**UNITED STATES SECURITIES AND EXCHANGE**

**COMMISSION**

**Washington, D.C.20549**

** **

**Form 10-K**

 
| **x**      | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|------------|----------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                     |
| ** ** | ** ** | **For the fiscal year ended  September 30, 2007**                                                   |
|       |       |                                                                                                     |
| ** ** | ** ** | **or**                                                                                                   |
|       |       |                                                                                                     |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
| ** ** | ** ** | ** **                                                                                               |
| ** ** | ** ** | **For the transition period  from          to**        |

 

**Commissionfile number: 000-30819**

 

**Particle DrillingTechnologies, Inc.**

(Exact name of registrant as specifiedin its charter)

 

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

 

| **5611 Baird Court   Houston, Texas 77041**  (Address of principal executive offices) |
|---------------------------------------------------------------------------------------|

 

Registrant’s telephone number, including area code:

**713-223-3031**

 

**11757Katy Freeway Suite 1300Houston, Texas 77079**

(Formername, former address and former fiscal year, if changed since last report)

 

Securities registered Pursuant to Section 12(b) of the Act:

**None**

 

Securities registered Pursuant to Section 12(g) of the Act:

**CommonStock, par value $0.001 per share**

 

Indicate bycheck mark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act.     Yes o No x

 

Indicate bycheck mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of theAct.    Yes o No x

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports) and (2) has been subject tosuch filing requirements for the past90 days.     Yes x No o

 

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

 

Indicate bycheck mark whether the registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer. see definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act. (check one)

 
| Large accelerated  filer  o |   | Accelerated  filer  x |   | Non-accelerated  filer  o |
|---------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

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

 

The aggregatemarket value of the voting and non-voting common equity held by non-affiliatesof the registrant was approximately $99,373,500 as of March 31, 2007(based on the last sale price of such stock as quoted on the NASDAQ CapitalMarket).

 

As of December 6,2007, there were 31,629,901 shares of the registrant’s common stock, parvalue $0.001 per share, outstanding.

 

Documentsincorporated by reference: **None**

 

 

----

 

**TABLEOF CONTENTS**

 
| ** ** | **PART I**                                                                                                     | 3      |
|------------|---------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.    | Business                                                                                                            | 3      |
| Item 1A.   | Risk  Factors                                                                                                       | 9      |
| Item 1B.   | Unresolved Staff Comments                                                                                           | 13     |
| Item 2.    | Properties                                                                                                          | 13     |
| Item 3.    | Legal  Proceedings                                                                                                  | 13     |
| Item 4.    | Submission of Matters to a Vote of Security Holders                                                                 | 14     |
|       |                                                                                                                |   |
| ** ** | **PART II**                                                                                                    | 14     |
| Item 5.    | Market for Registrant’s Common Equity, Related Stockholder Matters  and Issuer Purchasers of Equity Securities | 14     |
| Item 6.    | Selected Financial Data                                                                                             | 16     |
| Item 7.    | Management’s Discussion and Analysis of  Financial Condition and Results of Operation                          | 17     |
| Item 7A.   | Quantitative and Qualitative Disclosures  About Market Risk                                                         | 22     |
| Item 8.    | Financial Statements and Supplementary Data                                                                         | 22     |
| Item 9.    | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                               | 44     |
| Item 9A.   | Controls and Procedures                                                                                             | 44     |
| Item 9B.   | Other Information                                                                                                   | 45     |
|       |                                                                                                                |   |
| ** ** | **PART III**                                                                                                   | 45     |
| Item 10.   | Directors, Executive Officers and Corporate  Governance                                                             | 45     |
| Item 11.   | Executive and Director Compensation                                                                                 | 50     |
| Item 12.   | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                     | 64     |
| Item 13.   | Certain Relationships and Related  Transactions and Director Independence                                           | 65     |
| Item 14.   | Principal Accountant Fees and Services                                                                              | 67     |
|       |                                                                                                                |   |
| ** ** | **PART IV**                                                                                                    | 67     |
| Item 15.   | Exhibits and Financial Statement Schedules                                                                          | 67     |

 

2

----

 

*Unlessthe context otherwise requires, all references in this report to the “Company,”“we,” “us,” or “our” are to Particle Drilling Technologies, Inc. and itssubsidiary.*

 

**PART I**

 

**Item1. Business**

 

**General**

 

Particle Drilling Technologies, Inc., aNevada corporation, is a holding company organized on June 14, 2002 andwas formerly known as MedXLink Corp. We changed our name to Particle DrillingTechnologies, Inc. on January 25, 2005, following the merger onJanuary 14, 2005 of our wholly-owned subsidiary with and into ParticleDrilling Technologies, Inc., a Delaware corporation (“PDTI”). Prior to ouracquisition of PDTI, we were a shell company. Currently our business consists ofone segment and is conducted solely in the United States. Information about ournet loss and total assets is located under “Item 8. Financial Statements andSupplementary Data.”

 

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

 

The patented PID System utilizes aspecially-designed “fit for purpose” drill bit fitted with jetting nozzles andpolycrystalline diamond compact cutting structures. We refer to this bit as the“PID bit.” The nozzles in the PID bit serve to accelerate hardened steelparticles entrained within ordinary drilling mud to fracture and remove theformation ahead of the bit. The particles flow back up the well bore annulusalong with the drilling mud and formation cuttings to the surface where the PIDSystem separates and re-circulates the steel particles. The PID System isoperated primarily utilizing hydraulic energy that is available on drillingrigs used today in combination with the PID System equipment. Each particle isdriven into the rock formation at a high velocity and delivers a force manytimes greater than the compressional strength of the rock, even in formationsthat exist in the subsurface at elevated hardness and stress. Depending on thevolume of particles introduced into the drilling mud, the number of particlestrikes on the formation is typically in excess of four million per minute,thereby yielding a higher rate of penetration than conventional drill bits insuitable formations.

 

By comparison, conventional drilling methodsrely on mechanical energy created by the weight and torque applied to a bit,and the amount of total rotational mechanical energy available on drilling rigsis limited. The result is that the bit gouges out smaller volumes of rock asthe compressional strength of the rock increases with depth and pressure. Webelieve the volume of rock excavated by the PID System is less affected by rockhardness or depth.

 

The PID System is designed to entrain,circulate, and recover the particles in the mud system without allowing theparticles to circulate through the rig pumps. The PID System is designed as a mobileservice that we expect to be provided to the oil and gas operator as part ofthe normal drilling process and is configured to service a well in progresswith minimal interference. The particle injection system used on the previouscommercial trials consisted of a stage one and stage two eductor mechanismwhich was powered by a high horsepower quintaplex frac pump. As we have gainedmore experience with PID drilling and have run the system for longer periods oftime, we have determined that the continuously increasing and fluctuating wellpressure encountered on recent trials resulted in unexpected levels ofmaintenance on the frac pump and caused difficulty in maintaining a continuousflow of particles to the drill bit. While the current particle injection systemhas allowed us to demonstrate the potential of the PID technology, it has beenunreliable. In April 2007, we began testing an extruder based injectionsystem and the associated pressure diffuser. The pressure diffuser wasdetermined to be unreliable in July and therefore we began testing apressurized extruder system. In early August 2007, we were able tosuccessfully inject particles, at a controllable rate, into pressures up to5,200 pounds per square inch (“psi”). This was the first time that goal wasachieved. The next step in the development required a pressure barrier thatwould allow the pressurized extruder to continuously refill with particles. Weselected a high pressure gate valve to serve as the pressure barrier andsuccessfully tested the gate valve in September 2007 for 3,000 cycles,representing approximately three days of operating time. Following this test,all necessary components needed to build the new particle injection system wereplaced on order. We anticipate that we will be able to assemble and commencein-house testing of  the new injectionsystem prior to December 31, 2007.

 

3

----

 

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

 

**BusinessStrategy and Plan of Operation**

 

We believe the PID System has now demonstratedthat drilling using the PID technology is feasible and offers an increased rateof penetration compared to conventional drilling tools in hard and abrasiverock formations. During the fiscal year ended September 30, 2007, wecompleted a total of three commercial field trials, each of which demonstratedan incremental improved performance in terms of both footage drilled andproductive drilling time. During our most recent commercial trial inMarch 2007, a significant portion of our non-productive drilling time(which prevented us from fully commercializing the PID technology) was due toinconsistent performance from our frac pump-based injection system. Followingthis trial, we decided to halt further drilling until such time as our newparticle injection system was fully developed and tested.

 

In April 2007, we began shop testing ourextruder-based injection system. This system relies upon an auger stylevolumetric feeder that is capable of delivering a controllable volume of steelparticles to the drilling rigs’ high pressure standpipe. This system wasinitially designed to use the steel particles themselves as a dynamic seal toprevent the high pressure fluid from migrating through the extruder andreaching the atmospheric opening on the top side of the extruder. In order toachieve the dynamic seal, the packed particles were to be fed into a highpressure tubular of sufficient length to diffuse the high pressure fluid comingfrom the drilling rig’s standpipe. This diffusion principle was tested by a thirdparty firm specializing in porosity and permeability measurements, althoughthis testing was done only under static conditions (that is, the packedparticles were not moving at the time of the test).

 

During the period from April toJuly 2007, we attempted to inject particles into a high pressure fluidline using the diffusion principle under dynamic conditions with limitedsuccess. The properties of the particles, the drilling mud and the overallconditions resulted in the inability to create a particle-pack of sufficientlength to diffuse pressure and resulted in the high pressure fluid migrating tothe atmospheric side of the extruder. After rigorous testing and consultationwith outside experts, we concluded that this solution would not work in a commercialsetting and decided in late July 2007 that it was necessary to pressurizethe entire extruder system.

 

In late July 2007, we removed thediffuser from the high pressure side of the extruder and inserted a highpressure chamber on what was previously the atmospheric side of the extruder.The high pressure chamber was sufficiently large to contain enough steelparticles to inject at the desired rate for approximately one minute. Thismodification was successful and it was determined that the steel particlescould be injected at the desired rate over a broad range of pressures and withvarying mud properties. Following this successful test, we then developed asecond chamber separated by a pressure barrier that was capable of closing withsteel particles entrained in the system. These pressure barriers were testedthrough enough cycles to confirm  thatthey are durable enough for commercial application. The upper chamber has beendesigned to feed the lower chamber on a continuous basis. We believe the newextruder based injection system will be fabricated and ready for shop testingin December 2007. We intend to test the system for 24 to 48 hours beforeproceeding to the field to conduct our next commercial trial.

 

During the past two fiscal years, we hiredseveral industry veterans to assist in the development, commercialization androll-out of this technology.  Further, we have successfully resolved manyof the surface equipment issues identified during previous trials. We expect tocontinuously improve efficiencies as we gain more experience with the PIDSystem and as the new extruder—based injection system becomes field proven.

 

Our operations plan for the remainder offiscal year 2008 includes: (1) completing the assembly and initial testingof the new extruder-based injection system in the first quarter of fiscal 2008;(2) completing a commercial field trial early in the second quarter offiscal 2008; (3) securing additional commercial contracts with potentialcustomers; (4) hiring and training additional field and technicalpersonnel; and (5) assembling additional PID Units.

 

Our initial target customers will continue tobe oil and gas operators drilling onshore wells in geologic basins of the U.S.and Canada known to have hard rock and/or highly abrasive formations. We willinitially focus our marketing and sales efforts on operators with multi-welldrilling programs centered in a few basins. Additionally, we will targetcustomers that exhibit a willingness to embrace emerging technologies.

 

4

----

 

We expect to deliver value to our customersas a specialty service provider utilizing our patented technology incombination with propritery equipment executed by our engineering and fieldpersonnel. Based on the experience of our management team in the oilfieldservices industry, we believe that no other company currently attempts todeliver a comparable drilling service utilizing technology that is similar tothe PID System and that is targeted to serve the hard rock drilling market.Instead, we believe suppliers generally design and sell products for hard rockenvironments that are based on conventional drilling technology.

 

We expect to operate in a fashion morecomparable to a directional drilling or well stimulation service provider. Wewill provide our system and field personnel to exploration and productionoperators, service companies and drilling contractors to operate our system asan integral component of the drilling operation.  Initially, we intend tooffer our services on a gain sharing basis whereby the cost saved as a resultof using the PID System will be shared between us and the exploration andproduction operator. The PID System is expected to result in higher rates ofpenetration, thereby reducing drilling costs and lowering finding anddevelopment costs to improve the overall economics of the oil and gas industryin certain geologic intervals. In addition, we believe that our customer’sability to reduce drilling days on their hard rock intervals will translateinto more efficient rig utilization, which in turn should allow our customersto drill more wells per year per drilling rig.  While this gain sharingbusiness model is our preferred method to gain market share, we believe thatequal or greater returns can be achieved through the sale of PID bits andthrough a more traditional dayrate or fixed fee structure. Initially, we intendto utilize the revenue model most preferred by our potential customer base solong as satisfactory returns are realized.

 

**Industry**

 

Oil and natural gas markets have seen arobust pricing environment since 2002. While there has been a decline innatural gas prices during 2007, oil prices have reached record highs. Whilenatural gas prices have recently decreased from historic highs as a result ofmoderate temperatures and high inventories, we believe the underlyingfundamentals continue to support drilling activities and long term natural gasprices. As of November 16, 2007, the Baker Hughes U.S. land rig count was at1,706, a 7.5% increase from a year earlier.

 

 Theincrease in working rigs coupled with softer than expected natural gas pricesduring 2007 has resulted in a decrease in rig day rates that have otherwiseenjoyed significant and steady increases over the last five years; however,overall domestic and foreign drilling activity and rig utilization levels areprojected to continue to be strong. Current land rig utilization rates areapproximately 85% in the U.S. and approximately 95% in key foreign markets.Although there may be occasional decreases in rig day rates due to increasedrig supply, we expect rig utilization and drilling activity levels willcontinue to be robust throughout 2008.

 

We do not believe the current conventionaldrilling process using traditional rotary rig equipment and conventional drillbits has fundamentally changed for many years. Typically, gains in rates ofpenetration and absolute drilling efficiency were very small and incrementaluntil 1989. At that time, fixed cutter polycrystalline diamond compact bits, or“PDC bits,” became a functional alternative to roller cone bits for a limitedbut growing segment of the drilling market. This technology was focused onwells drilled in softer formations as PDC bits could achieve higher rates of penetrationand longer run times, both of which achieved appreciable cost savings byreducing drilling time. The industry has adopted PDC bits for these specificapplications, although a PDC bit often costs several times more than acomparable roller cone bit.  Despite the increased effectiveness of thePDC bit and other technologies, we believe that operators continue to activelyseek ways to improve rates of penetration, particularly in hard rock andabrasive formations, and are very receptive to using promising new technologiesto reduce well construction cost.

 

**The PID System**

 

*Particle RecoverySystem –* The PID System utilizes a mobile particledelivery and recovery system capable of operating with conventional drillingrigs used in our target markets. Our system is designed to entrain, circulate,and recover the particles without allowing the material to pass through the rigpumps. Previous particle abrasive drilling systems did not have the ability tocirculate, separate, and re-inject the abrasive or abrading particles and thematerial passed through the normal rig pumps. An example is the system known as“Abrasive-Jet Drilling” used by Gulf Research and Development Co., a divisionof Gulf Oil Corporation (“Gulf”), in the 1960’s and 1970’s. Gulf made a numberof significant advances in the technology of delivering particles underpressure for the purpose of increasing rate of penetration. Basically, the Gulfsystem used fine particle abrasives to abrade the formations in order to removeit. This technology requires very high surface pressures of up to 11,000 psi inorder to give the small particle the velocity to abrade the formation ahead ofthe drill bit. In contrast, the PID System utilizes larger particles at normalrig pressures to fracture the formation ahead of the drill bit.

 

5

----

 

*Rig Integration*—The PID System is designed to connect to and service an operational well inprogress with minimal interference to normal drilling operations. All PIDSystem equipment is either mounted on  skidsor trailers, and can be coupled to a conventional drilling rig during ascheduled bit trip. A good portion of the PID System is mobilized and rigged upoffline so as not to interfere with the drilling operation in progress. Oncethe operator is finished with the PID interval, the PID System can generally betaken offline during a bit trip without interfering with normal drillingoperations. We believe this operational transparency is extremely important forindustry acceptance of the PID System.

 

*PID Bit* – We arecontinuing the development of our fit-for-purpose PID bit. The PID bit is afixed-cutter and nozzle bit designed with a PDC cutting structure.  Todate, we have developed and tested a 7 7/8 inch PID bit and an 8 1/2 inch PIDbit and have completed the investment casting process on both PID bits so thatwe can mass produce PID bits at a cost that is less than half the cost of ourprevious PID bits.  Further, we have initiated the design of a 6 1/2 inchPID bit in order to address deeper drilling markets identified to us byprospective customers.

 

**Testing of the PID System**

 

We have now completed four full scalecommercial trials using the PID technology. The first three trials wereconducted in the Uinta basin in Utah with Gasco Energy, Inc. The firsttrial was completed in April of 2006 and the last trial was completed in December2006. During these trials, we deployed for the first time the patented PIDSystem on an actual gas well drilling at depths below 10,000 feet. During thesethree tests, we demonstrated (i) the PID System was capable of deliveringrates of penetration that were in-line with or greater than our targetpenetration rates, which are three times faster than conventional drillingtechniques, (ii) we could inject particles while drilling and(iii) we could successfully recover steel particles from the well bore.Due to the age and condition of the drilling rig used on the first trial, weexperienced certain rig integration issues which were resolved prior to thecompletion of the first trial. We also demonstrated our ability to recover thesteel particles from the well bore even following a complete rig pump shutdown. During this trial, we demonstrated on multiple occasions  that the PID technology does not damage thewell bore, even in situations where several thousand pounds of steel particlessettle on top of the PID bit.

 

In order to achieve continuous PID drillingoperations, it is critical to continuously inject and recover the injectedparticles from the well bore, process them and prepare them for reinjection.During the first field trial, the PID System particle recovery unit becameoverrun with steel particles and was no longer capable of recovering theparticles for re-injection. This accounted for 90% of the PID System’sdowntime. Based on this experience and the likelihood for this particlerecovery unit to cause problems on future wells, we designed a completely newparticle recovery unit that was tested successfully on trials two and three.This new recovery unit will be incorporated into all future PID Units.

 

In November 2006, we completed oursecond commercial trial with Gasco. On this trial, we entered the well at adepth of 11,535 feet and drilled approximately 92 feet in 7 hours during thefirst day of drilling. Certain issues with our frac pump driven injector systemlimited our drilling performance on the second day and the trial was concludedafter drilling a total of 118 feet. The subsequent conventional bit averaged 90feet in each 24-hour period during the following five days.

 

In December 2006, we completed our thirdcommercial trial with Gasco. On this trial, we further improved our performanceby drilling approximately 121 feet in 8 hours during a 24-hour period. This wasour best performance to date, although the frac pump suffered maintenanceissues and we were forced to suspend drilling.

 

In February 2007, we signed a one-yearcontract with a large independent oil and gas company that is operating in theUnited States to conduct a series of commercial trials in the Deep Bossiertrend in east Texas. In March 2007, we completed the assembly of our newPID System that included  a second fracpump. The new PID System is skid mounted, which allows for quicker rig-up andrig-down. It is also fully automated, based on a variable frequency electricdrive system and contains several redundant components further minimizing therisk of disruption.

 

In March 2007, we conducted our firstfield trial with this operator in the Travis Peak Formation, which we believeis one of the most abrasive and hard formations in the world. During this fieldtrial, we drilled approximately 212 feet in 12 hours during our first 24 hoursof drilling, a substantial improvement from our prior field trials. This trialwas suspended as a result of our inability to continue particle injectionbecause of  injector related issues.

 

The frac pump suffered a number ofperformance related issues on several of the commercial trials. For example,once drilling reached a total depth of approximately 12,500 feet on the TravisPeak trial, the frac pump was unable to generate enough pressure to continueconsistent particle injection rates though it was running at close to its peaksustainable performance level.

 

6

----

 

Despite the successful improvement indrilling performance from well to well, we determined in April 2007 tofocus on the continued development and testing of a new particle injectionsystem and notified our customers that we would not conduct any further fieldtrials until such time as a new injection system was field ready.

 

Our primary products still need todemonstrate commercial reliability in order to fully realize the potential ofthe PID technology. Our operations plan calls for completion of the newinjection system and further research and development,  followed by a second commercial trial in theTravis Peak formation in east Texas. Poor performance of our new particle injectionsystem or other unexpected events while conducting future commercial trialscould further extend the shop and laboratory testing phase, which would delaythe full commercialization of the PID System and increase the funds needed tocomplete our research and development. This would have the effect of slowingour advancement as funds otherwise intended to build new PID Systems and expandour operations may be needed to conduct additional research and development.

 

**Competition**

 

We believe that no other company currentlyattempts to deliver a comparable drilling service utilizing technology that issimilar to the PID System and that is targeted to serve the hard rock drillingmarket. It is important to note that the oilfield services industry is highlycompetitive, and most of our potential competitors have greater financialresources than we do. Many of our potential competitors have been in theoilfield service business for many years and have well-established businesscontacts with exploration and production companies. Competitors may enter marketsserved or proposed to be served by us, and we may not be able to competesuccessfully against such companies or have adequate funds to competeeffectively. Recent developments in PDC bits have made them more durable andcapable of drilling in certain hard rock environments; however, many customersoperating in our target markets continue to utilize conventional bits.

 

**Patents**

 

Our predecessor company acquired theintellectual property and certain assets and assumed certain liabilitiesunderlying the PID technology in January 2004 pursuant to certainacquisition agreements in which we agreed to (1) purchase certain of theassets and assume certain of the liabilities of ProDril Services Inc. (“PSI”)and ProDril Services International, Ltd. (“PSIL”) related to the PIDtechnology, (2) purchase certain patents related to the PID technologyfrom Curlett Family Limited Partnership, Ltd. (“CFLP”), (3) acquirecertain technology licenses from CCORE Technology and Licensing, Ltd. (“CTL”),(4) continue the funding of initial research and development expenses withrespect to the technology acquired, and (5) take steps towards thecommercialization of the PID technology.

 

Pursuant to such acquisition agreements withCFLP, we acquired from CFLP their entire right, title and interest throughoutthe world in and to patents related to the PID technology, including all CFLPinventions and the following patents:

 

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

•      Patentsin Canada, Australia, and Great Britain that correspond to U.S. PatentNo. 6,386,300

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

•      U.S.Patent No. 7,258,176, issued April 21, 2007, entitled “Drill Bit.”

 

In addition to the inventions embodied in theCFLP patents described above, we have made system improvements and inventionsapart from the CFLP agreement.  Accordingly, we have since made numerousother applications for patents, including provisional, utility andcontinuation-in-part patent applications for various PID System components andapparatuses.  There are presently 41 pending patentapplications:  15 in the United Statesand 26 outside of the United States.  One of the United Statesapplications was recently allowed and is in the process of being formallyissued by the United States patent office and all others are pending.

 

In connection with our acquisition of the PIDtechnology, we agreed to make certain royalty payments to PSI and PSIL. Under ouragreement with PSI, we are obligated to pay PSI a royalty on a quarterly basisequal to 18.0% of our earnings before interest, income taxes, depreciation andamortization (“EBITDA”) derived from the use of the PID technology for suchquarter until an aggregate of $67,500,000 has been paid to PSI. Under ouragreement with PSIL, we are obligated to pay PSIL a royalty on a quarterlybasis equal to 2.0% of our EBITDA derived from the use of the PID technologyfor such quarter until an aggregate of $7,500,000 has been paid. We have alsoentered into additional royalty agreements that require us to pay a total of4.0% of our quarterly gross revenue derived from the use of the PID technologyto certain entities from 

 

7

----

 

which we acquired the PID technology. These royalty obligations willhave the effect of limiting our liquidity and our profitability. As ofSeptember 30, 2007, no payments had been made or accrued with respect tothese royalty obligations.

 

We have continued to enhance and improve uponthe PID technology and to develop additional technology and know-how in theapplication of the PID technology. The PID technology and related technologiesremain core to our business, and we have continued to seek patent protection inthe United States and other countries in which we expect there to be asignificant market for our technology.

 

**Research and Development**

 

We are in the early phase of commercialdeployment and will continue to invest in research and development. Ourresearch and development program is intended to improve existing products andprocesses, develop new products and processes, and improve engineeringstandards and practices that will serve the changing needs of our customers.Our expenditures for research and development activities were $5,894,101 in2007, $5,964,438 in 2006, and $2,802,155 in 2005.

 

In oureffort to enhance the PID technology, we will continue to seek less expensiveways to manufacture PID bits and other key components of our system and toidentify efficiencies going forward. Further, we intend to continue investingin research and development in order to expand the market opportunities for PIDtechnology.

 

**Environmental Regulations**

 

We are subject to numerous and changinglocal, state, and federal laws and regulations concerning the use, storage,treatment, disposal and general handling of materials, some of which may beconsidered to be hazardous substances and wastes, and restrictions concerningthe release of pollutants and contaminants into the environment. These laws andregulations may require us to obtain and maintain certain permits and otherauthorizations mandating procedures under which we must operate and restrictemissions and discharges. Many of these laws and regulations provide for strictjoint and several liabilities for the costs of cleaning up contaminationresulting from releases of regulated materials, substances and wastes into theenvironment. Violation of these laws and regulations as well as terms and conditionsof operating permits issued to us may result in the imposition ofadministrative, civil, and criminal penalties and fines, remedial actions or,in more serious situations, shutdowns or revocation of permits orauthorizations. We believe that future compliance by our operating businesseswith existing laws and regulations will not have a material adverse effect onus and that future capital expenditures for environmental remediation will notbe material.

 

We regularly monitor and review ouroperations, procedures and policies for compliance with environmental laws andregulations and our operating permits. There can be no assurance that a reviewof our past, present or future operations by courts or federal, state, local orforeign regulatory authorities will not result in determinations that couldhave a material adverse effect on us. In addition, the revocation of any of ourmaterial operating permits, the denial of any material permit application orthe failure to renew any interim permit, could have a material adverse effecton us. In addition, compliance with more stringent environmental laws andregulations, more vigorous enforcement policies, or stricter interpretations ofcurrent laws and regulations, or the occurrence of an industrial accident, couldhave a material adverse effect on us.

 

**Employees**

 

As of December 13, 2007, we had 22employees. None of our employees are covered by collective bargainingagreements. We believe that relationships with our employees are satisfactory.

 

**Website**

 

Our website is www.particledrilling.com. Thefilings we make with the Securities and Exchange Commission (“SEC”), such asAnnual Reports on Form 10-K, Quarterly Reports on Form 10-Q, CurrentReports on Form 8-K, and amendments to those reports, are available free ofcharge through our website as soon as reasonably practicable after they havebeen filed with or furnished to the SEC pursuant to Section 13(a) or15(d) of the Securities and Exchange Act of 1934 (the “1934 Act”). Forms 3, 4 and 5 filed with respect to equity securities underSection 16(a) of the 1934 Act are also available on ourwebsite.  All of these materials are located at the “Investor Relations”link on our website.

 

Our website also includes the followingcorporate governance materials, at the link “Corporate Governance”: the Code ofBusiness Conduct & Ethics and charters of each Board committee,consisting of  the Audit Committee, theCompensation Committee, and the Nominating and Corporate Governance Committee.You may also obtain a printed copy of any of the 

 

8

----

 

materials referenced above by contacting us through our website or atthe following address: Particle Drilling Technologies, Inc., 5611 BairdCourt, Houston, Texas 77041.

 

**Item 1A. Risk Factors**

 

***We have limited sources ofliquidity and may not be able to obtain sufficient funding to realize positivecash flows***.

 

We require substantial capital to pursue ouroperating strategy and execute our business plan. As we have no revenue andtherefore limited sources of cash, we will continue to rely on external sourcesfor liquidity, and for the foreseeable future, our principal source of workingcapital will be from capital we have raised through private placements of oursecurities and other external sources. In management’s opinion, based onavailable cash and cash equivalents on hand as of September 30, 2007, wewill need to reduce overhead and research and development costs as compared toprevious years, complete the sale of various non-core assets or may need toraise additional outside capital in order to maintain sufficient liquidity tomeet our working capital and capital expenditure requirements for the next 12months.

 

Our current monthly operating overhead isapproximately $350,000, excluding research and development project costs andnon-cash expenses such as depreciation, stock-based compensation and othernon-cash expenses, and we expect that such amount will increase as we expandour operations. Should we require additional capital, we may not be able toobtain funds from external sources in sufficient amounts to fund our businessplan.

 

Even if we are able to demonstrate fullcommercial success with our products, we may require additional capital in thefuture to produce our products in sufficient commercial quantities in order forus to realize positive cash flows. Any such additional capital may lead toadditional dilution of our shareholders. Additionally, it may be difficult forus to raise additional capital in sufficient quantities or at all.

 

***We have a limited operatinghistory and no revenues and are subject to risks inherent in a new businessenterprise. As a result, we have not demonstrated to date that we can fullyimplement our business plan or that the PID technology will be profitable in acommercial application.***

 

The business of PDTI was originallyestablished in June 2003 to: (1) purchase certain of the assets andassume certain of the liabilities of PSI and PSIL related to the PIDtechnology; (2) purchase certain patents underlying the PID technologyfrom CFLP; (3) acquire certain technology licenses related to the PIDtechnology from CTL; (4) continue the funding of research and developmentexpenses with respect to the technology acquired; and (5) take stepstowards the commercialization of the PID technology. To date, the business hasnot generated revenue from its operations. We may not be able to fullycommercialize our product or generate profitable revenues. Additionally, we andour business have a limited operating history that investors can analyze to aidthem in making an informed judgment as to the merits of an investment in us.Any investment in us should be considered a high risk investment because youwill be investing in a company with unforeseen costs, expenses, competition,and other problems to which new ventures are often subject. In addition, thetechnology we acquired is still in the early stage of development forcommercial use and has produced only limited results in a commercial setting.Because we are an early stage company, our prospects must be considered inlight of the risks, expenses, and difficulties encountered in establishing anew business in a highly competitive industry.

 

***The PID System is a newtechnology and it may not be fully accepted in the marketplace to the degreeanticipated by management.***

 

The PID technology has only been used ordeployed in limited commercial gas wells. To management’s knowledge, no companyhas yet marketed a salable product using the technology we are developing.Market acceptance of our products will largely depend upon our ability todemonstrate the PID System’s efficiency, cost effectiveness, safety featuresand ease of use. We may not be able to demonstrate that the PID System caneffectively be deployed on a significant number of commercial oil and gas wellsin a safe and cost-effective manner. The use of the PID technology will alsodepend upon concerted sales efforts by our management team. The PID System maynever be fully accepted in the market in preference to other competingtechnologies that currently exist or that may subsequently be developed. If ourproducts are not fully accepted by the marketplace, we may not realizesufficient revenues or cash flow to execute our operations plan and we may beforced to pursue a different strategy or liquidate our company.

 

In order to enter the oilfield servicesmarket on a full scale basis, we must successfully complete additional researchand development, the cost of which may exceed the amounts we have budgeted inour operations plan. Any such cost overruns 

 

9

----

 

could exhaust our available capital and force us to raise additionalcapital, which capital may not be available or may lead to additional dilutionof our shareholders.

 

Our primary products must demonstratesatisfactory performance in a significant number of oil and gas wells. Ouroperations plan calls for further research and development, including thedevelopment of different bit sizes and the completion of our development effortto deliver a new particle injection system. Poor performance of the PID bit orother components of the PID System while conducting commercial trials couldreveal additional unidentified issues and further extend the shop andlaboratory testing phase, which could further delay the full commercializationof the PID System and increase the funds needed to complete our research anddevelopment. Further, in order to fully implement our business plan, we will berequired to hire and train a substantial number of new employees. Currently,the oilfield industry is strained and operating at near full capacity from ahuman resource perspective, which could limit our ability to hire and trainadequate qualified personnel. These circumstances would have the effect ofslowing our advancement as funds otherwise intended to build new PID Systemsand expand our operations may be needed to conduct additional research orprocure and train adequate human resources.

 

Regardless of the success of the initial researchand development, we will require additional research and development andcapital spending to continuously improve our service capabilities and expandour operations. In addition, regardless of the amount of research anddevelopment completed by us, our products may never be fully adopted in asignificant number of oil and gas wells.

 

***We are obligated to make certainroyalty payments that will limit our profitability.***

 

In connection with our acquisition of the PIDtechnology, we agreed to make certain royalty payments to PSI and PSIL. Underour agreement with PSI, we are obligated to pay PSI a royalty on a quarterlybasis equal to 18.0% of EBITDA derived from the use of the PID technology forsuch quarter until an aggregate of $67,500,000 has been paid to PSI. Under ouragreement with PSIL, we are obligated to pay PSIL a royalty on a quarterlybasis equal to 2.0% of our EBITDA derived from the use of the PID technologyfor such quarter until an aggregate of $7,500,000 has been paid. We have alsoentered into additional royalty agreements that require us to pay a total of4.0% of our quarterly gross revenue derived from the use of the PID technologyto certain entities from which we acquired the PID technology. These royaltyobligations will have the effect of limiting our liquidity and ourprofitability.

 

***We rely on the intellectualproperty rights we acquired to the PID technology and we may not be able tosuccessfully protect or defend our intellectual property rights. Ourcompetitive position depends to a significant extent on our ability to assertand defend our intellectual property rights in order to restrict othercompetitors from offering similar services.***

 

Our success depends on certain patents andpatent applications that we purchased from CFLP, CTL, PSI and PSIL, along withother proprietary intellectual property rights we have developed or intend todevelop. We rely on a combination of nondisclosure and other contractualarrangements and trade secret, patent, copyright, and trademark laws to protectour proprietary rights and the proprietary rights of third parties from whom welicense intellectual property. The steps we have taken to protect our rightsmay not be adequate to deter misappropriation of our proprietary information.We also may not be able to detect unauthorized use of and take appropriatesteps to enforce our intellectual property rights. In addition, the laws ofsome foreign countries may not protect our proprietary rights as fully or inthe same manner as do the laws of the United States. Also, despite the stepstaken by us to protect our proprietary rights, others may develop technologiesthat are similar or superior to the PID technology and/or design around theproprietary rights we own.

 

We are also subject to the risk of litigationalleging infringement of third-party intellectual property rights. Any suchclaims could require us to spend significant sums in litigation, pay damages,develop non-infringing intellectual property or acquire licenses to theintellectual property which is the subject of the asserted infringement. If weare unable to successfully enforce our intellectual property rights, or ifclaims are successfully brought against us for infringing the intellectualproperty rights of others, such events could cause us to pay substantialdamages, cause us to lose a key competitive advantage, force us to conductadditional research to develop non-infringing technology or cause us to have topursue a different business strategy.

 

***We may face intense competitionin our industry from companies with a more established reputation and greaterfinancial resources than us.***

 

The oilfield services industry is highlycompetitive, and most of our potential competitors have greater financialresources than we do. Many of our potential competitors have been in theoilfield drilling business for many years and have 

 

10

----

 

well-established business contacts with exploration and productioncompanies. Competitors may enter markets served or proposed to be served by us,and we may not be able to compete successfully against such companies or haveadequate funds to compete effectively.

 

***If weare able to successfully commercialize the PID technology, we expect thatdemand for our PID System will depend on oil and natural gas industry activityand expenditure levels that are directly affected by trends in oil and naturalgas prices and other factors.***

 

If we are able to successfully commercializethe PID technology, we expect that demand for our PID System will besubstantially dependent on the level of exploration, development and productionactivity of, and the corresponding capital spending by, oil and natural gascompanies. Oil and natural gas companies typically reduce exploration anddevelopment activity during periods of low or volatile oil and natural gasprices. The markets for oil and natural gas historically have been volatile andare likely to continue to be so in the future. Prices for oil and natural gasare subject to large fluctuations in response to relatively minor changes inthe supply of and demand for oil and natural gas, market uncertainty and avariety of other factors that are beyond our control. Any prolonged reductionin oil and natural gas prices will depress the level of exploration,development and production activity by our customers which will result in adecrease in the demand for our PID System and could have a material adverseeffect on our financial condition or results of operations.

 

Factors affecting the prices of oil andnatural gas include:

 

•                  thelevel of demand for oil and natural gas;

 

•                  worldwidepolitical, military and economic conditions, including, but not limited to, theability of the Organization of Petroleum Exporting Countries to set andmaintain production levels and prices for oil;

 

•                  oiland natural gas production/inventory levels;

 

•                  thepolicies of governments regarding the exploration for and production anddevelopment of their oil and natural gas reserves;

 

•                  globalweather conditions;

 

•                  interestrates and cost of capital; and

 

•                  taxlaws.

 

***Becauseour PID System is used in potentially hazardous applications and operations,our business is subject to risks associated with events that result in personalinjuries, loss of life, damage to or destruction of property, equipment or theenvironment and suspension of operations.***

 

Our PID System is used in potentiallyhazardous drilling applications. These activities are dangerous and accidentscan result in:

 

•                  personalinjury;

 

•                  lossof life;

 

•                  damageto or destruction of property, equipment and the environment; and

 

•                  suspensionof operations.

 

Litigation arising from a catastrophicoccurrence at a location where our PID System is used may result, in thefuture, in our being named as a defendant in lawsuits asserting potentiallylarge claims.

 

The frequency and severity of any of theseincidents would affect our operating costs, insurability and relationships withcustomers, employees and regulators. Any increase in the frequency or severityof these incidents, or the general level of 

 

11

----

 

compensation awards resulting from these incidents, could affect ourability to obtain projects from oil and natural gas companies or insurancecovering these incidents.

 

***Compliancewith environmental and other government regulations could adversely affect ourbusiness.***

 

Our business is significantly affected byfederal, state and local laws and regulations relating to:

 

•                  theoil and natural gas industry; and

 

•                  workersafety and environmental protection.

 

If we are able to successfully commercializethe PID technology, we expect that demand for our PID System will be affectedby a variety of factors, including taxes, price controls and the adoption oramendment of laws and regulations. For example, the adoption of laws andregulations curtailing the exploration and development of oil and natural gasin our expected areas of operation for economic, environmental or other policyreasons could adversely affect our operations by limiting demand for ourproducts and services.

 

 Thetechnical requirements of the foreign, federal, state and local laws andregulations affecting our businesses are becoming increasingly complex andstringent. For instance, some environmental laws may provide for “strictliability” for damages to natural resources or threats to public health andsafety, rendering a party liable for environmental damage without regard tonegligence or fault on the part of the party. Sanctions for noncompliance withthese laws and regulations may include:

 

•                  revocationof permits;

 

•                  issuanceof corrective action orders;

 

•                  assessmentof administrative, civil or criminal penalties; and

 

•                  issuanceof injunctions restricting or prohibiting our operations.

 

Some environmental laws provide for joint andseveral strict liability for remediation of spills and releases of hazardoussubstances. In addition, we may be subject to claims alleging personal injuryor property damage as a result of alleged exposure to hazardous substances, aswell as damage to natural resources. These laws and regulations also may exposeus to liability for the conduct of, or conditions caused by, others, or for ouracts that were in compliance with applicable laws at the time the acts wereperformed.

 

***Our stockholders may experiencesubstantial dilution as a result of the exercise of outstanding options andwarrants to purchase our common stock or future issuances of additional sharesof our common stock, any of which could have an adverse effect on the marketprice of our common stock.***

 

In connection with our acquisition of oursubsidiary, Particle Drilling Technologies, Inc., a Delaware corporation,we assumed warrants to purchase 86,141 shares of common stock and optionsissued under PDTI’s 2004 Incentive Stock Plan to purchase 2,760,000 shares ofcommon stock. In connection with the private placement of our common stock inFebruary 2005, we granted the placement agent warrants to purchase1,500,000 shares of our common stock, of which 205,000 were still outstandingas of  September 30, 2007. Inconnection with the private placement of our common stock in October 2006,we granted the investors warrants to purchase 1,500,000 shares of our commonstock. Since our acquisition of PDTI, we have issued options to purchase anadditional 1,303,375 shares of our common stock under our equity incentiveplans. The common stock issuable upon exercise of these options and warrantsrepresents approximately 18% of our outstanding shares of common stock on afully-diluted basis. The exercise of these options and warrants would result insubstantial dilution to our existing stockholders and any sales of these sharesof common stock, or the perception that these sales might occur, could lowerthe market price of our common stock.

 

We may also issue additional shares of ourcommon stock or other securities that are convertible into or exercisable forcommon stock in connection with the hiring of personnel, future acquisitions,future public offerings or private placements of 

 

12

----

 

our securities for capital raising purposes, or for other businesspurposes. Future sales of substantial amounts of our common stock, or theperception that sales could occur, could have a material adverse effect on themarket price of our common stock.

 

***Our common stock has experienced,and may continue to experience, price volatility. The limited trading volume ofour common stock may contribute to this price volatility.***

 

The trading price of our common stock hasbeen, and may continue to be, highly volatile. We believe this volatility isdue to, among other things, our lack of revenues, current expectations of ourfuture financial performance and the volatility of the stock market in general.

 

Moreover, our common stock, which begantrading on The NASDAQ Capital Market® on June 28, 2005, doesnot have substantial trading volume. During the year ended September 30,2007, the average daily trading volume of our common stock as reported by TheNASDAQ Capital Market® was approximately 121,000 shares, whichrepresents less than 1% of our outstanding shares of common stock. As a result,relatively small trades of our common stock may have a significant impact onthe price of our common stock and, therefore, may contribute to the pricevolatility of our common stock.

 

Because of the limited trading volume in ourcommon stock and the price volatility of our common stock, you may be unable tosell your shares of common stock when you desire or at the price you desire.Moreover, the inability to sell your shares in a declining market because ofsuch illiquidity or at a price you desire may substantially increase your riskof loss.

 

***We presently do not intend to paycash dividends on our common stock.***

 

We currently anticipate that no cashdividends will be paid on our common stock in the foreseeable future. While ourdividend policy will be based on the operating results and capital needs of thebusiness, we anticipate that all earnings, if any, will be retained to financethe future expansion of our company.

 

**Item 1B. Unresolved Staff Comments**

 

None Applicable

 

**Item 2. Properties**

 

We currently lease our 48,750 square footexecutive office and industrial facility located at 5611 Baird Court, Houston,Texas 77041. The term of this lease is for 60 months and commenced inSeptember 2007.

 

We believe that our property is generally ingood condition, is well maintained, and is generally suitable and adequate toconduct our business.

 

**Item 3.  Legal Proceedings**

 

On February 17, 2006, PDTI closed asettlement agreement, entered into on February 8, 2006, related to certainlitigation styled Cause No. 2004-63506, *ParticleDrilling Technologies, Inc. vs. Harry B. Curlett, Curlett Family LimitedPartnership, Ltd., CCore Technology and Licensing, Ltd., and Deep Heat EnergyCorporation*, in the 333rd Judicial District Court of Harris County,Texas.  As part of the settlement agreement, all parties released allclaims against each other, and, on February 21, 2006, the Court dismissedall claims among the parties with prejudice.  The Court’s dismissal becamefinal on March 24, 2006.

 

Also as part of the settlement agreement,PDTI and Curlett Family Limited Partnership, Ltd. (“CFLP”) amended theExclusive License Agreement between PDTI’s predecessor, ProDril AcquisitionCompany, and CFLP, dated June 1, 2003, to limit the parties’ respectiveobligations to share information with each other and to terminate as ofFebruary 18, 2006, the parties’ respective rights to the other party’simprovements to the PID Technology.  The settlement agreement providedthat the parties would integrate these amendments into an Amended ExclusiveLicense Agreement by March 10, 2006.

 

During efforts to draft an Amended ExclusiveLicense Agreement reflecting the amendments made in the settlement agreement,CFLP took the position that PDTI has a greater obligation to share informationwith it than provided in the amendments and that CFLP has greater rights inPDTI’s improvements than provided in the amendments.  On March 20, 

 

13

----

 

2006, PDTI and CFLP were unable to settle their dispute over theseissues through mediation.  Prior to the conclusion of that process,however, CFLP filed the following lawsuit.

 

On March 24, 2006, CFLP filed CivilAction No. 4:06-CV-01012, *Curlett Family LimitedPartnership, Ltd. v. Particle Drilling Technologies, Inc., a DelawareCorporation, and Particle Drilling Technologies, Inc., a NevadaCorporation*, in the United States District Court for the SouthernDistrict of Texas, Houston Division.  In that lawsuit, CFLP requested theCourt to construe the Exclusive License Agreement, as amended by the settlementagreement, as imposing a greater obligation on PDTI to share information with CFLPthan PDTI believes exists and as giving CFLP greater rights in PDTI’simprovements than PDTI believes exists.  In addition, CFLP claimed thatPDTI breached the settlement agreement and exclusive license agreement andsought specific performance of those agreements and lost profits damages of$26,000,000 per month.

 

On June 15, 2006, the Court granted asummary judgment in favor PDTI and against CFLP, thereby disposing of all ofCFLP’s claims against PDTI and granting PDTI declaratory relief as to theExclusive License Agreement, as amended by the settlement agreement. Thereafter, PDTI requested that the Court make an award against CFLP for a partof PDTI’s attorneys’ fees and expenses incurred in the lawsuit.  OnJuly 26, 2006, the Court ordered that PDTI recover $26,525 in attorneys’fees and $2,750 in expenses from CFLP.

 

On July 26, 2006, the Court signed ajudgment incorporating its orders on the summary judgment and attorneys’ feeissues.  Under the judgment, (1) CFLP took nothing by its claimsagainst PDTI, and PDTI was entitled to recover all taxable costs from CFLP; (2) after February 17, 2006, CFLPhad no license rights to any of PDTI’s improvements to the Licensed Patentsunder the Exclusive License Agreement, as amended by the settlement agreement,without qualification as to when PDTI made or acquired those improvements;(3) PDTI had no obligation to share any information with CFLP or discloseany information to CFLP except for information in the public domain that it isotherwise obligated to provide under the Exclusive License Agreement as amendedby the settlement agreement; and (4) PDTI was entitled to recover fromCFLP attorneys’ fees in the amount of $26,525 and expenses in the amount of$2,750 with interest thereon as provided by law and its taxable costs.  OnNovember 9, 2007, the United States Court of Appeals for the Fifth Circuitaffirmed the judgment in all respects except as to the award of attorneys’ feesand expenses.

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders**

 

No matters were submitted during the fourthquarter of fiscal year 2007 to a vote of the holders of our common stock,through the solicitation of proxies or otherwise.

 

**PART II**

 

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

** **

**Market Information**

 

Our common stock trades on the NASDAQ CapitalMarket under the symbol PDRT. The following table sets forth the high and lowbid prices per share of our common stock for the fiscal years endedSeptember 30, 2007 and 2006.

 
| ** **                                    | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------------------------------------|------------|----------|------------|---------|------------|
| **Fiscal Year Ended September 30, 2006** |       |     |       |    |       |
| First Quarter                                 |       | $        | 6.03       |    | $          | 3.58 |   |
| Second Quarter                                |       | $        | 7.50       |    | $          | 4.42 |   |
| Third Quarter                                 |       | $        | 6.22       |    | $          | 2.93 |   |
| Fourth Quarter                                |       | $        | 3.94       |    | $          | 2.50 |   |
|                                          |       |     |       |    |       |
| **Fiscal Year Ended September 30, 2007** |       |     |       |    |       |
| First Quarter                                 |       | $        | 4.50       |    | $          | 2.37 |   |
| Second Quarter                                |       | $        | 4.39       |    | $          | 3.34 |   |
| Third Quarter                                 |       | $        | 4.25       |    | $          | 2.05 |   |
| Fourth Quarter                                |       | $        | 3.42       |    | $          | 1.91 |   |

 

14

----

 

 

**Holders**

** **

The approximate number of holders of recordof the shares of our common stock was 243 as of December 3, 2007.

 

**Dividends**

 

Holders of shares of common stock will beentitled to receive cash dividends when, as and if declared by our Board ofDirectors, out of funds legally available for payment thereof. However, ifdividends are not declared by our Board of Directors, no dividends shall bepaid. We have not paid any dividends on our common stock during our two mostrecent fiscal years.

 

We do not anticipate that any cash dividendswill be paid in the foreseeable future. While our dividend policy will be basedon the operating results and capital needs of the business, we anticipate thatall earnings, if any, will be retained to finance our future expansion.Therefore, prospective investors who anticipate the need for immediate incomeby way of cash dividends from their investment should not purchase oursecurities.

 

**Securities Authorized for Issuance UnderEquity Compensation Plans**

 

The following table summarizes, as ofSeptember 30, 2007, certain information regarding equity compensation toour employees, officers, directors and other persons under our equitycompensation plans:

 
| **Plan category**                                        | ** ** | **Number of securities   to be issued upon   exercise of   outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise  price of   outstanding   options,   warrants and rights** | ** ** | **Number of securities   remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in   column (a))** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **(a)**                                                                                                                                                            | ** ** | **(b)**                                                                                                               | ** ** | **(c)**                                                                                                                                                                                                                  | ** ** |
| Equity compensation plans approved by  security holders*      |       | —                                                                                                                                                             |       | —                                                                                                                |       | 1,204,250                                                                                                                                                                                                                |       |
| Equity compensation plans not approved by  security holders** |       | 5,854,516                                                                                                                                                          |       | $                                                                                                                     | 2.18       |                                                                                                                                                                                                                     | 11,250     |   |
|                                                          |       |                                                                                                                                                               |       |                                                                                                                  |       |                                                                                                                                                                                                                     |       |
| Total                                                         |       | 5,854,516                                                                                                                                                          |       | $                                                                                                                     | 2.18       |                                                                                                                                                                                                                     | 1,215,500  |   |

 

----

*                    InMarch 2007, our shareholders approved and adopted the Particle DrillingTechnologies, Inc. 2007 Stock Incentive Plan. This plan provides for theissuance of up to 1,500,000 shares of common stock pursuant to incentive stockoptions, non-statutory stock options and restricted stock grants to ourdirectors, employees and consultants. Awards may be granted at not less thanthe fair market value (as defined in this plan) on the date the awards aregranted. The options expire ten years after the date of grant unless otherwisespecified in the award agreement.

 

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

 

•             InApril 2004, the Board of Directors of Particle Drilling, Inc.approved and adopted the 2004 Stock Plan. The stockholders of PDTI adopted thisplan in August 2004. This plan provides for the issuance of incentivestock options, non-statutory stock options and restricted stock grants to ourdirectors, employees and consultants. This plan provides for the issuance of optionsand restricted stock awards to purchase or issue up to 3,500,000 shares ofcommon stock. Awards may be granted at not less than the fair market value (asdefined in this plan) on the date such awards are granted. The options expireten years from the date granted unless otherwise specified in the awardagreement.

 

•             In March 2005, our Board of Directors approvedand adopted the Particle Drilling Technologies, Inc. 2005 Stock IncentivePlan. This plan provides for the issuance of non-statutory stock options andrestricted stock grants to our directors, employees and consultants. This planprovides for the issuance of options and restricted stock awards to purchase orissue up to 2,000,000 shares of common stock. Awards may be granted at not lessthan the fair market value (as defined in this plan) on the date the awards aregranted. The options expire ten years after date of grant unless otherwisespecified in the award agreement.

 

15

----

 

•             On April 30, 2004, Particle Drilling, Inc.granted warrants to ten consultants as consideration for services provided toParticle Drilling, Inc. Pursuant to these warrants, the ten consultantshave the right to purchase up to an aggregate of 19,000 shares of common stockof Particle Drilling, Inc. (consisting of warrants to purchase 5,000shares, 5,000 shares, 5,000 shares, and 4,000 shares). On June 17, 2004,Particle Drilling, Inc. granted warrants to an additional consultant forservices provided to Particle Drilling, Inc., pursuant to which suchconsultant has the right to purchase up to 10,000 shares of common stock ofParticle Drilling, Inc. The warrants described in this paragraph have anexercise price of $0.12 and a maximum term of five years from the date granted.All of these warrants were converted into warrants to purchase common stock ofPDTI in connection with the merger of Particle Drilling, Inc. into PDTI,and were then assumed by our company in connection with our acquisition ofPDTI.

 

•             On November 1, 2004, PDTI granted warrants totwo consultants as consideration for services provided to PDTI, pursuant towhich such consultants have the right to purchase up to 10,000 shares and 2,500shares, respectively, of common stock of PDTI. The warrants described in thisparagraph have an exercise price of $3.00 per share and maximum term of fiveyears from the date granted. In connection with our acquisition of PDTI, weassumed these warrants.

 

•             On January 11, 2005, PDTI granted warrants toeight parties affiliated with the placement agent as compensation for theirservices in connection with the private placement of PDTI Series Apreferred stock in January 2005. Pursuant to these warrants, the partiesaffiliated with the placement agent have the right to purchase up to anaggregate of 44,641 shares of our common stock (consisting of warrants topurchase 32,641 shares, 10,000 shares, and 2,000 shares). The warrantsdescribed in this paragraph have an exercise price of $2.00 and a maximum termof five years from the date granted. In connection with our acquisition ofPDTI, we assumed these warrants.

 

•             On February 9, 2005, we granted warrants toseven parties affiliated with the placement agent in connection with theprivate placement of our common stock in February 2005 as considerationfor services provided to us. Pursuant to these warrants, the parties affiliatedwith the placement agent have the right to purchase up to an aggregate of205,000 shares of our common stock (consisting of warrants to purchase 135,000 shares,30,000 shares, 25,000 shares and 15,000 shares). The warrants described in thisparagraph have an exercise price of $2.00 per share and a maximum term of tenyears from the date granted.

 

•             On October 17, 2006, we granted warrants toparties in connection with the private placement of our common stock inOctober 2006. Pursuant to these warrants, the parties affiliated with theplacement agent have the right to purchase up to an aggregate of 1,500,000shares of our common stock. The warrants described in this paragraph have anexercise price of $3.25 per share and a maximum term of ten years from the dategranted.

 

**UnregisteredSales of Equity Securities**

 

None.

 

**Item 6. Selected Financial Data**

 

The following table sets forth our selectedfinancial data derived from our consolidated financial statements. The selectedfinancial data should be read in conjunction with our consolidated financialstatements and notes thereto, included elsewhere in this report.

 

16

----

 
| ** **                                           | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | **Period from**       | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|-------------|------------------------|------------|-------------|------------|------------|------------|----------------------------|------------|
| ** **                                           | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | **June 9, 2003** | ** ** |
| ** **                                           | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | **(date of**          | ** ** |
| ** **                                           | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | **inception) to**     | ** ** |
| ** **                                           | ** ** | **Year Ended September 30,** | ** **  | **September 30,** | ** ** |
| ** **                                           | ** ** | **2007**                                    | ** **  | **2006**               | ** ** | **2005**    | ** ** | **2004**   | ** ** | **2003**                   | ** ** |
| ** **                                           | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | ** **                 | ** ** |
| **Statement of Operations Data:**                    |       |                                        |        |                   |       |        |       |       |       |                       |       |
| Revenues                                             |       | $                                           | —      |                   | $          | —      |       | $          | —     |                       | $          | — |   | $ | — |   |
| Operating expenses:                                  |       | —                                      |        | —                 |       | —      |       | —     |       | —                     |       |
| Research and development                             |       | 5,894,101                                   |        | 5,964,438              |       | 2,802,155   |       | 621,752    |       | 39,626                     |       |
| General and administrative                           |       | 4,942,621                                   |        | 4,581,604              |       | 3,182,313   |       | 2,683,024  |       | 503,158                    |       |
| Impairment of asset                                  |       | 295,260                                     |        | —                 |       | —      |       | —     |       | —                     |       |
| Loss from operations                                 |       | (11,131,982                                 | )           | (10,546,042            | )          | (5,984,468  | )          | (3,304,776 | )          | (542,784                   | )          |
| Other income (expenses)                              |       | 377,713                                     |        | 356,455                |       | 260,050     |       | (26,224    | )          | —                     |       |
| Net loss                                             |       | $                                           | (10,754,269 | )                      | $          | (10,189,587 | )          | $          | (5,724,418 | )                          | $          | (3,331,000 |   | $ | (542,784 | ) |
| ** **                                           | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | ** **                 | ** ** |
| **Basic and Diluted Net Loss Per Share:**            | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | ** **                 | ** ** |
| Loss from operations                                 |       | $                                           | (0.37       | )                      | $          | (0.43       | )          | $          | (0.27      | )                          | $          | (0.25 | ) | $ | (0.07 | ) |
| Net loss                                             |       | $                                           | (0.36       | )                      | $          | (0.42       | )          | $          | (0.26      | )                          | $          | (0.25 | ) | $ | (0.07 | ) |
| Weighted average shares outstanding                  |       | 30,185,030                                  |        | 24,520,619             |       | 22,150,365  |       | 13,364,183 |       | 7,741,646                  |       |
|                                                 |       |                                        |        |                   |       |        |       |       |       |                       |       |
| **Cash Flow Data:**                                  | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | ** **                 | ** ** |
| Net cash used in operating activities                |       | $                                           | (6,870,071  | )                      | $          | (7,192,123  | )          | $          | (4,625,184 | )                          | $          | (1,714,691 | ) | $ | (250,566 | ) |
| Net cash used in investing activities                |       | (1,629,629                                  | )           | (843,515               | )          | (1,723,254  | )          | (267,546   | )          | (351,031                   | )          |
| Net cash (used in) provided by financing  activities |       | 10,670,043                                  |        | (177,422               | )          | 16,832,721  |       | 1,999,098  |       | 605,099                    |       |
| ** **                                           | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | ** **                 | ** ** |
| **Balance Sheet Data (at end of period):**           | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | ** **                 | ** ** |
| Cash and cash equivalents                            |       | $                                           | 4,461,929   |                   | $          | 2,291,586   |       | $          | 10,504,646 |                       | $          | 20,363 |   | $ | 3,502 |   |
| Working capital surplus (deficiency)                 |       | 4,329,347                                   |        | 1,411,485              |       | 9,386,096   |       | (1,301,027 | )          | (5,575                     | )          |
| Total assets                                         |       | 7,827,079                                   |        | 5,483,362              |       | 13,548,413  |       | 1,570,585  |       | 362,033                    |       |
| Long-term debt                                       |       | 24,537                                      |        | 15,305                 |       | 9,463       |       | 20,201     |       | —                     |       |
| Total stockholders’ equity                      |       | 6,491,247                                   |        | 3,967,629              |       | 12,148,107  |       | 118,459    |       | 69,120                     |       |

 

**Item 7. Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

The following discussion of our financialcondition and results of operations should be read together with the unauditedconsolidated financial statements and related notes that are included elsewherein this report.

 

**Overview**

 

On January 14, 2005, we acquired Particle DrillingTechnologies, Inc., a privately-held Delaware corporation (“PDTI”). As aresult of this acquisition, our company, which previously had no materialoperations, acquired the business of PDTI and we are now engaged in thedevelopment of the Particle Impact Drilling System, a patented systemutilizing a specially designed “fit for purpose” drill bit fitted with jettingnozzles and polycrystalline diamond compact cutting structures for use in theoil and gas drilling industry.

 

We are a development-stage company and have alimited operating history. Our predecessor company for financial reportingpurposes was formed on June 9, 2003 to acquire the technology related tothe Particle Impact Drilling System (the “PID System” or “PID technology”).We are still developing this technology, and to date, we have not generated anyrevenues from our operations. As we continue to execute our operations plan, weexpect our development and operating expenses to increase.

 

*Research and development.*  We have made and expect to continue to make substantial investments in researchand development activities in order to develop and market the PID technology.Research and development costs consist primarily of general and administrativeand operating expenses related to research and development activities. Weexpense research and development costs as incurred except for property, plantand equipment related to research and development activity that have analternative future use. Property, plant and equipment for research anddevelopment activity that have an alternative future use are capitalized andthe related depreciation is expensed as research and development costs.

 

*General and administrative.*  General and administrative expenses consist primarily of salaries and benefits,office expense, professional services, and other corporate overhead costs. Wehave experienced and expect to continue to experience increases in general andadministrative expenses as a result of: (1) being subject to reporting andcompliance obligations applicable to publicly-held companies; (2) ourcontinuing efforts to develop, test and prepare the PID technology forcommercialization; and (3) the hiring of additional personnel.

 

17

----

 

***Comparison of YearEnded September 30, 2007 with Year Ended September 30, 2006***

 

*Research anddevelopment.*    Research anddevelopment expenses were $5,894,101 and $5,964,438 for the fiscal years endedSeptember 30, 2007 and 2006, respectively, representing a decrease of$70,337. During the fiscal year ended September 30, 2006, we conducted atest program with the PID System at Catoosa in November 2005 resulting incosts of approximately $385,000. A commercial trial with a customer inMay 2006 resulted in job differential time charges of approximately$135,000, and a second attempted commercial trial with the same customer inSeptember 2006 resulted in job differential time charges of approximately$81,000. We incurred other field charges of approximately $511,000 associatedwith the two customer trials during the fiscal year ended September 30,2006. During the fiscal year ended September 30, 2007, we only incurredapproximately $74,000 in job differential time charges and there have been noadditional test programs of the PID System at Catoosa. Further, during theperiod from October 2006 to September 30, 2007, we incurred costs ofapproximately $380,000 related to the design, engineering, construction andtesting of two alternative particle injection systems and approximately$500,000 related to the completion of the second PID Unit. These increases inresearch and development costs that are present in the current fiscal year wereoffset by a decrease of approximately $585,000 in consulting expenses.

 

*General and administrative.*    Generaland administrative expenses were $4,942,621 and $4,581,604 for the fiscal yearsended September 30, 2007 and 2006, respectively, representing an increaseof $361,017. Employee related costs increased approximately $912,000, includingan increase of approximately $600,000 related to stock based compensationcharges. Additional charges for services related to directors’ compensationincreased approximately $100,000, which consists mostly of stock basedcompensation charges. This increase was partially offset by a decrease in legaland litigation expenses which decreased $307,000. Other decreases are primarilyrelated to marketing, Sarbanes-Oxley compliance, and advisory fees, all ofwhich were substantially lower this year due to better terms or lack of similarexpenses incurred in the most recently completed fiscal year.

 

*Impairment of asset.*  In January 2007, we purchased aquintaplex frac pump for approximately $1.4 million. In September 2007,management decided to place this frac pump on the market for sale as a resultof the development of the new extruder-based injection system being constructedthat is meant to replace the frac pump based injection system. We commenced ourselling efforts during September 2007 at which time the carrying amount ofthe frac pump was reclassified as an asset held for sale, as currentlyreflected on the accompanying September 30, 2007 consolidated balancesheet. We recognized an impairment on the asset of $295,260, and the net bookvalue of the frac pump at September 30, 2007 was reduced to $900,000,reflecting management’s estimate of the realizable value of the frac pump.There were no such impairment charges in fiscal 2006.

 

*Other income.*    Otherincome was $377,713 and $356,455 for the years ended September 30, 2007and 2006, respectively, representing an increase in other income of $21,258.The increase was primarily attributable to an increase in interest income froma larger average cash balance throughout fiscal 2007 compared to fiscal 2006.

 

***Comparison of YearEnded September 30, 2006 with Year Ended September 30, 2005***

 

*Research anddevelopment.*    Research anddevelopment expenses were $5,964,438 and $2,802,155 for the fiscal years endedSeptember 30, 2006 and 2005, respectively, representing an increase of$3,162,283. During the fiscal year ended September 30, 2006, we conducteda test program with the PID System at Catoosa in November 2005 resultingin costs of approximately $385,000. A commercial trial with a customer inMay 2006 resulted in job differential time charges of approximately$135,000, and a second attempted commercial trial with the same customer inSeptember 2006 resulted in a job differential time charge of approximately$81,000. We incurred other field charges of approximately $511,000 associatedwith the two customer trials during the fiscal year ended September 30,2006. Further, during the period from October 2005 to September 30,2006, we incurred approximately $1.6 million related to the design,engineering, construction and testing of two alternative particle injectionsystems. Research and development costs also increased as a result of furtherdevelopment, testing and iterations to the PID drill bit and a completere-design of the PID particle recovery unit. Lastly, as a result of the shiftfrom laboratory testing to field testing, our employee related costs increasedby $1.7 million, including an increase of approximately $700,000 related tostock based compensation charges.

 

*General andadministrative.*    General andadministrative expenses were $4,581,604 and $3,182,313 for the years endedSeptember 30, 2006 and 2005, respectively, representing an increase of$1,399,291. Employee related costs increased approximately $420,000, includingan increase of approximately $200,000 related to stock based compensationcharges. Additional charges for services related to directors’ compensationincreased approximately $610,000, which includes an increase of approximately$480,000 in stock based compensation charges. Other increases are primarilyrelated to reporting 

 

18

----

 

and compliance obligations applicable to publicly-held companies, legalfees associated with litigation defense, legal fees associated with therestatement of the companies financial results and recruiting fees incurred tohire a new President and CEO and certain other key employees.

 

*Other income.*    Otherincome was $356,455 and $260,050 for the fiscal years ended September 30,2006 and 2005, respectively, representing an increase in other income of$96,405. The increase was primarily attributable to interest income, rentalincome and the gains on the assignment of a lease in fiscal 2006. Interestincome was due to the interest earned on the investment of funds received in ourprivate placement in February 2005.

 

**Liquidity and Capital Resources**

 

Our principal sources of liquidity are cashand cash equivalents. We are devoting substantially all of our efforts toproduct development, commercializing the PID technology and recruitingpersonnel. We have substantially funded our operations with proceeds from theissuance of common stock. In the course of our development activities, we havesustained operating losses and expect such losses to continue into fiscal 2008.We intend to finance our operations primarily through cash and cash equivalentson hand, future financing from the issuance of debt or equity instruments, thesale of various non-core assets and through cashflow from operations if we areable to successfully engage in commercial operations that generate revenue.However, we have yet to generate any revenues, and have no assurance of futurerevenues. To management’s knowledge, no company has yet marketed a salableproduct using the technology we are developing. Even if marketing efforts aresuccessful, substantial time may pass before revenues are realized.

 

In management’s opinion, based on availablecash and cash equivalents on hand as of September 30, 2007, we have theability to maintain sufficient liquidity to meet our working capital andcapital expenditure requirements for the next 12 months. Should there be anyunexpected delays in the development of the new particle injection system,management will either reduce certain overhead and research and developmentcosts as compared to previous years or will complete the sale of variousnon-core assets.  Alternatively, management may choose to raise additionaloutside capital in order to improve our liquidity position.  Our continuedexistence depends on the successful development of the PID technology and ourability to successfully commercialize this technology.

 

Since inception on June 9, 2003 throughSeptember 30, 2007, we have financed our operations through private salesof our equity and the issuance of convertible notes, totaling net proceeds of$30,147,913. As of September 30, 2007, we had $4,461,929 in cash and cashequivalents. In October 2006, we completed a private sale of 5.0 millionshares of our common stock for $2.35 per share and warrants to purchase 1.5 millionshares of common stock at $3.25 per share, yielding gross proceeds of$11,750,000.

 

*Cash Flows fromOperating Activities. *Cash flow used for operations is primarily affected by ourresearch and development progress and business development. Net cash flows usedin operating activities during the fiscal year ended September 30, 2007were $6,870,071 compared to $7,192,123 during the fiscal year endedSeptember 30, 2006. The decrease from fiscal 2006 to fiscal 2007 wasmainly the result of decreased cash spending on research and developmentactivities associated with the PID System development and commercial trialsfrom the prior year.

 

*Cash Flows fromInvesting Activities. *Cash flow used ininvesting activities during the fiscal year ended September 30, 2007 was$1,629,629 compared to $843,515 during the fiscal year ended September 30,2006. During the fiscal year ended September 30, 2007, we increasedcapital spending for our research and development activities, primarily as aresult of the frac pump purchased in January 2007 for $1,400,000. Weanticipate that our capital expenditures for the fiscal year endingSeptember 30, 2008 will continue to be fully funded from our availablecash and cash equivalents and from the sale of various non-core assets held forsale.

 

*Cash Flow fromFinancing Activities.  *Net cash provided by (usedin) financing activities during the fiscal year ended September 30, 2007was $10,670,043 compared to $(177,422) during the fiscal year endedSeptember 30, 2006. The majority of the cash provided by financingactivities in fiscal 2007 was from the private placement of 5.0 million sharesof common stock at $2.35 per share in October 2006 which yielded grossproceeds of $11,750,000.

 

*Contractual Obligations*.The lease for our previous commercial operating facility and previous corporatefacility expired on June 30, 2007 and May 31, 2007, respectively.

 

In April 2007, we entered into a 60 month leaseagreement that commenced in September 2007 for a new corporate office andoperating facility and delivered to the lessor a security deposit of$41,144.  The new facility combines the 

 

19

----

 

corporateoffice personnel and the operations personnel into one location at 5611 BairdCourt, Houston, Texas 77041.  The total future minimum lease paymentsunder this lease are $2,130,390.

 
| ** **                                                                          | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                                                    | ** ** | **Total**                                 | ** ** | **Less than 1  year** | ** ** | **1 - 3 years** | ** ** | **3 - 5 years** | ** ** | **More than 5  years** | ** ** |
|                                                                                |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-Term Debt Obligation and Short Term  Notes Payable (including current portion) |       | $                                         | 126,306    |   | $ | 101,769 |   | $ | 18,755 |   | $ | 5,782 |   | $ | — |   |
| Equipment Purchase Commitments                                                      |       | 272,335                                   |       | 272,335 |   |   |   |   |   |   |   |
| Operating Lease Obligations                                                         |       | 2,130,390                                 |       | 388,947 |   | 1,406,271 |   | 335,172 |   | — |   |
|                                                                                |       |                                      |       |   |   |   |   |   |   |   |   |
| Total                                                                               |       | $                                         | 2,529,031  |   | $ | 763,051 |   | $ | 1,425,026 |   | $ | 340,954 |   | $ | — |   |

 

**Off-Balance Sheet Arrangements**

 

In connection with the acquisition of the PIDtechnology in January 2004, PDTI entered into a Royalty Agreement withProDril Services, Incorporated (“PSI”) pursuant to which we are obligated topay PSI a royalty on a quarterly basis equal to 18% of our EBITDA derived fromthe use of the PID technology, until an aggregate of $67,500,000 has been paid.PDTI also entered into a Royalty Agreement in January 2004 with PSILpursuant to which we are obligated to pay PSIL a royalty on a quarterly basisequal to 2% of our EBITDA derived from the use of the PID technology, until anaggregate of $7,500,000 has been paid. In addition, we are obligated to pay CTL,PSI and PSIL a royalty equal to 1.6%, 1.2% and 1.2%, respectively, of ourquarterly gross revenue, derived from the use of the PID technology. As ofSeptember 30, 2006, we had no revenues or EBITDA; therefore no royaltieshave been paid or accrued.

 

**Critical Accounting Policies**

 

The discussion and analysis of our financialcondition and results of operations is based on our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America. The preparation of theseconsolidated financial statements requires us to make estimates and judgmentsthat affect the reported amounts of assets, liabilities and expenses. We baseour estimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form thebasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Actual results may differfrom these estimates under different assumptions or conditions. We believe thefollowing critical accounting policies affect our most significant judgmentsand estimates used in the preparation of our consolidated financial statements.

 

*Impairment of Long-Lived Assets*.  We evaluate our long-lived assets for indicators of possible impairment bycomparison of the carrying amounts to future net undiscounted cash flowsexpected to be generated by such assets when events or changes in circumstancesindicate the carrying amount of an asset may not be recoverable.  Shouldan impairment exist, the impairment loss would be measured based on the excesscarrying value of the asset over the asset’s fair value or discounted estimatesof future cash flows.  We also evaluate the capitalized costs for patentsand patent applications filed but not issued for possible impairments. We havenot identified any such impairment losses to date. The evaluation ofcapitalized costs for patents and patent applications is based on a subjectivecash flow forecast which is subject to change. We will reassess our cash flowforecast each time there are fundamental changes in the underlying potentialuse of the patents or patent applications in terms of performance, customeracceptance or other factors that may affect such cash flow forecasts.

 

*Depreciation and Amortization.*Propertyand equipment are stated at cost. Depreciation is calculated using thestraight-line method over the estimated useful life of the asset, which rangesfrom three to six years. Leasehold improvements are amortized using thestraight-line method over the estimated useful life of the asset or the term ofthe lease, whichever is shorter. Whenever assets are retired or otherwisedisposed of, the cost and related accumulated depreciation are removed from theaccounts, and any resulting gain or loss is recognized in income for theperiod. The cost of maintenance and repairs is expensed as incurred and anysignificant improvements that extend the useful life of an asset arecapitalized.

 

*Stock-Based Compensation*.  In December 2004, the Financial Accounting Standards Board (“FASB”) issueda revision to SFAS No. 123, *Share-Based Payment*,(“SFAS No. 123(R)”). This statement establishes standards for theaccounting for transactions in which an entity exchanges its equity instrumentsfor goods or services. It also addresses transactions in which an entity incursliabilities in exchange for goods or services that are based on the fair valueof the entity’s equity instruments or that may be settled by the issuance ofthose equity instruments. This statement focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. This statement does not 

 

20

----

 

change the accounting guidance for share-based payment transactionswith parties other than employees provided in SFAS No. 123 as originallyissued. This statement is effective for new awards and those modified, repurchasedor cancelled in interim or annual reporting periods beginning afterJune 15, 2005. We early adopted this standard upon inception.

 

*Research and Development.  *Thecosts of materials and equipment or facilities that are acquired or constructedfor research and development activities and that have alternative future usesare capitalized as tangible assets when acquired or constructed. The cost ofsuch materials consumed in research and development activities and thedepreciation of such equipment or facilities used in those activities areresearch and development costs. However, the costs of materials, equipment, orfacilities acquired or constructed for research and development activities thathave no alternative future uses are considered research and development costsand are expensed at the time the costs are incurred.

 

*Income Taxes.* We report our income taxes in accordance with SFAS 109, *Accountingfor Income Taxes*, (“SFAS 109”) which calls for the utilization ofthe asset and liability method of accounting for income taxes. Under thismethod, deferred taxes are determined based on differences between financialreporting and tax bases of assets and liabilities and are measured using theenacted marginal tax rates and laws that will be in effect when the differencesreverse. Temporary differences have been created for all stock option plans andare included in our SFAS 109 computation. At September 30, 2007, we hadcumulative net operating loss carryforwards of approximately $27,800,000, whichexpire in years 2008 through 2026. No effect has been shown in the consolidatedfinancial statements for the net operating loss carryforwards as the likelihoodof future tax benefit from such net operating loss carryforwards is notdeterminable at this time. Accordingly, the potential tax benefits of the netoperating loss carryforwards, estimated based upon tax rates atSeptember 30, 2007, have been offset by valuation reserves of the sameamount.

 

**Recent Accounting Pronouncements**

 

In July 2006, the FASB issued FASB InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes — An Interpretation of FASB Statement No. 109*(“FIN48”).  FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with SFASNo. 109*.*  It prescribesa recognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return.  This new standard also provides guidance on derecognition,classification, interest and penalties, accounting in interim periods,disclosure, and transition.  The provisions of FIN 48 are to be applied toall tax positions upon initial adoption of this standard.  Only taxpositions that meet the more-likely-than-not recognition threshold at theeffective date may be recognized or continue to be recognized upon adoption ofFIN 48.  The cumulative effect of applying the provisions of FIN 48 shouldbe reported as an adjustment to the opening balance of retained earnings (orother appropriate components of equity or net assets in the statement offinancial position) for that fiscal year.  The provisions of FIN 48 areeffective for fiscal years beginning after December 15, 2006. Earlier application is permitted as long as the enterprise has not yet issuedfinancial statements, including interim financial statements, in the period ofadoption.  We are in the process of assessing the impact of the adoptionof FIN 48.

 

In September 2006, the FASB issued SFASNo. 157, (“SFAS No. 157”) *Fair Value Measurements*. SFAS No. 157 clarifies the principle that fair value should be based onthe assumptions market participants would use when pricing an asset orliability and establishes a fair value hierarchy that prioritizes theinformation used to develop those assumptions.  Under the standard, fairvalue measurements would be separately disclosed by level within the fair valuehierarchy.  SFAS No. 157 is effective for financial statements issuedfor fiscal years beginning after November 15, 2007, and interim periodswithin those fiscal years, with early adoption permitted.  We believe thatthe adoption of SFAS No. 157 will not have a material impact on itsfinancial position, results of operations or cash flows.

 

In September 2006, the FASB issued FSPNo. AUG AIR-1, *Accounting for PlannedMajor Maintenance Activities*, (“FSP No. AUG AIR-1”).  FSPNo. AUG AIR-1 prohibits the use of the accrue-in-advance method foraccounting for major maintenance activities and confirms the acceptable methodsof accounting for planned major maintenance activities.  FSP No. AUGAIR-1 is effective the first fiscal year beginning after December 15,2006.  We believe that the adoption of FSP No. AUG AIR-1 will nothave a material impact on its financial position, results of operations or cashflows.

 

In September 2006, the SEC issued SAB 108, “*Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements*”(“SAB 108”)*.*SAB 108 provides interpretive guidanceon how the effects of the carryover or reversal of prior year misstatementsshould be considered in quantifying a current year misstatement. Thepronouncement prescribes an approach whereby the effect of all unrecordedidentified errors should be considered on all of the financial statementsrather than just either the effect on the balance sheet or the incomestatement. 

 

21

----

 

Weadopted the provisions of SAB 108 beginning in fiscal 2007. The adoption of SAB108 did not have a material impact on our Consolidated Financial Statements.

 

In February 2007, the FASB issued Statement ofFinancial Accounting Standards (“SFAS”) No. 159, *The Fair Value Option for Financial Assets andFinancial Liabilities*(“SFAS No. 159”). SFAS No. 159permits entities to choose to measure many financial assets and financialliabilities at fair value. Unrealized gains and losses on items for which thefair value option has been elected are reported in earnings. SFAS No. 159is effective for fiscal years beginning after November 15, 2007. We willadopt SFAS No. 159 on October 1, 2008 and have not yetdetermined the impact, if any, on our consolidated financial statements.

 

**Forward-Looking Statements**

 

Statements in this annual report onForm 10-K that are not historical facts (including any statementsconcerning plans and objectives of management for future operations or economicperformance, or assumptions or forecasts related thereto) are forward-lookingstatements subject to Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934. These statements canbe identified by the use of forward-looking terminology including “forecast,”“may,” “believe,” “expect,” “anticipate,” “estimate,” “continue” or othersimilar words. These statements discuss future expectations, containprojections of results of operations or of financial condition or state other“forward-looking” information. We and our representatives may from time to timemake other oral or written statements that are also forward-looking statements.

 

These forward-looking statements are madebased upon our management’s current plans, expectations, estimates, assumptionsand beliefs concerning future events impacting us and therefore involve anumber of risks and uncertainties. We caution that forward-looking statementsare not guarantees and that actual results could differ materially from thoseexpressed or implied in the forward-looking statements as a result of certainfactors, including but not limited to dependence upon energy industry spending,the volatility of oil and gas prices, weather interruptions, the results oftesting of our products, the availability of capital resources and the otherfactors described under “Item 1A. Risk Factors.”  We undertake no obligation to update anyforward-looking statements except as required by law.

 

**Item 7A. Quantitative and QualitativeDisclosures About Market Risk**

 

We believe that we do not have any materialexposure to financial market risk and we do not enter into foreign currency orinterest rate transactions.

 

**Item 8. Financial Statements andSupplementary Data**

 

22

----

 

**PARTICLEDRILLING TECHNOLOGIES, INC.**

**(adevelopment stage enterprise)**

 

**Index to ConsolidatedFinancial Statements**

 
| Management’s Report on  Internal Control over Financial Reporting                                                                                                                        |   | 24     |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                                                                                                          |   |   |
| Reports of Independent Registered Public Accounting  Firms                                                                                                                                    |   | 25     |
|                                                                                                                                                                                          |   |   |
| Consolidated  Balance Sheets as of September 30, 2007 and 2006                                                                                                                           |   | 27     |
|                                                                                                                                                                                          |   |   |
| Consolidated Statements of Operations for the years  ended September 30, 2007, 2006, and 2005, and for the period from  June 9, 2003 (date of inception) to September 30, 2007 |   | 28     |
|                                                                                                                                                                                          |   |   |
| Consolidated Statements of Stockholders’ Equity for  the period from June 9, 2003 (date of inception) to September 30,  2007                                                   |   | 29     |
|                                                                                                                                                                                          |   |   |
| Consolidated Statements of Cash Flows for the years  ended September 30, 2007, 2006, 2005, and for the period from  June 9, 2003 (date of inception) to September 30, 2007     |   | 33     |
|                                                                                                                                                                                          |   |   |
| Notes to Consolidated Financial Statements                                                                                                                                                    |   | 34     |

 

23

----

 

**MANAGEMENT’SREPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

Our company’smanagement is responsible for establishing and maintaining adequate internalcontrol over financial reporting, as such term is defined in Exchange ActRule 13a-15(f). Internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of our consolidated financial statements forexternal purposes in accordance with generally accepted accounting principles. Underthe supervision and with the participation of our company’s management,including the Chief Executive Officer and the Chief Financial Officer, weconducted an evaluation of the effectiveness of our internal control overfinancial reporting based on the framework in *InternalControl — Integrated Framework*issued by the Committee ofSponsoring Organizations of the Treadway Commission.

 

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

 

Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements. Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

Based on ourevaluation under the framework in *InternalControl — Integrated Framework,*the management of our companyconcluded that our internal control over financial reporting was effective asof September 30, 2007.

 

Our internal control over financial reportingas of September 30, 2007 has been audited by UHY LLP, anindependent registered public accounting firm, as stated in their report thatfollows.

 

 
| /s/ J. CHRIS BOSWELL                                                                                        |   |   |
|-------------------------------------------------------------------------------------------------------------|--------|--------|
| Senior Vice President  and                                                                                  |
| Chief Financial Officer                                                                                     |
|                                                                                                        |
| /s/ Jim B.  Terry                |   |   |
| President and                                                                                               |
| Chief Executive Officer                                                                                     |
|                                                                                                        |
| Houston, Texas                                                                                              |
| December 13, 2007                                                                                      |

 

24

----

 

**REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM**

 

To the Boardof Directors and Stockholders

ParticleDrilling Technologies, Inc.

Houston, Texas

 

We haveaudited Particle Drilling Technologies, Inc.’s (the “Company”) internal controlover financial reporting as of September 30, 2007, based on criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO). The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon the Company’s internal control over financial reporting based on our audit.

 

We conductedour audit in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether effectiveinternal control over financial reporting was maintained in all materialrespects. Our audit included obtaining an understanding of internal controlover financial reporting, assessing the risk that a material weakness exists,testing and evaluating the design and operating effectiveness of internalcontrol, and performing such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

A company’sinternal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. A company’s internal control overfinancial reporting includes those policies and procedures that (1) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company;(2) provide reasonable assurance that transactions are recorded asnecessary to permit preparation of financial statements in accordance withgenerally accepted accounting principles, and that receipts and expenditures ofthe company are being made only in accordance with authorizations of managementand directors of the company; and (3) provide reasonable assuranceregarding prevention or timely detection of unauthorized acquisition, use, ordisposition of the company’s assets that could have a material effect on thefinancial statements.

 

Because of itsinherent limitations, internal control over financial reporting may not preventor detect misstatements. Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with the policiesor procedures may deteriorate.

 

In our opinionParticle Drilling Technologies, Inc. maintained, in all material respects,effective internal control over financial reporting as of September 30,2007, based on criteria established in Internal Control—Integrated Frameworkissued by COSO.

 

We have alsoaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the consolidated balance sheet of the Companyas of September 30, 2007, and the related consolidated statements ofoperations, stockholders’ equity, and cash flows for each of the three yearsended September 30, 2007, 2006 and 2005, and for the period fromJune 9, 2003 (date of inception) to September 30, 2007 and our reportdated December 13, 2007 expressed an unqualified opinion on thoseconsolidated financial statements.

 

 
| /s/ UHY LLP            |   |   |
|------------------------|--------|--------|
|                   |   |   |
| Houston, Texas         |   |   |
| December 13, 2007 |   |   |

 

25

----

 

**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

 

To the Board of Directors and Stockholders

Particle Drilling Technologies, Inc.

Houston, Texas

 

We have audited the accompanying consolidatedbalance sheet of Particle Drilling Technologies, Inc. (a development stagecompany) as of September 30, 2007 and 2006, and the related consolidatedstatements of operations, stockholders’ equity, and cash flows for each of the threeyears ended September 30, 2007, 2006 and 2005, and for the period fromJune 9, 2003 (date of inception) to September 30, 2007. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

 

We conducted our audits in accordance withthe standards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audits to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

In our opinion, the consolidated financialstatements referred to above present fairly, in all material respects, theconsolidated financial position of Particle Drilling Technologies, Inc. asof September 30, 2007 and 2006, and the consolidated results of theiroperations and their cash flows for each of the three years endedSeptember 30, 2007, 2006, and 2005, and for the period from June 9, 2003 (date of inception) toSeptember 30, 2007, in conformity with accounting principles generallyaccepted in the United States of America.

 

We have also audited, in accordance with thestandards of the Public Company Accounting Oversight Board (United States), theeffectiveness of the Company’s internal control over financial reporting as ofSeptember 30, 2007, based on the criteria established in Internal Control— Integrated Framework issued by the Committee of Sponsoring Organizations ofthe Treadway Commission and our report dated December 13, 2007 expressedan unqualified opinion on the effectiveness of the Company’s internal controlover financial reporting.

 

 
| /s/ UHY LLP            |   |   |
|------------------------|--------|--------|
|                   |   |   |
| Houston, Texas         |   |   |
| December 13, 2007 |   |   |

 

26

----

 

**PARTICLEDRILLING TECHNOLOGIES, INC.**

**(adevelopment stage enterprise)**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                        | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                                                                                        | ** ** | ** **                   | ** ** | ** **                   | ** ** |
| **ASSETS**                                                                                                                                                                                                                                        | ** ** | ** **                   | ** ** | ** **                   | ** ** |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Current assets:                                                                                                                                                                                                                                   |       |                         |       |                         |       |
| Cash and cash equivalents                                                                                                                                                                                                                         |       | $                            | 4,461,929  |                         | $          | 2,291,586 |   |
| Short term investments                                                                                                                                                                                                                            |       | —                       |       | 385,839                      |       |
| Assets held for sale                                                                                                                                                                                                                              |       | 900,000                      |       | —                       |       |
| Prepaid expenses                                                                                                                                                                                                                                  |       | 233,174                      |       | 234,488                      |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Total current assets                                                                                                                                                                                                                              |       | 5,595,103                    |       | 2,911,913                    |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Property, plant & equipment, net                                                                                                                                                                                                         |       | 867,168                      |       | 1,326,713                    |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Intangibles, net                                                                                                                                                                                                                                  |       | 1,312,246                    |       | 1,230,086                    |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Other assets                                                                                                                                                                                                                                      |       | 52,562                       |       | 14,650                       |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Total assets                                                                                                                                                                                                                                      |       | $                            | 7,827,079  |                         | $          | 5,483,362 |   |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                    | ** ** | ** **                   | ** ** | ** **                   | ** ** |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Current liabilities:                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Accounts payable                                                                                                                                                                                                                                  |       | $                            | 1,028,999  |                         | $          | 830,552 |   |
| Short-term notes payable                                                                                                                                                                                                                          |       | 88,258                       |       | 179,143                      |       |
| Current portion of long-term debt                                                                                                                                                                                                                 |       | 13,511                       |       | 19,270                       |       |
| Accrued liabilities                                                                                                                                                                                                                               |       | 134,988                      |       | 471,463                      |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Total current liabilities                                                                                                                                                                                                                         |       | 1,265,756                    |       | 1,500,428                    |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Long-term debt                                                                                                                                                                                                                                    |       | 24,537                       |       | 15,305                       |       |
| Deferred Rent                                                                                                                                                                                                                                     |       | 45,539                       |       | —                       |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Commitments and contingencies - See Note 11                                                                                                                                                                                                       |       | —                       |       | —                       |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Stockholders’ equity:                                                                                                                                                                                                                        |       |                         |       |                         |       |
| Common stock, $.001 par value, 100,000,000  shares authorized, 34,632,987 shares issued and 31,629,901 shares outstanding  at September 30, 2007, and 28,013,291 shares issued and 25,010,205  shares outstanding at September 30, 2006 |       | 34,634                       |       | 28,014                       |       |
| Additional paid-in capital                                                                                                                                                                                                                        |       | 38,510,488                   |       | 25,239,221                   |       |
| Treasury stock at cost, 3,003,086 shares  and 3,003,086 shares at September 30, 2007 and September 30, 2006,  respectively                                                                                                              |       | (1,511,817                   | )          | (1,511,817                   | )          |
| Deficit accumulated during the development  stage                                                                                                                                                                                                 |       | (30,542,058                  | )          | (19,787,789                  | )          |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Total stockholders’ equity                                                                                                                                                                                                                   |       | 6,491,247                    |       | 3,967,629                    |       |
|                                                                                                                                                                                                                                              |       |                         |       |                         |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                   |       | $                            | 7,827,079  |                         | $          | 5,483,362 |   |

 

The accompanying notes are an integral part ofthese statements.

 

27

----

 

**PARTICLEDRILLING TECHNOLOGIES, INC.**

**(adevelopment stage enterprise)**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ** **                                                                               | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | **Period from   June 9, 2003  (date of   inception) to** | ** ** |
|------------------------------------------------------------------------------------------|------------|---------------------------------------------|-------------|------------------------|------------|-------------|------------|---------------------------------------------------------------------------------------------|------------|
| ** **                                                                               | ** ** | **Year Ended September 30,** | ** **  | **September 30,** | ** ** |
| ** **                                                                               | ** ** | **2007**                                    | ** **  | **2006**               | ** ** | **2005**    | ** ** | **2007**                                                                                    | ** ** |
| ** **                                                                               | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** **                                                                                  | ** ** |
| Revenues                                                                                 |       | $                                           | —      |                   | $          | —      |       | $                                                                                           | —     |   | $ | — |   |
|                                                                                     |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Operating expenses:                                                                      |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Research and development                                                                 |       | 5,894,101                                   |        | 5,964,438              |       | 2,802,155   |       | 15,322,072                                                                                  |       |
| General and administrative                                                               |       | 4,942,621                                   |        | 4,581,604              |       | 3,182,313   |       | 15,892,720                                                                                  |       |
| Impairment of asset                                                                      |       | 295,260                                     |        | —                 |       | —      |       | 295,260                                                                                     |       |
|                                                                                     |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Total operating expenses                                                                 |       | 11,131,982                                  |        | 10,546,042             |       | 5,984,468   |       | 31,510,052                                                                                  |       |
|                                                                                     |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Loss from operations                                                                     |       | (11,131,982                                 | )           | (10,546,042            | )          | (5,984,468  | )          | (31,510,052                                                                                 | )          |
|                                                                                     |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Other income (expenses)                                                                  |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Interest income                                                                          |       | 384,484                                     |        | 260,914                |       | 209,305     |       | 854,703                                                                                     |       |
| Rental income - related party                                                            |       | —                                      |        | 46,565                 |       | 27,162      |       | 73,727                                                                                      |       |
| Gain on debt extinguishment                                                              |       | —                                      |        | —                 |       | 35,283      |       | 35,283                                                                                      |       |
| Other                                                                                    |       | —                                      |        | 55,614                 |       | —      |       | 55,614                                                                                      |       |
| Interest expense                                                                         |       | (6,771                                      | )           | (6,638                 | )          | (11,700     | )          | (51,333                                                                                     | )          |
|                                                                                     |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Total other income (expenses)                                                            |       | 377,713                                     |        | 356,455                |       | 260,050     |       | 967,994                                                                                     |       |
|                                                                                     |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Net loss                                                                                 |       | $                                           | (10,754,269 | )                      | $          | (10,189,587 | )          | $                                                                                           | (5,724,418 | ) | $ | (30,542,058 | ) |
|                                                                                     |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Net loss per common share, basic and  diluted                                            |       | $                                           | (0.36       | )                      | $          | (0.42       | )          | $                                                                                           | (0.26      | ) | $ | (1.19 | ) |
|                                                                                     |       |                                        |        |                   |       |        |       |                                                                                        |       |
| Weighted average number of common shares  outstanding — basic and diluted |       | 30,185,030                                  |        | 24,520,619             |       | 22,150,365  |       | 25,687,274                                                                                  |       |

 

The accompanying notes are anintegral part of these statements.

 

28

----

 

**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY**

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

**to September 30, 2007**

 
| ** **                                                                                                                                             | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | **Deficit**     | ** ** | ** **             | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-------------|------------|-----------------|------------|----------------|------------|-----------------|------------|------------------------|------------|
| ** **                                                                                                                                             | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | **Accumulated** | ** ** | **Total**              | ** ** |
| ** **                                                                                                                                             | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **      | ** ** | **Additional** | ** ** | **During**      | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                                                                             | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid-in** | ** ** | **Development** | ** ** | **Equity**     | ** ** |
| ** **                                                                                                                                             | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Shares**  | ** ** | **Amount**      | ** ** | **Capital**    | ** ** | **Stage**       | ** ** | **(Deficit)**          | ** ** |
| Retroactive  restatement of stockholders’ equity prior to merger for recapitalization                                                             |       | 1,550,000             |       | $                       | 1,550      |        | —     |            | $          | —         |       | $               | (1,550     | )                      | $          | — |   | $ | — |   |
| Common stock  issued to founders at $0.001 per share in June 2003                                                                                 |       | 9,000,000             |       | 9,000                   |       | —      |       | —          |       | —         |       | —          |       | 9,000                  |       |
| Common stock  issued in private placement for cash at $2.00 per share from June 2003  to September 2003, less offering expense of $436,096   |       | 504,500               |       | 505                     |       | —      |       | —          |       | 572,399        |       | —          |       | 572,904                |       |
| Common stock  issued for services provided at $2.00 per share in July 2003                                                                        |       | 15,000                |       | 15                      |       | —      |       | —          |       | 29,985         |       | —          |       | 30,000                 |       |
| Net loss                                                                                                                                               |       | —                |       | —                  |       | —      |       | —          |       | —         |       | (542,784        | )          | (542,784               | )          |
| Balance,  September 30, 2003                                                                                                                      |       | 11,069,500            |       | 11,070                  |       | —      |       | —          |       | 600,834        |       | (542,784        | )          | 69,120                 |       |
| Common stock  issued in private placement for cash at $2.00 per share from  October 2003 to February 2004, less offering expense of $166,322 |       | 196,800               |       | 197                     |       | —      |       | —          |       | 227,080        |       | —          |       | 227,277                |       |
| Common stock  issued for services provided at $2.00 per share in October 2003                                                                     |       | 27,000                |       | 27                      |       | —      |       | —          |       | 53,973         |       | —          |       | 54,000                 |       |
| Common stock  issued for cash at $2.00 per share from October 2003 to March 2004                                                             |       | 325,000               |       | 325                     |       | —      |       | —          |       | 649,675        |       | —          |       | 650,000                |       |
| Common stock  issued for cash at $1.82 per share in October 2003                                                                                  |       | 2,750                 |       | 2                       |       | —      |       | —          |       | 4,998          |       | —          |       | 5,000                  |       |
| Common stock  issued in exchange for note payable at $2.00 per share in January 2004                                                              |       | 25,000                |       | 25                      |       | —      |       | —          |       | 49,975         |       | —          |       | 50,000                 |       |
| Common stock  issued for services provided at $2.00 per share in January 2004                                                                     |       | 12,000                |       | 12                      |       | —      |       | —          |       | 23,988         |       | —          |       | 24,000                 |       |
| Common stock  issued for cash at $0.72 per share in March 2004                                                                                    |       | 69,508                |       | 70                      |       | —      |       | —          |       | 49,930         |       | —          |       | 50,000                 |       |
| Common stock  issued for cash at $0.97 per share in March 2004                                                                                    |       | 15,480                |       | 15                      |       | —      |       | —          |       | 14,985         |       | —          |       | 15,000                 |       |
| Common stock  issued for cash at $0.75 per share in March 2004                                                                                    |       | 35,000                |       | 35                      |       | —      |       | —          |       | 26,215         |       | —          |       | 26,250                 |       |
| Common stock  issued for services provided at $2.00 per share in March 2004                                                                       |       | 70,000                |       | 70                      |       | —      |       | —          |       | 139,930        |       | —          |       | 140,000                |       |
| Common stock  issued for services provided at $2.00 per share in March 2004                                                                       |       | 75,000                |       | 75                      |       | —      |       | —          |       | 149,925        |       | —          |       | 150,000                |       |
| Common stock  issued for cash at $0.74 per share in April 2004                                                                                    |       | 23,500                |       | 23                      |       | —      |       | —          |       | 17,477         |       | —          |       | 17,500                 |       |
| Common stock  issued in exchange of accounts payable at $0.12 per share upon exercise of  warrants in April 2004                                  |       | 50,000                |       | 50                      |       | —      |       | —          |       | 6,850          |       | —          |       | 6,900                  |       |
| Common stock  issued for cash at $0.12 per share upon exercise of warrants from  April 2004 to June 2004                                     |       | 113,909               |       | 114                     |       | —      |       | —          |       | 15,605         |       | —          |       | 15,719                 |       |
|                                                                                                                                                        |            |                       |            |                         |            |             |            |                 |            |                |            |                 |            |                        |            |  |  |  |  |  |

 

29

----

 
| Common stock  issued for cash at $0.12 per share upon exercise of employee stock options in  June 2004                                |   | 200,000    |   | 200    |   | —     |       | —     |   | 32,062     |   | —     |       | 32,262     |   |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|------------|--------|--------|--------|------------|------------|------------|--------|------------|--------|------------|------------|------------|--------|
| Common stock  issued in connection with advisory agreement at $0.12 per share in  June 2004                                           |   | 5,000,000  |   | 5,000  |   | —     |       | —     |   | 595,000    |   | —     |       | 600,000    |   |
| Common stock  issued at $1.50 per share upon conversion of note payable in June 2004,  less offering expense                          |   | 410,000    |   | 410    |   | —     |       | —     |   | 553,090    |   | —     |       | 553,500    |   |
| Common stock  issued in private placement for cash at $2.00 per share from July 2004  to September 2004, less offering expense   |   | 375,000    |   | 375    |   | —     |       | —     |   | 717,125    |   | —     |       | 717,500    |   |
| Fair value of  common stock warrants issued for services                                                                                   |   | —     |   | — |   | —     |       | —     |   | 2,880      |   | —     |       | 2,880      |   |
| Stock-based  employee compensation                                                                                                         |   | —     |   | — |   | —     |       | —     |   | 42,551     |   | —     |       | 42,551     |   |
| Net loss                                                                                                                                   |   | —     |   | — |   | —     |       | —     |   | —     |   | (3,331,000 | )          | (3,331,000 | )      |
| Balance,  September 30, 2004                                                                                                          |   | 18,095,447 |   | 18,095 |   | —     |       | —     |   | 3,974,148  |   | (3,873,784 | )          | 118,459    |   |
| Common stock  issued in private placement for cash at $2.00 per share from  October 2004 to February 2005, less offering expense |   | 850,000    |   | 850    |   | —     |       | —     |   | 1,581,585  |   | —     |       | 1,582,435  |   |
| Common stock  issued for services provided at $1.75 per share in October 2004                                                         |   | 10,000     |   | 10     |   | —     |       | —     |   | 17,490     |   | —     |       | 17,500     |   |
| Common stock  issued upon cashless exercise of warrants at $0.12 per share in  December 2004                                          |   | 9,314      |   | 10     |   | —     |       | —     |   | (10        | )      | —     |       | —     |   |
| Common stock  issued for cash at $0.01 per share upon exercise of warrants in  December 2004                                          |   | 33,333     |   | 33     |   | —     |       | —     |   | 302        |   | —     |       | 335        |   |
| Common stock  cancelled at $0.12 per share in January 2005                                                                            |   | (700,000   | )      | (700   | )      | —     |       | —     |   | (83,300    | )      | —     |       | (84,000    | )      |
| Common stock  cancelled at $0.001 per share in January 2005                                                                           |   | (50,000    | )      | (50    | )      | —     |       | —     |   | 50         |   | —     |       | —     |   |
| Common stock  issued in private placement for cash at $2.00 per share in  February 2005, less offering expense                        |   | 9,000,000  |   | 9,000  |   | —     |       | —     |   | 14,605,332 |   | —     |       | 14,614,332 |   |
| Repurchase of  common stock at $0.50 per share in February 2005                                                                       |   | —     |   | — |   | (3,000,000 | )          | (1,500,000 | )      | —     |   | —     |       | (1,500,000 | )      |
| Restricted stock  issued to employees at $4.90 per share in May 2005                                                                  |   | 140,000    |   | 140    |   | —     |       | —     |   | (140       | )      | —     |       | —     |   |
| Restricted stock  issued to employees at $5.45 per share in May 2005                                                                  |   | 5,000      |   | 5      |   | —     |       | —     |   | (5         | )      | —     |       | —     |   |
| Common stock  issued upon cashless exercise of warrants at $0.12 per share in  August 2005                                            |   | 48,378     |   | 48     |   | —     |       | —     |   | (48        | )      | —     |       | —     |   |
| Fair value of  common stock warrants issued for services                                                                                   |   | —     |   | — |   | —     |       | —     |   | 2,508,564  |   |       |       | 2,508,564  |   |
| Stock-based  employee compensation                                                                                                         |   | —     |   | — |   | —     |       | —     |   | 614,900    |   |       |       | 614,900    |   |
| Net loss                                                                                                                                   |   | —     |   | — |   | —     |       | —     |   | —     |   | (5,724,418 | )          | (5,724,418 | )      |
| Balance,  September 30, 2005                                                                                                          |   | 27,441,472 |   | $      | 27,441 |       | (3,000,000 | )          | $      | (1,500,000 | )      | $          | 23,218,868 |       | $      | (9,598,202 | ) | $ | 12,148,107 |   |
| Common stock  issued for cash at $0.12 per share upon exercise of employee stock options in  January 2006                             |   | 53,750     |   | 54     |   |       |       |       |   | 6,396      |   |       |       | 6,450      |   |
| Common stock  issued upon cashless exercise of warrants at $2.00 per share in  February 2006                                          |   | 9,721      |   | 10     |   |       |       |       |   | (10        | )      |       |       |       |   |
|                                                                                                                                            |        |            |        |        |        |            |            |            |        |            |        |            |            |            |        |  |  |  |  |  |

 

30

----

 
| Restricted stock  issued to employee at $6.73 per share in January 2006                                                       |   | 150,000    |   | 150    |   |   |       |    |   | (150       | )      |        |       |        |   |
|------------------------------------------------------------------------------------------------------------------------------------|--------|------------|--------|--------|--------|--------|------------|---------|--------|------------|--------|-------------|------------|-------------|--------|
| Common stock  issued upon cashless exercise of warrants at $2.00 per share in  February 2006                                  |   | 176,458    |   | 176    |   |   |       |    |   | (176       | )      |        |       |        |   |
| Restricted stock  issued to employee at $5.87 per share in February 2006                                                      |   | 20,000     |   | 20     |   |   |       |    |   | (20        | )      |        |       |        |   |
| Common stock  issued upon cashless exercise of warrants at $2.00 per share in  March 2006                                     |   | 66,000     |   | 66     |   |   |       |    |   | (66        | )      |        |       |        |   |
| Repurchase of  common stock at $3.85 per share in June 2006                                                                   |   |       |   |   |   | (3,086 | )          | (11,817 | )      |       |   |        |       | (11,817     | )      |
| Restricted stock  issued to employee at $5.73 per share in June 2006                                                          |   | 12,500     |   | 13     |   |   |       |    |   | (13        | )      |        |       |        |   |
| Restricted stock  issued to employee at $3.40 per share in June 2006                                                          |   | 5,000      |   | 5      |   |   |       |    |   | (5         | )      |        |       |        |   |
| Restricted stock  issued to employee at $3.40 per share in June 2006                                                          |   | 10,000     |   | 10     |   |   |       |    |   | (10        | )      |        |       |        |   |
| Restricted stock  issued to employee at $3.40 per share in June 2006                                                          |   | 5,000      |   | 5      |   |   |       |    |   | (5         | )      |        |       |        |   |
| Restricted stock  issued to employee at $3.40 per share in June 2006                                                          |   | 5,000      |   | 5      |   |   |       |    |   | (5         | )      |        |       |        |   |
| Restricted stock  issued to employee at $3.40 per share in June 2006                                                          |   | 5,000      |   | 5      |   |   |       |    |   | (5         | )      |        |       |        |   |
| Common stock  issued upon cashless exercise of warrants at $2.00 per share in  April 2006                                     |   | 29,390     |   | 29     |   |   |       |    |   | (29        | )      |        |       |        |   |
| Common stock  issued for cash at $0.12 per share upon exercise of employee stock options in  July 2006                        |   | 14,500     |   | 15     |   |   |       |    |   | (15        | )      |        |       |        |   |
| Restricted stock  issued to employee at $3.51 per share in July 2006                                                          |   | 7,500      |   | 8      |   |   |       |    |   | (8         | )      |        |       |        |   |
| Common stock  issued upon exercise of warrants at $2.00 per share in August 2006                                              |   | 2,000      |   | 2      |   |   |       |    |   | (2         | )      |        |       |        |   |
| Stock-based  employee compensation                                                                                                 |   | —     |   | — |   | — |       | —  |   | 2,014,476  |   |        |       | 2,014,476   |   |
| Net loss                                                                                                                           |   | —     |   | — |   | — |       | —  |   | —     |   | (10,189,587 | )          | (10,189,587 | )      |
| Balance,  September 30, 2006                                                                                                  |   | 28,013,291 |   | $      | 28,014 |   | (3,003,086 | )       | $      | (1,511,817 | )      | $           | 25,239,221 |        | $      | (19,787,789 | ) | $ | 3,967,629 |   |
| Common stock  issued in private placement for cash at $2.35 per shares in  October 2006, less offering expenses of $1,034,005 |   | 5,000,000  |   | 5,000  |   |   |       |    |   | 10,710,995 |   |        |       | 10,715,995  |   |
| Restricted stock  issued to employee at $3.08 per share in October 2006                                                       |   | 3,000      |   | 3      |   |   |       |    |   | (3         | )      |        |       |        |   |
| Restricted stock  issued to employees at $2.85 per share in October 2006                                                      |   | 68,250     |   | 68     |   |   |       |    |   | (68        | )      |        |       |        |   |
| Common stock  issued upon exercise of warrants at $0.12 per share in October 2006                                             |   | 5,745      |   | 6      |   |   |       |    |   | (6         | )      |        |       |        |   |
| Common stock  issued for cash at $0.12 per share upon exercise of employee stock options in  November 2006                    |   | 6,000      |   | 6      |   |   |       |    |   | 714        |   |        |       | 720         |   |
|                                                                                                                                    |        |            |        |        |        |        |            |         |        |            |        |             |            |             |        |  |  |  |  |  |

 

31

----

 
| Common stock  issued upon cashless exercise of warrants at $0.12 per share in  February 2007           |   | 5,816      |   | 6      |   |   |       |   |   | (6         | )      |        |       |        |   |
|-------------------------------------------------------------------------------------------------------------|--------|------------|--------|--------|--------|--------|------------|--------|--------|------------|--------|-------------|------------|-------------|--------|
| Common stock  issued upon exercise of warrants at $0.12 per share in February 2007                     |   | 2,000      |   | 2      |   |   |       |   |   | 238        |   |        |       | 240         |   |
| Common stock  issued upon cashless exercise of warrants at $2.00 per share in  March 2007              |   | 486,558    |   | 487    |   |   |       |   |   | (487       | )      |        |       |        |   |
| Restricted stock  issued to certain directors at $3.93 per share in March 2007                         |   | 30,000     |   | 30     |   |   |       |   |   | (30        | )      |        |       |        |   |
| Restricted stock  issued to employees at $3.69 per share in April 2007                                 |   | 4,000      |   | 4      |   |   |       |   |   | (4         | )      |        |       |        |   |
| Restricted stock  cancelled in April 2007                                                              |   | (3,375     | )      | (3     | )      |   |       |   |   | 3          |   |        |       |        |   |
| Common stock  issued upon cashless exercise of warrants at $0.12 per share in May 2007                 |   | 24,202     |   | 24     |   |   |       |   |   | (24        | )      |        |       |        |   |
| Common stock  issued upon exercise of employee stock options at $0.12 per share in  June 2007          |   | 37,500     |   | 37     |   |   |       |   |   | 4,463      |   |        |       | 4,500       |   |
| Common stock  issued for cash at $0.12 per share upon exercise of employee stock options in  July 2007 |   | 300,000    |   | 300    |   |   |       |   |   | 35,700     |   |        |       | 36,000      |   |
| Restricted stock  issued to an employee at $2.18 per share in August 2007                              |   | 500,000    |   | 500    |   |   |       |   |   | (500       | )      |        |       |        |   |
| Restricted stock  issued to employees at $2.54 per share in September 2007                             |   | 150,000    |   | 150    |   |   |       |   |   | (150       | )      |        |       |        |   |
| Stock-based  employee compensation                                                                          |   | —     |   | — |   | — |       | — |   | 2,520,432  |   |        |       | 2,520,432   |   |
| Net loss                                                                                                    |   | —     |   | — |   | — |       | — |   | —     |   | (10,754,269 | )          | (10,754,269 | )      |
| Balance,  September 30, 2007                                                                           |   | 34,632,987 |   | $      | 34,634 |   | (3,003,086 | )      | $      | (1,511,817 | )      | $           | 38,510,488 |        | $      | (30,542,058 | ) | $ | 6,491,247 |   |
|                                                                                                             |        |            |        |        |        |        |            |        |        |            |        |             |            |             |        |  |  |  |  |  |

 

The accompanying notes are anintegral part of these statements.

 

32

----

 

**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                   | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | **Period from  June 9, 2003  (date of  inception) to** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------|-------------|------------------------|------------|-------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **Year Ended September 30,** | ** **  | **September 30,** | ** ** |
| ** **                                                                   | ** ** | **2007**                                    | ** **  | **2006**               | ** ** | **2005**    | ** ** | **2007**                                                                        | ** ** |
| ** **                                                                   | ** ** | ** **                                  | ** **  | ** **             | ** ** | ** **  | ** ** | ** **                                                                      | ** ** |
| Cash flows from operating activities:                                        |       |                                        |        |                   |       |        |       |                                                                            |       |
| Net loss                                                                     |       | $                                           | (10,754,269 | )                      | $          | (10,189,587 | )          | $                                                                               | (5,724,418 | ) | $ | (30,542,058 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                        |        |                   |       |        |       |                                                                            |       |
| Gain on debt extinguishment                                                  |       | —                                      |        | —                 |       | (35,283     | )          | (35,283                                                                         | )          |
| Impairment of asset                                                          |       | 295,260                                     |        | —                 |       | —      |       | 295,260                                                                         |       |
| Other                                                                        |       | —                                      |        | (54,103                | )          | —      |       | (54,103                                                                         | )          |
| Depreciation and amortization expense                                        |       | 811,754                                     |        | 688,185                |       | 391,467     |       | 2,038,816                                                                       |       |
| Short-term note issued for services                                          |       | —                                      |        | —                 |       | —      |       | 44,000                                                                          |       |
| Common stock issued for services                                             |       | —                                      |        | —                 |       | (66,500     | )          | 931,500                                                                         |       |
| Warrants issued for services                                                 |       | —                                      |        | —                 |       | 57,999      |       | 63,829                                                                          |       |
| Stock-based employee compensation                                            |       | 2,520,432                                   |        | 2,014,476              |       | 614,900     |       | 5,202,133                                                                       |       |
| Changes in operating assets and  liabilities:                                |       |                                        |        |                   |       |        |       |                                                                            |       |
| Increase in accounts receivable — related  party                        |       | —                                      |        | —                 |       | (42,330     | )          | (42,330                                                                         | )          |
| Decrease in note receivable                                                  |       | 385,839                                     |        | —                 |       | —      |       | 385,839                                                                         |       |
| (Increase) Decrease in prepaid expenses                                      |       | 1,314                                       |        | 249,460                |       | (68,428     | )          | 132,801                                                                         |       |
| Increase (Decrease) in accounts payable                                      |       | 198,447                                     |        | (226,181               | )          | 221,329     |       | 689,061                                                                         |       |
| Increase (Decrease) in accrued liabilities                                   |       | (336,475                                    | )           | 325,627                |       | 26,080      |       | 231,785                                                                         |       |
| Increase in other assets                                                     |       | (37,912                                     | )           | —                 |       | —      |       | (37,912                                                                         | )          |
| Increase in other liabilities                                                |       | 45,539                                      |        | —                 |       | —      |       | 45,539                                                                          |       |
|                                                                         |       |                                        |        |                   |       |        |       |                                                                            |       |
| Net cash used in operating activities                                        |       | (6,870,071                                  | )           | (7,192,123             | )          | (4,625,184  | )          | (20,652,634                                                                     | )          |
|                                                                         |       |                                        |        |                   |       |        |       |                                                                            |       |
| Cash flows from investing activities:                                        |       |                                        |        |                   |       |        |       |                                                                            |       |
| Payments to purchase property and equipment                                  |       | (1,496,985                                  | )           | (636,930               | )          | (1,167,134  | )          | (3,317,604                                                                      | )          |
| Proceeds from sale of property and  equipment                                |       | —                                      |        | —                 |       | —      |       | 20,957                                                                          |       |
| Payments to purchase intangibles                                             |       | (132,644                                    | )           | (178,170               | )          | (170,281    | )          | (741,258                                                                        | )          |
| Payments to purchase other assets                                            |       | —                                      |        | (28,415                | )          | (385,839    | )          | (419,504                                                                        | )          |
| Payments issued for note receivable                                          |       | —                                      |        | —                 |       | —      |       | (300,783                                                                        | )          |
| Payments issued for note receivable —  related party                    |       | —                                      |        | —                 |       | —      |       | (56,784                                                                         | )          |
| Net cash used in investing activities                                        |       | (1,629,629                                  | )           | (843,515               | )          | (1,723,254  | )          | (4,814,976                                                                      | )          |
|                                                                         |       |                                        |        |                   |       |        |       |                                                                            |       |
| Cash flows from financing activities:                                        |       |                                        |        |                   |       |        |       |                                                                            |       |
| Proceeds from issuance of common stock                                       |       | 10,757,455                                  |        | 6,089                  |       | 18,647,666  |       | 31,739,310                                                                      |       |
| Repurchase of common stock                                                   |       | —                                      |        | (11,817                | )          | (1,500,000  | )          | (1,511,817                                                                      | )          |
| Proceeds from issuance of convertible notes                                  |       | —                                      |        | —                 |       | —      |       | 553,500                                                                         |       |
| Repayments of notes payable                                                  |       | (87,412                                     | )           | (171,694               | )          | (314,945    | )          | (851,454                                                                        | )          |
| Proceeds from borrowings under loan  agreements — related parties       |       | —                                      |        | —                 |       | —      |       | 23,195                                                                          |       |
| Repayment of borrowings under loan  agreements — related parties        |       | —                                      |        | —                 |       | —      |       | (23,195                                                                         | )          |
|                                                                         |       |                                        |        |                   |       |        |       |                                                                            |       |
| Net cash provided (used in) by financing  activities                         |       | 10,670,043                                  |        | (177,422               | )          | 16,832,721  |       | 29,929,539                                                                      |       |
|                                                                         |       |                                        |        |                   |       |        |       |                                                                            |       |
| Net increase (decrease) in cash and cash  equivalents                        |       | 2,170,343                                   |        | (8,213,060             | )          | 10,484,283  |       | 4,461,929                                                                       |       |
|                                                                         |       |                                        |        |                   |       |        |       |                                                                            |       |
| Cash and cash equivalents — beginning of  period                        |       | 2,291,586                                   |        | 10,504,646             |       | 20,363      |       | —                                                                          |       |
| Cash and cash equivalents - end of period                                    |       | $                                           | 4,461,929   |                   | $          | 2,291,586   |       | $                                                                               | 10,504,646 |   | $ | 4,461,929 |   |
|                                                                         |       |                                        |        |                   |       |        |       |                                                                            |       |
| Supplemental disclosures of cash flow  information:                          |       |                                        |        |                   |       |        |       |                                                                            |       |
| Cash paid for interest                                                       |       | $                                           | 6,771       |                   | $          | 12,339      |       | $                                                                               | 14,004     |   | $ | 51,822 |   |
|                                                                         |       |                                        |        |                   |       |        |       |                                                                            |       |
| Non-cash investing and financing  activities:                                |       |                                        |        |                   |       |        |       |                                                                            |       |
| Prepaid insurance acquired with note  payable                                |       | $                                           | 112,869     |                   | $          | 253,985     |       | $                                                                               | 51,000     |   | $ | 478,844 |   |
| Common stock issued as consideration for  account payable                    |       | —                                      |        | —                 |       | —      |       | 6,000                                                                           |       |
| Common stock issued as consideration for  note payable                       |       | —                                      |        | —                 |       | —      |       | 50,000                                                                          |       |
| Related party note receivable exchanged for  property and equipment          |       | —                                      |        | —                 |       | —      |       | 56,783                                                                          |       |
| Note payable converted into common stock                                     |       | —                                      |        | —                 |       | —      |       | 553,500                                                                         |       |
| Property and equipment acquired with  assumed liabilities                    |       | —                                      |        | —                 |       | —      |       | 479,610                                                                         |       |
| Intangibles acquired with assumed  liabilities                               |       | —                                      |        | —                 |       | —      |       | 757,792                                                                         |       |
| Property and equipment acquired with note  payable                           |       | —                                      |        | 30,487                 |       | —      |       | 30,487                                                                          |       |
| Short-term investment reclassified from  other assets                        |       | —                                      |        | 385,839                |       | —      |       | 385,839                                                                         |       |
| Property and equipment reclassified from  other assets                       |       | —                                      |        | 19,015                 |       | —      |       | 19,015                                                                          |       |

 

The accompanying notes are an integral part ofthese statements.

 

33

----

 

**PARTICLEDRILLING TECHNOLOGIES, INC.(a development stage enterprise)**

**NOTES TO THECONSOLIDATED FINANCIAL STATEMENTS**

 

**1.ORGANIZATION AND NATURE OF BUSINESS**

 

Particle Drilling Technologies, Inc. (“PDTI” orthe “Company”) is a Nevada corporation, formerly named MedXLink, Corp. (“MXLK”).On January 14, 2005, Particle Drilling Technologies, Inc., a Delawarecorporation (“PDTI-DE”), merged with a subsidiary of MXLK in a stock-for-stocktransaction as a result of a merger and plan of reorganization agreement betweenMXLK and PDTI-DE. Pursuant to the above merger, MXLK assumed PDTI-DE’soperations and business plan and changed its name to Particle DrillingTechnologies, Inc.

 

PDTIis a development stage company engaged in the development of a proprietarydrilling system (“Particle Impact Drilling” or “PID”). The PID technology isdesigned to increase the rate-of-penetration in the drilling process,particularly in hard rock drilling environments. PDTI intends to develop andexploit this technology by commercializing the PID system in the oil and gasindustry.

 

PDTIis devoting substantially all of its efforts to product development,commercializing the PID technology and recruiting personnel. PDTI hassubstantially funded its operations with proceeds from the issuance of commonstock. In the course of its development activities, PDTI has sustainedoperating losses and expect such losses to continue into fiscal 2008. PDTI willfinance its operations primarily through cash and cash equivalents on hand,future financing from the issuance of debt or equity instruments, the sale ofvarious non-core assets and through cashflow from operations if PDTI is able tosuccessfully engage in commercial operations that generate revenue. However,PDTI has yet to generate any revenues, and have no assurance of future revenues.To management’s knowledge, no company has yet marketed a salable product usingthe PID technology. Even if marketing efforts are successful, substantial timemay pass before revenues are realized.

 

Inmanagement’s opinion, based on available cash and cash equivalents on hand asof September 30, 2007, the Company has the ability to maintain sufficientliquidity to meet its working capital and capital expenditure requirements forthe next 12 months. Should there be any unexpected delays in the development ofthe new particle injection system, management will either reduce certainoverhead and research and development costs as compared to previous years orwill complete the sale of various non-core assets.  Alternatively,management may choose to raise additional outside capital in order to improvethe Company’s liquidity position.  The Company’s continued existencedepends on the successful development of the PID technology and its ability tosuccessfully commercialize this technology.

 

**2.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Basisof Presentation**

 

Theaccompanying consolidated financial statements have been prepared in conformitywith accounting principles generally accepted in the United States of America. Certainreclassifications have been made to conform prior period amounts to the currentperiod presentation. These reclassifications had no effect on net loss, netloss per share or stockholders’ equity.

 

**ReverseAcquisition**

 

Forthe purposes of these consolidated financial statements, the merger of PDTI-DEinto MXLK was treated as a reverse acquisition. Pursuant to the guidance inAppendix B of SEC Accounting Disclosure Rules and Practices OfficialText, the merger of a private operating company into a non-operating publicshell corporation with nominal net assets typically results in the owners andmanagement of the private company having actual or effective operating controlof the combined company after the transaction, with the shareholders of theformer public shell continuing only as passive investors. These transactionsare considered by the staff of the Securities and Exchange Commission to becapital transactions in substance, rather than business combinations. That is,the transaction is equivalent to the issuance of stock by the private companyfor the net monetary assets of the shell corporation, accompanied by arecapitalization. Accordingly, the reverse acquisition has been accounted foras a recapitalization. For accounting purposes, PDTI is considered the acquirerin the reverse acquisition. The historical consolidated financial statementsare those of PDTI. Net loss per share for periods prior to the merger arerestated to reflect the number of equivalent shares received by the acquiringcompany.

 

34

----

 

**Principlesof Consolidation**

 

Theaccompanying consolidated financial statements include the accounts of theCompany and its subsidiary. All significant intercompany balances andtransactions have been eliminated.

 

**Useof Estimates**

 

Thepreparation of consolidated financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities, disclosure of contingent assets and liabilities atthe date of the consolidated financial statements and the reported amounts ofrevenues and expenses during the reporting periods. Actual results could differfrom these estimates.

 

**CashEquivalents**

 

Cashequivalents include highly liquid investments with a maturity of three monthsor less when acquired.

 

**FairValue of Financial Instruments**

 

Weinvest cash in excess of operating requirements in U.S. Money Market Funds. Thecarrying amounts reported in the consolidated balance sheets for current assetsand current liabilities approximate fair value due to the short maturity ofthese items.

 

**Concentrationof Credit Risk**

 

Financialinstruments that potentially subject PDTI to a concentration of credit riskconsist of cash and cash equivalents. Cash and cash equivalents are depositedin demand in one financial institution in the United States. Deposits held withfinancial institutions may exceed the amount of insurance provided on suchdeposits. PDTI has not experienced any material losses on its deposits of cashand cash equivalents.

 

**Propertyand Equipment**

 

Propertyand equipment are stated at cost. Depreciation is calculated using thestraight-line method over the estimated useful lives of the assets, whichranges from three to six years. Leasehold improvements are amortized using thestraight-line method over the estimated useful lives of the assets or the termof the lease, whichever is shorter. Whenever assets are retired or otherwisedisposed of, the cost and related accumulated depreciation are removed from theaccounts, and any resulting gain or loss is recognized in income for the period.The cost of maintenance and repairs is expensed as incurred and any significantimprovements that extend the useful life of the assets are capitalized.

 

**IntangibleAssets**

 

Anintangible asset that is acquired either individually or with a group of otherassets (but not those acquired in a business combination) is initiallyrecognized and measured based on its fair value. The costs of a group of assetsacquired in a transaction other than a business combination are allocated tothe individual assets acquired based on their relative fair values and are notconsidered goodwill. The cost is measured based on the fair value of theconsideration given or the fair value of the net assets acquired, whichever ismore reliably measurable. Intangible assets are amortized on a straight-linebasis over the best estimate of their useful lives. The amortization period andamortization method are reviewed annually at each fiscal year-end. Additionalpatent and application costs are capitalized, and amortized over their usefullives once the patents are issued.

 

**Impairmentof Long-Lived Assets**

 

PDTIevaluates its long-lived assets for indicators of possible impairment bycomparison of the carrying amounts to future net undiscounted cash flowsexpected to be generated by such assets when events or changes in circumstancesindicate the carrying amount of an asset may not be recoverable. Should animpairment exist, the impairment loss would be measured based on the excesscarrying value of the asset over the asset’s fair value or discounted estimatesof future cash flows. PDTI also evaluates the capitalized costs for patents andpatent applications filed but not issued for possible impairments.

 

35

----

 

**OfferingExpense**

 

Offeringexpenses consist primarily of placement fees and expenses, professional feesand printing costs. These expenses are charged against the related proceedsfrom the sale of Company stock in the periods in which they occur or charged toexpense in the event of a terminated offering.

 

**IncomeTaxes**

 

TheCompany follows Statements of Financial Accounting Standards (“SFAS”) No. 109*Accounting for Income Taxes*. Thisstatement requires an asset and liability approach for financial accounting andreporting for income tax purposes. This statement recognizes the amount oftaxes payable or refundable for the current year and deferred tax liabilitiesand assets for future tax consequences of events that have been recognized inthe consolidated financial statements or tax returns. Provisions (benefits) forincome taxes result from permanent and temporary differences in the recognitionof accounting transactions for tax and financial reporting purposes. Valuationallowances are established when necessary to reduce deferred tax assets to theamount expected to be realized.

 

**Stock-BasedCompensation**

 

TheCompany follows SFAS No. 123(R), *Share-BasedPayment.*This statement establishes standards for the accounting fortransactions in which an entity exchanges its equity instruments for goods orservices. It also addresses transactions in which an entity incurs liabilitiesin exchange for goods or services that are based on the fair value of theentities equity instruments or that may be settled by the issuance of thoseequity instruments. This statement focuses primarily on accounting fortransactions in which an entity obtains employee services in share-basedpayment transactions. This statement does not change the accounting guidancefor share-based payment transactions with parties other than employees providedin SFAS No. 123 as originally issued.

 

**Researchand Development**

 

Thecosts of materials and equipment or facilities that are acquired or constructedfor research and development activities and that have alternative future usesare capitalized as tangible assets when acquired or constructed. The cost ofsuch materials consumed in research and development activities and thedepreciation of such equipment or facilities used in those activities areresearch and development costs. However, the costs of materials, equipment, orfacilities acquired or constructed for research and development activities thathave no alternative future uses are considered research and development costsand are expensed at the time the costs are incurred.

 

**AssetsHeld for Sale**

 

In January 2007, the Company purchased aquintaplex frac pump for approximately $1.4 million. In September 2007,management decided to place the frac pump on the market for sale as a result ofthe development of the new extruder-based injection system being constructedthat is meant to replace the frac pump-based injection system. The Companycommenced its selling efforts during September of 2007 at which time thecarrying amount of the frac pump was reclassified as an asset held for sale, ascurrently reflected on the accompanying September 30, 2007 consolidatedbalance sheet. The net book value of the frac pump at September 30, 2007was $900,000, reflecting management’s estimate of the realizable value of thefrac pump.

 

**NetLoss Per Share**

 

TheCompany has presented basic and diluted net loss per share pursuant SFAS No. 128,*Earnings Per Share*. In accordancewith SFAS No. 128, basic and diluted net loss per share has been computedusing the weighted-average number of shares of common stock outstanding duringthe period. Dilutive net loss per share would give affect to the dilutiveeffect of common stock equivalents consisting of options and warrants. Potentiallydilutive securities have been excluded from the net loss per common sharecalculation as the effects would be antidilutive. Potentially dilutivesecurities for the years ended September 30, 2007, 2006 and 2005 that havebeen excluded are 1,063,474, 1,276,624 and 991,711, respectively.

 

Thefollowing is the calculation of basic and diluted weighted average sharesoutstanding and net loss per share for each of the years and periods ending September 30:

 

36

----

 
| ** **                                        | ** ** | ** **                                  | ** **  | **Period from**       | ** ** |
|---------------------------------------------------|------------|---------------------------------------------|-------------|----------------------------|------------|
| ** **                                        | ** ** | ** **                                  | ** **  | **June 9, 2003** | ** ** |
| ** **                                        | ** ** | ** **                                  | ** **  | **(date of**          | ** ** |
| ** **                                        | ** ** | ** **                                  | ** **  | **inception) to**     | ** ** |
| ** **                                        | ** ** | **Year Ended September 30,** | ** **  | **September 30,**     | ** ** |
| ** **                                        | ** ** | **2007**                                    | ** **  | **2006**                   | ** ** | **2005** | ** ** | **2007** | ** ** |
| ** **                                        | ** ** | ** **                                  | ** **  | ** **                 | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Net loss (numerator):                             |       |                                        |        |                       |       |   |   |   |   |
| Net loss — basic  and diluted                |       | $                                           | (10,754,296 | )                          | $          | (10,189,587 | ) | $ | (5,724,418 | ) | $ | (30,542,058 | ) |
|                                              |       |                                        |        |                       |       |   |   |   |   |
| Weighted average shares (denominator):            |       |                                        |        |                       |       |   |   |   |   |
| Weighted average  shares — basic and diluted |       | 30,185,030                                  |        | 24,520,619                 |       | 22,150,365 |   | 25,687,274 |   |
|                                              |       |                                        |        |                       |       |   |   |   |   |
| Net loss per share:                               |       |                                        |        |                       |       |   |   |   |   |
| Basic and  diluted                                |       | $                                           | (0.36       | )                          | $          | (0.42 | ) | $ | (0.26 | ) | $ | (1.19 | ) |

 

**RecentAccounting Pronouncements**

 

In July 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes — AnInterpretation of FASB Statement No. 109*(“FIN 48”).  FIN48 clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 109, *Accountingfor Income Taxes.*  It prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return.  This newstandard also provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure, and transition.  Theprovisions of FIN 48 are to be applied to all tax positions upon initialadoption of this standard.  Only tax positions that meet themore-likely-than-not recognition threshold at the effective date may berecognized or continue to be recognized upon adoption of FIN 48.  Thecumulative effect of applying the provisions of FIN 48 should be reported as anadjustment to the opening balance of retained earnings (or other appropriatecomponents of equity or net assets in the statement of financial position) forthat fiscal year.  The provisions of FIN 48 are effective for fiscal yearsbeginning after December 15, 2006.  Earlier application is permittedas long as the enterprise has not yet issued financial statements, includinginterim financial statements, in the period of adoption.  The Company isin the process of assessing the impact of the adoption of FIN 48.

 

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements* (“SFAS No. 157”). SFAS No. 157 clarifies the principle that fair value should be based onthe assumptions market participants would use when pricing an asset orliability and establishes a fair value hierarchy that prioritizes theinformation used to develop those assumptions.  Under the standard, fairvalue measurements would be separately disclosed by level within the fair valuehierarchy.  SFAS No. 157 is effective for financial statements issuedfor fiscal years beginning after November 15, 2007, and interim periodswithin those fiscal years, with early adoption permitted.  The Companybelieves that the adoption of SFAS No. 157 will not have a material impacton its financial position, results of operations or cash flows.

 

In September 2006, the FASB issued FSP No. AUGAIR-1, *Accounting for Planned Major Maintenance Activities*(“FSP No. AUG AIR-1”).  FSP No. AUG AIR-1 prohibits the use ofthe accrue-in-advance method for accounting for major maintenance activitiesand confirms the acceptable methods of accounting for planned major maintenanceactivities.  FSP No. AUG AIR-1 is effective the first fiscal yearbeginning after December 15, 2006.  The Company believes that theadoption of FSP No. AUG AIR-1 will not have a material impact on itsfinancial position, results of operations or cash flows.

 

In September 2006, the SEC issued SAB 108, *Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements*(“ SAB 108”)*.*SAB 108 provides interpretive guidanceon how the effects of the carryover or reversal of prior year misstatementsshould be considered in quantifying a current year misstatement. Thepronouncement prescribes an approach whereby the effect of all unrecordedidentified errors should be considered on all of the financial statementsrather than just either the effect on the balance sheet or the incomestatement. The Company adopted the provisions of SAB 108 beginning in fiscal2007. The adoption of SAB 108 did not have a material impact on the Company’sConsolidated Financial Statements.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets and FinancialLiabilities* (“SFAS No. 159”). SFAS No. 159 permitsentities to choose to measure many financial assets and financial liabilitiesat fair value. Unrealized gains and losses on items for which the fair valueoption has been elected are reported in

 

37

----

 

earnings. SFAS No. 159 is effective for fiscalyears beginning after November 15, 2007. We will adopt SFAS No. 159on October 1, 2008 and have not yet determined the impact, if any, onour consolidated financial statements.

 

**3.PROPERTY AND EQUIPMENT**

 

Thefollowing is a summary of property and equipment, at cost less accumulateddepreciation, at September 30:

 
| ** **                            | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|
|                                  |       |       |       |       |       |
| Office furniture  and equipment       |       | $          | 270,687    |       | $          | 227,372 |   |
| Machines and  equipment               |       | 2,073,205  |       | 1,869,586  |       |
| Leasehold  Improvements               |       | 217,423    |       | —     |       |
|                                  |       |       |       |       |       |
| Total cost of  property and equipment |       | 2,561,315  |       | 2,096,958  |       |
|                                  |       |       |       |       |       |
| Construction in  Progress             |       | —     |       | 320,499    |       |
|                                  |       |       |       |       |       |
| Less:  accumulated depreciation       |       | (1,694,147 | )          | (1,090,744 | )          |
|                                  |       |       |       |       |       |
| Total property  and equipment, net    |       | $          | 867,168    |       | $          | 1,326,713 |   |

 

Forthe fiscal years ended September 30, 2007, 2006 and 2005, depreciationexpense totaled $761,270, $637,701 and $340,977, respectively.

 

In January 2007, the Company purchased aquintaplex frac pump for approximately $1.4 million. In September 2007,management decided to place the frac pump on the market for sale as a result ofthe development of the new extruder-based injection system being constructedthat is meant to replace the frac pump based injection system. The Companycommenced its selling efforts during September of 2007 at which time thecarrying amount of the frac pump was reclassified as an asset held for sale, ascurrently reflected on the accompanying September 30, 2007 consolidatedbalance sheet. The net book value of the frac pump at September 30, 2007was $900,000, reflecting management’s estimate of the realizable value of thefrac pump.

 

**4.INTANGIBLE ASSETS**

 

Thefollowing is a summary of intangibles, at cost less accumulated amortization,at September 30:

 
| ** **                      | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
|                            |       |     |       |     |       |
| Intangibles, at  cost           |       | $        | 1,499,043  |     | $          | 1,366,403 |   |
| Less:  accumulated amortization |       | (186,797 | )          | (136,317 | )          |
|                            |       |     |       |     |       |
| Total  intangibles, net         |       | $        | 1,312,246  |     | $          | 1,230,086 |   |

 

Duringfiscal years 2007 and 2006, the Company incurred direct cost of $132,640 and$178,163, respectively, for patents filed but not issued.

 

Theestimated amortization expense for each of the five succeeding years following September 30,2007 is $50,000.

 

Forthe years ended September 30, 2007, 2006 and 2005, amortization expensetotaled $50,484, $50,484 and $50,490, respectively.

 

**5.SHORT-TERM NOTES**

 

Thefollowing is a table of PDTI’s short-term obligations at September 30:

 

38

----

 
| ** **                                                                                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                   |       |     |       |     |       |
| Short-term note  at 6.13% interest, unsecured with monthly principal and interest payments of  $26,117 |       | —   |       | 179,143  |       |
|                                                                                                   |       |     |       |     |       |
| Short-term note  at 6.5% interest, unsecured with monthly principal and interest payments of  $12,883  |       | 88,258   |       | —   |       |
|                                                                                                   |       |     |       |     |       |
| Total short-term  notes payable                                                                        |       | $        | 88,258     |     | $          | 179,143 |   |
|                                                                                                        |            |          |            |          |            |  |  |

 

**6. ACCRUED LIABILITIES**

 

Accrued liabilities consist of thefollowing at September 30:

 
| ** **                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
|                              |       |     |       |     |       |
| Payroll and  related expenses     |       | $        | 31,001     |     | $          | 352,592 |   |
| Other                             |       | 9,568    |       | —   |       |
| Professional  fees                |       | 30,196   |       | 26,907   |       |
| Audit fees                        |       | 32,342   |       | 8,624    |       |
| Research and  development expense |       | 10,228   |       | 67,476   |       |
| Other accrued  costs              |       | 21,653   |       | 15,864   |       |
|                              |       |     |       |     |       |
| Total accrued  liabilities        |       | $        | 134,988    |     | $          | 471,463 |   |

 

**7.LONG-TERM DEBT**

 

Long-term debt consists of thefollowing at September 30:

 
| ** **                                                                                                                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                                        |       |     |       |     |       |
| Note payable to  a bank in monthly installments of $974, including interest at 6.25%, due in  July 2007, secured by a vehicle          |       | $        | —     |     | $          | 9,473 |   |
|                                                                                                                                        |       |     |       |     |       |
| Note payable to  a bank in monthly installments of $954, including interest at 7.90%, due in  February 2009, secured by a vehicle      |       | 15,800   |       | 25,102   |       |
|                                                                                                                                        |       |     |       |     |       |
| Note payable to  a bank in monthly installments of $515, including interest at 12.60%, due in  September 2012, secured by phone system |       | 22,248   |       | —   |       |
|                                                                                                                                        |       |     |       |     |       |
| Less: current  portion                                                                                                                      |       | (13,511  | )          | (19,270  | )          |
|                                                                                                                                        |       |     |       |     |       |
| Total long-term  debt                                                                                                                       |       | $        | 24,537     |     | $          | 15,305 |   |

 

**8.COMMON STOCK**

 

Allcommon stock sold or issued in exchange for services included an anti-dilutionprovision with the exception of the founders’ shares, the 5,000,000 shares ofcommon stock issued in June 2004 to PDTI’s financial advisors, and sharesof common stock issued in exchange for warrants. In June 2004, allshareholders whose shares included an anti-dilution provision agreed toexchange the anti-dilution provision for registration rights, therebyeliminating the anti-dilution provision.

 

At September 30, 2007 and 2006, the Company had31,629,901 and 25,010,205 shares of common stock outstanding, respectively. Commonstock reserved for issuance consists of the following at September 30:

 

39

----

 
| ** **                                           | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|------------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                                 |       |      |       |      |       |
| Exercise of stock  options                           |       | 4,063,375 |       | 4,267,000 |       |
| Exercise of warrants                                 |       | 1,791,141 |       | 1,265,141 |       |
| Future grants of stock  options and restricted stock |       | 1,215,500 |       | 599,250   |       |
|                                                 |       |      |       |      |       |
| Total common stock  reserved for issuance            |       | 7,070,016 |       | 6,131,391 |       |

 

**9.STOCK OPTIONS AND WARRANTS**

 

**StockOptions**

 

In April 2004,the Board of Directors adopted the 2004 Stock Incentive Plan (the “2004 Plan”).The 2004 Plan provides for the issuance of incentive stock options,non-statutory stock options and restricted stock to directors, employees andconsultants of PDTI. Provisions under the 2004 Plan allow for the issuance ofup to 3,500,000 shares of common stock pursuant to awards under this plan. Asof September 30, 2007, the Company had 1,250 awards available for grantunder the 2004 Plan. Under the 2004 Plan, the exercise price of each optionequals the market value of the Company’s common stock on the date of grant andthe maximum term for the options is ten years.

 

In March 2005,the Board of Directors adopted the 2005 Stock Incentive Plan (the “2005 Plan”). The 2005 Plan provides for the issuance of incentive stock options, non-statutorystock options and restricted stock grants to directors, employees andconsultants of PDTI.  Provisions under the 2005 Plan allow for theissuance of options and restricted stock awards to purchase or issue up to2,000,000 shares of common stock.  As of September 30, 2007, theCompany had 10,000 shares of common stock available for issuance pursuant toawards under the 2005 Plan. Under the 2005 Plan, the exercise price of eachoption equals the market value of the Company’s common stock on the date of grantand the maximum term for the options is ten years.

 

In March 2007,the shareholders adopted the 2007 Stock Incentive Plan (the “2007 Plan”). The2007 Plan provides for the issuance of incentive stock options, non-statutorystock options and restricted stock to directors, employees and consultants ofPDTI. Provisions under the 2007 Plan allow for the issuance of up to 1,500,000shares of common stock pursuant to awards under this plan. As of September 30,2007, the Company had 1,204,250 awards available for grant under the 2007 Plan.Under the 2007 Plan, the exercise price of each option equals the market valueof the Company’s common stock on the date of grant and the maximum term for theoptions is ten years.

 

Stock-basedemployee compensation expense recorded for awards issued under the 2004 Plan,the 2005 Plan and for the 2007 Plan for the years ended September 30, 2007and 2006 was $2,520,432 and $2,014,476, respectively. Stock-based employeecompensation expense for awards issued under the 2004 Plan, the 2005 Plan, andthe 2007 Plan since inception (June 9, 2003) to September 30, 2007was $5,202,133.

 

**Warrants**

 

In October 2004,PDTI issued warrants to purchase 33,333 shares of the Company’s common stock at$0.01 per share.  The warrants were issued to a financial advisor forservices provided.  The Company recorded an expense of $58,000 using theBlack-Scholes option pricing model.

 

Inconnection with a private placement that commenced in April 2004 andcompleted in January 2005, PDTI issued warrants, in January 2005, topurchase 65,500 shares of the Company’s common stock to certain personsassociated with the Placement Agent of this private placement.  Offeringexpense recorded for these warrants was $80,565.  The related expense wasa direct cost of the associated financing and was therefore charged directly tostockholders’ equity.  Each warrant has an exercise price of $2.00 pershare with a maximum term of five years.  The fair value of each warrantgranted is estimated as of the grant date using the Black-Scholes optionpricing model.

 

Inconnection with a private placement that was completed February 9, 2005,PDTI issued warrants, in February 2005, to purchase 1,500,000 shares ofthe Company’s common stock to certain persons associated with the PlacementAgent of this private placement.  Offering expense recorded for thesewarrants was $2,370,000.  The related expense was a direct cost of theassociated financing and was therefore charged directly to stockholders’equity.  Each warrant has an exercise price of

 

40

----

 

$2.00 per share with a maximum term of ten years.  The fair valueof each warrant granted is estimated as of the grant date using theBlack-Scholes option pricing model.

 

Duringfiscal year 2004, PDTI issued warrants to purchase 323,909 of the Company’scommon stock to consultants. The exercise price of each warrant equals themarket value of the Company’s common stock on the date of grant and the maximumterm for the warrants is five years. For the fiscal year ended September 30,2004, compensation expense recorded for these warrants was $5,830.

 

Inconnection with a private placement that was completed in October 2006,PDTI issued warrants in October 2006, to purchase 1,500,000 shares of the Company’scommon stock.  Offering expense recorded for these warrants was$2,835,000.  The related expense was a direct cost of the associatedfinancing and was therefore charged directly to stockholders’ equity. Each warrant has an exercise price of $3.25 per share with a maximum term often years.  The fair value of each warrant granted is estimated as of thegrant date using the Black-Scholes option pricing model.

 

TheCompany did not have any stock option or stock warrant activity for the periodfrom June 9, 2003 (date of inception) to September 30, 2003;therefore, no compensation expense was recorded for this period.

 

**SummarizedInformation for Stock Options and Warrants**

 

Thefollowing is a summary of all stock option and warrant activity for fiscal years2007 and 2006:

 
| **      ** | ** ** | **Number of  Shares  Underlying  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares  Underlying  Warrants** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------------------|------------|-------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
| Outstanding at  September 30, 2005  |       | 3,915,000                                       |       | $                                      | 1.24       |                                             | 1,678,000  |                                   | $          | 1.90 |   |
|                                     |       |                                            |       |                                   |       |                                             |       |                                   |       |
| Granted                                  |       | 616,500                                         |       | 4.81                                   |       | —                                           |       | —                                 |       |
| Exercised                                |       | (68,750                                         | )          | 0.12                                   |       | (412,859                                         | )          | 1.85                                   |       |
| Forfeited                                |       | (195,750                                        | )          | 3.86                                   |       | —                                           |       | —                                 |       |
|                                     |       |                                            |       |                                   |       |                                             |       |                                   |       |
| Outstanding at  September 30, 2006  |       | 4,267,000                                       |       | $                                      | 1.66       |                                             | 1,265,141  |                                   | $          | 1.91 |   |
|                                     |       |                                            |       |                                   |       |                                             |       |                                   |       |
| Granted                                  |       | 251,250                                         |       | 3.28                                   |       | 1,500,000                                        |       | —                                 |       |
| Exercised                                |       | (343,500                                        | )          | 0.12                                   |       | (974,000                                         | )          | 1.92                                   |       |
| Forfeited                                |       | (111,375                                        | )          | 4.20                                   |       | —                                           |       | —                                 |       |
|                                     |       |                                            |       |                                   |       |                                             |       |                                   |       |
| Outstanding at  September 30, 2007  |       | 4,063,375                                       |       | $                                      | 1.82       |                                             | 1,791,141  |                                   | $          | 3.02 |   |
|                                     |       |                                            |       |                                   |       |                                             |       |                                   |       |
| Exercisable at  September 30, 2007  |       | 3,123,500                                       |       | $                                      | 1.35       |                                             | 291,141    |                                   | $          | 1.86 |   |

 

Theweighted average fair value of an option to purchase one share of common stockgranted during fiscal years 2007 and 2006 was $3.28 and $3.49, respectively. Thefair value of each stock option and warrant granted is estimated as of the dateof grant using the Black-Scholes option pricing model with the followingweighted average assumptions:

 
| ** **               | ** ** | **Weighted Average  Assumption for  Options Granted** | ** ** | **Weighted Average  Assumption for  Warrants Granted** | ** ** |
|--------------------------|------------|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **               | ** ** | **2007**                                                             | ** ** | **2006**                                                              | ** ** | **2007** | ** ** | **2006** | ** ** |
|                     |       |                                                                 |       |                                                                  |       |   |   |   |   |
| Risk-free  interest rate |       | 4.7                                                                  | %          | 4.4                                                                   | %          | N/A |   | N/A |   |
|                     |       |                                                                 |       |                                                                  |       |   |   |   |   |
| Expected  volatility     |       | 74.2                                                                 | %          | 75.0                                                                  | %          | N/A |   | N/A |   |
|                     |       |                                                                 |       |                                                                  |       |   |   |   |   |
| Dividend yield           |       | None                                                                 |       | None                                                                  |       | N/A |   | N/A |   |
|                     |       |                                                                 |       |                                                                  |       |   |   |   |   |
| Expected life            |       | 9.2 years                                                            |       | 9.3 years                                                             |       | N/A |   | N/A |   |

 

41

----

 

The following table summarizesinformation about stock options outstanding and exercisable at September 30,2007:

 
| **Options Outstanding**               | ** ** | **Options Exercisable**                    | ** ** |
|--------------------------------------------|------------|-------------------------------------------------|------------|
| **Range of Exercise Price** | ** ** | **Number of  Shares  Underlying  Options** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares  Underlying  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                       |       |                                            |       |   |   |   |   |   |   |   |   |
| $0.12 to $1.75                             |       | 2,760,000                                       |       | 6.7 years |   | $ | 0.44 |   | 2,502,500 |   | $ | 0.48 |   |
| $2.85 to $6.73                             |       | 1,303,375                                       |       | 8.2 years |   | $ | 4.72 |   | 621,000 |   | 4.94 |   |
|                                       |       | 4,063,375                                       |       | 7.1 years |   | $ | 1.82 |   | 3,123,500 |   | $ | 1.36 |   |

 

The following table summarizesinformation about warrants outstanding and exercisable at September 30,2007:

 
| **Warrants Outstanding**              | ** ** | **Warrants Exercisable**                    | ** ** |
|--------------------------------------------|------------|--------------------------------------------------|------------|
| **Range of Exercise Price** | ** ** | **Number of  Shares  Underlying  Warrants** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares  Underlying  Warrants** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                       |       |                                             |       |   |   |   |   |   |   |   |   |
| $0.12 to $3.25                             |       | 1,791,141                                        |       | 4.4 years |   | $ | 3.02 |   | 291,141 |   | $ | 1.86 |   |
|                                            |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |

 

The following table presentsinformation about stock options and warrants granted during the year indicatedwhere the exercise price of some stock options and warrants differed from themarket price of the Company’s stock on the grant date:

 
| ** **                                | ** ** | **Number of  Shares  Underlying  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Shares  Underlying  Warrants** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
|                                      |       |                                            |       |                                   |       |                                             |       |                                   |       |
| Year ended  September 30, 2007       |       |                                            |       |                                   |       |                                             |       |                                   |       |
| Exercise price  equals market value       |       | 251,250                                         |       | $                                      | 3.28       |                                             | —     |                                   | $          | — |   |
| Exercise price  greater than market value |       | —                                          |       | —                                 |       | —                                           |       | —                                 |       |
| Exercise price  less than market value    |       | —                                          |       | —                                 |       | —                                           |       | —                                 |       |
|                                      |       |                                            |       |                                   |       |                                             |       |                                   |       |
|                                      |       | 251,250                                         |       | $                                      | 3.28       |                                             | —     |                                   | $          | — |   |
|                                      |       |                                            |       |                                   |       |                                             |       |                                   |       |
| Year ended September 30,  2006       |       |                                            |       |                                   |       |                                             |       |                                   |       |
| Exercise price  equals market value       |       | 616,500                                         |       | $                                      | 4.89       |                                             | —     |                                   | $          | — |   |
| Exercise price  greater than market value |       | —                                          |       | —                                 |       | —                                           |       | —                                 |       |
| Exercise price  less than market value    |       | —                                          |       | —                                 |       | —                                           |       | —                                 |       |
|                                      |       |                                            |       |                                   |       |                                             |       |                                   |       |
|                                      |       | 616,500                                         |       | $                                      | 4.89       |                                             | —     |                                   | $          | — |   |

 

**10.INCOME TAXES**

 

For the year ended September 30,2007, there were permanent and temporary differences of approximately $20,000and $2,300,000, respectively, which decreased the tax loss for the currentyear.

 

At September 30, 2007, the Companyhas cumulative federal net operating loss carryforwards of approximately $27,800,000 which expire in years 2008through 2026. No benefit has been recorded in the financial statements for thenet operating loss carryforwards as the future tax benefit from such net operatingloss carryforwards is more likely than not ensured at this time. Accordingly,the deferred tax asset associated with the net operating loss carryforwards havebeen fully offset by a valuation allowance. The valuation allowance increased approximately $ 3,700,000 fromSeptember 30, 2006 to September 30, 2007 due primarily to the book lossgenerated during the year the utilization of which is not reasonably ensured.

 

Deferred tax assets consisted ofthe following at September 30, 2007 and 2006:

 

42

----

 
| ** **                       | ** ** | **2007**    | ** ** | **2006**   | ** ** |
|----------------------------------|------------|-------------|------------|------------|------------|
|                             |       |        |       |       |       |
| Deferred tax  asset:             |       |        |       |       |       |
| Net operating  loss carryforward |       | $           | 9,192,374  |       | $          | 6,313,017 |   |
| Intangibles                      |       | 31,296      |       | 31,296     |       |
| Stock warrants  exercised        |       | 834,807     |       | 834,807    |       |
| Property and equipment           |       | 122,788     |       | —     |       |
| Stock-based  compensation        |       | 1,626,119   |       | 817,109    |       |
| Deferred tax  liability:         |       |        |       |       |       |
| Stock Warrants                   |       | (203,351    | )          | (203,351   | )          |
| Intangibles                      |       | (338,743    | )          | (201,212   | )          |
| Property and  equipment          |       | —      |       | (39,382    | )          |
|                             |       |        |       |       |       |
| Deferred tax  asset              |       | 11,265,290  |       | 7,552,284  |       |
|                             |       |        |       |       |       |
| Valuation  allowance             |       | (11,265,290 | )          | (7,552,284 | )          |
|                             |       |        |       |       |       |
| Net deferred tax  asset          |       | $           | —     |       | $          | — |   |

 

Due to the losses that have occurred since theCompany’s inception, no statutory rate reconciliation of the Company’s tax rateis disclosed nor discussed within this footnote.

 

**11.COMMITMENTS AND CONTINGENCIES**

 

**LeaseCommitments**

 

Rent expense with respect to our lease commitmentsfor the year ended September 30, 2007 was $250,527. The Company isobligated under a non-cancellable operating lease for the Company’s newfacility in Houston, Texas. Future minimum payments required under these leasesas of September 30, 2007 are as follows:

 
| **Year Ending September 30:** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 388,947    |   |
| 2009                                         |       | 436,757    |       |
| 2010                                         |       | 466,757    |       |
| 2011                                         |       | 502,757    |       |
| 2012                                         |       | 335,172    |       |
|                                         |       |       |       |
| Total minimum  lease payments                |       | $          | 2,130,390  |   |
|                                              |            |            |            |  |  |

 

**RoyaltyAgreements**

 

In January 2004,PDTI entered into a Royalty Agreement with PSI whereby PDTI will be required topay PSI a royalty on a quarterly basis equal to 18% of the earnings beforeinterest, income taxes, depreciation and amortization (“EBITDA”) derived fromthe use of the PID technology, until an aggregate of $67,500,000 has been paid.PDTI also entered into a Royalty Agreement in January 2004 with PSILwhereby PDTI will be required to pay PSIL a royalty on a quarterly basis equalto 2% of EBITDA derived from the use of the PID technology, until an aggregateof $7,500,000 has been paid. In addition, PDTI will be required to pay CCORE,PSI and PSIL a royalty equal to 1.6%, 1.2% and 1.2%, respectively, of PDTI’squarterly gross revenue derived from the use of the PID technology. PDTI has norevenues or EBITDA; therefore no royalties have been paid or accrued as of September 30,2007.

 

**Litigation**

 

TheCompany may in the future be involved as a party to various legal proceedings,which are incidental to the ordinary course of business. The Company regularlyanalyzes current information and, as necessary, provides accruals for probableliabilities on the eventual disposition of these matters. In the opinion ofmanagement and legal counsel, as of September 30, 2007, there were nothreatened or pending legal matters that would have a material impact on theCompany’s results of operations, financial position or cash flows.

 

43

----

 

**PARTICLE DRILLING TECHNOLOGIES, INC.**

**(a development stage enterprise)**

**SUPPLEMENTAL INFORMATION TOCONSOLIDATED FINANCIAL STATEMENTS**

**SUMMARIZED QUARTERLY FINANCIAL DATA**

**(Unaudited)**

 
| ** **                              | ** ** | **Fiscal 2007 Quarter Ended** | ** ** |
|-----------------------------------------|------------|----------------------------------------------|------------|
| ** **                              | ** ** | **December 31**                         | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **Year** | ** ** |
|                                    |       |                                         |       |   |   |   |   |   |   |   |   |
| Year ended September 30, 2007:     |       |                                         |       |   |   |   |   |   |   |   |   |
| Revenues                                |       | $                                            | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Gross profit                            |       | —                                       |       | — |   | — |   | — |   | — |   |
| Loss from  operations                   |       | (2,963,387                                   | )          | (3,521,923 | ) | (2,470,639 | ) | (2,176,033 | ) | (11,131,982 | ) |
| Net loss                                |       | (2,838,461                                   | )          | (3,409,799 | ) | (2,390,167 | ) | (2,115,842 | ) | (10,754,269 | ) |
| Net loss per  share - basic and diluted |       | $                                            | (0.10      | ) | $ | (0.11 | ) | $ | (0.08 | ) | $ | (0.07 | ) | $ | (0.36 | ) |

 
| ** **                              | ** ** | **Fiscal 2006 Quarter Ended** | ** ** |
|-----------------------------------------|------------|----------------------------------------------|------------|
| ** **                              | ** ** | **December 31**                         | ** ** | **March 31** | ** ** | **June 30** | ** ** | **September 30** | ** ** | **Year** | ** ** |
| ** **                              | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Year ended September 30, 2006:     |       |                                         |       |   |   |   |   |   |   |   |   |
| Revenues                                |       | $                                            | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Gross profit                            |       | —                                       |       | — |   | — |   | — |   | — |   |
| Loss from  operations                   |       | (2,276,447                                   | )          | (2,829,316 | ) | (2,893,742 | ) | (2,546,537 | ) | (10,546,042 | ) |
| Net loss                                |       | (2,167,983                                   | )          | (2,676,907 | ) | (2,830,545 | ) | (2,514,152 | ) | (10,189,587 | ) |
| Net loss per  share - basic and diluted |       | $                                            | (0.09      | ) | $ | (0.11 | ) | $ | (0.11 | ) | $ | (0.11 | ) | $ | (0.42 | ) |

 

**Item 9. Changesin and Disagreements with Accountants on Accounting and Financial Disclosure**

 

None

 

**Item 9A. Controlsand Procedures**

 

**DisclosureControls and Procedures**

 

As ofthe end of the period covered by this report, we carried out an evaluation,under the supervision and with the participation of our principal executive andprincipal financial officers, of the effectiveness of the design and operationof our disclosure controls and procedures (as defined in Rule 13a-15(e) ofthe Securities Exchange Act of 1934). Based upon that evaluation, our principalexecutive and principal financial officers concluded that our disclosurecontrols and procedures were effective as of September 30, 2007.

 

**Management’sReport on Internal Control over Financial Reporting and Report of IndependentRegistered Public Accounting Firm**

 

Theinformation required to be furnished pursuant to this item is set forth underthe captions “Management’s Report on Internal Control over Financial Reporting”and “Report of Independent Registered Public Accounting Firm” in Item 8 of thisreport.

 

**Changesin Internal Control over Financial Reporting**

 

As ofthe end of the period covered by this report, we carried out an evaluation,under the supervision and with the participation of our principal executive andprincipal financial officers, of our internal control over financial reportingto determine whether any changes occurred during the fourth quarter of fiscal2007 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting. Based on thatevaluation, there were no changes in our internal control over financialreporting or in other factors that have materially affected or are reasonablylikely to materially affect our internal control over financial reporting.

 

44

----

 

**Item 9B. OtherInformation**

 

On December 7,2007, the Compensation Committee recommended that the Board of Directorsapprove a new Bonus Plan (the “Bonus Plan”) for the fiscal year ending September 30,2008.  The Bonus Plan was approved by the Board of Directors on the samedate.  Under the Bonus Plan, bonuses may be awarded to the Company’semployees, including the Company’s executive officers, upon the satisfaction ofcertain goals based on a percentage of annual base salaries.  The goalsinclude attaining measured results for some or all of the following categories:cash flow, capital and research and development budgets, revenues, research anddevelopment and operations performance, renew and obtain new contracts, andsafety.

 

Underthe terms of the Bonus Plan, the Company’s employees, including its executiveofficers, may receive a bonus calculated based on a percentage of their annualbase salary.  The ultimate percentage of annual base salary used tocalculate bonuses, if any bonuses are paid, will be at the sole discretion ofthe Compensation Committee.  The target percentage and the high percentageof base salary set by the Compensation Committee to be used for purposes ofcalculating bonuses to the Company’s employees, including its executiveofficers, are as follows:

 
| ** **                                                    | ** ** | **Target Percentage** | ** ** | **High Percentage** | ** ** |
|---------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|
| Staff  (Operations, Accounting & Administrative)     |       | 10                         | %          | 20                       | %          |
| Manager                                                       |       | 15                         | %          | 30                       | %          |
| Senior Manager                                                |       | 25                         | %          | 40                       | %          |
| Executive (other  than President and Chief Executive Officer) |       | 40                         | %          | 80                       | %          |
| President and  Chief Executive Officer                        |       | 50                         | %          | 100                      | %          |

 

Theannual base salaries of the Company’s Named Executive Officers that will beused for purposes of calculating the target and high percentage bonuses underthe Bonus Plan are as follows:

 
| ** **          | ** ** | **Base Salary** | ** ** |
|---------------------|------------|----------------------|------------|
| Jim B. Terry        |       | $                    | 252,000    |   |
| J. Chris Boswell    |       | $                    | 231,000    |   |
| Thomas E.  Hardisty |       | $                    | 189,000    |   |
| Gordon Tibbits      |       | $                    | 150,000    |   |

 

**PART III**

 

**Item10. Directors, Executive Officers and Corporate Governance**

 

The following table shows information regarding ourdirectors and executive officers. All of the persons named below other than Mr. Weyelbecame officers and directors of our company in January 2005, followingour acquisition of PDTI. Mr. Weyel resigned as a director of our companyin August 2007.

 
| **Name**                    | ** ** | **Age (1)** | ** ** | **Position with PDTI**                                        |
|-----------------------------|------------|-------------|------------|---------------------------------------------------------------|
| ** **                  | ** ** | ** **  | ** ** | ** **                                                    |
| Ken R. LeSuer               |       | 72          |       | Chairman of the  Board and Director                           |
| Jim B. Terry                |       | 54          |       | President, Chief  Executive Officer and Director              |
| J. Chris Boswell            |       | 46          |       | Senior Vice  President, Chief Financial Officer and Treasurer |
| Thomas E.  Hardisty         |       | 46          |       | Senior Vice  President of Corporate Development and Secretary |
| Gordon Tibbitts             |       | 60          |       | Vice President  of Technology                                 |
| John D.  Schiller, Jr. |       | 48          |       | Director                                                      |
| Michael S.  Mathews         |       | 67          |       | Director                                                      |
| Hugh A. Menown              |       | 49          |       | Director                                                      |
| Steve A. Weyel              |       | 54          |       | Director (2)                                                  |
| Byron Dunn                  |       | 50          |       | Director (3)                                                  |

 

----

(1) As of December 1, 2007

 

45

----

 

(2) Resigned as a director of our company in August 2007

 

(3) Was appointed as a director of our company inNovember 2007

 

**Ken R. LeSuer**was elected Chairman of PDTI in December 2004after serving as Vice Chairman of PDTI since June 2004. Mr. LeSuerretired in 1999 as Vice Chairman of Halliburton Company. Since his retirementfrom Halliburton in 1999, Mr. LeSuer has been a private investor. Prior tobecoming the Vice Chairman of Halliburton in May 1997, Mr. LeSuerserved as both the President and CEO of Halliburton Energy Services from March 1994to September 1996 and as President and CEO of Halliburton Energy Groupfrom September 1996 to May 1997. He also served as President and CEOof three Halliburton units during his tenure. Mr. LeSuer began his careerwith Halliburton as an engineer-in-training in 1959. From 1965 through 1982, heserved in managerial positions in Asia Pacific and Europe/Africa and wasserving as vice president of Europe/Africa before returning to Duncan, Oklahomato assume the position of vice president of International Operations in 1982.

 

Mr. LeSuer is a member of the Texas A&MUniversity Petroleum Engineering Industry Board, as well as the TAMU Dwight LookCollege of Engineering External Advisory and Development Council. He has servedas Vice President Services Division of the International Association ofDrilling Contractors, and is or at one time was a member of numerous petroleumand geological engineering societies, including the Society of PetroleumEngineers, the American Petroleum Institute, the National Ocean IndustriesAssociation, and the Petroleum Equipment Suppliers Association. Mr. LeSuerreceived his bachelor’s degree in petroleum engineering from Texas A&MUniversity in 1959. Mr. LeSuer is also a director of Horizon Offshore, Inc.(NNM: HOFF).

 

**Jim B. Terry** has served as our Presidentand Chief Executive Officer since January 23, 2006. From January 2003until September 2005, Mr. Terry served as Vice President, DrillingServices for Weatherford International, one of the largest global providers ofinnovative mechanical solutions, technology and services for the drilling andproduction sectors of the oil and gas industry, where he led the effort toconsolidate, develop and improve the performance of well construction productsand services by strategically aligning synergistic product lines in order toimprove both their financial and operational performance. His duties atWeatherford included responsibility for all phases of new product and servicedevelopment from inception through commercialization, which in some casesincluded securing project funding from customers. From September 2005 to January 2006,Mr. Terry served as a consultant to the oil and gas drilling servicesindustry.

 

From March 1994until January 2003, Mr. Terry was employed by Halliburton Company,the last three of those years as Director—Advanced Well Construction Systemswhere he was the lead inventor of a step change advanced well constructionsystem. During this time, he was responsible for all phases of this projectwhich included research and development, engineering, prototyping, field trialsand commercialization. During his first six years at Halliburton, he served invarious management capacities ranging from new product introduction to regionaloperations management. During this time he was responsible for, among otherthings, much of Halliburton’s consolidation effort following its acquisition ofSmith International’s Drilling Services Division.

 

Priorto joining Halliburton in March 1994, Mr. Terry served as RegionalVice President for Smith International in Singapore. He was responsible for allof Smith’s activities in the Asia Pacific, Middle East and East Africa regions.

 

Mr. Terrybegan his career at Eastman Whipstock, which was acquired by Baker Hughes in1990. Following Baker Hughes’ acquisition of Eastman Whipstock in 1990, Mr. Terryjoined Smith International.

 

Mr. Terrygraduated in 1978 from San Francisco State University with a BA in Business andis a member of the Society of Petroleum Engineers, the Independent PetroleumAssociation of America, the American Association of Drilling Engineers and theInternational Association of Drilling Contractors.

 

**J. Chris Boswell** has served as Senior Vice President and ChiefFinancial Officer of PDTI since June 2004. Mr. Boswell had previouslyserved as Director and Senior Vice President and Chief Financial Officer ofParticle Drilling, Inc. from August 2003 until it was merged intoPDTI in June 2004. He also served as a Director of PDTI from June 2004until March 2006. From October 2002 until August 2003, Mr. Boswellwas a private investor. Mr. Boswell has over 20 years of experiencein financial management focused in the energy industry and began his career asa Certified Public Accountant at Arthur Andersen & Co. and laterserved in management positions with Price Waterhouse in Houston, Texas. Heserved as Senior Vice President and Chief Financial Officer of Petroleum Geo-ServicesASA (“PGS”) from December 1995 until October 2002. PGS grew from asmall enterprise in 1994 when Mr. Boswell joined the company to a$1 billion annual revenue enterprise with a peak enterprise value of$6 billion. Subsequent to Mr. Boswell’s departure and

 

46

----

 

following a change of control within PGS, the new management of PGSfiled for bankruptcy protection in July 2003 in order to restructure PGS’sdebt portfolio. The restructuring was successfully completed and PGS emergedfrom bankruptcy in October 2003. In all, during his tenure as CFO at PGS, Mr. Boswelldirected financings for over $3 billion of capital expenditures tofacilitate PGS’ growth. Additionally during 1995, Mr. Boswell and othersenior executives at PGS developed the concept to create a unique oil and gascompany using a non-exclusive license in PGS’ seismic data library as seedcapital. This company became Spinnaker Exploration company, which was sold toNorsk Hydro ASA (NYSE:NHY) in 2006 for approximately $2.45 billion. Mr. Boswellis a 1984 graduate of the University of Texas at Austin.

 

**Thomas E. Hardisty**has served as SeniorVice President, Corporate Development of PDTI since June 2004. Mr. Hardistyhad previously served as Director and Senior Vice President, CorporateDevelopment of Particle Drilling, Inc. from June 2003 until it wasmerged into PDTI in June 2004. He also served as a Director of PDTI from June 2004until March 2006. Mr. Hardisty has over 21 years of experiencein the oil and gas industry, primarily in the area of land management,contracts and corporate development, and is co-founder of the company. From January 2001until June 2003, Mr. Hardisty was Vice President, Land of ShorelinePartners LLC, an independent exploration company and from January 2000until January 2001, Vice President, Land of Benz Resources LLC, aconsulting firm charged with managing certain exploration properties acquiredby Harken Energy Corporation. From May 1999 until January 2000, Mr. Hardistywas a Land Manager for Texstar Energy Inc. responsible for divestingcertain of the company’s exploration projects in the Texas Gulf Coast andMississippi areas. From 1994 until May 1999, Mr. Hardisty wasDivision Landman for PetroCorp Inc. responsible for company landpositions, contract negotiations and partner relations in exploration anddevelopment projects in PetroCorp’s Gulf Coast, Rockies and Canada Division.From 1984 until 1994, Mr. Hardisty was a land consultant and later SeniorProject Manager for Roger A. Soape Inc. in Houston, Texas. Mr. Hardistygraduated from the University of Texas at Austin in 1984 with a BBA inPetroleum Land Management. He is a member of the American Association ofDrilling Engineers (AADE), International Association of Drilling Contractors(IADC), the American Association of Professional Landmen (AAPL) and the HoustonAssociation of Professional Landmen (HAPL). Mr. Hardisty formerly servedas a Director of HAPL and is past Chairman of the HAPL Ethics Committee and pastChairman of HAPL Membership Committee.

 

**Gordon Tibbitts**has served as VicePresident of Technology of PDTI since June 2004, and served as VicePresident of Technology of Particle Drilling, Inc. from June 2003until it was merged into PDTI in June 2004. Prior to joining ParticleDrilling, Inc., Mr. Tibbitts was Vice President of Technology forProDril Services Inc. from October 2002 until June 2003. From April 2000until October 2002, Mr. Tibbitts was an in-house engineeringconsultant on drilling and coring activities for TerraTek Drilling &Completions Research Laboratory. Mr. Tibbitts was employed from May 1999until April 2000 by Pro Steel Inc as Chief Operating Officer. Prior tothat time and for the majority of his career, Mr. Tibbitts worked for HughesChristensen, one of the world’s largest makers of oil and gas drilling bits.While at Hughes Christensen, Mr. Tibbitts held the title of Director ofResearch and Development from 1987 until October 1998 and was responsiblefor managing and directing world-wide research, development, and technicalsupport through research groups in Houston, Salt Lake City and Tulsa. Hedirected and managed the building of a world-class drilling research laboratoryin Houston and a drilling operation in Oklahoma dedicated to field-testing anddevelopment of downhole tools. Mr. Tibbitts has over 30 years ofexperience in the upstream oil and gas industry, including 17 years inengineering, research, and development management. Mr. Tibbitts holds over70 patents related to drilling, coring, and diamond cutting tools. His work hasbeen published by the Society of Petroleum Engineers, International Associationof Drilling Contractors, Society of Core Analysts, and the Journal of PetroleumTechnology. Mr. Tibbitts graduated from the University of Utah with aBachelors degree in Mechanical Engineering.

 

**John D. Schiller, Jr.**has served as a Director of PDTI since May 2004. Between December 2004 and November 2005, Mr. Schiller acted asinterim chief executive officer of our Company.  Since July 2005, Mr. Schillerhas been Chairman and CEO of Energy XXI.  Between December 2003 and December 2004,Mr. Schiller pursued personal interests and private investmentopportunities. From April 2003 to December 2003, Mr. Schillerserved as Vice President, Exploration & Production, for Devon Energywith responsibility for domestic & international activities. Beforejoining Devon Energy, Mr. Schiller was Executive Vice President,Exploration & Production, for Ocean Energy, Inc. from 1999 to April 2003,with responsibility for Ocean’s worldwide exploration, production and drillingactivities. Mr. Schiller joined Ocean Energy from Seagull Energy in September 1998,where he served as Senior Vice President of Operations, prior to the merger ofthe two companies in March of 1999. From 1985 to 1998, Mr. Schillerserved in various positions with Burlington Resources, including as CorporateAcquisition Manager. From 1981 to 1985, Mr. Schiller was a staff engineerat Superior Oil.  Currently, Mr. Schiller serves as the Chairman andChief Executive Officer of Energy XXI and serves on the Board of Directors ofthe Escape Family Resource Center, a charitable organization.

 

47

----

 

Mr. Schiller is currently a member and PastChairman of the Texas A&M Petroleum Engineering Industry Board. Mr. Schillergraduated with honors from Texas A&M University with a Bachelor of Sciencein Petroleum Engineering in 1981. Mr. Schiller is a member of the Company’snominating and governance committee.

 

**Michael Mathews**has served as a Director of PDTI since June 2004.Mr. Mathews is managing director of Westgate Capital Co., a firm hefounded in 1993 to identify and structure investment opportunities on behalf ofprivate investors. Mr. Mathews served on the Board of PetroleumGeo-Services (PGS) from 1993 until September 2002. From 1998 to 2002, heserved as Vice Chairman of PGS and held the position as Chairman of theCompensation Committee and was a member of the Audit Committee. From 1989 to1992, Mr. Mathews served as managing director of BradfordVentures Ltd., a private investment firm involved in equity investments,including acquisitions. Prior to 1989, he was president of DNC CapitalCorporation and senior vice president and director of its parent, DNC AmericaBanking Corp., the US subsidiary of Den Norske Credit Bank Group, where hedirected merchant banking and investment activity in North America and foundedand acted as senior advisor to Nordic Investors Limited, N.V., a private venturecapital fund. Previously, Mr. Mathews was a Vice President in CorporateFinance at Smith Barney and prior to that he was an associate with the New Yorklaw firm of White & Case. Mr. Mathews received an A.B. fromPrinceton University in 1962 and received a J.D. from the University ofMichigan Law School in 1965. Mr. Mathews is also a Director and ViceChairman of Apptix ASA (OSE: APP).

 

**Hugh A. Menown**has served as a Director of PDTI since June 2004.Mr. Menown has over 27 years of experience in mergers &acquisitions, auditing and managerial finance. In May 2007, Mr. Menownjoined Energy XXI (Bermuda) Limited as the Chief Accounting Officer. From January 2006to May 2007, Mr. Menown worked as an independent consultant. From June 1999through December 2005, Mr. Menown worked with Quanta Services, Inc.(“Quanta”) (NYSE: PWR) as a financial consultant. Mr. Menown performed duediligence on a number of Quanta’s acquisitions and has served as ChiefFinancial Officer for two of their operating companies, most recently NorthHouston Pole Line, L.P. located in Houston, Texas. Prior to serving as afinancial consultant to Quanta, Mr. Menown was a Partner in the Houstonoffice of PricewaterhouseCoopers, LLP where he led the Transaction ServicesPractice providing due diligence, mergers & acquisition advisory andstrategic consulting to numerous clients in various industries. Mr. Menownalso worked in the Business Assurance Practice providing audit and relatedservices to clients. Mr. Menown is a Certified Public Accountant.

 

**Steve A. Weyel** has served as aDirector of PDTI since May 2005 and resigned as a board member in August 2007.Since July 2005, Mr. Weyel has served as President and ChiefOperating Officer of Energy XXI (Bermuda) Limited. Previously, Mr. Weyelco-founded and was a principal, and President and Chief Operating Officer ofEnerVen LLC, a privately-held company with strategic ventures in the energyindustry. EnerVen’s businesses include the start-up of WesCo LLC, a gascompression services company, and EnerVen Compression Services, a joint venturecompany with Enogex Inc., an unregulated subsidiary of OGE Energy Corp.(NYSE: OGE), providing compression asset rentals. Mr. Weyel was aprincipal of EnerVen LLC commencing in 2001 and sold his membership interestsin EnerVen in September 2005 and resigned as an officer and director ofEnerVen at that time.

 

From1999 until he co-founded EnerVen in 2001, Mr. Weyel was President ofInterGen North America, a Shell—Bechtel joint venture in the gas and power business.While President of InterGen, Mr. Weyel was responsible for the acquisitionand management of gas assets, including gas storage, mid-stream gas assets andover 15,000 miles of regulated pipelines, development of greenfield merchantpower projects, and board-level oversight of InterGen’s equity ownership inCoral Marketing and Trading.

 

Mr. Weyelwas employed by Dynegy Corporation (previously known as Natural GasClearinghouse and then NGC Corporation) from 1994 to 1999. While at Dynegy, heserved in several senior executive leadership roles, including Senior VicePresident—Power Development from 1998 to 1999. Mr. Weyel began his careerwith Baker Hughes in 1976 and rotated through a variety of assignments,including responsibility for Baker Production Service’s operations in North andSouth America. In 1985 he formed a start-up technology and engineering drivenoilfield services company, Resource Technology Corporation (“RTC”), evaluatingoil and gas reserves around the world. RTC’s assets and ongoing operations werelater sold to John Wood Group PLC in 1993.

 

Mr. Weyelis a 1976 graduate of Texas A&M University and received his MBA from theUniversity of Texas at Austin in 1989.

 

**Byron Dunn**has served as Senior Vice President,Corporate Development of Harvest Natural Resources, Inc. since September 28,2005, an independent energy company engaged in the acquisition, development,production and disposition of oil and natural gas properties. Mr. Dunnpreviously served on Harvest’s Board of Directors and was a member of the Auditand Compensation committees.

 

48

----

 

From 2003 through 2005, Mr. Dunn was withNational Oilwell, Inc., as Vice President, Corporate Business Development.In that capacity he chaired the National Oilwell/Varco integration team, servedas President of Eastern Hemisphere Rig Solutions, and Chairman of the Board ofTTS Marine ASA, a Bergen Norway ship equipment manufacturer. From 1997 to 2003,Mr. Dunn held increasingly responsible roles in UBS’ global energy andpower investment banking group. Earlier in his career, Mr. Dunn wasManager of Upstream Business Development and Acquisitions for Phibro Energy andproduction and reservoir engineer for Chevron USA.

 

Mr. Dunn holds a Bachelor of Science degree inChemical Engineering from the Illinois Institute of Technology, a Master ofBusiness Administration degree with a specialization in finance from theUniversity of Chicago, and is a Chartered Financial Analyst. Mr. Dunn is amember of the Board of Directors of Citizens National Bank.

 

**Audit Committee**

 

Our Board of Directors has a separately-designatedstanding Audit Committee, which committee consists of Messrs. Menown,Mathews and Dunn. Mr. Menown serves as Chairman of the Audit Committee.The Board of Directors has made the following determinations related to theAudit Committee:

 

·                  Messrs. Menown, Mathews and Dunn satisfy the independencerequirements as defined by the NASDAQ rules and as set forth in Rule 10A-3under the Securities Exchange Act of 1934.

 

·                  Each member of the Audit Committee is “financially literate” as theBoard of Directors, in its business judgment, interprets such qualification.

 

·                  Mr. Menown qualifies as an “audit committee financial expert”based on the definition and additional expertise factors outlined by theSecurities and Exchange Commission. Mr. Menown acquired the attributes toqualify as an “audit committee financial expert” through his experience as aPartner with PricewaterhouseCoopers LLP where he had extensive exposure to andobtained a working knowledge of generally accepted accounting principles andfinancial statements. Mr. Menown is also a Certified Public Accountant.

 

OurAudit Committee reviews, acts on and reports to the Board of Directors withrespect to various auditing and accounting matters, including the selection ofour independent auditors, the scope of the annual audits, fees to be paid tothe auditors, the performance of our independent auditors and our accountingpractices. The Audit Committee operates pursuant to a written charter, whichwas adopted on February 3, 2005 and amended on May 31, 2005.

 

**Section 16(a) BeneficialOwnership Reporting Compliance**

 

Section 16(a) ofthe Securities Exchange Act of 1934 requires our officers, directors and personswho own more than 10% of our common stock to file reports of ownership andchanges in ownership concerning the common stock with the SEC and to furnish uswith copies of all Section 16(a) forms they file.

 

Basedsolely upon a review of Forms 3 and 4 and amendments thereto furnished to uspursuant to Rule 16a-3(e) under the Securities Exchange Act of 1934during the fiscal year ended September 30, 2007 and Forms 5 and amendmentsthereto furnished to us with respect to the fiscal year ended September 30,2007, and any representations furnished to us that no Form 5 is required,we believe that all such forms required to be filed were timely filed, asnecessary, by the officers, directors and security holders required to file thesame during the fiscal year ended September 30, 2007.

 

**Code of Ethics**

 

OurBoard of Directors has adopted a code of ethics (we call it our “Code ofBusiness Conduct and Ethics”) that governs the business conduct and ethics ofour directors, all of our employees and our executive officers, including ourchief executive officer, our chief financial officer and our chief accountingofficer. Our code of ethics has been posted on our company’s internet websiteat www.particledrilling.com. In addition, we will provide a printed copy of ourcode of ethics without charge to any stockholder making a written request toCorporate Secretary, Particle Drilling Technologies, Inc., 5611 BairdCourt, Texas 77041. It is our intention to disclose on our internet websitewithin four business days of any amendment or waiver:

 

49

----

 

·  thedate and nature of any amendment we make to any provision of our code ofconduct that applies to our chief executive officer, our chief financialofficer and our chief accounting officer and that relates to any element of thecode of ethics definition enumerated in Item 406(b) of Regulation S-K; and

 

·  informationrelated to any waiver, including any implicit waiver, we grant to our chiefexecutive officer, our chief financial officer and our chief accounting officerthat relates to any element of the code of ethics definition enumerated in Item406(b) of Regulation S-K.

 

**Item 11.   ExecutiveCompensation**

 

**EXECUTIVECOMPENSATION**

 

**Compensation Discussion andAnalysis**

 

***Overview***

 

This CompensationDiscussion and Analysis section discusses the compensation programs andpolicies for our executive officers and the Compensation Committee’s role inthe design and administration of these programs and policies and in makingspecific compensation decisions for our executive officers and key employees,including our “named executive officers,” which consist of Jim B. Terry, ourPresident and Chief Executive Officer, J. Chris Boswell, our Senior VicePresident, Chief Financial Officer and Treasurer, Thomas E. Hardisty, ourSenior Vice President of Corporate Development and Secretary and Gordon E.Tibbitts, our Vice President of Technology.

 

***Philosophy***

 

Our executivecompensation program is designed to motivate, reward, attract and retain themanagement deemed essential to our success. The program seeks to align executive compensation with our corporateobjectives, business strategy and financial performance.  In applying these principles, we seek to:

 

·                 reward executives for long-termstrategic management and the enhancement of stockholder value;

 

·                 support an environment that rewardsperformance with respect to our goals, as well as our performance relative toindustry peers;

 

·                 integrate compensation programs withour short and long-term strategic plans;

 

·                 attract and retain key executivescritical to our long-term success; and

 

·                 align the interests of executives withthe long-term interests of stockholders through equity awards.

 

We use each element ofcompensation to satisfy one or more of these compensation objectives, and eachelement is an integral part of and supports our overall compensationobjectives.  We strive to offer ourexecutive officers compensation and benefits that are attractive andcompetitive in the marketplace for executive talent.

 

***Administration***

 

Our executivecompensation program is administered by the Compensation Committee, which iscomprised of Messrs. LeSuer, Schiller and Menown.  Mr. LeSuer is the Chairman of theCompensation Committee.  The Board ofDirectors has determined that Messrs. LeSuer, Schiller and Menown satisfythe independence requirements as defined by the listing standards of the NASDAQand Rule 16b-3 under the Securities Exchange Act of 1934.

 

Our CompensationCommittee is authorized to make recommendations concerning salaries andincentive compensation for our employees and consultants, establish and approvesalaries and incentive compensation for our executive officers and administerour employee benefit and stock option plans.  The Compensation Committee reviews and approves the specific base salaryand bonus compensation of our named executive officers.  Typically, the President and Chief ExecutiveOfficer and the Chief Financial Officer are requested to present to theCompensation Committee industry compensation data based on public filings aswell as the calculations required to support achievement of goals establishedby the Compensation

 

50

----

 

Committee.  These executiveofficers do not participate in the deliberation process of the CompensationCommittee.  Our executive officersparticipate in the review and award process for other key employees who are notexecutive officers.

 

***CompensationProgram Benchmarking***

 

The CompensationCommittee selected  twelve companies thatoperate in the oilfield services industry against which to compare ourexecutive compensation program.  Thesecompanies consist of Dawson Geophysical Company, Oyo Geospace Corporation,Horizon Offshore, Inc., NATCO Group, Inc., Allis Chalmers Energy, Inc.,AZZ, Inc., Core Laboratories NV, Electromagnetic GeoServices ASA, SuperiorEnergy Services, Inc., W-H Energy Services, Inc., WeatherfordInternational, Inc., and Halliburton Company.  We refer to these twelve companiescollectively as our “Peer Group.” Although many of these companies are larger and more established thanour company, we require personnel with comparable levels of experience.  As a result, we must offer compensation thatis generally competitive with larger and more established companies listed inour Peer Group in order to compete for personnel with the high level ofexperience and expertise we require.  TheCompensation Committee reviews this Peer Group composition on an annualbasis.  The Compensation Committee mayelect to modify the Peer Group for future periods to reflect best practices inexecutive compensation or changes in our business or the business of othercompanies, in and outside the Peer Group.

 

***Compensation******Program******Components***

 

An executive’scompensation typically consists of:

 

·                 base salary paid in cash;

 

·                 annual incentive compensation paid incash;

 

·                 long-term incentive awards comprisedof restricted stock and stock options;

 

·                 severance and change in controlarrangements; and

 

·                 other employee benefits.

 

The balance among thesecomponents is established annually by the Compensation Committee and isdesigned to recognize past performance, retain key employees and encouragefuture performance.  The particularelements of the compensation programs for our executive officers are set forthin more detail below.

 

***BaseSalary***.   Basesalaries are primarily determined by the Compensation Committee at levels theCompensation Committee deems necessary or appropriate to attract the level ofcompetence required for the position.  The Compensation Committee reviews base salaries annually and considersthe base salaries paid by the Peer Group in its decision-making process.  The Compensation Committee also takes intoaccount industry and market conditions, the executive’s salary history, levelof responsibility, breadth of knowledge, past performance, credentials andexperience, as well as his or her perceived future importance to us.   The Compensation Committee believes thatbase salaries for our executive officers are competitive and within a low tomedian range of our Peer Group and considers them reasonable and necessary toachieve the objectives of our executive compensation program.  It is the intent of the CompensationCommittee to continue to review and assess base salary levels in order tomaintain our competitive position relative to the Peer Group.

 

***AnnualIncentive Compensation***.  We provide incentive compensation to our executive officers and keyemployees in the form of annual cash bonuses that are paid based upon financialand operational achievements during the preceding fiscal year.   Our annual incentive compensation program isprimarily intended to motivate our executive officers to achieve certainshort-term strategic objectives established by the Compensation Committee on an annual basis.  We also believe our annual incentivecompensation program is an important part of our overall compensation programto attract and retain executive talent as discussed above.  In 2007, the Bonus Plan, as approved by theCompensation Committee, set forth certain objectives for management revolvingaround the commercialization of the PID technology and the development of a newparticle injection system.  The 2008 Bonus Plan, which has been approvedby the Compensation Committee, also sets forth objectives for management thatrevolve around the commercialization of the PID technology, achieving firstrevenue and generating positive cash flow from the business.  For fiscal 2007, the Compensation Committeeexercised its discretion and determined that the Company was not in a financialposition to pay cash bonuses even though some performance evaluation criteriahad been met. As such, no bonuses were paid for 2007 to our executive officers.

 

51

----

 

Our cash bonus awards arelinked to the achievement of the performance goals described above and aredesigned to put a significant portion of total compensation at risk. TheCompensation Committee has established a bonus target for each executiveofficer based upon a review of the competitive data for that position, level ofresponsibility and ability to impact our success. Individual executive officerbonus targets range from 40% to 80% of base salary, except the President andChief Executive Officer’s bonus, whose target ranges from 50% to 100% of basesalary.

 

***Long-termIncentive Awards***.  From time to time, we also provide long-term incentive compensation toour executive officers and key employees through equity awards pursuant to oneof the 2004, 2005 and 2007 Stock Incentive Plans. The use of equity awards isintended to provide incentives to our executive officers and key employees towork toward our long-term goals. Equity awards are not granted by theCompensation Committee as a matter of course as part of the regularcompensation of any executive or key employee. The decision by the CompensationCommittee to grant an equity award is based on the perceived incentive that anysuch grant will provide and the benefits that the grant may have on long-term stockholdervalue. The determination by the Compensation Committee of the number of sharesgranted is based on the level and contribution of the intended recipient aswell as an analysis of the intended recipient’s stock ownership positionrelative to other executive officers within our company. Consideration is alsogiven by the Compensation Committee to the anticipated contribution of thebusiness operations for which the intended recipient has responsibility tooverall stockholder value.

 

During fiscal 2007, theCompensation Committee awarded both options as well as restricted shares asreflected in the table below. A total of 735,000 restricted shares and 615,000options have been awarded to named executive officers during the last three fiscalyears.

 
| ** **          | ** ** | **2007**                        | ** ** |
|---------------------|------------|---------------------------------|------------|
| **Name**            | ** ** | **Restricted  Shares (1)** | ** ** | **Options (2)** | ** ** |
| Jim B. Terry        |       | 525,000                         |       | 75,000 |   |
| J. Chris Boswell    |       | —                          |       | — |   |
| Thomas E.  Hardisty |       | —                          |       | — |   |
| Gordon Tibbitts     |       | —                          |       | — |   |

 

(1)  With respect to 129,250 shares, therestrictions lapse on the date we file our first quarterly or annual reportwith the Securities and Exchange Commission in which we report Adjusted EBITDA(as defined in the award agreement) for a fiscal quarter that is greater than$0; with respect to 200,000 shares, the restrictions lapse on the date weconsummate a strategic transaction with a third party that the CompensationCommittee, in its sole discretion, determines satisfies certain criteriadescribed in the award agreement; and with respect to 170,750 shares, therestrictions lapse on the date we file our first quarterly or annual reportwith the Securities and Exchange Commission in which we report, for twoconsecutive fiscal quarters, cumulative revenues in an amount equal to orgreater than $1.0 million, in the aggregate. With respect to 25,000 shares, restrictions lapse in one-thirdincrements on each of the first, second and third anniversaries of the date ofgrant, October 24, 2006.

 

(2)       Options vest in 1/3increments on October 24 in each of the years 2007, 2008 and 2009.

 

The stock options whichhave been granted in fiscal 2007 and are currently outstanding are subject tovesting in one-third increments on each of the first, second and thirdanniversaries of the date of grant, October 24, 2006 and have exerciseprices based on the market price of the underlying common stock at the date ofgrant.

 

***Severanceand Change in Control Arrangements***.   We have entered into Employment Agreementswith each of our executive officers that contain severance and change ofcontrol arrangements.  The purpose ofthese Employment Agreements is to (i) ensure the continued dedication ofthe executive, notwithstanding the possibility, threat or occurrence of achange of control; (ii) diminish any distraction of the executiveresulting from the uncertainties and risks created by a pending or threatenedchange of control; and (iii) provide the executive with compensation andbenefits arrangements upon a change of control that are competitive with thoseof our Peer Group.  As discussed above,it is important that the terms of these Employment Agreements are competitivewith the terms of similar agreements that are found in the market place basedon compensation packages of our Peer Group to retain quality key employees. Thebenefits that each of our named executive officers will receive in the event oftermination or upon a change of control are described below under “-PotentialPayments upon Termination or Change in Control.”

 

52

----

 

The Employment Agreementsfor the President and Chief Executive Officer, Senior Vice President and ChiefFinancial Officer and Senior Vice President of Corporate Development andSecretary are effective for a three-year term and are automatically renewed fora one year term on the anniversary date, such that these agreements are alwaysfor a three-year term upon each annual renewal. The agreement for the Vice President of Technology is effective for aone-year term and is automatically renewed for a one-year term on theanniversary date.  Please see “-Employment Agreements.”

 

***Benefits***.   Our executive officers may also participatein our 401(k) plan on the same terms as other employees for which weautomatically contribute 3% of the employee’s base salary.  We also offer medical, dental and term lifeinsurance.  In addition, Messrs. Terry,Boswell, Hardisty, and Tibbitts each have life insurance policies for which wepay the annual premiums of $9,920, $2,870, $2,946, and $1,819, respectively.

 

***Determination of fiscal 2008 Annual Base Salary and IncentiveBonus Potential***

 

During fiscal 2007, theCompensation Committee also considered whether adjustments should be made tothe base salaries and incentive bonus potential for the named executiveofficers for fiscal 2008. The Compensation Committee adjusted each namedexecutive officer’s base salary and incentive bonus potential based onindividual performance, market conditions and the other factors discussedabove. The following table sets forth the 2008 base salaries and incentivebonus potential (as a percentage of base salary) for the named executiveofficers.

 
| **Name**            | ** ** | **Title**                                                              | ** ** | **Fiscal 2008 Base  Salary** | ** ** | **Maximum Fiscal  2008 Incentive  Bonus Potential  (as a % of Base  Salary)** | ** ** |
|---------------------|------------|------------------------------------------------------------------------|------------|----------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|
| Jim B. Terry        |       | President and Chief Executive Officer

Senior Vice President and Chief |       | $                                      | 252,000    |                                                                                                             | 100        | % |
| J. Chris Boswell    |       | Financial Officer

Senior Vice President of Business                   |       | 231,000                                |       | 80                                                                                                               | %          |
| Thomas E.  Hardisty |       | Development                                                            |       | 189,000                                |       | 80                                                                                                               | %          |
| Gordon Tibbitts     |       | Vice President of Technology                                           |       | 150,000                                |       | 80                                                                                                               | %          |
|                     |            |                                                                        |            |                                        |            |                                                                                                                  |            |  |

 

***Allocation of Compensation between Short and Long-TermBenefits and between Restricted Stock and Options***

 

The CompensationCommittee generally allocates the compensation program for our executiveofficers and key employees between equity-based and non-equity-basedcompensation in order to balance the policies of supporting long-termperformance measures while rewarding yearly performance goals. In evaluatingwhether or not to make awards of equity-based long-term compensation duringfiscal 2007, the Compensation Committee considered the amount of equity alreadyheld by our executive officers.  Because each of Messrs. Boswell,Hardisty and Tibbits were founders or executive officers of our company nearthe time it was founded, each of them already had significant equity ownershippositions in our company as of September 30, 2006.  Mr. Terry,on the other hand, became an executive officer of our company in January 2006. Therefore, the Compensation Committee exercised its discretion to make awardsof equity-based long-term compensation only to Mr. Terry during fiscal2007.  

 

Stock options representthe opportunity to purchase shares of our stock at a fixed price at a futuredate. Our long-term incentive plan requires that the per share exercise priceof our options not be less than the fair market value of a share of our commonstock on the date of grant. This means that our stock options have value forour executive officers only if our stock price appreciates from the date theoptions are granted and the executive officers remain employed by us throughthe vesting period. This design focuses our executive officers on increasingthe value of our common stock over the long-term, consistent with stockholders'interests.  Restricted stock awardsprovide some value to an employee during periods of stock price volatility andmay better achieve the goal of retaining and motivating employees when thecurrent value of our stock is less than the exercise price of a stock option.Accordingly, we believe that a mix of option and restricted stock awards morecompletely align management’s interests with those of our company and ourstockholders, while increasing our ability to retain key members of ourmanagement team.

 

Set forth below is thepercentage of short-term to long-term benefits given to Messrs. Terry,Boswell, Hardisty and Tibbitts based on the fiscal 2007 Summary CompensationTable reflecting the determinations of the Compensation Committee described inthe preceding paragraph.

 
| **Name**            | ** ** | **Short-Term  Benefits(1)** | ** ** | **Long-Term  Benefits(2)** | ** ** | **Total** | ** ** |
|---------------------|------------|-----------------------------|------------|----------------------------|------------|-----------|------------|
| Jim B. Terry        |       | 16                          | %          | 84                         | %          | 100.0     | %          |
| J. Chris Boswell    |       | 97                          | %          | 3                          | %          | 100.0     | %          |
| Thomas E.  Hardisty |       | 97                          | %          | 3                          | %          | 100.0     | %          |
| Gordon Tibbitts     |       | 96                          | %          | 4                          | %          | 100.0     | %          |

 

53

----

 

----

(1)   Short-Term Benefits include salary, bonus andinsurance premiums paid.

 

(2)  Long-Term Benefits include stock awards andsafe-harbor amounts under the 401(k) Plan.

 

***TaxConsiderations***

 

During 1993, Congressenacted legislation that could have the effect of limiting the deductibility ofexecutive compensation paid to each of a company’s five highest paid executiveofficers.  This legislation provides thatcompensation paid to any one executive in excess of $1,000,000 will not bedeductible unless it is performance-based and paid under a plan that has beenapproved by stockholders.  TheCompensation Committee considers the application of this legislation whenreviewing executive compensation; however, the limitation on deductibility ofexecutive compensation has not had any impact on us to date.

 

**COMPENSATIONCOMMITTEE REPORT**

 

The CompensationCommittee has reviewed and discussed the disclosure set forth above under theheading “Compensation Discussion and Analysis” with management and, based onthis review and discussion, the Compensation Committee has recommended to the Boardof Directors that the “Compensation Discussion and Analysis” be included inthis Annual Report on Form 10-K.

 
|                    | *The  Compensation Committee* |                        |
|-------------------------|-------------------------------|-----------------------------|
|                    | * *                      |                        |
| Ken R. LeSuer, Chairman | Hugh A. Menown                | John D.  Schiller, Jr. |

 

**Summary Compensation Table**

 

The following SummaryCompensation Table sets forth the compensation of our named executive officersfor fiscal year 2007.   Additionaldetails regarding the applicable elements of compensation in the SummaryCompensation Table are provided in the footnotes following the table.

 
| **Name and Principal Position**                  | ** ** | **Fiscal  Year** | ** ** | **Salary  ($)** | ** ** | **Restricted  Stock Awards  ($)** | ** ** | **Option  Awards  ($) (1)** | ** ** | **All Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|-----------------------------------------------------------------|------------|------------------|------------|-----------------|------------|----------------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|----------------|------------|
| Jim B. Terry                                                    |       | 2007             |       | 238,707         |       | 1,161,250                              | (2)        | 138,000                          |       | 19,332                                | (3)        | 1,557,289      |       |
| President and  Chief  Executive Officer                         |       |             |       |            |       |                                   |       |                             |       |                                  |       |           |       |
| J. Chris Boswell                                                |       | 2007             |       | 218,816         |       | —                                 |       | —                           |       | 19,393                                | (3)        | 238,209        |       |
| Senior Vice  President,  Chief Financial Officer  and Treasurer |       |             |       |            |       |                                   |       |                             |       |                                  |       |           |       |
| Thomas E.  Hardisty                                             |       | 2007             |       | 179,032         |       | —                                 |       | —                           |       | 9,517                                 | (3)        | 188,549        |       |
| Senior Vice  President of  Corporate Development  and Secretary |       |             |       |            |       |                                   |       |                             |       |                                  |       |           |       |
| Gordon Tibbitts                                                 |       | 2007             |       | 143,462         |       | —                                 |       | —                           |       | 7,323                                 | (3)        | 150,785        |       |
| Vice President  of   Technology                                 |       |             |       |            |       |                                   |       |                             |       |                                  |       |           |       |

 

----

(1)          Please see the discussion of the assumptionsmade in the valuation of this award in the financial statements and footnotesto the financial statements of this Annual Report on Form 10-K filed withthe SEC.  We adopted the fair valuerecognition provisions of SFAS No. 123(R) effective June 15,2005.  Under the SFAS No. 123(R), werecorded compensation expense in our Audited Consolidated Financial Statementsfor the year ended September 30, 2007 with respect to the award includedin this table.  See “Note 3 Summary ofSignificant Accounting Policies” in the financial statements of this AnnualReport on Form 10-K for further discussion of the accounting treatment forthese options.

 

(2)          Represents a combination of 500,000 shares ofrestricted stock valued at $2.18 per share, the average of the high and lowprices of our common stock on the NASDAQ Capital Market on August 7, 2007,the day of the grant, and 25,000 shares of restricted stock valued at $2.85

 

54

----

 

pershare, the average of the high and low prices of our common stock on the NASDAQCapital Market on October 24, 2006.  On September 30, 2007, the restricted stock granted to Mr. Terryin fiscal 2007 had a value of $1,722,050 based on the closing price of ourcommon stock of $3.28 per share on the NASDAQ Capital Market.   The restricted stock granted to Mr. Terryvests 33% on each anniversary of the date of grant for the shares granted on October 24,2006.   The restricted stock grant of500,000 shares vests upon satisfaction of specific performance goals set forthby the Compensation Committee.   See “—CompensationDiscussion and Analysis-Equity-based Incentive Awards.” for the description ofthe specific performance targets.  We donot currently pay dividends on our common stock; however, we would paydividends on the restricted stock should our dividend policy change and wedeclared a dividend on our common stock.

 

(3)          Represents company matching contributionspursuant to our 401(k) plan and the dollar value of insurance premiumspaid by our company with respect to term life insurance for the benefit of thenamed executive officer.

 

**Grants of Plan Based Awards**

 
| ** **         | ** ** | ** **     | ** ** | **Estimated Future Payouts Under** | ** ** | **All Other  Stock Awards:  Number of** | ** ** | **All Other  Option  Awards:  Number of  Securities** | ** ** | **Exercise or  Base Price** | ** ** | **Closing  Market  Price  of Common** | ** ** | **Grant Date  Fair Value  of Stock  and** | ** ** |
|--------------------|------------|----------------|------------|------------------------------------|------------|--------------------------------------------------------|------------|-----------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **         | ** ** | ** **     | ** ** | **Equity Incentive Plan Awards**   | ** ** | **Shares of Stock**                          | ** ** | **Underlying**                                                  | ** ** | **of Option**                    | ** ** | **Stock**                                  | ** ** | **Option**                                               | ** ** |
| **Name**           | ** ** | **Grant Date** | ** ** | **Threshold  (#)**                 | ** ** | **Target  (#)**                                        | ** ** | **Maximum (#)**                                                 | ** ** | **or Units  (#)**                | ** ** | **Options  (#)**                           | ** ** | **Awards  (1)($ / Sh)**                        | ** ** | **Awards  ($ / Sh)** | ** ** | **Awards  (2)($)** | ** ** |
| Jim B. Terry       |       | 10/24/06       |       | —                             |       | —                                                 |       | —                                                          |       | —                                |       | 75,000                                     |       | 2.85                                                     |       | 2.88 |   | 138,000 |   |
|               |       | 10/24/06       |       | —                             |       | 25,000                                                 |       | —                                                          |       | 25,000                                | (3)        | —                                     |       | —                                                   |       | — |   | — |   |
|               |       | 8/7/2007       |       | —                             |       | 170,750                                                |       | —                                                          |       | 170,750                               | (4)        | —                                     |       | —                                                   |       | — |   | — |   |
|               |       | 8/7/2007       |       | —                             |       | 129,250                                                |       | —                                                          |       | 129,250                               | (4)        | —                                     |       | —                                                   |       | — |   | — |   |
|               |       | 8/7/2007       |       | —                             |       | 200,000                                                |       | —                                                          |       | 200,000                               | (4)        | —                                     |       | —                                                   |       | — |   | — |   |
| J. Chris Boswell   |       | —         |       | —                             |       | —                                                 |       | —                                                          |       | —                                |       | —                                     |       | —                                                   |       | — |   | — |   |
| Thomas E. Hardisty |       | —         |       | —                             |       | —                                                 |       | —                                                          |       | —                                |       | —                                     |       | —                                                   |       | — |   | — |   |
| Gordon Tibbitts    |       | —         |       | —                             |       | —                                                 |       | —                                                          |       | —                                |       | —                                     |       | —                                                   |       | — |   | — |   |

 

----

(1)          Represents the average of the high and lowmarket prices of our common stock on the NASDAQ Capital Market on the date ofthe grant, which is the calculation used to determine fair market value underour equity incentive plans.

 

(2)          We adopted the fair value recognitionprovisions of SFAS No. 123(R) effective June 15, 2005.  Accordingly, the grant date fair value forthe award made in fiscal 2007 is calculated in accordance with SFAS 123(R).

 

(3)          Effective October 24, 2006, Mr. Terryreceived 25,000 shares of common stock, pursuant to the 2005 Stock IncentivePlan, vesting over three years, 33% on each anniversary of the grant date ineach of 2007, 2008, and 2009.

 

(4)          Effective August 7, 2007, Mr. Terryreceived 170,750 shares, 129,250 shares and 200,000 shares of restrictedstock.  See “—Compensation Discussion andAnaylsis-Equity-based Incentive Awards” for the description of the specificperformance targets.

 

**NarrativeDisclosure to Summary Compensation Table and Grants of Plan-Based Awards Table**

 

The following is adiscussion of material factors necessary to gain an understanding of theinformation disclosed in the Summary Compensation Table and the Grants ofPlan-Based Awards Table.

 

***EmploymentAgreements***

 

*EmploymentAgreement of Jim B. Terry*.   Mr. Terry entered into an employment agreement effective as of January 23,2006.  This agreement has a three-yearterm that is automatically extended for successive one-year periods followingthe end of the initial three-year term unless otherwise terminated by deliveryof written notice by either party no less than 90 days prior to the first dayof any one-year extension period.  Theagreement provides that Mr. Terry will serve as our Chief ExecutiveOfficer and President.  Under the termsof the agreement, Mr. Terry will receive an annual base salary of$240,000, which may be further increased at the sole discretion of theCompensation Committee.  We may decrease Mr. Terry’sbase salary only with the prior written consent of Mr. Terry.  Mr. Terry is also eligible to participatein our annual bonus incentive plan as approved by the Compensation Committee orthe Board of Directors in amounts approved by and based on criteria establishedby the Compensation Committee.  Mr. Terrywill also be eligible to participate, in the sole discretion of theCompensation Committee, in any long-term incentive arrangements we makeavailable to our executive officers from time to time.  Finally, Mr. Terry will receive certainperquisites, including reimbursement in accordance with our standard policiesand procedures of business and business-related business expenses and dues andfees to industry and professional organizations, four weeks of paid vacationeach calendar year, and participation by Mr. Terry and his spouse and

 

55

----

 

dependents in all benefits, plans and programs available to ourexecutive employees.  We have also agreedto use reasonable efforts to obtain life insurance for Mr. Terry in theamount of $500,000.

 

During the term of the agreement,we may terminate Mr. Terry’s employment at any time upon his (1) death,(2) disability, (3) for cause, or (4) for any other reasonwhatsoever in the sole discretion of the Board of Directors. If we desire toterminate Mr. Terry’s employment at any time prior to expiration of theterm of his employment, we must provide written notice to Mr. Terryindicating that we have elected to terminate his employment and stating theeffective date of termination and the reason for such termination. Mr. Terrymay terminate his employment (1) as a result of a change in duties (assuch term is defined in the employment agreement) after first giving us writtennotice of the specific occurrence that resulted in the change in duties and ifsuch occurrence remains uncorrected for 10 days following delivery of suchnotice, or (2) at any time for any reason whatsoever. If Mr. Terrydesires to terminate his employment at any time prior to expiration of the termof his employment, he must provide 30-days written notice to us indicating thathe has elected to terminate his employment and stating the effective date oftermination and the reason for such termination.

 

In the event Mr. Terry’semployment terminates upon expiration of the term of the employment agreementor if Mr. Terry’s employment is terminated by either Mr. Terry or ourCompany for any reason other than an Involuntary Termination (as definedbelow), all compensation and benefits to Mr. Terry under the agreementwill terminate contemporaneously with the termination of his employment. Forpurposes of the agreement, an “Involuntary Termination” means any terminationof Mr. Terry’s employment with our Company which:

 

·                  doesnot result from an expiration of the term of the employment agreement;

 

·                  doesnot result from a resignation by Mr. Terry (except as otherwise providedbelow);

 

·                  doesnot result from a termination for cause of Mr. Terry;

 

·                  doesnot result from Mr. Terry’s death or disability; or

 

·                  resultsfrom a resignation by Mr. Terry on or before the date which is 60 daysafter the date upon which Mr. Terry receives notice of a change of duties(as defined in the agreement).

 

Mr. Terry’semployment agreement also includes provisions governing the payment ofseverance benefits if his employment is terminated in connection with a Changein Control.  For a description of thesepayments, please read “—Potential Payments Upon Termination or Change inControl” below.

 

Additionally, if any ofthe payments or benefits described above are subject to the excise tax imposedby Section 4999 of the Internal Revenue Code of 1986, as amended, then Mr. Terryis entitled to receive a gross-up payment equal to the amount of excise taximposed plus all taxes imposed on the gross-up payment.

 

The agreement alsocontains customary confidentiality, nondisclosure and proprietary rightsprovisions. In addition, during his employment and for a period of two yearsfollowing the termination of Mr. Terry’s employment for any reason, Mr. Terryis prohibited from participating in the ownership, management, operation orcontrol in any business that conducts a business similar to that conducted byus or provides or sells a service or product that is the same, substantiallysimilar to or otherwise competitive with the products and services provided orsold by our Company in any of the business territories that we conduct businessfrom time to time, subject to certain limited exceptions. During that sameperiod, Mr. Terry may not solicit, among others, customers, suppliers andemployees of our Company.

 

*EmploymentAgreement of J. Chris Boswell*.    Mr. Boswell entered into an employmentagreement that was effective as of February 1, 2006.  This agreement, which replaced his previousemployment agreement, has a three-year term that is automatically extended forsuccessive one-year periods following the end of the initial three-year termunless otherwise terminated by delivery of written notice by either party noless than 90 days prior to the first day of any one-year extension period.  The agreement provides that Mr. Boswellwill serve as Chief Financial Officer and Senior Vice President.  Under the terms of the agreement, Mr. Boswellwill receive an annual base salary of $220,000, which may be further increasedat the sole discretion of the Compensation Committee.  We may decrease Mr. Boswell’s basesalary only with the prior written consent of Mr. Boswell.  Mr. Boswell is also eligible toparticipate in our annual bonus incentive plan as approved by the CompensationCommittee or the Board of Directors in amounts approved by and based oncriteria established by the Compensation Committee.  Mr. Boswell will also be eligible toparticipate, in the sole discretion of the Compensation

 

56

----

 

Committee, in any long-term incentive arrangements we make available toour executive officers from time to time. Finally, Mr. Boswell will receive certain perquisites, includingreimbursement in accordance with our standard policies and procedures ofbusiness and business-related business expenses and dues and fees to industryand professional organizations, four weeks of paid vacation each calendar year,and participation by Mr. Boswell and his spouse and dependents in allbenefits, plans and programs available to our executive employees.  We have also agreed to use reasonable effortsto obtain life insurance for Mr. Boswell in the amount of $500,000.

 

During the term of theagreement, we may terminate Mr. Boswell’s employment at any time upon his (1) death,(2) disability, (3) for cause, or (4) for any other reasonwhatsoever in the sole discretion of the Board of Directors. If we desire toterminate Mr. Boswell’s employment at any time prior to expiration of theterm of his employment, we must provide written notice to Mr. Boswellindicating that we have elected to terminate his employment and stating theeffective date of termination and the reason for such termination. Mr. Boswellmay terminate his employment (1) as a result of a change in duties (assuch term is defined in the employment agreement) after first giving us writtennotice of the specific occurrence that resulted in the change in duties and ifsuch occurrence remains uncorrected for 10 days following delivery of suchnotice, or (2) at any time for any reason whatsoever. If Mr. Boswelldesires to terminate his employment at any time prior to expiration of the termof his employment, he must provide 30-days written notice to us indicating thathe has elected to terminate his employment and stating the effective date oftermination and the reason for such termination.

 

In the event Mr. Boswell’semployment terminates upon expiration of the term of the employment agreementor if Mr. Boswell’s employment is terminated by either Mr. Boswell orour Company for any reason other than an Involuntary Termination (as definedbelow), all compensation and benefits to Mr. Boswell under the agreement will terminatecontemporaneously with the termination of his employment. For purposes of theagreement, an “Involuntary Termination” means any termination of Mr. Boswell’semployment with our Company which:

 

·                  doesnot result from an expiration of the term of the employment agreement;

 

·                  doesnot result from a resignation by Mr. Boswell (except as otherwise providedbelow);

 

·                  doesnot result from a termination for cause of Mr. Boswell;

 

·                  doesnot result from Mr. Boswell’s death or disability; or

 

·                  resultsfrom a resignation by Mr. Boswell on or before the date which is 60 daysafter the date upon which Mr. Boswell receives notice of a change ofduties (as defined in the agreement).

 

Mr. Boswell’semployment agreement also includes provisions governing the payment ofseverance benefits if his employment is terminated in connection with a Changein Control.  For a description of thesepayments, please read “—Potential Payments Upon Termination or Change inControl” below.

 

Additionally, if any ofthe payments or benefits described above are subject to the excise tax imposedby Section 4999 of the Internal Revenue Code of 1986, as amended, then Mr. Boswellis entitled to receive a gross-up payment equal to the amount of excise taximposed plus all taxes imposed on the gross-up payment.

 

The agreement alsocontains customary confidentiality, nondisclosure and proprietary rightsprovisions. In addition, during his employment and for a period of two yearsfollowing the termination of Mr. Boswell’s employment for any reason, Mr. Boswellis prohibited from participating in the ownership, management, operation orcontrol in any business that either (1) conducts a business similar to theparticle impact drilling system business conducted by us (or any other line ofbusiness involving technological processes that we have either developed oracquired) or (2) provides or sells a service or product that is the same,substantially similar to or otherwise competitive with the products andservices related to the particle impact drilling system business conducted byus (or any other line of business involving technological processes that wehave either developed or acquired) in any of the business territories that weconduct business from time to time, subject to certain limited exceptions.During that same period, Mr. Boswell may not solicit, among others,customers, suppliers and employees of our Company.

 

*EmploymentAgreement of Thomas E. Hardisty*.    Mr. Hardisty entered into anemployment agreement that was effective as of February 1, 2006.  This agreement, which replaced his previousemployment agreement, has a three-year term that is automatically extended forsuccessive one-year periods following the end of the initial three-year termunless

 

57

----

 

otherwise terminated by delivery of written notice by either party noless than 90 days prior to the first day of any one-year extension period.  The agreement provides that Mr. Hardistywill serve as a Senior Vice President. Under the terms of the agreement, Mr. Hardisty will receive anannual base salary of $180,000, which may be further increased at the solediscretion of the Compensation Committee. We may decrease Mr. Hardisty’s base salary only with the priorwritten consent of Mr. Hardisty.  Mr. Hardistyis also eligible to participate in our annual bonus incentive plan as approvedby the Compensation Committee or the Board of Directors in amounts approved byand based on criteria established by the Compensation Committee.  Mr. Hardisty will also be eligible toparticipate, in the sole discretion of the Compensation Committee, in anylong-term incentive arrangements we make available to our executive officersfrom time to time.  Finally, Mr. Hardistywill receive certain perquisites, including reimbursement in accordance withour standard policies and procedures of business and business-related businessexpenses and dues and fees to industry and professional organizations, fourweeks of paid vacation each calendar year, and participation by Mr. Hardistyand his spouse and dependents in all benefits, plans and programs available toour executive employees.  We have alsoagreed to use reasonable efforts to obtain life insurance for Mr. Hardistyin the amount of $500,000.

 

During the term of theagreement, we may terminate Mr. Hardisty’s employment at any time upon his(1) death, (2) disability, (3) for cause, or (4) for anyother reason whatsoever in the sole discretion of the Board of Directors. If wedesire to terminate Mr. Hardisty’s employment at any time prior toexpiration of the term of his employment, we must provide written notice to Mr. Hardistyindicating that we have elected to terminate his employment and stating theeffective date of termination and the reason for such termination. Mr. Hardistymay terminate his employment (1) as a result of a change in duties (as such term isdefined in the employment agreement) after first giving us written notice ofthe specific occurrence that resulted in the change in duties and if suchoccurrence remains uncorrected for 10 days following delivery of such notice,or (2) at any time for any reason whatsoever. If Mr. Hardisty desiresto terminate his employment at any time prior to expiration of the term of hisemployment, he must provide 30-days written notice to us indicating that he haselected to terminate his employment and stating the effective date of terminationand the reason for such termination.

 

In the event Mr. Hardisty’semployment terminates upon expiration of the term of the employment agreementor if Mr. Hardisty’s employment is terminated by either Mr. Hardistyor our Company for any reason other than an Involuntary Termination (as definedbelow), all compensation and benefits to Mr. Hardisty under the agreementwill terminate contemporaneously with the termination of his employment. Forpurposes of the agreement, an “Involuntary Termination” means any terminationof Mr. Hardisty’s employment with our Company which:

 

·                  doesnot result from an expiration of the term of the employment agreement;

 

·                  doesnot result from a resignation by Mr. Hardisty (except as otherwiseprovided below);

 

·                  doesnot result from a termination for cause of Mr. Hardisty;

 

·                  doesnot result from Mr. Hardisty’s death or disability; or

 

·                  resultsfrom a resignation by Mr. Hardisty on or before the date which is 60 daysafter the date upon which Mr. Hardisty receives notice of a change ofduties (as defined in the agreement).

 

Mr. Hardisty’s employmentagreement also includes provisions governing the payment of severance benefitsif his employment is terminated in connection with a Change in Control.  For a description of these payments, pleaseread “—Potential Payments Upon Termination or Change in Control” below.

 

Additionally, if any ofthe payments or benefits described above are subject to the excise tax imposedby Section 4999 of the Internal Revenue Code of 1986, as amended, then Mr. Hardistyis entitled to receive a gross-up payment equal to the amount of excise taximposed plus all taxes imposed on the gross-up payment.

 

The agreement alsocontains customary confidentiality, nondisclosure and proprietary rightsprovisions. In addition, during his employment and for a period of two yearsfollowing the termination of Mr. Hardisty’s employment for any reason, Mr. Hardistyis prohibited from participating in the ownership, management, operation orcontrol in any business that conducts a business similar to that conducted byus or provides or sells a service or product that is the same, substantiallysimilar to or otherwise competitive with the products and services provided orsold by our Company in any of the business territories that we conduct businessfrom time to time, subject to certain limited exceptions. During that sameperiod, Mr. Hardisty may not solicit, among others, customers, suppliersand employees of our Company.

 

58

----

 

*EmploymentAgreement of Gordon Tibbitts*.    Mr. Tibbitts entered into anemployment agreement effective as of August 1, 2003.  The agreement has an initial term of one yearand automatically renews each August 1st for an addition twelve monthperiod.  The agreement provides that Mr. Tibbittswill serve as Vice President—Technology. Mr. Tibbitts receives an annual base salary of $130,000 and iseligible to participate in benefits and insurance packages of the Company.  We also agreed to provide Mr. Tibbittswith the use of office and communication equipment normal for the operation ofa satellite office in Salt Lake City, Utah. Mr. Tibbitts will also be eligible to receive a bonus at such timeand in such amount as determined by the Board of Directors of the Company.

 

During the term of theagreement, we may terminate Mr. Tibbitts’ employment at any time forcause, and Mr. Tibbitts may terminate the agreement for any reason uponwritten notice delivered no less than 15 days and no more than 60 days prior tothe date of termination. The employment agreement with Mr. Tibbitts alsocontains customary nondisclosure and proprietary rights provisions.

 

**Outstanding Equity Awards as of September 30,2007**

 

The following tableprovides information concerning unexercised options and restricted stock thathave not vested for each named executive officer as of September 30, 2007:

 
| ** **          | ** ** | **Options Awards**                                                                      | ** ** | **Stock Awards**                                                            | ** ** |
|---------------------|------------|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| **Name**            | ** ** | **Number of  Securities  Underlying  Unexercised  Unearned  Options  Exercisable** | ** ** | **Number  of  Securities  Underlying  Unexercised  Options  Unexercisable** | ** ** | **Equity Incentive  Plan Awards:  Number of  Securities  Underlying  Unexercised  Unearned  Options** | ** ** | **Option  Exercise  Price** | ** ** | **Option  Expiration Date** | ** ** | **Number of  Shares or Units  of Stock That  Have Not  Vested** | ** ** | **Market  Value of  Shares or  Units of  Stock That  Have Not  Vested(1)** | ** ** | **Equity Incentive  Plan Awards:  Number of  Unearned Shares,  Units or Other  Rights That Have  Not Vested** | ** ** | **Equity Incentive  Plan Awards:  Market or Payout Value of  Unearned Shares,  Units or Other  Rights That Have  Not Vested** | ** ** |
| Jim B. Terry        |       | 50,000                                                                                  |       | 100,000                                                                     | (6)        | — |   | $ | 6.73 |   | 1/23/2016 |   | — |   | $ | — |   | — |   | $ | — |   |
|                |       | —                                                                                  |       | 75,000                                                                      | (7)        | — |   | 2.85 |   | 10/24/2016 |   | — |   | — |   | — |   | — |   |
|                |       | —                                                                                  |       | —                                                                      |       | — |   | — |   | — |   | 100,000 | (2) | 328,000 |   | — |   | — |   |
|                |       | —                                                                                  |       | —                                                                      |       | — |   | — |   | — |   | 25,000 | (3) | 82,000 |   | — |   | — |   |
|                |       | —                                                                                  |       | —                                                                      |       | — |   | — |   | — |   | — |   | — |   | 129,250 | (4) | 423,940 |   |
|                |       | —                                                                                  |       | —                                                                      |       | — |   | — |   | — |   | — |   | — |   | 200,000 | (4) | 656,000 |   |
|                |       | —                                                                                  |       | —                                                                      |       | — |   | — |   | — |   | — |   | — |   | 170,750 | (4) | 560,060 |   |
| J. Chris Boswell    |       | 640,000                                                                                 |       | 120,000                                                                     | (8)        | — |   | 0.12 |   | 4/8/2014 |   | — |   | — |   | — |   | — |   |
|                |       | 106,667                                                                                 |       | 53,333                                                                      | (9)        | — |   | 4.90 |   | 5/20/2015 |   | — |   | — |   | — |   | — |   |
|                |       | —                                                                                  |       | —                                                                      |       | — |   | — |   | — |   | 10,000 | (5) | 32,800 |   | — |   | — |   |
| Thomas E.  Hardisty |       | 525,000                                                                                 |       | 75,000                                                                      | (8)        | — |   | 0.12 |   | 4/8/2014 |   | — |   | — |   | — |   | — |   |
|                |       | 106,667                                                                                 |       | 53,333                                                                      | (9)        | — |   | 4.90 |   | 5/20/2015 |   | — |   | — |   | — |   | — |   |
|                |       | —                                                                                  |       | —                                                                      |       | — |   | — |   | — |   | 10,000 | (5) | 32,800 |   | — |   | — |   |
| Gordon Tibbitts     |       | 287,500                                                                                 |       | 62,500                                                                      | (8)        | — |   | 0.12 |   | 4/8/2014 |   | — |   | — |   | — |   | — |   |
|                |       | 23,333                                                                                  |       | 46,667                                                                      | (10)       | — |   | 4.50 |   | 10/3/2015 |   | — |   | — |   | — |   | — |   |
|                     |            |                                                                                         |            |                                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)      Value based on the market value of our commonstock on September 30, 2007 ($3.28).

 

(2)      Restricted stock award lapses 1/2 on each on January 23,2008 and 2009.

 

(3)      Restricted stock award lapses 1/3 on each on October 23,2007, 2008 and 2009.

 

(4)      Restricted stock award lapses on specificperformance targets set by the Compensation Committee.  See “—Compensation Discussion and Analysis-Equity-basedIncentive Awards” for the description ofthe specific performance targets.

 

(5)      Restricted stock award lapses on May 20,2008.

 

(6)  Option award vests in 1⁄2 increments on January 23,2008 and 2009.

 

(7)  Option award vests in 1/3 increments on October 24,2007, 2008, and 2009.

 

(8)  Option award vests on April 8, 2008.

 

(9)  Option award vests on May 20, 2008.

 

(10)  Option award vests in 1⁄2 increments on  October 3, 2007 and 2008.

 

59

----

 

**Option Exercises and Stock Vested**

 
| ** **          | ** ** | **Option Awards**                                         | ** ** | **Stock Awards**                        | ** ** |
|---------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------|------------|
| **Name**            | ** ** | **Number of Shares  Acquired on Exercise** | ** ** | **Value Realized on  Exercise(1)** | ** ** | **Number of Shares  Acquired on Vesting** | ** ** | **Value Realized on  Vesting(2)** | ** ** |
| Jim B. Terry        |       | —                                                         |       | $                                            | —     |   | 50,000 |   | $ | 172,000 |   |
| J. Chris Boswell    |       | —                                                         |       | —                                       |       | 10,000 |   | 27,400 |   |
| Thomas E.  Hardisty |       | —                                                         |       | —                                       |       | 10,000 |   | 27,400 |   |
| Gordon Tibbitts     |       | —                                                         |       | —                                       |       | — |   | — |   |
|                     |            |                                                                |            |                                              |            |  |  |  |  |  |  |

 

----

(1)             Value realized represents the difference ofthe fair market value of the shares at the time of exercise over the exerciseprice.

 

(2)             Value realized represents the fair marketvalue of the shares at the vest date.

 

**Potential Payments uponTermination or Change in Control**

 

*SeveranceUnder Employment Agreement of Jim B. Terry*.   Except as provided in the followingsentence, in the event Mr. Terry’s employment is subject to an InvoluntaryTermination (as defined above), we shall pay to Mr. Terry a lump sum cashpayment within 30 days of termination equal to two times his annual base salaryin effect at the time of termination. If Mr. Terry’s employment is subjectto an Involuntary Termination that occurs at any time during the periodbeginning 60 days prior to the date a definitive agreement concerning a Changeof Control (as defined below) is executed and ending on the one-yearanniversary of the consummation of such Change of Control (such period being a “Changeof Control Period”), Mr. Terry will be entitled to receive a lump sum cashpayment within 30 days of termination equal to two times the sum of his annualbase salary in effect at the time of termination and the average of the bonuseshe received in the two preceding fiscal years (as calculated in accordance withthe agreement). If Mr. Terry’s employment is subject to an InvoluntaryTermination during a Change of Control Period or as a result of his death or disability,we have also agreed to accelerate the vesting of all options to purchase commonstock granted to Mr. Terry and to remove the restrictions on vesting orforfeiture of all restricted stock and all other accrued benefits under anynon-qualified deferred compensation plans granted to Mr. Terry. Finally, Mr. Terryand his dependents will be eligible to receive COBRA continuation coverageunder our group health plans for a period of up to two years following anyInvoluntary Termination of his employment, in accordance with and to the extentprovided by COBRA.

 

For purposes of theagreement, a “Change of Control” means:

 

·       a merger of our Companywith another entity, a consolidation involving our Company or the sale of allor substantially all of our assets to another entity if, in any such case, (A) theholders of our equity securities immediately prior to such transaction do notbeneficially own after such transaction 50% or more of the votes to electdirectors generally in substantially the same proportions that they ownedsecurities of our Company prior to such transaction, or (B) the personswho were members of our Board of Directors immediately prior to suchtransaction do not constitute at least a majority of the Board of Directors ofthe resulting entity after such transaction;

 

·       a dissolution orliquidation of our Company;

 

·       whenany person or entity acquires or gains ownership or control of more than 50% ofthe combined voting power of the outstanding securities of our Company; or

 

·       as a result of or inconnection with a contested election of directors, the persons who were membersof our Board of Directors immediately before such election cease to constitutea majority of our Board of Directors.

 

In the event Mr. Terryis a “disqualified individual” (as defined in Section 280G(c) of theInternal Revenue Code) and the payments and benefits that Mr. Terry hasthe right to receive would constitute a “parachute payment” (as defined in Section 280G(b)(2) ofthe Internal Revenue Code), then the benefits provided under the agreement willbe either (1) reduced to an amount so that no portion of such amounts andbenefits received by Mr. Terry will be subject to the excise tax imposedby Section 4999 of the Internal Revenue Code or (2) paid in full,whichever produces the better net after-tax position to Mr. Terry.

 

In the event that anypayment or distribution to Mr. Terry is subject to the excise tax imposedby Section 4999 of the Internal Revenue Code or any interest or penaltieswith respect to such excise tax, we have agreed to make an additional paymentto Mr. Terry in an amount such that after payment by Mr. Terry of alltaxes (including such excise tax imposed on such additional payment), Mr. Terrywill retain an amount of such payment equal to the amount of the excise taximposed upon such payment (the “Gross Up” payment).

 

60

----

 

The following tabledescribes the potential payments upon termination or a change in control of theCompany for Mr. Terry, our President and Chief Executive Officer.

 
| ** **                                                                | ** ** | ** **                   | ** ** | **Involuntary termination on  change of control** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------------------------------------------------|------------|
| **Executive Benefits and Payments  Upon Termination** | ** ** | **Involuntary  termination** | ** ** | **Purchase price of  $4 or more**                 | ** ** | **Purchase  price of less  than $4** | ** ** |
| Compensation:                                                             |       |                         |       |                                                                  |       |   |   |
| Cash payment                                                              |       | $                            | 504,000    |                                                                  | $          | 541,500 |   | $ | 541,500 |   |
| Gross Up (1)                                                              |       | —                       |       | —                                                                |       | — |   |
| Vacation                                                                  |       | 19,385                       |       | 19,385                                                                |       | 19,385 |   |
| Medical Benefits                                                          |       | 31,414                       |       | 31,414                                                                |       | 31,414 |   |
| Long-term  incentives:                                                    |       |                         |       |                                                                  |       |   |   |
| Stock Options:  Unvested                                                  |       | 574,000                      |       | 574,000                                                               |       | 574,000 |   |
| Restricted  Stock: Unvested                                               |       | 2,050,000                    |       | 2,050,000                                                             |       | 2,050,000 |   |
| Total                                                                     |       | $                            | 3,178,799  |                                                                  | $          | 3,216,299 |   | $ | 3,216,299 |   |

 

----

(1) As of  September 30, 2007, the amount of thetermination benefit due under Mr. Terry’s employment contract would nottrigger the excise tax imposed by Section 4999.

 

*SeveranceUnder Employment Agreement of J. Chris Boswell*.   Except as provided in the followingsentence, in the event Mr. Boswell’s employment is subject to anInvoluntary Termination (as defined above), we shall pay to Mr. Boswell alump sum cash payment within 30 days of termination equal to the greater of (1) twotimes his annual base salary in effect at the time of termination, or (2) $600,000.If Mr. Boswell’s employment is subject to an Involuntary Termination thatoccurs at any time during the period beginning 60 days prior to the date adefinitive agreement concerning a Change of Control (as defined below) isexecuted and ending on the one-year anniversary of the consummation of suchChange of Control (such period being a “Change of Control Period”), Mr. Boswellwill be entitled to receive a lump sum cash payment within 30 days oftermination equal to the greater of (1) two times the sum of his annualbase salary in effect at the time of termination and the average of the bonuseshe received in the two preceding fiscal years (as calculated in accordance withthe agreement), or (2) $600,000, which amount will be increased to$950,000 if Mr. Boswell is not provided with an opportunity to sell theshares of our common stock then held by Mr. Boswell at a purchase price of$4.00 or more per share in connection with a Change of Control transaction. If Mr. Boswell’semployment is subject to an Involuntary Termination during a Change of ControlPeriod or as a result of his death or disability, we have also agreed toaccelerate the vesting of all options to purchase common stock granted to Mr. Boswelland to remove the restrictions on vesting or forfeiture of all restricted stockand all other accrued benefits under any non-qualified deferred compensationplans granted to Mr. Boswell. Finally, Mr. Boswell and his dependentswill be eligible to receive COBRA continuation coverage under our group healthplans for a period of up to two years following any Involuntary Termination ofhis employment, in accordance with and to the extent provided by COBRA.

 

For purposes of theagreement, a “Change of Control” has the same meaning as set forth in Mr. Terry’semployment agreement.

 

In the event that anypayment or distribution to Mr. Boswell is subject to the excise taximposed by Section 4999 of the Internal Revenue Code or any interest orpenalties with respect to such excise tax, we have agreed to make an additionalpayment to Mr. Boswell in an amount such that after payment by Mr. Boswellof all taxes (including such excise tax imposed on such additional payment), Mr. Boswellwill retain an amount of such payment equal to the amount of the excise taximposed upon such payment.

 

The following tabledescribes the potential payments upon termination or a change in control of theCompany for Mr. Boswell, our Senior Vice President - Chief FinancialOfficer.

 

61

----

 
| ** **                                                                | ** ** | ** **                   | ** ** | **Involuntary termination on  change of control** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------------------------------------------------|------------|
| **Executive Benefits and Payments Upon  Termination** | ** ** | **Involuntary  termination** | ** ** | **Purchase price of  $4 or more**                 | ** ** | **Purchase  price of less  than $4** | ** ** |
| Compensation:                                                             |       |                         |       |                                                                  |       |   |   |
| Cash payment                                                              |       | $                            | 600,000    |                                                                  | $          | 600,000 |   | $ | 950,000 |   |
| Gross Up (1)                                                              |       | —                       |       | —                                                                |       | 370,619 |   |
| Vacation                                                                  |       | 17,769                       |       | 17,769                                                                |       | 17,769 |   |
| Long-term incentives:                                                     |       |                         |       |                                                                  |       |   |   |
| Stock Options:  Unvested                                                  |       | 568,532                      |       | 568,532                                                               |       | 568,532 |   |
| Restricted  Stock: Unvested                                               |       | 32,800                       |       | 32,800                                                                |       | 32,800 |   |
| Total                                                                     |       | $                            | 1,219,101  |                                                                  | $          | 1,219,101 |   | $ | 1,939,720 |   |

 

----

(1) As of  September 30, 2007, the amount of thetermination benefit due under Mr. Boswell’s employment contract would onlytrigger the excise tax imposed by Section 4999 if the company were to besold for less than $4 per share.

 

*SeveranceUnder Employment Agreement of Thomas E. Hardisty*.   Except as provided in the following sentence,in the event Mr. Hardisty’s employment is subject to an InvoluntaryTermination (as defined above), we shall pay to Mr. Hardisty a lump sumcash payment within 30 days of termination equal to the greater of (1) twotimes his annual base salary in effect at the time of termination, or (2) $450,000.If Mr. Hardisty’s employment is subject to an Involuntary Termination thatoccurs at any time during the period beginning 60 days prior to the date adefinitive agreement concerning a Change of Control (as defined below) isexecuted and ending on the one-year anniversary of the consummation of suchChange of Control (such period being a “Change of Control Period”), Mr. Hardistywill be entitled to receive a lump sum cash payment within 30 days of terminationequal to the greater of (1) two times the sum of his annual base salary ineffect at the time of termination and the average of the bonuses he received inthe two preceding fiscal years (as calculated in accordance with theagreement), or (2) $450,000, which amount will be increased to $650,000 ifMr. Hardisty is not provided with an opportunity to sell the shares of ourcommon stock then held by Mr. Hardisty at a purchase price of $4.00 ormore per share in connection with a Change of Control transaction. If Mr. Hardisty’semployment is subject to an Involuntary Termination during a Change of ControlPeriod or as a result of his death or disability, we have also agreed toaccelerate the vesting of all options to purchase common stock granted to Mr. Hardistyand to remove the restrictions on vesting or forfeiture of all restricted stockand all other accrued benefits under any non-qualified deferred compensationplans granted to Mr. Hardisty. Finally, Mr. Hardisty and hisdependents will be eligible to receive COBRA continuation coverage under ourgroup health plans for a period of up to two years following any InvoluntaryTermination of his employment, in accordance with and to the extent provided byCOBRA.

 

For purposes of theagreement, a “Change of Control” has the same meaning as set forth in Mr. Terry’semployment agreement.

 

In the event that anypayment or distribution to Mr. Hardisty is subject to the excise taximposed by Section 4999 of the Internal Revenue Code or any interest orpenalties with respect to such excise tax, we have agreed to make an additionalpayment to Mr. Hardisty in an amount such that after payment by Mr. Hardistyof all taxes (including such excise tax imposed on such additional payment), Mr. Hardistywill retain an amount of such payment equal to the amount of the excise taximposed upon such payment.

 

The following tabledescribes the potential payments upon termination or a change in control of theCompany for Mr. Hardisty, our Senior Vice President of BusinessDevelopment and Secretary.

 
| ** **                                                                | ** ** | ** **                   | ** ** | **Involuntary termination on  change of control** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------------------------------------------------|------------|
| **Executive Benefits and Payments Upon  Termination** | ** ** | **Involuntary  termination** | ** ** | **Purchase price of  $4 or more**                 | ** ** | **Purchase price of  less than $4** | ** ** |
| Compensation:                                                             |       |                         |       |                                                                  |       |   |   |
| Cash payment                                                              |       | $                            | 450,000    |                                                                  | $          | 450,000 |   | $ | 650,000 |   |
| Gross Up (1)                                                              |       | —                       |       | —                                                                |       | 237,629 |   |
| Vacation                                                                  |       | 14,538                       |       | 14,538                                                                |       | 14,538 |   |
| Long-term  incentives:                                                    |       |                         |       |                                                                  |       |   |   |
| Stock Options:  Unvested                                                  |       | 420,932                      |       | 420,932                                                               |       | 420,932 |   |
| Restricted  Stock: Unvested                                               |       | 32,800                       |       | 32,800                                                                |       | 32,800 |   |
| Total                                                                     |       | $                            | 918,270    |                                                                  | $          | 918,270 |   | $ | 1,355,899 |   |

 

62

----

 

----

(1) As of  September 30, 2007, the amount of thetermination benefit due under Mr. Hardisty’s employment contract wouldonly trigger the excise tax imposed by Section 4999 if the company were tobe sold for less than $4 per share.

 

*SeveranceUnder Employment Agreement of Gordon Tibbitts*.     If  Mr. Tibbitsis involuntarily terminated, he will be entitled to receive a payment equal toone month of his base salary as well as any vacation unused at that time andall stock options and restricted stock not then vested or exercisable, as thecase may be, shall immediately vest and become fully exercisable.

 

The following tabledescribes the potential payments upon termination or a change in control of theCompany for Mr. Tibbitts, our Vice President of Technology.

 
| ** **                                                                | ** ** | ** **                   | ** ** | **Involuntary termination on  change of control** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------------------------------------------------|------------|
| **Executive Benefits and Payments Upon  Termination** | ** ** | **Involuntary  termination** | ** ** | **Purchase price of  $4 or more**                 | ** ** | **Purchase  price of  less than $4** | ** ** |
| Compensation:                                                             |       |                         |       |                                                                  |       |   |   |
| Cash payment                                                              |       | $                            | 12,500     |                                                                  | $          | 12,500 |   | $ | 12,500 |   |
| Gross Up (1)                                                              |       | —                       |       | —                                                                |       | — |   |
| Vacation                                                                  |       | 11,538                       |       | 11,538                                                                |       | 11,538 |   |
| Long-term  incentives:                                                    |       |                         |       |                                                                  |       |   |   |
| Stock Options:  Unvested                                                  |       | 358,068                      |       | 358,068                                                               |       | 358,068 |   |
| Restricted  Stock: Unvested                                               |       | —                       |       | —                                                                |       | — |   |
| Total                                                                     |       | $                            | 382,106    |                                                                  | $          | 382,106 |   | $ | 382,106 |   |

 

----

(1) As of  September 30, 2007, the amount of thetermination benefit due under Mr. Tibbitts’ employment contract would nottrigger the excise tax imposed by Section 4999.

 

**DIRECTORCOMPENSATION**

 

The following table setsforth the compensation earned by our non-employee directors for the year ended September 30,2007:

 
| **Name**                    | ** ** | **Fees Earned  or Paid in  Cash** | ** ** | **Stock Awards  (1)** | ** ** | **Option  Awards  (2)** | ** ** | **Non-Equity  Incentive Plan  Compensation** | ** ** | **All Other  Compensation** | ** ** | **Total** | ** ** |
|-----------------------------|------------|--------------------------------------------------|------------|----------------------------|------------|-------------------------|------------|---------------------------------------------------|------------|----------------------------------|------------|-----------|------------|
| Len R. LeSuer               |       | $                                                | 41,250     |                       | $          | 39,300                  |       | $                                                 | 74,100     |                             | —     |      | —     |   | $ | 154,650 |   |
| John D.  Schiller, Jr. |       | 28,500                                           |       | 19,650                     |       | 37,050                  |       | —                                            |       | —                           |       | 85,200    |       |
| Michael Mathews             |       | 41,500                                           |       | 19,650                     |       | 37,050                  |       | —                                            |       | —                           |       | 98,200    |       |
| Hugh A. Menown              |       | 38,500                                           |       | 19,650                     |       | 37,050                  |       | —                                            |       | —                           |       | 95,200    |       |
| Steve Weyel(3)              |       | 23,625                                           |       | 19,650                     |       | 37,050                  |       |                                              |       |                             |       | 80,325    |       |
|                             |            |                                                  |            |                            |            |                         |            |                                                   |            |                                  |            |           |            |  |  |  |  |

 

----

(1)          Based on the the average of the high and lowmarket prices of our common stock on the NASDAQ Capital Market on the date ofthe grant.

 

(2)  Based on the fair value computed inaccordance with FAS 123(R)

 

63

----

 

(3)          Steve Weyel resigned in August 2007.

 

Certain of our directors,who are also officers, do not receive any compensation for their services asmembers of our Board of Directors.  Wereimburse our directors for travel and lodging expenses in connection withtheir attendance at board and committee meetings.

 

Our Board of Directorsadopted our current Board Compensation Package effective as of June 1,2005.  Under the Board CompensationPackage, our non-employee directors will receive an annual retainer of $20,000and $1,500 for each formal Board meeting attended.  In addition, each non-employee director whois also a committee member will receive an annual committee retainer fee of$2,500 and $750 for each formal committee meeting attended.  Each non-employee director who is also acommittee chair will receive an additional annual retainer of $2,500.  The Board Compensation Package also providesfor annual equity compensation for each non-employee director consisting of5,000 shares of our restricted common stock and an option for 15,000 shares ofour common stock.  In addition, any newnon-employee directors will be granted an option for 25,000 shares of ourcommon stock as a one time award upon joining the Board of Directors.  In addition to receiving the compensationdescribed above as a director, the Chairman of the Board will receive an annualretainer of $2,500, as well as an annual award of 5,000 shares of ourrestricted common stock and an option for 15,000 shares of our commonstock.  All option awards will benon-qualified stock options and, together will all awards of restricted stock,will be issued pursuant to our equity compensation plans in effect at the timeof the award and will be exercisable for a ten-year period from the date ofgrant of the award.  The restricted stockand option awards will vest in 50% installments on each anniversary of the dateof grant of the award.

 

**CompensationCommittee Interlocks and Insider Participation**

 

During the fiscal yearended September 30, 2007, Messrs. LeSuer, Schiller and Menown servedon the Compensation Committee of our Board of Directors. None of Messrs. LeSuernor Menown has ever been an officer or employee of Particle DrillingTechnologies, Inc. Mr. Schiller served as the Company’s interimPresident and Chief Executive Officer from January 2005 until November 2005.  None of our executive officers serve as amember of the Board of Directors or compensation committee of any entity thathas any executive officer serving as a member of our Board of Directors orCompensation Committee.

 

**Item 12. Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters**

 

The following table setsforth the number of shares of common stock of the company beneficially owned asof November 30, 2007 by (1) those persons or any group (as that termis used in Section 13(d)(3) of the Securities Exchange Act of 1934)known by our company to beneficially own more than 5% of our common stock, (2) eachnamed executive officer and director of our company, and (3) all directorsand executive officers of our company as a group. For purposes of this table,beneficial ownership is determined in accordance with Rule 13d-3promulgated under the Securities Exchange Act of 1934. The following tableincludes shares of restricted stock of our company held by our executiveofficers and directors over which they have voting power but no investmentpower. The following percentage information is calculated based on 31,629,901shares of common stock that were outstanding as of November 30, 2007.Except as indicated below, the stockholders listed possess sole voting andinvestment power with respect to the shares beneficially owned by that person.

 

| LC Capital Master Fund, Ltd.(1)                         |   | 1,734,300 |     |   | 5.5  | %      |
|---------------------------------------------------------|--------|-----------|----------|--------|------|--------|
| Greywolf Capital Management LP(2)                       |   | 2,026,000 |     |   | 6.4  | %      |
| John D. Schiller, Jr. (3)                          |   | 1,844,167 | (4)      |   | 5.6  | %      |
| Jim B. Terry                                            |   | 810,500   | (5)      |   | 2.6  | %      |
| Thomas E. Hardisty                                      |   | 1,477,667 | (6)      |   | 4.6  | %      |
| J. Chris Boswell                                        |   | 1,825,807 | (7)      |   | 5.6  | %      |
| Gordon Tibbitts                                         |   | 334,167   | (8)      |   | 1.1  | %      |
| Ken R. LeSuer                                           |   | 175,000   | (9)      |   | *    |   |
| Michael S. Mathews                                      |   | 87,500    | (10)     |   | *    |   |
| Hugh A. Menown                                          |   | 87,500    | (11)     |   | *    |   |
| Byron Dunn                                              |   | 5,000     | (11)     |   | *    |   |
| Directors and executive officers as a group (9 persons) |   | 6,647,308 | (3)-(11) |   | 19.0 | %      |

 

----

*                    Lessthan 1%

 

64

----

 

(1)             Address:c/o Lampe Conway, 680 Fifth Avenue, Suite 1202, New York, New York 10019.Richard F. Conway has sole voting and investment power with respect to theshares of common stock held by LC Capital Master Fund, Ltd.

 

(2)             Address:c/o Joe McInnis, 4 Manhattanville Road, Suite 201, Purchase, NY10577-2119.  We have been advised thatthe shares are owned directly by Greywolf Capital Partners II LP (“GreywolfCapital II”) and by Greywolf Capital Overseas Fund (“Greywolf Overseas”).Greywolf Advisors LLC (the “General Partner”), as general partner to GreywolfCapital II, may be deemed to be the beneficial owner of all such shares ownedby Greywolf Capital II. Greywolf Management LP (“Investment Manager”), asinvestment manager of Greywolf Overseas and Greywolf Capital II, may be deemedto be the beneficial owner of all such shares owned by Greywolf Overseas andGreywolf Capital II. Greywolf GP LLC (the “Investment Manager General Partner”),as general partner of the Investment Manager, may be deemed to be thebeneficial owner of all such shares owned by Greywolf Capital II and GreywolfOverseas. Jonathan Savitz (“Savitz”), as the senior managing member of theGeneral Partner and as the sole managing member of the Investment ManagerGeneral Partner, may be deemed to be the beneficial owner of all such sharesowned by Greywolf Capital II and Greywolf Overseas. Each of the GeneralPartner, the Investment Manager, the Investment Manager General Partner andSavitz hereby disclaims any beneficial ownership of any such shares. Theaddress of the principal business office of (i) Greywolf Capital II,General Partner, Investment Manager and Investment Manager General Partner is 4Manhattanville Road, Suite 201, Purchase, NY 10577 and (ii) GreywolfOverseas is 6 Front Street, Hamilton, HM11 Bermuda.

 

(3)             Address:1021 Main Street Suite 2626 Houston, Texas 77002.

 

(4)             Includes70,000 shares of restricted stock and 724,167 shares of common stock that Mr. Schillermay purchase upon exercise of stock options that are currently vested or willbecome vested within 60 days of the date of this Form 10-K.

 

(5)             Includes650,000 shares of restricted stock and 125,000 shares of common stock that Mr. Terrymay purchase upon exercise of stock options that are currently vested or willbecome vested within 60 days of the date of this Form 10-K.

 

(6)             Includes30,000 shares of restricted stock and 631,667 shares of common stock that Mr. Hardistymay purchase upon exercise of stock options that are currently vested or willbecome vested within 60 days of the date of this Form 10-K.

 

(7)             Includes30,000 shares of restricted stock and 746,667 shares of common stock that Mr. Boswellmay purchase upon exercise of stock options that are currently vested or willbecome vested within 60 days of the date of this Form 10-K.

 

(8)             Includes334,167 shares of common stock that Mr. Tibbitts may purchase uponexercise of stock options that are currently vested or will become vestedwithin 60 days of this Form 10-K.

 

(9)             Includes30,000 shares of restricted stock and 145,000 shares of common stock that Mr. LeSuermay purchase upon exercise of stock options that are currently vested or willbecome vested within 60 days of this Form 10-K.

 

(10)       Includes15,000 shares of restricted stock and 72,500 shares of common stock that eachof Messrs. Mathews and Menown may purchase upon exercise of stock optionsthat are currently vested or will become vested within 60 days of this Form 10-K.

 

(11)       Consists of5,000 shares of restricted stock.

 

**Securities Authorized for Issuance Under EquityCompensation Plans.**

 

        Incorporatedby reference from “Item 5.  Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities” in this Annual Report on Form 10-K.

 

**Item 13. Certain Relationshipsand Related Transactions and Director Independence**

 

**Transactions with Related Persons**

 

None Applicable.

 

65

----

 

**DirectorIndependence**

 

OurBoard of Directors has determined that Messrs. LeSuer, Schiller, Mathews,Menown and Dunn are, and Mr. Weyel previously was, “independent,” as thatterm is defined by the rules of the NASDAQ. Prior to December 12,2006, our Board of Directors had determined that Mr. Schiller was notindependent. This was because Mr. Schiller served as interim President andChief Executive Officer of our company and PDTI from December 2004 until November 14,2005. During that time, Mr. Schiller received compensation in the form ofadditional grants of restricted stock for serving as an interim executiveofficer. Because of modifications to the NASDAQ rules in 2006 related tothe definition of an independent director, our Board of Directors re-evaluatedthis determination with respect to Mr. Schiller in December 2006. Asa result of this evaluation, our Board of Directors determined that Mr. Schilleris now an independent director under the rules and regulations of theNASDAQ. In making the independence determinations with respect to ourdirectors, our Board of Directors considered transactions and relationshipsbetween each director or his immediate family and our company. The purpose ofthis review was to determine whether any such relationships or transactionswere material and, therefore, inconsistent with a determination that thedirector is independent. The Board of Directors concluded that any suchrelationships and transactions during the past three years were not materialand that any such transactions were at arm’s-length. As a result of thisreview, the Board of Directors affirmatively determined based on itsunderstanding of such transactions and relationships that the directors namedabove, other than Mr. Terry, are independent of the Company under thestandards set forth by NASDAQ.

 

The Board of Directorshas the following standing committees:

 

***Audit Committee.***   Our Board of Directors has aseparately-designated standing Audit Committee, which committee consists of Messrs. Menown,Mathews and Dunn. Mr. Menown serves as Chairman of the Audit Committee.The Board of Directors has made the following determinations related to theAudit Committee:

 

•                  Messrs. Menown, Mathews and Dunnsatisfy the independence requirements as defined by the NASDAQ rules andas set forth in Rule 10A-3 under the Securities Exchange Act of 1934.

 

•                  Each member of the Audit Committee is “financiallyliterate” as the Board of Directors, in its business judgment, interprets suchqualification.

 

•                  Mr. Menown qualifies as an “auditcommittee financial expert” based on the definition and additional expertisefactors outlined by the Securities and Exchange Commission. Mr. Menownacquired the attributes to qualify as an “audit committee financial expert”through his experience as a Partner with PricewaterhouseCoopers LLP where hehad extensive exposure to and obtained a working knowledge of generallyaccepted accounting principles and financial statements. Mr. Menown isalso a Certified Public Accountant.

 

Our Audit Committee reviews, acts on and reports tothe Board of Directors with respect to various auditing and accounting matters,including the selection of our independent auditors, the scope of the annualaudits, fees to be paid to the auditors, the performance of our independentauditors and our accounting practices. The Audit Committee met four timesduring fiscal 2007 and operates pursuant to a written charter, which wasadopted February 3, 2005 and amended on May 31, 2005.

 

The Audit Committee Charter is available on ourwebsite at www.particledrilling.com or in print to any stockholder who requestsit. The Audit Committee has performed an annual review and assessment of itscharter and determined that no amendments are necessary at this time.

 

***Nominating andCorporate Governance Committee.***  TheNominating and Corporate Governance Committee, which consists of Messrs. Mathews,LeSuer and Schiller met four times during fiscal 2007. Mr. Mathews is theChairman of the Nominating and Corporate Governance Committee. The Board ofDirectors has determined that Messrs. Mathews, LeSuer and Schiller satisfythe independence requirements as defined by the rules of the NASDAQ.

 

The Nominating andCorporate Governance Committee is responsible for (1) reviewing theappropriate size, function and needs of the Board of Directors, (2) developingthe Board’s policy regarding tenure and retirement of directors, (3) establishingcriteria for evaluating and selecting new members of the Board, subject toBoard approval thereof, (4) identifying and recommending to the Board forapproval individuals qualified to become members of the Board of Directors,consistent with criteria established by the Committee and the Board, (5) overseeingthe evaluation of management and the Board, and (6) monitoring and makingrecommendations to the Board on matters relating to corporate governance.

 

66

----

 

The Nominating andCorporate Governance Committee Charter is available on our website atwww.particledrilling.com or in print to any stockholder who requests it. TheNominating and Corporate Governance Committee has performed an annual reviewand assessment of its charter and determined that no amendments are necessaryat this time.

 

***CompensationCommittee.***  The Compensation Committee,which consists of Messrs. LeSuer, Schiller and Menown met six times duringfiscal 2007. Mr. LeSuer is the Chairman of the Compensation Committee. TheBoard of Directors has determined that Messrs. LeSuer, Schiller and Menownsatisfy the independence requirements as defined by the listing standards ofthe NASDAQ and Rule 16b-3 under the Securities Exchange Act of 1934.

 

Our CompensationCommittee is authorized to make recommendations concerning salaries andincentive compensation for our employees and consultants, establish and approvesalaries and incentive compensation for certain of our executive officers andadminister our employee benefit and stock option plans.

 

The CompensationCommittee Charter is available on our website at www.particledrilling.com or inprint to any stockholder who requests it. The Compensation Committee hasperformed an annual review and assessment of its charter and determined that noamendments are necessary.

 

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

 

**Audit Fees**

 

The aggregate fees billed for professional servicesrendered for the audit of our consolidated financial statements, audit ofinternal control over financial reporting, issuance of consents and the reviewsof financial statements included in our annual reports on Form 10-K forthe fiscal years ended September 30, 2007 and 2006 were $98,897 and$122,694, respectively. Our Audit Committee pre-approved all fees forprofessional services for the audit of our consolidated financial statementsfor the fiscal year ended September 30, 2007.

 

**Audit-Related Fees**

 

There were no audit-related services provided by ourindependent registered public accounting firm for the fiscal years ended September 30,2007 and 2006.

 

**Tax Fees**

 

There were no tax services provide by our independentregistered public accounting firm for the fiscal years ended September 30,2007 and 2006.

 

**All Other Fees**

 

There were no other services provide by ourindependent registered public accounting firm for the fiscal years ended September 30,2007 and 2006.

 

The Audit Committee is responsible for approving inadvance any audit services and all permitted audit-related services, taxservices, and other non-audit services to be performed by the independentregistered public accounting firm. The Audit Committee may delegate itspre-approval authority for these services to one or more members, whosedecisions shall be presented to the full Audit Committee at its scheduledmeetings. Each of these services must receive specific pre-approval by the AuditCommittee unless the Audit Committee has provided general pre-approval for suchcategory of services in accordance with policies and procedures that complywith applicable laws and regulations.

 

**PART IV**

 

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

** **

(a) List ofdocuments filed as part of this Annual Report:

 

(1) ConsolidatedFinancial Statements

 

67

----

 

All ofour consolidated financial statements are set forth under Item 8 of thisAnnual Report on Form 10-K.

 

(2) Financial Statement Schedules:

 

Financial statement schedules listed under SEC rules butnot included in this report are omitted because they are not applicable or therequired information is provided in the notes to our consolidated financial statements.

 

(3) Exhibits

 

See Exhibit Index

 

68

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized, onthe thirteenth day of December, 2007.

 
|        | PARTICLE DRILLING  TECHNOLOGIES, INC |
|--------|--------------------------------------|
|   |                                 |
|   | By                                   | /s/ J. CHRIS BOSWELL |   |
|   |                                 | J. Chris Boswell |
|   |                                 | Chief Financial Officer |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities indicated and on the thirteenth day of December, 2007.

 
| **Signature**           | ** **                                                      | **Title**                                           |
|-------------------------|-----------------------------------------------------------------|-----------------------------------------------------|
|                    |                                                            |
| /s/  KENNETH R. LESUER  |                                                            | Chairman of the Board  and Director                 |
| Kenneth  R. LeSuer      |                                                            |
|                    |                                                            |
| /s/  JIM TERRY          |                                                            | President and Chief  Executive Officer              |
| Jim  Terry              | (principal executive  officer)                                  |
|                    |                                                            |
| /s/  J. CHRIS BOSWELL   |                                                            | Senior Vice President,  and Chief Financial Officer |
| J.  Chris Boswell       | (principal financial  officer and principal accounting officer) |
|                    |                                                            |
| /s/  JOHN D. SCHILLER   |                                                            | Director                                            |
| John.  D. Schiller      |                                                            |
|                    |                                                            |
| /s/  MICHAEL S. MATHEWS |                                                            | Director                                            |
| Michael  S. Mathews     |                                                            |
|                    |                                                            |
| /s/  HUGH A. MENOWN     |                                                            | Director                                            |
| Hugh  A. Menown         |                                                            |
|                    |                                                            |
| /s/  BYRON DUNN         |                                                            | Director                                            |
| Byron  Dunn             |                                                            |

 

69

----

 

**EXHIBIT INDEX**

 
| Exhibit   No. | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|---------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 2.1           |       | Acquisition Agreement  dated as of January 20, 2004 among Particle Drilling, Inc., ProDril  Partners L.L.C., ProDril Services Incorporated, Mr. Harry B.  Curlett, CCORE Technology and Licensing,  Ltd. and Curlett Family  Limited Partnership, Ltd. (Incorporated herein by reference to  Exhibit 10.3 to our current report filed on Form 8-K dated January 20,  2005.)                                                                                                    |
| 2.2           |       | Acquisition Agreement  dated as of January 20, 2004 among Particle Drilling, Inc., ProDril  Partners L.L.C., ProDril Services International Limited,  Mr. Harry B. Curlett, CCORE Technology and Licensing, Ltd. and  Curlett Family Limited Partnership, Ltd. (Incorporated herein by reference to  Exhibit 10.4 to our current report on Form 8-K dated  January 20, 2005).                                                                                                                 |
| 2.3           |       | Agreement and Plan of  Reorganization dated July 14, 2004 by and among MedXLink Corp., a  Nevada corporation, PDTI Acquisition Corp., a Delaware corporation, Dean  Becker, Particle Drilling Technologies,  Inc., a Delaware corporation,  ProDril Partners L.L.C., a Texas limited liability company, and  Thomas E. Hardisty. (Incorporated herein by reference to Exhibit 2.1  to our current report filed on Form 8-K dated July 14, 2004.)                                    |
| 2.4           |       | Amendment No. 1 to  the Agreement and Plan of Reorganization dated January 10, 2005 by and  among MedXLink Corp., a Nevada corporation, PDTI Acquisition Corp.,  a Delaware corporation, Dean Becker, Particle Drilling  Technologies, Inc., a Delaware corporation, ProDril  Partners L.L.C., a Texas limited liability company, and Thomas E.  Hardisty. (Incorporated herein by reference to Exhibit 99.1 to our  current report filed on Form 8-K dated January 12, 2005.) |
| 2.5           |       | Plan of Merger and  Merger Agreement, dated January 19, 2005, between Particle Drilling  Technologies, Inc. and MedXLink Corp. (Incorporated herein by reference  to Exhibit 2.3 to our current report filed on Form 8-K dated  January 31, 2005.)                                                                                                                                                                                                                                                      |
| 3.1           |       | Articles of  Incorporation of MedePort, Inc. (Incorporated herein by reference to  Exhibit 3.1 to our current report filed on Form 8-K dated  January 20, 2005.)                                                                                                                                                                                                                                                                                                                                             |
| 3.2           |       | Articles of Amendment  to the Articles of Incorporation of MedePort, Inc. (Incorporated herein  by reference to Exhibit 3.2 to our current report filed on Form 8-K  dated January 20, 2005.)                                                                                                                                                                                                                                                                                                                |
| 3.3           |       | Articles of Merger  dated January 25, 2005 changing the name of the Company to Particle  Drilling Technologies, Inc. (Incorporated herein by reference to  Exhibit 3.3 to our Registration Statement on Form S-1 (Registration  No. 333-123925 filed on April 7, 2005.)                                                                                                                                                                                                                            |
| 3.4           |       | Bylaws of the Company  (Incorporated herein by reference to Exhibit 3.3 to our current report  filed on Form 8-K dated January 20, 2005.)                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1†    |       | Particle  Drilling, Inc. 2004 Stock Incentive Plan. (Incorporated herein by  reference to Exhibit 10.5 to our current report filed on Form 8-K  dated January 20, 2005.)                                                                                                                                                                                                                                                                                                                                     |
| 10.2†    |       | Particle Drilling  Technologies, Inc. 2005 Stock Incentive Plan. (Incorporated herein by reference  to Exhibit 99.1 to our current report filed on Form 8-K dated  April 4, 2005.)                                                                                                                                                                                                                                                                                                                           |
| 10.3†    |       | Form of Incentive  Stock Option Agreement. (Incorporated herein by reference to  Exhibit 10.6 to our current report filed on Form 8-K dated  January 20, 2005.)                                                                                                                                                                                                                                                                                                                                              |
| 10.4†    |       | Form of  Non-Statutory Stock Option Agreement. (Incorporated herein by reference to  Exhibit 10.7 to our current report filed on Form 8-K dated  January 20, 2005.)                                                                                                                                                                                                                                                                                                                                          |
| 10.5†    |       | Employment Agreement by  and between Particle Drilling Technologies, Inc. and Jim B. Terry  (Incorporated by reference to Exhibit 10.1 to our current report on  Form 8-K filed with the Securities and Exchange Commission on  January 25, 2006)                                                                                                                                                                                                                                                            |
| 10.6†    |       | Form of  Non-Statutory Stock Option Agreement (employees) (Incorporated by reference  to Exhibit 10.2 to our current report on Form 8-K filed with the  Securities and Exchange Commission on January 25, 2006)                                                                                                                                                                                                                                                                                              |
| 10.7†    |       | Form of Restricted  Stock Agreement (employees) (Incorporated by reference to Exhibit 10.3  to our current report on Form 8-K filed with the Securities and Exchange  Commission on January 25, 2006)                                                                                                                                                                                                                                                                                                        |
| 10.8†    |       | Employment Agreement by  and between Particle Drilling Technologies, Inc. and Jon Christopher  Boswell (Incorporated by reference to Exhibit 10.4 to our current report  on Form 8-K filed with the Securities and Exchange Commission on  January 25, 2006)                                                                                                                                                                                                                                                 |
| 10.9†    |       | Employment Agreement by  and between Particle Drilling Technologies, Inc. and Thomas E. Hardisty  (Incorporated by reference to Exhibit 10.5 to our current report on  Form 8-K filed with the Securities and Exchange Commission on  January 25, 2006)                                                                                                                                                                                                                                                      |
| 10.10†   |       | Employment Agreement  dated August 1, 2003 between ProDril Acquisition Company and Gordon  Tibbitts. (Incorporated herein by reference to Exhibit 10.10 to our  current report filed on Form 8-K dated January 20, 2005.)                                                                                                                                                                                                                                                                                    |
| 10.11†   |       | Letter agreement dated  December 2, 2004 between Particle Drilling Technologies, Inc. and  Prentis Tomlinson, Jr. (Incorporated herein by reference to  Exhibit 10.11 to our current report filed on Form 8-K dated  January 20, 2005.)                                                                                                                                                                                                                                                            |

 

70

----

 
| 10.12       |   | Securities Purchase  Agreement, dated as of February 9, 2005, by and among Particle Drilling  Technologies, Inc. and the Purchasers listed on Schedule I thereto.  (Incorporated herein by reference to Exhibit 10.1 to our current report  filed on Form 8-K dated February 10, 2005.)                                                                                                                                                            |
|-------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13       |   | Registration Rights  Agreement, dated as of February 9, 2005, by and among Particle Drilling  Technologies, Inc. and each of the Purchasers. (Incorporated herein by  reference to Exhibit 10.2 to our current report filed on Form 8-K  dated February 10, 2005.)                                                                                                                                                                                      |
| 10.14       |   | Common Stock Purchase  Warrant issued by Particle Drilling Technologies, Inc. to Rita Barr  (with attached schedule of substantially identical Common Stock Purchase  Warrants not filed with the Securities and Exchange Commission).  (Incorporated herein by reference to Exhibit 10.3 to our current report  filed on Form 8-K dated February 10, 2005.)                                                                                                 |
| 10.15       |   | Stock Purchase  Agreement, dated as of February 8, 2005, by and between Particle  Drilling Technologies, Inc. and Prentis B. Tomlinson, Jr.  (Incorporated herein by reference to Exhibit 10.4 to our current report  filed on Form 8-K dated February 10, 2005.)                                                                                                                                                                             |
| 10.16       |   | Form of Common  Stock Purchase Warrant issued by Particle Drilling Technologies, Inc. to  Tejas Securities Group, Inc. (Incorporated herein by reference to  Exhibit 10.5 to our current report filed on Form 8-K dated  February 10, 2005.)                                                                                                                                                                                                       |
| 10.17       |   | Assignment and Assumption  Agreement dated January 20, 2004 among Curlett Family Limited  Partnership, Ltd., ProDril Services Incorporated, Harry B. Curlett,  CCORE Technology and Licensing, Ltd. ProDril Services International Limited  and Particle Drilling, Inc. (Incorporated by reference to  Exhibit 10.14 to Amendment No. 1 to our Registration Statement on  Form S-1 (Registration No. 333-123925) filed on May 20, 2005.) |
| 10.18       |   | Royalty Agreement dated  January 20, 2004 between Particle Drilling, Inc. and ProDril  Services Incorporated. (Incorporated by reference to Exhibit 10.15 to  Amendment No. 1 to our Registration Statement on Form S-1  (Registration No. 333-123925) filed on May 20, 2005.)                                                                                                                                                                |
| 10.19       |   | Royalty Agreement dated  January 20, 2004 between Particle Drilling, Inc. and ProDril Services  International Limited. (Incorporated by reference to Exhibit 10.16 to  Amendment No. 1 to our Registration Statement on Form S-1  (Registration No. 333-123925) filed on May 20, 2005.)                                                                                                                                                       |
| 10.20       |   | Sublease Agreement  dated March 21, 2005 between Particle Drilling Technologies, Inc.  and The Exploitation Company, LLP. (Incorporated by reference to  Exhibit 10.17 to Amendment No. 2 to our Registration Statement on  Form S-1 (Registration No. 333-123925) filed on June 27,  2005.)                                                                                                                                                  |
| 10.21       |   | Securities Purchase  Agreement, dated as of October 19, 2006, by and among Particle Drilling  Technologies, Inc. and the Purchasers listed on Schedule I thereto.  (Incorporated herein by reference to Exhibit 10.1 to our current report  filed on Form 8-K dated October 19, 2006.)                                                                                                                                                                  |
| 10.22       |   | Registration Rights  Agreement, dated as of October 19, 2006, by and among Particle Drilling  Technologies, Inc. and each of the purchasers. (Incorporated herein by  reference to Exhibit 10.2 to our current report filed on Form 8-K  dated October 19, 2006.)                                                                                                                                                                                       |
| 10.23       |   | Common Stock Purchase  Warrant issued by Particle Drilling Technologies, Inc. to Milfam I, LP  (with attached schedule of substantially identical Common Stock Purchase  Warrants not filed with the Securities and Exchange Commission).  (Incorporated herein by reference to Exhibit 10.3 to our current report  filed on Form 8-K dated October 19, 2006.)                                                                                               |
| 10.24† |   | 2007 Bonus Plan.  (Incorporated herein by reference to Exhibit 10.1 to our Form 10-Q  for the quarterly period ended December 31, 2006.)                                                                                                                                                                                                                                                                                                                          |
| 10.25† |   | Particle Drilling  Technologies, Inc. 2007 Stock Incentive Plan. (Incorporated herein by  reference to Exhibit 10.2 to our Form 10-Q for the quarterly period  ended December 31, 2006.)                                                                                                                                                                                                                                                                     |
| 10.26† |   | Restricted Stock  Agreement, dated August 7, 2007, between Particle Drilling  Technologies, Inc. and Jim B. Terry. (Incorporated herein by reference  to Exhibit 10.1 to our Form 10-Q for the quarterly period ended  June 30, 2007.)                                                                                                                                                                                                                  |
| 10.27† |   | Restricted Stock  Agreement, dated August 7, 2007, between Particle Drilling  Technologies, Inc. and Jim B. Terry. (Incorporated herein by reference  to Exhibit 10.2 to our Form 10-Q for the quarterly period ended  June 30, 2007.)                                                                                                                                                                                                                  |
| 10.28† |   | First Amendment to  Employment Agreement, dated August 7, 2007, by and between Particle  Drilling Technologies, Inc. and Jim B. Terry. (Incorporated herein by  reference to Exhibit 10.3 to our Form 10-Q for the quarterly period  ended June 30, 2007.)                                                                                                                                                                                              |
| 10.29*      |   | Bonus Plan for fiscal  2008.                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 14.1        |   | Particle Drilling  Technologies, Inc. Code of Business Conduct and Ethics. (Incorporated  herein by reference to Exhibit 14.1 to our current report filed on  Form 8-K dated February 9, 2005.)                                                                                                                                                                                                                                                              |
| 16.1        |   | Letter of Chisholm,  Bierwolf & Nilson, LLC. (Incorporated herein by reference to  Exhibit 16.1 to our current report filed on Form 8-K dated  April 4, 2005.)                                                                                                                                                                                                                                                                                      |
| 16.2        |   | Letter of UHY Mann  Frankfort Stein & Lipp CPAs, LLP (Incorporated herein by reference  to Exhibit 16.1 to our current report filed on Form 8-K dated  August 7, 2006.)                                                                                                                                                                                                                                                                                  |
| 21.1*       |   | Subsidiaries of  Particle Drilling Technologies, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 23.1*       |   | Consent of  UHY, LLP.                                                                                                                                                                                                                                                                                                                                                                                                                                                       |

 

71

----

 
| 31.1* |   | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002 |
|-------|--------|-------------------------------------------------------------------------------|
| 31.2* |   | Certification pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002      |
| 32.1* |   | Certification pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 |
| 32.2* |   | Certification pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

----

*Filed herewith

 

†Management contract orcompensatory plan or arrangement

 

72

----