incurred substantial net losses since inception while engaging primarily in research and development. As of March 31, 2011, we had accumulated losses of ($24,249,000) and had negative working capital of ($3,146,000). In addition, the current economic environment, which is characterized by tight credit markets, investor uncertainty about how to safely invest funds and low investor confidence, has introduced additional risk and difficulty in our challenge to secure needed additional working capital. These factors raise substantial doubt about our ability to continue as a going concern. Our Independent Registered Public Accounting Firm has stated in its independent auditors’ report on our financial statements as of December 31, 2010 and for the year then ended that these factors raise substantial doubt about our ability to continue as a going concern.





The doubt about our ability to continue to operate as a going concern has existed for a number of years. We have been successful in raising sufficient new working capital throughout that time to enable us to continue as a going concern and, although we can not provide assurances that we can be successful, we believe that we can continue to do so in the future. On May 3, 2011, the Company received a firm commitment letter from Black Swan Capital Group, Inc. for a proposed term loan of $10 million (the “Loan”) which is expected to close and fund the Company before the end of May 2011.The proposed Loan may be drawn down in two tranches consisting of $5 million at the closing and $5 million at any time thereafter, within 9 months after the closing date, upon 30 days’ prior notice. Management is continuing to carefully monitor its costs and is restricting variable costs to only those expenses that are necessary to carry out our business plans. We continue to actively seek out new sources of working capital; however, there can be no assurance that we will be successful in these efforts.





The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty.





Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Not applicable.





Item 4. CONTROLS AND PROCEDURES





a) Evaluation of Disclosure Controls. Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “Exchange Act”), we carried out an evaluation, with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) (our principal financial and accounting officer), of the effectiveness of our disclosure controls and procedures (as defined under Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.





(b)   Changes in internal control over financial reporting. There have been no changes in our internal control over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.











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PART II - OTHER INFORMATION





Item 1. LEGAL PROCEEDINGS





Not applicable.





Item 1A. RISK FACTORS





Not required.





Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS





In January 2011, the Company issued $32,500 of convertible notes. The notes are convertible into shares of unregistered common stock at any time beginning six months after issuance. The conversion rate is equal to 61% of the average of the three lowest closing bid prices of the stock during the ten trading days prior to the date of conversion.





In February and March 2011, an aggregate of $97,000 principal amount of the convertible promissory notes, including interest thereon amounting $3,000, was converted by the holder into 883,434 unregistered shares of the Company’s common stock.





We sold, in a series of transactions, 600,000 shares of our common stock and 600,000 warrants to purchase one share of our common stock at an exercise price of $0.25 per share in consideration for $150,000 received from the son of a director. These transactions were private sales of unregistered, restricted securities pursuant to a stock purchase agreement.





In February 2011, we sold 200,000 shares of our common stock in consideration for $50,000 to one of our directors. This transaction was a private sale of unregistered, restricted securities pursuant to a stock purchase agreement.





All of the above shares were issued pursuant to an exemption from registration contained in Section 4(2) of the Securities Act of 1933.





Item 3. DEFAULTS UPON SENIOR SECURITIES





None.





Item 4. (REMOVED AND RESERVED)





Item 5. OTHER INFORMATION





None.





Item 6. EXHIBITS.





Exhibit

Number

Description31.1 *

Section 302 Certification of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2 *

Section 302 Certification of Principal Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1 *

Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2 *

Certification of Principal Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.





* Filed herewith.








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SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.








COATES INTERNATIONAL, LTD.Date: May 16, 2011
By:
/s/ George J. CoatesGeorge J. CoatesPresident, Chief Executive Officer

and Principal Executive Officer





Date: May 16, 2011
By:
/s/ Barry C. KayeBarry C. KayeTreasurer, Chief Financial Officer

and Principal Financial Officer














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