**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-K**

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**Forthe Year Ended December 31, 2006**

**Commissionfile number 1-11512**

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**SATCON TECHNOLOGYCORPORATION**

(Exact name of registrantas specified in its charter)

| **DELAWARE**                                                     | **04-2857552**                           |
|------------------------------------------------------------------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification Number) |
| **27 Drydock Avenue, Boston, Massachusetts**                     | **02210**                                |
| (Address of  principal executive offices)                        | (Zip Code)                               |

 

**(617) 897-2400**

(Registrant’s telephonenumber, including area code)

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

| **Title of Class**            |   | **Name of Exchange on Which Registered** |
|-------------------------------|--------|------------------------------------------|
| Common Stock,  $.01 Par Value |   | The NASDAQ Stock  Market, LLC            |

 

Securities registeredpursuant to Section 12(g) of the Act: **None**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o  No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o  No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and large acceleratedfiler” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer o | Accelerated filer  o | Non-accelerated  Filer x |
|---------------------------|----------------------|--------------------------|

 

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

The aggregate market valueof the registrant’s Common Stock, $.01 par value per share, held by non-affiliatesof the registrant was $68,018,065 based on the last reported sale price of theregistrant’s Common Stock on the Nasdaq Capital Market as of the close ofbusiness on the last business day of the registrant’s most recently completedsecond quarter ($1.89). There were 41,536,053 shares of Common Stockoutstanding as of March 1, 2007.

**DOCUMENTS INCORPORATED BY REFERENCE:**  Portions of the registrant’s Proxy Statementfor its 2007 Annual Meeting of Stockholders are incorporated by reference into Part IIIof this Form 10-K.

 

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**SatCon TechnologyCorporation**

**TABLEOF CONTENTS**
|                   | ** ** | ** ** | ** ** | ** **                                                                                                               | ** ** | **PAGE** |
|-------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------|------------|----------|
| **Part I**   |       |       |       |                                                                                                                     |       |     |
| ** **        |       | Item 1.    |       | Business                                                                                                                 |       | 3        |   |
| ** **        |       | Item 1A.   |       | Risk Factors                                                                                                             |       | 15       |   |
| ** **        |       | Item 1B.   |       | Unresolved Staff Comments                                                                                                |       | 25       |   |
| ** **        |       | Item 2.    |       | Properties                                                                                                               |       | 25       |   |
| ** **        |       | Item 3.    |       | Legal  Proceedings                                                                                                       |       | 25       |   |
| ** **        |       | Item  4.   |       | Submission  of Matters to a Vote of Security Holders                                                                     |       | 25       |   |
| **Part II**  |       |       |       |                                                                                                                     |       |     |   |
| ** **        |       | Item  5.   |       | Market For Registrant’s  Common Equity, Related Stockholder Matters and Issuer Purchases of  Equity Securities |       | 26       |   |
| ** **        |       | Item 6.    |       | Selected Consolidated  Financial Data                                                                                    |       | 28       |   |
| ** **        |       | Item  7.   |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operation                          |       | 30       |   |
| ** **        |       | Item  7A.  |       | Quantitative and Qualitative  Disclosures About Market Risk                                                              |       | 50       |   |
| ** **        |       | Item 8.    |       | Consolidated Financial  Statements and Supplementary Data                                                                |       | 51       |   |
| ** **        |       | Item  9.   |       | Changes in and Disagreements  with Accountants on Accounting and Financial Disclosure                                    |       | 107      |   |
| ** **        |       | Item  9A.  |       | Controls  and Procedures                                                                                                 |       | 107      |   |
| ** **        |       | Item 9B.   |       | Other  Information                                                                                                       |       | 107      |   |
| **Part III** |       |       |       |                                                                                                                     |       |     |   |
| ** **        |       | Item  10.  |       | Directors,  Executive Officers and Corporate Governance                                                                  |       | 108      |   |
| ** **        |       | Item  11.  |       | Executive  Compensation                                                                                                  |       | 108      |   |
| ** **        |       | Item  12.  |       | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters                          |       | 108      |   |
| ** **        |       | Item  13.  |       | Certain Relationships and  Related Transactions, and Director Independence                                               |       | 108      |   |
| ** **        |       | Item  14.  |       | Principal Accounting Fees  and Services                                                                                  |       | 108      |   |
| **Part IV**  |       |       |       |                                                                                                                     |       |     |   |
| ** **        |       | Item 15.   |       | Exhibits, Financial  Statement Schedules                                                                                 |       | 109      |   |
| ** **        |       | Signatures |       | 110                                                                                                                      |       |

 

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**PART I**

This Annual Report on Form 10-Kcontains or incorporates forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933 and Section 21E of the Securities Act of1934. You can identify these forward-looking statements by our use of the words“believes,” “anticipates,” “plans,” “expects,” “may,” “will,” “intends,” “estimates,”“and similar expressions, whether in the negative or in the affirmative. Theforward-looking statements contained in this Annual Report are generally locatedin the material set forth under the headings “Item 1. Business” and “Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” but may be found in other locations as well. Although we believethat these forward-looking statements reasonably reflect our plans, intentionsand expectations disclosed in the forward-looking statements, our actualresults could differ materially from the plans, intentions and expectationsdisclosed in the forward-looking statements we make. We have included importantfactors in the cautionary statements under the heading “Risk Factors” underItem 1A that we believe could cause our actual results to differ materiallyfrom the forward-looking statements that we make. We do not intend to updateinformation contained in any forward-looking statements we make.

**Item 1.**                        BUSINESS

**Overview**

SatCon TechnologyCorporation designs and manufactures enabling technologies and products forelectrical power conversion and control for high-performance, high-efficiencyapplications in large, growth markets such as alternative energy, hybridelectric vehicles, distributed power generation, power quality, semiconductorfabrication capital equipment, industrial motors and drives, and highreliability defense electronics.

**Recent Developments**

On July 19,2006, we entered into a Securities Purchase Agreement (the “Purchase Agreement”)with thirteen institutional investors (the “Purchasers”) in connection with theprivate placement (the “Private Placement”) of:

·       $12,000,000aggregate principal amount of senior secured convertible notes (the “Notes”),convertible into shares of our common stock at a conversion price of $1.65 pershare;

·       WarrantA’s to purchase up to an aggregate of 3,636,368 shares of our common stock at aprice of $1.815 per share for a period beginning six months from the date ofsuch warrants and ending on the seventh anniversary of the date of suchwarrants; and

·       WarrantB’s to purchase up to an aggregate of 3,636,368 shares of our common stock at aprice of $1.68 per share for a period of 90 trading days beginning the later ofsix months from the date of such warrants and the date the Securities andExchange Commission (the “SEC”) declares effective a shelf registrationstatement covering the resale of the common stock underlying the securitiesissued in the Private Placement (the “Registration Statement”); to the extentthe Warrant B’s are exercised, the Purchasers will receive additionalseven-year warrants to purchase a number of shares of common stock equal to 50%of the number of shares of common stock purchased upon exercise of the WarrantB’s at a price of $1.815 per share. Because the registration statement wasdeclared effective on September 27, 2006, these warrants were originallyexercisable for the 90 trading day period beginning six months from the date ofsuch warrants (i.e. May 30, 2007). As discussed below, in connection withan amendment to the Purchase Agreement enabling us to issue common stock forthe early termination of the lease for our Worcester facility, the expirationdate of the Warrant B’s was extended to August 31, 2007.

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The net proceeds of the sale were approximately $11million, after deducting placement fees and other offering-related expenses. Inconnection with the Private Placement, we also entered into a SecurityAgreement, dated July 19, 2006, with the Purchasers (the “SecurityAgreement”).

In addition, First Albany Capital (“FAC”) acted asplacement agent in connection with the Private Placement. In addition to a cashtransaction fee of $590,000, FAC or its designees were entitled to receivefive-year warrants to purchase 218,182 shares of our common stock at anexercise price of $1.87 per share. At the discretion of FAC, these warrantswere issued to First Albany Companies, Inc., the parent of FAC. We also paidArdour Capital, our financial advisor, approximately $250,000 for its servicesrelated to the Private Placement.

In connection with, and as a condition precedent to,the completion of the Private Placement, on July 20, 2006, we paid allamounts due and owing under our credit facility with Silicon Valley Bank(approximately $2 million) and terminated such facility. In doing so weincurred a termination fee of $17,500 and legal fees of $8,500.

See Note G to our consolidated financial statementsincluded in this Annual Report on Form 10-K for a detaileddescription of the Notes and related warrants.

As a result of our failure to comply with thecontinued listing requirements of the Nasdaq Global Market (in particular, therequirement that the market value of our common stock be at least $50,000,000),on October 17, 2006 we applied to transfer our securities to The NasdaqCapital Market. On October 23, 2006 we received notification that ourapplication for listing with the Nasdaq Capital Market was approved. Our stockbegan trading on the Nasdaq Capital Market at the opening of business on October 25,2006.

On September 19,2006, our Board of Directors approved a change in our fiscal year end from September 30to December 31. As a result, the financial periods presented and discussedin this Annual Report on Form 10-K will be defined as follows:

| 1. | Year ended  December 31, 2006 represents the twelve months ended December 31,  2006,                         |
|----|------------------------------------------------------------------------------------------------------------------------|
| 2. | Three-month  transition period ended December 31, 2005 represents the three months  ended December 31, 2005, |
| 3. | Fiscal year ended  September 30, 2005 represents the twelve month period ended  September 30, 2005, and      |
| 4. | Fiscal year ended  September 30, 2004 represents the twelve month period ended  September 30, 2004.          |

 

On September 19, 2006, our Board of Directorsapproved a plan to close our Worcester, Massachusetts manufacturing facility byapproximately December 31, 2006. The decision to close this facility was infurtherance of our continuing efforts to streamline operations and reduceoperating costs. We intend to focus spending on our renewable energy business.As a result of this decision, we recorded approximately $1.6 million related tolease termination costs, warrant revaluation, employee severance and retentionbonuses and asset impairments, in our results of operations for the year ended December 31,2006. Additionally, we anticipate incurring approximately $0.1 million relatedto employee severance and retention bonus’ which will be paid out during 2007. Wecurrently expect this action will result in a reduction of total overheadexpenses of rent, facility and personnel costs of approximately $3.0 millionper year.

On December 20, 2006, we entered into aModification, Termination and Release of Lease (the “Termination Agreement”)with Paul E. Hanlon, Trustee of C&M Realty Trust (the “Landlord”), thelandlord with respect to the lease for our manufacturing facility located inWorcester, Massachusetts (the “Worcester Facility”). Our execution of, andperformance under the Termination Agreement was in 

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furtherance of our effortsto streamline operations and reduce operating costs. Under the existing leasefor the Worcester Facility, the aggregate base rent payable for the remainingterm of the lease was approximately $1.3 million. Pursuant to the TerminationAgreement, as consideration for the early expiration of the lease, we issued tothe Landlord 850,000 shares of our common stock (the “Shares”) on January 2,2007. Under the Termination Agreement, the lease expired on February 15,2007.

On December 20, 2006, we entered into a FirstAmendment to Securities Purchase Agreement (the “Amendment”) with certain ofthe Purchasers who participated in the Private Placement

Pursuant to theAmendment:

·       thedefinition of “Excluded Stock” set forth in the Purchase Agreement was amendedto enable us to issue up to 1.1 million shares of our common stock inconnection with the early termination of the lease for the Worcester facility,without such shares being subject to the Purchasers’ right of participation setforth in the Purchase Agreement and certain prohibitions set forth in the Notesand related warrants (as noted above, we ultimately settled the lease for850,000 shares); and

·       weagreed to extend the expiration date of the Warrant B’s issued in the PrivatePlacement from May 30, 2007 to August 31, 2007.

As a result of theextension of the expiration date of the Warrant B’s, we recorded a non-cashcharge of approximately $193,117 in the period ended December 31, 2006.

**Our History,Beginning**in R &D and Transitioning to a Product Based Corporation

From inception in 1985,through the early 1990’s, we were primarily funded through research anddevelopment contracts with the U.S. government. These contracts were directedat developing new technologies in motion control, control software andelectronics. Through this work, we built an engineering base in magnetics,motor and motor drive technology, digital signal processing and high-speedelectronics. In the 1990’s, we expanded that base through commercially fundedresearch and development to include design and packaging of high-powerelectronics, high reliability electronic components and advanced materials.These engineering skills form the technical basis of our business. Since themid 1990’s, through a combination of internal product development and targetedacquisitions, we have leveraged our core technical capabilities into productmanufacturing. Our products include: commercial high power conversion andcontrol systems for alternative energy applications, a variety of advancedpower control systems for hybrid electric vehicles, commercial motors includingmotors for hybrid electric vehicles, uninterruptible power supplies andride-through devices for applications requiring high quality sustainable power,specialty magnetically levitated products and microelectronics primarily usedin high reliability applications.

**Building OurCapability Through Acquisitions**

In January 1997, we acquired our MagMotordivision, a manufacturer of custom and standard electric motors. In April 1997,we acquired Film Microelectronics, Inc., a manufacturer of thin film substratesand custom hybrid microelectronics. In January 1999, we acquired InductiveComponents, Inc., a value-added supplier of customized electric motors. InApril 1999 we acquired HyComp, Inc., a manufacturer of hybridmicroelectronics, followed in October 1999 by Ling Electronics, Inc.,a manufacturer of shaker vibration test and measurement systems, powerconverters, amplifiers and controllers (although we sold our shaker andamplifier product lines in 2005). In November 1999, we acquiredintellectual property, tooling, engineers and technicians and other assets fromNorthrop Grumman Corporation applicable to power electronics and hybridelectric vehicles. In July 2001, we acquired most of the assets ofInverpower Controls, Ltd., a manufacturer of power electronics andhigh-speed digital controls for use in industrial power and power qualitysystems. The acquisition included Inverpower’s UL and CE certification 

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capability. In September 2002,we acquired the machinery, inventory, backlog and intellectual property ofSipex Corporation’s hybrid assembly operations that supply product to thedefense and aerospace industry. These acquisitions have provided us withincreased revenues, a manufacturing capability to transition our technologyinto commercial products, and an expanded customer base.

In fiscal year 2006 weincreased our focus on power distribution and alternative energy as high growthpotential markets for SatCon’s products.

**Alternative Energy**

We believe that thefastest growth area for SatCon involves alternative energy and distributedpower generation. We sell solar (photo-voltaic) power installations and highpower inverters for stationary fuel cell power plants. In almost all cases theelectricity produced by alternative energy technology requires an inverter totransform the power produced into usable AC electrical power compatible withtypical household and commercial appliances. In this fast emerging market in2006 we improved our products, added new product offerings for wind powergeneration and technology for connecting to the existing utility gridconnection and increased our business development activities.

**Hybrid ElectricVehicles**

SatCon has had extensiveexperience since the mid 1990’s in advanced technology applicable to hybridelectric vehicles, or HEV’s, and holds significant intellectual property inthis area. In fiscal 2006, we generated motor and DC-DC converter sales in asegment of the HEV market associated with fleets of delivery vans. The HEVmarket is developing rapidly and SatCon has technology and manufacturing andoutsourcing capability to expand sales into very high annual volume levels ofmotors, controllers and converters. In addition, SatCon continues to developnew HEV electrical and electronic technology that will be suitable for avariety of future vehicle types. HEV motors and electronics are a principalfocus for our future plans.

**Other Products andMarkets**

In addition, we have seen increased revenue from ournew high reliability microelectronic products for space and avionicsapplications. We participated in several defense related development programsthrough our Small Business Innovative Research (“SBIR’s”) projects, ourCooperative Agreement with the Army Research Laboratory and as a sub-contractorto prime contractors such as General Dynamics and the Electric BoatCorporation.

Our products are describedin more detail under the “Products by Business Segment**”**.

**Revenue Comparison with Prior Years**

| ** **    | ** ** | **Year Ended**   | ** ** | **Three Months Ended** | ** ** | ** **                                  | ** ** |
|---------------|------------|-----------------------|------------|----------------------------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **December 31,** | ** ** | **December 31,**            | ** ** | **Year Ended September 30,** | ** ** |
| ** **    | ** ** | **2006**              | ** ** | **2005**                         | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| United States |       | $                     | 30,475,297 |                             |       | $                                           | 6,662,983  |   |   | $ | 32,570,592 |   | $ | 30,424,627 |   |
| International |       | 3,281,372             |       |                             | 454,098    |                                        |       | 3,384,520 |   | 3,733,196 |   |
| **Total**     |       | $                     | 33,756,669 |                             |       | $                                           | 7,117,081  |   |   | $ | 35,955,112 |   | $ | 34,157,823 |   |

 

**Reports**

Our web site is *www.satcon.com.*We make available on this site our annualreports on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and amendments to those reports, filedor furnished pursuant to Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934, as amended, as soon 

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asreasonably practicable after such reports are electronically filed with theSEC. These reports may be accessed through our website’s investor relations page at*www.satcon.com/investors/facts.html*.

**Industry Background**

Global trends aredeveloping which have the effect of accelerating the demand for powerelectronics and innovative motor technology, including:

·       Growingdemand for alternative energy sources such as fuel cells, solar photo-voltaicand wind-turbines as the cost, environmental impact and security implicationsof dependence on fossil fuel gain recognition. This demand is alsosignificantly impacted by the burgeoning energy needs of rapidly growing Asianeconomies,

·       Growingdemand for high-quality, high-reliability power, as more critical and sensitiveelectronics are interconnected,

·       Increasedconcerns regarding the capacity and reliability of the electric utility grid,

·       Increasingper capita demand for electricity, driven by the increase in computers andelectronics technology coupled with population growth,

·       Increaseduse of electrical systems versus mechanical systems,

·       Growingconcerns for the inefficiency and adverse environmental impact of conventionalautomotive power technology leading to high interest in hybrid electricvehicles (HEVs).

These trends and concernshave lead individuals, businesses and governments to seek more reliable,efficient, cleaner and cost-effective solutions for their power needs. Thisdemand creates a growing market for alternative energy and power managementsystems. All of these systems require power control products to manageelectricity. In order to be commercially viable and operate effectively, thesepower products must be highly reliable, efficient, low-cost and compact. Manyof these products must be customized to meet the evolving needs in themarketplace. We apply SatCon’s technical expertise to meet these needs forpower control products in emerging global markets for alternative energy,energy storage and power quality systems, distributed power systems, hybridelectric vehicles and high-reliability defense systems.

**SatCon ProductAttributes**

We strive to meet our customers’ needs by providingpower control products and systems that encompass the following key attributes:

*Performance.*   Ourproducts use proprietary designs to ensure that high-quality power isefficiently produced in all operating conditions.

*Reliability.*   Wedesign and manufacture high-reliability, long-life electronics for applicationssuch as aircraft navigation systems and satellite uplink electronics. Wedesign, manufacture and test our electronics to last at least fifteen years. Wedesign our products to support the long-life, always-on requirements of thepower quality markets.

*Efficiency.*   Wedesign and manufacture our products to meet the efficiency needs of ourcustomers as defined by their specifications and the end use of the product.The overall efficiency of an alternative energy system, or its ability todeliver power with minimum energy loss, is vital to its effectivecommercialization and depends on the efficiency of all of its component parts.For example, in the specific case of the market for solar photo-voltaicinverters in California, the California Energy Commission requires thatrebate-eligible products be tested by a nationally recognized test laboratoryin accordance with an Underwriter’s Laboratory protocol to objectively measurethe product’s efficiency. The twelve 

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different models of powercontrol units we currently sell in California have been tested, as required,with the result that we deliver the highest efficiency units in the market.

*Quality.**  *We maintain high quality standards. For example, weare a certified manufacturer for hybrid microcircuits in accordance withMIL-PRF-38534 for military microelectronics (“class H”) andmicroelectronics for applications in space (“class K”), the highest levels ofquality and reliability reserved for these classes. Our Electronics businesssegment operates with Quality Management Systems and is certified as ISO9001:2000 compliant. Our Applied Technology business segment is also ISO9001:2000 certified.

All of the high power level inverters manufactured inour Power Systems business unit are Underwriter Laboratory listed as meetingtheir requirements for safety.

*HighPower Density.*   We design our products to meetmarket demands for high power density. High power density, or the ability toconvert, condition and manage large amounts of energy within a compact design,is required for cost reduction and is critical in applications such asvehicles, aboard ships and especially in aircraft and spacecraft where weightand space requirements are stringent.

*Flexibility.*   Wedevelop and manufacture our products for use in various alternative energy andpower quality systems such as fuel cells, photo-voltaics, wind turbines,micro-turbines and UPS systems. Our products are modular and scalable to meet awide range of power requirements. Our engineers work closely with our customersto address overall systems design issues and to ensure that our products meettheir system specifications. A close working relationship between the customers’engineers and our engineers is particularly important in the rapidly evolvingalternative energy, power quality and hybrid electric vehicle industries.

**Strategy**

*Leverageour diverse expertise and proprietary technologies.*   Ourstrategy is to use our diverse expertise and proprietary technologies in thefields of power electronics, motors and microelectronics to develop productswith cross-market applications. Our success should be sustainable in the longerterm because it depends on fundamental knowledge of key power technology. Weare not critically dependent on the technology of a specific application, thebusiness of a single customer or the success of a single product. We strive tocreate balance between breadth and focus.

*Developproprietary products.**  *Webelieve that we have a competitive advantage resulting from our proprietarytechnology in the areas of power electronics, electro-magnetics, mechanical andthermal dynamics, system controls and microelectronics design. Our products arespecifically applicable to the rapidly developing alternative energy andhybrid-electric vehicle markets.

*Establishour products as industry standards.*   We are amajor supplier of power control units, frequently called inverters, inalternative energy applications. We are gaining ground in providing standardmotors, controllers and converters for hybrid electric vehicles. We alsoproduce standardized high reliability microelectronic products into aerospaceapplications.

*Developor acquire new technology.**  *Webelieve that new products, manufacturing capabilities and technologies willenhance our competitive position and growth opportunities. In fiscal 2006 webuilt relationships and were funded through SBIR’s to develop applicationtechnology for the introduction of silicon-carbide semi-conductor material intosystems. Silicon-carbide will enable much more power dense electronics, whichare especially important in applications for vehicles, ships, and aerospace.

*Develop strategicalliances and relationships.*   These alliances maytake the form of marketing, sales, distribution or manufacturing agreements. Wealso continue to develop and deepen the relationships we have for manufacturingor motor products in China.

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**Financial Resultsby Business Segment**

Our financial results bybusiness segments for the calendar year ended December 31, 2006, thethree-month transition period ended December 31, 2005 and fiscal yearsended September 30, 2005 and 2004 are presented in Note S to theConsolidated Financial Statements included in this Annual Report on Form 10-K.

**Products byBusiness Segment**

Our products are soldthrough our four business segments: SatCon Power Systems US, Satcon PowerSystems, Canada, SatCon Electronics and SatCon Applied Technology.

***SatCon Power Systems***

SatConPower Systems manufactures and sells our high power line of power controlsystems StarSineTM amplifiers and power converters. We also make and sell RotaryUPS Systems for back-up power and power quality. In 2006 we also continueddevelopment, manufacture and sales of inverters for alternative energyincluding Underwriter Laboratory (“UL”) compliance testing, and manufacturingand sales of StarSineTM industrial and commercial power conversion andconditioning products. Revenues for the year ended December 31, 2006 andour fiscal years ended September 30, 2005 and 2004 from our Power Systemsbusiness unit were as follows:

| ** **                               | ** ** | **Year Ended**       | ** ** | **Year Ended**    | ** ** |
|------------------------------------------|------------|---------------------------|------------|------------------------|------------|
| ** **                               | ** ** | **December 31,**     | ** ** | **September 30,** | ** ** |
| **Product  Revenue**                     | ** ** | ** **                | ** ** | **2006**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                               | ** ** | **(Amounts in Millions)** | ** ** |
| Alternative  Energy Products             |       |                      | $          | 10.6                   |       |   | $ | 6.1 |   | $ | 2.8 |   |
| Industrial Power                         |       |                      | 1.3        |                   |       | 0.3 |   | — |   |
| Plasma                                   |       |                      | —     |                   |       | 2.6 |   | 0.7 |   |
| Frequency  Converters                    |       |                      | 1.2        |                   |       | 1.6 |   | 1.7 |   |
| Other                                    |       |                      | 1.0        |                   |       | 1.0 |   | 0.8 |   |
| **Total  Power Systems Canada**          | ** ** | ** **                | **$**      | **14.1**               |       | ** ** | **$** | **11.6** | ** ** | **6.0** | ** ** |
| **Total Power Systems US**               | ** ** | ** **                | **$**      | **4.4**                |       | ** ** | **$** | **8.8** | ** ** | **$** | **11.4** | ** ** |
| **Total  Power Systems Product Revenue** | ** ** | ** **                | **$**      | **18.5**               |       | ** ** | **$** | **20.4** | ** ** | **$** | **17.4** | ** ** |
|                                          |            |                           |            |                        |            |  |  |  |  |  |  |  |  |  |

 

*HighPower Inverters.**  *We havedeveloped modular inverters such as our Three Phase Utility InteractiveMulti-Mode Inverter for use in connection with large, commercial sized, fuelcell alternative energy power systems such as stationary fuel cell powerplants, photo-voltaic power plants, wind turbines or microturbine distributedpower generation systems that produce power ranging from 30 kilowatts to 10 megawatts.Our Powergate® inverters are designed to convert the DC powergenerated by an alternative energy source, such as a fuel cell, into useable ACpower. They also provide the interface with the electric utility grid, anenergy storage device, like a battery or flywheel, and the end userapplications. These units use a technology that allows them to be combined andscaled to handle high-power requirements. We introduced this product duringfiscal year 2002 and, further, introduced inverters for photovoltaic applicationsin fiscal year 2003. Product offerings and orders for these kinds of units havegrown quickly in 2005 and 2006.

*Rotary UPS Systems.**  *Our Rotary Uninterruptible Power Supply (UPS) systemsare designed to provide both power quality and UPS functions in power rangesfrom 250 kilowatts to 2.2 megawatts and beyond in single or multiple unitsystems. For comparison, 2.2 megawatts would be enough power to supply 440homes each using an average of 5 kilowatts of power. Our Rotary UPS productcombines a diesel generator, supplied by Cummins, Inc., SatCon’s preferredsupplier, a flywheel energy storage system, 

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electronics and aproprietary control system into an uninterruptible power supply. We believethat this system is an attractive alternative to lead-acid battery based UPSsystems due to its seamless transition during power outages, increasedreliability, longer life and the ability to operate effectively in remotelocations. The protection provided by these systems is critical to defense,government and commercial entities that cannot be out of power even for afraction of a second. We also combined several of the RUPS technical elementsinto a Rotary Ride Through Device concept in which the customer already has aninstalled emergency generator set but requires the addition of our technologyfor power sustainability and high power quality. We shipped our third RotaryUPS System in 2005 and our fourth unit in 2006.

*SatCon MagMotor*

*IndustrialAutomation Motors.*   We manufacture brush andbrushless DC motors for the industrial automation market. These small,high-efficiency motors are available with a variety of options includingoptical encoders, tachometers, brakes, custom cables and connectors. Ourindustrial automation motors are typically used in semiconductor equipmentmanufacturing, medical device assembly and other automated assembly processes. Thismotor business underlies our entry into the hybrid electric vehicle motormarket.

*MachineTool Motors.*   We manufacture a line of precisepositioning motors for use with machine tools such as computer numericalcontrolled machines. These include machining centers, lathes and millingmachines.

*MagneticLevitation Systems.*   We manufacture magneticlevitation, or MagLevTM, systems that enable machinery to rotate or move withoutcontacting other machine parts. Our MagLevTM systems use electro-magnetic fieldsto lift mechanical components without any surface contact. Sensors within thesystem determine the actual position of the levitated object and send signalsto a high-speed digital controller, which commands electricity to activate theelectro-magnets thereby making the object move away from any surface it isabout to contact. This is done at extremely high speeds in order to maintainthe stability of the levitated object and can be accomplished with objects thatspin, such as motors, or objects that move in one direction, like pistons orpush rods.

*Other Power Products.**  *We also sell static transferswitches, static voltage regulators, frequency converters and AC arc furnaceline controllers from 5 kilowatts to 100 megawatts. In addition we also sellMotors and converters for hybrid electric vehicles, which have seen modestrevenue growth.

***SatCon Electronics***

SatConElectronics designs and manufactures advanced electronic assemblies for theaerospace, defense, wireless and telecom industries including thin filmproducts and custom modules. Revenue for the year ended December 31, 2006,and our fiscal years ended September 30, 2005 and 2004 from ourElectronics business unit is as follows:

| ** **      | ** ** | **Year Ended**                 | ** ** | **Year Ended**                                      | ** ** |
|-----------------|------------|-------------------------------------|------------|----------------------------------------------------------|------------|
| ** **      | ** ** | **December 31,**               | ** ** | **September 30,**                                   | ** ** |
| ** **      | ** ** | **2006**                            | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| *** ***    | ** ** | **(Amounts in Millions)** | ** ** |
| Product Revenue |       |                                | $          | 10.2                                                     |       |   |   | $ | 9.5 |   |   |   | $ | 9.5 |   |   |
|                 |            |                                     |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

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The following are descriptions of some of our productswithin the Electronics business unit:

*HybridMicrocircuits.**  *Wemanufacture standard and custom hybrid microcircuits, which are a combinationof several electronic components imbedded in a miniature circuit assembly. Dueto their size, versatility and high reliability, these hybrid microcircuits areused in a broad spectrum of applications. Using our semi-automatedmanufacturing capability, we build and test modules, sub-assemblies and fullyintegrated electronic systems for both military and commercial customers thatrequire compact, high reliability systems.

*ThinFilm Substrates.**  *Thinfilm substrates are miniature circuit assemblies onto which small electroniccomponents are mounted, such as those used in hybrid microcircuits. Some of ourthin film substrates are sold directly to customers and some are furtherintegrated at SatCon Electronics into devices. Thin film substrate and resistorproducts manufactured by SatCon Electronics are used for high-speedtelecommunications applications, military modules and high-frequency wirelessdevices in military and commercial markets.

*Radio Frequency Products.**  *SatCon Electronics sells products into both militaryand commercial wireless communications markets. Using our design, analysis andtest capability, we build standard and custom amplifiers, switches and passivedevices for secure communication systems, cell tower base stations,point-to-point data transmission, and wireless networks.

***SatCon Applied Technology***

OurApplied Technology business segment develops, designs and builds powerconversion products, which include power electronics, high-efficiency machinesand control systems for a variety of defense and commercial applications. Oneof our objectives is to transition prototype development contracts intoproduction programs. Revenue for the year ended December 31, 2006 and ourfiscal years ended September 30, 2005 and 2004 from Applied Technology wasas follows: 

| ** **                                         | ** **   | **Year Ended**                 | ** **   | **Year Ended**    | ** ** |
|----------------------------------------------------|--------------|-------------------------------------|--------------|------------------------|------------|
| ** **                                         | ** **   | **December 31,**               | ** **   | **September 30,** | ** ** |
| ** **                                         | ** **   | **2006**                            | ** **   | **2005**               | ** ** | **2004** | ** ** |
| *** ***                                       | *** *** | **(Amounts in Millions)** | *** *** |
| Funded Research  and Development and other revenue |         |                                | $            | 5.0                    |       |   | $ | 6.1 |   | $ | 7.2 |   |
|                                                    |              |                                     |              |                        |            |  |  |  |  |  |  |  |

 

We pursue developmentprograms in areas where we have technical expertise and where we believe thereis significant long-term production potential for the developed technology.Technical disciplines represented at our Applied Technology business unitinclude electromechanics, digital and analog electronics, power electronics andelectronic packaging, thermal management, motor dynamics, materials, softwaredevelopment, control technology and system integration. To date, SatCon AppliedTechnology has built products for use in distributed power generation, energystorage and power quality, high performance electric machinery, transportationand defense systems, including components for military hybrid-electricvehicles, “all-electric” ships and aircraft subsystems.

**SignificantCustomers**

There were no customersthat were classified as a significant customer (i.e. sales to any one customer exceeded10% of our revenue or gross accounts receivable exceeding 10% of our grossaccounts receivable) for the year ended December 31, 2006, the three monthtransition period ended December 31, 2005 and the year ended September 30,2005. Approximately 40% of our revenue during the year ended December 31,2006 was derived from government contracts and subcontracts with the U.S.government’s prime contractors.

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**Research andDevelopment**

We believe that the continued and timely development ofnew products and enhancements to our existing products is necessary to maintainour competitive position. We use technologies developed by our business units,together with information supplied by our distributors and customers, to designand develop new products and product enhancements and to reduce thetime-to-market for our products.

During the year ended December 31,2006 and fiscal years ended September 30, 2005 and 2004, we expendedapproximately $4.0 million, $5.4 million and $6.0 million, respectively,on funded research and development and other revenue activities funded bycommercial customers and U.S. government agency sponsors. Under the agreementsfunded by the U.S. government, the government retains a royalty-free license touse the technology developed for government purposes and we retain exclusiverights to the technology for commercial and industrial applications. The rightsto technology developed under contracts funded by commercial customers arenegotiated on a case-by-case basis. We expended approximately $2.0 million,$0.5 million and $0 on internally-funded research and developmentduring the year ended December 31, 2006 and our fiscal years ended September 30,2005 and 2004, respectively.

**Sales and Marketing**

We sell our products and services both domesticallyand internationally through our direct sales force and through independentdistributors and representatives. Our direct sales staff manages our keycustomer accounts, provides customer support and identifies significant market opportunitiesin their respective markets.

Each of our three divisions manages its own marketingorganization and is responsible for developing sales and advertisingliterature, such as product announcements, catalogs, brochures and magazinearticles in trade and other publications. Publication of significant events ormaterial information is handled through our corporate office.

We maintain close contact with our customers’ designand engineering staffs in order to provide the appropriate products for our customers’applications. We maintain this close working relationship with our customersthroughout the life of a product, and we believe that it has been a key part ofour customers’ satisfaction.

We compete for and marketour research and development contracts through several methods, includingpursuing new and existing customer relationships in the commercial andgovernment sectors and responding to unsolicited requests for proposals andthrough our Internet site.

**Backlog**

Our backlog consistsprimarily of product development contracts, orders for power control systems,electronics and motion control products. At December 31, 2006, our backlogwas approximately $35.5 million. Of this amount, approximately$32.1 million is scheduled to be shipped during 2007. Many of ourcontracts and sales orders may be canceled at any time with limited or nopenalty. In addition, contract awards may be subject to funding approval fromthe U.S. government and commercial entities, which involves political,budgetary and other considerations over which we have no control.

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**Competition**

We believe thatcompetitive performance in the marketplace for power control products dependsupon several factors, including product price, technical innovation, productquality and reliability, range of products, customer service and technicalsupport. We believe our technical innovation emphasizing product performanceand reliability, supported by our commitment to strong customer service andtechnical support, enables us to continue to compete successfully against thefollowing competitors:

·       Manufacturersof inverters for alternative energy such as Xantrex Technology, Inc., AseaBrown Boveri Ltd., Siemens Corporation and Alstom S.A.;

·       Manufacturersof custom microcircuit such as Natal Engineering, Aeroflex Inc., MSKennedy and Sensitron;

·       Manufacturersof thin film substrates and resistors such as Vishnay and Ultrasource, Inc.;

·       Manufacturersof power regulators such as International Rectifier, Sensitron and MS Kennedy;

·       Manufacturersof DC to DC converters such as International Rectifier, VPT, Interpoint andModular Devices;

·       Manufacturersof motors such as MCG Inc., Reliance Electric CO/DE and other regional andspecialty motor manufacturers;

·       Manufacturersof Uninterruptible Power Supplies such as Piller, Inc. and Hitech PowerProtection bv.; and

·       Developersof advanced power electronics and machines such as Moog, Semikron, DRS andSilicon Power.

Some of our competitorshave substantially greater financial resources than we do and could devotegreater resources to the development, promotion, sale and support of theirproducts and may have more manufacturing expertise and capacity. In addition,some of our competitors have more extensive customer bases and broader customerrelationships than we do.

**ManufacturingFacilities**

We manufacture our products at our facilities locatedin Marlborough, Massachusetts; West Boylston, Massachusetts; and Burlington,Ontario, Canada. We believe our existing manufacturing capacity is sufficientto meet our current needs. We believe that most of the raw materials used inour products are readily available from a variety of vendors. Additionally, wedesign and develop our products to use commodity parts in order to simplify themanufacturing process. We have a semi-automated production line in ourMarlborough, Massachusetts’ facility. We intend to add additional productionlines for our products in the future as demand dictates and our revenuesenable. We have made and expect to continue to make technological improvementsthat reduce the costs to manufacture our products.

Our manufacturingfacilities are subject to numerous environmental laws and regulations,particularly with respect to industrial waste and emissions. Compliance withthese laws and regulations has not had a material impact on our capitalexpenditures or competitive position.

**IntellectualProperty**

Our success and competitiveness depend on our abilityto develop and maintain the proprietary aspects of our technology and operatewithout infringing on the proprietary rights of others. We rely on acombination of patent, trademark, trade secret and copyright law and contractrestrictions to protect the proprietary aspects of our technologies. We seek tolimit disclosure of our intellectual property by 

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requiring employees,consultants, and any third parties with access to our proprietary informationto execute confidentiality agreements and by restricting access to thatinformation.

As of December 31, 2006, we held approximately 68U.S. patents and had 7 patent applications pending with the U.S. Patent andTrademark Office. We have also obtained corresponding patents in the rest ofNorth America, Europe and Asia. In addition, we have a non-exclusive,royalty-free license for non-automotive applications for 38 other patents thatwere issued to our employees and subsequently assigned to DaimlerChrysler. Theexpiration dates of our patents range from 2009 to 2021, with the majorityexpiring after 2015.

In 1997, we granted Beacon Power Corporation aperpetual, worldwide, royalty-free, exclusive right and license to our flywheeltechnology for stationary, terrestrial applications. Beacon Power was formed asa spin-off of SatCon Technology Corporation.

Many of the U.S. patentsdescribed above are the result of retaining ownership of inventions made underU.S. government-funded research and development programs. As a qualifyingsmall business, we have retained commercial ownership rights to proprietarytechnology developed under various U.S. government contracts and grants,including small business innovation research contracts. With respect to anyinvention made with government assistance, the government has a nonexclusive,nontransferable, irrevocable, paid-up license to use the technology or have thetechnology employed for or on behalf of the U.S. government throughout theworld. Under certain conditions, the U.S. government also has “march-in rights.”These rights enable the U.S. government to require us to grant a nonexclusive,partially exclusive, or exclusive license in any field of use to responsibleapplicants, upon terms that are reasonable under the circumstances.

**Foreign Operations:**

We have foreign operationsthrough our Power Systems, Canada subsidiary in Burlington, Ontario, Canada.

**GovernmentRegulation**

We presently are subjectto various federal, state and local laws and regulations relating to, amongother things, export control energy generation, safe working conditions,handling and disposal of hazardous and potentially hazardous substances andemissions of pollutants into the atmosphere. To date, we believe that we haveobtained all the necessary government permits and have been in substantialcompliance with all of these applicable laws and regulations.

**GovernmentContracts**

We act as a prime contractor or major subcontractorfor many different U.S. government programs, including those that involve thedevelopment of electro-mechanical transportation, navigation and energy-relatedproducts. Over its lifetime, a program may be implemented by the award of manyindividual contracts and subcontracts, or contracts with option years, orpartially funded contracts.

U.S. government contracts include provisionspermitting termination, in whole or in part, without prior notice, at the U.S.government’s discretion. The U.S. government generally pays compensation forwork actually done and commitments made at the time of termination, and someallowance for profit on the work performed. The U.S. government may alsoterminate for default in performance and pay only the value delivered to theU.S. government. It can also hold the contractor responsible for re-procurementcosts.

Our government contract business is also subject tospecific procurement statutes and regulations and a variety of socio-economicand other factors. Failure to comply with these regulations and requirements 

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could lead to loss ofcontract or suspension or debarment from U.S. government contracting orsubcontracting for a period of time. Examples of these statutes and regulationsare those related to procurement integrity, export control, employmentpractices, the accuracy of records and the recording of costs.

Sales to the U.S.government may be affected by changes in research interests in the areas inwhich we engage, changing government department budgets, and changingprocurement policies.

**Employees**

At December 31, 2006,we had a total of 195 full-time employees, 8 part-time employees and 48 contractemployees. Of the total, 74 persons were employed in engineering, 122 inmanufacturing, 37 in administration and 18 in sales and marketing. Our futuresuccess depends in large part on the continued service of our key technical andsenior management personnel, and on our ability to attract, retain and motivatequalified employees, particularly those highly skilled design, process and testengineers involved in the manufacture of existing products and the developmentof new products and processes. The competition for such personnel is intense,and the loss of key employees could have a material adverse effect on us. Noneof our employees are represented by a union. We believe that our relations withour employees are good.

**Item 1A.**                RiskFactors

*Our future results remain difficult to predict and maybe affected by a number of factors which could cause actual results to differmaterially from forward-looking statements contained in this AnnualReport on Form 10-K and presented elsewhere by management from timeto time. These factors include business conditions within the distributedpower, power quality, aerospace, transportation, industrial, utility,telecommunications, silicon wafer manufacturing, factory automation, aircraftand automotive industries and the world economies as a whole. Our revenuegrowth is dependent, in part, on technology developments and contract researchand development for both the government and commercial sectors and no assurancecan be given that we will continue to obtain such funds. In addition, ourgrowth opportunities are dependent on our new products penetrating the distributedpower, power quality, aerospace, transportation, industrial, utility,telecommunications, silicon wafer manufacturing, factory automation, aircraftand automotive markets. No assurance can be given that new products can bedeveloped, or if developed, will be commercially viable; that competitors willnot force prices to unacceptably low levels or take market share from us; orthat we can achieve and maintain profitability in these or any new markets.Because of these and other factors, including, without limitation, the factorsset forth below, past financial performance should not be considered anindicator of future performance. Investors should not use historical trends toanticipate future results and should be aware that the market price of our commonstock experiences significant volatility.*

**Risks Related toOur Company**

**We have a historyof operating losses, may not be able to achieve profitability and may requireadditional capital in order to sustain our businesses.**

For each of the past tenfiscal years, we have experienced losses from operating our businesses. As of December 31,2006, we had an accumulated deficit of approximately $159.0 million. During thetwelve months ended December 31, 2006 we had a loss from operations ofapproximately $14.8 million. In July 2006, we sold senior securedconvertible notes and related warrants for $12 million. The net proceeds of thesale were approximately $11 million, after deducting placement fees and otheroffering-related expenses. If, however, we are unable to operate on a cash flowbreakeven basis in the future, we may need to raise additional capital in orderto sustain our operations. There can be no assurance that we will be able toachieve such results or to raise such funds if they are required.

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**We may not be ableto continue as a going concern.**

Our financial statementsfor the twelve months ended December 31, 2006, which are included in thisAnnual Report on Form 10-K, contain an audit report from Vitale,Caturano and Company. The audit report contains a going concern qualification,which raises substantial doubt with respect to our ability to continue as agoing concern. The receipt of a going concern qualification may create aconcern among our current and future customers and vendors as to whether wewill be able to fulfill our contractual obligations.

**We could issueadditional common stock, which might dilute the book value of our common stock.**

We have authorized100,000,000 shares of our common stock, of which 40,105,073 shares were issuedand outstanding as of December 31, 2006. Our board of directors has theauthority, without action or vote of our stockholders in most cases, to issueall or a part of any authorized but unissued shares. Such stock issuances maybe made at a price that reflects a discount from the then-current trading priceof our common stock. In addition, in order to raise the capital that we mayneed at today’s stock prices, we will need to issue securities that areconvertible into or exercisable for a significant amount of our common stock.For example, in July 2006, we sold senior secured convertible notes andrelated warrants for $12 million. These issuances would dilute yourpercentage ownership interest, which will have the effect of reducing yourinfluence on matters on which our stockholders vote, and might dilute the bookvalue of our common stock. You may incur additional dilution of net tangiblebook value if holders of stock options, whether currently outstanding orsubsequently granted, exercise their options or if warrant holders exercisetheir warrants to purchase shares of our common stock.

**The sale orissuance of a large number of shares of our common stock could depress ourstock price.**

As of March 1, 2007,we have reserved 9,392,479 shares of common stock for issuance upon exercise ofstock options and warrants, 1,207,536 shares for future issuances under ourstock plans and 353,632 shares for future issuances as matchingcontributions under our 401(k) plan*.*Wehave also reserved 845,588 shares of common stock for issuance upon conversionof the outstanding Series B Preferred Stock, which can be converted at anytime. In addition, we have reserved 6,969,697 shares of common stock forissuance upon conversion of the outstanding Notes, which can be converted atany time. Furthermore, because principal and interest may be paid in shares ofcommon stock at a price per share equal to a 10% discount to a volume weightedaverage price preceding the payment date, a significantly larger number ofshares of common stock may be issued under the Notes. As of December 31,2006, holders of warrants and options to purchase an aggregate of 7,596,068shares of our common stock may exercise those securities and transfer theunderlying common stock at any time subject, in some cases, to Rule 144.

**We have notconsistently complied with Nasdaq’s Marketplace Rules for continuedlisting, which exposes us to the risk of delisting from the Nasdaq StockMarket.**

As a result of our failureto comply with the continued listing requirements of The Nasdaq Global Market,on October 25, 2006 we transferred our securities to The Nasdaq CapitalMarket. However, if we fail to maintain compliance with the rules forcontinued listing on The Nasdaq Capital Market, including, without limitation,the minimum $1.00 bid price requirement, and our common stock is delisted fromThe Nasdaq Capital Market, there could be a number of negative implications,including reduced liquidity in our common stock as a result of the loss ofmarket efficiencies associated with The Nasdaq Capital Market, the potentialloss of confidence by suppliers, customers and employees, as well as the lossof analyst coverage and institutional investor interest, fewer businessdevelopment opportunities and greater difficulty in obtaining financing. Inaddition, if our common stock does not remain listed on a U.S. nationalsecurities exchange, we may be required to repurchase our outstanding seniorsecured convertible notes at 

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apremium and/or incur liquidated damages. In that event, we would likely havesignificant limitations on our ability to raise capital, including capitalnecessary in order to fund the repurchase of the senior secured convertiblenotes or pay the liquidated damages.

**We expect to generate a significant portion of ourfuture revenues from sales of our power control products and cannot assuremarket acceptance or commercial viability of our power control products.**

We intend to continue toexpand development of our power control products. We cannot assure you thatpotential customers will select SatCon’s products to incorporate into theirsystems or that our customers’ products will realize market acceptance, thatthey will meet the technical demands of their end users or that they will offercost-effective advantages over existing products. Our marketing efforts haveincluded development contracts with several customers and the targeting ofspecific market segments for power and energy management systems. We cannotknow if our commercial marketing efforts will be successful in the future.Additionally, we may not be able to develop competitive products, our productsmay not receive market acceptance, and we may not be able to compete profitablyin this market, even if market acceptance is achieved. If our products do notgain market acceptance or achieve commercial viability, we will not attain ouranticipated levels of profitability and growth.

**If we are unable to maintain our technologicalexpertise in design and manufacturing processes, we will not be able tosuccessfully compete.**

We believe that our futuresuccess will depend upon our ability to develop and provide products that meetthe changing needs of our customers. This requires that we successfullyanticipate and respond to technological changes in design and manufacturingprocesses in a cost-effective and timely manner. As a result, we continuallyevaluate the advantages and feasibility of new product design and manufacturingprocesses. We cannot, however, assure you that our process improvement effortswill be successful. The introduction of new products embodying new technologiesand the emergence of shifting customer demands or changing industry standardscould render our existing products obsolete and unmarketable, which would havea significant impact on our ability to generate revenue. Our future successwill depend upon our ability to continue to develop and introduce a variety ofnew products and product enhancements to address the increasingly sophisticatedneeds of our customers. We may experience delays in releasing new products andproduct enhancements in the future. Material delays in introducing new productsor product enhancements may cause customers to forego purchases of our productsand purchase those of our competitors.

**We are heavily dependent on contracts with the U.S.government and its agencies or from subcontracts with the U.S. government’sprime contractors for revenue to develop our products, and the loss of one ormore of our government contracts could preclude us from achieving ouranticipated levels of growth and revenues.**

Our ability to develop andmarket our products is dependent upon maintaining our U.S. government contractrevenue and research grants. Many of our U.S. government contracts are fundedincrementally on a year-to-year basis. Approximately 40% of our revenue duringthe twelve months ended December 31, 2006 was derived from governmentcontracts and subcontracts. Changes in government policies, priorities orprograms that result in budget reductions could cause the government to cancel existingcontracts or eliminate follow-on phases in the future which would severelyinhibit our ability to successfully complete the development andcommercialization of our products. In addition, there can be no assurance that,once a government contract is completed, it will lead to follow-on contractsfor additional research and development, prototype build and test orproduction. Furthermore, there can be no assurance that our U.S. governmentcontracts or subcontracts will not be terminated or suspended in the future. Inthe event that any of our government contracts are terminated for cause, itcould significantly affect our ability to 

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obtainfuture government contracts, which could seriously harm our ability to developour technologies and products.

**Our contracts withthe U.S. government are subject to audit by the Defense Contract Audit Agencyand other agencies of the government, which may challenge our treatment ofdirect and indirect costs and reimbursements, resulting in a materialadjustment and adverse impact on our financial condition.**

The accuracy and appropriateness of our direct andindirect costs and expenses under our contracts with the U.S. government aresubject to extensive regulation and audit by the Defense Contract Audit Agencyor by other appropriate agencies of the U.S. government. These agencies havethe right to challenge our cost estimates or allocations with respect to anysuch contract. Additionally, substantial portions of the payments to us underU.S. government contracts are provisional payments that are subject topotential adjustment upon audit by such agencies. Adjustments that result frominquiries or audits of our contracts could have a material adverse impact onour financial condition or results of operations.

Since our inception, wehave not experienced any material adjustments as a result of any inquiries oraudits, but there can be no assurance that our contracts will not be subject tomaterial adjustments in the future.

**The U.S. governmenthas certain rights relating to our intellectual property.**

Many of our patents arethe result of inventions made under U.S. government-funded research anddevelopment programs. With respect to any invention made with governmentassistance, the government has a nonexclusive, nontransferable, irrevocable,paid-up license to use the technology or have the technology employed for or onbehalf of the U.S. government throughout the world. Under certain conditions,the U.S. government also has “march-in rights,” which enable the U.S. governmentto require us to grant a nonexclusive, partially exclusive, or exclusivelicense in any field of use to responsible applicants, upon terms that arereasonable under the circumstances.

**Our business could be adversely affected if we areunable to protect our patents and proprietary technology.**

As of March 1,2007, we held approximately 68 U.S. patents and had 7 patent applicationspending with the U.S. Patent and Trademark Office. We have also obtainedcorresponding patents in the rest of North America, Europe, and Asia for manyof these patents. The expiration dates of our patents range from 2009 to 2021,with the majority expiring after 2015. As a qualifying small business from ourinception to date, we have retained commercial ownership rights to proprietarytechnology developed under various U.S. government contracts and grants.

Our patent and tradesecret rights are of significant importance to us and to our future prospects.Our ability to compete effectively against other companies in our industry willdepend, in part, on our ability to protect our proprietary technology andsystems designs relating to our products. Although we have attempted tosafeguard and maintain our proprietary rights, we do not know whether we havebeen or will be successful in doing so. Further, our competitors mayindependently develop or patent technologies that are substantially equivalentor superior to ours. No assurance can be given as to the issuance of additionalpatents or, if so issued, as to their scope. Patents granted may not providemeaningful protection from competitors. Even if a competitor’s products were toinfringe patents owned by us, it would be costly for us to pursue our rights inan enforcement action and there can be no assurance that we would be successfulin enforcing our intellectual property rights. Because we intend to enforce ourpatents, trademarks and copyrights and protect our trade secrets, we may beinvolved from time to time in litigation to determine the enforceability, scopeand validity of these rights. This litigation could result in substantial coststo us and divert resources from operational goals. In addition, effectivepatent, trademark, service mark, 

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copyrightand trade secret protection may not be available in every country where we operateor sell our products.

**We may not be ableto maintain confidentiality of our proprietary knowledge.**

In addition to our patentrights, we also rely on treatment of our technology as trade secrets throughconfidentiality agreements, which all of our employees are required to sign,assigning to us all patent rights and other intellectual property developed byour employees during their employment with us. Our employees have also agreednot to disclose any trade secrets or confidential information without our priorwritten consent. We also rely on non-disclosure agreement to protect our tradesecrets and proprietary knowledge. These agreements may be breached, and we maynot have adequate remedies for any breach. Our trade secrets may also be knownwithout breach of these agreements or may be independently developed bycompetitors. Failure to maintain the proprietary nature of our technology andinformation could harm our results of operations and financial condition byreducing or eliminating our technological advantages in the marketplace.

**Others may assertthat our technology infringes their intellectual property rights.**

We believe that we do notinfringe the proprietary rights of others and, to date, no third parties haveasserted an infringement claim against us, but we may be subject toinfringement claims in the future. The defense of any claims of infringementmade against us by third parties could involve significant legal costs andrequire our management to divert time from our business operations. If we areunsuccessful in defending any claims of infringement, we may be forced toobtain licenses or to pay royalties to continue to use our technology. We maynot be able to obtain any necessary licenses on commercially reasonable termsor at all. If we fail to obtain necessary licenses or other rights, or if theselicenses are costly, our operating results may suffer either from reductions inrevenues through our inability to serve customers or from increases in costs tolicense third-party technologies.

**Our success isdependent upon attracting and retaining highly qualified personnel and the lossof key personnel could significantly hurt our business.**

To achieve success, wemust attract and retain highly qualified technical, operational and executiveemployees. The loss of the services of key employees or an inability toattract, train and retain qualified and skilled employees, specificallyengineering, operations and business development personnel, could result in theloss of business or could otherwise negatively impact our ability to operateand grow our business successfully.

**We expectsignificant competition for our products and services.**

In the past, we have facedlimited competition in providing research services, prototype development andcustom and limited quantity manufacturing. We expect competition to intensifygreatly as commercial applications increase for our products under development.Many of our competitors and potential competitors are well established and havesubstantially greater financial, research and development, technical,manufacturing and marketing resources than we do. Some of our competitors andpotential competitors are much larger than we are. If these larger competitorsdecide to focus on the development of distributed power and power qualityproducts, they have the manufacturing, marketing and sales capabilities tocomplete research, development and commercialization of these products morequickly and effectively than we can. There can also be no assurance thatcurrent and future competitors will not develop new or enhanced technologiesperceived to be superior to those sold or developed by us. There can be noassurance that we will be successful in this competitive environment.

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**We are dependent onthird-party suppliers for the supply of key components for our products.**

We use third-partysuppliers for components in many of our systems. From time to time, shipmentscan be delayed because of industry-wide or other shortages of necessarymaterials and components from third-party suppliers. A supplier’s failureto supply components in a timely manner, or to supply components that meet ourquality, quantity or cost requirements, or our inability to obtain substitutesources of these components on a timely basis or on terms acceptable to us,could impair our ability to deliver our products in accordance with contractualobligations.

**On occasion, weagree to fixed price engineering contracts in our Applied Technology Division,which exposes us to losses.**

Most of our engineeringdesign contracts are structured on a cost-plus basis. However, on occasion wehave entered into fixed price contracts, which may expose us to loss. A fixedpriced contract, by its very nature, requires cost estimates during the biddingprocess and throughout the contract, as the program proceeds to completion. Dependingupon the complexity of the program, the estimated completion costs could changefrequently and significantly during the course of the contract. We regularlyinvolve the appropriate people on the program and finance staffs to arrive at areasonable estimate of the cost to complete. However, due to unanticipatedtechnical challenges and other factors, there is the potential for substantialcost overruns in order to complete the contract in accordance with the contractspecifications. Currently we do not have any contracts of this type. During thefiscal year ended September 30, 2005, we had recorded losses on thesecontracts of approximately $0.1 million related to a fixed price contract whichwas completed during the period. No other losses were recorded on thesecontracts during fiscal 2005 or 2006.

**If we experience aperiod of significant growth or expansion, it could place a substantial strainon our resources.**

If our power controlproducts are successful in achieving rapid market penetration, we may berequired to deliver large volumes of technically complex products or componentsto our customers on a timely basis at reasonable costs to us. We have limitedexperience in ramping up our manufacturing capabilities to meet large-scaleproduction requirements and delivering large volumes of our power controlproducts. If we were to commit to deliver large volumes of our power controlproducts, we cannot assure you that we will be able to satisfy large-scalecommercial production on a timely and cost-effective basis or that such growthwill not strain our operational, financial and technical resources.

**Our business could be subject to product liabilityclaims.**

Ourbusiness exposes us to potential product liability claims, which are inherentin the manufacturing, marketing and sale of our products, and we may facesubstantial liability for damages resulting from the faulty design ormanufacture of products or improper use of products by end users. We currentlymaintain a moderate level of product liability insurance, and there can be noassurance that this insurance will provide sufficient coverage in the event ofa claim. Also, we cannot predict whether we will be able to maintain suchcoverage on acceptable terms, if at all, or that a product liability claimwould not harm our business or financial condition. In addition, negativepublicity in connection with the faulty design or manufacture of our products wouldadversely affect our ability to market and sell our products.

**We are subject to avariety of environmental laws that expose us to potential financial liability.**

Our operations areregulated under a number of federal, state and foreign environmental and safetylaws and regulations that govern, among other things, the discharge or releaseof hazardous materials into the air and water as well as the handling, storageand disposal of these materials. These laws and 

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regulationsinclude the Clean Air Act, the Clean Water Act, the Resource, Conservation andRecovery Act, and the Comprehensive Environmental Response, Compensation andLiability Act, as well as analogous state and foreign laws. Because we usehazardous materials in certain of our manufacturing processes, we are requiredto comply with these environmental laws. In addition, because we generatehazardous wastes, we, along with any other person who arranges for the disposalof our wastes, may be subject to potential financial exposure for costs associatedwith an investigation and remediation of sites at which we have arranged forthe disposal of hazardous wastes if those sites become contaminated and even ifwe fully comply with applicable environmental laws. If we were found to be aresponsible party, we could be held jointly and severably liable for the costsof remedial actions. To date, we have not been cited for any improper dischargeor release of hazardous materials.

**Businesses andconsumers might not adopt alternative energy solutions as a means for obtainingtheir electricity and power needs.**

On-site distributedpower generation solutions, such as fuel cell, photovoltaic and wind turbinesystems, which utilize our products, provide an alternative means for obtainingelectricity and are relatively new methods of obtaining electrical power thatbusinesses may not adopt at levels sufficient to grow this part of ourbusiness. Traditional electricity distribution is based on the regulatedindustry model whereby businesses and consumers obtain their electricity from agovernment regulated utility. For alternative methods of distributed power tosucceed, businesses and consumers must adopt new purchasing practices and mustbe willing to rely upon less upon traditional means of purchasing electricity.We cannot assure you that businesses and consumers will choose to utilizeon-site distributed power at levels sufficient to sustain our business in thisarea. The development of a mass market for our products may be impacted by manyfactors which are out of our control, including:

·       marketacceptance of fuel cell, photovoltaic and wind turbine systems that incorporateour products;

·       thecost competitiveness of these systems;

·       regulatoryrequirements; and

·       theemergence of newer, more competitive technologies and products.

If a mass market fails todevelop or develops more slowly than we anticipate, we may be unable to recoverthe losses we will have incurred to develop these products.

**Our quarterlyoperating results are subject to fluctuations, and if we fail to meet theexpectations of securities analysts or investors, our share price may decreasesignificantly.**

Our annual and quarterlyresults may vary significantly depending on various factors, many of which arebeyond our control. Because our operating expenses are based on anticipatedrevenue levels, our sales cycle for development work is relatively long and ahigh percentage of our expenses are fixed for the short term, a small variationin the timing of recognition of revenue can cause significant variations inoperating results from quarter to quarter. If our earnings do not meet theexpectations of securities analysts or investors, the price of our stock coulddecline.

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**Provisionsin our charter documents and Delaware law may delay, deter or prevent theacquisition of SatCon, which could decrease the value of your shares.**

Someprovisions of our certificate of incorporation and bylaws may delay, deter orprevent a change in control of SatCon or a change in our management that you,as a stockholder, may consider favorable. These provisions include:

·       authorizingthe issuance of “blank check” preferred stock that could be issued by our boardof directors to increase the number of outstanding shares and deter a takeoverattempt;

·       aboard of directors with staggered, three-year terms, which may lengthen thetime required to gain control of our board of directors;

·       prohibitingcumulative voting in the election of directors, which would otherwise allowless than a majority of stockholders to elect director candidates; and

·       limitationson who may call special meetings of stockholders.

In addition, Section 203of the Delaware General Corporation Law and provisions in some of our stockincentive plans may delay, deter or prevent a change in control of SatCon. Thoseprovisions serve to limit the circumstances in which a premium may be paid forour common stock in proposed transactions, or where a proxy contest for controlof our board may be initiated. If a change of control or change in managementis delayed, deterred or prevented, the market price of our common stock couldsuffer.

**We are subject to stringent export laws and risksinherent in international operations.**

We market and sell ourproducts and services both inside and outside the United States. We are currentlyselling our products and services throughout North America and in certaincountries in South America, Asia, Canada and Europe. Certain of ourproducts are subject to the International Traffic in Arms Regulations (ITAR) 22U.S.C 2778, which restricts the export of information and material that may beused for military or intelligence applications by a foreign person.Additionally, certain products of ours are subject to export regulationsadministered by the Department of Commerce, Bureau of Industry Security, whichrequire that we obtain an export license before we can export certain productsor technology. Failure to comply with these laws could result in enforcementresponses by the government, including substantial monetary penalties, denialof export privileges, debarment from government contracts and possible criminalsanctions.

Revenue from sales to ourinternational customers for the year ended December 31, 2006, the threemonth transition period ended December 31, 2005 and our fiscal year ended September 30,2005, were approximately $3.3 million, $0.5 million and $3.4 million,respectively. Our success depends, in part, on our ability to expand our marketfor our products and services to foreign customers and our ability tomanufacture products that meet foreign regulatory and commercial requirements.We have limited experience developing and manufacturing our products to complywith the commercial and legal requirements of international markets. We facenumerous challenges in penetrating international markets, including unforeseenchanges in regulatory requirements, export restrictions, fluctuations incurrency exchange rates, longer accounts receivable cycles, difficulties inmanaging international operations, and the challenges of complying with a widevariety of foreign laws.

**We are exposed to credit risks with respect to some ofour customers.**

To the extent ourcustomers do not advance us sufficient funds to finance our costs during theexecution phase of our contracts, we are exposed to the risk that they will beunable to accept delivery or that they will be unable to make payment at thetime of delivery. Occasionally, we accept the risk of dealing with thinlyfinanced entities. We attempt to mitigate this risk by seeking to negotiate moretimely progress payments and utilizing other risk management procedures.

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**The holders of our Series BPreferred Stock are entitled to receive liquidation payments in preference tothe holders of our common stock.**

As of March 1, 2007,345 shares of our Series B Preferred Stock were outstanding. Pursuant tothe terms of the certificate of designation creating the Series BPreferred Stock, upon a liquidation of our company, the holders of shares ofthe Series B Preferred Stock are entitled to receive a liquidation paymentprior to the payment of any amount with respect to the shares of our commonstock. The amount of this preferential liquidation payment is $5,000 per shareof Series B Preferred Stock, plus the amount of any accrued but unpaiddividends on those shares. Prior to October 1, 2005, dividends accrued onthe shares of Series B Preferred Stock at a rate of 6% per annum. On October 1,2005, dividends began accruing on the Series B Preferred Stock at a rateof 8% per annum.

**Risks Related toOur Private Placement of Senior Secured Convertible Notes and Warrants**

**Substantialleverage and debt service obligations may adversely affect our cash flows*.***

In connection withthe sale of our senior secured convertible notes in July 2006, we incurrednew indebtedness of $12 million (of which $11.5 million is out standing as of March 1,2007). As a result of this indebtedness, our principal and interest paymentobligations increased substantially. The degree to which we are leveragedcould, among other things:

·       requireus to dedicate a substantial portion of our future cash flows from operationsand other capital resources to debt service, to the extent we are unable tomake payments of principal and interest in common stock, due to, among otherthings failure to satisfy the equity conditions that must be met to enable usto do so;

·       makeit difficult for us to obtain necessary financing in the future for workingcapital, acquisitions or other purposes on favorable terms, if at all;

·       makeit more difficult for us to be acquired;

·       makeus more vulnerable to industry downturns and competitive pressures; and

·       limitour flexibility in planning for, or reacting to changes in, our business.

Our ability to meet ourdebt service obligations will depend upon our future performance, which will besubject to financial, business and other factors affecting our operations, manyof which are beyond our control.

**We could be required to make substantial cash paymentsupon an event of default or change of control under our senior securedconvertible notes and related warrants, and, because the notes are secured,holders of the notes could take action against our assets upon an event ofdefault.**

Our senior securedconvertible notes provide for events of default including, among others, paymentdefaults, cross-defaults, breaches of any representation, warranty or covenantthat is not cured within the proper time periods, failure to perform certainrequired activities in a timely manner, our common stock no longer being listedon an eligible market, the effectiveness of the registration statement of whichthis prospectus is a part lapses beyond a specified period and certainbankruptcy-type events involving us or any significant subsidiary. Upon anevent of default, the holders of the notes may elect to require us torepurchase all or any portion of the outstanding principal amount of the notesfor a purchase price equal to the greater of (i) 115% of such outstandingprincipal amount, plus all accrued but unpaid interest or (ii) 115% of thethen value of the underlying common stock.

In addition, under the terms of the notes andwarrants, upon a change of control of our company, (i) the holders of thenotes may elect to require us to purchase the notes for 115% of the outstanding

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principal amount plus anyaccrued and unpaid interest and (ii) the holders of the warrants may electto require us to purchase the warrants for a purchase price equal to theBlack-Scholes value of the remaining unexercised portion of each warrant.

If either an event of defaultor change of control occurs, our available cash could be seriously depleted andour ability to fund operations could be materially harmed. Furthermore, becausethe notes are secured, if an event of default occurs, the holders of the notesmay take action against our assets (including the stock of our subsidiaries)under the terms of a Security Agreement.

**We are responsiblefor having the resale of shares of common stock underlying the convertiblenotes and warrants issued in our July 2006 private placement registeredwith the SEC within defined time periods and will incur liquidated damages ifthe shares are not registered with the SEC within those defined time periods.**

Pursuant to our agreementwith the investors in the July 2006 private placement, we were obligatedto (i) file a registration statement covering the resale of the commonstock underlying the securities issued in the private placement with the SECwithin 30 days following the closing of the private placement (which we havesatisfied), (ii) use our best efforts to cause the registration statementto be declared effective within 90 days following the closing of the privateplacement (which we have satisfied, as the registration statement was declaredeffective on September 27, 2006) and (iii) use our best efforts tokeep the registration statement effective until the earlier of (x) thefifth anniversary of the effective date of the registration statement, (y) thedate all of the securities covered by the registration statement have been publiclysold and (z) the date all of the securities covered by the registrationstatement may be sold without restriction under SEC Rule 144(k). If wefail to comply with these or certain other provisions, then we will be requiredto pay liquidated damages of 1% of the aggregate purchase price paid by theinvestors in the private placement for the initial occurrence of such failureand 1.5% of such amount for each subsequent 30 day period the failure continues.The total liquidated damages under this provision are capped at 24% of theaggregate purchase price paid by the investors in the private placement. Anysuch payments could materially affect our ability to fund operations.

**The agreements governing the senior securedconvertible notes and related warrants contain various covenants andrestrictions which may limit our ability to operate our business.**

The agreementsgoverning the senior secured convertible notes and related warrants containvarious covenants and restrictions, including, among others:

·       forso long as the notes are outstanding, the obligation that we offer to theholders the opportunity to participate in subsequent securities offerings (upto 50% of such offerings), subject to certain exceptions for, among otherthings, certain underwritten public offerings and strategic alliances;

·       forso long as the notes are outstanding, the obligation that we not incur anyindebtedness that is senior to, or on parity with, the notes in right ofpayment, subject to limited exceptions for purchase money indebtedness andcapital lease obligations;

·       forso long as the notes are outstanding, we must maintain aggregate cash and cashequivalents equal to the greater of (i) $1,000,000 or (ii) $3,000,000*minus* 80% of eligible receivables; and

·       forso long as the notes and warrants are outstanding, we may not issue any commonstock or common stock equivalents at a price per share less than the conversionprice.

These restrictions couldlimit our ability to plan for or react to market conditions or meetextraordinary capital needs or otherwise restrict corporate activities, any ofwhich could have a material adverse impact on our business.

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**Item 1B.**               UNRESOLVEDSTAFF COMMENTS

None.

**Item 2.**                        PROPERTIES

Welease office, manufacturing and research and development space in the followinglocations:

| **Location**                 | ** ** | ** **                                           | ** ** | **Primary Use** | ** ** | **Approximate  Number of  Square Feet** | ** ** | **Expiration  of Lease** | ** ** |
|------------------------------|------------|------------------------------------------------------|------------|----------------------|------------|---------------------------------------------------|------------|-------------------------------|------------|
| Boston, MA                   |       | Corporate  headquarters and research and development |       |                 | 28,000     |                                              |       |                          | 2011       |   |   |
| Marlborough, MA              |       | Manufacturing                                        |       |                 | 24,000     |                                              |       |                          | 2010       |   |   |
| West Boylston, MA            |       | Manufacturing                                        |       |                 | 13,000     |                                              |       |                          | 2008       |   |   |
| Baltimore, MD                |       | Research  and development                            |       |                 | 16,000     |                                              |       |                          | 2007       |   |   |
| Burlington, Ontario,  Canada |       | Manufacturing                                        |       |                 | 57,000     |                                              |       |                          | 2009       |   |   |

 

We believe our facilitiesare adequate for our current needs and that adequate facilities for expansion,if required, are available. On December 22, 2006 we negotiated asettlement with the landlord of our Worcester facility with respect to theearly termination of the related lease. As a result of this negotiation, weagreed to issue to the landlord 850,000 shares of common stock on January 3,2007 as consideration for the early termination of the lease. As a result ofthis settlement we recorded a restructuring charge during the three and twelvemonth period ended December 31, 2006 of approximately $1.1 million. Thelease terminated on February 15, 2007, and is not represented in the tableabove.

**Item 3.**                        LEGALPROCEEDINGS

From time to time, we are a party to routinelitigation and proceedings in the ordinary course of business.

On May 19, 2006, we filed a suit in U.S. districtcourt, District of Massachusetts, against one of our customers. The suitdemands full payment of all outstanding amounts due us from our customer. Thecustomer filed a counterclaim that we believed was without merit. The suit wassettled on March 9, 2007.

We are not aware of anycurrent or pending litigation to which we are or may be a party that we believecould materially adversely affect our results of operations or financialcondition or net cash flows.

**Item 4.**                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

No matter was submitted to a vote of security holdersduring the fourth quarter of 2006 covered by this report through thesolicitation of proxies or otherwise.

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**PART II**

**Item 5.**                     MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

Our common stock is publicly traded on the NasdaqCapital Market under the symbol “SATC.”

Thefollowing table sets forth the range of high and low sales prices of our commonstock as reported on the Nasdaq Capital Market for our years ended December 31,2005 and 2006:

| ** **                            | ** ** | **High** | ** ** | **Low** | ** ** |
|---------------------------------------|------------|----------|------------|---------|------------|
| **Year Ended December 31, 2005** |       |     |       |    |       |
| First Quarter                         |       | $        | 1.96       |    | $          | 1.51 |   |
| Second Quarter                        |       | $        | 1.64       |    | $          | 1.30 |   |
| Third Quarter                         |       | $        | 2.22       |    | $          | 1.34 |   |
| Fourth Quarter                        |       | $        | 2.09       |    | $          | 1.32 |   |
| **Year ended December 31, 2006** |       |     |       |    |       |
| First Quarter                         |       | $        | 2.44       |    | $          | 1.36 |   |
| Second Quarter                        |       | $        | 3.24       |    | $          | 1.80 |   |
| Third Quarter                         |       | $        | 1.88       |    | $          | 0.89 |   |
| Fourth Quarter                        |       | $        | 1.52       |    | $          | 0.86 |   |

 

On March 1, 2007, thelast reported sale price of our common stock as reported on the Nasdaq CapitalMarket was $1.56 per share. As of March 1, 2007, there were 41,536,053shares of our common stock outstanding held by approximately 260 holders ofrecord. The number of record holders does not include beneficial owners ofcommon stock whose shares are held in the names of banks, brokers, nominees orother fiduciaries.

**Dividend Policy**

We have never paid cashdividends on our common stock. We currently intend to retain earnings, if any,to fund the development and growth of our business and do not anticipate payingcash dividends for the foreseeable future. Payment of future cash dividends, ifany, will be at the discretion of our board of directors after taking intoaccount various factors, including our financial condition, operating results,current and anticipated cash needs and plans for expansion. In addition, underthe terms of our Series B Preferred Stock, we may not pay dividends on ourcommon stock without the consent of the holders of at least 75% of theoutstanding shares of Series B Preferred Stock. Furthermore the SecuritiesPurchase Agreement entered into in connection with our Private Placement on July 19,2006 prohibits the payment of dividends without the consent of the holders ofthe Notes for so long as at least $3.0 million in principal amount of the Notesremain outstanding.

**Recent Sales ofUnregistered Securities**

None

**Comparative StockPerformance Graph**

The comparative stock performancegraph below compares the cumulative total stockholder return (assumingreinvestment of cash dividends, if any) from investing $100 on December 31,2001, and plotted at the end of the last trading day of each year, in each of (i) ourcommon stock; (ii) the Nasdaq National Market Index of U.S. Companies (the“Nasdaq Market Index”); and (iii) a peer group index of four companiesthat provide similar services to those of our company (Ballard Power Systems, Inc.,IMPCO Technologies, Inc., Mechanical Technology Incorporated and UQM Technologies, Inc.(formerly known as Unique Mobility, Inc.) (the “Peer Group Index”)).

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The comparisons shown inthe graph below are based upon historical data. We caution that the stock priceperformance shown in the graph below is not necessarily indicative of, nor isit intended to forecast, the potential future performance of our common stock.

**COMPARISON OF 5-YEARCUMULATIVE TOTAL RETURN**

**AMONG SATCON TECHNOLOGY CORPORATION,**

**NASDAQMARKET INDEX AND PEER GROUP INDEX**

****

| ** **               | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| SATCON TECHNOLOGY  CORP. |       | $        | 100.00     |     | $          | 26.92    |       | $        | 39.42      |     | $          | 38.85    |       | $ | 28.85 |   | $ | 21.92 |   |
| PEER GROUP INDEX         |       | $        | 100.00     |     | $          | 38.34    |       | $        | 46.10      |     | $          | 30.76    |       | $ | 19.26 |   | $ | 24.15 |   |
| NASDAQ MARKET INDEX      |       | $        | 100.00     |     | $          | 69.97    |       | $        | 106.36     |     | $          | 115.98   |       | $ | 120.15 |   | $ | 134.80 |   |

 

The performance graph above shall not be deemed “filed”for purposes of Section 18 of the Securities Exchange Act of 1934, asamended (the “Exchange Act”), or otherwise subject to the liability of thatsection. This graph will not be deemed incorporated by reference into anyfiling under the Securities Act of 1933, as amended, or the Exchange Act,whether made before or after the date hereof, regardless of any generalincorporation language in such filing.

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**Item6.**                        SELECTEDCONSOLIDATED FINANCIAL DATA

Youshould read the data set forth below in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andour consolidated financial statements and related notes appearing elsewhere inthis Annual Report on Form 10-K. The selected consolidated financialdata set forth below for the year ended December 31, 2006, the three-monthtransition period ended December 31, 2005, and the fiscal years ended September 30,2005 and 2004, and the consolidated balance sheet data as of December 31,2006 and 2005 are derived from our audited consolidated financial statementsappearing elsewhere in this Annual Report on Form 10-K. The selectedconsolidated statement of operations data for our fiscal years ended September 30,2003 and 2002 and the consolidated balance sheet data as of September 30,2005, 2004, 2003 and 2002 are derived from our audited consolidated financialstatements that are not included in this Annual Report on Form 10-K.

| ** **                                                                                             | ** ** | **Year  Ended**                                                                 | ** ** | **Three  Months  Ended** | ** ** | ** **                                              | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **December 31,**                                                           | ** ** | **December 31,**    | ** ** | **Fiscal Year Ended September 30,** | ** ** |
| ** **                                                                                             | ** ** | **2006**                                                                        | ** ** | **2005**                 | ** ** | **2005**                                                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                             | ** ** | **(Amounts in thousands, except per share data)** | ** ** |
| **Statement of Operations Data**                                                        |       |                                                                            |       |                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Revenue:                                                                                               |       |                                                                            |       |                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Product revenue                                                                                        |       |                                                                            | $          | 28,767                   |       |                                                    |       | $ | 6,038 |   |   | $ | 29,891 |   | $ | 26,971 |   | $ | 21,648 |   | $ | 30,799 |   |
| Funded research  and development and other   revenue                                              |       |                                                                            | 4,990      |                     |       |                                                    | 1,079      |   |   | 6,064 |   | 7,187 |   | 5,282 |   | 10,831 |   |
| Total revenue                                                                                          |       |                                                                            | 33,757     |                     |       |                                                    | 7,117      |   |   | 35,955 |   | 34,158 |   | 26,930 |   | 41,630 |   |
| Operating costs and expenses:                                                                          |       |                                                                            |       |                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Cost of product  revenue                                                                               |       |                                                                            | 27,824     |                     |       |                                                    | 5,802      |   |   | 27,631 |   | 22,373 |   | 26,019 |   | 29,644 |   |
| Research and development and other revenue expenses:                                              |       |                                                                            |       |                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Funded research  and development and other revenue expenses                                       |       |                                                                            | 4,041      |                     |       |                                                    | 1,111      |   |   | 5,412 |   | 5,982 |   | 5,038 |   | 7,177 |   |
| Unfunded research  and development   expenses                                                          |       |                                                                            | 2,000      |                     |       |                                                    | 260        |   |   | 514 |   | 3 |   | 1,492 |   | 5,850 |   |
| Total research and  development and other revenue expenses                                             |       |                                                                            | 6,041      |                     |       |                                                    | 1,371      |   |   | 5,926 |   | 5,985 |   | 6,530 |   | 13,027 |   |
| Selling, general  and administrative expenses                                                          |       |                                                                            | 13,008     |                     |       |                                                    | 2,488      |   |   | 10,802 |   | 9,363 |   | 13,564 |   | 15,851 |   |
| Amortization of  intangibles                                                                           |       |                                                                            | 431        |                     |       |                                                    | 112        |   |   | 447 |   | 447 |   | 505 |   | 589 |   |
| Gain on sale of  assets                                                                                |       |                                                                            | (399       | )                        |       |                                                    | (1,443     | ) |   | (318 | ) | — |   | — |   | — |   |
| Restructuring  costs                                                                                   |       |                                                                            | 1,612      |                     |       |                                                    | —     |   |   | (256 | ) | — |   | — |   | 1,500 |   |
| Write-off of  impaired long-lived assets                                                               |       |                                                                            | —     |                     |       |                                                    | —     |   |   | 1,190 |   | — |   | 700 |   | — |   |
| Write-off of  impaired goodwill and intangible   assets                                           |       |                                                                            | —     |                     |       |                                                    | —     |   |   | — |   | — |   | 5,751 |   | — |   |
| Total operating  costs and expenses                                                                    |       |                                                                            | 48,517     |                     |       |                                                    | 8,330      |   |   | 45,422 |   | 38,168 |   | 53,069 |   | 60,611 |   |
| Operating loss                                                                                         |       |                                                                            | (14,760    | )                        |       |                                                    | (1,213     | ) |   | (9,467 | ) | (4,010 | ) | (26,139 | ) | (18,981 | ) |
| Net realized gain  on sale of marketable   securities                                                  |       |                                                                            | —     |                     |       |                                                    | —     |   |   | — |   | — |   | — |   | 17 |   |
| Net unrealized  gain (loss) on warrants to purchase common stock                                       |       |                                                                            | —     |                     |       |                                                    | —     |   |   | (7 | ) | (90 | ) | 82 |   | (519 | ) |
| Unrealized loss on  Series B warrants                                                             |       |                                                                            | —     |                     |       |                                                    | —     |   |   | — |   | 35 |   | (1,879 | ) | — |   |
| Write-down  of investment in Beacon Power Corporation common stock                                     |       |                                                                            | —     |                     |       |                                                    | —     |   |   | — |   | — |   | (542 | ) | (1,400 | ) |
| Realized gain on  sale of Beacon Power Corporation common stock                                        |       |                                                                            | —     |                     |       |                                                    | —     |   |   | — |   | — |   | 899 |   | — |   |
| Other income  (loss)                                                                                   |       |                                                                            | (4,251     | )                        |       |                                                    | (4         | ) |   | (117 | ) | (1 | ) | 71 |   | (10 | ) |
| Interest income                                                                                        |       |                                                                            | 384        |                     |       |                                                    | 47         |   |   | 42 |   | 12 |   | 5 |   | 292 |   |
| Interest expense                                                                                       |       |                                                                            | (1,151     | )                        |       |                                                    | (138       | ) |   | (697 | ) | (6,905 | ) | (3,978 | ) | (160 | ) |
| Net loss                                                                                               |       |                                                                            | $          | (19,778                  | )          |                                                    |       | $ | (1,308 | ) |   | $ | (10,246 | ) | $ | (10,959 | ) | $ | (31,481 | ) | $ | (20,761 | ) |
| Net loss  attributable to common stockholders per weighted average share, basic and  diluted |       |                                                                            | $          | (0.50                    | )          |                                                    |       | $ | (0.03 | ) |   | $ | (0.31 | ) | $ | (0.41 | ) | $ | (1.72 | ) | $ | (1.25 | ) |
| Weighted average number  of common shares, basic and diluted                                      |       |                                                                            | 39,290     |                     |       |                                                    | 38,356     |   |   | 32,900 |   | 26,834 |   | 18,258 |   | 16,597 |   |

 

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| ** **                                                                      | ** ** | **Year  Ended  December 31,** | ** ** | **Three  Months  Ended  December 31,** | ** ** | **As of September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                           | ** ** | **2005**                                    | ** ** | **2005**                               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                      | ** ** | **(in thousands)**            | ** ** |
| **Balance Sheet Data**                                                |       |                               |       |                                        |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents, including restricted cash  and cash equivalents |       |                               | $          | 8,275                                       |       |                                   |       | $ | 9,279 |   |   | $ | 6,711 |   | $ | 2,183 |   | $ | 1,235 |   | $ | 2,120 |   |
| Investment in Beacon Power Corporation                                          |       |                               | —     |                                        |       |                                   | —     |   |   | — |   | — |   | — |   | 800 |   |
| Total assets                                                                    |       |                               | 30,577     |                                        |       |                                   | 28,328     |   |   | 27,732 |   | 25,586 |   | 24,982 |   | 42,360 |   |
| Working capital                                                                 |       |                               | 6,007      |                                        |       |                                   | 10,690     |   |   | 11,393 |   | 5,141 |   | (1,413 | ) | 10,971 |   |
| Redeemable convertible Series A preferred stock                            |       |                               | —     |                                        |       |                                   | —     |   |   | — |   | — |   | 1,659 |   | — |   |
| Redeemable convertible Series B preferred stock                            |       |                               | 1,725      |                                        |       |                                   | 2,125      |   |   | 2,125 |   | 2,125 |   | — |   | — |   |
| Convertible subordinated debentures                                             |       |                               | 12,740     |                                        |       |                                   | —     |   |   | — |   | — |   | 763 |   | — |   |
| Investor warrant and Placement Agent Warrant Liability                     |       |                               | 2,921      |                                        |       |                                   | —     |   |   | — |   | — |   | — |   | — |   |
| Other long-term liabilities, net of current  portion                            |       |                               | 108        |                                        |       |                                   | 452        |   |   | 460 |   | 875 |   | 770 |   | 1,217 |   |
| Stockholders’  equity (deficit)                                            |       |                               | $          | (2,468                                      | )          |                                   |       | $ | 14,501 |   |   | $ | 15,602 |   | 11,659 |   | 6,162 |   | 29,926 |   |
|                                                                                 |            |                                    |            |                                             |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item 7.**                        MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**Special NoteRegarding Forward-Looking Information**

This Annual Report on Form 10-K,including, without limitations, this Item 7, contains or incorporates forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Act of 1934. You can identify theseforward-looking statements by our use of the words “believes,” “anticipates,”“plans,” “expects,” “may,” “will,” “intends,” “estimates,” and similarexpressions, whether in the negative or in the affirmative. Although we believethat these forward-looking statements reasonably reflect our plans,intentions and expectations, our actual results could differ materially fromthe plans, intentions and expectations disclosed in the forward-lookingstatements we make. We have included important factors in the cautionarystatements under the heading “Risk Factors” under Item 1A above that we believecould cause our actual results to differ materially from the forward-lookingstatements that we make. We do not intend to update information contained inany forward-looking statements we make.

**Recent Developments**

On July 19,2006, we entered into a Securities Purchase Agreement (the “Purchase Agreement”)with thirteen institutional investors (the “Purchasers”) in connection with theprivate placement (the “Private Placement”) of:

·       $12,000,000aggregate principal amount of senior secured convertible notes (the “Notes”), convertibleinto shares of our common stock at a conversion price of $1.65 per share;

·       WarrantA’s to purchase up to an aggregate of 3,636,368 shares of our common stock at aprice of $1.815 per share for a period beginning six months from the date ofsuch warrants and ending on the seventh anniversary of the date of suchwarrants; and

·       WarrantB’s to purchase up to an aggregate of 3,636,368 shares of our common stock at aprice of $1.68 per share for a period of 90 trading days beginning the later ofsix months from the date of such warrants and the date the Securities andExchange Commission (the “SEC”) declares effective a shelf registrationstatement covering the resale of the common stock underlying the securitiesissued in the Private Placement (the “Registration Statement”); to the extentthe Warrant B’s are exercised, the Purchasers will receive additionalseven-year warrants to purchase a number of shares of common stock equal to 50%of the number of shares of common stock purchased upon exercise of the WarrantB’s at a price of $1.815 per share. Because the registration statement wasdeclared effective on September 27, 2006, these warrants were originallyexercisable for the 90 trading day period beginning six months from the date ofsuch warrants (i.e. May 30, 2007). As discussed below, in connection with anamendment to the Purchase Agreement enabling us to issue common stock for theearly termination of the lease for our Worcester facility, the expiration dateof the Warrant B’s was extended to August 31, 2007.

The net proceeds of the sale were approximately $11million, after deducting placement fees and other offering-related expenses. Inconnection with the Private Placement, we also entered into a SecurityAgreement, dated July 19, 2006, with the Purchasers (the “SecurityAgreement”).

In addition, First Albany Capital (“FAC”) acted asplacement agent in connection with the Private Placement. In addition to a cashtransaction fee of $590,000, FAC or its designees were entitled to receive five-yearwarrants to purchase 218,182 shares of our common stock at an exercise price of$1.87 per share. At the discretion of FAC, these warrants were issued to FirstAlbany Companies, Inc., the parent of FAC. We also paid Ardour Capital, ourfinancial advisor, approximately $250,000 for its services related to thePrivate Placement.

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In connection with, and as a condition precedent to,the completion of the Private Placement, on July 20, 2006, we paid allamounts due and owing under our credit facility with Silicon Valley Bank(approximately $2 million) and terminated such facility. In doing so weincurred a termination fee of $17,500 and legal fees of $8,500.

See Note G to our consolidated financial statementsincluded in this Annual Report on Form 10-K for a detaileddescription of the Notes and related warrants.

On September 19,2006, our Board of Directors approved a change in our fiscal year end from September 30to December 31. As a result, the financial periods presented and discussedin this Annual Report on Form 10-K will be defined as follows:

1.                Yearended December 31, 2006 represents the twelve months endedDecember 31, 2006,

2.                Three-monthtransition period ended December 31, 2005 represents the three monthsended December 31, 2005,

3.                Fiscal year endedSeptember 30, 2005 represents the twelve month period endedSeptember 30, 2005, and

4.                Fiscal year endedSeptember 30, 2004 represents the twelve month period endedSeptember 30, 2004.

For purposes of ourManagement Discussion and Analysis of Financial Condition and Results of Operationswe will be comparing the following periods:

·       Twelvemonths ended December 31, 2006 compared to the Twelve months ended September 30,2005

·       Threemonths ended December 31, 2005 compared to the three months ended January 1,2005 (unaudited)

·       Twelvemonths ended September 30, 2005 compared to the twelve months ended September 30,2004.

On September 19, 2006, our Board of Directorsapproved a plan to close our Worcester, Massachusetts manufacturing facility byapproximately December 31, 2006. The decision to close this facility wasin furtherance of our continuing efforts to streamline operations and reduceour operating costs. We intend to focus spending on our renewable energybusiness. As a result of this decision, we incurred approximately $1.6 millionrelated to employee severance and retention bonuses and asset impairments,warrant revaluation and lease termination costs. On December 22, 2006, wenegotiated a settlement with the Worcester landlord, issuing 850,000 shares ofcommon stock on January 3, 2007 as consideration for the early terminationof the lease. The lease terminated on February 15, 2007. We currentlyexpect this action will result in a reduction of total overhead expenses ofrent, facilities and personnel costs of approximately $3.0 million per year.

On December 20, 2006, in connection with theearly termination of the lease for the Worcester facility, we entered into aFirst Amendment to Securities Purchase Agreement (the “Amendment”) with certainof the Purchasers who participated in the Private Placement.

Pursuant to theAmendment:

·       thedefinition of “Excluded Stock” set forth in the Purchase Agreement was amendedto enable us to issue up to 1.1 million shares of our common stock inconnection with the early termination of the lease for our facility located inWorcester, Massachusetts, without such shares being subject to the Purchasers’right of participation set forth in the Purchase Agreement and certainprohibitions 

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set forth in the Notes andrelated warrants (as noted above, we ultimately settled the lease for 850,000shares); and

·       we agreed to extend theexpiration date of the Warrant B’s issued in the Private Placement from May 30,2007 to August 31, 2007.

**Overview**

We design and manufactureenabling technologies and products for electrical power conversion and controlfor high-performance, high-efficiency applications in large, growth marketssuch as alternative energy, hybrid electric vehicles, distributed powergeneration, power quality, semiconductor fabrication capital equipment,industrial motors and drives, and high reliability defense electronics.

**Critical AccountingPolicies and Significant Judgments and Estimates**

Our discussion and analysis of our financial conditionand results of our operations are 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 management to make significantestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at the dateof the financial statements and the reported revenue and expenses during thereporting periods. On an ongoing basis, management evaluates its estimates andjudgments, including those related to revenue recognition, receivable reserves,inventory reserves, investment in Beacon Power Corporation, goodwill andintangible assets, contract losses and income taxes. Management bases itsestimates on historical experience and on various other factors that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying value of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions. Ourcritical accounting estimates were discussed with our Audit Committee.

The significant accountingpolicies that management believes are most critical to aid in fullyunderstanding and evaluating our reported financial results include thefollowing:

***Revenue Recognition***

We recognize revenue from product sales in accordancewith SEC Staff Accounting Bulletin No. 104, *Revenue Recognition*. Product revenue is recognized whenthere is persuasive evidence of an arrangement, the fee is fixed ordeterminable, delivery of the product to the customer has occurred and we havedetermined that collection of the fee is probable. Title to the product passesupon shipment of the product, as the products are typically shipped FOBshipping point, except for certain foreign shipments. If the product requiresinstallation to be performed by us, all revenue related to the product isdeferred and recognized upon the completion of the installation. If the productrequires specific customer acceptance, revenue is deferred until customeracceptance occurs or the acceptance provisions lapse, unless we can objectivelyand reliably demonstrate that the criteria specified in the acceptanceprovisions are satisfied. When appropriate, we provide for a warranty reserveat the time the product revenue is recognized.

We perform funded research and development and productdevelopment for commercial companies and government agencies under both costreimbursement and fixed-price contracts. Cost reimbursement contractsprovide for the reimbursement of allowable costs and, in some situations, thepayment of a fee. These contracts may contain incentive clauses providing forincreases or decreases in the fee depending on how costs compare with a budget.On fixed-price contracts, revenue is generally recognized on thepercentage of completion method based upon the proportion of costs incurred tothe total estimated costs for the contract. Revenue from reimbursementcontracts is recognized as services are performed. In each type of contract, wereceive periodic progress payments or payment upon reaching interim milestonesand 

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retain the rights to theintellectual property developed in government contracts. All payments to us forwork performed on contracts with agencies of the U.S. government are subject toaudit and adjustment by the Defense Contract Audit Agency. Adjustments arerecognized in the period made. The Defense Contract Audit Agency hasagreed-upon the final indirect cost rates for the fiscal year ended September 30,2003. When the current estimates of total contract revenue and contract costsfor product development contracts indicate a loss, a provision for the entireloss on the contract is recorded. As of December 31, 2006, and 2005, wehave accrued approximately $0 and $0.1 million, respectively, foranticipated contract losses.

Cost of product revenue includes material, labor andoverhead. Costs incurred in connection with funded research and development andother revenue arrangements are included in funded research and development andother revenue expenses.

Deferred revenue consists of payments received fromcustomers in advance of services performed, product shipped or installationcompleted.

Unbilled contract costsand fees represent revenue recognized in excess of amounts billed due to contractualprovisions or deferred costs that have not yet been recognized as revenue orbilled to the customer.

***Accounts Receivable***

Accounts receivable arereduced by an allowance for amounts that may become uncollectible in thefuture. The estimated allowance for uncollectible amounts is based primarily ona specific analysis of accounts in the receivable portfolio and historicalwrite-off experience. While management believes the allowance to be adequate,if the financial condition of our customers were to deteriorate, resulting inimpairment of their ability to make payments, additional allowances may berequired.

***Inventory***

We value our inventory at the lower of actual cost topurchase and/or manufacture the inventory or the current estimated market valueof the inventory. We periodically review inventory quantities on hand andrecord a provision for excess and/or obsolete inventory based primarily on ourestimated forecast of product demand, as well as based on historical usage. Dueto the custom and specific nature of certain of our products, demand and usagefor products and materials can fluctuate significantly. A significant decreasein demand for our products could result in a short-term increase in the cost ofinventory purchases and an increase of excess inventory quantities on hand. Inaddition, our industry is characterized by rapid technological change, frequentnew product development, and rapid product obsolescence that could result in anincrease in the amount of obsolete inventory quantities on hand. Therefore,although we make every effort to ensure the accuracy of our forecasts of futureproduct demand, any significant unanticipated changes in demand ortechnological developments could have a significant impact on the value of ourinventory and our reported operating results.

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At theend of June 2003, we were actively engaged in selling our Shaker productline, and we were pursuing a strategy that we hoped would lead to a strategicalliance with a larger company for the development and exploitation of theadvantages embodied in our Uninterruptible Power Supply (“UPS”) system. At thattime the gross inventory for our Shaker product line inventory totaledapproximately $2.1 million and our valuation reserve against thatinventory was $2.0 million, or 95%. In addition, we had originally accruedapproximately $0.9 million for purchase commitments related to the UPS andShaker product lines (See Note D to our Consolidated Financial Statementsincluded in this Annual Report on Form 10-K). The table belowdetails the resulting approximate reduction of costs related to both the inventoryreserves of our Shaker and UPS product lines, as well as reserves establishedrelated to the purchase commitments as follows:

| **Year**                                  | ** ** | ** ** | *** *** | **Value of  Inventory  Reserve  Used** | *** *** | **Value of  Purchase  Commitments  Reserve  Used** | *** *** | **Period  Reduction to  Cost of  Sales** | *** *** | **Cumulative  Reduction  to Cost of  Sales** | *** *** |
|-------------------------------------------|------------|------------|--------------|---------------------------------------------|--------------|---------------------------------------------------------|--------------|----------------------------------------------------|--------------|--------------------------------------------------------|--------------|
| Fiscal Year 2005                          |       | $          | 141,000      |                                        |         | $                                                       | 88,000       |                                               |         |                                                   | $            | 229,000 |   |   | $ | 1,003,000 |   |
| Three Months Ended December 31, 2005 |       | $          | —       |                                        |         | $                                                       | —       |                                               |         |                                                   | $            | — |   |   | $ | 1,003,000 |   |
| Year Ended  December 31, 2006        |       | $          | —       |                                        |         | $                                                       | —       |                                               |         |                                                   | $            | — |   |   | $ | 1,003,000 |   |

 

Although it is unclear howmuch of the remaining inventory we will sell and during which periods it willoccur, as we sell this inventory our cost of product revenue will be lower thannormal as this inventory has been largely written-down. As a result, to theextent this inventory is sold in the future, our margins will be favorablyimpacted compared with results that would otherwise be achieved.

On December 13, 2005,we sold our shaker and amplifier product lines, and the associated inventoryand intellectual property to Qualmark, Inc., for proceeds of approximately$2.3 million. This sale involved shakerand amplifier inventory of approximately $1.8 million. This inventory hadapproximately $1.0 million in reserves, due to the fiscal 2003 write-downas described above. Remaining reserves related to the fiscal 2003 write-down,as described above, relate only to our UPS inventory and will be accounted forin future sales of these products.

***Goodwill andIntangible Assets***

Purchase accountingrequires extensive use of accounting estimates and judgments to allocate thepurchase price to the fair market value of the assets purchased and liabilitiesassumed. We have accounted for our acquisitions using the purchase method ofaccounting. Values were assigned to goodwill and intangible assets based onthird-party independent valuations, as well as management’s forecasts andprojections that include assumptions related to future revenue and cash flows generatedfrom the acquired assets.

We have adopted theprovisions of SFAS No. 142, *Goodwilland Other Intangible Assets*. This statement affects our treatment ofgoodwill and other intangible assets. The statement requires impairment testsbe periodically repeated and on an interim basis, if certain conditions exist,with impaired assets written down to fair value. Additionally, existinggoodwill and intangible assets must be assessed and classified within thestatement’s criteria. Intangible assets with finite useful lives will continueto be amortized over those periods. Amortization of goodwill and intangibleassets with indeterminable lives ceased.

We determine the fairvalue of each of the reporting units based on a discounted cash flow incomeapproach. The income approach indicates the fair value of a business enterprisebased on the discounted value of the cash flows that the business can beexpected to generate in the future. This analysis is largely based uponprojections prepared by us and data from sources of publicly availableinformation available at the time of preparation. These projections are basedon management’s best estimate of future results. In 

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makingthese projections, we consider the markets we are addressing, the competitiveenvironment and our advantages. There will usually be differences betweenestimated and actual results as events and circumstances frequently do notoccur as expected, and those differences may be material. In addition, weperform a macro assessment of the overall likelihood that we would achieve theprojected cash flows and performed sensitivity analysis using historical dataas the basis for projected cash flows.

***Long-Lived Assets***

We have adopted SFAS No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets,* which supersedes SFAS No. 121, *Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to be Disposed Of*, and the accounting and reportingprovisions of APB Opinion No. 30. SFAS No. 144 addressesfinancial accounting and reporting for the impairment or disposal of long-livedassets. The statement requires that long-lived assets be reviewed for possibleimpairment, if certain conditions exist, with impaired assets written down tofair value.

We determine the fairvalue of certain of the long-lived assets based on a discounted cash flowincome approach. The income approach indicates the fair value of a long-livedassets based on the discounted value of the cash flows that the long-livedasset can be expected to generate in the future over the life of the long-livedasset. This analysis is based upon projections prepared by us. Theseprojections represent management’s best estimate of future results. In makingthese projections, we consider the markets we are addressing, the competitiveenvironment and our advantages. There will usually be differences betweenestimated and actual results as events and circumstances frequently do notoccur as expected, and those differences may be material. In addition, weperform a macro assessment of the overall likelihood that we would achieve theprojected cash flows and performed sensitivity analysis using historical dataas the basis for projected cash flows.

***Convertible DebtInstruments and Warrant Liabilities***

We account for our seniorsecured convertible Notes and associated warrants in accordance with SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities.” Our convertibleNotes include features that qualify as embedded derivatives, such as (i) theholders’ conversion option, (ii) our option to settle the Notes at thescheduled dates in cash or shares of our common stock, and (iii) premiumsand penalties we would be liable to pay in the event of default. As permitted under SFAS 155, we have elected, asof January 1, 2007, to measure the Notes in their entirety at fair valuewith changes in fair value recognized as either gain or loss. This election wasmade by us after determining that the aggregate fair value of the Notes to bemore meaningful in the context of our financial statements than if separatefair values were assigned to each of the multiple embedded instrumentscontained such Notes.

We record interest expenseunder our convertible Notes based on the greater of (i) 7% or (ii) thesix-month LIBOR, in effect at the time plus 350 basis points, as well asthe amortization of the debt discount, which we compute using the effectiveinterest method. The debt discount represents the difference between our grossproceeds of $12.0 million and the fair value of the convertible debt uponissuance, after separately valuing the investor warrants, the placement agentwarrants and the convertible Notes on a relative fair value basis. Byamortizing the debt discount to interest expense, rather than recognizing it asa change in fair value of the convertible debt instrument and warrants, whichis a separate line item in our statement of operations, we believe our interestexpense line item more appropriately reflects the cost of the debt associatedwith our convertible Notes.

We determined the fairvalues of our convertible Notes, investor warrants and placement agent warrantsin consultation with valuation specialists, using valuation models we considerto be appropriate. Our stock price has the most significant influence on thefair value of our convertible Notes and our warrants. An increase in our commonstock price would cause the fair values of both convertible Notes and warrantsto increase, because the conversion and exercise prices, respectively, of suchinstruments are fixed 

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at $1.65and $1.68 per share, respectively, and result in a charge to our statement ofoperations. A decrease in our stock price would likewise cause the fair valueof the convertible Notes and the warrants to decrease and result in a credit toour statement of operations. If the price of our common stock were to declinesignificantly, however, the decrease in the fair value of the convertible Noteswould be limited by the instrument’s debt characteristics. Under suchcircumstances, our estimated cost of capital would become another significantvariable affecting the fair value of the convertible Notes.

***Income Taxes***

The preparation of ourconsolidated financial statements requires us to estimate our income taxes ineach of the jurisdictions in which we operate, including those outside theUnited States, which may be subject to certain risks that ordinarily would notbe expected in the United States. The income tax accounting process involvesestimating our actual current exposure together with assessing temporarydifferences resulting from differing treatment of items, such as deferredrevenue, for tax and accounting purposes. These differences result in therecognition of deferred tax assets and liabilities. We must then record avaluation allowance to reduce our deferred tax assets to the amount that ismore likely than not to be realized.

Significant managementjudgment is required in determining our provision for income taxes, ourdeferred tax assets and liabilities and any valuation allowance recordedagainst deferred tax assets. We have recorded a full valuation allowanceagainst our deferred tax assets of approximately $47.4 million and $ 41.0million as of December 31, 2006 and 2005, respectively, due touncertainties related to our ability to utilize these assets. The valuationallowance is based on our estimates of taxable income by jurisdiction in whichwe operate and the period over which our deferred tax assets will berecoverable. In the event that actual results differ from these estimates or weadjust these estimates in future periods we may need to adjust our valuationallowance which could materially impact our financial position and results ofoperations.

***Recent AccountingPronouncements***

In February 2006, the FASBissued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”(“SFAS 155”), which amends SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140,“Accounting for Transfers and Servicing of Financial Assets and Extinguishmentsof Liabilities” (“SFAS 140”). SFAS 155 simplifies the accounting forcertain derivatives embedded in other financial instruments by allowing them tobe accounted for as a whole if the holder elects to account for the wholeinstrument on a fair value basis. SFAS 155 also clarifies and amendscertain other provisions of SFAS 133 and SFAS 140. SFAS 155 iseffective for all financial instruments acquired, issued or subject to aremeasurement event occurring in fiscal years beginning afterSeptember 15, 2006. We adopted SFAS 155 on January 1, 2007. Webelieve that the adoption of SFAS 155 will not have a material effect onour consolidated financial statements.

In June 2006, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48,“*Accounting for Uncertainty in Income Taxes*,”(“FIN No. 48”) which is effective for fiscal years beginning after December 15,2006. FIN No. 48 clarifies the accounting for uncertainty in income taxesrecognized in the financial statements by prescribing a recognition thresholdand measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN No. 48 also provides guidance on derecognition, classification, interestand penalties, accounting in interim periods, disclosure and transition. We arecurrently evaluating the potential impact of the adoption of FIN No. 48 on ourconsolidated financial position, results of operations and cash flows.

In September 2006, theFASB issued Statement of Financial Accounting Standards No. 157 (SFAS 157),Fair Value Measurements, which defines fair value, establishes guidelines formeasuring fair value and expands disclosures regarding fair value measurements.SFAS 157 does not require any new fair 

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valuemeasurements but rather eliminates inconsistencies in guidance found in variousprior accounting pronouncements. SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007. Earlier adoption is permitted, provided thecompany has not yet issued fiancial statements, including for interim periods,for that fiscal year. We are currently evaluating the impact of SFAS 157.

In September 2006, the SECreleased SAB 108, Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements. SAB 108 allowsregistrants to adjust for the cumulative effect of certain errors relating toprior years in the carrying amount of assets and liabilities as of thebeginning of the current year, with an offsetting adjustment to the openingbalance of retained earnings in the year of adoption provided that managementhas properly concluded that the errors were not material to prior periods. SAB108 also requires the adjustment of any prior quarterly financial statementswithin the fiscal year of adoption for the effects of such errors on thequarters when the information is next presented. Such adjustments do notrequire previously filed reports with the SEC to be amended. We have adoptedthe provisions of SAB 108 and determined that the impact on our consolidatedfinancial position, results of operations and cash flows not to be material.

**Results of Operations**

***Twelve Months Ended December 31, 2006 Compared tothe Twelve Months Ended September 30, 2005.***

*Product Revenue.**  *Product revenue decreased by$1.1 million, or 3.8%, from $29.9 million in 2005 to $28.8 million in2006. Product revenue by segment for the fiscal year ended December 31,2006 and September 30, 2005 is as follows:

| ** **            | ** ** | **Twelve Months Ended** | ** **    |
|-----------------------|------------|-----------------------------------|---------------|
| **Division**          | ** ** | ** **                        | ** **    | **December 31, 2006** | ** ** | **September 30, 2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **(in thousands)**           | ** **    |
| Power Systems, US     |       |                              | $             | 4,361 |   |   |   | $ | 8,803 |   |   |   | $ | (4,442 | ) |   |   | -50.5 | % |   |
| Power Systems, Canada |       |                              |   14,164 |   |   |   |   11,557 |   |   |   | 2,607 |   |   |   | 22.6 | % |   |
| Electronics           |       |                              | 10,241        |   |   |   | 9,532 |   |   |   |        709 |   |   |   | 7.4 | % |   |
| Total product revenue |       |                              | $             | 28,766 |   |   |   | $ | 29,892 |   |   |   | $ | (1,126 | ) |   |   | -3.8 | % |   |
|                       |            |                                   |               |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in productrevenue was comprised of approximately $4.4 million from our Power Systems, US,division offset by increases of approximately $2.6 million and $0.7 millionfrom our Power Systems, Canada, and Electronics divisions, respectively.

PowerSystems, Canada, which focuses on alternative energy products and includesSolar Converters and Fuel Cell Inverters, saw revenues increase fromapproximately $11.6 million in 2005 to approximately $14.2 million in 2006. Theincrease in product revenue related to our Power Systems Canada product lineswere as follows:

·       SolarConverter line revenue increased by approximately $5.5 million, fromapproximately $3.3 million in 2005 to approximately $8.8 million in 2006and

·       IndustrialPower Supply revenue increased approximately $1.0 million as compared to 2005.

Theseincreases were partially offset by decreases in the following lines ofbusiness:

·       PlasmaTorch product line revenues decreased approximately $2.6 million. In 2005 werecognized approximately $2.6 million in revenue related to sales tointernational customers. There were virtually no sales in 2006 related to thePlasma Torch product line,

·       FuelCell Inverter line revenues decreased approximately $0.7 million, toapproximately $1.8 million and

·       otherdecreases amounting to approximately $0.1 million.

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Power Systems, US,which currently focuses on Motors and Hybrid Electric Vehicle (HEV) components,saw revenues decrease from approximately $8.8 million in 2005 to approximately$4.4 million in 2006. The decrease in product revenue related to our Power Systems,US product lines were as follows:

·       Testand Measurement product line revenue decreased approximately $2.7 million. Thedecrease is due to our sale of our Shaker product line in December 2005,which accounted for approximately $3.5 million of revenue in 2005 compared to$0.9 million in 2006,

·       MagLevproduct line revenue decreased approximately $1.9 million from approximately$3.5 million in 2005 to approximately $0.8 million in 2006. Currently weare not selling MagLev products and a majority of our revenues from our MagLevproduct line was from one customer and

·       Otherdecreases amounting to approximately $0.3 million.

These decreaseswere partially offset by increases in the following lines of business:

·       Motor,HEV product line revenues increased by less than $0.4 million.

Revenues in the Electronics division increasedapproximately $0.7 million. The increase was primarily due to increased salesto commercial non-government customers as compared to 2005.

*Fundedresearch and development and other revenue.**  *Funded research and development andother revenue decreased $1.1 million, or 18%, from $6.1 million infiscal 2005 to $5.0 million in 2006. This decrease was primarilyattributable to the recognition of $1.5 million in revenue related to ourcontract with EDO Corporation in 2005, which did not repeat in 2006. (See Note K.Commitments and Contingencies—Contract Losses). 

*Cost of product revenue.**  *Cost of product revenue increasedapproximately $0.2 million, or 0.7%, from $27.6 million in 2005 to$27.8 million in 2006. Cost of product revenue by segment for the yearsended December 31, 2006 and September 30, 2005 is as follows:

| ** **             | ** ** | **Twelve Months Ended** | ** ** |
|------------------------|------------|-----------------------------------|------------|
| **Division**           | ** ** | ** **                        | ** ** | **December 31, 2006** | ** ** | **September 30, 2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **             | ** ** | **(in thousands)**           | ** ** |
| Power Systems, US      |       |                              | $          | 5,765 |   |   |   | $ | 9,367 |   |   |   | $ | (3,602 | ) |   |   | -38.5 | % |   |
| Power Systems,  Canada |       |                              | 13,545     |   |   |   | 10,462 |   |   |   | 3,083 |   |   |   | 29.5 | % |   |
| Electronics            |       |                              | 8,514      |   |   |   | 7,802 |   |   |   | 712 |   |   |   | 9.1 | % |   |
| Total product revenue  |       |                              | $          | 27,823 |   |   |   | $ | 27,631 |   |   |   | $ | 192 |   |   |   | 0.7 | % |   |
|                        |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase was primarily attributable to increasedmanufacturing and materials costs as compared to 2005. The decrease in ourPower Systems, US division is a direct result of lower revenues as compared to2005 offset by manufacturing inefficiencies in our Worcester, Massachusettsfacility. The increase in our Power Systems, Canada division is primarilyattributable to the increase in product revenue and increases in materials andmanufacturing costs. The Electronics division saw a slight increase in the costof product revenue commensurate with the increase in revenue for the period.

*Gross Margin.**  *Gross margins on product revenue decreased from 8% in2005 to 3% in 2006. Gross margin by division is broken out below. 

|                        | ** ** | **Twelve Months Ended** | ** ** |
|------------------------|------------|-----------------------------------|------------|
| **Division**           | ** ** | ** **                        | ** ** | **December 31, 2006** | ** ** | **September 30, 2005** | ** ** |
| Power Systems, US      |       |                              | -32        | % |   |   | -6 | % |   |
| Power Systems,  Canada |       |                              | 4          | % |   |   | 9 | % |   |
| Electronics            |       |                              | 17         | % |   |   | 18 | % |   |
| Total gross margin %   |       |                              | 3          | % |   |   | 8 | % |   |
|                        |            |                                   |            |  |  |  |  |  |  |  |  |

 

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The decrease in PowerSystems, US, from approximately -6% to approximately -32%is a result of increases in warranty costs, inventory reserves andmanufacturing depreciation. In our Power Systems, Canada division the decreasefrom approximately 9% to approximately 4% was a result of increases in warrantycosts, due to higher sales, increases in product engineering costs due toincreases in staffing, increases in manufacturing labor due to overtime,increases in raw materials cost and to some extent some lower margin businessas compared to 2005. The gross margin as a percentage of revenue remainedvirtually unchanged in our Electronics division at approximately 17%.

*Funded research anddevelopment and other revenue expenses.**  *Funded research and development andother revenue expenses decreased by $1.4 million, or 25%, from $5.4 million in2005 to $4.0 million in 2006. This decrease was primarily attributable to thecompletion of the EDO fixed price contract in 2005. The gross margin on fundedresearch and other revenue increased from 11% in 2005 to 19% in 2006. Thisincrease is primarily attributable to the completion of the EDO contract in2005, which had $0 margin offset by costs related to share-based compensationof approximately $0.1 million in 2006.

*Unfunded research anddevelopment expenses.**  *Weexpended approximately $2.0 million on unfunded research and development in2006 compared with approximately $0.5 million spent in 2005. The spendingin 2006 and 2005 was related to unfunded engineering in our Electronics andPower Systems divisions for the continued development of new products andtechnologies. 

*Selling, general andadministrative expenses.**  *Selling, general and administrative expensesincreased by approximately $2.2 million, or approximately 20%, from $10.8million in 2005 to $13.0 million in 2006. Approximately $0.7 million ofthe increase is directly attributable to non-cash compensation costs related tothe issuance of stock options to our employees and directors pursuant to SFAS123(R) charged to operations during the period. Corporate costs increasedapproximately $0.5 million primarily as a result of increased compensationcosts related to the issuance of stock options to our employees and directorspursuant to SFAS 123(R) charged to operations during the period andincreased accounting and legal fees for the period as compared to 2005. Increasedsales and marketing costs in our Applied Technology, Electronics and PowerSystems divisions accounted for the remainder of the increase over that of2005.

*Amortization ofintangibles.**  *Amortizationof intangibles remained flat at $0.4 million. 

*Gain on sale of assets.*   In 2006, we received approximately$0.4 million related to our 2004 sale of our SPLC technology. In 2005, wereceived approximately $0.3 million related to this sale. We record the gain onsale as payments are received. There are no further amounts due related to thissale.

*Restructuring costs.*   During2006 we commenced a restructuring plan designed to streamline our manufacturingand production base, improve efficiency and enhance our competitiveness andrecorded a restructuring charge of approximately $1.6 million. Thesecharges are comprised employeeseverance and benefits costs and the write-down in carrying value of assetsalong with the settlement of the Worcester facility lease. (See Note V.Restructuring Costs). The total pre-tax charges are estimated to includeemployee severance and benefits costs of approximately $0.2 million, the writedown in carrying value of assets (of which approximately $0.2 million have beenrecorded in the period ended December 31, 2006) and facility exit costs ofapproximately $1.1 million, for which we issued 850,000 shares of common stockto the landlord on January 3, 2007 as consideration for the earlytermination of the lease. These shares were issued subsequent to year end andthis amount is recorded in accrued liabilities as of December 31, 2006. Weanticipate additional costs associated with our restructuring to beapproximately $0.1 million in 2007.

*Net unrealized gain onwarrants to purchase common stock.**  *In 2005 we had an approximately$7,000 unrealized loss on warrants to purchase common stock, related towarrants we held in Beacon Power Corporation. We accounted for our warrants topurchase Beacon Power Corporation’s common stock in accordance with SFAS No. 133,*Accounting for Derivative Instruments andHedging Activities*, and, therefore, we had recorded these warrantsat their fair value. These warrants expired un-exercised in April 2005.

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*Other income (expense).**  *Other income was approximately $4.3 million, which iscomprised primarily of charges related to the fair valuation of our derivativeinstruments. Other expense in 2005 was approximately $0.1 million, which iscomprised of state tax payments, the amortization of the Silicon Valley Bankwarrants and costs related to the August 2005 financing transaction. 

*Interest income.*   Interestincome was approximately $0.4 million for 2006 compared to approximately$41,000 in 2005. This increase is directly attributable to our cash on hand. 

*Interest expense.**  *Interest expense for 2006 wasapproximately $1.2 million, which is comprised primarily of the following:

·       Approximately$0.5 million in interest related to the Notes, which was paid in shares ofcommon stock, 

·       $0.2million in amortization of the debt discount related to the valuation of theNotes, 

·       $0.1million of non-cash interest associated with dividends on the Series BPreferred Stock, 

·       approximately$0.1 million related to change in the Series B Preferred Stock conversionprice as a result of the Private Placement and 

·       $0.1million in interest charges related to our credit facility with Silicon ValleyBank, which was terminated on July 19, 2006. 

In2005 interest expense was approximately $0.7 million and was comprised of thefollowing:

·       Approximately$0.1 million of non-cash interest associated with dividends on the Series BPreferred Stock, 

·       approximately$0.3 million related to the change in the Series B Preferred Stockconversion price as a result of the August 2005 financing transaction,

·       approximately$0.1 million in interest charges related to our credit facility and

·       approximately $0.1 millionrelated to interest on our capital leases and other items.

***Three Months Ended December 31, 2005 (“2005”)Compared to the Three Months Ended January 1, 2005 (“2004”).***

*Product Revenue.**  *Product revenue decreased by$2.2 million, or 27%, from $8.3 million in 2004 to $6.0 million in 2005. 

| ** **             | ** ** | **Three months ended** | ** ** |
|------------------------|------------|----------------------------------|------------|
| **Division**           | ** ** | ** **                       | ** ** | **December 31, 2005** | ** ** | **January 1, 2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **             | ** ** | **(in thousands)**          | ** ** |
| Power Systems, US      |       |                             | $          | 1,648 |   |   |   | $ | 2,404 |   |   |   | $ | (756 | ) |   |   | -31.5 | % |   |
| Power Systems,  Canada |       |                             | 1,817      |   |   |   | 3,626 |   |   |   | (1,809 | ) |   |   | -49.9 | % |   |
| Electronics            |       |                             | 2,574      |   |   |   | 2,240 |   |   |   | 334 |   |   |   | 14.9 | % |   |
| Total product revenue  |       |                             | $          | 6,038 |   |   |   | $ | 8,270 |   |   |   | $ | (2,232 | ) |   |   | -27.0 | % |   |
|                        |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in product revenue was comprised ofapproximately $0.8 million from our Power Systems, US division andapproximately $1.8 million from our Power Systems, Canada division, offset byan increase of approximately $0.3 million from our Electronics division.

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PowerSystems, Canada, saw revenues decrease by approximately $1.8 million fromapproximately $3.6 million in 2004 to approximately $1.8 million in 2005. Thedecrease in Power Systems, Canada revenues, as compared to the same period in2004 was largely due to the following:

·       PlasmaTorch product line revenues decreased approximately $1.7 million. In the sameperiod in 2004 we recognized approximately $1.7 million in revenue related tosales to international customers. There were virtually no sales in 2005 relatedto the Plasma Torch product line,

·       FuelCell Inverter line revenues decreased approximately $0.8 million. The decreasewas in part due to revenue of approximately $0.4 million related to shipmentsduring 2005 being deferred as their contract terms were FOB destination.

Thesedecreases were partially offset by increases in the following lines ofbusiness:

·       SolarConverter line revenue increased by approximately $0.7 million.

PowerSystems, US, saw revenues decrease by approximately $0.8 million fromapproximately $2.4 million in 2004 to approximately $1.6 million in 2005. Thedecrease in Power Systems, US revenues, as compared to the same period in 2004was largely due to the following:

·       MagLevproduct line revenue decreased approximately $0.7 million,

·       Testand Measurement product line revenue decrease of approximately $0.1 million. Comparedto the same period in 2004, revenues in our test and measurement product line,which includes the shaker and amplifier product lines that were sold in December 2005,were not significantly different. Moving forward there will be no more revenuefrom shaker and amplifier products. For 2004, shaker and amplifier revenueswere approximately $2.4 million,

·       Otherdecreases amounting to approximately $0.1 million.

Thesedecreases were partially offset by increases in the following lines ofbusiness:

·       Motorproduct line revenues increased by approximately $0.1 million.

Revenues in theElectronics division increased approximately $0.3 million. The increase wasprimarily due to increased sale to commercial non-government customers ascompared to 2004.

*Funded research anddevelopment and other revenue.**  *Funded research and development andother revenue increased $0.2 million, or 18%, from $0.9 million in2004 to $1.1 million in 2005. This increase was primarily attributable tomore business in our Applied Technology division in 2005. During 2004, delaysin starting-up several existing contracts, combined with efforts focused oncompleting the EDO contract, took away from our ability to work on otherrevenue generating opportunities. (See Note K. Commitments andContingencies—Contract Losses). 

*Cost of product revenue.**  *Cost of product revenue decreased$1.4 million, or 20%, from $7.2 million in 2004 to $5.8 million in2005. 

| ** **                     | ** ** | **Three months ended** | ** ** |
|--------------------------------|------------|----------------------------------|------------|
| **Division**                   | ** ** | ** **                       | ** ** | **December 31, 2005** | ** ** | **January 1, 2005** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                     | ** ** | **(in thousands)**          | ** ** |
| Power Systems, US              |       |                             | $          | 1,812 |   |   |   | $ | 2,373 |   |   |   | $ | (561 | ) |   |   | -23.7 | % |   |
| Power Systems,  Canada         |       |                             | 1,888      |   |   |   | 2,972 |   |   |   | (1,084 | ) |   |   | -36.5 | % |   |
| Electronics                    |       |                             | 2,102      |   |   |   | 1,873 |   |   |   | 229 |   |   |   | 12.2 | % |   |
| Total cost of product  revenue |       |                             | $          | 5,802 |   |   |   | $ | 7,218 |   |   |   | $ | (1,416 | ) |   |   | -19.6 | % |   |
|                                |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease was primarily attributable to lowerrevenues compared to 2004 in our Power Systems divisions. These savings wereoffset, in part, by a slight increase in overhead costs during the period. The 

41

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Electronics division saw aslight increase in the cost of product revenue commensurate with the increasein revenue for the period. 

*Gross Margin.**  *Gross margins on product revenue decreased from 13%for 2004 to 4% for 2005. Gross margin by division is broken out below.

|                        | ** ** | **Three months ended** | ** ** |
|------------------------|------------|----------------------------------|------------|
| **Division**           | ** ** | ** **                       | ** ** | **December 31, 2005** | ** ** | **January 1, 2005** | ** ** |
| Power Systems, US      |       |                             | -10        | % |   |   | 1 | % |   |
| Power Systems,  Canada |       |                             | -4         | % |   |   | 18 | % |   |
| Electronics            |       |                             | 18         | % |   |   | 16 | % |   |
| Total gross margin %   |       |                             | 4          | % |   |   | 13 | % |   |
|                        |            |                                  |            |  |  |  |  |  |  |  |  |

 

In our Power Systemsdivisions, the decrease in gross margin by 18% is a direct result of lowerrevenues, continued manufacturing inefficiencies (which includes overhead coststhat are attributable to manufacturing), combined with higher materials costs,costs of labor and to a lesser extent the mix of products for the period ascompared to the same period in 2004. The increase in gross margins in ourElectronics division is primarily due to mix of products sold during the periodcompared to that of 2004.

*Funded research anddevelopment and other revenue expenses.**  *Funded research and development andother revenue expenses increased by $0.4 million, or 49%, from $0.7 million in2004 to $1.1 million in 2005. The gross margin on funded research and otherrevenue decreased from 18% in 2004 to (3%) in 2005. This decrease is a partlyattributable to efforts spent during the quarter focused on continued bid andproposal activities, as well as, other non-revenue generating activities, suchas ISO 9001 certification which are categorized as funded research anddevelopment and other revenue expenses.

*Unfunded research anddevelopment expenses.**  *Weexpended approximately $260,000 on unfunded research and development in 2005compared with approximately $45,000 spent in 2004. The spending in 2005and 2004 was related to unfunded engineering in our Electronics and PowerSystems division for the development of new products and technologies.

*Selling, general andadministrative expenses.**  *Selling, general and administrative expensesdecreased by approximately $34,000, or 1.5%, from $2.5 million in 2004 to$2.5 million in 2005. Increases in corporate costs were offset byreductions in our Applied Technology, Power Systems and Electronics divisions. Corporatecosts increased approximately $0.1 million primarily as a result of increasedaccounting and legal fees for the period as compared to 2004.

*Amortization ofintangibles.**  *Amortizationof intangibles remained flat at $0.1 million.

*Gain on sale of assets.*   On December 13, 2005, we soldour shaker and amplifier product lines, and the associated inventory andintellectual property for proceeds of approximately $2.3 million. We recorded again on the sale of these assets of approximately $1.4 million for the quarterended December 31, 2005.

*Restructuring costs.*   DuringApril 2002, we commenced a restructuring plan designed to streamline ourproduction base, improve efficiency and enhance our competitiveness andrecorded a restructuring charge of $1.5 million. As of September 30,2004 the balance of the restructuring accrual was $495,612. On January 27,2005 we agreed to settle our outstanding lawsuit with the landlord of theAnaheim, California facility for $240,000, for which approximately $300,000 hadbeen allocated. As a result of this settlement and our evaluation of theremaining restructuring charges we recorded a benefit in our statement ofoperations for the period ended January 1, 2005 in the amount of $255,612.(See Note T. Restructuring Costs).

*Net unrealized gain onwarrants to purchase common stock.**  *We had an approximately $22,000unrealized gain on warrants to purchase common stock in the first quarter of2004. We accounted for our warrants to purchase Beacon Power Corporation’scommon stock in accordance with SFAS No. 133, 

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*Accountingfor Derivative Instruments and Hedging Activities*, and,therefore, we had recorded these warrants at their fair value at January 1,2005. These warrants expired un-exercised in April 2005.

*Other (expense).**  *Other expense was approximately $4,000 for 2005compared to approximately $18,000 for 2004. Other expense for 2005 consistsprimarily of tax payments.

*Interest income.*   Interestincome was approximately $47,000 for 2005 and is directly attributable to ourcash on hand.

*Interest expense.**  *Interest expense was approximately$0.1 million for 2005 compared with interest expense of approximately$0.2 million for 2004. Interest expense in 2005 includes approximately$42,500 of non-cash interest associated with dividends on the Series Bpreferred stock, as well as, $45,000 of non-cash interest associated withamortization of warrants issued to Silicon Valley Bank. Interest expense in2004 includes non-cash interest of approximately $0.2 million associated withour December 2004 financing and the related anti-dilution effects on the Series Bpreferred stock and warrants issued with the Series B preferred stock. Inaddition, during the quarter we had borrowing under our credit facility withSilicon Valley Bank, interest expense related to our line of credit during thequarter was approximately $16,000, and there was $2.0 million outstanding underthe line at December 31, 2005.

***Fiscal Year EndedSeptember 30, 2005, Compared to Fiscal Year Ended September 30, 2004.***

*Product Revenue.**  *Product revenue increased by$2.9 million, or 10.8%, from $27.0 million in fiscal year 2004 to$29.9 million in fiscal year 2005. Product revenue by segment for thefiscal year ended September 30, 2005 and 2004 is as follows:

| ** **             | ** ** | **Fiscal Year Ended** | ** ** |
|------------------------|------------|---------------------------------|------------|
| **Division**           | ** ** | ** **                      | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **$ Increase** | ** ** | **% Increase** | ** ** |
| ** **             | ** ** | **(in thousands)**         | ** ** |
| Power Systems, US      |       |                            | $          | 8,803 |   |   |   | $ | 11,370 |   |   | ($2,567 | ) |   | -22.6 | % |   |
| Power Systems,  Canada |       |                            | 11,557     |   |   |   | 6,055 |   |   | 5,502 |   |   | 90.9 | % |   |
| Electronics            |       |                            | 9,532      |   |   |   | 9,546 |   |   | (14 | ) |   | -0.1 | % |   |
| Total product revenue  |       |                            | $          | 29,892 |   |   |   | $ | 26,971 |   |   | $ | 2,921 |   |   | 10.8 | % |   |
|                        |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

This increase ofapproximately $2.9 million in product revenue was comprised of approximately$5.5 million from our Power Systems, Canada division, offset by a decrease inproduct revenue from out Power Systems, US division of approximately $2.6million, as compared to the same period in 2004.

PowerSystems, Canada revenues increased by approximately $5.5 million, fromapproximately $6.1 million in 2004 to approximately $11.6 million in 2005. Theincrease in product revenue related to our Power Systems, Canada product lineswas as follows:

·       SolarConverter line of approximately $2.8 million,

·       FuelCell Inverters line of approximately $0.5 million,

·       thePlasma Torch line of approximately $2.1 million and

·       otherincreases amounting to approximately $0.1 million.

PowerSystems, US, revenues decreased approximately $2.6 million, from approximately$11.4 million in 2004 to approximately $8.8 million in 2005. The decrease inproduct revenue related to our Power Systems, US product lines was as follows:

·       Testand Measurement product line of approximately $1.4 million,

·       MagLevproduct line of approximately $0.6 million and

·       RotaryUPS line of approximately $0.9 million.

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These decreases in our Power Systems, US product linerevenue were offset in part by increases in other product lines ofapproximately $0.4 million.

During the fiscal year ended September 30, 2005we shipped a Rotary UPS to a customer and have deferred approximately $1.3million in revenue until all elements of revenue recognition are achieved. Infiscal 2004 we recognized revenue of approximately $0.9 million related to aRUPS unit sale for which revenue recognition was deferred in the prior year.

The Electronics division remained relatively flat ascompared to the prior year.

*Fundedresearch and development and other revenue.**  *Funded research and development andother revenue decreased by $1.1 million, or 16%, from $7.2 million infiscal year 2004 to $6.1 million in fiscal year 2005. This decrease wasprimarily attributable to less overall business in our Applied Technologydivision, delays in starting-up several existing contracts, a decrease inrevenue of $1.5 million from a Naval program which existed in fiscal 2004, anda decrease in revenue of $0.6 million from a contract with General Atomicsto deliver power converter and control assemblies for the RV Triton, a Britishresearch vessel, combined with efforts focused on completing the contract withEDO Corporation in the first and second quarters of fiscal 2005, which tookaway from our ability to work on other opportunities. The EDO program wascompleted and delivered during the second quarter of fiscal 2005, and duringour fourth quarter ended September 30, 2005 the customer accepted allelements previously delivered by us and we have included approximately $1.5million in revenue offset by approximately $1.6 million in costs during theperiod. (See Note K. to our Consolidated Financial Statements included inthis Annual Report on Form 10-K). These factors resulted in lowerfunded research and development and other revenue during fiscal 2005 ascompared to same period in fiscal 2004.

*Cost of product revenue.**  *Cost of product revenue increasedby $5.3 million, or 23.5%, from $22.4 million in fiscal year 2004 to$27.6 million in fiscal year 2005. Cost of product revenue by segment forthe fiscal year ended September 30, 2005 and 2004 is as follows:

| ** **                    | ** ** | **Fiscal Year Ended** | ** ** |
|-------------------------------|------------|---------------------------------|------------|
| **Division**                  | ** ** | ** **                      | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** | **$ Increase** | ** ** | **% Increase** | ** ** |
| ** **                    | ** ** | **(in thousands)**         | ** ** |
| Power Systems, US             |       |                            | $          | 9,367 |   |   |   | $ | 9,302 |   |   |   | $ | 65 |   |   |   | 0.7 | % |   |
| Power Systems,  Canada        |       |                            | 10,462     |   |   |   | 5,509 |   |   |   | 4,953 |   |   |   | 89.9 | % |   |
| Electronics                   |       |                            | 7,802      |   |   |   | 7,562 |   |   |   | 240 |   |   |   | 3.2 | % |   |
| Total cost of product revenue |       |                            | $          | 27,631 |   |   |   | $ | 22,373 |   |   |   | $ | 5,258 |   |   |   | 23.5 | % |   |
|                               |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The increase was primarily attributable to theincrease in product revenue in our Power Systems, Canada division, as well asan increase in material costs, such as steel and copper which are material componentsto our products, the mix of products sold, and higher manufacturing labor andoverhead costs as compared to the same period in fiscal 2004.

*Gross Margin.**  *Gross margins on product revenue decreased from 17%for the fiscal year ended September 30, 2004 to 8% for the fiscal yearended September 30, 2005. Gross margin by division is broken out below.

| ** **             | ** ** | **Fiscal Year Ended** | ** ** |
|------------------------|------------|---------------------------------|------------|
| **Division**           | ** ** | ** **                      | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
| Power Systems, US      |       |                            | -6         | % |   |   | 18 | % |   |
| Power Systems,  Canada |       |                            | 9          | % |   |   | 9 | % |   |
| Electronics            |       |                            | 18         | % |   |   | 21 | % |   |
| Total gross margin %   |       |                            | 8          | % |   |   | 17 | % |   |
|                        |            |                                 |            |  |  |  |  |  |  |  |  |

 

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In our Power Systems, US division, the decrease ingross margin by 24% is a direct result of the product mix for the year ascompared to the same period in fiscal 2004, along with higher materials costsand continued manufacturing inefficiencies. Our gross margins in our PowerSystems, Canada division remained consistent as compared to the same period in2004.

In our Electronics division, the decrease in grossmargins by 3% was attributable to the sales mix consisting of lower marginbusiness in conjunction with manufacturing efficiencies and higher materialscosts.

*Fundedresearch and development and other revenue expenses.**  *Funded research and development andother revenue expenses decreased by $0.6 million, or 10%, from $6.0 million infiscal year 2004 to $5.4 million in fiscal year 2005. A primary reason for thedecrease was directly related to efforts focused on the completion of the EDOcontract and less overall business. The gross margin on funded research andother revenue declined from 16.7% in fiscal year 2004 to 11% in fiscal year2005. The primary reason for the decline in gross margin is directly related toour efforts in completing the EDO contract which led to lower efficiency levelsof our staff due to the slower start-up of new programs and the EDO contractwhich resulted in approximately $1.5 million in revenues offset byapproximately $1.6 million in deferred costs, resulting in no margin.

*Unfundedresearch and development expenses.**  *We expended approximately $0.5million on unfunded research and development in fiscal year 2005 and a minimalamount in fiscal year 2004. Funds were expended in 2005 in order to facilitatenew product development and modifications and enhancements to existing productsin our Electronics and Power Systems divisions.

*Selling,general and administrative expenses.**  *Selling, general and administrativeexpenses increased by approximately $1.4 million, or 15%, from$9.4 million in fiscal year 2004 to $10.8 million in fiscal year 2005.The increase was primarily the result of approximately $0.5 million incurred asa result of increased head count and payroll related costs across all operatingunits, approximately $0.2 million related to the settlement of a law suit,approximately $0.2 million in costs related to our efforts to comply with Section 404of the Sarbanes-Oxley Act, and approximately $0.5 million primarily consistingof increased legal, accounting and other corporate costs, as compared to fiscal2004 across all operating divisions.

*Amortizationof intangibles.**  *Amortizationof intangibles remained flat at $0.4 million for the fiscal years ended September 30,2005 and 2004.

*Gainon sale of assets.**  *Gain onsale of assets held for sale of approximately $0.3 million consisted of thereceipt of payment related to the sale of our SPLC technology in 2004, forwhich we deferred recognition until payments were received.

*Restructuringcosts.*   We recorded a reduction in accruedrestructuring costs of $255,512 during fiscal 2005. This reduction was a directresult of our determining that the remaining balance was no longer warranted. (SeeNote T. to our Consolidated Financial Statements included in this AnnualReport on Form 10-K).

*Write-offof long-lived assets.*   We recorded a $1.2 millioncharge representing an impairment in the carrying value of the long-livedassets in our Worcester, Massachusetts manufacturing facility. Based in largepart on our recent history, we prepared a cash flow forecast of the Worcesterfacility’s product lines over four and a half years, the then remaining life ofour lease on the facility. Based on these cash flow projections we did notexpect to recoup the value of our long-lived assets in our Power SystemsWorcester Division. The assets evaluated, before the write-down, approximate anet book value of $1.2 million and are comprised primarily of leaseholdimprovements and plant equipment. Given this situation, we performed a fairmarket analysis of these assets and determined that a $1.2 million charge wasrequired in our fiscal fourth quarter representing an impairment of theselong-lived assets.

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*Netrealized and unrealized loss on warrants to purchase common stock.**  *Net realized loss on warrants topurchase common stock in fiscal year 2005 was approximately $7,000 compared toa net unrealized loss of approximately $100,000 in 2004. We accounted for ourwarrants to purchase Mechanical Technology Incorporated’s common stock and topurchase Beacon Power Corporation’s common stock in accordance with SFAS No. 133,*Accounting for Derivative Instruments andHedging Activities*, and, therefore, we have recorded these warrantsat their fair value at June 26, 2004. Our warrants to purchase MechanicalTechnology Incorporated’s common stock expired unexercised on October 21,2003 and January 31, 2004. Our warrants to purchase Beacon PowerCorporation’s common stock expired unexercised on April 7, 2005.

*Other(loss) income.**  *Otherexpense was approximately $0.1 million in fiscal 2005. This consisted primarilyof the payment of state taxes from prior years.

*Interest expense.**  *Interest expense was approximately$0.7 million for fiscal year 2005 compared with approximately $6.9 millionfor fiscal year 2004, a decrease of approximately $6.2 million. Interestexpense in fiscal 2005 includes non-cash interest of approximately $350,000associated with our December 2004 financing transaction and our August 2005financing transaction and the related anti-dilution effects on the Series Bpreferred stock and warrants issued with the Series B preferred stock. Inaddition, non-cash interest of approximately $127,500 related to the issuanceof common stock in lieu of cash dividends for the Series B Preferred Stock.In addition, during the fiscal year ended September 30, 2005 we hadborrowing under our credit facility with Silicon Valley Bank, and interestexpense related to our line of credit during this period was approximately$35,000. In addition, we amortized a portion of the value of the warrantsissued in connection with a loan modification agreement and related fees ofapproximately $95,000 and interest related to lease obligations during fiscal2005 was approximately $75,000. There were no outstanding amounts under theline of credit at September 30, 2005. Interest expense for fiscal year2004 was comprised of virtually all non-cash items, including $6.1 millionamortization of discount on the convertible redeemable Series B PreferredStock, $0.2 million amortization of the discount on the subordinatedconvertible debentures, $0.2 million associated with the redeemable convertibleSeries A Preferred Stock and subordinated debentures, $0.2 millionassociated with the line of credit with Silicon Valley Bank and $0.1 millionassociated with the Series B Preferred Stock, offset by a benefit from thenegotiated reduction in fees associated with the February 2003 financingtransaction.

**Quarterly Results of Operations (Unaudited)**

The following tablepresents unaudited quarterly statement of operations data for the eightquarters ended December 31, 2006. This data has been prepared on a basisconsistent with our audited consolidated financial statements includedelsewhere in this Annual Report on Form 10-K. This data includes alladjustments, consisting solely of normal recurring adjustments, which webelieve necessary for a fair presentation of this information. The historicalquarterly data for the quarters ended January 1, 2005, April 2, 2005and July 2, 2005 have been adjusted to reflect the reclassification ofamounts previously accounted for as cost of product sales to un-funded researchand development expenses. The impact of the reclassification is as follows:

| ** **                                                                                       | ** ** | **Three Months Ended**                                   | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                       | ** ** | **July 2,**                                                   | ** ** | **April 2,** | ** ** | **Jan. 1,** | ** ** |
| ** **                                                                                       | ** ** | **2005**                                                           | ** ** | **2005** | ** ** | **2005** | ** ** |
| ** **                                                                                       | ** ** | **(In thousands, except per share data)** | ** ** |
| Cost of product revenue                                                                          |       | $                                                                  | (143       | ) |   | $ | (82 | ) |   |   | $ | (45 | ) |   |
| Un-funded research and  development expense                                                      |       | 143                                                                |       |   | 82 |   |   |   | 45 |   |   |
| Operating loss                                                                                   |       | —                                                             |       |   | — |   |   |   | — |   |   |
| Net loss                                                                                         |       | —                                                             |       |   | — |   |   |   | — |   |   |
| Net loss attributable to common stockholders per  weighted average share, basic and diluted |       | $                                                                  | —     |   |   | $ | — |   |   |   | $ | — |   |   |

 

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The operating results for any quarter are notnecessarily indicative of results to be expected for any future period.

| ** **                                                                                       | ** ** | **Three Months Ended**                                   | ** ** |               |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------|
| ** **                                                                                       | ** ** | **Dec. 31,**                                                  | ** ** | **Sept. 30,** | ** ** | **July 1,** | ** ** | **April 1,** | ** ** | **Dec. 31,** | ** ** | **Sept. 30,** | ** ** | **July 2,** | ** ** | **April 2,** | ** ** |   |
| ** **                                                                                       | ** ** | **2006**                                                           | ** ** | **2006**           | ** ** | **2006** | ** ** | **2006** | ** ** | **2005** | ** ** | **2005** | ** ** | **2005** | ** ** | **2005** | ** ** |   |
| ** **                                                                                       | ** ** | **(in thousands, except per share data)** | ** ** |               |
| **Statement of Operations Data**                                                                 | ** ** |                                                               | ** ** | ** **         |   |   | ** ** | ** ** |   | ** ** | ** ** | ** ** | ** ** |   | ** ** |   |   |   |   |   |   |   |   |   |   |
| Revenue:                                                                                         |       |                                                               |       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Product revenue                                                                                  |       |                                                               | $          | 8,021              |   |   |   | $ | 7,232 |   |   | $ | 6,853 |   | $ | 6,661 |   |   | $ | 6,038 |   |   |   | $ | 7,518 |   |   | $ | 6,972 |   | $ | 7,132 |   |
| Funded research and development and other revenue                                                |       |                                                               | 1,534      |               |   |   | 1,259 |   |   | 1,250 |   | 946 |   |   | 1,079 |   |   |   | 2,823 |   |   | 1,186 |   | 1,142 |   |
| Total revenue                                                                                    |       |                                                               | 9,555      |               |   |   | 8,491 |   |   | 8,103 |   | 7,607 |   |   | 7,117 |   |   |   | 10,341 |   |   | 8,158 |   | 8,274 |   |
| Operating costs and   expenses:                                                                  |       |                                                               |       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost of product revenue                                                                          |       |                                                               | 8,039      |               |   |   | 7,264 |   |   | 6,676 |   | 5,845 |   |   | 5,802 |   |   |   | 7,765 |   |   | 6,182 |   | 6,466 |   |
| Research and development  and other revenue expenses:                                            |       |                                                               |       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Funded research and development and other revenue  expenses                                      |       |                                                               | 839        |               |   |   | 1,123 |   |   | 1,100 |   | 978 |   |   | 1,111 |   |   |   | 2,513 |   |   | 1,206 |   | 946 |   |
| Unfunded research and development expenses                                                       |       |                                                               | 405        |               |   |   | 522 |   |   | 513 |   | 560 |   |   | 260 |   |   |   | 232 |   |   | 145 |   | 90 |   |
| Total research and development and other revenue  expenses                                       |       |                                                               | 1,244      |               |   |   | 1,645 |   |   | 1,613 |   | 1,538 |   |   | 1,371 |   |   |   | 2,745 |   |   | 1,351 |   | 1,036 |   |
| Selling, general and administrative expenses                                                     |       |                                                               | 3,356      |               |   |   | 2,899 |   |   | 3,394 |   | 3,359 |   |   | 2,488 |   |   |   | 2,757 |   |   | 2,723 |   | 2,800 |   |
| Gain on sale of assets                                                                           |       |                                                               | —     |               |   |   | (209 | ) |   | (190 | ) | — |   |   | (1,443 | ) |   |   | (318 | ) |   | — |   | — |   |
| Restructuring costs                                                                              |       |                                                               | 1,350      |               |   |   | 262 |   |   | — |   | — |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Amortization of intangibles                                                                      |       |                                                               | 110        |               |   |   | 98 |   |   | 112 |   | 112 |   |   | 112 |   |   |   | 112 |   |   | 112 |   | 112 |   |
| Write-off of impaired long-lived assets                                                          |       |                                                               | —     |               |   |   | — |   |   | — |   | — |   |   | — |   |   |   | 1,190 |   |   | — |   | — |   |
| Total operating costs and expenses                                                               |       |                                                               | 14,099     |               |   |   | 11,959 |   |   | 11,605 |   | 10,854 |   |   | 8,330 |   |   |   | 14,251 |   |   | 10,368 |   | 10,414 |   |
| Operating loss                                                                                   |       |                                                               | (4,544     | )                  |   |   | (3,468 | ) |   | (3,502 | ) | (3,247 | ) |   | (1,213 | ) |   |   | (3,910 | ) |   | (2,210 | ) | (2,140 | ) |
| Net unrealized gain (loss) on warrants to  purchase common stock                            |       |                                                               | —     |               |   |   | — |   |   | — |   | — |   |   | — |   |   |   | — |   |   | — |   | (29 | ) |
| Unrealized loss on Series B warrants                                                        |       |                                                               | —     |               |   |   | — |   |   | — |   | — |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Other income (loss)                                                                              |       |                                                               | (592       | )                  |   |   | (3,723 | ) |   | 42 |   | 21 |   |   | (4 | ) |   |   | 36 |   |   | (23 | ) | (111 | ) |
| Interest income                                                                                  |       |                                                               | 110        |               |   |   | 122 |   |   | 57 |   | 95 |   |   | 47 |   |   |   | 14 |   |   | 16 |   | 9 |   |
| Interest expense                                                                                 |       |                                                               | (448       | )                  |   |   | (515 | ) |   | (85 | ) | (103 | ) |   | (138 | ) |   |   | (314 | ) |   | (57 | ) | (95 | ) |
| Net loss                                                                                         |       |                                                               | $          | (5,474             | ) |   |   | $ | (7,584 | ) |   | $ | (3,488 | ) | $ | (3,234 | ) |   | $ | (1,308 | ) |   |   | $ | (4,174 | ) |   | $ | (2,274 | ) | $ | (2,366 | ) |
| Net loss attributable to common stockholders per weighted  average share, basic and diluted |       |                                                               | $          | (0.14              | ) |   |   | $ | (0.19 | ) |   | $ | (0.09 | ) | $ | (0.08 | ) |   | $ | (0.03 | ) |   |   | $ | (0.12 | ) |   | $ | (0.07 | ) | $ | (0.07 | ) |
| Weighted average  number of common shares, basic and diluted                                |       |                                                               | 40,002     |               |   |   | 39,519 |   |   | 39,115 |   | 38,524 |   |   | 38,356 |   |   |   | 35,871 |   |   | 33,364 |   | 33,249 |   |

 

**Liquidity andCapital Resources**

As of December 31, 2006, we had $8.3 millionof cash, of which $1.1 million was restricted. In addition, under theterms of the Notes, we are required, for so long as any Notes are outstanding,to maintain aggregate cash and cash equivalents equal to the greater of (i) $1.0million or (ii) $3.0 million 

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minus 80% of eligiblereceivables (as defined therein). Based on the level of eligible receivables,we are required to maintain aggregate cash and cash equivalents of $1.0million.

On July 19,2006, we entered into a Purchase Agreement with the Purchasers in connectionwith the Private Placement of:

·       $12,000,000aggregate principal amount of senior secured convertible Notes, convertibleinto shares of our common stock at a conversion price of $1.65 per share;

·       WarrantA’s to purchase up to an aggregate of 3,636,368 shares of our common stock at aprice of $1.815 per share for a period beginning six months from the date ofsuch warrants and ending on the seventh anniversary of the date of suchwarrants; and

·       WarrantB’s to purchase up to an aggregate of 3,636,368 shares of our common stock at aprice of $1.68 per share for a period of 90 trading days beginning the later ofsix months from the date of such warrants and the date the SEC declareseffective the Registration Statement covering the resale of the common stockunderlying the securities issued in the Private Placement; to the extent theWarrant B’s are exercised, the Purchasers will receive additional seven-yearwarrants to purchase a number of shares of common stock equal to 50% of thenumber of shares of common stock purchased upon exercise of the Warrant B’s ata price of $1.815 per share. Because the Registration Statement was declaredeffective on September 27, 2006, these warrants were originallyexercisable for the 90 trading day period beginning six months from the date ofsuch warrants (i.e. May 30, 2007). As discussed above, in connection with anamendment to the Purchase Agreement enabling us to issue common stock for theearly termination of the lease for our Worcester facility, the expiration dateof the Warrant B’s was extended to August 31, 2007.

The net proceeds of the sale were approximately $11million, after deducting placement fees and other offering-related expenses. Inconnection with the Private Placement, we also entered into the SecurityAgreement.

We anticipate that our current cash will be sufficientto fund our operations at least through December 31, 2007. This assumesthat we will achieve our business plan and that we will be able to payprincipal and interest under the Notes in shares of common stock and complywith all other terms of the Notes. The business plan envisions a significantincrease in revenue and significant reductions in the cost structure and thecash burn rate from the results experienced in the recent past. If, however, weare unable to realize our business plan, or are unable to pay principal andinterest under the Notes in shares of common stock or otherwise comply with theterms of the Notes, we may be forced to raise additional funds by selling stockor taking other actions to conserve our cash position, subject to therestrictions in the Purchase Agreement and the Notes.

If additional funds are raised in the future throughthe issuance of equity or convertible debt securities, the percentage ownershipof our stockholders will be reduced and our stockholders may experienceadditional dilution. The terms of additional funding may also limit ouroperating and financial flexibility. There can be no assurance that additionalfinancing of any kind will be available to us on terms acceptable to us, or atall. Failure to obtain future funding when needed or on acceptable terms wouldmaterially, adversely affect our results of operations.

Our financial statements for our year ended December 31,2006, which are included in this Annual Report on Form 10-K, containan audit report from Vitale, Caturano and Company, PC. The audit reportcontains a going concern qualification, which raises substantial doubt withrespect to our ability to continue as a going concern. However, our businessplan, which envisions a significant improvement in results from the recentpast, contemplates sufficient liquidity to fund operations at least through December 31,2007. The receipt of a going concern qualification may create a concern amongour current and future customers and vendors as to whether we will be able tofulfill our contractual obligations.

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We have incurred significant costs to develop ourtechnologies and products. These costs have exceeded total revenue. As aresult, we have incurred losses in each of the past five years. As of December 31,2006, we had an accumulated deficit of $159.0 million. Since inception, we havefinanced our operations and met our capital expenditure requirements primarilythrough the sale of private equity securities and convertible debt, publicsecurity offerings, borrowings under our previous line of credit and capitalequipment leases.

As of December 31, 2006, our cash and cashequivalents were $8.3 million, including restricted cash and cash equivalentsof $1.1 million; this represents decrease in our cash and cash equivalentsof approximately $0.9 million from the $9.3 million on hand at December 31,2005. Cash used in operating activities for the twelve months ended December 31,2006 was $9.8 million as compared to $7.9 million for the twelve monthsended September 30, 2005. Cash used in operating activities during thetwelve months ended December 31, 2006 was primarily attributable to thenet loss of approximately $20.0 million offset by non-cash items such as thechange in the fair value of the senior secured convertible Notes and placementagent fees, depreciation and amortization, deferred revenue, increases inallowances for uncollectible accounts and excess and obsolete inventory,non-cash compensation and consulting expense, non-cash interest expense anddecreases in working capital.

Cash used in investing activities during the twelvemonths ended December 31, 2006 was $0.1 million as compared to $0.3million for the twelve months September 30, 2005. Cash used in investingactivities during the fiscal years ended December 31, 2006 and September 30,2005, was a result of capital expenditures during each of the respectiveperiods. In addition, during the fiscal year ended December 31, 2006 werecorded approximately $0.4 million related to the sale of our SPLC technology.

Cash provided by financingactivities for the twelve months ended December 31, 2006 was $9.1 millionas compared to $12.7 million for the twelve months ended September 30,2005. Net cash provided by financing activities during 2006 includes $11.0million of net proceeds from the July 19, 2006 Private Placement, andapproximately $0.3 million received from the exercise of incentive stockoptions and warrants to purchase common stock, offset in part by approximately$0.2 million related to payments on our capital lease obligations and $2.0million related to payments on our bank line of credit. Net cash provided byfinancing activities during fiscal 2005 includes $7.5 million of net proceedsfrom the December 2004 financing transaction, $5.2 million of net proceedsfrom the August 2005 financing transaction and approximately $0.2 millionreceived from the exercise of incentive stock options, offset in part byapproximately $0.2 million related to payments on our capital leaseobligations.

**Payments Due UnderContractual Obligations**

Thefollowing table summarizes the payments due under our contractual obligationsat December 31, 2006, and the effect such obligations are expected to haveon liquidity and cash flow in future periods:

| **Calendar Years Ending December 31,** | ** ** | ** ** | ** ** | **Capital Leases** | ** ** | **Operating Leases** | ** ** | **Long-Term Debt** | ** ** |
|------------------------------------------------------------|------------|------------|------------|-------------------------|------------|---------------------------|------------|-------------------------|------------|
| 2007                                                       |       |       | $          | 123,219                 |       |                      |       | $                       | 1,129,761  |   |   |   | $ | 6,374,933 |   |   |
| 2008                                                       |       |       | —     |                    |       |                      | $          | 967,614                 |       |   |   | $ | 3,876,579 |   |   |
| 2009                                                       |       |       | —     |                    |       |                      | $          | 825,537                 |       |   |   | $ | 361,001 |   |   |
| 2010                                                       |       |       | —     |                    |       |                      | $          | 523,797                 |       |   |   | $ | 361,001 |   |   |
| 2011                                                       |       |       | —     |                    |       |                      | $          | 159,408                 |       |   |   | $ | 3,202,012 |   |   |
| Thereafter                                                 |       |       | —     |                    |       |                      | —     |                    |       |   | — |   |   |
| Total                                                      |       |       | $          | 123,219                 |       |                      |       | $                       | 3,606,117  |   |   |   | $ | 14,175,526 |   |   |

 

Long-term debt consists of scheduled principal andinterest payments on our Notes. Principal is payable in 18 equal installments,which represents 75% of the Notes, with the remaining 25%, at the election ofthe investor, is either (i) due on the 18th month or (ii) due on the 60th month. Principal 

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payments, representing 75%of the Notes, commenced on February 28, 2007. The Notes accrue interest atthe greater of (i) 7% or (ii) six month LIBOR plus 350 basis points. AtDecember 31, 2006 the six month LIBOR was 5.4%. For purposes of theschedule above, interest for all periods has been calculated using the December 31,2006 six month LIBOR plus 350 basis points as this rate was greater than 7%. Principaland interest may be paid, at our option, in cash of shares of our common stock.Because investors may convert principal into common stock at any time, at theiroption, the timing of principal and interest payments may accelerate relativeto this schedule.

We lease equipment andoffice space under non-cancelable capital and operating leases. The futureminimum rental payments, as of December 31, 2006, under the capital and operatingleases with non-cancelable terms are included in the table above.

**Off-Balance SheetArrangements**

We have not created, andare not party to, any special-purpose or off-balance sheet entities for thepurpose of raising capital, incurring debt or operating parts of our businessthat are not consolidated into our financial statements. We do not have anyarrangements or relationships with entities that are not consolidated into ourfinancial statements that are reasonably likely to materially affect our liquidityor the availability of capital resources.

**Effects ofInflation**

We believe that inflationand changing prices over the past three years have not had a significant impacton our net revenue or on our income from continuing operations.

**Item 7A.**                QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussionabout our market risks disclosures involves forward-looking statements.Actual results could differ materially from those discussed in the forward-lookingstatements. We are exposed to market risk related to changes in interest ratesand foreign currency exchange rates. We do not use derivative financialinstruments for speculative or trading purposes.

*Interest Rate Risk*

We are exposed to marketrisk from changes in interest rates primarily through our financing activities.At December 31, 2006, $12.0 million was outstanding on the Notes. Intereston the Notes accrues at a rate equal to the greater of (i) 7% per annum or(ii) the six month LIBOR plus 350 basis points, currently 8.9%. Ourability to carry out our business plan or our ability to finance future workingcapital requirements may be impacted if the cost of carrying debt fluctuates tothe point where it becomes a burden on our resources. We account for the Notesand warrant liability on a fair value basis, and changes in share price andmarket interest rates will affect our earnings but will not affect our cashflows, assuming that we are able to make interest payments due on the Notes inshares of our common stock.

*Foreign CurrencyRisk*

Nearly all of our sales outside the United States arepriced in US Dollars. If the US Dollar strengthens versus local currencies, itmay result in our products becoming more expensive in foreign markets. Inaddition, approximately 15-20% of our costs are incurred in foreigncurrencies, especially the Canadian Dollar. If the US Dollar weakens versusthese local currencies, it may result in an increase in our cost structure.

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**Item 8.**                        CONSOLIDATEDFINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

**TABLEOF CONTENTS**

|                                                                                                                                                                                                                                                       | ** ** | **Page** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **Consolidated Financial  Statements of SatCon Technology Corporation**                                                                                                                                                                               |       |     |       |
| Report of Independent  Registered Public Accounting Firm (Vitale, Caturano & Company, Ltd.)                                                                                                                                                  |       | 52       |       |
| Report of Independent Registered Public Accounting  Firm (Grant Thornton LLP)                                                                                                                                                                         |       | 53       |       |
| Consolidated Financial  Statements:                                                                                                                                                                                                                   |       |     |       |
| Consolidated Balance Sheets as of  December 31, 2006 and 2005                                                                                                                                                                                    |       | 54       |       |
| Consolidated Statements of  Operations for the Year Ended December 31, 2006, the Three-Month Period  Ended December 31, 2005 and for Fiscal Years Ended September 30,  2005 and 2004                                    |       | 55       |       |
| Consolidated Statements of Changes in Stockholders’  Equity and Comprehensive Loss for the Year Ended December 31, 2006, the  Three-Month Period Ended December 31, 2005 and Fiscal Years Ended  September 30, 2005 and 2004 |       | 56       |       |
| Consolidated Statements of  Cash Flows for the Year Ended December 31, 2006, the Three-Month Period  Ended December 31, 2005 and Fiscal Years Ended September 30, 2005  and 2004                                             |       | 60       |       |
| Notes to Consolidated  Financial Statements                                                                                                                                                                                                           |       | 61       |       |
| Report of Independent  Registered Public Accounting Firm on Supplementary Schedule (Vitale, Caturano  & Company, Ltd.)                                                                                                                       |       | 104      |       |
| Report of Independent  Registered Public Accounting Firm on Supplementary Schedule (Grant Thornton LLP).                                                                                                                                    |       | 105      |       |
| Schedule II: Valuation  and Qualifying Accounts for the Year Ended December 31, 2006, the  Three-Month Period Ended December 31, 2005 and Fiscal Year Ended  September 30, 2005                                                        |       | 106      |       |

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Shareholders ofSatCon Technology Corporation:

We have audited the accompanying consolidated balancesheets of SatCon Technology Corporation and its subsidiaries (the Company) (aDelaware corporation) as of December 31, 2006 and December 31, 2005and the related consolidated statements of operations, changes in stockholders’equity (deficit) and comprehensive loss and cash flows for the year ended December 31,2006 and the three month period ended December 31, 2005. 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 with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of SatCon Technology Corporation and its subsidiaries as of December 31,2006 and 2005 and the consolidated results of their operations and their cashflows for the year ended December 31, 2006 and the three month period endedDecember 31, 2005, in conformity with accounting principles generallyaccepted in the United States of America.

As discussed in Note C of the Notes to theConsolidated Financial Statements, effective October 1, 2005, the Companyadopted Statement of Financial Accounting Standards No. 123R, *Share-Based Payment.*

Theaccompanying consolidated financial statements have been prepared assuming thatthe Company will continue as a going concern. As discussed in Note B tothe consolidated financial statements, during the year ended December 31,2006, the Company incurred a net loss of $19.8 million and used $9.8 millionof cash in its operating activities and as of December 31, 2006 has astockholders’ deficit of $2.5 million. In addition, the Company has historicallyincurred losses and used cash, rather than provided cash, from operations. Thesefactors, among others, as discussed in Note B to the consolidatedfinancial statements, raise substantial doubt about the Company’s ability tocontinue as a going concern. Management’s plan in regards to these matters isalso described in Note B. The consolidated financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.
|                        | /s/ VITALE, CATURANO AND COMPANY, LTD |
|------------------------|---------------------------------------|
| Boston,  Massachusetts |                                  |
| March 23,  2007   |                                  |

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Shareholders ofSatCon Technology Corporation:

We have audited the accompanying consolidated balancesheets of SatCon Technology Corporation and its subsidiaries (the Company) (aDelaware corporation) as of September 30, 2005 and 2004 and the relatedconsolidated statements of operations, changes in stockholders’ equity andcomprehensive loss and cash flows for each of the two years in the period endedSeptember 30, 2005. These consolidated financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standardsof the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of SatCon Technology Corporation and its subsidiaries as of September 30,2005 and the consolidated results of their operations and their cash flows foreach of the two years in the period ended September 30, 2005, inconformity with accounting principles generally accepted in the United Statesof America.

Theaccompanying consolidated financial statements have been prepared assuming thatthe Company will continue as a going concern. As discussed in Note B tothe consolidated financial statements, during the fiscal year ended September 30,2005, the Company incurred a net loss of $10.2 million and used $7.9 millionin its operating activities. In addition, the Company has historically incurredlosses and used cash, rather than provided cash, from operations. The Companycurrently has a line of credit agreement which expires on January 30, 2006.The line of credit contains certain restrictive covenants. The Company needs tocontinue to maintain certain monthly tangible net worth milestones in order toremain in compliance with the loan. The Company believes that in order toremain in compliance it will need to reach an estimated breakeven cash run rate.These factors, among others, as discussed in Note B to the consolidatedfinancial statements, raise substantial doubt about the Company’s ability tocontinue as a going concern. Management’s plan in regards to these matters isalso described in Note B. The consolidated financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.
|                         | /s/ GRANT THORNTON LLP |
|-------------------------|------------------------|
| Boston,  Massachusetts  |                   |
| December 15,  2005 |                   |

 

53

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**SATCON TECHNOLOGY CORPORATIONCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                                                                          | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                          |       |                        |       |                        |       |
| Current assets:                                                                                                                                                                                                                                                     |       |                        |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                                           |       | $                           | 7,190,827  |                        | $          | 9,194,720 |   |
| Restricted cash and cash  equivalents                                                                                                                                                                                                                               |       | 84,000                      |       | 84,000                      |       |
| Accounts receivable, net  of allowance of $792,245 and $800,654 at December 31, 2006 and 2005,  respectively                                                                                                                                                   |       | 8,549,923                   |       | 5,332,668                   |       |
| Unbilled contract costs  and fees                                                                                                                                                                                                                                   |       | 267,247                     |       | 114,899                     |       |
| Inventory                                                                                                                                                                                                                                                           |       | 7,945,874                   |       | 6,502,168                   |       |
| Prepaid expenses and  other current assets                                                                                                                                                                                                                          |       | 756,884                     |       | 710,924                     |       |
| Total current assets                                                                                                                                                                                                                                                |       | $                           | 24,794,755 |                        | $          | 21,939,379 |   |
| Property and  equipment, net                                                                                                                                                                                                                                        |       | 2,783,900                   |       | 3,396,432                   |       |
| Goodwill, net                                                                                                                                                                                                                                                       |       | 704,362                     |       | 704,362                     |       |
| Intangibles, net                                                                                                                                                                                                                                                    |       | 1,224,488                   |       | 1,736,152                   |       |
| Restricted cash                                                                                                                                                                                                                                                     |       | 1,000,000                   |       | —                      |       |
| Other long-term  assets                                                                                                                                                                                                                                             |       | 69,782                      |       | 551,750                     |       |
| Total assets                                                                                                                                                                                                                                                        |       | $                           | 30,577,287 |                        | $          | 28,328,075 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                       |       |                        |       |                        |       |
| Current  liabilities:                                                                                                                                                                                                                                               |       |                        |       |                        |       |
| Bank line of credit                                                                                                                                                                                                                                                 |       | $                           | —     |                        | $          | 2,000,000 |   |
| Current portion of long-term  debt                                                                                                                                                                                                                                  |       | 123,219                     |       | 155,919                     |       |
| Accounts payable                                                                                                                                                                                                                                                    |       | 4,538,569                   |       | 3,243,675                   |       |
| Accrued payroll and  payroll related expenses                                                                                                                                                                                                                       |       | 1,449,185                   |       | 1,502,681                   |       |
| Other accrued expenses                                                                                                                                                                                                                                              |       | 2,405,447                   |       | 1,903,130                   |       |
| Accrued contract losses                                                                                                                                                                                                                                             |       | —                      |       | 84,779                      |       |
| Accrued restructuring  costs                                                                                                                                                                                                                                        |       | 1,200,326                   |       | —                      |       |
| Current portion of senior  secured convertible notes                                                                                                                                                                                                                |       | 5,500,000                   |       | —                      |       |
| Current portion of warrant  liability                                                                                                                                                                                                                               |       | 436,919                     |       | —                      |       |
| Deferred revenue                                                                                                                                                                                                                                                    |       | 5,834,537                   |       | 2,359,672                   |       |
| Total current  liabilities                                                                                                                                                                                                                                          |       | $                           | 21,488,202 |                        | $          | 11,249,856 |   |
| Redeemable  convertible Series B preferred stock (345 and 425 shares issued and  outstanding at December 31, 2006 and 2005, respectively; face value  $5,000 per share; liquidation preference $1,725,000 and $2,125,000,    respectively) |       | 1,725,000                   |       | 2,125,000                   |       |
| Long-term  debt, net of current portion                                                                                                                                                                                                                             |       | —                      |       | 117,715                     |       |
| Long-term Senior  secured convertible notes, net of current portion                                                                                                                                                                                                 |       | 7,240,482                   |       | —                      |       |
| Long-term warrant  liability, net of current portion                                                                                                                                                                                                                |       | 2,483,634                   |       | —                      |       |
| Other long-term  liabilities                                                                                                                                                                                                                                        |       | 108,049                     |       | 334,435                     |       |
| Total Liabilities                                                                                                                                                                                                                                                   |       | $                           | 33,045,367 |                        | $          | 13,827,006 |   |
| Commitments and  contingencies (Note L)                                                                                                                                                                                                                             |       |                        |       |                        |       |
| Stockholders’  equity (deficit):                                                                                                                                                                                                                               |       |                        |       |                        |       |
| Common stock; $0.01 par  value, 100,000,000 and 50,000,000 shares authorized; 40,105,073 and  38,382,706 shares issued and outstanding at December 31, 2006 and 2005,  respectively                                                                       |       | 401,051                     |       | 383,827                     |       |
| Additional paid-in  capital                                                                                                                                                                                                                                         |       | 156,379,193                 |       | 153,450,771                 |       |
| Accumulated deficit                                                                                                                                                                                                                                                 |       | (158,991,838                | )          | (139,213,827                | )          |
| Accumulated other  comprehensive loss                                                                                                                                                                                                                               |       | (256,486                    | )          | (119,702                    | )          |
| Total stockholders’  equity (deficit)                                                                                                                                                                                                                          |       | $                           | (2,468,080 | )                           | $          | 14,501,069 |   |
| Total liabilities and stockholders’ equity (deficit)                                                                                                                                                                                                           |       | $                           | 30,577,287 |                        | $          | 28,328,075 |   |

 

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

54

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**SATCON TECHNOLOGY CORPORATIONCONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                                                       | ** ** | ** **            | ** **  | **Three Months** | ** ** | ** **                                               | ** ** | ** ** | ** **  |
|--------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|-----------------------|------------|----------------------------------------------------------|------------|------------|-------------|
| ** **                                                                                       | ** ** | **Year Ended**   | ** **  | **Ended**             | ** ** | **For the Fiscal Years Ended ** | ** ** |
| ** **                                                                                       | ** ** | **December 31,** | ** **  | **December 31,** | ** ** | **September 30,**                                   | ** ** |
| ** **                                                                                       | ** ** | **2006**              | ** **  | **2005**              | ** ** | **2005**                                                 | ** ** | **2004**   | ** **  |
| Revenue:                                                                                         |       |                  |        |                  |       |                                                     |       |       |        |
| Product revenue                                                                                  |       | $                     | 28,766,647  |                  | $          | 6,038,029                                                |       | $          | 29,891,604  |   | $ | 26,971,109 |   |
| Funded research and development and other revenue                                           |       | 4,990,022             |        | 1,079,052             |       | 6,063,508                                                |       | 7,186,714  |        |
| Total revenue                                                                                    |       | 33,756,669            |        | 7,117,081             |       | 35,955,112                                               |       | 34,157,823 |        |
| Operating costs  and expenses:                                                                   |       |                  |        |                  |       |                                                     |       |       |        |
| Cost of product  revenue                                                                         |       | 27,823,402            |        | 5,801,833             |       | 27,631,184                                               |       | 22,373,241 |        |
| Research and development  and other revenue expenses:                                       |       |                  |        |                  |       |                                                     |       |       |        |
| Funded research and development and other revenue  expenses                                      |       | 4,041,137             |        | 1,111,102             |       | 5,412,071                                                |       | 5,981,716  |        |
| Unfunded research and development expenses                                                       |       | 2,000,271             |        | 260,396               |       | 513,203                                                  |       | 3,354      |        |
| Total research and development and other revenue  expenses                                       |       | 6,041,408             |        | 1,371,498             |       | 5,925,274                                                |       | 5,985,070  |        |
| Selling, general  and administrative expenses                                                    |       | 13,007,946            |        | 2,487,852             |       | 10,801,996                                               |       | 9,362,522  |        |
| Amortization of intangibles                                                                      |       | 430,959               |        | 111,671               |       | 446,684                                                  |       | 446,685    |        |
| Gain on sale of  assets                                                                          |       | (399,015              | )           | (1,442,915            | )          | (317,802                                                 | )          | —     |        |
| Restructuring  costs                                                                             |       | 1,612,045             |        | —                |       | (255,612                                                 | )          | —     |        |
| Write-off  of impaired long-lived assets                                                         |       | —                |        | —                |       | 1,190,436                                                |       | —     |        |
| Total operating  costs and expenses                                                              |       | 48,516,745            |        | 8,329,939             |       | 45,422,160                                               |       | 38,167,518 |        |
| Operating loss                                                                                   |       | (14,760,076           | )           | (1,212,858            | )          | (9,467,048                                               | )          | (4,009,695 | )           |
| Net realized and unrealized (loss) gain on warrants  to purchase common stock                    |       | —                |        | —                |       | (7,036                                                   | )          | (90,454    | )           |
| Unrealized gain  (loss) on series B warrants                                                     |       | —                |        | —                |       | —                                                   |       | 35,442     |        |
| Other (loss)  income                                                                             |       | 41,086                |        | (4,397                | )          | (116,622                                                 | )          | (1,629     | )           |
| Change in fair  value of Notes and warrants                                                      |       | (4,292,251            | )           | —                |       | —                                                   |       | —     |        |
| Interest income                                                                                  |       | 384,394               |        | 47,098                |       | 41,909                                                   |       | 12,456     |        |
| Interest expense                                                                                 |       | (1,151,164            | )           | (137,570              | )          | (697,310                                                 | )          | (6,904,590 | )           |
| Net loss                                                                                         |       | $                     | (19,778,011 | )                     | $          | (1,307,727                                               | )          | $          | (10,246,107 | ) | $ | (10,958,470 | ) |
| Net loss attributable  to common stockholders per weighted average share, basic and diluted |       | $                     | (0.50       | )                     | $          | (0.03                                                    | )          | $          | (0.31       | ) | $ | (0.41 | ) |
| Weighted average  number of common shares, basic and diluted                                |       | 39,290,167            |        | 38,355,974            |       | 32,899,632                                               |       | 26,834,470 |        |

 

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

55

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**SATCON TECHNOLOGY CORPORATIONCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT) ANDCOMPREHENSIVE LOSSFor the Year Ended December 31, 2006**

| ** **                                                                                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **      | ** ** | **Accumulated**                | ** **  | ** **                        | ** ** | ** **              | ** **   |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|-----------------------------|------------|-----------------|------------|--------------------------------|-------------|-----------------------------------|------------|-------------------------|--------------|
| ** **                                                                                                                                         | ** ** | **Common** | ** ** | **Common** | ** ** | **Additional Paid-in** | ** ** | **Accumulated** | ** ** | ** Other  Comprehensive** | ** **  | **Total Stockholders’** | ** ** | **Comprehensive ** | ** **   |
| ** **                                                                                                                                         | ** ** | **Shares** | ** ** | **Stock**  | ** ** | **Capital**                 | ** ** | **Deficit**     | ** ** | ** Loss**                 | ** **  | **Equity  (Deficit)**             | ** ** | **Loss**                | ** **   |
| Balance, December 31, 2005                                                                                                                    |       | 38,382,706 |       |       | $          | 383,827                     | ** ** |            |       | $                              | 153,450,771 |                              |       | $                       | (139,213,827 | ) |   | $ | (119,702 | ) |   |   | $ | 14,501,069 |   |   |   |   |   |   |
| Net loss                                                                                                                                           |       |       |       |       |       | ** **                  |       |            |       |                           |        | (19,778,011                       | )          |                    | —       |   |   |   | (19,778,011 | ) |   |   | (19,778,011 | ) |   |
| Issuance of common stock to 401(k) Plan                                                                                                       |       | 391,431    |       |       | 3,914      | ** **                  |       |            | 600,826    |                           |        | —                            |       |                    | —       |   |   |   | 604,740 |   |   |   | — |   |   |
| Issuance of common stock in connection with the  exercise of stock options to purchase common stock and issuance of restricted  stock to employees |       | 279,851    |       |       | 2,799      | ** **                  |       |            | 359,973    |                           |        | —                            |       |                    | —       |   |   |   | 362,772 |   |   |   | — |   |   |
| Issuance of common stock in lieu of six -months  dividend on redeemable convertible Series B preferred stock                                  |       | 70,792     |       |       | 708        | ** **                  |       |            | 151,070    |                           |        | —                            |       |                    | —       |   |   |   | 151,778 |   |   |   | — |   |   |
| Issuance of common stock in connection with the  exercise of warrants to purchase common stock                                                     |       | 430,134    |       |       | 4,301      | ** **                  |       |            | (4,097     | )                              |        | —                            |       |                    | —       |   |   |   | 204 |   |   |   | — |   |   |
| Issuance of common stock in connection with the  conversion of redeemable convertible Series B preferred stock                                |       | 180,995    |       |       | 1,810      | ** **                  |       |            | 398,190    |                           |        | —                            |       |                    | —       |   |   |   | 400,000 |   |   |   | — |   |   |
| Issuance of common stock in lieu of cash interest on  July 19, 2006 Notes                                                                     |       | 369,164    |       |       | 3,692      | ** **                  |       |            | 311,168    |                           |        | —                            |       |                    | —       |   |   |   | 314,860 |   |   |   | — |   |   |
| Employee stock-based compensation.                                                                                                                 |       | —     |       |       | —     | ** **                  |       |            | 986,251    |                           |        | —                            |       |                    | —       |   |   |   | 986,251 |   |   |   | — |   |   |
| Adjustment to conversion price of Series B  preferred stock, due to anti-dilution provisions                                                  |       | —     |       |       | —     | ** **                  |       |            | 125,041    |                           |        | —                            |       |                    | —       |   |   |   | 125,041 |   |   |   | — |   |   |
| Foreign currency translation adjustment.                                                                                                           |       | —     |       |       | —     | ** **                  |       |            | —     |                           |        | —                            |       |                    | (136,784     | ) |   |   | (136,784 | ) |   |   | (136,784 | ) |   |
| Comprehensive loss                                                                                                                                 |       | —     |       |       | —     | ** **                  |       |            | —     |                           |        | —                            |       |                    | —       |   |   |   | — |   |   |   | $ | (19,914,795 | ) |   |
| Balance,  December 31, 2006                                                                                                                   |       | 40,105,073 |       |       | $          | 401,051                     | ** ** |            |       | $                              | 156,379,193 |                              |       | $                       | (158,991,838 | ) |   | $ | (256,486 | ) |   |   | $ | (2,468,080 | ) |   |   |   |   |   |
|                                                                                                                                                    |            |            |            |            |            |                             |            |                 |            |                                |             |                                   |            |                         |              |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

56

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**SATCON TECHNOLOGY CORPORATIONCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT) ANDCOMPREHENSIVE LOSS (Continued)For the three-month Period Ended December 31, 2005**

| ** **                                                                                                        | ** ** | **Common** | ** ** | **Common** | ** ** | **Additional Paid-in** | ** ** | **Accumulated** | ** ** | **Accumulated   Other  Comprehensive** | ** **  | **Total Stockholders’** | ** ** | **Comprehensive** | ** **   |
|-------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|-----------------------------|------------|-----------------|------------|---------------------------------------------|-------------|-----------------------------------|------------|-------------------|--------------|
| ** **                                                                                                        | ** ** | **Shares** | ** ** | **Stock**  | ** ** | **Capital**                 | ** ** | **Deficit**     | ** ** | ** Loss**                              | ** **  | **Equity  (Deficit)**             | ** ** | **Loss**          | ** **   |
| Balance, September 30, 2005                                                                                  |       | 38,283,208 |       |       | $          | 382,832                     |       |            |       | $                                           | 153,239,276 |                              |       | $                 | (137,906,100 | ) |   | $ | (113,752 | ) |   |   | $ | 15,602,256 |   |   |   |   |   |   |
| Net loss                                                                                                          |       |       |       |       |       |                        |       |            |       |                                        |        | (1,307,727                        | )          |              | —       |   |   |   | (1,307,727 | ) |   |   | $ | (1,307,727 | ) |   |
| Issuance of common stock to 401(k) Plan                                                                      |       | 68,049     |       |       | 680        |                        |       |            | 140,179    |                                        |        | —                            |       |              | —       |   |   |   | 140,859 |   |   |   | — |   |   |
| Issuance of common stock in connection with the  exercise of stock options to purchase common stock               |       | 1,000      |       |       | 10         |                        |       |            | 620        |                                        |        | —                            |       |              | —       |   |   |   | 630 |   |   |   | — |   |   |
| Issuance of common stock in lieu of six -months  dividend on redeemable convertible Series B preferred stock |       | 30,449     |       |       | 305        |                        |       |            | 66,987     |                                        |        | —                            |       |              | —       |   |   |   | 67,292 |   |   |   | — |   |   |
| Employee stock-based compensation                                                                                 |       | —     |       |       | —     |                        |       |            | 3,709      |                                        |        | —                            |       |              | —       |   |   |   | 3,709 |   |   |   |   |   |   |
| Foreign currency translation adjustment                                                                           |       | —     |       |       | —     |                        |       |            | —     |                                        |        | —                            |       |              | (5,950       | ) |   |   | (5,950 | ) |   |   | (5,950 | ) |   |
| Comprehensive loss                                                                                                |       | —     |       |       | —     |                        |       |            | —     |                                        |        | —                            |       |              | —       |   |   |   | — |   |   |   | $ | (1,313,677 | ) |   |
| Balance,  December 31, 2005                                                                                  |       | 38,382,706 |       |       | $          | 383,827                     |       |            |       | $                                           | 153,450,771 |                              |       | $                 | (139,213,827 | ) |   | $ | (119,702 | ) |   |   | $ | 14,501,069 |   |   |   |   |   |   |
|                                                                                                              |       |       |       |       |       |                        |       |            |       |                                        |        |                              |       |              |         |   |   |   |   |   |   |   |   |   |   |

 

The accompanying notes arean integral part of these consolidated financial statements

57

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**SATCON TECHNOLOGYCORPORATIONCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT) ANDCOMPREHENSIVE LOSS (Continued)For the Fiscal Year Ended September 30, 2005**
|                                                                                                              | ** ** | **Common  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Accumulated  Other   Comprehensive  Loss** | ** ** | **Total Stockholders’   Equity (Deficit)** | ** **   | **Comprehensive  Loss** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|----------------------------------|------------|--------------------------|------------|----------------------------------------------------------|------------|-----------------------------------------------------------|--------------|-------------------------|------------|
| Balance, September 30, 2004                                                                                  |       | 28,226,010         |       |              | $          | 282,261                          |       |                     | $          | 139,208,000                                              |       | $                                                         | (127,659,993 | )                       |       | $ | (171,608 | ) |   |   | $ | 11,658,660 |   |   |   | — |   |   |
| Net loss                                                                                                     |       | —             |       |              | —     |                             |       | —                   |       | (10,246,107                                              | )          |                                                      | —       |                    |       |   | (10,246,107 | ) |   |   | $ | (10,246,107 | ) |   |
| Issuance of common stock to  401(k) Plan                                                                     |       | 335,928            |       |              | 3,359      |                             |       | 582,638                  |       | —                                                   |       |                                                      | —       |                    |       |   | 585,997 |   |   |   | — |   |   |
| Issuance of common stock in  connection with the exercise of stock options to purchase common stock          |       | 144,000            |       |              | 1,440      |                             |       | 154,443                  |       | —                                                   |       |                                                      | —       |                    |       |   | 155,883 |   |   |   | — |   |   |
| Issuance  of common stock in lieu of six-months dividend on redeemable convertible  Series B preferred stock |       | 52,636             |       |              | 526        |                             |       | 126,974                  |       | —                                                   |       |                                                      | —       |                    |       |   | 127,500 |   |   |   | — |   |   |
| Issuance  of common stock in connection with the December 2004 Financing Transaction                         |       | 4,848,484          |       |              | 48,485     |                             |       | 5,835,521                |       | —                                                   |       |                                                      | —       |                    |       |   | 5,884,006 |   |   |   | — |   |   |
| Issuance  of warrants to Common stockholders, related to December 2004 Financing  Transaction                |       | —             |       |              | —     |                             |       | 1,602,954                |       | —                                                   |       |                                                      | —       |                    |       |   | 1,602,954 |   |   |   | — |   |   |
| Issuance of common stock in  connection with the August 2005 Financing Transaction                           |       | 4,676,150          |       |              | 46,761     |                             |       | 4,662,853                |       | —                                                   |       |                                                      | —       |                    |       |   | 4,709,614 |   |   |   | — |   |   |
| Issuance of warrants to  Common stockholders, related to August 2005 Financing Transaction                   |       | —             |       |              | —     |                             |       | 513,489                  |       | —                                                   |       |                                                      | —       |                    |       |   | 513,489 |   |   |   | — |   |   |
| Issuance of warrants to  Ardour Capital, related to August 2005 Financing Transaction                        |       | —             |       |              | —     |                             |       | 43,122                   |       | —                                                   |       |                                                      | —       |                    |       |   | 43,122 |   |   |   | — |   |   |
| Adjustment  to conversion price related to re-pricing of Convertible Series B Preferred  Stock               |       | —             |       |              | —     |                             |       | 270,290                  |       | —                                                   |       |                                                      | —       |                    |       |   | 270,290 |   |   |   | — |   |   |
| Adjustment  in conversion price of Series B warrants                                                         |       | —             |       |              | —     |                             |       | 64,745                   |       | —                                                   |       |                                                      | —       |                    |       |   | 64,745 |   |   |   | — |   |   |
| Issuance  of warrants to purchase common stock to Ardour Capital Investments                                 |       | —             |       |              | —     |                             |       | 20,490                   |       | —                                                   |       |                                                      | —       |                    |       |   | 20,490 |   |   |   | — |   |   |
| Issuance  of warrants to purchase common stock to Silicon Valley Bank                                        |       | —             |       |              | —     |                             |       | 119,427                  |       | —                                                   |       |                                                      | —       |                    |       |   | 119,427 |   |   |   | — |   |   |
| Compensation  charge associated with the acceleration of unvested incentive stock options                    |       | —             |       |              | —     |                             |       | 34,330                   |       | —                                                   |       |                                                      | —       |                    |       |   | 34,330 |   |   |   | — |   |   |
| Foreign currency  translation adjustment                                                                     |       | —             |       |              | —     |                             |       | —                   |       | —                                                   |       |                                                      | 57,856       |                    |       |   | 57,856 |   |   |   | 57,856 |   |   |
| Comprehensive loss                                                                                           |       | —             |       |              | —     |                             |       | —                   |       | —                                                   |       |                                                      | —       |                    |       |   | — |   |   |   | $(10,188,251 | ) |   |
|                                                                                                         |       |               |       |              |       |                             |       |                     |       |                                                     |       |                                                      |         |                    |       |   |   |   |   |   |   |   |   |
| Balance, September 30, 2005                                                                                  |       | 38,283,208         |       |              | $          | 382,832                          |       |                     | $          | 153,239,276                                              |       | $                                                         | (137,906,100 | )                       |       | $ | (113,752 | ) |   |   | $ | 15,602,256 |   |   |   |   |   |   |
|                                                                                                              |            |                    |            |                   |            |                                  |            |                          |            |                                                          |            |                                                           |              |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

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**SATCON TECHNOLOGYCORPORATIONCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT) ANDCOMPREHENSIVE LOSS (Continued)For the Fiscal Year Ended September 30, 2004**
|                                                                                                                   | ** ** | **Common  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Accumulated  Other  Comprehensive  Loss** | ** ** | **Total Stockholders’  Equity (Deficit)** | ** **   | **Comprehensive  Loss** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|----------------------------------|------------|--------------------------|------------|----------------------------------------------------|------------|-----------------------------------------------------|--------------|-------------------------|------------|
| Balance, September 30, 2003                                                                                       |       | 21,023,200         |       |              | $          | 210,232                          |       |                     | $          | 122,792,791                                        |       | $                                                   | (116,701,523 | )                       |       | $ | (139,354 | ) |   |   | $ | 6,162,146 |   |   |   |   |   |   |
| Net loss                                                                                                          |       | —             |       |              | —     |                             |       | —                   |       | (10,958,470                                        | )          |                                                | —       |                    |       |   | (10,958,470 | ) |   |   | (10,958,470 | ) |   |
| Issuance of common stock to 401(k) Plan                                                                           |       | 213,019            |       |              | 2,130      |                             |       | 529,364                  |       | —                                             |       |                                                | —       |                    |       |   | 531,494 |   |   |   | — |   |   |
| Issuance of common stock in connection with exercise of Series A  warrant to purchase common stock                |       | 28,000             |       |              | 280        |                             |       | —                   |       | —                                             |       |                                                | —       |                    |       |   | 280 |   |   |   | — |   |   |
| Issuance of common stock in connection with exercise of warrants to  purchase common stock                        |       | 2,246,467          |       |              | 22,465     |                             |       | 1,834,850                |       | —                                             |       |                                                | —       |                    |       |   | 1,857,315 |   |   |   | — |   |   |
| Issuance of common stock in connection with cashless exercise of  warrants to purchase common stock               |       | 209,422            |       |              | 2,094      |                             |       | (2,094                   | )          | —                                             |       |                                                | —       |                    |       |   | — |   |   |   | — |   |   |
| Issuance of common stock in connection with the exercise of stock  options to purchase common stock               |       | 118,550            |       |              | 1,186      |                             |       | 76,624                   |       | —                                             |       |                                                | —       |                    |       |   | 77,810 |   |   |   | — |   |   |
| Issuance of common stock in connection with the conversion of  redeemable convertible Series A preferred stock    |       | 1,327,000          |       |              | 13,270     |                             |       | 1,645,480                |       | —                                             |       |                                                | —       |                    |       |   | 1,658,750 |   |   |   | — |   |   |
| Issuance of common stock in connection with the conversion of  convertible subordinated debentures                |       | 666,000            |       |              | 6,660      |                             |       | 825,840                  |       | —                                             |       |                                                | —       |                    |       |   | 832,500 |   |   |   | — |   |   |
| Issuance of common stock in lieu of first year interest on  convertible subordinated debentures                   |       | 8,298              |       |              | 83         |                             |       | 23,981                   |       | —                                             |       |                                                | —       |                    |       |   | 24,064 |   |   |   | — |   |   |
| Issuance of common stock in lieu of first six-months dividend on  redeemable convertible Series B preferred stock |       | 76,054             |       |              | 761        |                             |       | 229,454                  |       | —                                             |       |                                                | —       |                    |       |   | 230,215 |   |   |   | — |   |   |
| Issuance of common stock to Auerelius Consulting Group                                                            |       | 90,000             |       |              | 900        |                             |       | 193,950                  |       | —                                             |       |                                                | —       |                    |       |   | 194,850 |   |   |   | — |   |   |
| Issuance of options and warrants to purchase common stock to  non-employees                                       |       | —             |       |              | —     |                             |       | 46,634                   |       | —                                             |       |                                                | —       |                    |       |   | 46,634 |   |   |   | — |   |   |
| Issuance of warrants to convertible subordinated debentures holders                                               |       | —             |       |              | —     |                             |       | 46,577                   |       | —                                             |       |                                                | —       |                    |       |   | 46,577 |   |   |   | — |   |   |
| Beneficial conversion feature of convertible subordinated debentures                                              |       | —             |       |              | —     |                             |       | 138,977                  |       | —                                             |       |                                                | —       |                    |       |   | 138,977 |   |   |   | — |   |   |
| Issuance of warrants to Series B preferred stockholders                                                           |       | —             |       |              | —     |                             |       | 1,242,441                |       | —                                             |       |                                                | —       |                    |       |   | 1,242,441 |   |   |   | — |   |   |
| Beneficial conversion feature of the Series B preferred  stock                                                    |       | —             |       |              | —     |                             |       | 3,655,607                |       | —                                             |       |                                                | —       |                    |       |   | 3,655,607 |   |   |   | — |   |   |
| Issuance of warrants to BHP in connection with the issuance of the  Series B preferred stock                      |       | —             |       |              | —     |                             |       | 435,166                  |       | —                                             |       |                                                | —       |                    |       |   | 435,166 |   |   |   | — |   |   |
| Issuance of common stock in connection with the conversion of  redeemable convertible Series B preferred stock    |       | 2,220,000          |       |              | 22,200     |                             |       | 5,527,800                |       | —                                             |       |                                                | —       |                    |       |   | 5,550,000 |   |   |   | — |   |   |
| Mark-to-market Series B warrants                                                                                  |       | —             |       |              | —     |                             |       | (35,442                  | )          | —                                             |       |                                                | —       |                    |       |   | (35,442 | ) |   |   | — |   |   |
| Foreign currency translation adjustment                                                                           |       | —             |       |              | —     |                             |       | —                   |       | —                                             |       |                                                | (32,254      | )                       |       |   | (32,254 | ) |   |   | (32,254 | ) |   |
| Comprehensive loss                                                                                                |       | —             |       |              | —     |                             |       | —                   |       | —                                             |       |                                                | —       |                    |       |   | — |   |   |   | $(10,990,724 | ) |   |
|                                                                                                              |       |               |       |              |       |                             |       |                     |       |                                               |       |                                                |         |                    |       |   |   |   |   |   |   |   |   |
| Balance, September 30, 2004                                                                                       |       | 28,226,010         |       |              | $          | 282,261                          |       |                     | $          | 139,208,000                                        |       | $                                                   | (127,659,993 | )                       |       | $ | (171,608 | ) |   |   | $ | 11,658,660 |   |   |   |   |   |   |

 

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

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**SATCON TECHNOLOGY CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                                                                                                                                                                                                                                                     | ** ** | ** **            | ** ** | **Three-Months**     | ** ** | ** **                  | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------------|------------|-----------------------------|------------|------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                     | ** ** | **Year Ended**   | ** ** | **Ended**            | ** ** | **Fiscal Years Ended** | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                     | ** ** | **December 31,** | ** ** | **December 31** | ** ** | **September 30,**      | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                     | ** ** | **2006**              | ** ** | **2005**             | ** ** | **2005**                    | ** ** | **2004**   | ** ** |
| Cash flows from operating activities:                                                                                                                                                                                                                                                                                          |       |                  |       |                 |       |                        |       |       |       |   |   |   |   |   |   |
| Net loss                                                                                                                                                                                                                                                                                                                       |       |                  | $          | (19,778,011          | )          |                        |       | $          | (1,307,727 | ) |   |   | $ | (10,246,107 | ) |   | $ | (10,958,470 | ) |
| Adjustments to reconcile net loss to net cash used in  operating activities:                                                                                                                                                                                                                                                   |       |                  |       |                 |       |                        |       |       |       |   |   |   |   |   |   |
| Depreciation and  amortization                                                                                                                                                                                                                                                                                                 |       |                  | 1,446,121  |                 |       |                        | 372,866    |       |       |   | 1,870,216 |   |   | 1,942,544 |   |
| Provision  (recovery) for uncollectible accounts                                                                                                                                                                                                                                                                               |       |                  | (8,409     | )                    |       |                        | —     |       |       |   | 119,802 |   |   | (16,429 | ) |
| Provision for  excess and obsolete inventory                                                                                                                                                                                                                                                                                   |       |                  | 248,299    |                 |       |                        | 72,030     |       |       |   | (851,569 | ) |   | 95,008 |   |
| Net realized and  unrealized loss (gain) on warrants to purchase common stock                                                                                                                                                                                                                                                  |       |                  | —     |                 |       |                        | —     |       |       |   | 7,036 |   |   | 90,454 |   |
| Unrealized (gain)  loss on Series B warrants                                                                                                                                                                                                                                                                              |       |                  | —     |                 |       |                        | —     |       |       |   | — |   |   | (35,442 | ) |
| Write-off of  impaired long-lived assets                                                                                                                                                                                                                                                                                       |       |                  | —     |                 |       |                        | —     |       |       |   | 1,190,436 |   |   | — |   |
| Non-cash  compensation expense related issuance of stock options and warrants to  employees and non-employees and issuance of common stock to  401(k) Plan, including stock based compensation costs of $986,251 for  the year ended December 31, 2006 and $3,709 for the three months ended  December 31, 2005 |       |                  | 1,588,554  |                 |       |                        | 144,568    |       |       |   | 769,035 |   |   | 740,891 |   |
| Change in fair  value of senior secured convertible notes and investor and placement agent  warrant liability                                                                                                                                                                                                                  |       |                  | 4,292,251  |                 |       |                        | —     |       |       |   | — |   |   | — |   |
| Non-cash  interest expense                                                                                                                                                                                                                                                                                                     |       |                  | 1,021,147  |                 |       |                        | 87,285     |       |       |   | 475,579 |   |   | 6,785,004 |   |
| Non-cash  restructuring charges                                                                                                                                                                                                                                                                                                |       |                  | 1,532,231  |                 |       |                        | —     |       |       |   | — |   |   | — |   |
| Gain on sale of  assets                                                                                                                                                                                                                                                                                                        |       |                  | (399,015   | )                    |       |                        | (1,442,915 | )          |       |   | — |   |   | — |   |
| Compensation  expense related to acceleration of stock option vesting schedule                                                                                                                                                                                                                                                 |       |                  | —     |                 |       |                        | —     |       |       |   | 34,330 |   |   | — |   |
| Changes in operating assets and liabilities:                                                                                                                                                                                                                                                                                   |       |                  |       |                 |       |                        |       |       |       |   |   |   |   |   |   |
| Accounts  receivable                                                                                                                                                                                                                                                                                                           |       |                  | (3,208,846 | )                    |       |                        | 1,140,997  |       |       |   | (319,289 | ) |   | (758,751 | ) |
| Unbilled contract  costs and fees                                                                                                                                                                                                                                                                                              |       |                  | (152,348   | )                    |       |                        | 33,039     |       |       |   | 299,467 |   |   | 355,399 |   |
| Prepaid expenses  and other assets                                                                                                                                                                                                                                                                                             |       |                  | (60,889    | )                    |       |                        | (168,626   | )          |       |   | 652,768 |   |   | (627,071 | ) |
| Inventory                                                                                                                                                                                                                                                                                                                      |       |                  | (1,692,005 | )                    |       |                        | (375,137   | )          |       |   | 18,822 |   |   | (477,560 | ) |
| Other long-term  assets                                                                                                                                                                                                                                                                                                        |       |                  | 481,968    |                 |       |                        | 8,271      |       |       |   | (58,387 | ) |   | (383,024 | ) |
| Accounts payable                                                                                                                                                                                                                                                                                                               |       |                  | 1,294,894  |                 |       |                        | (154,778   | )          |       |   | (459,371 | ) |   | (2,144,402 | ) |
| Accrued expenses  and payroll                                                                                                                                                                                                                                                                                                  |       |                  | 321,593    |                 |       |                        | (322,732   | )          |       |   | (569,035 | ) |   | (330,676 | ) |
| Accrued  restructuring                                                                                                                                                                                                                                                                                                         |       |                  | 78,326     |                 |       |                        | —     |       |       |   | — |   |   | — |   |
| Accrued contract  losses                                                                                                                                                                                                                                                                                                       |       |                  | (84,779    | )                    |       |                        | —     |       |       |   | (690,367 | ) |   | 387,368 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                               |       |                  | 3,474,865  |                 |       |                        | 220,238    |       |       |   | 90,992 |   |   | (398,612 | ) |
| Other current  liabilities                                                                                                                                                                                                                                                                                                     |       |                  | (226,386   | )                    |       |                        | 17,591     |       |       |   | (259,572 | ) |   | 264,022 |   |
| Total adjustments                                                                                                                                                                                                                                                                                                              |       |                  | 9,947,572  |                 |       |                        | (367,303   | )          |       |   | 2,320,893 |   |   | 5,488,723 |   |
| Net cash used in  operating activities                                                                                                                                                                                                                                                                                         |       |                  | (9,830,439 | )                    |       |                        | (1,675,030 | )          |       |   | (7,925,214 | ) |   | (5,469,747 | ) |
| Cash flows from investing activities:                                                                                                                                                                                                                                                                                          |       |                  |       |                 |       |                        |       |       |       |   |   |   |   |   |   |
| Purchases of  property and equipment                                                                                                                                                                                                                                                                                           |       |                  | (546,388   | )                    |       |                        | (31,622    | )          |       |   | (286,112 | ) |   | (401,349 | ) |
| Proceeds from sale  of assets                                                                                                                                                                                                                                                                                                  |       |                  | 406,364    |                 |       |                        | 2,316,884  |       |       |   | — |   |   | — |   |
| Net cash (used in)  provided by investing activities                                                                                                                                                                                                                                                                           |       |                  | (140,024   | )                    |       |                        | 2,285,262  |       |       |   | (286,112 | ) |   | (401,349 | ) |
| Cash flows from financing activities:                                                                                                                                                                                                                                                                                          |       |                  |       |                 |       |                        |       |       |       |   |   |   |   |   |   |
| Net borrowing  (repayment) under line of credit                                                                                                                                                                                                                                                                                |       |                  | (2,000,000 | )                    |       |                        | 2,000,000  |       |       |   | — |   |   | (1,801,869 | ) |
| Repayment of long-term  debt                                                                                                                                                                                                                                                                                                   |       |                  | (150,415   | )                    |       |                        | (37,544    | )          |       |   | (184,177 | ) |   | (277,325 | ) |
| Net proceeds from  issuance of convertible redeemable preferred stock                                                                                                                                                                                                                                                          |       |                  | —     |                 |       |                        | —     |       |       |   | — |   |   | 6,925,000 |   |
| Net proceeds from  issuance of convertible subordinated debentures                                                                                                                                                                                                                                                             |       |                  | 10,935,793 |                 |       |                        | —     |       |       |   | — |   |   | 70,000 |   |
| Increase in  restricted cash                                                                                                                                                                                                                                                                                                   |       |                  | (1,000,000 | )                    |       |                        | —     |       |       |   | — |   |   | — |   |
| Net proceeds from  issuance of common stock and warrants                                                                                                                                                                                                                                                                       |       |                  | —     |                 |       |                        | —     |       |       |   | 12,710,064 |   |   | — |   |
| Proceeds from  exercise of stock options                                                                                                                                                                                                                                                                                       |       |                  | 317,772    |                 |       |                        | 630        |       |       |   | 155,883 |   |   | 77,450 |   |
| Proceeds from  exercise of warrants                                                                                                                                                                                                                                                                                            |       |                  | 204        |                 |       |                        | —     |       |       |   | — |   |   | 1,857,955 |   |
| Net cash provided  by financing activities                                                                                                                                                                                                                                                                                     |       |                  | 8,103,354  |                 |       |                        | 1,963,086  |       |       |   | 12,681,770 |   |   | 6,851,211 |   |
| Effect of foreign  currency exchange rates on cash and cash equivalents                                                                                                                                                                                                                                                        |       |                  | (136,784   | )                    |       |                        | (5,950     | )          |       |   | 57,856 |   |   | (32,254 | ) |
| Net increase  (decrease) in cash and cash equivalents, including restricted cash and cash  equivalents                                                                                                                                                                                                                         |       |                  | (2,003,893 | )                    |       |                        | 2,567,368  |       |       |   | 4,528,300 |   |   | 947,861 |   |
| Cash and cash  equivalents at beginning of year, including restricted cash and cash  equivalents                                                                                                                                                                                                                          |       |                  | $          | 9,278,720            |       |                        |       | 6,711,352  |       |   |   | 2,183,052 |   |   | 1,235,191 |   |
| Cash and cash equivalents  at end of year, including restricted cash and cash equivalents                                                                                                                                                                                                                                      |       |                  | $          | 7,274,827            |       |                        |       | $          | 9,278,720  |   |   |   | $ | 6,711,352 |   |   | $ | 2,183,052 |   |

 

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

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**SATCON TECHNOLOGYCORPORATIONNOTES TO CONSOLIDATED FINANCIAL STATEMENTSDECEMBER 31, 2006 and 2005, SEPTEMBER 30,2005 and 2004**

**A.**                ORGANIZATION

SatCon TechnologyCorporation (the “Company” or “SatCon”) was organized as a Massachusettscorporation in February 1985 and reincorporated in Delaware in 1992. TheCompany designs and manufactures enabling technologies and products forelectrical power conversion and control for high-performance, high-efficiencyapplications in large, growth markets such as alternative energy, hybridelectric vehicles, distributed power generation, power quality, semiconductorfabrication capital equipment, industrial motors and drives, and highreliability defense electronics.

**B.**               REALIZATIONOF ASSETS, RECENT DEVELOPMENTS AND LIQUIDITY

The accompanying consolidated financial statementshave been prepared in conformity with accounting principles generally acceptedin the United States of America, which contemplates continuation of the Companyas a going concern. However, the Company has sustained substantial losses fromoperations in recent years. In addition, the Company has used, rather thanprovided, cash in its operations. These factors raise substantial doubt overthe Company’s ability to continue as a going concern.

The Company has incurred significant costs to developits technologies and products. These costs have exceeded total revenue. As aresult, the Company has incurred losses in each of the past five years. As of December 31,2006, it had an accumulated deficit of $159.0 million. During the year ended December 31,2006, the Company incurred a net loss of $19.8 million and used cash inoperations of $9.8 million. The Company’s restricted cash balances at December 31,2006 and 2005 were $1,084,000 and $84,000, respectively. Under the terms of theNotes (as defined below), the Company is required, for so long as any Notes areoutstanding, to maintain aggregate cash and cash equivalents equal to thegreater of (i) $1.0 million or (ii) $3.0 million minus 80% of theeligible receivables (as defined therein). Based on the level of eligiblereceivables, we are required to maintain aggregate cash and cash equivalents of$1.0 million.

In view of the matters described in the precedingparagraph, recoverability of a major portion of the recorded asset amountsshown in the accompanying consolidated balance sheet is dependent upon thecontinued operations of the Company. The consolidated financial statements donot include any adjustments relating to the recoverability and classificationof recorded asset amounts or amounts and classification of liabilities thatmight be necessary should the Company be unable to continue in existence.

On July 19, 2006, the Company entered into aSecurities Purchase Agreement (the “Purchase Agreement”) with thirteeninstitutional investors (the “Purchasers”) in connection with the privateplacement (the “Private Placement”) of $12,000,000 aggregate principal amountof senior secured convertible notes (the “Notes”), in addition, the Companyissued warrants to the holders of the Notes. The net proceeds of the sale wereapproximately $11 million, after deducting placement fees and otheroffering-related expenses. In connection with the Private Placement, theCompany also entered into a Security Agreement, dated July 19, 2006, withthe Purchasers (the “Security Agreement”).

In connection with, and as a condition precedent to,the completion of the Private Placement, on July 20, 2006, the Companypaid all amounts due and owing under its credit facility with Silicon ValleyBank (approximately $2 million) and terminated such facility. In doing so theCompany incurred a termination fee of $17,500 and legal fees of $8,500.

On September 19, 2006, our Board of Directorsapproved a plan to close the Company’s Worcester, Massachusetts manufacturingfacility by approximately December 31, 2006. The decision to close this 

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facility was infurtherance of the Company’s continuing efforts to streamline operations andreduce operating costs. As a result of this decision, The Company recorded acharge to operations as a restructuring cost of approximately $1.6 millionrelated to employee severance and retention bonuses and asset impairments,warrant revaluation and lease termination costs. On December 22, 2006, wenegotiated a settlement with the Worcester landlord, issuing850,000 shares of common stock on January 3, 2007 as considerationfor the early termination of the lease. The lease terminated onFebruary 15, 2007. (See Note T “Restructuring Costs”).

See Note G for a detailed description of the Notes andrelated warrants.

The Company anticipatesthat its current cash will be sufficient to fund its operations at leastthrough December 31, 2007. This assumes the Company achieves its businessplan. The business plan envisions a significant increase in revenue andsignificant reductions in the cost structure and the cash burn rate from theresults experienced in the recent past. Further, this assumes that the Companywill be able to make payments of principal and interest under the Notes inshares of common stock and otherwise comply with the terms of the Notes; if,however, the Company is unable to realize its business plan or is unable to payprincipal and interest under the Note in shares of common stock, or otherwisecomply with the terms of the Notes, the Company may be forced to raiseadditional funds by selling stock or taking other actions to conserve its cashposition, subject to the restrictions contained in the Purchase Agreement andthe Notes.

**C.**               SIGNIFICANTACCOUNTING POLICIES AND BASIS OF PRESENTATION

*Basis ofConsolidation*

The consolidated financialstatements include the accounts of SatCon and its wholly-ownedsubsidiaries (SatCon Applied Technology, SatCon Electronics and SatCon PowerSystems). All intercompany accounts and transactions have been eliminated inconsolidation.

*Revenue Recognition*

The Company recognizes revenue from product sales inaccordance with Staff Accounting Bulletin (SAB) No. 104, *Revenue Recognition*. Product revenue isrecognized when there is persuasive evidence of an arrangement, the fee isfixed or determinable, delivery of the product to the customer has occurred andthe Company has determined that collection of the fee is probable. Title to theproduct passes upon shipment of the product, as the products are typicallyshipped FOB shipping point, except for certain foreign shipments. If theproduct requires installation to be performed by the Company, all revenuerelated to the product is deferred and recognized upon the completion of theinstallation. If the product requires specific customer acceptance, revenue isdeferred until customer acceptance occurs or the acceptance provisions lapse,unless the Company can objectively and reliably demonstrate that the criteriaspecified in the acceptance provisions are satisfied. When appropriate theCompany provides for a warranty reserve at the time the product revenue isrecognized.

The Company performsfunded research and development and product development for commercialcompanies and government agencies under both cost reimbursement and fixed-pricecontracts. Product development revenue is included in product revenue. Costreimbursement contracts provide for the reimbursement of allowable costs and,in some situations, the payment of a fee. These contracts may contain incentiveclauses providing for increases or decreases in the fees depending on how costscompare with a budget. On fixed-price contracts, revenue is generallyrecognized on the percentage of completion method based upon the proportion ofcosts incurred to the total estimated costs for the contract. Revenue fromreimbursement contracts is recognized as the services are performed. In eachtype of contract, the Company receives periodic progress payments or paymentsupon reaching interim milestones. All payments to the Company for workperformed on contracts with agencies of the U.S. government are subject toaudit and adjustment by the Defense Contract Audit Agency. Adjustments arerecognized in the 

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periodmade. When the current estimates of total contract revenue for commercialproduct development contracts indicate a loss, a provision for the entire losson the contract is recorded. As of December 31, 2006 and 2005, the Companyhas accrued $0 and $0.1 million, respectively, for anticipated contract losseson commercial contracts.

Cost of product revenueincludes materials, labor and overhead. Costs incurred in connection withfunded research and development and other revenue arrangements are included inresearch and development and other revenue expenses.

Deferred revenue consistsof payments received from customers in advance of services performed, productshipped or installation completed.

*Cash and Cash Equivalents*

Cashand cash equivalents include demand deposits, overnight repurchase agreementswith Silicon Valley Bank and highly liquid investments with maturities of threemonths or less when acquired. Cash equivalents are stated at cost, whichapproximates market value. At December 31, 2006 and 2005, the Company hasrestricted cash as indicated in the table below. In addition, at December 31,2006 and 2005, the Company had overnight repurchase agreements with SiliconValley Bank of $296,844 and $2,084,492, respectively.

| **Restricted Cash** | ** ** | ** ** | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------|------------|------------|------------|-----------------------------|------------|-----------------------------|------------|
| Security deposits        |       |       | $          | 34,000                      |       |                        |       | $ | 34,000 |   |   |
| Certificates of  Deposit |       |       | 50,000     |                        |       |                        | 50,000     |   |   |
| Senior Secured  Notes    |       |       | 1,000,000  |                        |       |                        | —     |   |   |
| Total restricted Cash    |       |       | $          | 1,084,000                   |       |                        |       | $ | 84,000 |   |   |

 

In addition, under theterms of the Notes, the Company is required, for so long as any Notes areoutstanding, to maintain aggregate cash and cash equivalents equal to thegreater of (i) $1.0 million or (ii) $3.0 million minus 80% ofeligible receivables (as defined therein). Based on the level of eligiblereceivables, we are required to maintain aggregate cash and cash equivalents of$1.0 million. The Company is in compliance with this requirement as of December 31,2006.

*Accounts Receivable*

Accounts receivable arereduced by an allowance for amounts that may become uncollectible in thefuture. The estimated allowance for uncollectible amounts is based primarily ona specific analysis of accounts in the receivable portfolio and historicalwrite-off experience. While management believes the allowance to be adequate,if the financial condition of our customers were to deteriorate, resulting inimpairment of their ability to make payments, additional allowances may berequired.

*Unbilled ContractCosts and Fees and Funded Research and Development Costs In Excess of Billings*

*Unbilledcontract costs and fees represents revenue recognized in excess of amountsbilled due to contractual provisions.*

*Inventory*

Inventory is stated at thelower of cost or market and costs are determined based on the first-in,first-out method of accounting and include material, labor and manufacturingoverhead costs. The Company periodically reviews quantities of inventory onhand and compares these amounts to expected usage of each particular product orproduct line. The Company records, as a charge to cost of sales, any amountsrequired to reduce the carrying value to net realizable value.

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*Property andEquipment*

Propertyand equipment are stated at cost. Depreciation and amortization is computedusing the straight-line method over the asset’s estimated useful life. Theestimated useful lives of property and equipment are as follows:

| ** **              | ** ** | **Estimated Lives**                                                              |
|-------------------------|------------|----------------------------------------------------------------------------------|
| Machinery and equipment |       | 3-10 years                                                                       |
| Furniture and fixtures  |       | 7-10 years                                                                       |
| Computer software       |       | 3 years                                                                          |
| Leasehold improvements  |       | Lesser of the remaining life of the lease or the  useful life of the improvement |

 

When assets are retired orotherwise disposed of, the cost and related depreciation and amortization areeliminated from the accounts and any resulting gain or loss is reflected inoperating expenses.

*Long-lived Assets*

The Company applies the provisions of Statement ofFinancial Accounting Standards (“SFAS”) No. 142, *Goodwill and Other Intangible Assets*. Thisstatement affects the Company’s treatment of goodwill and other intangibleassets. The statement requires that goodwill existing at the date of adoptionbe reviewed for possible impairment and that impairment tests be periodicallyrepeated, with impaired assets written down to fair value. Additionally,existing goodwill and intangible assets must be assessed and classified withinthe statement’s criteria. Intangible assets with finite useful lives willcontinue to be amortized over those periods.

The Company performs a goodwill impairment test as ofthe beginning of its fiscal fourth quarter, as required by SFAS No. 142 onan annual basis. The Company determines the fair value of each of the reportingunits based on a discounted cash flow income approach.

The Company performed its annual goodwill impairmenttest as of the beginning of its fiscal fourth quarter 2006. The Company, basedon the results of these tests, determined the fair value of each of the AppliedTechnology and Electronics reporting units based on a discounted cash flowincome approach. Based on the results of the first step of the annual goodwillimpairment test, the Company determined that the fair value of these reportingunits exceeded their carrying amounts and, therefore, no goodwill impairmentexisted as of the beginning of its fiscal fourth quarter 2006. As a result, thesecond step of the annual goodwill impairment test was not required. TheCompany will continue to perform a goodwill impairment test on the AppliedTechnology and Electronics reporting units on an annual basis and on an interimbasis, if certain conditions exist.

TheCompany has determined that all of its intangible assets have finite lives and,therefore, the Company has continued to amortize its intangible assets. TheCompany recorded expense related to the amortization of its intangible assetsfor the periods presented below as follows:

| ** **            | ** ** | **Year Ended**             | ** ** | **Three Months Ended** | ** ** | **Year Ended**              | ** ** |
|-----------------------|------------|---------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **            | ** ** | **December 31, 2006** | ** ** | **December 31, 2005**  | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
| Amortization  expense |       |                            | $511,664   |                             |       |                             | $130,966   |   |   |   | $524,076 |   |   |   | $516,027 |   |   |
|                       |            |                                 |            |                                  |            |                                  |            |  |  |  |  |  |  |  |  |  |  |

 

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Goodwillby reporting segment consists of the following:

| ** **              | ** ** | **December 31,** | ** ** |
|-------------------------|------------|-----------------------|------------|
| **Reporting Unit** | ** ** | ** **            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Applied  Technology     |       | $123,714              |       | $123,714 |   |
| Power Systems           |       | —                |       | — |   |
| Electronics             |       | 580,648               |       | 580,648 |   |
|                    |       | $704,362              |       | $704,362 |   |
|                         |            |                       |            |  |  |  |  |

 

Intangibleassets consist of the following:

| ** **              | ** ** | ** **                      | ** ** | ** **      | ** ** | **As of December 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-------------------------|------------|---------------------------------|------------|-----------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **Reporting Unit** | ** ** | ** **                      | ** ** | **Description** | ** ** | **Estimated  Useful Life**                 | ** ** | **Gross  Carrying  Value**                      | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** |
| Applied Technology      |       | Patents                         |       |            | 15-20      |                                            |       | $                                               | 744,780    |   |   | $ | 460,343 |   |   | $ | 744,780 |   |   | $ | 379,638 |   |   |
| Applied Technology      |       | Completed  Technology           |       |            | 10         |                                            |       | 3,142,882                                       |       |   | 2,240,217 |   |   | 3,142,882 |   |   | 1,934,257 |   |   |
| Applied Technology      |       | Favorable  Lease                |       |            | 5          |                                            |       | 36,999                                          |       |   | 36,074 |   |   | 36,999 |   |   | 36,074 |   |   |
| Electronics             |       | Customer  List                  |       |            | 10         |                                            |       | 250,000                                         |       |   | 242,705 |   |   | 250,000 |   |   | 217,707 |   |   |
| Electronics             |       | Drawings  and Documentation     |       |            | 10         |                                            |       | 300,000                                         |       |   | 291,250 |   |   | 300,000 |   |   | 261,250 |   |   |
| Electronics             |       | Design  and Manufacturing Cert. |       |            | 10         |                                            |       | 700,000                                         |       |   | 679,584 |   |   | 700,000 |   |   | 609,583 |   |   |
|                    |       |                            |       |            |       |                                            |       | $                                               | 5,174,661  |   |   | $ | 3,950,173 |   |   | $ | 5,174,661 |   |   | $ | 3,438,509 |   |   |
|                         |            |                                 |            |                 |            |                                                 |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theestimated remaining amortization expense for each of the five succeeding years:

| **Fiscal Years ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------|------------|
| 2007                                                    |       | 431,673    |       |
| 2008                                                    |       | 394,288    |       |
| 2009                                                    |       | 354,090    |       |
| 2010                                                    |       | 44,437     |       |
| 2011                                                    |       | —     |       |
| Thereafter                                              |       | —     |       |

 

*Foreign CurrencyTranslation*

The functional currency ofthe Company’s foreign subsidiary is the local currency. Assets and liabilitiesof foreign subsidiaries are translated at the rates in effect at the balancesheet date, while stockholders’ equity (deficit) is translated at historicalrates. Statements of operations and cash flow amounts are translated at theaverage rate for the period. Translation adjustments are included as acomponent of accumulated other comprehensive loss. Foreign currency gains andlosses arising from transactions are reflected in the loss from operations andwere not significant during the year ended December 31, 2006, the threemonths ended December 31, 2005 and the fiscal years ended September 30,2005 and 2004.

*Use of Estimates*

The preparation offinancial statements, in conformity with accounting principles generallyaccepted in the United States of America, requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during the periodreported. Management believes the most significant estimates include the netrealizable value of accounts receivable and inventory, the recoverability oflong lived assets and intangible assets, the accrued contract losses on 

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fixed pricecontracts, the recoverability of deferred tax assets and the fair value ofequity and financial instruments. Actual results could differ from theseestimates.

*Income Taxes*

The Company accounts forincome taxes in accordance with SFAS No. 109, *Accounting for Income Taxes*, which is the asset andliability method for accounting and reporting for income taxes. UnderSFAS No. 109, deferred tax assets and deferred tax liabilities arerecognized based on temporary differences between the financial reporting andincome tax basis of assets and liabilities using statutory rates. In addition,SFAS No. 109 requires a valuation allowance against net deferred taxassets if, based upon the available evidence, it is more likely than not thatsome or all of the deferred tax assets will not be realized.

*Accounting forStock-based Compensation*

The Company has several stock-based employeecompensation plans. On October 1, 2005, the Company adopted Statement ofFinancial Accounting Standards No. 123R (“SFAS 123R”) *Accounting forStock-based Compensation*, using the modified prospective method,which results in the provisions of SFAS 123R only being applied to theconsolidated financial statements on a going-forward basis (that is, the priorperiod results have not been restated). At the time of adoption the Company hadno un-vested outstanding options. Under the fair value recognition provisionsof SFAS 123R, stock-based compensation cost is measured at the grant date basedon the value of the award and is recognized as expense over the service period.Previously, the Company had followed Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees*, and related interpretations, which resulted inthe accounting for employee share options at their intrinsic value in theconsolidated financial statements.

On March 29, 2005, the SEC issued SAB 107which expresses the view of the SEC regarding the interaction betweenSFAS No. 123R and certain SEC rules and regulations concerning thevaluation of share-based payment arrangements for public companies. Inparticular, SAB 107 provides guidance related to share-based paymenttransactions with non-employees, the transition from nonpublic to public entitystatus, valuation methods (including assumptions such as expected volatilityand expected term), the accounting for certain redeemable financial instrumentissues under shares-based payment arrangements, the classification ofcompensation expense, non-GAAP financial measures, first-time  adoption of SFAS No. 123R in aninterim period, capitalization of compensation costs related to share-basedpayment arrangements, the accounting for income tax effects of share-basedpayment arrangements, the accounting for income tax effects of share-based paymentarrangements upon adoption of SFAS No. 123R, the modification ofemployee share options prior to adoption of SFAS No. 123R, anddisclosures in Management’s Discussion and Analysis of Financial Condition andResults of Operations subsequent to adoption of SFAS No. 123R. TheCompany has accounted for its stock option grants in compliance with SAB 107.

On November 10, 2005, the Financial AccountingStandards Board (“FASB”) issued FASB Staff Position SFAS 123R-3 *“Transition Election Related to Accounting for Tax Effects of Share-BasedPayment Awards.”*The Company has elected to adopt the alternativetransition method provided the FASB Staff Position for calculating the taxeffects (if any) of stock-based compensation expense pursuant toSFAS 123R. The alternative transition method includes simplified methodsto establish the beginning balance of the additional paid-in capital poolrelated to the tax effects of employee stock-based compensation, and todetermine the subsequent impact to the additional paid-in capital pool and theconsolidated statements of operations and cash flows of the tax effects ofemployee stock-based compensation awards that are outstanding upon adoption ofSFAS 123R.

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TheCompany recognized the full impact of its share-based payment plans in theconsolidated financial statements for the year ended December 31, 2006 andthe three months ended December 31, 2005 under SFAS 123R and did notcapitalize any such costs on the consolidated balance sheets, as such coststhat qualified for capitalization were not material. The following tablepresents share-based compensation expense included in the Company’sconsolidated statement of operations:

| ** **                                                     | ** ** | **Year Ended  December 31  2006** | ** ** | **Three Months  ended  December 31,  2005** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------------|------------|
| Cost of product  revenue                                       |       |                                        | $          | 82,979                                                |       |   |   | $ | — |   |   |
| Funded research  and development and other revenue expense     |       |                                        | 138,694    |                                                  |       |   | 326 |   |   |
| Un-funded  research and development and other revenue expenses |       |                                        | 15,817     |                                                  |       |   | 297 |   |   |
| Selling, general  and administrative expenses(1)               |       |                                        | 748,761    |                                                  |       |   | 3,086 |   |   |
| Share based  compensation expense before tax                   |       |                                        | $          | 986,251                                               |       |   |   | $ | 3,709 |   |   |
| Income tax benefit                                             |       |                                        | —     |                                                  |       |   | — |   |   |
| Net share-based compensation  expense                          |       |                                        | $          | 986,251                                               |       |   |   | $ | 3,709 |   |   |

----

(1)          Includes non-cashcompensation expense associated with restricted stock issued (see below).

Compensation expense associated with the granting ofstock options to employees is being recognized on a straight line basis overthe service period of the option. In instances where the actual compensationexpense would be greater than that calculated using the straight line method,the actual compensation expense is recorded in that period.

The Company had previously adopted the provisions ofSFAS No. 123, *Accounting for Stock-BasedCompensation,* as amended by SFAS No. 148, *Accountingfor Stock-Based Compensation—Transition and Disclosure*, throughdisclosure only. SFAS No. 123, *Accounting for Stock-BasedCompensation*, requires the measurement of the fair value of stockoptions or warrants granted to employees to be included in the statement ofoperations or, alternatively, disclosed in the notes to consolidated financialstatements. The Company previously accounted for stock- basedcompensation of employees under the intrinsic value method of APB Opinion No. 25,*Accounting for Stock Issued to Employees*,and had elected the disclosure-only alternative under SFAS No. 123. TheCompany records the fair value as determined using the Black- Scholesoption-pricing model of stock options and warrants granted tonon-employees in exchange for services in accordance with Emerging Issues TaskForce (“EITF”) No. 96-18, *Accounting for EquityInstruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods or Services*, and is amortizedratably over the period the service is performed in the consolidated statementof operations.

During the fiscal year ended September 30, 2005,$34,330 of stock based employee compensation was included in the determinationof net loss.

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Thefollowing table illustrates the effect on net loss and loss per share for thefiscal years ended September 30, 2005 and 2004, as if the Company hadapplied the fair value recognition provisions of SFAS 123 to allstock-based awards.

| ** **                                                                                   | ** ** | **2005**                                                      | ** **  | **2004**                         | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|-------------|----------------------------------|------------|
| ** **                                                                                   | ** ** | **Net Loss  Attributable  To Common  Stockholders** | ** **  | **Loss Per  Common  Share** | ** ** | **Net Loss  Attributable  To Common  Stockholders** | ** ** | **Loss Per  Common  Share** | ** ** |
| As Reported                                                                                  |       | $                                                             | (10,246,107 | )                                |       | $ | (0.31 | ) |   | $ | (10,958,470 | ) |   | $ | (0.41 | ) |   |
| Stock based  employee compensation expense included in results of operations for the  period |       | $                                                             | 34,330      |                             |       | $ | — |   |   | $ | — |   |   | $ | — |   |   |
| Adjusted as reported net loss                                                                |       | $                                                             | (10,211,777 | )                                |       | $ | (0.31 | ) |   | $ | (10,958,470 | ) |   | $ | (0.41 | ) |   |
| Stock based employee compensation expense                                                    |       | $                                                             | (3,458,765  | )                                |       | $ | (0.11 | ) |   | $ | (1,909,582 | ) |   | $ | (0.07 | ) |   |
| Pro Forma                                                                                    |       | $                                                             | (13,670,542 | )                                |       | $ | (0.42 | ) |   | $ | (12,868,052 | ) |   | $ | (0.48 | ) |   |

 

On April 8, 2005, the Board of Directors of theCompany voted to accelerate the vesting of all outstanding and unvested optionsheld by directors, officers and employees under the Company’s stock optionplans. As a result of the acceleration, options to acquire 633,333 shares ofthe Company’s common stock, which otherwise would have vested from time to timeover the next 48 months, became immediately exercisable. Included in theoptions to acquire 633,333 shares of the Company’s common stock were (i) optionsto purchase 591,583 shares with exercise prices greater than the Company’sclosing stock price on April 8, 2005 ($1.59) (the “underwater options”)and (ii) options to purchase 41,750 shares with exercise prices below theCompany’s closing stock price on April 8, 2005 (the “in-the-money options”).The underwater options had a weighted average exercise price of $2.23 per share.The in-the-money options had a weighted average exercise price of $1.04 pershare. Under the accounting guidance of APB 25, the accelerated vestingrelating to the in-the-money options resulted in a charge for stock-basedcompensation of approximately $34,330, which was recognized by the Company inthe third fiscal quarter of fiscal 2005. The Company had calculated this chargebased on the intrinsic value of each option at the date of acceleration, takinginto account the remaining unvested shares, each unvested share’s exerciseprice as compared to the price on the day the vesting of the options wasaccelerated.

In taking this action, the Boardof Directors considered whether it would be advantageous to the employeebase to have their options become fully vested. The Board of Directorsconcluded that, because the employees had not had significant raises over thepast few years and had stayed with the Company during difficult times, andbecause the financial impact to the Company of the vesting was minimal, theseoptions should be vested.

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As adirect result of the acceleration of the employee stock options, the amountshown above for fiscal year ended September 30, 2005, includeapproximately $860,000 of stock based employee compensation expense that wouldhave been accounted for in subsequent periods had the unvested options not beenaccelerated. The table below details the Stock Based Employee CompensationExpense for fiscal year ended September 30, 2005:

| **Description**                                                                        | ** ** | ** ** | ** ** | **$’s** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------|------------|--------------|------------|
| Expense prior to acceleration of unvested options        |       | $          | 2,011,978  |         |
| Expense related  to options granted subsequent to the acceleration of unvested options |       | 587,217    |       |
| Result of option  acceleration                                                         |       | 859,570    |       |
| Total                                                                                  |       | $          | 3,458,765  |         |

 

The effects of applying SFAS No. 123 in this proforma disclosure are not indicative of future amounts. SFAS No. 123 doesnot apply to awards prior to 1996.

Theweighted-average grant-date fair value of options granted during the year endedDecember 31, 2006, the three month period ended December 31, 2005 andthe fiscal years ended September 30, 2005 and 2004 were $1.82, $1.13,$1.77 and $1.95, respectively, per option. The fair value of each stock optionis estimated on the date of the grant using the Black-Scholes option-pricingmodel with the following range of assumptions:

| ** **                        | ** ** | ** **                   | ** ** | **Three Month**          | ** ** | ** **             | ** ** | ** **     | ** ** |
|-----------------------------------|------------|------------------------------|------------|-------------------------------|------------|------------------------|------------|----------------|------------|
| ** **                        | ** ** | **Year Ended**          | ** ** | **Period Ended**         | ** ** | **Year Ended**    | ** ** |
| ** **                        | ** ** | **December 31,**        | ** ** | **December 31,**         | ** ** | **September 30,** | ** ** |
| **Assumptions:**                  | ** ** | ** **                   | ** ** | **2006**                      | ** ** | **2005**               | ** ** | **2005**       | ** ** | **2004** | ** ** |
| Expected life                     |       | 5.0  years to 6.25  years(1) |       | 5.75  years to 6.25  years(1) |       | 7  years               |       | 7  years       |       |
| Expected  volatility ranging from |       | 87.46%  - 96.54%(2)          |       | 96.5%  - 96.54%(2)            |       | 52.2%  - 63.9%         |       | 84.9%  to 120% |       |
| Dividends                         |       | none                         |       | none                          |       | none                   |       | none           |       |
| Risk-free interest rate           |       | 4.29% - 5.30%(3)             |       | 4.35% - 4.46%(3)              |       | 4%                     |       | 4%             |       |
|                                   |            |                              |            |                               |            |                        |            |                |            |  |  |

----

(1)          The option life was determined using thesimplified method for estimating expected option life, which qualify as“plain-vanilla” options.

(2)          The stock volatility for each grant ismeasured using the weighted average of historical daily price changes of theCompany’s common stock over the most recent period equal to the expected optionlife of the grant, the historical short term trend of the option and otherfactors, such as expected changes in volatility arising from planned changes inthe Company’s business operations.

(3)          The risk-free interest rate for each grant isequal to the U.S. Treasury yield curve in effect at the time of grant forinstruments with a similar expected life.

(4)          The forfeiture rate for each option grant is6.25%. Upon adoption of the provision all outstanding stock options werevested. The forfeiture rate is reviewed by the Company periodically.

In December 2005, theCompany granted 50,000 shares of restricted common stock to a senior executiveas permitted under the 2005 Stock Incentive Compensation Plan. This grant vests12,500 shares per quarter over four quarters. 12,500 of these restricted sharesvested during each of the quarters ended April 1, 2006, July 1, 2006,September 30, 2006 and December 31, 2006. Compensation expense forthe number of shares issued is recognized over the service period and isrecorded in the consolidated statement of operations as a component of selling,general and administrative expense. For the year ended December 31, 2006and the three month period ended December 31, 2005, compensation expenseof 

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$69,476and $1,523, respectively, have been recognized related to this restricted stockaward. The Company valued this restricted stock grant of $1.41 per shareusing the Black-Scholes option pricing model. This amount is included in thetable above that presents share-basedcompensation expense included in the Company’s consolidated statement ofoperations.

*Net Loss per Basicand Diluted Common Share*

The Company reports netloss per basic and diluted common share in accordance with SFAS No. 128, *Earnings Per Share*, which establishesstandards for computing and presenting earnings per share. Basic earnings pershare excludes dilution and is computed by dividing income available to commonstockholders by the weighted average number of common shares outstanding forthe period. Diluted earnings per share reflects the potential dilution thatcould occur if securities or other contracts to issue common stock wereexercised or converted into common stock or resulted in the issuance of commonstock that then shared in the earnings of the Company, except when the effectwould be anti-dilutive.

*Concentration ofCredit Risk*

Financial instruments that subject the Company toconcentrations of credit risk principally consist of cash equivalents, tradeaccounts receivable, unbilled contract costs and deposits in bank accounts.Deposits in excess of amounts insured by the Federal Deposit InsuranceCorporation (FDIC) of $100,000 are exposed to loss in the event ofnonperformance by the institution. The Company has had cash deposits in excessof the FDIC insurance coverage. The Company deposits its cash and invests inshort-term investments primarily through a national commercial bank.

The Company’s tradeaccounts receivable and unbilled contract costs and fees are primarily fromsales to U.S. government agencies and commercial customers. The Company doesnot require collateral and has not historically experienced significant creditlosses related to receivables or unbilled contract costs and fees fromindividual customers or groups of customers in any particular industry orgeographic area.

*Research andDevelopment Costs*

The Company expensesresearch and development costs as incurred. Research and development and otherrevenue expenses include costs incurred in connection with both funded researchand development and other revenue arrangements and unfunded research anddevelopment activities.

*ComprehensiveIncome (Loss)*

Comprehensive income(loss) includes net loss, change in unrealized gains and losses on marketablesecurities and foreign currency translation adjustments.

*Fair Value ofFinancial Instruments*

The Company’s financial instruments consist of cashequivalents, accounts receivable, unbilled contract costs and fees, warrants topurchase shares of common stock, accounts payable, debt instruments, convertiblenotes, and Series B preferred stock. The estimated fair values of thesefinancial instruments approximate their carrying values at December 31,2006 and 2005. The estimated fair values have been determined throughinformation obtained from market sources and management estimates.

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**D.     INVENTORY**

Inventoryincludes material, labor and overhead and consisted of the following:

| ** **      | ** ** | **December 31,** | ** ** |
|-----------------|------------|-----------------------|------------|
| ** **      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Raw material    |       | $                     | 3,042,286  |   | $ | 2,669,812 |   |
| Work-in-process |       | 2,554,871             |       | 2,880,637 |   |
| Finished goods  |       | 2,348,717             |       | 951,719 |   |
|            |       | $                     | 7,945,874  |   | $ | 6,502,168 |   |

 

The provision for excess and obsolete inventory, net ofusage, for the year ended December 31, 2006, the three months ended December 31,2005 and the fiscal year ended September 30, 2005 and 2004 was $248,299, $72,030,$(708,569) and $(316,386), respectively.

At the end of June 2003,the Company was actively engaged in selling the Shaker product line, and waspursuing a strategy that it hoped would lead to a strategic alliance with alarger company for the development and exploitation of the advantages embodiedin the Uninterruptible Power Supply (“UPS”) system. During the process ofconsidering various options, the Company concluded that both its Shaker and UPSsystem inventories were overvalued based upon the June 2003 plan. TheCompany analyzed the situation, recorded an increase to its valuation reserveof approximately $2.0 million and was actively considering offers for thisproduct line. This reserve was based on the Company’s assessment of thesituation as of that time; The Company had no orders associated with thisreserved inventory and there was no sales force dedicated to the sales andmarketing of these products. During the first quarter of fiscal 2004, theCompany decided to terminate discussions about the possible sale of the Shakerproduct line and focus on generating orders. At the end of the first quarter offiscal 2004, the gross inventory for the Shaker product line inventory totaled$2.1 million and the valuation reserve against that inventory was $2.0 million,or 95%. During the second, third and fourth quarters of fiscal 2004, theCompany was successful in resuming sales levels of Shakers. As a result,inventory that had largely been written-down was used. In addition, the Companyhad originally accrued approximately $900,000 for purchase commitments relatedto the UPS and Shaker product lines (See Note L. Commitments and Contingencies).In December 2005 the Company sold its Shaker and Amplifier product lines andassociated inventory. The table below details the resulting approximatereduction of costs related to both the inventory reserves of our Shaker and UPSproduct lines, as well as reserves established related to the purchasecommitments as follows:

| **Period**                            | ** ** | ** ** | ** ** | ** ** | ** ** | **Value of  Inventory   Reserve Used** | ** ** | **Value of  Purchase  Commitments  Reserve Used** | ** ** | **Period  Reduction to  Cost of  Sales** | ** ** | **Cumulative  Reduction to  Cost of Sales** | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------------|------------|----------------------------------------------------|------------|------------------------------------------------------------|------------|
| 12 Months ended:                      |       |       |       |       |       |                                                  |       |                                                        |       |                                               |       |                                                       |       |   |   |   |   |   |   |
| September 30,                    |       | 2004       |       |       | $          | 525,000                                               |       |                                                        |       | $                                                  | 168,000    |                                                       |       |   | $ | 693,000 |   |   |   | $ | 693,000 |   |   |
| September 30,                    |       | 2005       |       |       | $          | 222,000                                               |       |                                                        |       | $                                                  | 88,000     |                                                       |       |   | $ | 310,000 |   |   |   | $ | 1,003,000 |   |   |
| Three Months Ended  December 31, |       | 2006       |       |       | $          | —                                                |       |                                                        |       | $                                                  | —     |                                                       |       |   | $ | — |   |   |   | $ | 1,003,000 |   |   |
| 12 Months Ended  December 31,    |       | 2006       |       |       | $          | —                                                |       |                                                        |       | $                                                  | —     |                                                       |       |   | $ | — |   |   |   | $ | 1,003,000 |   |   |

 

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**E.**               PROPERTYAND EQUIPMENT

Propertyand equipment consisted of the following: 

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Machinery and  equipment                        |       | $9,675,958            |       | $9,922,080 |   |
| Furniture and  fixtures                         |       | 407,910               |       | 542,110 |   |
| Computer software                               |       | 1,468,078             |       | 1,405,424 |   |
| Leasehold  improvements                         |       | 616,377               |       | 583,178 |   |
|                                            |       | 12,168,323            |       | 12,452,792 |   |
| Less: accumulated depreciation and amortization |       | (9,384,423            | )          | (9,056,360 | ) |
|                                            |       | $2,783,900            |       | $3,396,432 |   |

 

Depreciation and amortization expense relating toproperty and equipment for the year ended December 31, 2006, the threemonth period ended December 31, 2005 and for fiscal years ended September 30,2005 and 2004 was $934,457, $241,899, $1,346,142 and $1,426,343, respectively.

As of December 31, 2006 and 2005, there was$1,486,360, respectively, of property under capital leases included inmachinery and equipment. As of December 31, 2006 and 2005, there was $29,910,respectively, of property under capital leases that were included in computersoftware.

As of December 31, 2006 and 2005, accumulateddepreciation and amortization included $894,303 and $745,667, respectively,associated with these capital leases.

In September 2006 the Company commenced arestructuring in its Power Systems US Division. As a result of thisrestructuring approximately $0.2 million of the net book value ofmachinery and equipment was written-off, see Note V “Restructuring Costs” formore information.

The Company performed animpairment test in the fourth quarter of fiscal 2005, based on historicalresults and cash flow forecast of the operations in the Worcester facility overthe next four years, representing then remaining term of the lease. The Companydid not expect to recoup the value of its long-lived assets at the Worcesterfacility. These assets, before write-down, had an approximate net book value of$1.2 million and were comprised primarily of leasehold improvements madeto the facility and other fixed assets. The Company performed a fair marketanalysis of these assets and determined that a $1.2 million charge wasrequired in the quarter ending September 30, 2005, representing an impairmentof the long-lived assets.

**F.**                INVESTMENTIN BEACON POWER CORPORATION

On September 28, 2001, the Company distributed5,000,000 shares of Beacon Power common stock to its stockholders. Upon thedistribution of the 5,000,000 shares, the Company recorded the distribution ofthe 5,000,000 shares as a reduction of additional paid-in-capital based on thebook value per share prior to the distribution, or $0.59 per share. After thedistribution, the Company owned approximately 11.0% of Beacon Power’s outstandingvoting stock. During June and July 2003, the Company sold all of its shares ofBeacon Power Corporation.

Additionally, the Companyhad a warrant to purchase 173,704 shares of Beacon Power’s common stock thathad an exercise price of $1.25 per share and expired in April 2005. TheCompany accounted for this warrant in accordance with SFAS No. 133 and,therefore, records the warrant at its fair value with changes in fair valuereflected in earnings. In April 2005, the warrant expired unexercised.

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**G.**              CONVERTIBLEDEBT INSTRUMENT AND WARRANT LIABILITIES

*Features of theConvertible Notes and Warrants*

On July 19,2006, the Company entered into a Securities Purchase Agreement (the “PurchaseAgreement”) with the purchasers named therein (the “Purchasers”) in connectionwith the private placement (the “Private Placement”) of:

·       $12,000,000aggregate principal amount of senior secured convertible notes (the “Notes”),convertible into shares of our the Company’s common stock at a conversion priceof $1.65 per share;

·       WarrantA’s to purchase up to an aggregate of 3,636,368 shares of our the Company’scommon stock at a price of $1.815 per share for a period beginning six monthsfrom the date of such warrants and ending on the seventh anniversary of thedate of such warrants; and

·       WarrantB’s to purchase up to an aggregate of 3,636,368 shares of the Company’s commonstock at a price of $1.68 per share for a period of 90 trading days beginningthe later of six months from the date of such warrants and the date the Securitiesand Exchange Commission (the “SEC”) declares effective a shelf registrationstatement covering the resale of the common stock underlying the securitiesissued in the Private Placement (the “Registration Statement”); to the extentthe Warrant B’s are exercised, the Purchasers will receive additional warrants,as described below. Because the registration statement was declared effectiveon September 27, 2006, these warrants were originally exercisable for the90 trading day period beginning six months from the date of such warrants (i.e.May 30, 2007). On December 20, 2006 the Warrant B’s were amended toextend the expiration date of the Warrant B’s issued in the PrivatePlacement from May 30, 2007 to August 31, 2007. In addition, thisamendment amended the definition of “Excluded Stock” set forth in the PurchaseAgreement to enable the Company to issue up to 1.1 million shares of theCompany’s common stock in connection with the early termination of the leasefor the Company’s facility located in Worcester, Massachusetts, without suchshares being subject to the Purchasers’ right of participation set forth in thePurchase Agreement and certain prohibitions set forth in the Notes and relatedwarrants (as discussed in Note V, we ultimately settled the lease for 850,000shares).

In connection with thePrivate Placement, we the Company also entered into a Security Agreement, datedJuly 19, 2006, with the Purchasers, pursuant to which we the Companygranted the Purchasers a security interest in all of our its right, title andinterest in, to and under all of our its personal property and other assets,including the our its ownership interest in the capital stock of our its subsidiaries,as security for the prompt payment in full of all amounts due and owing under theNotes. The following is a summary of the material provisions of the PurchaseAgreement, the Notes, the Warrant A’s and the Warrant B’s. These summaries arenot complete and are qualified in their entirety by reference to the full textof such agreements, each of which is attached as an exhibit to our CurrentReport on Form 8-K filed with the SEC on July 21, 2006 (and isincorporated herein by reference). Readers should review those agreements for acomplete understanding of the terms and conditions associated with the PrivatePlacement.

*Securities PurchaseAgreement*

As noted above, thePurchase Agreement provided for the issuance and sale to the Purchasers of theNotes, the Warrant A’s and the Warrant B’s for an aggregate purchase price of$12,000,000. Other significant provisions of the Purchase Agreement include,among others:

·       therequirement that the Company we pay off all amounts outstanding under ourcredit facility with Silicon Valley Bank (See Note I);

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·       forso long as the Notes are outstanding, the obligation that the Company we offerto the Purchasers the opportunity to participate in subsequent securitiesofferings (up to 50% of such offerings), subject to certain exceptions for,among other things, certain underwritten public offerings and strategicalliances;

·       forso long as the Notes are outstanding, the obligation that the Company we notincur any indebtedness that is senior to, or on parity with, the Notes in rightof payment, subject to limited exceptions for purchase money indebtedness andcapital lease obligations; and

·       the Company’s our obligationto (i) file the Registration Statement with the SEC within 30 daysfollowing the closing of the Private Placement (which we it has satisfied byfiling a Registration Statement on Form S-3 on August 16, 2006),(ii) use our its best efforts to cause the Registration Statement to bedeclared effective within 90 days following the closing of the PrivatePlacement, (which we have it has satisfied , as the Registration Statement wasdeclared effective on September 27, 20072006) and (iii) use our its bestefforts to keep the Registration Statement effective until the earlier of(x) the fifth anniversary of the effective date of the RegistrationStatement, (y) the date all of the securities covered by the RegistrationStatement have been publicly sold and (z) the date all of the securitiescovered by the Registration Statement may be sold without restriction under SECRule 144(k). If wethe Company fails to comply with these or certain otherprovisions, then we the Company will be required to pay liquidated damages of1% of the aggregate purchase price paid by the Purchasers in the PrivatePlacement for the initial occurrence of such failure and 1.5% of such amountfor each subsequent 30 day period the failure continues. The total liquidateddamages under this provision are capped at 24% of the aggregate purchase pricepaid by the Purchasers in the Private Placement.

*Senior SecuredConvertible Notes*

The Notes have an aggregate principal amount of $12million and are convertible into shares of our the Company’s common stock at aconversion price of $1.65, subject to adjustment for stock splits, stockdividends, combinations, distributions of assets or evidence of indebtedness,mergers, consolidations, sales of all or substantially all assets, tenderoffers, exchange offers, reclassifications or compulsory share exchanges.

The Notes bear interest at the higher of (i) 7.0%per annum or (ii) the six-month LIBOR plus 3.5%. Interest is payablequarterly, beginning on October 31, 2006, and may be made in cash or, at theCompany’s option if certain equity conditions are satisfied, in shares of theCompany’s common stock. If interest is paid in shares of common stock, theprice per share will be at a 10% discount to the volume weighted average pricefor the 20 trading days preceding the payment date.

75% of the original principal amount of the Notes isto be repaid in 18 equal monthly installments ($500,000 per month) beginning onFebruary 28, 2007. Such principal payments may be made in cash or, at our theCompany’s option if certain equity conditions are satisfied, in shares of ourcommon stock. If principal is paid in shares of common stock, the price pershare will be the lesser of (i) the conversion price or (ii) a 10%discount to the volume weighted average price for the 20 trading days precedingthe payment date. At any time following the 24 month anniversary of theissuance of the Notes, the holders may elect to require us the Company toredeem for cash all or any portion of the outstanding principal on the Notes;provided, however, that on the 60th month anniversary of the issuance ofthe Notes, the Company we will be required to redeem any remaining outstandingprincipal and unpaid interest. Notwithstanding the foregoing, at any timefollowing the one year anniversary of the effective date of the RegistrationStatement, the Company we may, under certain circumstances, redeem the Notesfor cash equal to 120% of the aggregate outstanding principal amount plus anyaccrued and unpaid interest.

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The Notes areconvertible at the option of the holders into shares of the Company’s commonstock at any time at the conversion price. If at any time following the oneyear anniversary of the effective date of the Registration Statement, thevolume weighted average price per share of common stock for any 20 consecutivetrading days exceeds 175% of the conversion price, then, if certain equityconditions are satisfied, the Company we may require the holders of the Notesto convert all or any part of the outstanding principal into shares of commonstock at the conversion price. The Notes contain certain limitations onoptional and mandatory conversion, including that, absent stockholder approvalof the transaction, the Company we may not issue shares of common stock underthe Notes in excess of 19.99% of the our outstanding shares on the closingdate.

·       TheNotes contain certain covenants and restrictions, including, among others, thefollowing (for so long as any Notes remain outstanding):

·        theCompany we must maintain aggregate cash and cash equivalents equal to thegreater of (i) $1,000,000 or (ii) $3,000,000 *minus*80% of eligible receivables (as defined therein);

·        ifa change of control of the Company occurs, as defined, the holders may elect torequire us to purchase the Notes for 115% of the outstanding principal amountplus any accrued and unpaid interest; and

·        theCompany we may not issue any common stock or common stock equivalents at aprice per share less than the conversion price.

Events of default underthe Notes include, among others, payments defaults, cross-defaults, breaches ofany representation, warranty or covenant that is not cured within the propertime periods, failure to perform certain required activities in a timelymanner, the Company’s our common stock is no longer listed on an eligiblemarket, the effectiveness of the Registration Statement lapses beyond aspecified period and certain bankruptcy-type events involving us or anysignificant subsidiary. Upon an event of default, the holders may elect torequire the Company us to repurchase all or any portion of the outstandingprincipal amount of the Notes for a purchase price equal to the greater of(i) 115% of such outstanding principal amount, plus all accrued but unpaidinterest or (ii) 115% of the then value of the underlying common stock.

*Warrant A’s*

The Warrant A’s entitle the holders thereof topurchase up to an aggregate of 3,636,368 shares of the Company’s our commonstock at a price of $1.815 per share for a period beginning six months from thedate of such warrants and ending on the seventh anniversary of the date of suchwarrants. The exercise price and the number of shares underlying these warrantsare subject to adjustment for stock splits, stock dividends, combinations,distributions of assets or evidence of indebtedness, mergers, consolidations,sales of all or substantially all assets, tender offers, exchange offers,reclassifications or compulsory share exchanges.

If a change of control of the Company occurs, asdefined, the holders may elect to require us to purchase the Warrant A’s for apurchase price equal to the Black-Scholes value of the remaining unexercisedportion of each Warrant A.

For so long as any Warrant A’s remain outstanding, wemay not issue any common stock or common stock equivalents at a price per shareless than the conversion price of the Notes. In the event of a breach of thisprovision, the holders may elect to require us to purchase the Warrant A’s fora purchase price equal to the Black-Scholes value of the remaining unexercisedportion of each Warrant A.

If following the later of(i) the effective date of the Registration Statement and (ii) the sixmonth anniversary of the issuance date, the volume weighted average price pershare of our common stock for any 

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20consecutive trading days exceeds 200% of the exercise price, then, if certainequity conditions are satisfied, we may require the holders of the Warrant A’sto exercise up to 50% of the unexercised portions of such warrants. Iffollowing the 24 month anniversary of the issuance date, the volume weightedaverage price per share of our common stock for any 20 consecutive trading daysexceeds 300% of the exercise price, then, if certain equity conditions aresatisfied, we may require the holders of the Warrant A’s to exercise all or anypart of the unexercised portions of such warrants.

*Warrant B’s*

The Warrant B’s entitle the holders thereof topurchase up to an aggregate of 3,636,368 shares of our common stock at a priceof $1.68 per share for a period of 90 trading days beginning the later of sixmonths from the date of such warrants and the date the SEC declares effectivethe Registration Statement. As noted above, as a result of an amendment, the expirationdate of the Warrant B’s is now August 31, 2007. The exercise price and thenumber of shares underlying these warrants are subject to adjustment for stocksplits, stock dividends, combinations, distributions of assets or evidence ofindebtedness, mergers, consolidations, sales of all or substantially allassets, tender offers, exchange offers, reclassifications or compulsory shareexchanges.

If a change of control of the Company occurs, theholders may elect to require us to purchase the Warrant B’s for a purchaseprice equal to the Black-Scholes value of the remaining unexercised portion ofeach Warrant B.

For so long as any Warrant B’s remain outstanding, wemay not issue any common stock or common stock equivalents at a price per shareless than the conversion price of the Notes. In the event of a breach of thisprovision, then the holders may elect to require us to purchase the Warrant B’sfor a purchase price equal to the Black-Scholes value of the remainingunexercised portion of each Warrant B.

If following the effective date of the RegistrationStatement, the volume weighted average price per share of our common stock forany 20 consecutive trading days exceeds 150% of the exercise price, then, ifcertain equity conditions are satisfied, we may require the holders of theWarrant B’s to exercise any unexercised portions of such warrants.

To the extent the WarrantB’s are exercised, the holders thereof will receive additional seven-yearwarrants to purchase a number of shares of our common stock equal to 50% of thenumber of shares of common stock purchased upon exercise of the Warrant B’s(the “Additional Warrants”). The Additional Warrants will have an exerciseprice of $1.815 per share and shall be substantially the same as the Warrant A’s.

*Placement AgentWarrants*

First Albany Capital (“FAC”) acted as placement agentin connection with the Private Placement. In addition to a cash transactionfee, FAC or its designees were entitled to receive five-year warrants topurchase 218,182 shares of the Company’s common stock at an exercise price of$1.87 per share. These warrants will be callable after the second anniversaryof the closing of the Private Placement if the 20-day volume weightedaverage price per share of the Company’s common stock exceeds 175% of theexercise price. At the direction of FAC, these warrants were issued to FirstAlbany Companies Inc., the parent of FAC.

On December 20, 2006, in connection with theearly termination of the lease for the Company’s Worcester facility (see Note T),the Company entered into a First Amendment to Securities Purchase Agreement(the “Amendment”) with certain of the Purchasers who participated in theCompany’s Private Placement.

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Pursuant to theAmendment:

·       thedefinition of “Excluded Stock” set forth in the Purchase Agreement was amendedto enable the Company to issue up to 1.1 million shares of the Company’s commonstock in connection with the early termination of the lease for the Company’sfacility located in Worcester, Massachusetts, without such shares being subjectto the Purchasers’ right of participation set forth in the Purchase Agreementand certain prohibitions set forth in the Notes and related warrants; and

·       the Company agreed toextend the expiration date of the Warrant B’s issued in the Private Placementfrom May 30, 2007 to August 31, 2007.

*Accounting for theConvertible Debt Instrument and Warrants*

The Company has determined that the Notes constitute ahybrid instrument that has the characteristics of a debt host contract containingseveral embedded derivative features that would require bifurcation andseparate accounting as a derivative instrument pursuant to the provisions ofSFAS 133,. “Accounting for Derivative Instruments and Hedging Activities” (SFAS133). The Company has identified all of thederivatives associated with the July 19, 2006 financing, and concludedthat two of the derivatives cannot be reliably measured nor reliably associatedwith another derivative that can be reliably measured. As such, the Company hasappropriately valued these derivatives as a single hybrid contracttogether with the Notes. The contract will be remeasured at each period atthe fair value with the changes in fair value recognized in the statement ofoperations until the notes are settled. As permitted under SFAS 155, theCompany has elected, as of January 1, 2007, to measure the Notes in theirentirety at fair value with changes in fair value recognized as either gain orloss. This election was made by the Company after determining that theaggregate fair value of the Notes to be more meaningful in the context of theCompany’s financial statements than if separate fair values were assigned toeach of the multiple embedded instruments contained such Notes.

The Company has determined that thiselection will have no impact on the accounting for the Notes.

Upon issuance, the Warrant A’s and Warrant B’s, alongwith the Placement Agent Warrants did not meet the requirements for equityclassification set forth in EITF Issue 00-19, “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in a Company’s OwnStock,” because such warrants (a) must be settled in registered shares, and(b) are subject to substantial liquidated damages if the Company s unableto maintain the effectiveness of the resale registration of the shares and (c) thereis a cash out election using a Black-Scholes valuation under various circumstances.Therefore such Warrants are required to be accounted for as freestandingderivative instruments pursuant to the provisions of SFAS 133. Changes in fairvalue are recognized as either a gain or loss in the statement of operationsunder the caption “other expense”. In addition, the Warrant B’s are beingclassified as a current liability on the balance sheet as they are outstandingfor less than one year.

Upon issuance of the Notes and Warrants the Companyallocated the proceeds received to the Notes and the Warrants on a relativefair value basis. As a result of such allocation, the Company determined theinitial carrying value of the Notes to be $9.4 million. The Notes wereimmediately marked to fair value, resulting in a derivative liability in theamount of $16.3 million. As of December 31, 2006, the Notes have beenmarked to fair value resulting in a derivative liability of $12.7 million. The netcharge to other (income) expense for the year ended December 31, 2006 was$4.2 million.

Upon issuance, the Company allocated $2.7 million ofthe initial proceeds to the Warrants and immediately marked them to fair valueresulting in a derivative liability of $4.9 million. As of December 31,2006, the Warrants have been marked to fair value resulting in a derivativeliability of $2.9 million. The charge to other (income) expense for the yearended December 31, 2006 was $0.3 1 million. The Company paid approximately$1.1 million in cash transaction costs and incurred another $0.2 million incosts based upon the fair value of the Placement Agent Warrants. These costswere immediately expensed in the three 

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and nine month periodsended September 30, 2006 as other (income) expense. The transaction costswere immediately expensed as part of the fair value adjustment.

The debt discount in the amount of $2.6 million(resulting from the allocation of proceeds) is being amortized to interestexpense using the effective interest method over the expected term of theNotes. The Company amortized approximately $0.2 million for the year endedDecember 31, 2006, which is a component of interest expense.

A summaryof changes in the Notes, Warrants and Placement Agent Warrants is as follows:

| ** **                                  | ** ** | **Fair Value  of Notes** | ** ** | **Fair Value  of Warrant  Liabilities** | ** ** | **Total**  | ** ** |
|---------------------------------------------|------------|------------------------------------|------------|---------------------------------------------------|------------|------------|------------|
| Allocation of  initial proceeds             |       | $                                  | 9,351,084  |                                              | $          | 2,648,916  |       | $ | 12,000,000 |   |
| Transaction costs                           |       | $                                  | (1,064,207 | )                                                 | $          | —     |       | $ | (1,064,207 | ) |
| Initial fair  value adjustment              |       | $                                  | 8,002,518  |                                              | $          | 2,204,950  |       | $ | 10,207,468 |   |
| July 19, 2006                               |       | $                                  | 16,289,395 |                                              | $          | 4,853,866  |       | $ | 21,143,261 |   |
| Amortization of  debt discount              |       | $                                  | 239,874    |                                              | $          | —     |       | $ | 239,874 |   |
| Restructuring charge  fair value adjustment |       | $                                  | —     |                                              | $          | 193,117    |       | $ | 193,117 |   |
| Fair value  adjustment                      |       | $                                  | (3,788,787 | )                                                 | $          | (2,126,430 | )          | $ | (5,915,217 | ) |
| Balance December 31,  2006                  |       | $                                  | 12,740,482 |                                              | $          | 2,920,553  |       | $ | 15,661,035 |   |

 

**H.**              LINEOF CREDIT

On December 12, 2003, the Company amended itsloan agreement with Silicon Valley Bank (the “Bank”). Under the amendedagreement, the Bank agreed to provide the Company with a line of credit of upto $6,250,000 (the “Amended Loan”). The Amended Loan was secured by most of theassets of the Company and advances under the Amended Loan were limited to 80%of eligible accounts receivables, which would permit borrowings up to$5,000,000. Interest on outstanding borrowings accrued at a rate equal to theBank’s prime rate of interest plus 1.5% per annum. In addition, the Companyagreed to pay to the Bank a collateral handling fee of 2.4% per annum of theaverage daily outstanding balance. The interest rate could increase to the Bank’sprime rate plus 3.0% per annum and the collateral handling fee increases to3.0% per annum if the Company failed to meet certain financial ratios. Inaddition, the Company had agreed to the following fees: (i) a $23,250non-refundable facility fee upon the execution of the agreement; (ii) anunused line fee in an amount equal to 0.50% per annum on the difference between$5 million and the average daily principal balance of the loansoutstanding during the month; and (iii) an early termination fee of$25,000 if the Company terminates the agreement before June 12, 2004. TheAmended Loan contained certain financial covenants relating to net tangibleworth, as defined, which the Company had to satisfy in order to continueborrowing from the Bank. The Amended Loan was due to mature on December 9,2004. In connection with the Amended Loan, the Company issued to the Bank awarrant to purchase up to 16,164 shares of its common stock, at an exerciseprice of $2.32 per share. This warrant was immediately exercisable and expireson December 11, 2010. The Company valued this warrant at $32,087, usingthe Black-Scholes option-pricing model and treated this as a deferred financingcost and amortized this value on a straight line basis through December 9,2004. As of September 30, 2004, the Company was in compliance with thecovenants of this agreement. On December 21, 2004 the Company amended theAmended Loan to extend its expiration through March 1, 2005.

Effective January 31, 2005, the Company enteredinto a new loan agreement with the Bank (the “New Loan”), which replaced theAmended Loan. Under the terms of the New Loan, the Bank agreed to provide theCompany with a credit line of up to $7.0 million. The New Loan was secured bymost of the assets of the Company and advances under the New Loan were limitedto 80% of eligible receivables and up to $1.0 million based on the levels ofeligible inventory. Interest on outstanding borrowings accrued at 

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the Bank’s prime rate ofinterest plus 2% per annum. In addition, the Company paid to the Bank acollateral handling fee of $1,000 per month and agreed to the followingadditional fees: (i) $25,000 commitment fee; (ii) an unused line feein the amount of 0.5% per annum; and (iii) an early termination fee of0.5% of the total credit line if the Company terminated the New Loan within thefirst six months. The New Loan contained certain financial covenants relatingto tangible net worth, as defined, which the Company was required to satisfy inorder to continue to borrow from the Bank.

On June 29, 2005, the New Loan was modifiedpursuant to a Loan Modification Agreement (the “Modification Agreement”)between the Company and the Bank. The Modification Agreement had an effectivedate of May 31, 2005. Under the Modification Agreement, certain financialcovenants relating to tangible net worth and minimum cash, which covenants theCompany had to satisfy in order to continue to borrow from the Bank, weremodified. The Bank alsoprovided a waiver for the Company’s failure to comply with the minimum tangiblenet worth requirements as of May 31, 2005. In addition, certainconditions precedent to the making of advances were also modified. TheModification Agreement was set to expire on January 30, 2006. Asconsideration for the modifications, the Company (i) paid the Bank amodification fee of $20,000 and (ii) issued to the Bank a 10-year warrantto purchase 151,515 shares of the Company’s common stock at an exercise priceof $1.386 per share. The Company valued these warrants at $119,427 using the Black-Scholesoption pricing model with the followingassumptions: an expected life of seven years, expected volatility of 52.3%, nodividends, and risk-free interest rate of 4.0%. The Company has treated this asa deferred financing cost and amortized this value on a straight line basisthrough the remaining term of the New Loan.

On November 21, 2005, the New Loan was modifiedagain pursuant to a Second Loan Modification and Security Agreement (the “SecondLoan Modification Agreement”) between the Company and the Bank. Under the Second Loan Modification Agreement,the Bank modified the terms related to the collection of receivables foramounts outstanding under the New Loan, as well as the minimum tangible networth covenant, as defined, which the Company had to maintain in order tocontinue to borrow from the Bank. The Bank also provided waivers for theCompany’s failure to comply with the minimum tangible net worth requirements asof August 6, 2005 and September 30, 2005. In addition, the SecondLoan Modification Agreement provided the ability to borrow up to $3,000,000 ona revolver basis paying only interest provided that the Company remained incompliance with all financial covenants, as defined. The Company paidthe Bank’s legal costs associated with the Second Loan Modification Agreement,which were approximately $5,000.

Effective January 31, 2006, the Company enteredinto a Third Loan Modification Agreement (“Third Loan Modification Agreement”)with the Bank, which amended the Company’s credit facility with the Bank. TheThird Loan Modification Agreement, modified the credit facility by extendingthe maturity date through February 28, 2006. There were no othermodifications.

Effective February 10, 2006, the Company enteredinto a Fourth Loan Modification Agreement (the “Fourth Loan ModificationAgreement”) with the Bank, which amended its then existing credit facility (asamended, the “Loan Agreement”). Under the terms of the Loan Agreement, the Bankagreed to provide the Company with a credit line of up to $7.0 million. TheLoan Agreement was secured by most of the assets of the Company and advancesunder the Loan Agreement were limited to 80% of eligible receivables and up to$1.0 million based on the levels of eligible inventory. Interest on outstandingborrowings accrued at the Bank’s prime rate of interest plus 1.5% per annum. Inaddition, the Loan Agreement provided the ability to borrow up to $3,000,000 ona revolver basis paying only interest provided that the Company remained incompliance with all financial covenants, as defined. In addition, the Companyagreed to pay to the Bank a collateral handling fee of $750 per month andagreed to the following additional fees: (i) $25,000 commitment fee; (ii) anunused line fee in the amount of 0.5% per annum; and (iii) an earlytermination fee of 0.5% of the total credit line if we terminated the LoanAgreement within the first six months. The Loan Agreement contained certainfinancial covenants relating 

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to tangible net worth, asdefined, which we had to satisfy in order to continue to borrow from the Bank. TheLoan Agreement was set to expire on January 29, 2007.

In connection with, and asa condition precedent to, the completion of the Private Placement, on July 19,2006, the Company paid all amounts due and owing under its credit facility withSilicon Valley Bank (approximately $2 million) and terminated such facility. Indoing so the Company incurred a termination fee of $17,500 and legal fees of$8,500. In addition the Company charged to interest expense the remainingdeferred financing costs of $14.583 upon termination of the credit facility.

**I.**                   REDEEMABLECONVERTIBLE SERIES A AND SERIES B PREFERRED STOCK AND CONVERTIBLE SUBORDINATEDDEBENTURES

*Series AConvertible Preferred Stock.*

On February 18, 2003, the Company entered into afinancing transaction that totaled approximately $4 million. As part ofthis transaction, the Company raised approximately $3.2 million of equitycapital through the issuance of 253.8 shares of its Series A convertiblepreferred stock, $0.01 par value per share, (“Series A”), and warrants topurchase up to 2,538,000 shares of its Common Stock from 21 accreditedinvestors. During the years ended September 30, 2004 and 2003, 132.7 and121.1 shares of the Series A Preferred Stock were converted into 1,327,000and 1,211,000 shares of Common Stock, respectively. After these conversions, asof September 30, 2004, there were no Series A Preferred Stockoutstanding.

On September 5, 2003, the Company completed thesale of $762,500 secured subordinated convertible debentures as contemplated bythe Series A financing transaction. The Company received proceeds of$731,060, net of transaction costs. The subordinated convertible debentureswere due and payable on September 5, 2006. The secured convertiblesubordinated debentures were initially convertible at a conversion price pershare of $1.25 into 666,000 shares of Common Stock. The subordinatedconvertible debentures accrued interest of 10% per annum, increasing to 12% perannum on January 1, 2004. The interest for the first year was paid atclosing by issuing 90,390 shares of Common Stock, valued based on the averageof the closing bid and ask price of the Common Stock on the Nasdaq NationalMarket for the five trading days preceding September 5, 2003, or $79,181.The Company had recorded this as prepaid interest and amortized the pro-ratashare of the interest through September 30, 2003, or $5,432. All furtherdividends were to be paid on a quarterly basis. The Company had the right topay these dividends in cash or in shares of its Common Stock; in October 2003all outstanding convertible debentures were converted into Common Stock of theCompany.

H.C. Wainwright & Co., Inc. (“HCW”)served as the placement agent for this transaction. As part of their commissionHCW received a cash placement fee of $228,275 and a warrant to purchase anaggregate of 163,145 shares of Common Stock at an exercise price of $0.01 pershare. This warrant was immediately exercisable and expires on February 18,2008. The Company has valued this warrant at $142,332, using the Black-Scholesoption-pricing model and has treated this as a transaction cost. During2004, HCW exercised a portion of these warrants for 67,162 shares of CommonStock. As of December 31, 2006 and 2005, warrants to purchase an aggregateof 10,197 and 30,590 shares of Common Stock remain outstanding, respectively.

In connection with the debt portion of this financing,HCW received a cash placement fee of $58,275 and an additional warrant from theCompany to purchase an aggregate of 42,920 shares of Common Stock at anexercise price of $0.01. The warrant was issued on February 18, 2003 butwas not exercisable until the closing of the debt portion of this financing andexpires on February 18, 2008. The Company has valued this warrant at$37,444, using the Black-Scholes option-pricing model and hastreated this as a transaction cost. As of December 31, 2006, warrants topurchase an aggregate of 4,599 shares of Common Stock remain outstanding. Inlieu of the cash placement fee, HCW elected to receive a warrant from theCompany to purchase an aggregate of 100,148 shares of Common Stock at anexercise price of $0.01 per 

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share. This warrant wasissued on February 18, 2003 but was not exercisable until the closing ofthe debt portion of the financing and will expire on February 18, 2008.The Company has valued this warrant at $87,371, using the Black-Scholesoption-pricing model and has treated this as a transaction cost. During2004, HCW exercised a portion of these Warrants for 37,400 shares of CommonStock. As of December 31, 2006, warrants to purchase an aggregate of19,864 shares of Common Stock remain outstanding.

In October 2003,the holders of the convertible subordinated debentures converted $762,500 into610,000 shares of the Company’s Common Stock. As a result of this conversion,the Company recorded the remaining unamortized balance of the prepaid firstyear interest, or $81,155, in October 2003. Also in October 2003, anadditional investment of $70,000 was made by issuing $70,000 of convertiblesubordinated debentures. The Company also issued 8,298 shares of Common Stockas payment of the first year interest, valued based on the average of theclosing bid and ask price of the Common Stock on the Nasdaq National Market forthe five trading days preceding February 18, 2003. These securedconvertible subordinated debentures were subsequently converted at a conversionprice per share of $1.25 into 56,000 shares of Common Stock. As a resultof this conversion, the Company recorded all of the interest on thesedebentures in October 2003. In connection with this transaction, theCompany issued warrants to purchase up to 28,000 shares of Common Stock.Warrants which were exercised at a price of $1.00 per share, and warrants topurchase up to 28,000 shares of Common Stock which were exercisable for onebusiness day after the date of their issuance and had an exercise price of$0.01 per share. The note purchase agreement required the registrationstatement underlying the common stock being declared effective by the SEC.Failure to satisfy this contingency may have resulted in a portion or all ofthe proceeds being returned to the investors. The Company filed the requiredregistration statement with the SEC on December 23, 2003 and it wasdeclared effective on December 31, 2003. After the resolution of this itemoutside the Company’s control, the Company accounted for the transaction inaccordance with Emerging Issues Task Force (“EITF”) No.00-27, *Application of Issue No. 98-5 to CertainConvertible Instruments (“EITF No. 00-27”),* allocating theproceeds received net of transaction costs based on the relative fair value ofthe subordinated convertible debentures and the warrants issued to theinvestor, and then to any beneficial conversion rights contained in theconvertible redeemable preferred securities as follows:

| **Security**                         | ** ** | ** ** | ** ** | **Face Value** | ** ** | **Fair Value** | ** ** | **Allocation of  Proceeds, Net of  Transaction Costs** | ** ** | **Beneficial  Conversion  Feature** | ** ** | **Discount** | ** ** |
|--------------------------------------|------------|------------|------------|---------------------|------------|---------------------|------------|----------------------------------------------------------------------------|------------|-------------------------------------|------------|--------------|------------|
| Subordinated  convertible debentures |       |       | $          | 70,000              |       |                | $          | 70,000                                                                     |       |                                | $          | 23,423       |       |   |   | $ | 138,977 |   |   | $ | 185,554 |   |
| Warrants                             |       |       | —     |                |       | $                   | 139,196    |                                                                       |       | $                                   | 46,577     |         |       |   | — |   |   | — |   |
|                                      |            |            |            |                     |            |                     |            |                                                                            |            |                                     |            |              |            |  |  |  |  |  |  |  |  |  |  |  |

 

The Company recognized thediscount as interest expense through the earliest date of conversion andaccordingly, the Company recorded $185,554 of additional interest expenseduring the period ended September 30, 2004.

*Series BConvertible Preferred Stock.*

On October 31, 2003, the Company completed a$7.7 million equity transaction involving the issuance of 1,535 shares ofits Series B Convertible Preferred Stock, $0.01 par value per share (the “Series BPreferred Stock”), and warrants to purchase up to 1,228,000 shares of theCompany’s Common Stock, to accredited investors (the “October 2003Financing Transaction”).

Inconnection with the October 2003 Financing Transaction, the Company issuedshares of Series B Preferred Stock for $5,000 per share. The Series BPreferred Stock is convertible into a number of shares of Common Stock equal to$5,000 divided by the conversion price of the Series B Preferred Stock,which was initially $2.50. The total number of shares of Common Stock issuableupon conversion of the shares of 

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Series B Preferred Stock issued and sold wasinitially 3,070,000. As of September 30, 2006 and 2005, 1,190 and 1,110shares of the Series B Preferred Stock had been converted into 2,400,995and 2,220,000 shares of Common Stock. As a result of the conversions in fiscal2004, the Company recorded the unamortized balance of the prepaid firstsix-month dividend on the converted securities, or $83,248, during the twelvemonths ended September 30, 2004. In April 2006, upon the conversionof 80 shares of Series B Preferred Stock, the Company issued 180,995shares of common stock. As of December 31, 2006 and 2005, the liquidationpreference of the remaining 345 and 425 shares of Series B Preferred Stockwas $1,725,000 and $2,125,000, respectively, and these were convertible into837,379 and 961,538 shares of Common Stock, respectively. Prior to October 1,2005, the Series B Preferred Stock accrued dividends of 6% per annum. On October 1,2005, dividends began accruing on the Series B Preferred Stock at a rateof 8% per annum. The dividend for the first six months was paid at closing byissuing 76,054 shares of Common Stock, valued based on the average of theclosing bid and ask price of the Common Stock on the Nasdaq National Market forthe five trading days preceding October 31, 2003. All further dividendspaid on a semi-annual basis. Except in certain limited circumstances, theCompany may opt to pay these dividends in cash or in shares of Common Stock. TheCompany has paid all dividends in shares of common stock, in lieu of cashdividends. The table below details out the number of shares and the amountcharged to other expense during the respective periods:

| **Period**                                   | ** ** | ** ** | ** ** | **Shares Issued** | ** ** | **$ Value of Dividend** | ** ** |
|----------------------------------------------|------------|------------|------------|------------------------|------------|----------------------------------------|------------|
| Twelve Months  ended September 30, 2004 |       |       | 76,054     |                   |       |                                   | $          | 230,215 |   |   |
| Twelve Months  ended September 30, 2005 |       |       | 52,636     |                   |       |                                   | $          | 127,500 |   |   |
| Three Months  Ended December 31, 2005   |       |       | 30,449     |                   |       |                                   | $          | 67,292 |   |   |
| Twelve Months ended  December 31, 2006  |       |       | 70,792     |                   |       |                                   | $          | 146,444 |   |   |

 

As part of the October 2003 Financing Transaction,the Company also issued warrants to purchase up to 1,228,000 shares of itsCommon Stock (See Note O). These warrants are exercisable for a five-year termand had an initial exercise price of $3.32 per share, which represented 110% ofthe average closing price of the Common Stock for the five trading dayspreceding October 31, 2003. These warrants were immediately exercisableand expire on October 31, 2008. The Company has valued these warrants at$2,935,558, using the Black-Scholes option-pricing model. As of December 31,2006 and 2005, warrants to purchase an aggregate of 1,116,000 and 1,228,000shares of Common Stock remain outstanding, respectively. During the year ended December 31,2006, 112,000 of the warrants were exercised in a cashless exercise, resultingin the issuance of 6,142 shares of Common Stock.

Burnham Hill Partners, LLC, a division of Pali Capital, Inc.(“BHP”), served as placement agent for this transaction. As part of itscommission, BHP received a cash placement fee equal to 7% of the gross proceedsreceived by the Company in connection with the financing. Based on the amountof the financing, this cash placement fee was approximately $540,000 (includingreimbursement of out-of-pocket expenses), which was paid from gross proceeds receivedby the Company. BHP will also receive a cash placement fee of 4% of theaggregate consideration received by the Company in connection with the cashexercise of warrants issued to the investors in the financing, as well ascertain warrants issued in the Company’s previous financing (which wereexercised prior to October 31, 2003). In addition, BHP, or its assigns,received warrants, with an exercise price of $0.01 per share, to purchase anaggregate of 150,430 shares of Common Stock. These warrants were immediatelyexercisable and expire on October 21, 2008. The Company has valued thesewarrants at $435,166, using the Black-Scholes option-pricing model and hastreated this as a transaction cost. As of December 31, 2006 and 2005,warrants to purchase an aggregate of 5,182 shares of Common Stock remainoutstanding.

Thestock purchase agreement required that the registration statement registeringthe resale of the Common Stock, underlying the Series B Preferred Stockand related warrants, be filed with the SEC within 45 days following theclosing and be declared effective by the SEC, within 120 days following theclosing. 

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Failure to satisfy this contingency may have resultedin liquidating damages or a portion or all of the proceeds being returned tothe investors. The Company filed the required registration statement with theSEC on December 23, 2003 and it was declared effective on December 31,2003. However, because the Company failed to initially file this registrationstatement with the SEC on or before December 15, 2003, it was potentiallyrequired to pay liquidated damages to each of the investors in the privateoffering of 3% of the investor’s investment in cash for the first month ofdelay and 1.5% of the investor’s investment for each additional month of delayin cash or shares of the Company’s common stock, at its option. During fiscal2004, the Company had accrued $61,400, for these potential penalties, which isincluded in selling, general and administrative expenses. After the resolutionof this item outside the Company’s control, the Company accounted for thetransaction in accordance with EITF 00-27, *Applicationof Issue No. 98-5 to Certain Convertible Instruments,*allocating the proceeds received net of transaction costs based on the relativefair value of the redeemable convertible Series B Preferred Stock and thewarrants issued to the investors, and then to any beneficial conversion rightscontained in the convertible redeemable preferred securities as follows:

| ** **                                            | ** ** | ** ** | ** ** | ** ** | ** ** | **Allocation of**         | ** ** | **Beneficial**             | ** ** | ** **  | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|--------------------------------|------------|----------------------------|------------|-------------|------------|
| ** **                                            | ** ** | **Face**   | ** ** | **Fair**   | ** ** | **Proceeds, Net of** | ** ** | **Conversion**             | ** ** | ** **  | ** ** |
| **Security**                                          | ** ** | ** ** | ** ** | **Value**  | ** ** | **Value**                      | ** ** | **Transaction Costs** | ** ** | **Feature** | ** ** | **Discount** | ** ** |
| Redeemable  convertible Series B Preferred Stock |       | $          | 7,675,000  |       | $          | 12,398,195                     |       |                       | $          | 5,247,393   |       |   | $ | 3,655,607 |   | $ | 6,083,214 |   |
| Warrants                                              |       | —     |       | $          | 2,935,558  |                           |       | $                          | 1,242,441  |        |       | — |   | — |   |
|                                                       |            |            |            |            |            |                                |            |                            |            |             |            |  |  |  |  |  |  |  |  |  |

 

The Company recognized the discount as interestexpense through the earliest date of conversion and accordingly, the Companyrecorded $6,083,214 of additional interest expense during the year ended September 30,2004.

As a result of the December 2004 financingtransaction (as described in Note N), in accordance with the anti-dilutionprovisions of the Company’s Series B Convertible Preferred Stock, theCompany was required to adjust the conversion price of the remaining 425 sharesof Series B Preferred Stock outstanding at that time. These shares of Series BPreferred Stock have a liquidation preference of $5,000 per share and areconvertible into a number of shares of Common Stock equal to $5,000 divided bythe conversion price of the Series B Preferred Stock, which, as a resultof the December 2004 Financing Transaction, was adjusted from $2.50 pershare to $2.36 per share. As of the December 2004 financing transaction,the liquidation preference of the remaining 425 shares of Series BPreferred Stock was $2,125,000, and these were convertible into 900,424 sharesof Common Stock, after adjustment. The result of the December 2004financing transaction was an additional adjustment of $126,059, which wasrecorded as interest expense for the fiscal year ended September 30, 2005.

In addition, in accordance with the anti-dilutionprovisions of the warrants issued in connection with the sale of theSeries B Preferred Stock (the “Series B Warrants”), the Company wasalso required to adjust the exercise price of the Series B Warrants. TheSeries B Warrants are exercisable for up to 1,228,000 shares of CommonStock, are exercisable for a five-year term and had an initial exercise priceof $3.32 per share. As a result of the December 2004 financingtransaction, the exercise price on these warrants was adjusted to $3.06 pershare (See Note N). The Company re-valued these warrants using theBlack-Scholes option pricing model with the following assumptions: an expectedlife of four years, expected volatility of 73.4%, no dividends, and risk-freeinterest rate of 4.0%, resulting in an additional adjustment of $42,920, whichwas recorded as interest expense for the fiscal year ended September 30,2005.

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As aresult of the December 2004 financing transaction, the Company recordedthe following non-cash charges as interest expense in its Statement ofOperations during the fiscal year ended September 30, 2005:

| **Security**                                          | ** ** | ** ** | ** ** | **Conversion/  Exercise Price** | ** ** | **Adjusted  Conversion/  Exercise Price** | ** ** | **Interest  Expense** | ** ** |
|-------------------------------------------------------|------------|------------|------------|--------------------------------------|------------|------------------------------------------------|------------|-----------------------|------------|
| Redeemable convertible  Series B Preferred Stock |       |       | $          | 2.50                                 |       |                                           |       | $                     | 2.35       |   |   | $ | 126,059 |   |
| Warrants to purchase  Common Stock                    |       |       | $          | 3.32                                 |       |                                           |       | $                     | 3.06       |   |   | $ | 42,920 |   |
| Total                                                 |       |       |       |                                 |       |                                           |       |                  | * *   | $168,979 | * * |

 

As a result of the August 2005financing transaction (as described in Note N), in accordance with theanti-dilution provisions of the Company’s Series B Convertible PreferredStock, the Company was required to adjust the conversion price of the remaining425 shares of Series B Preferred Stock outstanding at that time. Theseshares of Series B Preferred Stock have a liquidation preference of $5,000per share and are convertible into a number of shares of Common Stock equal to$5,000 divided by the conversion price of the Series B Preferred Stock,which, as a result of the December 2004 Financing Transaction, had beenadjusted from $2.50 per share to $2.35 per share and as a result of the August 2005Financing transaction had been adjusted from $2.35 per share to $2.21 pershare. At the time of the August 2005 financing transaction, 425 shares ofthe Series B Preferred Stock remained un-converted into shares of CommonStock. As of the August 2005 financing transaction, the liquidationpreference of the remaining 425 shares of Series B Preferred Stock was$2,125,000, and these were convertible into 961,538 shares of Common Stock,after adjustment. The result of the August 2005 financing transaction wasan additional adjustment of $144,231, which was recorded as interest expensefor the fiscal year ended September 30, 2005.

In addition, in accordance with the anti-dilutionprovisions of the Series B warrants issued in connection with the sale ofthe Series B Preferred Stock (the “Series B Warrants”), the Companywas also required to adjust the exercise price of the Series B Warrants. TheSeries B Warrants are exercisable for up to 1,228,000 shares of CommonStock, are exercisable for a five-year term and had an initial exercise priceof $3.32 per share. As a result of the December 2004 financingtransaction, the exercise price on these warrants was adjusted to $3.06 pershare (See Note N). As discussed above, as a result of the August 2005financing transaction, the exercise price on these warrants was adjusted to$2.93 per share (See Note N). In addition, as a result of the August 2005financing transaction The Company re-valued these warrants using theBlack-Scholes option pricing model with the following assumptions: an expectedlife of four years, expected volatility of 52.98%, no dividends, and risk-freeinterest rate of 4.0%, resulting in an additional adjustment of $21,825, whichwas recorded as interest expense for the fiscal year ended September 30,2005.

As aresult of the August 2005 financing transaction, the Company recorded thefollowing non-cash charges as interest expense in its Statement of Operationsduring the fiscal year ended September 30, 2005:

| **Security**                                          | ** ** | ** ** | ** ** | **Conversion/  Exercise Price** | ** ** | **Adjusted  Conversion/  Exercise Price** | ** ** | **Interest  Expense** | ** ** |
|-------------------------------------------------------|------------|------------|------------|--------------------------------------|------------|------------------------------------------------|------------|-----------------------|------------|
| Redeemable convertible  Series B Preferred Stock |       |       | $          | 2.35                                 |       |                                           |       | $                     | 2.21       |   |   | $ | 144,231 |   |
| Warrants to purchase Common  Stock                    |       |       | $          | 3.06                                 |       |                                           |       | $                     | 2.93       |   |   | $ | 21,825 |   |
| Total                                                 |       |       |       |                                 |       |                                           |       |                  | * *   | $ | 166,056 | * * |

 

Ardour CapitalInvestments, LLC (“Ardour”), acted as the Company’s financial advisor inconnection with the August 2005 financing transaction. The Company agreedto pay Ardour a fee equal to 6% of the gross proceeds received by the Companyin connection with the financing. Based on the amount of the financing, thisfee was approximately $350,000, which was paid from gross proceeds received bythe Company. In addition, the Company, as part of Ardour’s fee, issuedwarrants, with an exercise price of 

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$1.84per share, to purchase 93,523 shares of Common Stock. These warrants areimmediately exercisable and have a five year term. The Company valued thesewarrants at $43,122, using the Black-Scholes option pricing model, with thefollowing assumptions: an expected life of five years, expected volatility of52.98%, no dividends, and risk-free interest rate of 4%.

As a result of the July 19, 2006 PrivatePlacement (as described in Note G), in accordance with the anti-dilutionprovisions of the Company’s Series B Convertible Preferred Stock, theCompany was required to adjust the conversion price of the remaining 345 sharesof Series B Preferred Stock outstanding at that time. These shares of Series BPreferred Stock have a liquidation preference of $5,000 per share and areconvertible into a number of shares of Common Stock equal to $5,000 divided bythe conversion price of the Series B Preferred Stock, which, as a resultof the July 19, 2006 Private Placement, had been adjusted from $2.21 pershare to $2.07 per share. At the time of the July 19, 2006 PrivatePlacement, 345 shares of the Series B Preferred Stock remainedun-converted into shares of Common Stock. As of the July 19, 2006 Private Placementthe liquidation preference of the remaining 345 shares of Series BPreferred Stock was $1,725,000, and these are convertible into 833,333 sharesof Common Stock, after adjustment. The result of the July 19, 2006 PrivatePlacement was an additional adjustment of $116,667, which was recorded asinterest expense for the year ended December 31, 2006.

As aresult of July 19, 2006 Private Placement, the Company recorded thefollowing non-cash charges as interest expense in its Statement of Operationsduring the year ended December 31, 2006, which is included in its resultsof operations for the year ended December 31, 2006:

| **Security**                                          | ** ** | ** ** | ** ** | **Conversion/  Exercise Price** | ** ** | **Adjusted  Conversion/  Exercise Price** | ** ** | **Interest  Expense** | ** ** |
|-------------------------------------------------------|------------|------------|------------|--------------------------------------|------------|------------------------------------------------|------------|-----------------------|------------|
| Redeemable convertible  Series B Preferred Stock |       |       | $          | 2.21                                 |       |                                           |       | $                     | 2.07       |   |   | $ | 116,667 |   |
| Warrants to purchase  Common Stock                    |       |       | $          | 2.93                                 |       |                                           |       | $                     | 2.93       |   |   | — |   |
| Total                                                 |       |       |       |                                 |       |                                           |       |                  |       | $ | 116,667 |   |

 

As a result of the Companymaking the October 31, 2006 interest payment on the Notes in stock,issuing 369,159 shares of common stock, the conversion price of the Series BPreferred Stock was adjusted again and the following non-cash interest expensecharge was recorded in its Statement of Operations for the year ended December 31,2006, which is included in its results of operations for the year ended December 31,2006:

| **Security**                                         | ** ** | ** ** | ** ** | **Conversion/  Exercise Price** | ** ** | **Adjusted  Conversion/  Exercise Price** | ** ** | **Interest  Expense** | ** ** |
|------------------------------------------------------|------------|------------|------------|--------------------------------------|------------|------------------------------------------------|------------|-----------------------|------------|
| Redeemable convertible Series B Preferred Stock |       |       | $          | 2.07                                 |       |                                           |       | $                     | 2.06       |   |   |   | $ | 8,374 |   |   |
| Warrants to purchase Common Stock                    |       |       | $          | 2.93                                 |       |                                           |       | $                     | 2.93       |   |   |   | — |   |   |
| Total                                                |       |       |       |                                 |       |                                           |       |                  |       |   | $ | 8,374 |   |   |

 

**J.**                  LONG-TERMDEBT

Long-termdebt consists of the following:

| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Long Term Debt             |       | $                     | 12,740,482 |   | $ | — |   |
| Capital lease  obligations |       | 123,219               |       | 273,634 |   |
| Less: Current portion      |       | (5,623,219            | )          | (155,919 | ) |
|                       |       | $                     | 7,240,482  |   | $ | 117,715 |   |

 

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At December 31,2006, maturities of the Company’s Capital Lease obligations are as follows:

| **Fiscal Year** | ** ** | ** ** | ** ** | **Principal** | ** ** | **Interest** | ** ** | **Total** | ** ** |
|----------------------|------------|------------|------------|---------------|------------|--------------|------------|-----------|------------|
| 2007                 |       | $          | 123,219    |          | $          | 2,472        |       | $125,691  |       |
|                 |       | $          | 123,219    |          | $          | 2,472        |       | $         | 125,691    |   |
|                      |            |            |            |               |            |              |            |           |            |  |  |  |

 

On September 29, 2005, the Company re-financedthe amount currently outstanding under its capital lease facility to extendover the twenty-four months ending September 2007.

At December 31,2006, based on the face value of the notes, maturities of the Company’s Notesare as follows:

| **Calendar Years Ending December 31,** | ** ** | ** ** | ** ** | **Principal** | ** ** |
|------------------------------------------------------------|------------|------------|------------|---------------|------------|
| 2007                                                       |       | $          | 5,500,000  |          |
| 2008                                                       |       | 3,500,000  |       |
| 2009                                                       |       | —     |       |
| 2010                                                       |       | —     |       |
| 2011                                                       |       | 3,000,000  |       |
| Thereafter                                                 |       | —     |       |
| Total                                                      |       | $          | 12,000,000 |          |

 

Long-term debt consists ofscheduled principal and interest payments on the Company’s Notes. Principal ispayable in 18 equal installments, which represents 75% of the Notes, with theremaining 25%, at the election of the investor, is either (i) due on the18th month or (ii) due on the 60th month. Principal payments, representing 75% ofthe Notes, commenced on February 28, 2007. The Notes accrue interest atthe greater of (i) 7% or (ii) six month LIBOR plus 350 basis points. AtDecember 31, 2006 the six month LIBOR was 5.4%. Principal and interest maybe paid, at our option, in cash of shares of our common stock. Becauseinvestors may convert principal into common stock at any time, at their option,the timing of principal and interest payments may accelerate relative to thisschedule.

**K.**              COMMITMENTS ANDCONTINGENCIES

*Operating Leases*

The Company leases its facilities under various operatingleases that expire through October 2011.

Futureminimum annual rentals under lease agreements at December 31, 2006 are asfollows:

| **Fiscal Year** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------|------------|------------|------------|------------|------------|
| 2007                 |       | $          | 1,129,761  |       |
| 2008                 |       | $          | 967,614    |       |
| 2009                 |       | $          | 825,537    |       |
| 2010                 |       | $          | 523,797    |       |
| 2011                 |       | $          | 159,408    |       |
| Thereafter           |       | $          | —     |       |
| Total                |       | $          | 3,606,117  |       |

 

Total rental expenseincluding operating expenses and real estate taxes for operating leasesamounted to $1,682,232, $447,845, $1,654,443 and $1,562,307 for the year ended December 31,2006, the three month period ended December 31, 2005 and for the fiscalyears ended September 30, 2005 and 2004, respectively.

Certain of the facilityleases contain escalation clauses, and rental expense has been recognized on astraight-line basis over the remaining lease term. At December 31, 2006and 2005, deferred rent expense amounted to $206,611, and $206,170,respectively.

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*Letters of Credit*

The Company utilizes astandby letter of credit to satisfy a security deposit requirement and in someinstances to satisfy warranty commitments. Outstanding standby letters ofcredit as of December 31, 2006 and 2005 were $34,000, respectively. TheCompany is required to pledge cash as collateral on these outstanding lettersof credit. As December 31, 2006 and 2005, the cash pledged as collateralfor these letters of credit was $34,000, respectively, and is included inrestricted cash and cash equivalents on the balance sheet.

*Purchase Commitments*

In the ordinary course ofbusiness the Company enters into agreements with vendors for the purchase ofgoods and services through the issuance of purchase orders. In general themajority of these purchases do not represent commitments of the Company untilthe goods or services are received. In the third quarter of fiscal 2003 thecompany provided for approximately $900,000 related to outstanding purchasecommitments that were related to its Shaker and UPS product lines (see Note D—Inventory).At December 31, 2006 and 2005 the balance outstanding on these purchasecommitments was $237,150 and $327,800, respectively. These amounts are includedin other accrued expenses in the Company’s consolidated balance sheet.

*Royalty Agreements*

In connection with thepurchase of certain intellectual property, equipment and other assets fromSipex Corporation on September 27, 2002, Sipex received royalty payments of$118,422 and $87,594 during fiscal years ended September 30, 2005 and2004, respectively.

*Employment Agreements*

The Company has employmentagreements with certain employees that provide severance payments andaccelerated vesting of options upon termination of employment under certaincircumstances or a change of control, as defined. As of December 31, 2006and 2005, the Company’s potential obligation to these employees wasapproximately $300,000, and $500,000, respectively. During fiscal 2005 theCompany severed the employment of an employee that had an employment agreementthat provided for severance. The Company recorded a charge to operations ofapproximately $100,000 related to this severance agreement as selling, generaland administrative expense in its results of operations for the fiscal yearended September 30, 2005. During the year ended December 31, 2006 theCompany severed the employment of an employee that had an employment agreementthat provided for severance. The Company recorded a charge to operations ofapproximately $250,000 related to this severance agreement as selling, generaland administrative expense in its results of operations for the year ended December 31,2006. At December 31, 2006 approximately $0.2 million was accrued.

*Contract Losses*

In late fiscal 2002, theCompany entered into a fixed price contract with a customer. The fixed pricecontract, which initially totaled $1.1 million, involved milestones andprogress payments and called for the delivery of four prototype power units. Thesenew power units required substantial engineering to meet the space, thermal andperformance requirements of the customer. At the end of fiscal 2003 the Companyforecasted that the project would be completed during fiscal 2004 and theCompany accrued $0.7 million for the then anticipated cost overrun to beincurred for the project. Subsequently, the Company was successful innegotiating with the customer to increase the contract value by $0.4 million toa total of $1.5 million which was not recorded at that time due to technologicaluncertainties that existed at that time.

In the third and fourthquarters of fiscal 2004 and through December 23, 2004, the Companyencountered unanticipated problems related to performance requirements. At theend of the third quarter 

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of fiscal2004 the Company had completed the technical design and was working onintegration and testing. At that time, the Company estimated that it wouldincur costs of approximately $3.0 million to complete the project. Accordingly,the Company has recorded additional charges in fiscal 2004 totaling $0.9million. During fiscal 2005, there were no changes to the Company’s estimateand upon completion of the contract $0.1 million was recorded as an additionalcharge. All contract elements were delivered to the customer. During the fourthquarter of fiscal 2005 the Company recognized approximately $1.5 million inrevenue related to this contract. In addition, due to the loss related to thiscontract, the Company recorded approximately $0.1 million in costs duringfiscal 2005. As of December 31, 2006 the Company did not have any accruedcontract losses recorded.

*Litigation*

From time to time, theCompany is a party to routine litigation and proceedings in the ordinary courseof business. On May 19, 2006, the Company filed a suit in U.S. districtcourt, District of Massachusetts, against one of its customers. The suitdemands full payment of all outstanding amounts due to the Company from itscustomer. The customer filed a counterclaim that the Company believed waswithout merit. The suit was settled on March 9, 2007. The settlement isnot expected to have a material effect on the Company’s financial position oroperations.

The Company is not awareof any current or pending litigation in which the Company is or may be a partythat it believes could materially adversely affect the results of operations orfinancial condition or net cash flows.

**L.**                EMPLOYEEBENEFIT PLAN

TheCompany offers a 401(k) Employee Benefit Plan (the “Plan”). Under thePlan, any regular employee of the Company or its wholly owned US subsidiaries,as defined by the Plan, who has attained the age of 21 years is eligibleto participate. The Plan allows an employee to defer up to 100% of his or hercompensation, as limited under IRC Section 402(g), through contributionsto the Plan. The Company matches 100% in the Company’s Common Stock up to thefirst 6% of an employee’s pay that he or she contributes to the Plan. Participantsare vested immediately in the matches of the Company Common Stock. The matchcontribution will be determined and accrued in dollars and converted to sharesof the Company’s Common Stock using the share price of the last business day ofeach calendar quarter. The stock will be issued as soon as practical in thefollowing period. The table below details out the Company’s matchingcontributions made under the Plan, the number of shares of the Company’s CommonStock issued under the Plan and the value of the Common Stock issued by theCompany as matching contributions to the Plan for the year ended December 31,2006, the three month period ended December 31, 2005 and fiscal yearsended September 30, 2005 and 2004, as follows:

| ** **                                 | ** ** | **Matching  Contribution $’s** | ** ** | **Shares of  Common  Stock  Issued** | ** ** | **Value of  Common  Stock  Issued $’s** | ** ** |
|--------------------------------------------|------------|------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------------------------|------------|
| Year ended  September 30, 2004        |       |                                     | $          | 659,134                                   |       |                                                   | 213,019    |   | $ | 531,494 |   |
| Year ended  September 30, 2005        |       |                                     | $          | 578,113                                   |       |                                                   | 335,928    |   | $ | 585,996 |   |
| Three months ended  December 31, 2005 |       |                                     | $          | 154,967                                   |       |                                                   | 68,049     |   | $ | 140,859 |   |
| Year ended December 31, 2006          |       |                                     | $          | 602,303                                   |       |                                                   | 391,431    |   | $ | 604,740 |   |

 

The value of the CommonStock issued as matching contributions is based on the closing price of theCompany’s Common Stock on the Nasdaq Market for the last day of the calendarquarter in which the contributions were earned.

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**M.**            INCOMETAXES

Theprovision for income taxes consists of the following:

| ** **                                                                     | ** ** | **Year Ended  December 31,** | ** ** | **Three Month  Period Ended  December 31,** | ** ** | **Fiscal Years Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                               | ** ** | **2005**                                                   | ** ** | **2005**                                        | ** ** | **2004** | ** ** |
| Current payable:                                                               |       |                                   |       |                                                       |       |                                            |       |   |   |   |   |
| Federal                                                                        |       | $                                      | —     |                                                       |       | $                                               | —     |   |   | $ | — |   | $ | — |   |
| State                                                                          |       | 3,000                                  |       |                                                       | —     |                                            |       | — |   | — |   |
| Foreign                                                                        |       | —                                 |       |                                                       | —     |                                            |       | — |   | — |   |
|                                                                           |       | $                                      | 3,000      |                                                       |       | $                                               | —     |   |   | $ | — |   | $ | — |   |
| Deferred income tax  benefit                                                   |       |                                   |       |                                                       |       |                                            |       |   |   |   |   |
| Federal                                                                        |       | $                                      | 5,424,853  |                                                       |       | $                                               | 237,589    |   |   | $ | 2,941,084 |   | $ | 795,401 |   |
| Foreign                                                                        |       | —                                 |       |                                                       | —     |                                            |       | — |   | — |   |
| State                                                                          |       | 923,202                                |       |                                                       | 41,424     |                                            |       | 945,639 |   | 29,060 |   |
|                                                                           |       | $                                      | 6,348,055  |                                                       |       | $                                               | 279,013    |   |   | $ | 3,886,723 |   | $ | 824,461 |   |
| Adjustment of  beginning of period valuation allowance for deferred tax assets |       | $                                      | (6,348,055 | )                                                          |       | $                                               | (279,013   | ) |   | $ | (3,886,723 | ) | $ | (824,461 | ) |
| Income tax expense, net,  reported in the accompanying statement of operations |       | $                                      | 3,000      |                                                       |       | $                                               | —     |   |   | $ | — |   | $ | — |   |

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. As of December 31, 2005 and2006, the components of the net deferred tax assets/ (liabilities) are asfollows:

| ** **                                | ** ** | **Year Ended  December 31,  2006** | ** ** | **Three Month  Period Ended  December 31,  2005** | ** ** |
|-------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------------|------------|
| Federal net operating  loss carryforwards |       | $                                            | 36,740,414 |                                                             | $          | 31,449,155 |   |
| Tax credits                               |       | 4,293,010                                    |       | 3,396,183                                                        |       |
| Depreciation and  amortization            |       | 1,237,518                                    |       | 1,237,518                                                        |       |
| Other                                     |       | 1,437,445                                    |       | 1,174,108                                                        |       |
| Federal net operating  loss carryforwards |       | 3,661,275                                    |       | 3,764,644                                                        |       |
| Valuation allowance                       |       | (47,369,662                                  | )          | (41,021,608                                                      | )          |
| Net deferred income taxes                 |       | $                                            | —     |                                                             | $          | — |   |

 

At December 31, 2006,the Company had available net operating loss carryforwards for federal andstate tax purposes of approximately $108,000,000 and $64,000,000, respectively.The federal net operating losses expire beginning in 2007 through 2025. Thestate net operating losses expire beginning in 2006 through 2015.

As required by SFAS No. 109,*Accounting for Income Taxes*, managementhas evaluated the positive and negative evidence bearing upon the realizabilityof the Company’s deferred tax assets. Management has determined that it is morelikely than not that the Company will not realize the benefits of federal deferredtax assets, and as a result, a full valuation allowance has been established.

Of the changes in thevaluation allowance described above for the period ended December 31,2006, an immaterial amount may relate to tax return deductions attributable tothe exercise of non-qualifying 

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stockoptions or disqualifying dispositions of incentive stock options, and are notbenefited through income.

Under the Internal Revenue Code, certain substantialchanges in the Company’s ownership may result in an annual limitation on theamount of net operating loss and tax credit carryforwards, which may beutilized in future periods.

The provision forincome taxes differs from the federal statutory rate due to the following:

| ** **                           | ** ** | **Years Ended**  | ** ** | **Three Month  Period Ended** | ** ** | **Fiscal Years Ended** | ** ** |
|--------------------------------------|------------|-----------------------|------------|-----------------------------------------|------------|-----------------------------|------------|
| **December 31,**                | ** ** | **December 31,** | ** ** | **September 30,**                  |
| **2006**                             | **2005**   | **2005**              | ** ** | **2004**                                |
| Tax at statutory rate                |       |                  | (34.0      | )%                                      |       |                        | (34.0      | )% |   | (34.0 | )% | (34.0 | )% |
| State taxes, net of  federal benefit |       |                  | (6.7       | )%                                      |       |                        | (6.7       | )% |   | (6.1 | )% | (0.1 | )% |
| Other                                |       |                  | 2.0        | %                                       |       |                        | 2.3        | % |   | 2.2 | % | 26.5 | % |
| Change in valuation  allowance       |       |                  | 38.7       | %                                       |       |                        | 38.4       | % |   | 37.9 | % | 7.6 | % |
| Effective tax rate                   |       |                  | —     | %                                       |       |                        | —     | % |   | — | % | — | % |

 

**N.**              STOCKHOLDERS’ EQUITY

As of December 31,2006, the Company has reserved 9,397,478 shares of Common Stock for issuanceupon exercise of stock options and warrants, 1,116,161 shares for futureissuances under its stock plans and 487,429 shares for future issuances asmatching contributions under its 401(k) plan. The Company has alsoreserved 837,379 shares of Common Stock for issuance upon conversion of theoutstanding Series B Preferred Stock, which can be converted at any time.As of December 31, 2006, holders of warrants to purchase an aggregate of11,097,308 shares of the Company’s Common Stock may exercise. As ofDecember 31, 2006, the notes were convertible into 7,272,727 of theCompany’s Common Stock.

*Stock Option Plans*

Under the Company’s 1992,1994, 1996, 1998, 1999, 2000, 2002 and 2005 Stock Option Plans (collectively,the “Plans”), both qualified and non-qualified stock options may be granted tocertain officers, employees, directors and consultants to purchase up to7,250,000 shares of the Company’s common stock. At December 31, 2006,4,456,745 of the 7,250,000 stock options available for grant under the Planshave been granted.

ThePlans are subject to the following provisions:

·       Theaggregate fair market value (determined as of the date the option is granted)of the Company’s common stock that any employee may purchase in any calendaryear pursuant to the exercise of qualified options may not exceed $100,000. Noperson who owns, directly or indirectly, at the time of the granting of aqualified option to him or her, more than 10% of the total combined votingpower of all classes of stock of the Company shall be eligible to receive anyqualified options under the Plans unless the option price is at least 110% ofthe fair market value of the Company’s Common Stock subject to the option,determined on the date of grant. Non-qualified options are not subject to thislimitation.

·       Qualifiedoptions are issued only to employees of the Company, while non-qualifiedoptions may be issued to non-employee directors, consultants and others, aswell as to employees of the Company. Options granted under the Plans may not begranted with an exercise price less than 100% of fair value of the Company’scommon stock, as determined by the Board of Directors on the grant date.

·       Optionsunder the Plans must be granted within 10 years from the effective date ofthe Plan. Qualified options granted under the Plans cannot be exercised morethan 10 years from the date of grant, except that qualified options issuedto 10% or greater stockholders are limited to five-year terms.

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·       Generally,the options vest and become exercisable ratably over a four-year period.

·       ThePlans contain antidilutive provisions authorizing appropriate adjustments incertain circumstances.

·       Sharesof the Company’s common stock subject to options that expire without beingexercised or that are canceled as a result of the cessation of employment areavailable for future grants.

Thefollowing table summarizes activity of the Company’s stock plans sinceSeptember 30, 2003:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | ** **                                 | ** **  |
|---------------------------------------------|------------|------------------------------|------------|--------------------------------------------|-------------|
| ** **                                  | ** ** | **Number  of  Shares**       | ** ** | **Weighted  Average  Exercise Price** | ** **  | **Weighted  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| **Outstanding at  September 30, 2003** | ** ** | **3,068,682**                | ** ** |                                       | **$**       | **8.21** | ** ** |   |   | **7.06** | ** ** |   | ** ** | ** ** |
| Grants                                      |       | 298,000                      |       |                                       | $           | 2.43 |   |   |   |   |   |   |   |   |
| Exercises                                   |       | (118,550                     | )          |                                       | $           | 0.66 |   |   |   |   |   |   |   |   |
| Cancellations                               |       | (1,186,838                   | )          |                                       | $           | 10.86 |   |   |   |   |   |   |   |   |
| **Outstanding at  September 30, 2004** | ** ** | **2,061,294**                | ** ** |                                       | **$**       | **6.30** | ** ** |   |   | **6.74** | ** ** |   | ** ** | ** ** |
| Grants                                      |       | 2,329,008                    |       |                                       | $           | 1.77 | ** ** |   |   | ** ** | ** ** |   |   |   |
| Exercises                                   |       | (144,000                     | )          |                                       | $           | 1.08 | ** ** |   |   | ** ** | ** ** |   |   |   |
| Cancellations                               |       | (568,207                     | )          |                                       | $           | 4.08 | ** ** |   |   | ** ** | ** ** |   |   |   |
| **Outstanding at  September 30, 2005** | ** ** | **3,678,095**                | ** ** |                                       | **$ ** | **3.98** | ** ** |   |   | **7.12** | ** ** |   | ** ** | ** ** |
| Grants                                      |       | 123,500                      |       |                                       | $           | 1.43 | ** ** |   |   | ** ** | ** ** |   |   |   |
| Exercises                                   |       | (1,000                       | )          |                                       | $           | 0.63 | ** ** |   |   | ** ** | ** ** |   |   |   |
| Cancellations                               |       | (22,500                      | )          |                                       | $           | 5.43 | ** ** |   |   | ** ** | ** ** |   |   |   |
| **Outstanding at  December 31, 2005**  | ** ** | **3,778,095**                | ** ** |                                       | **$**       | **3.89** | ** ** |   |   | **7.00** | ** ** |   |   |   |
| Grants                                      |       | 1,000,500                    |       |                                       | $           | 2.48 | ** ** |   |   | ** ** | ** ** |   |   |   |
| Exercises                                   |       | (229,850                     | )          |                                       | $           | 1.37 | ** ** |   |   | ** ** | ** ** |   |   |   |
| Cancellations                               |       | (92,000                      | )          |                                       | $           | 2.82 | ** ** |   |   | ** ** | ** ** |   |   |   |
| **Outstanding at  December 31, 2006**  | ** ** | **4,456,745**                | ** ** |                                       | **3.73**    | ** ** |   |   | **6.71** | ** ** |   | **$ ** | **130,060** | ** ** |
| **Exercisable at  December 31, 2006**  | ** ** | **3,786,745**                | ** ** |                                       | **$**       | **3.95** | ** ** |   |   | **6.24** | ** ** |   | **$** | **127,155** | ** ** |

 

Informationrelated to stock options outstanding as of December 31, 2006 is asfollows:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Remaining  Contractual  Life  (years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Exercisable  Number of  Shares** | ** ** | **Exercisable  Weighted  Average  Exercise  Price** | ** ** |
| $  0.41  to $  1.39     |       | 669,950                      |       |                         | 8.10       |   |   |   | $ | 1.08 |   |   | 598,450 |   |   | $ | 1.05 |   |   |   |
| $  1.42  to $  1.76     |       | 999,000                      |       |                         | 8.33       |   |   |   | $ | 1.65 |   |   | 940,000 |   |   | $ | 1.66 |   |   |   |
| $  1.78  to $  2.05     |       | 779,133                      |       |                         | 5.33       |   |   |   | $ | 2.01 |   |   | 724,133 |   |   | $ | 2.01 |   |   |   |
| $  2.07  to $  2.95     |       | 842,000                      |       |                         | 9.23       |   |   |   | $ | 2.72 |   |   | 357,500 |   |   | $ | 2.53 |   |   |   |
| $  3.05  to $  9.00     |       | 650,412                      |       |                         | 3.69       |   |   |   | $ | 5.59 |   |   | 650,412 |   |   | $ | 5.59 |   |   |   |
|     9.20  to $17.56     |       | 508,750                      |       |                         | 3.39       |   |   |   | $ | 13.03 |   |   | 508,750 |   |   | $ | 13.03 |   |   |   |
| $17.75                                      |       | 7,500                        |       |                         | 3.86       |   |   |   | $ | 17.75 |   |   | 7,500 |   |   | $ | 17.75 |   |   |   |
| $  0.41   to $17.75          |       | 4,456,745                    |       |                         | 6.71       |   |   |   | $ | 3.73 |   |   | 3,786,745 |   |   | $ | 3.95 |   |   |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Options for the purchase of 3,673,595 shares wereexercisable at September 30, 2005, with a weighted-average exercise priceof $3.98. Options for the purchase of 3,662,595 shares were exercisable at December 31,2005, with a weighted average exercise price of $3.96.

Thefollowing table summarizes the Company’s non-vested restricted share activity:

| ** **                                 | ** ** | **Non-vested Restricted Stock Awards**                                                      | ** ** |
|--------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **Number  of**                                                                                             | ** ** | **Weighted Average  Grant Date** | ** ** |
| ** **                                 | ** ** | **        Shares        ** | ** ** | **      Fair Value       ** | ** ** |
| **Non-vested  at September 30, 2005** | ** ** | ** **                                                                                                 | **—** |   | ** ** | ** ** | **$** | **—** |   |   |
| Granted                                    |       |                                                                                                       | 50,000     |   |   |   | $ | 1.41 |   |   |
| Vested                                     |       |                                                                                                       | —     |   |   |   | $ | — |   |   |
| Forfeited                                  |       |                                                                                                       | —     |   |   |   | $ | — |   |   |
| **Non-vested  at December 31, 2005**  | ** ** | ** **                                                                                                 | **50,000** |   | ** ** | ** ** | **$** | **1.41** |   |   |
| Granted                                    |       |                                                                                                       | —     |   |   |   | $ | — |   |   |
| Vested                                     |       |                                                                                                       | (50,000    | ) |   |   | $ | 1.41 |   |   |
| Forfeited                                  |       |                                                                                                       | —     |   |   |   | $ | — |   |   |
| **Non-vested At December 31,  2006**  |       |                                                                                                       | **—** |   | ** ** | ** ** | **$** | **—** |   |   |

 

As of December 31, 2006, there was approximately$1.0 million of total unrecognized costs related to non-vested share-basedcompensation arrangements granted under the Company’s stock plans. That cost isexpected to be recognized over a weighted average period of approximately 4years. Options to purchase 229,850 shares were exercised during the year ended December 31,2006; these options had an intrinsic value of approximately $0.2 million ontheir date of exercise. Options to purchase 1,000 shares were exercised duringthe three month period ended December 31, 2005; these options had anintrinsic value of $580 on their date of exercise.

During 2000, the Company granted 216,000 non-qualifiedstock options to employees at an exercise price of $17.56 per share outside ofthe Board approved Plans. As of December 31, 2006 and 2005, there were21,000 options outstanding, respectively, which are included in the abovetable. As of December 31, 2006 and 2005, an additional 195,000 shares,respectively, included above were available outside of the Board approved Plansfor future grants.

On April 19, 2004, the Company completed thefirst phase of its stock option exchange offer. A total of 781,158 options withan average exercise price of approximately $12.30 were tendered by employeesand directors and then cancelled by the Company in exchange for the futureissuance of options. New options were to be issued in the final phase of theexchange offer on or after October 20, 2004 at the then current marketprice to employees and directors who were employed by the Company or served asdirectors of the Company from the acceptance date through the date that the newoptions were granted. The Company was obligated to issue 684,008 optionsassociated with the exchange, subject to certain conditions. Executive officersof the Company elected not to participate in the program. Ultimately, in October 2004,the Company issued 656,008 options with an exercise price of $2.05 per share. Thetable above summarizing the stock option activity for the years ended September 30,2005 and 2004 reflects the effect of the stock option exchange offer.

On April 8, 2005, the Board of Directors of theCompany voted to accelerate the vesting of all outstanding and unvested optionsheld by directors, officers and employees under the Company’s stock optionplans. As a result of the acceleration, options to acquire 633,333 shares ofthe Company’s Common Stock, which otherwise would have vested from time to timeover the next 48 months, became immediately exercisable. Included in theoptions to acquire 633,333 shares of the Company’s Common Stock were (i) optionsto purchase 591,583 shares with exercise prices greater than the Company’sclosing stock price on April 8, 2005 ($1.59) (the “underwater options”)and (ii) options to purchase 41,750 shares with 

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exercise prices below theclosing stock price of the Common Stock on April 8, 2005 (the “in-the-moneyoptions”). The underwater options have a weighted average exercise price of$2.23 per share. The in-the-money options have a weighted average exerciseprice of $1.04 per share. Under the accounting guidance of APB 25, theaccelerated vesting relating to the in-the-money options resulted in a chargefor stock-based compensation of approximately $34,330, which was recognized bythe Company in the third fiscal quarter. The Company had calculated this chargeusing the Black-Scholes option pricing model, taking into account the remainingunvested shares, each unvested share’s exercise price as compared to the priceon the day the vesting of the options was accelerated.

Intaking this action, the Board of Directors considered whether it wouldbe advantageous to the employee base to have their options become fully vested.The Board of Directors concluded that, because the employees had not hadsignificant raises over the past few years and had stayed with the Companyduring difficult times, and because the financial impact to the Company of thevesting was minimal, these options should be vested.

*Warrants*

On December 19, 2002, the Company issued toSilicon Valley Bank, in connection with entering into a forbearance agreementwith Silicon Valley Bank, a warrant exercisable for 15,763 shares of theCompany’s Common Stock, at an exercise price of $1.586 per share. The warrantexpires on December 18, 2007. The Company has valued this warrant at$20,100 using the Black-Scholes option-pricing model and hasdesignated the warrant as an equity instrument in accordance with EITF 00-19.As of December 31, 2006, this warrant remains outstanding.

HCW served as placement agent for the February 2003Series A financing transaction and on February 18, 2003 received aspart of its commission warrants to purchase an aggregate of 163,145 shares ofCommon Stock at an exercise price of $0.01 per share. These warrants wereimmediately exercisable and expire on February 18, 2008. In connectionwith the closing of the transactions contemplated by the note and warrantpurchase agreement, HCW received additional warrants from the Company topurchase an aggregate of 42,920 shares of Common Stock at an exercise price of$0.01. These warrants are exercisable from the closing of the transactionscontemplated by the note and warrant purchase agreement and expire on February 18,2008. In addition, HCW agreed to receive warrants to purchase an aggregate of100,148 shares of Common Stock at an exercise price of $0.01 per share in lieuof the cash placement fee in connection with the closing of the transactionscontemplated by the Note and Warrant Purchase Agreement. These warrants wereissued on February 18, 2003 and were exercisable from the closing of thetransactions contemplated by the note and warrant purchase agreement and willexpire on February 18, 2008. The Company had valued these warrants at$267,147, using the Black-Scholes option-pricing model and hasdesignated the warrant as an equity instrument in accordance with EITF 00-19.See Note J.

As of December 31,2006, the table below details the balance of the warrants issued to HCW by theCompany:

| **Date of Issuance** | ** ** | ** ** | ** ** | **Warrant to  Purchase  Shares of  Common Stock** | ** ** | **Exercise  Price $** | ** ** | **Shares of  Common  Stock issued** | ** ** | **Remaining  Shares of  Common Stock** | ** ** | **Date of Warrant  Expiration** | ** ** |
|--------------------------------|------------|------------|------------|------------------------------------------------------------------|------------|----------------------------|------------|-----------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------|------------|
| February 18,  2003        |       |       | 163,145    |                                                             |       |                       | $          | 0.01                                          |       |                                             |       | 152,948                                   |       |   |   | 10,197 |   |   | February 18, 2008 |   |
| February 18,  2003        |       |       | 42,920     |                                                             |       |                       | $          | 0.01                                          |       |                                             |       | 38,321                                    |       |   |   | 4,599 |   |   | February 18, 2008 |   |
| February 18,  2003        |       |       | 100,148    |                                                             |       |                       | $          | 0.01                                          |       |                                             |       | 80,284                                    |       |   |   | 19,864 |   |   | February 18,  2008 |   |

 

In October 2003, the holders of the convertiblesubordinated debentures converted $762,500 into 610,000 shares of the Company’sCommon Stock. As a result of this conversion, the Company recorded theremaining unamortized balance of the prepaid first year interest, or $81,155,in October 2003. Also in 

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October 2003, anadditional investment of $70,000 was made by issuing $70,000 of convertiblesubordinated debentures. The Company also issued 8,298 shares of Common Stockas payment of the first year interest, valued based on the average of theclosing bid and ask price of the Common Stock on the Nasdaq National Market forthe five trading days preceding February 18, 2003. These securedconvertible subordinated debentures were subsequently converted at a conversionprice per share of $1.25 into 56,000 shares of Common Stock. As a result ofthis conversion, the Company recorded all of the interest on these debenturesin October 2003. In connection with this transaction, the Company issuedwarrants to purchase up to 28,000 shares of Common Stock, which were exercisedat a price of $1.00 per share, and warrants to purchase up to 28,000 shares ofCommon Stock, which were exercisable for one business day after the date oftheir issuance and had an exercise price of $0.01 per share. As of December 31,2006 and 2005, none of these warrants remained outstanding.

On October 31, 2003, the Company completed a$7.7 million financing transaction involving the issuance of 1,535 sharesof the Company’s Series B Preferred Stock, and warrants to purchase up to1,228,000 shares of the Company’s common stock, from 25 accredited investors. Thewarrants had an initial exercise price of $3.32 per share, which represents110% of the average closing price of Common Stock for the five trading daysprior to October 31, 2003. These warrants were immediately exercisable andexpire on October 31, 2008. As of September 30, 2006, 112,000 ofthese warrants were exercised, leaving 1,116,000 outstanding as of September 30,2006. Burnham Hill Partners, LLC, a division of Pali Capital, Inc. (“BHP”),served as placement agent for the transaction. As part of its commission, BHPreceived a cash placement fee equal to 7% of the gross proceeds received by theCompany in connection with the financing. Based on the amount of the financing,this cash placement fee was approximately $540,000 (including reimbursement ofout-of-pocket expenses), which was paid from gross proceeds received by theCompany. BHP will also receive a cash placement fee of 4% of the aggregateconsideration received by the Company in connection with the cash exercise ofwarrants issued to the investors in the financing, as well as certain warrantsissued in the Company’s previous financing (which were exercised prior to October 31,2003). In addition, BHP, or its assigns, received warrants, with an exerciseprice of $0.01 per share, to purchase an aggregate of 150,430 shares of CommonStock. These warrants were immediately exercisable and expire on October 1,2008. The Company valued these warrants at $435,166, using the Black-Scholesoption-pricing model and treated this as a transaction cost. As of December 31,2006 and 2005, these warrants were exercised for 145,248 shares of the Company’sCommon Stock. These warrants contained anti-dilution features and as a directresult of the Company’s December 2004 Financing Transaction and the August 2005Financing Transaction, the exercise price for these warrants have been adjustedto $2.93 per share.

On December 12, 2003, the Company amended itsagreement with the Bank. In connection with the Amended Loan, the Companyissued to the Bank a warrant to purchase up to 16,164 shares of its commonstock, at an exercise price of $2.32 per share. This warrant was immediatelyexercisable and expires on December 11, 2010.  The Company has valued this warrant at$32,087, using the Black-Scholes option-pricing model and treated this as adeferred financing cost and amortized this value on a straight line basisthrough December 9, 2004. As of December 31, 2006 none of thiswarrant has been exercised.

On December 22, 2004, the Company sold 4,848,485shares of Common Stock under its universal shelf registration statement to agroup of investors for proceeds of $7,470,000, net of transaction costs. Aspart of the December 2004 financing the Company also issued warrants topurchase up to 2,181,818 shares of Common Stock. These warrants have anexercise price of $2.00 per share.  Thesewarrants were immediately exercisable and expire on December 21, 2009. Duringthe year ended December 31, 2006, 1,227,272 of these warrants wereexercised, resulting in the Company issuing 403,600 shares of common stock. Asof December 31, 2006 954,546 warrants, were outstanding.

On March 21, 2005, the Company entered into anagreement with Ardour to serve as the Company’s financial advisor. As part ofthis agreement the Company issued to Ardour a 3-year warrant to purchase 

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50,000 shares of theCompany’s Common Stock at an exercise price of $2.75 per share. The Companyvalued these warrants at $20,490, using the Black-Scholes option-pricingmodel and designated the warrant as an equity instrument in accordance withEITF 00-19. At December 31, 2006, none of these warrants have beenexercised.

On June 29, 2005, the New Loan was modifiedpursuant to a Loan Modification Agreement (the “Modification Agreement”)between the Company and the Bank. The Modification Agreement had an effectivedate of May 31, 2005. In connection with the Modification Agreement theCompany issued to the Bank a 10-year warrant to purchase 151,515 sharesof the Company’s Common Stock at an exercise price of $1.386 per share. TheCompany valued these warrants at $119,427 using the Black-Scholes option pricing and has treated this as a deferred financing costand was amortizing this value on a straight line basis through the remainingterm of the New Loan. At December 31, 2006 none of these warrants havebeen exercised.

On August 15, 2005, the Company sold 4,676,151shares of Common Stock to accredited investors for proceeds of approximately$5.4 million, net of transaction costs. As part of this financing the Companyalso issued warrants to purchase up to 1,169,038 shares of Common Stock. Thesewarrants have an exercise price of $1.99 per share, were immediatelyexercisable and expire on August 12, 2010. In addition, the Company agreedto pay Ardour a fee of 6% of the net proceeds from the August 2005financing, approximately $347,000 and warrants equal to 2% of the Common Stockissued in the August 2005 financing. The Company issued to Ardour awarrant to purchase 93,523 shares of Common Stock at an exercise price of $1.84.These warrants were immediately exercisable and have an expiration date of August 14,2010. As of December 31, 2006 none of these warrants have been exercised.

Asummary of the Company’s warrants currently outstanding as of December 31,2006 by issuance date is summarized below:

| **Date of  Warrant Issuance**             | ** ** | ** **                                    | ** ** | **Holder of Warrant** | ** ** | **Original  Warrant to  Purchase  Shares of  Common Stock** | ** ** | **Exercise  Price $ ** | ** ** | **Warrants  Exercised** | ** ** | **Remaining  Shares of  Common  Stock  underlying  the warrant** | ** ** | **Term  (Years)** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------|------------|-------------------------|------------|----------------------------------------------------------------------------|------------|-------------------|------------|
| December 19, 2002                              |       | Silicon Valley  Bank                          |       |                            | 15,763     |                                                                       |       |                             | $          | 1.59                    |       |                                                                       |       |              |       |   |   | 15,763 |   |   |   | 5 |   |   |
| February 18, 2003                              |       | H.C. Wainwright                               |       |                            | 163,145    |                                                                       |       |                             | $          | 0.01                    |       |                                                                       |       | 152,948           |       |   |   | 10,197 |   |   |   | 5 |   |   |
| February 18, 2003                              |       | H.C. Wainwright                               |       |                            | 42,920     |                                                                       |       |                             | $          | 0.01                    |       |                                                                       |       | 38,321            |       |   |   | 4,599 |   |   |   | 5 |   |   |
| February 18, 2003                              |       | H.C. Wainwright                               |       |                            | 100,148    |                                                                       |       |                             | $          | 0.01                    |       |                                                                       |       | 80,284            |       |   |   | 19,864 |   |   |   | 5 |   |   |
| October 31, 2003                               |       | Series B Preferred  Investors            |       |                            | 1,228,000  |                                                                       |       |                             | $          | 2.93                    |       |                                                                       |       | 112,000           |       |   |   | 1,116,000 |   |   |   | 5 |   |   |
| October 31, 2003                               |       | Burnham Hill  Partners, LLC                   |       |                            | 150,430    |                                                                       |       |                             | $          | 0.01                    |       |                                                                       |       | 145,248           |       |   |   | 5,182 |   |   |   | 5 |   |   |
| December 12, 2004                              |       | Silicon Valley  Bank                          |       |                            | 16,164     |                                                                       |       |                             | $          | 2.32                    |       |                                                                       |       |              |       |   |   | 16,164 |   |   |   | 5 |   |   |
| December 23, 2004                              |       | December 2004  Financing Investors       |       |                            | 2,181,818  |                                                                       |       |                             | $          | 2.00                    |       |                                                                       |       |              |       |   |   | 954,544 |   |   |   | 5 |   |   |
| March 21, 2005                                 |       | Ardour Capital  Investment, LLC               |       |                            | 50,000     |                                                                       |       |                             | $          | 2.75                    |       |                                                                       |       |              |       |   |   | 50,000 |   |   |   | 3 |   |   |
| May 31, 2005                                   |       | Silicon Valley  Bank                          |       |                            | 151,515    |                                                                       |       |                             | $          | 1.39                    |       |                                                                       |       |              |       |   |   | 151,515 |   |   |   | 10 |   |   |
| August 11, 2005                                |       | August 2005  Financing Investors         |       |                            | 1,169,038  |                                                                       |       |                             | $          | 1.99                    |       |                                                                       |       |              |       |   |   | 1,169,038 |   |   |   | 5 |   |   |
| August 11, 2005                                |       | Ardour Capital  Investment, LLC               |       |                            | 93,523     |                                                                       |       |                             | $          | 1.84                    |       |                                                                       |       |              |       |   |   | 93,523 |   |   |   | 5 |   |   |
| July 19, 2006                                  |       | Warrant A,  July 2006 Private  Placement |       |                            | 3,636,368  |                                                                       |       |                             | $          | 1.82                    |       |                                                                       |       |              |       |   |   | 3,636,368 |   |   |   | 7 |   |   |
| July 19, 2006                                  |       | Warrant B,  July 2006 Private  Placement |       |                            | 3,636,368  |                                                                       |       |                             | $          | 1.68                    |       |                                                                       |       |              |       |   |   | 3,636,368 |   |   |   | 0.5 |   |   |
| July 19, 2006                                  |       | First Albany  Warrants                        |       |                            | 218,183    |                                                                       |       |                             | $          | 1.87                    |       |                                                                       |       |              |       |   |   | 218,183 |   |   |   | 5 |   |   |
| Total Warrants  outstanding as of December 31, 2006 |       |                                          |       |                            |       |                                                                       |       |                             |       |                    |       | 11,097,308                                                                 |       |              |       |   |   |   |

 

Asummary of the status of the Company’s warrants as of the year ended December 31,2006 and the three month period ended December 31, 2005 and the changesfor these periods are presented below. The actual Common Stock issued onwarrants exercises in 2006 is less than the table presented below due tocashless exercises. The actual Common Stock issued under warrant exercises for2006 was 430,135 and the 

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Company received proceeds of $204. There were nowarrant exercises during the three month period ended December 31, 2005 orthe twelve month period ended September 30, 2005. The table below reflectsthe change in warrant price due to the anti-dilutive provisions of the Series Bwarrants as a result of the December 2004, August 2005 and July 19,2006 Financing Transactions.

| ** **                        | ** ** | **Year Ended  December 31, 2006** | ** ** | **Three Months Ended  December 31, 2005** | ** ** | **Fiscal  Year Ended  September 30, 2005** | ** ** | **Fiscal  Year Ended  September 30, 2004** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                        | ** ** | **Number of  Shares**                       | ** ** | **Weighted  Average  Price**                                  | ** ** | **Number of  Shares**                                | ** ** | **Weighted  Average  Price**                              | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Price** | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Price** | ** ** |
| Outstanding at  beginning of year |       | 4,966,056                                        |       |                                                          | $          | 2.19                                                      |       |                                                      | 4,966,056  |   |   | $ | 2.19 |   |   | 1,320,162 |   |   | $ | 2.77 |   |   | 3,084,085 |   |   | $ | 4.03 |   |   |
| Granted                           |       | 7,490,919                                        |       |                                                          | 1.75       |                                                      |       | —                                                    |       |   | — |   |   | 3,645,894 |   |   | 1.98 |   |   | 1,450,594 |   |   | 2.47 |   |   |
| Exercised                         |       | (1,359,667                                       | )          |                                                          | 2.05       |                                                      |       | —                                                    |       |   | — |   |   | — |   |   | — |   |   | (2,609,467 | ) |   | 1.24 |   |   |
| Canceled                          |       | —                                           |       |                                                          | —     |                                                      |       | —                                                    |       |   | — |   |   | — |   |   | — |   |   | (605,050 | ) |   | 15.24 |   |   |
| Outstanding at end of  year       |       | 11,097,308                                       |       |                                                          | $          | 1.91                                                      |       |                                                      | 4,966,056  |   |   | $ | 2.19 |   |   | 4,966,056 |   |   | $ | 2.19 |   |   | 1,320,162 |   |   | $ | 2.77 |   |   |

 

*ConsultingArrangement with Aurelius Consulting Group, Inc.*

Pursuant to a marketingagreement, dated September 2, 2003, with Aurelius Consulting Group, Inc.,as part of the compensation for the services to be provided by Aurelius underthe agreement, which had an initial term of 12 months, the Company agreedto issue to Aurelius 45,000 shares of Common Stock per quarter, payable at themidpoint of each quarter, subject to renegotiation after the first six months.  As of September 30, 2004, the agreementwas renegotiated and the Company issued 90,000 shares of common stock toAurelius. Accordingly, the Company expensed approximately $192,000 duringfiscal year 2004.

**O.**              PREFERREDSTOCK

The Company is authorizedto issue up to 1,000,000 shares of Preferred Stock, $0.01 par value per share.The Preferred Stock may be issued in one or more series, the terms of which maybe determined at the time of issuance by the Board of Directors, withoutfurther action by stockholders, and may include voting rights (including theright to vote as a series on particular matters), preferences as to dividendsand liquidation, conversion and redemption rights and sinking fund provisions. SeeNote I for a discussion of redeemable convertible Series A PreferredStock issued in February 2003 and Series B Preferred Stock issued in October 2003.

**P.**                SIGNIFICANTCUSTOMERS

Significant customers defined as those customers thataccount for 10% or more of total net revenue in a fiscal year or 10% or more ofaccounts receivable and unbilled contract costs and fees at the end of a fiscalyear. At December 31, 2006 and 2005 no single customer accounted for morethan 10% of accounts receivables. In addition, for the fiscal year endedDecember 31, 2006, the three month period ended December 31, 2005, nosingle customer accounted for more than 10% of total net revenue.

In addition, managementestimates that approximately 40%, 40%, 40% and 50% of the revenue during theyear ended December 31, 2006, the three months ended December 31,2005 and the fiscal years ended September 30, 2005 and 2004, respectively,was derived from government contracts and subcontracts with the U.S. government’sprime contractors.

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**Q.**              SUPPLEMENTALDISCLOSURE OF CASH FLOW INFORMATION

*Non-Cash Investing and Financing Activities*

| ** **                                                                                                                                                                                               | ** ** | **Year Ended**   | ** ** | **Three Months Ended** | ** ** | **Fiscal Years Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                               | ** ** | **December 31.** | ** ** | **December 31,**            | ** ** | **September 30,**      | ** ** |
| ** **                                                                                                                                                                                               | ** ** | **2006**              | ** ** | **2005**                         | ** ** | **2005**                    | ** ** | **2004** | ** ** |
| Employee  stock-based compensation                                                                                                                                                                       |       |                  | $          | 986,251                          |       |                        |       | $ | 3,709 |   |   | $ | — |   | $ | — |   |
| Common Stock  issued in lieu of interest on redeemable convertible Series B Preferred Stock                                                                                                    |       |                  | 151,778    |                             |       |                        | 67,292     |   |   | 127,500 |   | 230,215 |   |
| Common Stock  issued in lieu of interest on Senior Secured Notes                                                                                                                                    |       |                  | 314,860    |                             |       |                        | —     |   |   | — |   | — |   |
| Amortization of  debt discount associated with the valuation of the July 19,  2006 Senior Secured Notes                                                                                   |       |                  | 239,874    |                             |       |                        | —     |   |   | — |   | — |   |
| Common stock  issued related to 401(K) contributions                                                                                                                                                |       |                  | 604,740    |                             |       |                        | 140,859    |   |   | 585,997 |   | 531,494 |   |
| Conversion of Series B  preferred stock for common stock                                                                                                                                            |       |                  | 400,000    |                             |       |                        | —     |   |   | — |   | 5,550,000 |   |
| Issuance of  warrants to purchase common stock to consultant                                                                                                                                        |       |                  | —     |                             |       |                        | —     |   |   | 63,612 |   | — |   |
| Compensation  charge associated with the acceleration of unvested employee stock options                                                                                                                 |       |                  | —     |                             |       |                        | —     |   |   | 34,330 |   | — |   |
| Valuation  adjustment for redeemable convertible Series B Preferred Stock as a  result of the December 2004, August 2005 financing transactions and  July 19, 2006 Private Placement |       |                  | 125,041    |                             |       |                        | —     |   |   | 270,290 |   | — |   |
| Valuation  adjustment for Series B Warrants as a result of the December 2004  and August 2005 financing transactions                                                                      |       |                  | —     |                             |       |                        | —     |   |   | 64,745 |   | — |   |
| Accretion of  redeemable convertible preferred stock discount                                                                                                                                            |       |                  | —     |                             |       |                        | —     |   |   | — |   | 6,083,214 |   |
| Accretion of  convertible subordinated debentures discount                                                                                                                                          |       |                  | —     |                             |       |                        | —     |   |   | — |   | 185,554 |   |
| Valuation  adjustment for warrants to purchase Common Stock                                                                                                                                              |       |                  | —     |                             |       |                        | —     |   |   | (7,036 | ) | (90,454 | ) |
| Non-cash restructuring  charges due to issuance of Common Stock to settle future lease  obligations, impairment and fair value adjustment of Investor Warrants                                      |       |                  | $          | 1,532,231                        |       |                        |       | $ | — |   |   | $ | — |   | $ | — |   |

 

*Interest and IncomeTaxes Paid*

Cashpaid for interest and income taxes was as follows:

| ** **   | ** ** | **Year Ended**   | ** ** | **Three Months Ended** | ** ** | **Fiscal Years ended** | ** ** |
|--------------|------------|-----------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **   | ** ** | **December 31,** | ** ** | **December 31,**            | ** ** | **September 30,**           | ** ** |
| ** **   | ** ** | **2006**              | ** ** | **2005**                         | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Interest     |       |                  | $          | 130,019                          |       |                             |       | $ | 50,284 |   |   | $ | 97,717 |   | $ | 175,663 |   |
| Income taxes |       |                  | —     |                             |       |                             | —     |   |   | — |   | — |   |
|              |            |                       |            |                                  |            |                                  |            |  |  |  |  |  |  |  |  |  |  |

 

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**R.**               LOSSPER SHARE

Thefollowing is the reconciliation of the numerators and denominators of the basicand diluted loss per share computations:

| ** **                                                  | ** ** | **Year  Ended**             | ** **  | **Three  Months  Ended**    | ** ** | **Fiscal Years Ended**  | ** ** |
|-------------------------------------------------------------|------------|-----------------------------|-------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                  | ** ** | **December 31,  2006** | ** **  | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
| Net loss                                                    |       | $                           | (19,778,011 | )                           | $          | (1,307,727                   | )          | $ | (10,246,107 | ) | $ | (10,958,470 | ) |
| Basic and diluted:                                          |       |                        |        |                        |       |                         |       |   |   |
| Common shares  outstanding, beginning of period             |       | 38,382,706                  |        | 38,283,208                  |       | 28,226,010                   |       | 21,023,200 |   |
| Weighted average  common shares issued during the period    |       | 907,461                     |        | 72,766                      |       | 4,673,622                    |       | 5,811,270 |   |
| Weighted average shares outstanding—basic and  diluted |       | 39,290,167                  |        | 38,355,974                  |       | 32,899,632                   |       | 26,834,470 |   |
| Net loss per  weighted average share, basic and diluted     |       | $                           | (0.50       | )                           | $          | (0.03                        | )          | $ | (0.31 | ) | $ | (0.41 | ) |

 

As ofthe year ended December 31, 2006, the three month period ended December 31,2005 and the fiscal years ended September 30, 2005 and 2004, shares ofCommon Stock issuable upon the exercise of options and warrants were excludedfrom the diluted average common shares outstanding, as their effect would havebeen antidilutive. In addition, shares of Common Stock issuable upon theconversion of redeemable convertible Preferred Stock and Notes were excludedfrom the diluted weighted average common shares outstanding as their effectwould also have been dilutive. The table below summarizes the option andwarrants and convertible Preferred Stock that were excluded from thecalculation above due to their effect being antidilutive:

| ** **                                                                                                                             | ** ** | **Year  Ended**       | ** ** | **Three  Months  Ended** | ** ** | **Fiscal Years Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                             | ** ** | **December 31,** | ** ** | **September 30,**   | ** ** |
| ** **                                                                                                                             | ** ** | **2006**              | ** ** | **2005**                 | ** ** | **2005**                    | ** ** | **2004** | ** ** |
| Common Stock issuable  upon the exercise of:                                                                                      |       |                  |       |                     |       |                        |       |   |   |
| Options                                                                                                                                |       | 3,786,745             |       | 3,662,595                |       | 3,678,095                   |       | 2,061,294 |   |
| Warrants                                                                                                                               |       | 11,097,308            |       | 4,966,056                |       | 4,966,056                   |       | 1,320,162 |   |
| Total Options and Warrants excluded                                                                                                    |       | 14,884,053            |       | 8,628,651                |       | 8,644,151                   |       | 3,381,456 |   |
| Common stock issuable upon the conversion of  senior secured convertible notes, at conversion price of $1.65 per  share |       | 7,272,727             |       | —                   |       | —                      |       | — |   |
| Common Stock issuable  upon the conversion of redeemable convertible Series B  Preferred Stock                          |       | 837,839               |       | 961,538                  |       | 961,538                     |       | 850,000 |   |

 

**S.**                SEGMENTDISCLOSURES

The Company’s organizational structure is based onstrategic business units that perform services and offer various products tothe principal markets in which the Company’s products are sold. These business 

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units equate to fourreportable segments: Applied Technology, Power Systems, US, Power Systems,Canada and Electronics.

SatCon Applied Technology, Inc. performs researchand development services in collaboration with third parties. SatCon PowerSystems, Canada, ltd. specializes in the engineering and manufacturing ofpower systems. Satcon Power Systems, US specializes in the engineering andmanufacturing of electric motors and hybrid electric automobile systems. SatConElectronics, Inc. designs and manufactures electronic products. TheCompany’s principal operations and markets are located in the United States. Inprevious years the Company has shown SatCon Power Systems US and Canada as onesegment; the table below has been adjusted to show the Power Systems divisionsas separate segments.

The accounting policies of each of the segments arethe same as those described in the summary of significant accounting policies.The Company evaluates performance based on revenue and profit and loss fromoperations, including amortization of intangibles. Common costs not directlyattributable to a particular segment are included in the corporate segment.These costs include corporate costs such as executive officer compensation,facility costs, legal, audit and tax and other professional fees.

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Thefollowing is a summary of the Company’s operations by operating segment:

| ** **                                                                                                                                                                                                                                                                                                     | ** ** | **Year  Ended**       | ** **  | **Three  Months  Ended** | ** ** | **Fiscal Years Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                     | ** ** | **December 31,** | ** **  | **September 30,**   | ** ** |
| ** **                                                                                                                                                                                                                                                                                                     | ** ** | **2006**              | ** **  | **2005**                 | ** ** | **2005**                    | ** ** | **2004** | ** ** |
| Applied Technology:                                                                                                                                                                                                                                                                                            |       |                  |        |                     |       |                        |       |   |   |
| Funded research and development and other revenue                                                                                                                                                                                                                                                         |       | $                     | 4,990,022   |                     | $          | 1,079,052                   |       | $ | 6,063,508 |   | $ | 7,186,714 |   |
| Loss from operations, including amortization of intangibles  of $305,960 for the year ended December 31, 2006, $80,421 for  the three month period ended December 31, 2005 and $321,684 and $321,685  for the fiscal years ended September 30, 2005 and 2004,  respectively |       | $                     | (1,389,022  | )                        | $          | (590,476                    | )          | $ | (1,659,536 | ) | $ | (986,187 | ) |
| Power Systems, US                                                                                                                                                                                                                                                                                              |       |                  |        |                     |       |                        |       |   |   |
| Product revenue                                                                                                                                                                                                                                                                                                |       | $                     | 4,361,322   |                     | $          | 1,647,572                   |       | $ | 8,802,657 |   | $ | 11,376,433 |   |
| Income (loss) from operations, including (i) a gain  on sale of assets of $1,442,915 million in the three month period ended  December 31, 2005 and (ii) write-off of impaired assets of  $1,190,436 for the fiscal year ended September 30, 2005                                     |       | $                     | (6,298,598  | )                        | $          | 662,327                     |       | $ | (4,321,707 | ) | $ | 432,194 |   |
| Power Systems,  Canada:                                                                                                                                                                                                                                                                                        |       |                  |        |                     |       |                        |       |   |   |
| Product revenue                                                                                                                                                                                                                                                                                                |       | $                     | 14,163,897  |                     | $          | 1,816,586                   |       | $ | 11,556,842 |   | $ | 6,048,651 |   |
| Loss from operations, including gain on sale of assets  held for sale of $406,364, $0 and $317,802 for the year ended  December 31, 2006, the three month period ended December 31,  2005 and the fiscal year ended September 30, 2005,  respectively                       |       | $                     | (2,530,615  | )                        | $          | (580,232                    | )          | $ | (343,881 | ) | $ | (1,191,605 | ) |
| Electronics:                                                                                                                                                                                                                                                                                                   |       |                  |        |                     |       |                        |       |   |   |
| Product revenue                                                                                                                                                                                                                                                                                                |       | $                     | 10,241,428  |                     | $          | 2,573,871                   |       | $ | 9,532,105 |   | $ | 9,546,025 |   |
| Income (loss) from operations                                                                                                                                                                                                                                                                                  |       | $                     | (677,217    | )                        | $          | (64,238                     | )          | $ | (279,075 | ) | $ | 181,410 |   |
| Corporate:                                                                                                                                                                                                                                                                                                     |       |                  |        |                     |       |                        |       |   |   |
| Loss from operations, including share—based compensation  expense of $1.0 million for the year ended December 31, 2006,  $0 for the three months ended December 31, 2005                                                                                               |       | $                     | (3,864,624  | )                        | $          | (640,239                    | )          | $ | (2,862,849 | ) | $ | (2,445,507 | ) |
| Consolidated:                                                                                                                                                                                                                                                                                                  |       |                  |        |                     |       |                        |       |   |   |
| Product revenue                                                                                                                                                                                                                                                                                                |       | $                     | 28,766,647  |                     | $          | 6,038,029                   |       | $ | 29,891,604 |   | $ | 26,971,109 |   |
| Funded research and development and other revenue                                                                                                                                                                                                                                                         |       | $                     | 4,990,022   |                     | $          | 1,079,052                   |       | $ | 6,063,508 |   | $ | 7,186,714 |   |
| Total revenue                                                                                                                                                                                                                                                                                                  |       | $                     | 33,756,669  |                     | $          | 7,117,081                   |       | $ | 35,955,112 |   | $ | 34,157,823 |   |
| Operating loss                                                                                                                                                                                                                                                                                                 |       | $                     | (14,760,076 | )                        | $          | (1,212,858                  | )          | $ | (9,467,048 | ) | $ | (4,009,695 | ) |
| Net unrealized gain (loss) on warrants to purchase  common stock                                                                                                                                                                                                                                               |       | —                |        | —                   |       | (7,036                      | )          | (90,454 | ) |
| Unrealized loss on series B warrants                                                                                                                                                                                                                                                                           |       | —                |        | —                   |       | —                      |       | 35,442 |   |
| Write-down of investment in Beacon Power  Corporation common stock                                                                                                                                                                                                                                             |       | —                |        | —                   |       | —                      |       | — |   |
| Realized gain from sale of Beacon Power Corporation  common stock                                                                                                                                                                                                                                              |       | —                |        | —                   |       | —                      |       | — |   |
| Other (loss) income                                                                                                                                                                                                                                                                                            |       | $                     | (4,251,165  | )                        | (4,397     | )                           | (116,622   | ) | (1,629 | ) |
| Interest income                                                                                                                                                                                                                                                                                                |       | $                     | 384,394     |                     | 47,098     |                        | 41,909     |   | 12,456 |   |
| Interest expense                                                                                                                                                                                                                                                                                               |       | $                     | (1,151,164  | )                        | (137,570   | )                           | (697,310   | ) | (6,904,590 | ) |
| Net loss                                                                                                                                                                                                                                                                                                       |       | $                     | (19,778,011 | )                        | $          | (1,307,727                  | )          | $ | (10,246,107 | ) | $ | (10,958,470 | ) |

 

100

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Commonassets not directly attributable to a particular segment are included in theCorporate segment. These assets include cash and cash equivalents, prepaid andother corporate assets. The following is a summary of the Company’s assets byoperating segment:

| ** **            | ** ** | **December 31,** | ** ** |
|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Applied Technology:   |       |                  |       |   |   |
| Segment assets        |       | $                     | 2,995,181  |   | $ | 3,514,073 |   |
| Power Systems, US:    |       |                  |       |   |   |
| Segment assets        |       | 4,196,821             |       | 4,197,560 |   |
| Power Systems, Canada |       |                  |       |   |   |
| Segment assets        |       | 8,594,046             |       | 5,014,645 |   |
| Electronics:          |       |                  |       |   |   |
| Segment assets        |       | 5,883,674             |       | 5,901,619 |   |
| Corporate:            |       |                  |       |   |   |
| Segment assets        |       | 8,907,565             |       | 9,700,178 |   |
| Total assets          |       | $                     | 30,577,287 |   | $ | 28,328,075 |   |

 

TheCompany operates and markets its services and products on a worldwide basiswith its principal markets as follows:

| ** **                                                   | ** ** | **Year  Ended**       | ** ** | **Three Months  Ended** | ** ** | **Fiscal Years Ended** | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                   | ** ** | **December 31,** | ** ** | **September 30,**       | ** ** |
| ** **                                                   | ** ** | **2006**              | ** ** | **2005**                     | ** ** | **2005**                    | ** ** | **2004** | ** ** |
| Revenue by geographic  region based on location of customer: |       |                  |       |                         |       |                        |       |   |   |   |   |
| United States                                                |       | $                     | 30,475,297 |                         |       | $                           | 6,662,983  |   |   | $ | 32,570,592 |   | $ | 30,424,627 |   |
| Rest of World                                                |       | 3,281,372             |       |                         | 454,098    |                        |       | 3,384,520 |   | 3,733,196 |   |
| Total Revenue                                                |       | $                     | 33,756,669 |                         |       | $                           | 7,117,081  |   |   | $ | 35,955,112 |   | $ | 34,157,823 |   |

 

| ** **                                                                                                           | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                           | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| Long-lived  assets (including goodwill and intangible assets) by geographic region based  on location of operations: |       |                  |       |                  |       |   |   |   |   |
| United States                                                                                                        |       |                  | $          | 4,406,166             |       |   |   | $ | 5,776,239 |   |   |
| Rest of world                                                                                                        |       |                  | 306,584    |                  |       |   | 60,707 |   |   |
| Total long-lived  assets (including goodwill and intangible assets)                                                  |       |                  | $          | 4,712,750             |       |   |   | $ | 5,836,946 |   |   |

 

**T.**                RESTRUCTURINGCOSTS

As of September 30, 2004, the Company had$495,612 accrued related to a restructuring cost, which was established in April 2002.On January 27, 2005, the Company reached a settlement with the landlord ofthe Anaheim, California facility in the amount of $240,000 as final settlementfor all claims. In addition, at that time, the Company determined that all remainingrestructuring liabilities accrued were no longer warranted and that all mattersrelated to the restructuring charge have been settled; accordingly, the Companyhas adjusted all remaining balances related to severance costs, facilities costand equipment costs remaining as of January 1, 2005, resulting in areduction of accrued restructuring charges of $255,612. The remaining balancewas paid by the Company in the quarter ending April 2, 2005.

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Thefollowing is a status of the Company’s accrued restructuring costs and thechanges for the periods then ended:

| ** **                   | ** ** | **Balance  September 30,  2004** | ** ** | **Amounts Paid  or Assets  Disposed Of** | ** ** | **Adjustments** | ** ** | **Balance  September 30,  2005** | ** ** |
|------------------------------|------------|---------------------------------------|------------|---------------------------------------------------------|------------|-----------------|------------|---------------------------------------|------------|
| Severance costs              |       |                                  | $          | 89,353                                                  |       |            |       | $                                     | —     |   |   |   | ($89,353 | ) |   |   | $ | — |   |   |
| Facility costs               |       |                                  | 306,320    |                                                    |       |            | (240,000   | )                                     |       |   | (66,320 | ) |   |   | — |   |   |
| Equipment costs              |       |                                  | 99,939     |                                                    |       |            | —     |                                  |       |   | (99,939 | ) |   |   | — |   |   |
| Accrued restructuring  costs |       |                                  | $          | 495,612                                                 |       |            |       | $                                     | (240,000   | ) |   |   | ($255,612 | ) |   |   | $ | — |   |   |

 

On September 19,2006, the Board of Directors approved a plan to close the Company’s Worcester,Massachusetts manufacturing facility by approximately December 31, 2006 infurtherance of the Company’s continuing efforts to streamline operations andreduce its operating costs.

As of December 31,2006, approximately $1.6 million has been incurred by the Company related tothe restructuring. This charge represents approximately $42,000 related toemployee severance, $45,000 related to employee retention payments and $0.2million in impairment charges related to property, plant and equipment. Inaddition, on December 22, 2006 the Company came to an agreement with thelandlord of the Worcester facility, whereby the Company would issue 850,000shares of common stock in exchange for allowing the Company to terminate thelease early. The stock was issued to the landlord on January 3, 2007. TheCompany recorded a restructuring charge in the period ended December 31,2006 in the amount of $1.1 million related to this agreement and approximately$0.2 million related to the revaluation of investor warrants. The Companyanticipates approximately $0.1 million of additional costs related to therestructuring to be paid out in 2007.

Thefollowing is a summary of the Company’s accrued restructuring costs at December 31,2006:

| ** **                                 | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|
| Severance costs  and payroll-related costs |       |                        | $          | 78,326 |   |   |
| Facility costs                             |       |                        | $          | 1,122,000 |   |   |
| Accrued restructuring  costs               |       |                        | $          | 1,200,326 |   |   |

 

**U.**              PRODUCTWARRANTIES

In its Power Systems Divisions the Company provides awarranty to its customers for most of its products sold. In general the Company’swarranties are for one year after the sale of the product, and in someinstances five years. The Company reviews its warranty liability quarterly. Factorstaken into consideration when evaluating the Company’s warranty reserve are (i) historicalclaims for each product, (ii) the development stage of the product, and (iii) otherfactors.

Thefollowing is a summary of the Company’s accrued warranty activity for thefollowing periods:

| ** **                    | ** ** | **Year Ended**   | ** ** | **Three Months  Ended** | ** ** | **Fiscal  Year Ended** | ** ** |
|-------------------------------|------------|-----------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                    | ** ** | **December 31,** | ** ** | **September 30,**       | ** ** |
| ** **                    | ** ** | **2006**              | ** ** | **2005**                     | ** ** | **2005**                    | ** ** |
| Balance at beginning of  year |       | $                     | 556,314    |                         |       | $                           | 680,469    |   |   |   | $ | 642,119 |   |   |
| Provision                     |       | 748,595               |       |                         | 40,200     |                        |       |   | 455,950 |   |   |
| Usage                         |       | (625,162              | )          |                         | (117,990   | )                           |       |   | (417,600 | ) |   |
| other                         |       | —                |       |                         | (46,365    | )                           |       |   | — |   |   |
| Balance at end of year        |       | $                     | 679,747    |                         |       | $                           | 556,314    |   |   |   | $ | 680,469 |   |   |

 

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**V.**                Recent Accounting Pronouncements

In February 2006, the FASB issued SFAS No. 155,“Accounting for Certain HybridFinancial Instruments” (“SFAS No. 155”) which amends SFASNo. 133, “Accounting for DerivativeInstruments and Hedging Activities” (“SFAS No. 133”) and SFASNo. 140, “Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities” (“SFASNo. 140”). SFAS 155 simplifies the accounting for certain derivativesembedded in other financial instruments by allowing them to be accounted for asa whole if the holder elects to account for the whole instrument on a fairvalue basis. SFAS 155 also clarifies and amends certain other provisionsof SFAS 133 and SFAS 140. SFAS 155 is effective for allfinancial instruments acquired, issued or subject to a remeasurement eventoccurring in fiscal years beginning after September 15, 2006. The Companyadopted SFAS 155 on January 1, 2007. The Company believes that theadoption of SFAS 155 will not have a material effect on our consolidatedfinancial statements.

In June 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48, “*Accounting for Uncertainty in Income Taxes*,”(“FIN No. 48”) which is effective for fiscal years beginning after December 15,2006. FIN No. 48 clarifies the accounting for uncertainty in income taxesrecognized in the financial statements by prescribing a recognition thresholdand measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN No. 48 also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition. The Company is currently evaluating the potential impact of theadoption of FIN No. 48 on our consolidated financial position, results ofoperations and cash flows.

In September 2006, the FASB issued Statement ofFinancial Accounting Standards No. 157 (SFAS 157), Fair ValueMeasurements, which defines fair value, establishes guidelines for measuringfair value and expands disclosures regarding fair value measurements. SFAS 157does not require any new fair value measurements but rather eliminatesinconsistencies in guidance found in various prior accounting pronouncements.SFAS 157 is effective for fiscal years beginning after November 15, 2007.Earlier adoption is permitted, provided the company has not yet issuedfinancial statements, including for interim periods, for that fiscal year. TheCompany is currently evaluating the impact of SFAS 157.

In September 2006,the SEC released SAB 108, Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements. SAB 108allows registrants to adjust for the cumulative effect of certain errorsrelating to prior years in the carrying amount of assets and liabilities as ofthe beginning of the current year, with an offsetting adjustment to the openingbalance of retained earnings in the year of adoption provided that managementhas properly concluded that the errors were not material to prior periods. SAB108 also requires the adjustment of any prior quarterly financial statementswithin the fiscal year of adoption for the effects of such errors on thequarters when the information is next presented. Such adjustments do notrequire previously filed reports with the SEC to be amended. The Company adoptedthe provisions of SAB 108 during fiscal 2006 and determined that the impact onits consolidated financial position, results of operations and cash flows notto be material.

**W.**            SUBSEQUENTEVENTS

On January 31, 2007, the Company elected tosatisfy the February 28, 2007 principal payment due on the Notes byissuing shares of common stock. This issuance was a prepayment, resulting inthe issuance of 445,899 shares of common stock. In addition, on February 26,2007, the Company elected to satisfy the April 1, 2007 principal paymentdue on the Notes by paying cash in the amount of $500,000 when due onApril 1, 2007.

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ONSUPPLEMENTAL SCHEDULE**

To the Board of DirectorsandStockholders of SatCon Technology Corporation:

We have audited, in accordance with the Standards ofthe Public Company Accounting Oversight Board (United States), the consolidatedfinancial statements of SatCon Technology Corporation and its subsidiaries asof December 31, 2006 and 2005, and the consolidated results of theiroperations and cash flows for the year ended December 31, 2006 and the threemonth period ended December 31, 2005, included in this Form 10-K,and have issued our report thereon dated March 23, 2007. Our audits weremade for the purpose of forming an opinion on those consolidated financialstatements taken as a whole. The schedule listed in the financial statementschedule index is the responsibility of the Company’s management and ispresented for purposes of complying with the Securities and Exchange Commission’srules and is not a part of the basic consolidated financial statements. Theschedule for the year ended December 31, 2006 and the three month periodended December 31, 2005 has been subjected to auditing procedures appliedin the audits of the basic consolidated financial statements and, in ouropinion, fairly states, in all material aspects, the financial data required tobe set forth therein in relation to the basic consolidated financial statementstaken as a whole.

/s/ Vitale Caturano &Company, Ltd.

VITALE, CATURANO &COMPANY, LTD.

March 23, 2007Boston, Massachusetts

104

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ONSUPPLEMENTARY SCHEDULE**

To the Board of Directors of SatCon TechnologyCorporation:

Wehave audited, in accordance with the Standards of the Public Company AccountingOversight Board (United States), the consolidated financial statements ofSatCon Technology Corporation and its subsidiaries as of September 30,2005 and the consolidated results of their operations and their cash flows foreach of the two years in the period ended September 30, 2005, included inthis Form 10-K, and have issued our report thereon dated December 15,2005. Our audits were made for the purpose of forming an opinion on thoseconsolidated financial statements taken as a whole. The schedule listed in thefinancial statement schedule index is the responsibility of the Company’smanagement and is presented for purposes of complying with the Securities andExchange Commission’s rules and is not a part of the basic consolidatedfinancial statements. This schedule for the fiscal years ended September 30,2005 and 2004 has been subjected to auditing procedures applied in the auditsof the basic consolidated financial statements and, in our opinion, fairlystates, in all material respects, the financial data required to be set forththerein in relation to the basic consolidated financial statements taken as awhole.
|                        | /s/ GRANT THORNTON LLP |
|------------------------|------------------------|
| Boston, Massachusetts  |
| December 15, 2005 |

 

105

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**FINANCIAL STATEMENT SCHEDULESCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS**

| ** **                                      | ** ** | **Balance at  beginning  of period** | ** ** | **Additions  charged to  costs and  expenses** | ** ** | **Deductions  and  Adjustments** | ** ** | **Balance  at end  of period** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|------------------------------------------|------------|
| **Fiscal Year Ended  September 30, 2004:** |       |                                           |       |                                                     |       |                             |       |                                     |       |
| Allowance for uncollectible accounts            |       | $                                              | 1,049,375  |                                                     | —     |                             | $          | (15,943                                  | )          | $ | 1,033,433 |   |
| Deferred tax valuation allowance                |       | $                                              | 36,031,412 |                                                     | 824,461    |                             | —     |                                     | 36,855,873 |   |
| Reserve for product warranty expense            |       | $                                              | 765,337    |                                                     | $          | 35,127                           |       | $                                        | (158,345   | ) | $ | 642,119 |   |
| Accrued restructuring costs                     |       | $                                              | 495,612    |                                                     | —     |                             | —     |                                     | $          | 495,612 |   |
| **Fiscal Year Ended  September 30, 2005:** |       |                                           |       |                                                     |       |                             |       |                                     |       |
| Allowance for uncollectible accounts            |       | $                                              | 1,033,433  |                                                     | $          | 119,802                          |       | $                                        | 351,964    |   | $ | 801,271 |   |
| Deferred tax valuation allowance                |       | $                                              | 36,855,873 |                                                     | $          | 3,886,722                        |       | —                                   |       | $ | 40,742,595 |   |
| Reserve for product warranty expense            |       | $                                              | 642,119    |                                                     | $          | 455,950                          |       | $                                        | (417,600   | ) | $ | 680,469 |   |
| Accrued restructuring costs                     |       | $                                              | 495,612    |                                                     | $          | (255,612                         | )          | $                                        | (240,000   | ) | $ | — |   |
| **Three Months Ended  December 31, 2005:** |       |                                           |       |                                                     |       |                             |       |                                     |       |
| Allowance for uncollectible accounts            |       | $                                              | 801,271    |                                                     | —     |                             | (617       | )                                        | $          | 800,654 |   |
| Deferred tax valuation allowance                |       | $                                              | 40,742,595 |                                                     | $          | 279,013                          |       | —                                   |       | $ | 41,021,608 |   |
| Reserve for product warranty expense            |       | $                                              | 680,469    |                                                     | $          | 40,200                           |       | $                                        | (164,355   | ) | $ | 556,314 |   |
| Accrued restructuring costs                     |       | $                                              | —     |                                                     | —     |                             | —     |                                     | $          | — |   |
| **Year Ended December 31,  2006:**         |       |                                           |       |                                                     |       |                             |       |                                     |       |
| Allowance for uncollectible accounts            |       | $                                              | 800,654    |                                                     | $          | 271,195                          |       | $                                        | (265,604   | ) | $ | 792,245 |   |
| Deferred tax valuation allowance                |       | $                                              | 41,021,608 |                                                     | $          | 6,348,054                        |       | —                                   |       | $ | 47,369,662 |   |
| Reserve for product warranty expense            |       | $                                              | 556,314    |                                                     | $          | 748,595                          |       | $                                        | (625,162   | ) | $ | 679,747 |   |
| Accrued  restructuring costs                    |       | $                                              | —     |                                                     | $          | 1,612,045                        |       | $                                        | (411,719   | ) | $ | 1,200,326 |   |

 

106

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**Item 9.**                        CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

**Item 9A.**                CONTROLSAND PROCEDURES

*(a) Evaluationof Disclosure Controls and Procedures.*

As required by Rule 13a-15 under theSecurities Exchange Act of 1934, as of the end of the period covered by thisreport, we carried out an evaluation under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of December 31, 2006. While we have identified certaininternal control deficiencies, which are discussed below, our evaluationindicated that these deficiencies did not impair the effectiveness of ouroverall disclosure controls and procedures. Based upon that evaluation, theChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures are effective as of December 31, 2006to ensure that information required to be disclosed by us in the reports wefile or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms.

Our management and Audit Committee were notified by Vitale,Caturano & Company (“Vitale”) of two significant deficiencies in ourinternal control over financial reporting that they observed during the auditof the December 31, 2006 financial statements.

The first significant deficiency relates to a need to formalizepolicies and procedures (including a comprehensive accounting and financialreporting policies and procedures manual, a policy that requires an annualvacation for all employees and periodic rotation of duties, and policies andprocedures relating to information technology). We had begun to formalizepolicies in this area prior to receiving Vitale’s observations and willcontinue with these plans.

The second significantdeficiency relates to our review and analysis of the carrying value ofinventory and improving/retaining applicable documentation at certain of ourbusiness segments. Vitale noted an instance of under capitalized labor andoverhead costs at one of our business segments. During 2007, we plan oncontinuing efforts to enhance our documentation process and monitoring controlsin this area.

*(b) Changes inInternal Control Over Financial Reporting.*

There was no change in ourinternal control over financial reporting that occurred during the fourthquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

**Item 9B.**               OTHERINFORMATION

Not applicable

107

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**PART III**

**Item 10.**                 DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information requiredunder this item is incorporated herein by reference to the informationregarding directors, executive officers and corporate governance included inour proxy statement for our 2007 Annual Meeting of Stockholders.

**Item 11.**                 EXECUTIVECOMPENSATION

The information requiredunder this item is incorporated herein by reference to information regardingexecutive compensation included in our 2007 proxy statement.

**Item 12.**                 SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The information requiredunder this item is incorporated herein by reference to the informationregarding security ownership of certain beneficial owners and management andrelated stockholder matters included in our 2007 proxy statement.

**Item 13.**                 CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information requiredunder this item is incorporated herein by reference to the informationregarding certain relationships and related transactions, and directorindependence included in our 2007 proxy statement.

**Item 14.**                 PRINCIPALACCOUNTING FEES AND SERVICES

The information required under this item isincorporated herein by reference to the information regarding principalaccounting fees and services included in our 2007 proxy statement.

108

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**PART IV**

**Item 15.**                 EXHIBITS,FINANCIAL STATEMENT SCHEDULES

The following documents are filed as part of thisAnnual Report on Form 10-K:

1.*                 ConsolidatedFinancial Statements of SatCon Technology Corporation and its Subsidiaries:*

Consolidated Balance Sheets as of December 31,2006 and December 31, 2005

Consolidated Statements of Operations for the CalendarYear Ended December 31, 2006, the Three Month Period Ended December 31,2005 and the Fiscal Years Ended September 30, 2005 and 2004

Consolidated Statements of Changes in Stockholders’Equity (Deficit) and Comprehensive Loss for the Calendar Year Ended December 31,2006, the Three Month Period Ended December 31, 2005 and the Fiscal YearsEnded September 30, 2005 and 2004

Consolidated Statements of Cash Flows for the CalendarYear Ended December 31, 2006, the Three Month Period Ended December 31,2005 and the Fiscal Years Ended September 30, 2005 and 2004

Notesto Consolidated Financial Statements

2.*                 FinancialStatement Schedule of SatCon Technology Corporation and its Subsidiaries:*

Schedule II: Valuation and Qualifying Accountsfor the Calendar Year Ended December 31, 2006, the Three Month PeriodEnded December 31, 2005 and the Fiscal Years Ended September 30, 2005and 2004

Allother financial statement schedules not listed have been omitted because theyare either not required, not applicable, or the information has been includedelsewhere in the consolidated financial statements or notes thereto.

3.*                 Exhibits:*

The exhibits listed in the Exhibit Indeximmediately preceding the exhibits are filed as part of this Annual Report on Form 10-K.

109

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this Annual Report on Form 10-Kto be signed on its behalf by the undersigned, thereunto duly authorized, inthe City of Boston, Commonwealth of Massachusetts on March 30, 2007.

|        |   | SATCON TECHNOLOGY  CORPORATION |
|--------|--------|--------------------------------|
|   |   | By:                            | /s/ DAVID B. EISENHAURE |
|   |   |                           | David B. Eisenhaure*President and Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed by the following persons in the capacities and on the datesindicated.

|                                 | **Signature** | ** **                                          | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|---------------------------------|---------------|-----------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/  DAVID B. EISENHAURE        |          | Chief Executive Officer,  President and             |       |                |
| David B. Eisenhaure             |          | Chairman of the Board (Principal Executive Officer) |       | March 30, 2007 |
| /s/  DAVID E. O’NEIL       |          | Vice President, Finance  and Treasurer              |       |                |
| David E. O’Neil            |          | (Principal Financial Officer)                       |       | March 30, 2007 |
| /s/  JOHN W. PEACOCK            |          | Controller and Chief  Accounting Officer            |       |                |
| John W. Peacock                 |          | (Principal Accounting Officer)                      |       | March 30, 2007 |
| /s/  JAMES L. KIRTLEY, JR. |          |                                                |       |                |
| James L.  Kirtley, Jr.     |          | Director                                            |       | March 30, 2007 |
| /s/  MARSHALL J. ARMSTRONG      |          |                                                |       |                |
| Marshall J.  Armstrong          |          | Director                                            |       | March 30, 2007 |
| /s/  JOHN M. CARROLL            |          |                                                |       |                |
| John M. Carroll                 |          | Chairman of the Board                               |       | March 30, 2007 |
| /s/ DANIEL R. DWIGHT            |          |                                                |       |                |
| Daniel R. Dwight                |          | Director                                            |       | March 30, 2007 |
| /s/  JOSEPH E. LEVANGIE         |          |                                                |       |                |
| Joseph E.  Levangie             |          | Director                                            |       | March 30, 2007 |
|                            |          |                                                |       |                |
| Andrew R. Muir                  |          | Director                                            |       | March 30, 2007 |

 

110

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**EXHIBITINDEX**
| Exhibit No. | ** ** | ** **                                                                                                                                                                                                                                                                                                                                         | ** ** | **Description** |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 3.1              |       | Certificate of  Incorporation of the Registrant is incorporated herein by reference to  Exhibits to the Registrant’s Registration Statement on Form S-1  (File No. 33-49286).                                                                                                                                                       |
| 3.2              |       | Bylaws of the Registrant  is incorporated herein by reference to Exhibits to the Registrant’s  Registration Statement on Form S-1 (File No. 33-49286).                                                                                                                                                                              |
| 3.3              |       | Certificate of Amendment  of Certificate of Incorporation of the Registrant, as filed with the  Secretary of State of the State of Delaware on May 12, 1997, is  incorporated herein by reference to Exhibits to the Registrant’s Quarterly  Report on Form 10-Q for the period ended March 31, 1997 (File  No. 1-11512). |
| 3.4              |       | Bylaws Amendment of the  Registrant is incorporated herein by reference to Exhibits to the  Registrant’s Quarterly Report on Form 10-Q for the period ended  March 31, 1997 (File No. 1-11512).                                                                                                                                |
| 3.5              |       | Certificate of Amendment  of Certificate of Incorporation of the Registrant, as filed with the  Secretary of State of the State of Delaware on March 17, 1999, is  incorporated herein by reference to Exhibits to the Registrant’s Current  Report on Form 8-K dated August 25, 1999 (File No. 1-11512).                 |
| 3.6              |       | Certificate of Amendment  of Certificate of Incorporation of the Registrant, as filed with the  Secretary of State of the State of Delaware on March 15, 2000 is  incorporated by reference to Exhibits to the Registrant’s Annual Report on  Form 10-K for the fiscal year ended September 30, 2000 (File  No. 1-11512). |
| 3.7              |       | Certificate of Amendment  of Certificate of Incorporation of the Registrant, as filed with the  Secretary of State of the State of Delaware on May 4, 2001, is  incorporated herein by reference to Exhibits to the Registrant’s Quarterly  Report on Form 10-Q for the period ended March 31, 2001 (File  No. 1-11512).  |
| 3.8              |       | Certificate of  Designation of the Relative Rights and Preferences of the Series A  Convertible Preferred Stock of the Registrant, dated as of February 14,  2003, is incorporated herein by reference to Exhibits to the Registrant’s  Current Report on Form 8-K dated February 18, 2003 (File  No. 1-11512).      |
| 3.9              |       | Certificate of  Designation of the Relative Rights and Preferences of the Series B  Convertible Preferred Stock of the Registrant, dated as of October 31,  2003, is incorporated herein by reference to Exhibits to the Registrant’s  Current Report on Form 8-K dated October 31, 2003 (File  No. 1-11512).        |
| 3.10             |       | Certificate of Amendment  of Certificate of Incorporation of the Company, as filed with the Secretary  of State of the State of Delaware on March 23, 2006 is incorporated herein by reference to Exhibits  to the Registrant’s Quarterly Report on Form 10-Q for the period  ended May 11, 2006 (File No. 1-11512).      |
| 3.11             |       | Amendment to Bylaws of  the Company (Adopted by the Board of Directors on February 27, 2007) is  incorporated herein by reference to Exhibits to the Registrant’s Current  Report on Form 8-K dated March 2, 2007 (File No. 1-11512).                                                                                     |
| 4.1              |       | Specimen Certificate of  Common Stock, $.01 par value, is incorporated herein by reference to Exhibits  to the Registrant’s Registration Statement on Form S-1 (File  No. 33-49286).                                                                                                                                                |
| 10.1             |       | Employment Agreement,  dated July 1, 1992, between the Registrant and David B. Eisenhaure is  incorporated herein by reference to Exhibits to the Registrant’s Registration  Statement on Form S-1 (File No. 33-49286).                                                                                                        |
| 10.2             |       | Employment Agreement,  dated July 1, 1992, between the Registrant and Michael C. Turmelle is  incorporated herein by reference to Exhibits to the Registrant’s Registration  Statement on Form S-1 (File No. 33-49286).                                                                                                        |

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| 10.3  |   | 1992 Stock Option Plan  is incorporated herein by reference to Exhibits to the Registrant’s  Registration Statement on Form S-1 (File No. 33-49286).                                                                                                                                                                                                                                             |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.4  |   | 1994 Stock Option Plan  is incorporated herein by reference to Exhibits to the Registrant’s Annual  Report on Form 10-K for the fiscal year ended September 30,  1994 (File No. 1-11512).                                                                                                                                                                                                   |
| 10.5  |   | 1996 Stock Option Plan  is incorporated herein by reference to Exhibits to the Registrant’s Annual  Report on Form 10-K for the fiscal year ended September 30,  1996 (File No. 1-11512).                                                                                                                                                                                                   |
| 10.6  |   | 1998 Stock Incentive  Plan is incorporated herein by reference to Exhibit B to the  Registrant’s Definitive Schedule 14A filed January 26, 1999 (File  No. 1-11512).                                                                                                                                                                                                                        |
| 10.7  |   | 1999 Stock Incentive  Plan is incorporated herein by reference to Exhibits to the Registrant’s  Annual Report on Form 10-K for the fiscal year ended  September 30, 1999 (File No. 1-11512).                                                                                                                                                                                                |
| 10.8  |   | 2000 Stock Incentive  Plan is incorporated herein by reference to Exhibit C to the  Registrant’s Preliminary Schedule 14A filed March 19, 2001 (File  No. 1-11512).                                                                                                                                                                                                                         |
| 10.9  |   | 2002 Stock Incentive  Plan is incorporated herein by reference to Exhibit A to the  Registrant’s Definitive Schedule 14A filed January 28, 2002 (File  No. 1-11512).                                                                                                                                                                                                                        |
| 10.10 |   | Asset Purchase  Agreement, dated as of January 4, 1999, among K&D MagMotor Corp.,  the Registrant, Inductive Components, Inc., Lighthouse  Software, Inc. and Thomas Glynn is incorporated herein by reference to  Exhibits to the Registrant’s Current Report on Form 8-K dated  January 4, 1999 (File No. 1-11512).                                                    |
| 10.11 |   | Asset Purchase  Agreement, dated as of March 31, 1999, by and between HyComp, Inc.  and HyComp Acquisition Corp., a wholly-owned subsidiary of the  Registrant, is incorporated herein by reference to Exhibits to the  Registrant’s Quarterly Report on Form 10-Q for the period ended  June 30, 1999 (File No. 1- 11512).                                                       |
| 10.12 |   | Note Purchase Agreement,  dated as of June 22, 1999, by and among Beacon Power Corporation,  Perseus Capital, L.L.C., DQE Enterprises, Inc., Micro Generation  Technology Fund, L.L.C. and the Registrant is incorporated herein by  reference to Exhibits to the Registrant’s Quarterly Report on Form 10-Q  for the period ended June 30, 1999 (File No. 1-11512).              |
| 10.13 |   | Note and Warrant  Purchase Agreement, dated as of August 2, 1999, by and among Beacon  Power Corporation, Perseus Capital, L.L.C., DQE Enterprises, Inc., Micro  Generation Technology Fund, L.L.C. and the Registrant is incorporated herein  by reference to Exhibits to the Registrant’s Quarterly Report on Form 10-Q  for the period ended June 30, 1999 (File No. 1-11512). |
| 10.14 |   | Form of Stock  Purchase Warrant issued on October 21, 1999 by the Registrant to  Mechanical Technology Incorporated is incorporated herein by reference to Exhibits  to the Registrant’s Current Report on Form 8-K dated  October 21, 1999 (File No. 1-11512).                                                                                                                   |
| 10.15 |   | Form of Stock  Purchase Warrant issued on October 21, 1999 by Mechanical Technology  Incorporated to the Registrant is incorporated herein by reference to  Exhibits to the Registrant’s Current Report on Form 8-K dated  October 21, 1999 (File No. 1-11512).                                                                                                                   |
| 10.16 |   | Agreement between the  Department of Energy and the Registrant is incorporated by reference to  Exhibits to the Registrant’s Annual Report on Form 10-K for the  fiscal year ended September 30, 2000 (File No. 1-11512).                                                                                                                                                                   |
| 10.17 |   | Co-Operation,  License and Supply Agreement by and among Hatch Steltech Ltd., Siemens AG and  SatCon Power Systems Canada Ltd., dated April 26, 2002, is incorporated  herein by reference to Exhibits to the Registrant’s Quarterly Report on  Form 10-Q for the period ended June 29, 2002 (File No. 1-11512).                                                                       |

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| 10.18 |   | Co-Operation,  License and Supply Agreement by and between Hatch Steltech Ltd. and SatCon  Power Systems Canada Ltd., dated October 11, 2001 is incorporated herein  by reference to Exhibits to Registrant’s Annual Report on Form 10-K  for the fiscal year ended September 30, 2002 (File No. 1-11512).                                                                                                                                                                                                                                                                                                                                                                                   |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.19 |   | Investment Banking  Agreement, by and between J.P. Turner & Company, LLC and the Registrant,  dated August 23, 2002 is incorporated herein by reference to Exhibits to  Registrant’s Annual Report on Form 10-K for the fiscal year ended  September 30, 2002 (File No. 1-11512).                                                                                                                                                                                                                                                                                                                                                                                                   |
| 10.20 |   | Loan and Security  Agreement, dated September 13, 2002, between the Registrant, SatCon  Power Systems, Inc., SatCon Electronics, Inc., SatCon Applied  Technology, Inc., SatCon Power Systems Canada LTD. and Silicon Valley  Bank together with Negative Pledge Agreement, dated as of September 13,  2002, by and among the Registrant, SatCon Power Systems, Inc., SatCon  Electronics, Inc., SatCon Applied Technology, Inc., SatCon Power  Systems Canada LTD. and Silicon Valley Bank is incorporated herein by  reference to Exhibits to Registrant’s Annual Report on Form 10-K  for the fiscal year ended September 30, 2002 (File No. 1-11512). |
| 10.21 |   | Stock Purchase Warrant  issued on September 13, 2002 by the Registrant to Silicon Valley Bank  together with Registration Rights Agreement, dated September 13, 2002,  by and between the Registrant and Silicon Valley Bank is incorporated herein  by reference to Exhibits to Registrant’s Annual Report on Form 10-K  for the fiscal year ended September 30, 2002 (File No. 1-11512).                                                                                                                                                                                                                                                                                              |
| 10.22 |   | Stock Purchase Warrant  issued on December 19, 2002 by the Registrant to Silicon Valley Bank  together with Amendment No. 1 to Registration Right Agreement, dated  December 19, 2002, by and among Silicon Valley Bank, Silicon Valley  Bancshares and the Registrant is incorporated herein by reference to Exhibits  to Registrant’s Annual Report on Form 10-K for the fiscal year  ended September 30, 2002 (File No. 1-11512).                                                                                                                                                                                                                                               |
| 10.23 |   | Amended and Restated  Accounts Receivable Financing Agreement, dated April 4, 2003, by and  among the Registrant and Silicon Valley Bank is incorporated herein by  reference to Exhibits to the Registrant’s Quarterly Report on Form 10-Q  for the period ended March 29, 2003 (File No. 1-11512).                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.24 |   | Stock Purchase Warrant  issued on April 4, 2003 by the Registrant to Silicon Valley Bank  together with Amendment No. 2 to the Registration Rights Agreement,  dated April 4, 2003, by and among Silicon Valley Bank, Silicon Valley  Bancshares and the Registrant is incorporated herein by reference to Exhibits  to the Registrant’s Quarterly Report on Form 10-Q for the period  ended March 29, 2003 (File No. 1-11512).                                                                                                                                                                                                                                                    |
| 10.25 |   | First Amendment to  Amended and Restated Accounts Receivable Financing Agreement, dated  June 24, 2003, by and among the Registrant and Silicon Valley Bank  together with Second Amendment to Amended and Restated Accounts Receivable  Financing Agreement, dated August 11, 2003, by and among the Registrant  and Silicon Valley Bank is incorporated herein by reference to Exhibits to  the Registrant’s Quarterly Report on Form 10-Q for the period  ended June 28, 2003 (File No. 1-11512).                                                                                                                                                                                    |
| 10.26 |   | Third Amendment to  Amended and Restated Accounts Receivable Financing Agreement dated as of  September 2, 2003, by and among the Registrant, SatCon Power  Systems, Inc., SatCon Electronics, Inc., SatCon Applied  Technology, Inc., SatCon Power Systems Canada Ltd. and Silicon Valley  Bank is incorporated herein by reference to Exhibits to the Registrant’s  Current Report on Form 8-K dated September 2, 2003 (File  No. 1-11512).                                                                                                                                                                                                                                 |

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| 10.27 |   | Fourth Amendment to  Amended and Restated Accounts Receivable Financing Agreement dated as of  September 10, 2003, by and among the Registrant, SatCon Power  Systems, Inc., SatCon Electronics, Inc., SatCon Applied  Technology, Inc., SatCon Power Systems Canada Ltd. and Silicon Valley  Bank is incorporated herein by reference to Exhibits to the Registrant’s  Current Report on Form 8-K dated September 10, 2003 (File  No. 1-11512).                             |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.28 |   | Fifth Amendment to  Amended and Restated Accounts Receivable Financing Agreement dated as of  October 20, 2003, by and among the Registrant, SatCon Power  Systems, Inc., SatCon Electronics, Inc., SatCon Applied  Technology, Inc., SatCon Power Systems Canada Ltd. and Silicon Valley  Bank is incorporated herein by reference to Exhibits to the Registrant’s  Annual Report on Form 10-K to Form 10-K for the year  ended September 30, 2003 (File No. 1-11512). |
| 10.29 |   | Sixth Amendment to  Amended and Restated Accounts Receivable Financing Agreement dated  December 12, 2003, by and among the Registrant, SatCon Power  Systems, Inc., SatCon Electronics, Inc., SatCon Applied  Technology, Inc., SatCon Power Systems Canada Ltd. and Silicon Valley  Bank is incorporated herein by reference to Exhibits to the Registrant’s  Annual Report on Form 10-K to Form 10-K for the year  ended September 30, 2003 (File No. 1-11512).      |
| 10.30 |   | Stock Purchase Warrant  issued on December 12, 2003 by the Registrant to Silicon Valley together  with Amendment No. 3 to the Registration Rights Agreement, dated  December 12, 2003, by and among Silicon Valley Bank, Silicon Valley  Bancshares and the Registrant is incorporated herein by reference to Exhibits  to the Registrant’s Annual Report on Form 10-K to Form 10-K  for the year ended September 30, 2003 (File No. 1-11512).                               |
| 10.31 |   | Series A  Convertible Preferred Stock Purchase Agreement, dated as of February 18,  2003, by and among the Registrant and the purchasers set forth on  Exhibit A thereto is incorporated herein by reference to Exhibits to the  Registrant’s Current Report on Form 8-K dated February 18,  2003 (File No. 1-11512).                                                                                                                                                             |
| 10.32 |   | Registration Rights  Agreement, dated as of February 18, 2003, by and among the Registrant  and the purchasers listed on Schedule I thereto is incorporated herein by  reference to Exhibits to the Registrant’s Current Report on Form 8-K  dated February 18, 2003 (File No. 1-11512).                                                                                                                                                                                                    |
| 10.33 |   | Form of  Series A Warrant to purchase shares of Common Stock of the Registrant  issued on February 18, 2003 in connection with the sale of the  Series A Convertible Preferred Stock is incorporated herein by reference  to Exhibits to the Registrant’s Current Report on Form 8-K dated  February 18, 2003 (File No. 1- 11512).                                                                                                                                           |
| 10.34 |   | Form of  Series B Warrant to purchase shares of Common Stock of the Registrant  issued on February 18, 2003 in connection with the sale of the  Series A Convertible Preferred Stock is incorporated herein by reference  to Exhibits to the Registrant’s Current Report on Form 8-K dated  February 18, 2003 (File No. 1- 11512).                                                                                                                                           |
| 10.35 |   | Note and Warrant  Purchase Agreement, dated as of February 18, 2003, by and among the  Registrant and the purchasers set forth on Exhibit A thereto is  incorporated herein by reference to Exhibits to the Registrant’s Registration  Statement on Amendment No. 3 to Form S-3 dated July 2,  2003.                                                                                                                                                                                   |
| 10.36 |   | Registration Rights  Agreement (for convertible notes), dated as of February 18, 2003, by and  among the Registrant and the purchasers listed on Schedule I thereto is  incorporated herein by reference to Exhibits to the Registrant’s Current  Report on Form 8-K dated February 18, 2003 (File No. 1-11512).                                                                                                                                                                            |

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| 10.37 |   | Form of Secured  Convertible Promissory Note to be issued by the Registrant pursuant to Note  and Warrant Purchase Agreement, dated as of February 18, 2003, by and  among the Registrant and the purchasers set forth on Exhibit A thereto  is incorporated herein by reference to Exhibits to the Registrant’s Current  Report on Form 8-K dated February 18, 2003 (File No. 1-11512).                                                                    |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.38 |   | Security Agreement,  dated as of February 18, 2003, made by the Registrant in favor of each  of the Secured Parties whose names are set forth on Exhibit A thereto is  incorporated herein by reference to Exhibits to the Registrant’s Current  Report on Form 8-K dated February 18, 2003 (File No. 1-11512).                                                                                                                                                  |
| 10.39 |   | Letter Agreement, dated  February 12, 2003, by and between the Registrant and Silicon Valley Bank  is incorporated herein by reference to Exhibits to the Registrant’s Current  Report on Form 8-K dated February 18, 2003 (File No. 1-11512).                                                                                                                                                                                                                        |
| 10.40 |   | Series B  Convertible Preferred Stock Purchase Agreement, dated as of October 31,  2003, by and among the Registrant and the purchasers set forth on  Exhibit A thereto is incorporated herein by reference to Exhibits to the  Registrant’s Current Report on Form 8-K/A dated October 31,  2003 (File No. 1-11512).                                                                                                                                       |
| 10.41 |   | Registration Rights  Agreement, dated as of October 31, 2003, by and among the Registrant and  the purchasers listed on Schedule I thereto is incorporated herein by  reference to Exhibits to the Registrant’s Current Report on Form 8-K/A  dated October 31, 2003 (File No. 1-11512).                                                                                                                                                                              |
| 10.42 |   | Form of Warrant to purchase  shares of Common Stock of the Registrant issued on October 31, 2003 in  connection with the sale of the Series B Convertible Preferred Stock  thereto is incorporated herein by reference to Exhibits to the Registrant’s  Current Report on Form 8-K dated October 31, 2003 (File  No. 1-11512).                                                                                                                              |
| 10.43 |   | Teaming Agreement by and  between General Atomics and the Registrant, dated February 20, 2003 is  incorporated herein by reference to Exhibits to the Registrant’s Annual  Report on Form 10-K/A Amendment No. 2 to Form 10-K  for the year ended September 30, 2002 (File No. 1-11512).                                                                                                                                                                    |
| 10.44 |   | Modification to Teaming  Agreement (Extension of Term) by and between General Atomics and the  Registrant, dated October 4, 2003 is incorporated herein by reference to  Exhibits to the Registrant’s Annual Report on Form 10-K to  Form 10-K for the year ended September 30, 2003 (File  No. 1-11512).                                                                                                                                                        |
| 10.45 |   | Seventh Amendment to  Amended and Restated Accounts Receivable Financing Agreement dated  December 3, 2004, by and among the Registrant, SatCon Power  Systems, Inc., SatCon Electronics, Inc., SatCon Applied  Technology, Inc., SatCon Power Systems Canada Ltd. and Silicon Valley  Bank is incorporated herein by reference to Exhibits to the Registrant’s  Annual Report on Form 10-K for the year ended September 30,  2004 (File No. 1-11512). |
| 10.46 |   | Facilities Lease, dated  May 12, 2004, between the Registrant and Zoom Group, LLC is incorporated  herein by reference to Exhibits to the Registrant’s Annual Report on  Form 10-K for the year ended September 30, 2004 (File  No. 1-11512).                                                                                                                                                                                                                         |
| 10.47 |   | Eighth Amendment to  Amended and Restated Accounts Receivable Financing Agreement dated  December 21, 2004, by and among the Registrant, SatCon Power  Systems, Inc., SatCon Electronics, Inc., SatCon Applied  Technology, Inc., SatCon Power Systems Canada Ltd. and Silicon Valley is  incorporated herein by reference to Exhibits to the Registrant’s Annual  Report on Form 10-K for the year ended September 30, 2004  (File No. 1-11512).      |

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| 10.48 |   | Loan and Security  Agreement Dated January 28, 2005, by and among the Registrant, SatCon  Power Systems, Inc., SatCon Electronics, Inc., SatCon Applied  Technology, Inc., SatCon Power Systems Canada LTD. And Silicon Valley  Bank is incorporated herein by reference to Exhibits to the Registrant’s  Quarterly Report on Form 10-Q for the period ended April 2,  2005 (File No. 1-11512). |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.49 |   | Cooperative Agreement  between Satcon Technology Corporation and U.S. Army Research Laboratory,  concerning Power Conversion Systems  for Future Army Applications, agreement number: W911NF-05-2-0020  is incorporated herein by reference to Exhibits to the Registrant’s Quarterly  Report on Form 10-Q for the period ended July 2, 2005 (File  No. 1-11512).                                                   |
| 10.50 |   | Loan Modification  Agreement dated June 29, 2005, by and among the Registrant, SatCon Power  Systems, Inc., SatCon Electronics, Inc., SatCon Applied  Technology, Inc., SatCon Power Systems Canada Ltd. and Silicon Valley  Bank is incorporated herein by reference to Exhibits to the Registrant’s  Quarterly Report on Form 10-Q for the period ended July 2,  2005 (File No. 1-11512).     |
| 10.51 |   | Form of Satcon  Technology Corporation 2005 Incentive Compensation Plan, Incentive Stock  Option agreement for Directors and Officer’s of the Corporation is  incorporated herein by reference to Exhibits to the Registrant’s Quarterly  Report on Form 10-Q for the period ended July 2, 2005 (File  No. 1-11512).                                                                                      |
| 10.52 |   | Form of Satcon  Technology Corporation 2005 Incentive Compensation Plan, Non-Qualified Stock  Option agreement for Directors and Officer’s of the Corporation is  incorporated herein by reference to Exhibits to the Registrant’s Quarterly  Report on Form 10-Q for the period ended July 2, 2005 (File  No. 1-11512).                                                                                  |
| 10.53 |   | Form of Warrant to  purchase shares of Common Stock of the Registrant issued on December 22,  2004 is incorporated herein by reference to Exhibits to the Registrant’s  Current Report on Form 8-K dated December 22, 2004 (File  No. 1-11512).                                                                                                                                                           |
| 10.54 |   | Form of  Warrant to purchase shares of Common Stock issued in connection with the  Private Placement is incorporated herein by reference to Exhibits to  the Registrant’s Current Report on Form 8-K dated August 11,  2005 (File No. 1-11512).                                                                                                                                                                |
| 10.55 |   | Securities Purchase  Agreement dated as of July 19, 2006, by and among the Company and the  Purchasers identified on the signature pages thereto is incorporated  herein by reference to Exhibits to the Registrants Current Report on  Form 8-K dated July 19, 2006 (File No. 1-11512).                                                                                                                       |
| 10.56 |   | Form of Senior  Secured Convertible Note Due July 19, 2011 is incorporated herein by  reference to Exhibits to the Registrants Current Report on Form 8-K  dated July 19, 2006 (File No. 1-11512).                                                                                                                                                                                                             |
| 10.57 |   | Form of Warrant A  is incorporated herein by reference to Exhibits to the Registrants Current  Report on Form 8-K dated July 19, 2006 (File No. 1-11512).                                                                                                                                                                                                                                                           |
| 10.58 |   | Form of Warrant B  is incorporated herein by reference to Exhibits to the Registrants Current  Report on Form 8-K dated July 19, 2006 (File No. 1-11512).                                                                                                                                                                                                                                                           |
| 10.59 |   | Security Agreement,  dated as of July 19, 2006, by and among the Company, the Purchasers  identified on the signature pages thereto and Iroquois Master Fund Ltd.,  as agent for the Purchasers is incorporated herein by reference to Exhibits  to the Registrants Current Report on Form 8-K dated July 19,  2006 (File No. 1-11512).                                                                        |
| 10.60 |   | First Amendment to  Securities Purchase Agreement dated as of December 20, 2006, by and  among the Company and the entities identified on the signature  pages thereto is incorporated herein by reference to Exhibits to the  Registrants Current Report on Form 8-K dated December 20,  2006 (File No. 1-11512).                                                                                             |

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| 10.61 |   | Modification,  Termination and Release of Lease, dated as of December 22, 2006, between  the Company and Paul E. Hanlon, Trustee of C&M Realty Trust is  incorporated herein by reference to Exhibits to the Registrants Current  Report on Form 8-K dated December 20, 2006 (File No. 1-11512). |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 14.1  |   | Code of Ethics is  incorporated herein by reference to Exhibits to the Registrant’s Annual  Report on Form 10-K for the year ended September 30, 2004  (File No. 1-11512).                                                                                                                           |
| 21.1  |   | Subsidiaries of the  Registrant.                                                                                                                                                                                                                                                                                         |
| 23.1  |   | Consent of Vitale,  Caturano and Company                                                                                                                                                                                                                                                                                 |
| 23.2  |   | Consent of Grant  Thornton LLP.                                                                                                                                                                                                                                                                                          |
| 31.1  |   | Certification by Chief  Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                |
| 31.2  |   | Certification by Chief  Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                |
| 32.1  |   | Certification Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                       |

 

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