**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

**FORM 10-KSB**

**x**      **ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For theFiscal Year Ended December 31, 2006**

**o**      **TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For thetransition period from                             to                             .**

**CommissionFile No.:  0-1561**

**MAGSTAR TECHNOLOGIES, INC.**

(Exact name ofregistrant as specified in its charter)

| **Minnesota**                             |   | **41-0780999**       |
|-------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer     |
| incorporation or  organization)           |   | Identification  No.) |
|                                      |   |                 |
| **410  11th Avenue South**                |   | ** **           |
| **Hopkins,  Minnesota**                   |   | **55343**            |
| (Address of  principal executive offices) |   | (Zip Code)           |

 

Registrant’stelephone number, including area code:  **(952)935-6921**

Securitiesregistered pursuant to Section 12(b) of the Act:  **None**

Securitiesregistered pursuant to Section 12(g) of the Act:

**CommonStock, par value $0.1875 per share**

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Check whether the issueris not required to file reports pursuant to Section 13 or 15(d) of the ExchangeAct.      o

Check whether the issuer(1) filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act during the preceding 12 months (or for such shorterperiod that the Registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.      YES   x         NO   o

Check if there is nodisclosure of delinquent filers in response to Item 405 of Regulation S-Bcontained in this form, and no disclosure will be contained, to the best ofRegistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB.      o

Indicate by check markwhether the registrant is a shell company as defined in Rule 12b-2 of theSecurities Exchange Act.

YES   o         NO   x

The Registrant’s revenuesfor the fiscal year ended December 31, 2006 were $9,983,086.

The aggregate marketvalue of the common stock of the Company held by non-affiliates as of March 19,2007 was approximately $2,420,229 (based on the last sale price of the commonstock on that date).

The total number ofshares of the Company’s common stock outstanding on March 19, 2007 was9,137,223 shares.

Transitional SmallBusiness Disclosure Format (Check one): YES   o         NO   x

 

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**PARTI**

**Forward Looking Statements**

*The information in this discussion may containforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended.  These forward-lookingstatements involve risks and uncertainties, including statements regarding theCompany’s capital needs, business strategy and expectations.  Any statements that are not of historicalfact may be deemed to be forward-looking statements.  These forward-looking statements involvesubstantial risks and uncertainties.  Insome cases you can identify forward-looking statements by terminology such as “may,”“will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,”“predict,” “potential,” or “continue”, or the negative of such terms or othercomparable terminology.  Forward-lookingstatements in this Report also include references to anticipated sales volumeand product margins, efforts aimed at establishing new or improving existingrelationships with customers, other business development activities,anticipated financial performance, business prospects and similar matters.  Actual events or results may differmaterially from the anticipated results or other expectations expressed in theforward-looking statements.  Inevaluating these statements, you should consider various factors, including therisks included from time to time in other reports or registration statementsfiled with the United States Securities and Exchange Commission.  These factors may cause the Company’s actualresults to differ materially from any forward-looking statements.  The Company disclaims any obligation topublicly update these statements, or disclose any difference between actualresults and those reflected in these statements. Such information constitutesforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995 which provides a safe harbor for forward-lookingstatements.*

*In addition, the Company has historically had ahigh concentration of business with one major customer.  The risks and uncertainties the Company facesinclude, but are not limited to, the ability to expand sales and productofferings, to develop a reputation in manufacturing products for selectindustries such as medical industries and factory and laboratory automation, tomanufacture and ship in a timely manner and to the ability to acquire rawmaterials, as well as the risks and uncertainties described in “Management’sDiscussion and Analysis or Plan of Operations” in this Report.*

**ITEM 1.  DESCRIPTION OFBUSINESS.**

***Business Overview***

MagStar Technologies, Inc. (“MagStar” or the “Company”)is a leading global provider of products, technologies, solutions, and servicesto businesses of all sizes.  Our offeringincludes:

·                  Quickdraw Conveyors

·                  Spindles and Motion Control

·                  Industrial Centrifuges

·                  Contract Manufacturing

MagStar is a publicly owned company headquartered inHopkins, Minnesota that trades over the counter on the Bulletin Board (“OTCBB”)under the symbol “MGST.”

The Company was established in 1948 as ReuterManufacturing, Inc., and specialized in precision machining andassemblies.  In late 2000, the Companyacquired the assets of MagStar Technologies, Inc., a private high-energy magnetand magnetic assembly company.  In early2001, the

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Company changed its nameto MagStar Technologies, Inc.  InFebruary 2001, the Company acquired the assets of Quickdraw Conveyors, aprovider of conveyers and technology for factory, laboratory and equipmentautomation.

The Company is a Minnesota corporation.  The principal executive offices of theCompany are located at 410 Eleventh Avenue South, Hopkins, Minnesota55343.  The Company’s telephone number is(952) 935-6921.

See “Item 2.Description of Property” below for information regarding the sale and leasebackof the Company’s executive office and manufacturing facilities in February2003.

***Products and Services***

MagStar is a manufacturer of material handling, motioncontrol, magnetic assemblies, and contract manufactured parts and devices.  MagStar’s primary product is Quickdraw brandconveyor systems, used in factory and laboratory automation.  MagStar also manufactures customized motioncontrol products, spindles, medical devices, and its other proprietary product,oil centrifuges.  MagStar offersengineering, precision machining, and assembly strengths.  Products include conveyors for high techmanufacturing, assembly, and laboratory processes, custom servo motors andspindles, motion control devices, linear slides, disposable-based medicalcentrifuges, and oil centrifuges.

**PROPRIETARYPRODUCTS**

**Conveyors**

MagStar’s Quickdraw Conveyor product line is marketed to automationintegrators, process upgrades, and OEMs seeking to automate a process that hadbeen previously accomplished manually in factories and laboratories. Typicalprocesses include factory assembly, inspection, laboratory analysis, testing,and packaging.  Industries using theseproducts include high-tech manufacturers, semi-conductor, academic and researchinstitutions, microelectronics, biotech, and automotive. These industries arecontinually striving to increase productivity, decrease rejected products, andminimize workers exposure to strenuous and tedious operations or hazardous environments.  MagStar makes five types of modular, lowprofile conveyor systems, three with slip roller accumulation, one with a beltedge drive, and one with individual drives. Each provides electrostaticdischarge protection, low power consumption, and are clean room certified.

**Spindles/MotionControlled Devices**:

Spindles and motion control devices are predominantly manufactured percustomer specification for assemblies whose uses range from medical centrifugesto silicon wafer saws to printed circuit board saws, routers, and opticalinspection systems. The Company’s spindles are used to position various deviceswhich allow for greater flexibility in the customer’s designatedprocesses.  One customer’s spindleapplication includes electronically controlled feedback devices and is used inoptical inspection systems.  Anotherspindle manufactured for a customer controls various medical nuclear imagingdevices on gantry-mounted systems.  Bloodcentrifuge spindle assemblies and devices allow for high-speed separation ofblood into various components and are used in operating rooms, laboratories andblood banks.

**Industrial centrifuges**

Industrial oil centrifuges facilitate increased drain intervals and oilpurification for engine operation.  Oilcentrifuges are used in marine engines, over the road trucking, powergeneration, and oil and gas production. Current centrifuge product projectsinclude blood centrifuges,

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proprietary oil centrifuges, private label oil centrifuges, watercentrifuges, gaseous/vapor centrifuges, fuel line centrifuges, and industrialcentrifuges (coolants/lubrication).

**CONTRACT MANUFACTURING**

**Precision Magnet Assemblies**

The Company buildsprecision magnet assemblies for aerospace, medical, and motion controlledapplications.  These assemblies generallyinclude high-energy permanent magnetic material that may be components ofmachined parts or sub assemblies of rotors, pumps, stators, motors, anddirectional control devices.

**Production machining**

The Company designs andmachines metal parts for a small number of customers.  The Company has unique expertise in CNCmachining precision, close tolerance components.

***Technology***

MagStar has technical abilities in the following areas:

**ConveyorDesign and Manufacturing**

Conveyor and roboticmovement devices tend to require fast orientation and movement, minimum surfacecontrast and high-density boards and chips. MagStar aims to meet these needs with its high tolerance machining andassembly skills, its edge belt handling technology, and its skills in servomotorcontrol feedback.  Production of unwantedparticulate can be a side effect of using conveyor devices inmanufacturing.  MagStar’s patent pendingclean room conveyor technology is designed to solve customers’ problems indealing with clean room requirements.

**Spindle Design and Manufacturing**

Spindles are precisionelectrical motor-based devices.  MagStarmanufactures and designs spindles that rotate from 1,000 up to 40,000RPMs.  Spindles are similar to motorsused to power its centrifugal devices and typically include a DC brushlesselectric motor, bearings, and a feedback/control device all driving a shaftthat engages something else.  Forexample, in a centrifuge, the motor-driven shaft engages the container holdingfluid to which centrifugal force is being applied.  MagStar’s spindles are especially well knownfor generating minimal noise, vibration, and heat.  The skills and technology that this type ofmanufacturing requires include strong engineering, precision, and specializedassembly.

**NewGeneration High Energy Magnetic Materials**

New generation highenergy magnetic materials require higher speed performance, improved torquetransmission and improved holding power. MagStar’s magnet assemblies use bonding capabilities and custom matchingof materials to specific applications enhancing performance for its customers.

**High Tech Centrifugal Separation Design andManufacturing**

High tech centrifugalseparation design and manufacturing involve high-speed electrical motors,precision manufacturing, and precision assembly abilities.  This knowledge is applied to design andmanufacture technological applications. These applications generally involve high-speed rotation while generatingminimal noise, heat, and vibration.

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***Markets***

MagStar supplies itsproducts and services to OEMs in the following markets:

**High Tech Manufacturing andLaboratory Automation**

MagStar’s conveyor lineprovides solutions for a variety of markets, usually integrated into largermanufacturing solutions for markets such as automated assembly of electronicsand medical devices, semiconductors, wafer boards, flat screen monitorcomponents, fluid analysis, pharmaceuticals, and medical devices.  The conveyor line also is frequently used inlaboratory automation.

**Motion Control**

MagStar is a supplier ofcustom spindle/electric motor assemblies for high technology applications.  These applications require state of the artcapabilities for large OEM market leaders. Precision magnet assemblies and magnetizing capabilities along withprecision movement and placement systems from Quickdraw technology contributeto and broaden the Company’s capabilities.

**Medical**

MagStar is a manufacturerof blood separation spindle devices used in analysis and component isolation ofwhole blood.  MagStar’s primary customeris a leading supplier of automated blood processing systems which providesreadily available blood components for pharmaceutical use or patienttransfusions.  These products are used inoperating rooms and in many of the world’s blood banks and laboratories.  Other blood centrifuge applications includethe market for thrombin-based orthobiologics. The Company also manufactures medical components used in bloodcirculatory devices.

**Combustion Engines**

MagStarmanufactures an engine oil centrifuge used primarily by OEMs on stationary andnon-stationary engines of 150 hp and above. The centrifuges are also an after market addition to oil field enginesand power generators.  The centrifuge isdesigned to provide filtration to .5 micron, the ability to recover and analyzeparticulate for preventive maintenance, and the Company is developing thecentrifuge’s efficiency for soot removal. The oil centrifuge also uses MagStar’s centrifuge technology.  Markets that use this technology includepower generation, gas and oil production, marine engines, over the roadtrucking, and off road and construction equipment.

**Filtration/High Tech Separation**

MagStar is a manufacturerof centrifugal separation and filtering spindle devices used with a variety ofliquids including water and gaseous streams. These devices are used to remove a variety of mineral particulate andbiological material.

***Strategy***

The Company isstrategically focused on growing its Quickdraw Conveyors and establishingitself as a premiere manufacturer of custom and standard spindles.  While the Company intends to continue itscontract manufacturing businesses, the Company views Quickdraw Conveyors,spindles, and motion control as its primary growth opportunities.  MagStar is also developing the distributionchannels for its proprietary oil and industrial centrifuge products.

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***Sales and Marketing***

The Company’s sales and marketing effort is focused on the strategicmarkets outlined above.  The Company usesboth an outside sales team and regional representatives.  The sales force is supported by anapplications design and manufacturing engineering team.

The Company’sproducts are sold directly to OEMs, integrators, academic and researchinstitutions, end users and master dealers who market to other distributors.

Marketing effortsfocus on MagStar’s reputation for high quality, precision assemblies thatinclude blood and industrial centrifuges, conveyor systems, spindles, andmagnetic assemblies.  MagStar uses paidadvertising and trade shows, among other methods, to market its products.MagStar’s website (www.magstar.com) provides in-depth descriptions of MagStar’ssales and products.

***Customers***

In 2006, theCompany had sales to its largest customer of $4,283,009, approximately a 27%increase from sales of $3,373,257 to the same customer in 2005.  This customer accounted for approximately 43%of the Company’s sales in 2006, compared to 42% of the Company’s sales in2005.  It is reasonable to assume that alarge portion of the sales growth from this customer was due to uniqueopportunities during the first quarter of 2006. Management anticipates that these unique opportunities were exceptionsabove and beyond the Company’s business plan. Sales with this customer are expected to remain at levels consistentwith the third and fourth quarters of 2006 and possibly increase during2007.  Sales in 2006 to the Company’ssecond largest customer were $1,222,046, compared to $1,039,926 in 2005.  This accounted for approximately 12% of theCompany’s 2006 sales.  The increase of$182,120, or 18%, from 2005 sales to the customer is due to cyclical demandfrom this customer originating in the semiconductor industry.  The Company anticipates sales to thiscustomer to remain at current levels and possibly increase in 2007.  The Company has no intention of issuing anyspecific performance guidance for future periods.  The Company’s backlog of orders and releaseson December 31, 2006 was approximately $3.3 million, compared to approximately$4.2 million on December 31, 2005.

***Supplies***

The raw materialsused by the Company in its manufacturing operations are reasonably available inthe competitive market.  The Companyseeks to maintain multiple sources of the parts and materials; however, certainsignificant customers limit the number of or designate specific suppliers to beused by MagStar.  The availability ofsuch parts and materials could affect the Company’s ability to fill customers’orders on a timely basis.  The Companybelieves that the interruption of existing relationships with suppliers wouldnot have a material adverse effect over the long term, as parts and materialssuitable for the production of our products would be available from othersuppliers.

The Companygenerally manufactures products to customer specifications on a contract basis,and as a result carries minimal amounts of inventory.

***Competition***

With regard to theQuickdraw Conveyor product group, there are many manufacturers of parts andcomponents used in these systems. However, the Company is not aware of any other manufacturers that alsohave the ability to engineer and manufacture high performance, precision,custom designed and highly cosmetic conveyors for these markets to thesatisfaction of its customers.  TheCompany believes that its high speed, high precision and high performanceproducts give it the ability to compete effectively in the conveyor market.

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The contractmanufacturing, machining, and magnetic business in which the Company engages ishighly competitive.  Many of the Company’scompetitors have greater sales volume and resources than the Company.  The principal elements of competition arequality, service, delivery, price and meeting customer requirements.  The Company believes that it accounts foronly a small portion of aggregate national sales of the manufacturing serviceit provides.  The Company believes,however, that its strong engineering and manufacturing capabilities give it acompetitive advantage.

There are many OEMmanufacturers of medical and industrial centrifuges.  However, the Company is not aware of anyother contract manufacturers that also have the ability to engineer andmanufacture high speed, precision, custom designed and highly cosmeticcentrifuges for these markets to the satisfaction of its customers.  It believes that its high speed, highprecision products give it the ability to compete effectively in the centrifugemarket.

The Company facescompetition from several national manufacturers of precision magnets, many ofwhich are capable of supplying magnet assemblies.  With its complete engineering andmanufacturing capabilities, the Company can play a more significant role in itscustomers’ supply programs and benefit more directly from all of the value thatis created in the manufacturing process.

***Researchand Development***

There were nosignificant research and development expenses that were not customer funded in2006 or 2005, nor does the Company anticipate significant expenses of thisnature in 2007.

***IntellectualProperty***

The Company hasfour patents on its Quickdraw Conveyor products.  The Company has trademarks on its oilcentrifuge product and conveyor products.

The Company hasits employees sign confidentiality and nondisclosure agreements at the time ofhiring.  The Company also requirescertain vendors to sign such agreements.

***Backlog***

The Company makesproduct forecasts for future delivery based upon frequently updated informationfrom customers; such forecasts are then adjusted or replaced by actual purchaseorders or production releases.  The Company’sbacklog of orders and releases on December 31, 2006 was approximately $3.3million, compared to approximately $4.2 million on December 31, 2005. TheCompany’s backlog often fluctuates because of blanket orders placed bycustomers who schedule delivery of the product over future months.  The usual period between receipt of an orderfor a new assembly and the first delivery of the product by the Company is 2 to6 months.  The delivery period forsubsequent orders generally is shorter. The Company believes its backlog is firm.

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***Employees***

As of December 31,2006, the Company had 59 employees, which includes 58 full time employees and 1part time employee.  As of December 31,2005, the Company had 57 employees, which included 56 full time employees and 1part time employee.

**ITEM 2. DESCRIPTION OF PROPERTY.**

The Company’sexecutive offices and manufacturing facilities are located at 410 EleventhAvenue South, Hopkins, Minnesota.  TheCompany currently leases 57,545 square feet of the building from HopkinsEleventh Avenue LLC (a related partythrough common ownership).  The new leaseterm is month to month, with monthly payments totaling $16,250.

**ITEM 3.  LEGALPROCEEDINGS.**

None.

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.**

No matter was submitted to a vote of security holdersduring the fourth quarter of the fiscal year covered by this Annual Report onForm 10-KSB, through the solicitation of proxies or otherwise.

**PARTII**

**ITEM 5. MARKET FOR COMMON EQUITYAND RELATED STOCKHOLDER MATTERS.**

***MarketInformation***

The Company’s common stock is not listed on anexchange; however, market quotes for the Company’s common stock are availableon the Over-The-Counter Bulletin Board (“OTCBB”) under the symbol “MGST.”  The following table sets forth, for each ofthe calendar periods indicated, the quarterly high and low bid quotations forthe Company’s common stock quoted on the OTCBB. The prices in this table represent prices between dealers, and do notinclude adjustments for retail mark-ups, markdowns or commissions and may notrepresent actual transactions.
|        | ** ** | ** **      | ** ** | **High** | ** ** | **Low** | ** ** |
|--------|------------|-----------------|------------|----------|------------|---------|------------|
| 2006:  |       | First  Quarter  |       | $        | 1.00       |    | $          | 0.60 |   |
|   |       | Second  Quarter |       | $        | 0.89       |    | $          | 0.52 |   |
|   |       | Third  Quarter  |       | $        | 0.80       |    | $          | 0.55 |   |
|   |       | Fourth  Quarter |       | $        | 0.58       |    | $          | 0.33 |   |

 
|        | ** ** | ** **      | ** ** | **High** | ** ** | **Low** | ** ** |
|--------|------------|-----------------|------------|----------|------------|---------|------------|
| 2005:  |       | First  Quarter  |       | $        | 0.65       |    | $          | 0.45 |   |
|   |       | Second  Quarter |       | $        | 0.45       |    | $          | 0.40 |   |
|   |       | Third  Quarter  |       | $        | 0.75       |    | $          | 0.40 |   |
|   |       | Fourth Quarter  |       | $        | 0.65       |    | $          | 0.45 |   |

 

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***Holders***

As of March 19, 2007 there were approximately 1,250registered record holders of the Company’s common stock and 3 record holders ofthe Company’s Series A preferred stock.

***Dividends***

No cash dividends were declared or paid by the Companyduring 2006 or 2005, and the Company does not intend to pay dividends on itscommon stock or Series A preferred stock in the foreseeable future.

***SecuritiesAuthorized for Issuance Under Equity Compensation Plans.***

See “Item 11. Security Ownership of Certain BeneficialOwners and Management” below for Equity Compensation Plan Information.

**ITEM 6. MANAGEMENT’S DISCUSSIONAND ANALYSIS OR PLAN OF OPERATIONS**

***General***

During 2006 compared to 2005, the Company experiencedincreased sales for its blood centrifuge spindles and conveyors to the Company’slargest customers.  Quickdraw Conveyorand spindle orders account for the majority of the December 31, 2006backlog.  The Company sees continuedconveyor and spindle sales growth as the key areas to the Company’s strategicgrowth.  There can be no assurance thatsales to the Company’s largest customers or sales of other products will be sufficientto allow the Company to maintain positive cash flow or profitability.

***Critical Accounting Policies***

Note 2 of theNotes to the Financial Statements includes a summary of the significantaccounting policies and methods used in the preparation of our FinancialStatements.  The following is a briefdiscussion of the more significant accounting policies and methods used by theCompany.

*General*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires general management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and the disclosure of contingent assets and liabilities at thedates of the financial statements and reported amounts of revenues and expensesduring the reporting periods.  The mostsignificant estimates and assumptions relate to the valuation of inventory andthe recognition of revenue.  Actualamounts could differ from these estimates.

*Inventory Valuation*

The Companyconsiders recent historic usage and future demand in estimating its netrealizable value of its inventory. Inventory at December 31, 2006 reflects write-downs of $51,116.  Should it be determined that write downs areinsufficient, then the Company would be required to record additional inventorywrite-downs, which would have a negative impact on gross profit.

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*Revenue Recognition*

The Companyrecognizes sales when products are shipped, collectability is probable and thesales price is fixed or determinable.

*Results of Operations*

Total revenues for2006 were $9,983,086, compared to $8,104,646 for 2005.  Net sales by classifications were as follows:

|                              | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|------------------------------|------------|-----------|------------|-----------|------------|
| Quickdraw  Conveyors         |       | $         | 2,826,729  |      | $          | 1,937,525 |   |
| Spindles and  Motion Control |       | 5,159,455 |       | 3,780,717 |       |
| Industrial  Centrifuges      |       | 1,097,321 |       | 918,952   |       |
| Contract  manufacturing      |       | 885,263   |       | 1,410,467 |       |
| Other revenue                |       | 14,318    |       | 56,985    |       |
| Total                        |       | $         | 9,983,086  |      | $          | 8,104,646 |   |

 

The Company’s netsales increased by approximately 23% in 2006 from 2005, compared to an increasein net sales of 10% in 2005 from 2004. Sales are not subject to seasonalvolatility.  The increase in sales from2006 over 2005 was due to a unique opportunity with a significant spindlecustomer during the first two quarters of 2006. The increase in Quickdraw conveyor sales was attributable to changingthe Company’s strategic focus from contract manufacturing to conveyor sales.

Cost of sales was$7,710,100 for 2006, compared to $6,552,155 in 2005, an increase in the cost ofsales of approximately 18%.  While thecost of sales increased in 2006 over 2005, gross profit dollars and percentagesalso increased.  The increase in the costof sales reflects increased sales and proportional improvements in cost controland management of variable expenses including material, labor, benefits, andprocess and productivity improvement.

Gross profit was $2,272,986, or 23% for 2006, comparedto $1,552,491 or 19% in 2005.  Thisincrease in gross profit was due to the factors discussed above.

Selling, general and administrative expenses were$1,352,274 or 14% of net sales in 2006, compared to $1,217,782 or 15% of netsales in 2005.  The increase in selling,general and administrative expenses of $134,492 or 11% is due primarily to anincrease in personnel, trade shows, advertising and sales commissions.  These increased expenses were offset bydeferred gain recognition due to restructuring the building and equipmentleases in July 2006.

As a consequence of the foregoing factors, the Companyhad operating income in 2006 of $920,712 or 9% of net sales, compared tooperating income of $334,709 or 4% in 2005, an increase of $586,003 or 175% ofnet sales.

Interest expense in 2006 was $122,616, compared to$149,669 in 2005.  The decrease ininterest expense of $27,053 is a result of a lower average outstanding balanceof our senior debt during 2006 compared to 2005.  Total other income, net of interest expensesin 2006 was $15,606, compared to $7,804 in 2005, an increase of $7,802 or 100%.

Total other expense, net in 2006 was $107,010,compared to total other expense, net in 2005 of $141,865, a decrease of $34,855or 25% which was primarily due to a lower average outstanding balance of oursenior debt during 2006 compared to 2005.

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The effect of inflation on the Company’s results hasnot been significant.

Net income attributable to common shareholders during2006, was $741,702, or $.08 per basic and $.07 per diluted share, compared to anet income attributable to common shareholders of $120,844, or $.01 per basicand diluted share for 2005.  Net incomeor loss is due to the reasons discussed above.

The Company recorded net income for 2006.  Generally, the Company does not pay regularincome taxes because of the availability of its net operating loss carryforwards.

***Liquidityand Capital Resources***

At December 31, 2006, the Company had working capitalof $586,603, compared to a working capital deficit of $3,004,467 at December31, 2005.  The current ratio was****1.42 at December 31, 2006, compared to .44 at December 31,2005.  The increase in the workingcapital is due to debt restructuring, modification of lease agreements and as aresult of profits during 2006.

The Company had positive cash flows from operations of$805,481 for the year ended December 31, 2006, compared to cash flows fromoperations of $34,972 for the year ended December 31, 2005. The Company’sability to meet its continuing cash requirements in the future is dependent onsustaining adequate sales and margins from its manufacturing operations.

Net cash used in investing activities was $127,372 forthe year ended December 31, 2006, compared to net cash used in of $85,328 forthe year ended December 31, 2005.

Net cash (used in) financing activities was $587,028for the year ended December 31, 2006, compared to cash provided by financingactivities of $50,456 for the year ended December 31, 2005.

*Preferred Stock*

On October 10, 2000, the Company completed a privatefinancing (the “Financing”) pursuant to the terms of a Securities PurchaseAgreement dated October 10, 2000 (the “Securities Purchase Agreement”) by andamong the Company, Activar, Inc., James L. Reissner and Michael J. Tate(collectively, the “Investors”). Pursuant to the Securities Purchase Agreement, the Company sold to theInvestors an aggregate of 3,500,000 shares of the Company’s common stock, parvalue $.1875 per share (“Common Stock”), and an aggregate of 1,000,000 sharesof the Company’s Series A convertible preferred stock, par value $.1875 pershare (“Series A Preferred”; together with the Common Stock, the “Shares”), allat a purchase price of $.1777778 per share, for an aggregate purchase price of$800,000.  Of the $800,000 total, Activarand Mr. Reissner purchased $700,000.  Theshares were sold in a transaction exempt from the registration requirements ofthe Securities Act of 1933, as amended (the “Securities Act”), and are “restrictedsecurities” within the meaning of Securities Act.

The Series A Preferred is convertible at any time,without the payment of any additional consideration, into fully paid andnonassessable shares of common stock on a one for one basis subject toanti-dilution.  The Series A Preferredgenerally votes with the common stock on matters submitted to the shareholders,with each share of Series A Preferred having that number of votes that is equalto the number of whole shares of common stock into which such share of Series APreferred is then convertible.  TheSeries A Preferred is entitled to 9% dividends in preference to any dividendspaid on the common stock, but such 9% dividends are payable only if, as andwhen declared by the Company’s board of directors.

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*Notes Payable to Related Parties*

The Company has notes payable to different entities,all related through common ownership. The balance outstanding on the related party notes was $3,071,154 atDecember 31, 2006 and 2005.  All therelated party notes accrue interest at 3%. For the years ended 2006 and 2005, all accrued interest was forgivenwhich was $92,135 and $89,597, respectively. The forgiveness of accrued interest was recorded to additional paid-incapital.  On June 30, 2006 the relatedparties agreed to extend the due dates of the notes to July 1, 2008.

*Credit Agreement*

On June 30, 2006, the Company entered into its firstamendment to the second amended and restated senior credit agreement consistingof an asset-based line of credit with availability of up to $1,200,000, subject to a borrowing base limitation of 85% of theCompany’s eligible accounts receivable. In addition the Company can borrow up to 40% of eligible raw materialsand 30% of eligible finished goods for a one time 120-day period.  The asset-based line of credit bears interestat the bank’s reference rate plus one-half percent and matures in June2007.  At December 31, 2006, theeffective rate was 8.75% on the line of credit.

The credit facility is collateralized by all of theCompany’s assets, except for certain equipment obtained with purchase-moneyfinancing. The bank may at any time apply the funds available in any Companybank account against the outstanding loan balances.  As of December 31, 2006, $0 was outstandingunder the credit facilities.  The line ofcredit is due on demand; accordingly, is classified as a current liability asof December 31, 2006 and 2005.

*Building and Equipment LeaseFinancing*

On March 21, 2001,the Company entered into two sale-leaseback agreements with Activar Properties (a related party through common ownership).  On February 25, 2003, the Company sold thebuilding to Hopkins Eleventh Avenue LLC (arelated party through common ownership) and entered into asale-leaseback arrangement.  Since 2001,the leases have been modified with the most recent on July 1, 2006.  The amended leasecombined the former building and equipment lease agreements into onelease.  The new lease term is month tomonth, with monthly payments totaling $16,250. As part of the new lease agreements, the related party agreed to forgiveall deferred rent totaling $942,792 which was recorded to additional paid-incapital.

The Company has determined that the amended lease is in substance a termlease based on the Company’s intent to continue to use the equipment andbuilding under the lease for an extended period of time.  Since the Company now leases only a portionof the building, the Company recognized $494,094 of the deferred gain onsale-leaseback immediately into income related to the portion of the buildingno longer leased.  The remaining gain onsale-leaseback related to the building as of July 1, 2006 totaling $557,169 willbe amortized over the previous remaining term of thirty-eight months. The gainon sale-leaseback of equipment will continue to be amortized over the remaininglife of the previous term which was eighteen months as of July 1, 2006.

12

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*Expected Capital Needs for 2007*

The Company does not expect capital needs in 2007 toexceed the capacity of its asset based line of credit as allowable receivablesand inventory borrowings are expected to cover operating requirements.  While the asset based line of credit expiresin June 2007, the Company believes it will be able to replace thisfacility.  The Company believes that cashfrom operations, and renewal of and advances from its credit facility willprovide enough liquidity for the next 12 months of operations.

***BusinessConditions***

The Company recognized net income of $813,702 for theyear ended December 31, 2006, and has working capital of $586,603 andstockholders’ deficiency of $2,559,341 at December 31, 2006.

Management’s plans and objectives to improve the financialcondition of the Company are based on a strategy to become a technology leaderin conveyor, spindle, and motion control design and production by being aproduct focused company, growing sales, reducing debt, and accumulating cash.

Continued growth may be achieved by identifying theCompany’s core business (conveyors, motion control and spindles), seekingrelationships that move beyond the manufacturing of specific parts and into thepreparation of sub-assemblies and completed assemblies for its customers,developing a focus towards proprietary products and away from contractmanufacturing and building long-term, sustainable comparative advantages overcompetitors.  The Company seeks to becomeinvolved with its customers early in their development and design processallowing the Company to participate in the earlier, higher value added stage ofproduct development and to establish a closer working relationship with itscustomers.

The Company intends to add new conveyor, spindle, andmotion control customers by expanding its distribution network, creatingstrategic alliances, and new marketing initiatives.  The Company seeks to pursue a courseinvesting in market driven research and development that will lead to innovationand new value propositions in the future, establishing a reputation andexpertise for product development.  TheCompany seeks to be identified as a conveyor, motion control, and spindlemanufacturer and intends to focus on higher value added products that allow itto use its design, manufacturing, and engineering capabilities.

Cash control, cost management, and margin preservationare fundamental to the Company’s profitability. Any new corporate strategiesconsidered must be accountable to existing headcounts and capital resourcesmeaning the Company must resist strategies that require significant inflows ofcapital, unless capital can be prudently raised.  Other priorities include recapitalizing thebalance sheet, generating liquidity, monitoring and changing processes toincrease productivity, and strategically adding key managers and operationalexpertise as a measured response as required in a prudent and responsiblemanner.  The Company also has excesscapacity.  Through mergers, acquisitionsand organic growth, it believes it can increase its revenues while incurringproportionally less additional overhead. By increasing productivity, improving cost control, reducing expensesand keeping expenses in proportion to the Company’s current sales level, theCompany intends to sustain positive cash flow.

There can be no assurance that management will be ableto accomplish all of the above plans and objectives or achieve the necessaryimprovements in its cash flows and financial position to meet its obligationsas they become due.  Senior managementexecutive needs and expenses are expected to increase in the future.

13

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Accordingly, there can be no assurance that theCompany will continue as a going concern in its current form.  The financial statements do not include anyadjustments that might result from the outcome of this uncertainty as thisprobability is indeterminate.

***Summary***

Sales increasedoverall during 2006 compared to the same period in 2005 due to a dramaticincrease in sales to the Company’s largest customer.  The improvedoperating performance for 2006 is the result of operational efficiencies andimprovements at a constant and measured pace, debt restructuring, and abalanced approach to the risk management of operations and sales.  Withthe appropriate managerial policy actions, the upside and downside risks to theattainment of both sustainable growth and operational stability should be keptroughly equal.  Management is cautiously optimistic and intends to respondto changes in economic prospects as needed to fulfill its obligation to prudentfiscal management and stable and fiscally responsible growth, while focusing onits profitable strengths and advantages.

During 2006, theCompany had unique sales opportunities with multiple customers. Management anticipates that these unique opportunities are exceptions above andbeyond the Company’s business plan.  Despite this uncertainty, the Company’sbusiness plan will continue to include the execution of strategic plansdesigned to increase sales and profitability.  The Company has no intentionof issuing any specific performance guidance for future periods.  Except for the historical financialinformation reported above, this report contains forward-looking statementsthat involve risk and uncertainties, including references to anticipated andprojected sales volume, the risk associated with establishing new or improvingexisting relationships with customers of the Company, other businessdevelopment activities, anticipated financial performance, business prospects,and similar matters.  In addition, theCompany has a high concentration of business with one major customer and anyreduction in sales to this customer may affect net income.  Because of these and other uncertainties,actual results could differ materially from those reflected in theforward-looking statements.

***FactorsThat May Affect Future Results***

Dependence on Major Customers.  Sales were affected by increases in sales tomajor medical and conveyor customers in 2006. These increases were driven by higher demand and reduced customerinventories.  The Company continues totake orders from these major customers and although the Company enjoyed uniquesales growth in the first quarter of 2006, the Company expects overall businesswith such customers to remain steady or increase for 2007 compared to the lastsix months of 2006.  However, noassurance can be given that sales to these customers will reach or exceedprevious levels.  The Company has noproduction contracts with its major customers and believes that reductions inorders from these customers would have material adverse effects on futureoperating results.  The Company continuesto pursue customer diversification to reduce dependence on sales to itssignificant customer.

Dependence on New Products and Continued Growth in SalesVolume.  The Company’sfuture success will depend on its ability to retain current customers and addnew customers.  The Company also looks todevelop new customers for products manufactured under its own trade names,Quickdraw conveyors and oil centrifuges. The Company looks to obtain productionorders for existing conveyor and prototype products including motion control,magnetic, spindle, and centrifuge assemblies, and maintain a satisfactoryvolume of orders for current customers.

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Competition. While the Companybelieves its engineering capability is a competitive advantage, and that itoffers value added assistance and solutions for improved design,manufacturability and reliability of higher-level assemblies, customers withexisting products may not change from suppliers of discrete components.  Company management believes the Companyrepresents only a small portion of the aggregate national sales of proprietaryproduct and contract manufacturing services.

***Impactof Recent Accounting Pronouncements.***

**In September 2006, the SEC issued Staff Accounting BulletinNo. 108, “Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements” (SAB 108).SAB 108 provides interpretive guidance on how the effects of the carryoveror reversal of prior year misstatements should be considered in quantifying acurrent year misstatement. Under SAB 108, registrants should quantify errorsusing both a balance sheet and income statement approach (“dual approach”) andevaluate whether either approach results in a misstatement that is materialwhen all relevant quantitative and qualitative factors are considered. TheCompany adopted SAB 108 on December 31, 2006.**

InJune 2006, the FASB issued FASB Interpretation No. 48, Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109,Accounting for Income Taxes (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in a company’s financial statements in accordance with FASBStatement No. 109.  FIN 48 stipulates arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN 48 also provides guidance on de-recognition, classification,and interest and penalties. The provisions of FIN 48 are to beeffective for fiscal years beginning after December 15, 2006 andmanagement is currently evaluating the impact, if any, that FIN 48 will have onthe results of operations or financial position.

*Theremainder of this page is intentional left blank*

15

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**ITEM 7.  FINANCIALSTATEMENTS.**

The following Financial Statements and Report ofIndependent Registered Public Accountant Firm thereon are included herein (pagenumbers refer to pages in this Report):
| Report of Independent  Registered Public Accounting Firm                                     |   |   |
|----------------------------------------------------------------------------------------------|--------|--------|
|                                                                                         |   |   |
| Balance Sheets as of  December 31, 2006 and 2005                                             |   |   |
|                                                                                         |   |   |
| Statements  of Operations for the years  ended December 31, 2006 and 2005                    |   |   |
|                                                                                         |   |   |
| Statements  of Stockholders’ Deficiency for the years  ended December 31, 2006 and 2005 |   |   |
|                                                                                         |   |   |
| Statements  of Cash Flows for the years ended  December 31, 2006 and 2005                    |   |   |
|                                                                                         |   |   |
| Notes to the Financial Statements                                                            |   |   |

 

**ITEM 8.  CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**

Not applicable.

**ITEM 8A.  CONTROLS AND PROCEDURES.**

Management of the Company has evaluated, with theparticipation of the Chief Executive Officer and Chief Financial Officer of theCompany, the effectiveness of the Company’s disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (the “Exchange Act”)) as of the end of the fiscal yearcovered by this Annual Report on Form 10-KSB. Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer of the Company have concluded that the Company’s disclosurecontrols and procedures as of the end of the fiscal year covered by this AnnualReport on Form 10-KSB are effective to provide reasonable assurance thatinformation required to be disclosed by the Company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the rules and forms of theSecurities and Exchange Commission. However, due to the limited number of Company employees engaged in theauthorization, recording, processing and reporting of transactions, there isinherently a lack of segregation of duties. The Company periodically assesses the cost versus benefit of adding theresources that would remedy or mitigate this situation and currently, does notconsider the benefits to outweigh the costs of adding additional staff in lightof the oversight of the financial statements by senior management.

Management of the Company has also evaluated, with theparticipation of the Chief Executive Officer and Chief Financial Officer of theCompany, any change in the Company’s internal control over financial reporting(as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) thatoccurred during the fourth fiscal quarter of the fiscal year covered by thisAnnual Report on Form 10-KSB.  There wasno change in the Company’s internal control over financial reporting identifiedin that evaluation that occurred during the fourth fiscal quarter of the fiscalyear covered by this Annual Report on Form 10-KSB that has materially affected,or is reasonably likely to materially affect, the Company’s internal controlover financial reporting.

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**ITEM 8B.****                                            OTHERINFORMATION.**

Not applicable.

**PART III**

**ITEM 9.  DIRECTORS,EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS, COMPLIANCE WITH SECTION16(A) OF THE EXCHANGE ACT.**

**Directors and Executive Officersof the Registrant**
| Name                 | ** ** | **Age** | ** ** | **Position**                                                                        |
|----------------------|------------|---------|------------|-------------------------------------------------------------------------------------|
| ** **           |       |    |       |                                                                                |
| Richard F. McNamara  |       | 74      |       | Chairman of the Board and Director                                                  |
|                 |       |    |       |                                                                                |
| James L. Reissner    |       | 67      |       | Director, Former Chief Executive Officer, President,  and Secretary                 |
|                 |       |    |       |                                                                                |
| Michael J. Tate      |       | 67      |       | Director and Former President, Chief Executive  Officer and Chief Financial Officer |
|                 |       |    |       |                                                                                |
| Robert L. Stehlik    |       | 68      |       | Director                                                                            |
|                 |       |    |       |                                                                                |
| Dr. James H. Zavoral |       | 68      |       | Director                                                                            |
|                 |       |    |       |                                                                                |
| Jon L. Reissner      |       | 37      |       | Director, Chief Executive Officer, President, and  Secretary                        |
|                 |       |    |       |                                                                                |
| Joseph A. Petrich    |       | 46      |       | Treasurer and Chief Financial Officer                                               |
|                 |       |    |       |                                                                                |
| Duane R. Bryngelson  |       | 45      |       | Chief Operating Officer                                                             |
|                 |       |    |       |                                                                                |
| David E. Helgerson   |       | 44      |       | Chief Technology Officer                                                            |

 

*Mr. McNamara* has served asChairman of the Board and as a director of the Company since October 2000.  Mr. McNamara has been a director of variousother public companies including Rimage Corporation and TCF FinancialCorporation and was also member of the University of Minnesota Board of Regents.  Mr. McNamara is a graduate of the Universityof Minnesota.

*Mr. James L. Reissner*has servedas a director of the Company since October 2000.  From September 2001 to August 2004, Mr.Reissner served as the Chief Executive Officer of the Company and as Presidentof the Company from October 2002 until August 2004.  He served as Secretary of the Company fromOctober 2000 until August 2004.  Mr.Reissner also served as Chief Financial Officer from September 2001 to March2002.  Mr. Reissner has been President ofActivar, Inc. since January 1996 and served as Chief Financial Officer ofActivar from 1992 until becoming President. Mr. Reissner is a director of several other public companies, includingthe Chairman of the Board of Rimage Corporation and a member of the Board ofWinland Electronics.  Mr. Reissner is agraduate of Macalester College in Minnesota.

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*Mr. Tate* hasserved as a director of the Company since April 1998.  From April 1998 to September 2001, Mr. Tateserved as Chief Executive Officer and President of the Company.  From April 1998 to December 1998 and fromDecember 1999 to September 2001, Mr. Tate also served as the Chief FinancialOfficer of the Company.  Previously, heserved as Vice President/Chief Operating Officer of Minnesota Valley Engineeringfrom August 1996 until joining the Company.   Prior to serving at Minnesota Valley Engineering, Mr. Tate was employedin the Consulting divisions of Coopers & Lybrand and KPMG LLP. 

*Mr. Stehlik* hasbeen a director since 2005 and has been an independent Director of KoppEmerging Growth Fund since September 1997. Mr. Stehlik is retired and served as Vice President of Peoples Bank ofCommerce, Minneapolis, MN, from September 1998 to September 2003.  For four years prior to that, Mr. Stehlikserved as the Senior Vice President of Richfield Bank and Trust Co., based inRichfield, MN.  Prior to his service atRichfield Bank, Mr. Stehlik served in various capacities at First Bank (now USBank) from 1961 to 1994, including as a Senior Vice President and as Presidentof the Southdale Branch from 1982 to 1991.

*Dr. Zavoral* hasbeen a director since 2005 and is a practicing clinical and researchcardiologist.  Dr. Zavoral is a graduateof the University of Minnesota Medical School and University of St. Thomas.  Since 1992, Dr. Zavoral has been the Directorof the Preventive Cardiology Institute. Dr. Zavoral is also an Assistant Professor at the University ofMinnesota.  He is the author of 55peer-reviewed journal articles and is the past President of the MinnesotaChapter of the American Heart Association. Dr. Zavoral specializes in preventive cardiology, treatment ofhypertension, hyperlipidemia, diabetes and obesity.  Dr. Zavoral is a principal investigator forRadiant Research Company conducting Phase I-IV Human Clinical Trials for thebiopharmaceutical industry. He has earned international recognition for hisachievements in lipids and obesity research. Dr. Zavoral is a Fellow of the American Heart Association.

*Mr. JonL. Reissner* has served as President, Chief Executive Officerand Secretary since August, 2004 and was nominated to the Company’s Board ofDirectors in 2006.  Formerly and sinceMay 2002, he was the Company’s Director of Finance.  Since May 2002, Mr. Reissner has served on apart-time consulting basis for Activar, Inc., performing corporate and realestate financing services.  Mr. Reissneris also a member of Activar’s Board of Directors.  From November 2001 to May 2002, he wasemployed by Vermillion State Bank in Hastings, Minnesota, performing commerciallending and general banking functions. From 1992 to 2000, Mr. Reissner served as a Director of Capital Marketsand traded Fixed Income Securities and derivatives and also structured AssetBacked Securities for GMAC-RFC, a division of General Motors.  Mr. Reissner is the Past Chairman of the St.Johns University Private Investment Fund Advisory Board, a member of theFinance Committee for The Association for Laboratory Automation, and a memberof the Federal Reserve Bank of Minneapolis’ Advisory Council on Small Businessand Labor.  Mr. Reissner received hisBachelor of Science degree in Economics from St. Johns University inCollegeville, Minnesota and his Masters of Business Administration from theUniversity of St. Thomas.

18

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*Mr.Petrich*has served as Treasurer and Chief Financial Officersince March 2002.  As of November 1, 2005Mr. Petrich also serves as Chief Financial Officer of Activar, Inc.  He joined Activar in 1997 as the OperationsManager for its Plastics Products Group and became General Manager of thatgroup in 1998. The Activar Plastics Products Group includes Seelye Plastics,Eiler Plastics, Circuit Chemistry, and Afton Plastics.   Prior to joining Seelye, Mr. Petrich was acontroller for Frank W. Griswold and Companies from 1980 through 1994.  He has served as General Manger/VicePresident of Sentry Technologies and Sentry Metal Forming from 1994 through1995, and served as Chief Financial Officer for Famous Dave’s of America from1995 through 1996.  Mr. Petrich is agraduate from Bethel College with a business management degree.

*Mr. Bryngelson* was appointedChief Operating Officer on January 3, 2006. Prior to that, Mr. Bryngelson served as Vice President - Operations ofthe Company since September 2002.  Mr.Bryngelson was the General Manager of Bending Technologies and Comfort Ride,members of the Activar group from 1995 to 2005. Mr. Bryngelson joined Bending Technologies in 1995 as the Director ofOperations and took over as Director of Sales as well in 1997, before receivinghis current and continuing role as General Manager in 1998.  Mr. Bryngelson served as President of D &D Technical Design from 1991 to 1993 before joining Bending Technologies.

*Mr. Helgerson* has served as Chief Technology Officer since2004.  Prior to that, Mr. Helgerson hadserved as the Vice President of Product Development since March, 2001.  Prior to joining MagStar, Mr. Helgerson wasthe President and CEO of Quickdraw Conveyor Systems, Inc., a Burnsville,Minnesota based manufacturer of proprietary conveyor systems and other factoryautomation devices. Mr. Helgerson has been awarded two patents in conveyortechnology.  He worked as a Test Engineerat Honeywell’s Defense Division (now Alliant Techsystems, Inc.) before joiningQuickdraw.  Mr. Helgerson is a graduateof the University of Minnesota with a Bacherlor’s Degree in MechanicalEngineering

***FamilyRelationships***

Jon L. Reissner, the current President and ChiefExecutive Officer of the Company, is the son of James L. Reissner, a directorand former President and Chief Executive Officer of the Company.

*Theremainder of this page is intentional left blank*

19

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**Compliance with Section 16(a) ofthe Exchange Act**

Section 16(a) ofthe Securities Exchange Act of 1934 requires the directors and executiveofficers of the Company and all persons who beneficially own more than 10% ofthe outstanding shares of common stock of the Company to file with theSecurities and Exchange Commission initial reports of ownership and reports ofchanges in ownership of the common stock. Executive officers, directors and greater than 10% beneficial owners arealso required to furnish the Company with copies of all Section 16(a) formsthey file.  Based upon a review of thecopies of such reports furnished to the Company and upon other informationknown to the Company, the Company believes that all filing requirementsapplicable to its directors, executive officers and beneficial owners of morethan 10% of the Company’s outstanding shares of common stock were complied withduring the fiscal year ended December 31, 2006, except for the transaction inthe following table:
| **Name of Filer**   | ** ** | **Description of Transaction** | ** ** | **Transaction Date** | ** ** | **Filing Date**  | ** ** |
|---------------------|------------|--------------------------------|------------|----------------------|------------|------------------|------------|
|                |       |                           |       |                 |       |             |       |
| Duane Bryngelson    |       | Option Grant                   |       | 5/12/05              |       | 1/11/06          |       |
|                |       |                           |       |                 |       |             |       |
| David Helgerson     |       | Option Grant                   |       | 2/14/06              |       | 3/9/06           |       |
|                |       |                           |       |                 |       |             |       |
| Richard F. McNamara |       | Option Grant  Option Grant     |       | 6/10/05  5/19/06     |       | 3/28/06  5/30/06 |       |
|                |       |                           |       |                 |       |             |       |
| Joseph A. Petrich   |       | Option Grant                   |       | 2/14/06              |       | 3/9/06           |       |
|                |       |                           |       |                 |       |             |       |
| Jon L. Reissner     |       | Option Grant  Option Grant     |       | 5/12/05  2/14/06     |       | 3/9/06  3/9/06   |       |
|                |       |                           |       |                 |       |             |       |
| Robert L. Stehlik   |       | Option Grant                   |       | 5/19/06              |       | 5/30/06          |       |
|                |       |                           |       |                 |       |             |       |
| Michael Tate        |       | Option Grant  Option Grant     |       | 5/19/06  10/5/06     |       | 5/30/06  2/14/07 | (1)        |
|                |       |                           |       |                 |       |             |       |
| James Zavoral       |       | Option Grant                   |       | 5/19/06              |       | 5/30/06          |       |

 

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(1) Reported on a Form 5.

**Code of Ethics**

The Company hasadopted a Code of Ethics and Business Conduct that applies to all directors,officers and employees, including the Company’s Chief Executive Officer, ChiefFinancial Officer and Controller.  Inaddition, the Company has a supplemental Code of Ethics for Senior Financial****Executives.  TheCompany’s Code of Ethics and Business Conduct and Code of Ethics for SeniorFinancial Executives are set forth as exhibits to this Annual Report on Form10-KSB.  In addition, copies of theCompany’s Code of Ethics and Business Conduct and Code of Ethics for SeniorFinancial Executives may be obtained from the Company upon request to Jon L.Reissner, in his capacity as Secretary of the Company.

**Corporate Governance**

See Item 12, “CertainRelationships and Related Transactions” for a discussion of corporategovernance.

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**ITEM 10.  EXECUTIVECOMPENSATION.**

**Summary CompensationTable**

The following table providessummary information concerning cash and non-cash compensation paid to or earnedby (i) each individual serving as our principal executive officer during thefiscal year ended December 31, 2006 and (ii) the Company’s two most highlycompensated executive officers, other than the principal executive officer, atthe conclusion of the fiscal year ended December 31, 2006 and who received orearned total compensation of more than $100,000 for the fiscal year ended December31, 2006 (the “named executive officers”).
| **Name and  principal  Position** | ** ** | **Year** | ** ** | **Salary** | ** ** | **Bonus  (5)** | ** ** | **Option  Awards  (1)** | ** ** | **All Other  Compensation** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|----------|------------|------------|------------|----------------|------------|-------------------------|------------|----------------------------------|------------|-----------|------------|
| Jon  L. Reissner                       |       | 2006     |       | $          | 158,176    |           | $          | 30,000                  |       | $                                | 22,500     | (6)       | $          | 18,972 | (10) | $ | 229,648 |   |
| Joseph  A. Petrich                     |       | 2006     |       | $          | 0          | (4)            | $          | 10,000                  |       | $                                | 4,500      | (7)       | $          | 0 |   | $ | 14,500 |   |
| Theodore  A. Colvin(2)                 |       | 2006     |       | $          | 127,990    |           | $          | 0                       |       | $                                | 6,750      | (8)       | $          | 9,377 | (11) | $ | 144,117 |   |
| Duane Bryngelson(3)                    |       | 2006     |       | $          | 104,315    |           | $          | 10,000                  |       | $                                | 6,750      | (9)       | $          | 21,343 | (12) | $ | 142,408 |   |

 

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#### (1)                                 Amountreflects the dollar amount recognized for financial statement reportingpurposes for the fiscal year ended December 31, 2006 in accordance with SFAS123R of stock option awards, and include amounts from awards granted in2006.  Assumptions used in thecalculation of this amount for employees are identified in Note 2 to ourfinancial statements for the fiscal year ended December 31, 2006 of this AnnualReport.

(2)                                 Theodore Colvin became the Vice President of Sales inJanuary 2006 and resigned in January 2007.

(3)                                 Duane Bryngelson became Chief Operating Officer inJanuary 2006.

(4)                                 Mr. Petrich is employed (and paid) by Activar, Inc.,an affiliated company.  Other than thecompensation referenced in the summary compensation table, he does not receiveany compensation from the Company for his services as Chief Financial Officer.

(5)                                 Bonuses are determined annually by the Board and arediscretionary calculated.  Such bonuseswere accrued on the balance sheet at December 31, 2006 and subsequently paid inMarch 2007.

(6)                                 Mr. Reissner was issued 50,000 options in February2006, with 16,667 shares vesting immediately, 16,667 shares will vest inFebruary 2007 and 16,667 shares will vest in February 2008.

(7)                                 Mr. Petrich was issued 10,000 options in February2006, with 3,333 shares vesting immediately, 3,333 shares will vest in February2007 and 3,334 shares will vest in February 2008.

(8)                                 Mr. Colvin was issued 15,000 options in February2006, with 5,000 shares vesting immediately, 5,000 shares will vest in February2007 and 5,000 shares will vest in February 2008.

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(9)                                 Mr. Bryngelson was issued 15,000 options in February2006, with 5,000 shares vesting immediately, 5,000 shares will vest in February2007 and 5,000 shares will vest in February 2008.

(10)                           Mr. Reissner’s other compensation included a companyautomobile, auto insurance, gasoline, 401k match and health insurance for$9,788, $1,402, $2,400, $1,882 and $3,500 respectively.

(11)                           Mr. Colvin’s other compensation included 401k match,and health insurance for $1,225 and $8,152 respectively.

(12)                           Mr. Bryngelson’s other compensation included acompany automobile, auto insurance, gasoline, 401k match, and health insurancefor $7,423, $1,125, $3,600, $1,043 and $8,152 respectively.

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***Outstanding Equity Awards at Fiscal Year-End***

The following table setsforth information regarding each unexercised option held by each of our namedexecutive officers as of December 31, 2006. None of our named executive officers received any stock awards duringthe fiscal year ended December 31, 2006.
| **Name**         | ** ** | **Number of Securities  Underlying  Unexercised Options  (#) Exercisable** | ** ** | **Number of Securities  Underlying Unexercised  Options  (#) Unexercisable** | ** ** | **Option Exercise  Price  ($)** | ** ** | **Option Expiration  Date** | ** ** |
|------------------|------------|------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|----------------------------------|------------|
| Duane Bryngelson |       | 25,000                                                                                         |       |                                                                                             |       | $                                    | 0.05       |                             | 11/06/12   |   |
|             |       | 25,000                                                                                         |       |                                                                                             |       | $                                    | 0.05       |                             | 07/01/13   |   |
|             |       | 100,000                                                                                        |       |                                                                                             |       | $                                    | 1.03       |                             | 04/08/14   |   |
|             |       | 13,333                                                                                         |       | 6,667                                                                                            | (1)        | $                                    | 0.36       |                             | 05/13/15   |   |
|             |       | 5,000                                                                                          |       | 10,000                                                                                           | (2)        | $                                    | 0.61       |                             | 02/15/16   |   |
| Joseph Petrich   |       | 25,000                                                                                         |       |                                                                                             |       | $                                    | 0.50       |                             | 01/27/11   |   |
|             |       | 5,000                                                                                          |       |                                                                                             |       | $                                    | 0.25       |                             | 01/05/12   |   |
|             |       | 25,000                                                                                         |       |                                                                                             |       | $                                    | 0.05       |                             | 11/06/12   |   |
|             |       | 25,000                                                                                         |       |                                                                                             |       | $                                    | 0.05       |                             | 07/01/13   |   |
|             |       | 100,000                                                                                        |       |                                                                                             |       | $                                    | 1.03       |                             | 04/08/14   |   |
|             |       | 13,333                                                                                         |       | 6,667                                                                                            | (1)        | $                                    | 0.36       |                             | 05/13/15   |   |
|             |       | 3,333                                                                                          |       | 6,667                                                                                            | (2)        | $                                    | 0.61       |                             | 05/15/16   |   |
| Jon Reissner     |       | 25,000                                                                                         |       |                                                                                             |       | $                                    | 0.05       |                             | 11/06/12   |   |
|             |       | 25,000                                                                                         |       |                                                                                             |       | $                                    | 0.05       |                             | 07/01/13   |   |
|             |       | 100,000                                                                                        |       |                                                                                             |       | $                                    | 1.03       |                             | 04/08/14   |   |
|             |       | 33,333                                                                                         |       | 16,667                                                                                           | (1)        | $                                    | 0.36       |                             | 05/13/15   |   |
|             |       | 16,667                                                                                         |       | 33,333                                                                                           | (2)        | $                                    | 0.61       |                             | 02/15/16   |   |
| Theodore Colvin  |       | 3,333                                                                                          |       | 1,667                                                                                            | (3)        | $                                    | 0.45       |                             | 05/21/15   |   |
|             |       | 5,000                                                                                          |       | 10,000                                                                                           | (2)        | $                                    | 0.61       |                             | 02/15/16   |   |

 

----

(1)                                 Theseoptions were issued on 05/12/05 with one-third vesting immediately, one-thirdon its first anniversary, and one-third on its second anniversary.

(2)                                 Theseoptions were issued on 02/14/06 with one-third vesting immediately, one-thirdon its first anniversary, and one-third on its second anniversary.

(3)                                 Theseoptions were issued on 05/20/05 with one-third vesting immediately, one-thirdon its first anniversary, and one-third on its second anniversary.

Pursuant to theCompany’s 2001 Stock Option Plan (the “Plan”), in the event an optionee’semployment or other service with the Company and all Subsidiaries is terminatedby reason of the optionee’s death, Disability or Retirement (as defined in thePlan), the option will remain exercisable, to the extent exercisable as of thedate of such termination, for three months in the case of Retirement and oneyear in the case of death or Disability (but in no event after the Time ofTermination).  In the event that theoptionee’s employment or other service with the Company and all Subsidiaries isterminated for any reason other than death, Disability or Retirement, or theoptionee is in the employ or service of a Subsidiary and the Subsidiary ceasesto be a Subsidiary of the Company (unless the optionee continues in the employor service of the Company or another Subsidiary), all rights of the optioneeunder the Plan will immediately

23

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terminate without noticeof any kind, and the option will no longer be exercisable; provided, however,that if such termination is due to any reason other than termination by theCompany or any Subsidiary for “cause” (as defined in the Plan), the option, tothe extent that it is currently exercisable by the optionee as of the time ofsuch termination, will remain exercisable for a period of three months aftersuch termination (but in no event after the Time of Termination).

If a Change inControl (as defined in the Plan) occurs, then, subject to the discretion of theoption committee in its sole discretion,, the option will become immediatelyexercisable in full and will remain exercisable for the remainder of theirterms, regardless of whether the optionee remains in the employ or service ofthe Company or any Subsidiary.  Inaddition, if a Change in Control of the Company occurs, the option committee,in its sole discretion and without the consent of the Optionee, may determinethat the optionee will receive, with respect to some or all of the optionshares cash in an amount equal to the excess of the Fair Market Value (asdefined in the Plan) of such option shares immediately prior to the effectivedate of such Change in Control of the Company over the option exercise priceper share of the option.

***Director Compensation***

The following tableprovides summary information concerning director compensation for fiscal yearending December 31, 2006.
| Name                | ** ** | **Fees  Earned or  Paid In  Cash** | ** ** | **Stock  Option  Awards  (1)** | ** ** | **Total** | ** ** |
|---------------------|------------|----------------------------------------------|------------|--------------------------------|------------|-----------|------------|
| Richard McNamara(2) |       | $                                            | 0          |                           | $          | 4,074     |       | $ | 4,074 |   |
| James Reissner(3)   |       | $                                            | 5,500      |                           | $          | 4,074     |       | $ | 9,574 |   |
| Michael Tate(4)     |       | $                                            | 5,500      |                           | $          | 8,714     |       | $ | 14,214 |   |
| Robert Stehlik(5)   |       | $                                            | 5,500      |                           | $          | 4,074     |       | $ | 9,574 |   |
| James  Zavoral(6)   |       | $                                            | 5,000      |                           | $          | 4,074     |       | $ | 9,074 |   |

 

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(1)                                 Amountreflects the dollar amount recognized for financial statement reportingpurposes for the fiscal year ended December 31, 2006 in accordance with SFAS123R of stock option awards, and include amounts from awards granted in2006.  Assumptions used in thecalculation of this amount for employees are identified in Note 2 to ourfinancial statements for the fiscal year ended December 31, 2006 of this AnnualReport.

(2)                                 Mr.McNamara has 90,000 outstanding options, with 70,000 vested and 20,000unvested.

(3)                                 Mr.Reissner has 90,000 outstanding options, with 70,000 vested and 20,000unvested.

(4)                                 Mr.Tate has 90,000 outstanding options, with 70,000 vested and 20,000 unvested.

(5)                                 Mr.Stehlik has 30,000 outstanding options, with 10,000 vested and 20,000 unvested.

(6)                                 Mr.Zavoral has 30,000 outstanding options, with 10,000 vested and 20,000 unvested.

24

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Non-employee directors ofthe Company receive 15,000 options of common stock annually and a $600 fee foreach board meeting attended.  The optionsvest one-third on its first anniversary, one-third on its second anniversary,and one-third on its third anniversary of grant date.  Committee members receive an additional $250for each meeting attended.  Employeedirectors do not receive compensation for their services as directors inaddition to their compensation received for services as employees.

***Employment Contracts/Termination of Employment/Change in Control***

The Company does not have any employment contracts in place with any of itsemployees, nor has it entered into any change in control or severancearrangements with its current employees.

**ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT.**

***Principal Shareholders and Beneficial Ownership of Management***

Thefollowing table sets forth information known to the Company with respect to thebeneficial ownership of each class of the Company’s capital stock as of March19, 2007 for (1) each person known by the Company to beneficially own more than5% of any class of the Company’s voting securities, (2) each of the executiveofficers named in the Summary Compensation Table under the heading “ExecutiveCompensation,” (3) each of the Company’s directors and (4) all of theCompany’s executive officers and directors as a group.  Except as otherwise indicated, the Companybelieves that each of the beneficial owners of the Company’s capital stocklisted below, based on information provided by these owners, has soleinvestment and voting power with respect to its shares, subject to communityproperty laws where applicable.
| ** **                                                                  | ** ** | **Common Stock** | ** ** | **Series A Preferred Stock** | ** ** | **Total Voting  Stock Beneficially  Owned (2)** | ** ** | **Percent of  Total  Voting** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|----------------------------------------------------------------|------------|------------------------------------|------------|
| **Name**                                                                    | ** ** | **Number**            | ** ** | **Percent**                            | ** ** | **Number**                                                     | ** ** | **Percent**                        | ** ** | **Number** | ** ** | **Power** | ** ** |
| Jon  L. Reissner 410 11th Avenue South Hopkins, MN 55343               |       | 250,000               | (3)        | 2.3                                    | %          | —                                                         |       | 0.0                                | %          | 250,000 |   | 2.1 | % |
|                                                                        |       |                  |       |                                   |       |                                                           |       |                               |       |   |   |   |   |
| Joseph  A. Petrich 410 11th Avenue South Hopkins, MN 55343                  |       | 210,000               | (4)        | 2.0                                    | %          | —                                                         |       | 0.0                                | %          | 210,000 |   | 1.8 | % |
|                                                                        |       |                  |       |                                   |       |                                                           |       |                               |       |   |   |   |   |
| Duane  R. Bryngelson 410 11th Avenue South Hopkins, MN 55343                |       | 185,000               | (5)        | 1.7                                    | %          | —                                                         |       | 0.0                                | %          | 185,000 |   | 1.6 | % |
|                                                                        |       |                  |       |                                   |       |                                                           |       |                               |       |   |   |   |   |
| Theodore  A. Colvin 410 11th Avenue South Hopkins, MN 55343                 |       | 20,000                | (6)        | 0.2                                    | %          | —                                                         |       | 0.0                                | %          | 20,000 |   | 0.2 | % |
|                                                                        |       |                  |       |                                   |       |                                                           |       |                               |       |   |   |   |   |
| Richard  F. McNamara 7808 Creekridge Circle Suite 200 Minneapolis, MN 55439 |       | 2,535,000             | (7)        | 23.6                                   | %          | 625,000                                                        | (7)        | 62.5                               | %          | 3,160,000 |   | 26.9 | % |

 

25

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| ** **                                                                   | ** ** | **Common Stock** | ** ** | **Series A Preferred Stock** | ** ** | **Total Voting  Stock Beneficially  Owned (2)** | ** ** | **Percent of  Total  Voting** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------|------------|----------------------------------------|------------|----------------------------------------------------------------|------------|------------------------------------|------------|
| **Name**                                                                     | ** ** | **Number**            | ** ** | **Percent**                            | ** ** | **Number**                                                     | ** ** | **Percent**                        | ** ** | **Number** | ** ** | **Power** | ** ** |
| James  L. Reissner 7808 Creekridge Circle Suite 200 Minneapolis, MN 55439    |       | 967,327               | (8)        | 9.0                                    | %          | 250,000                                                        | (8)        | 25.0                               | %          | 1,217,327 |   | 10.4 | % |
|                                                                         |       |                  |       |                                   |       |                                                           |       |                               |       |   |   |   |   |
| Michael  J. Tate 410 11th Avenue South Hopkins, MN 55343                |       | 769,372               | (9)        | 7.2                                    | %          | 125,000                                                        | (9)        | 12.5                               | %          | 894,372 |   | 7.6 | % |
|                                                                         |       |                  |       |                                   |       |                                                           |       |                               |       |   |   |   |   |
| Robert  Stehlik 410 Eleventh Avenue S Hopkins, MN 55343                      |       | 32,027                | (10)       | 0.3                                    | %          | —                                                         |       | 0.0                                | %          | 32,027 |   | 0.3 | % |
|                                                                         |       |                  |       |                                   |       |                                                           |       |                               |       |   |   |   |   |
| Dr.  James R. Zavoral 410 Eleventh Avenue S Hopkins, MN 55343                |       | 31,277                | (11)       | 0.3                                    | %          | —                                                         |       | 0.0                                | %          | 31,277 |   | 0.3 | % |
|                                                                         |       |                  |       |                                   |       |                                                           |       |                               |       |   |   |   |   |
| All  executive officers and Directors as a group (9 persons)                 |       | 5,055,003             | (12)       | 47.1                                   | %          | 1,000,000                                                      |       | 100.0                              | %          | 6,055,003 |   | 51.6 | % |
|                                                                         |       |                  |       |                                   |       |                                                           |       |                               |       |   |   |   |   |
| Perkins Capital Management, Inc. 730 East Lake Street Wayzata, MN 55391-1769 |       | 684,900               | (13)       | 6.4                                    | %          | —                                                         |       | 0.0                                | %          | 684,900 |   | 5.8 | % |

 

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(1)                                 Unless otherwise stated, the principal businessaddress is 410-11th Avenue South,Hopkins, MN 55343.

(2)                                 Represents number of shares of voting capital stockof the Company held by the shareholder, including shares of common stock andshares of Series A Preferred Stock (on an as-converted basis).

(3)                                 Includes 250,000 shares of common stock that Mr. JonReissner has the right to acquire within 60 days upon the exercise of options.

(4)                                 Includes 210,000 shares of common stock that Mr. JoePetrich has the right to acquire within 60 days upon the exercise of options.

(5)                                 Includes 185,000 shares of common stock that Mr.Duane Bryngelson has the right to acquire within 60 days upon the exercise ofoptions.

(6)                                 Includes 20,000 shares of common stock that Mr. TedColvin has the right to acquire within 60 days upon the exercise of options.

(7)                                 Does not include 625,000 shares of Series A PreferredStock held by Mr. McNamara, which are convertible into 625,000 shares of commonstock, but does include (i) 115,000 shares of common stock that Mr. McNamarahas the right to acquire within 60 days and (ii) 250,000 shares of common stockthat Mr. McNamara has the right to acquire within 60 days upon the exercise ofwarrants, (iii) 2,187,500 shares of

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                                               common stock and (iv) 7,500 shares held by ActivarProperties, Inc.  Mr. McNamara is aprincipal and Chief Executive Officer of and Activar Properties, Inc.

(8)                                 Does not include 250,000 shares of Series A PreferredStock which is convertible into 250,000 shares of Common Stock, but includes(i) options to purchase 90,000 shares of common stock that Mr. Reissner has theright to acquire within 60 days.

(9)                                 Does not include 125,000 shares of Series A PreferredStock, which is convertible into an aggregate of 125,000 shares of commonstock, but includes options to purchase 196,058 shares of common stock that Mr.Tate has the right to acquire within 60 days.

(10)                           Includes 30,000 shares of common stock that Mr.Stehlik has the right to acquire within 60 days upon the exercise of options.

(11)                           Includes 30,000 shares of common stock that Dr.Zavoral has the right to acquire within 60 days upon the exercise of options.

(12)                           Includes an aggregate of 281,061 shares of commonstock and 250,000 shares of common stock that executive officers and directorshave the right to acquire within 60 days upon the exercise of options andwarrants, respectively.

(13)                           According to a Schedule 13G/A, dated January 12,2007, as filed with the Securities and Exchange Commission, Perkins CapitalManagement, Inc. has sole voting power with respect to 155,000 of such shares,and sole dispositive power over all such shares.

27

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***Equity Compensation Plan Information***

The following table below presentsthe Company’s Equity Compensation Plan information as of December 31, 2006.
| **Plan Category**                                       | ** ** | **Number of securities to be  issued upon exercise of  outstanding options, warrants  and rights (a)** | ** ** | **Weighted average  exercise price of  outstanding options,  warrants and rights (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  column (a)) (c)** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans  approved by security holders     |       | 1,602,673                                                                                                                                                     | (1)(2)     | $                                                                                                                         | 0.65       |                                                                                                                                                                                                                  | 693,327    | (3) |
|                                                         |       |                                                                                                                                                          |       |                                                                                                                      |       |                                                                                                                                                                                                                  |       |
| Equity  compensation plans not  approved by security holders |       | —                                                                                                                                                        |       | —                                                                                                                    |       | —                                                                                                                                                                                                                |       |
| Total                                                        |       | 1,602,673                                                                                                                                                     |       | $                                                                                                                         | 0.65       |                                                                                                                                                                                                                  | 693,327    |   |

 

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(1)           Includes2,000,000 shares authorized for issuance pursuant to the 2001 Stock Option Planand 20,000 shares authorized for issuance pursuant to the 2001 Employee StockPurchase Plan, both Plans are registered by the Company on Form S-8 datedSeptember 24, 2004.  Under the 2001 StockOption Plan, eligible recipients include all employees of the Company or anySubsidiary and any non-employee directors, consultants and independentcontractors of the Company or any Subsidiary. Under the 2001 Employee Stock Purchase Plan only employees of theCompany are eligible to participate.

(2)           Includes125,000 shares authorized for issuance pursuant to the 1997 Non-EmployeeDirector Stock Option Plan, registered on Form S-8 dated August 10, 1998.  These shares may only be issued to directorsthat are not employees of the Company.

(3)           Represents318,327 shares remaining under the 2001 Stock Option Plan; 250,000 sharesremaining under the 2001 Employee Stock Purchase Plan; and 125,000 sharesremaining under the 1997 Non-Employee Director Stock Option Plan.

**ITEM 12.  CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS.**

The Company has notes payable to different entities,all related through common ownership. The balance outstanding on the related party notes was $3,071,154 atDecember 31, 2006 and 2005.  All therelated party notes accrue interest at 3%. For the years ended 2006 and 2005, all accrued interest was forgivenwhich was $92,135 and $89,597 respectively. The forgiveness of accrued interest was recorded to additional paid incapital.  On June 30, 2006 the relatedparties agreed to extend the due dates of the notes to July 1, 2008.

On March 21, 2001,the Company entered into two sale-leaseback agreements with Activar Properties (a related party through common ownership).  On February 25, 2003, the Company sold thebuilding to Hopkins Eleventh Avenue LLC (arelated party through common ownership) and entered into asale-leaseback arrangement.  Since 2001,the leases have been modified with the most recent on July 1, 2006.  The amended leasecombined the former building and equipment lease agreements into onelease.  The new lease term is month tomonth, with monthly payments totaling $16,250. As part of the new lease agreements, the related party agreed to forgiveall deferred rent totaling $942,792 which was recorded to additional paid incapital.

28

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The Company has determined that the amended lease is in substance a termlease based on the Company’s intent to continue to use the equipment andbuilding under the lease for an extended period of time.  Since the Company now leases only a portionof the building, the Company recognized $494,094 of the deferred gain onsale-leaseback immediately into income. The remaining gain on sale-leaseback related to the building as of July1, 2006 totaling $557,169 will be amortized over thirty-eight months. The gainon sale-leaseback of equipment will continue to be amortized over the remaininglife of the previous term which had eighteen months remaining as of July 1,2006.

Rent expense on the lease was$213,319 and $343,392 for the years ended December 31, 2006 and 2005,respectively.  Included in rent expenseis deferred rent of ($29,792) and $343,392 for the years ended December 31,2006 and December 31, 2005 respectively.

Joseph Petrich, the Company’s Chief Financial Officer, is the ChiefFinancial Officer for Activar, Inc., an affiliated entity.  Mr. Petrich does not receive a salaryfrom the Company for his services, but is eligible for bonuses and optionawards in line with the Company’s other employees and executives.  In 2006, Mr. Petrich received from theCompany a bonus of $10,000 and an option to purchase 10,000 shares of theCompany’s common stock at an exercise price of $0.61 per share.  Mr. Petrich is not compensated by Activar,Inc. for services he provides to us, nor is his compensation from Activar, Inc.in any way based upon our performance.

***Independence Of The Board Of Directors***

In determiningwhether the members of our Board and its committees are independent, we haveelected to use the definition of “independence” set forth by the The NasdaqStock Market, whereby a majority of the members of a listed company’s board ofdirectors must qualify as “independent.” as determined by the board.  Our Board of Directors consults with ourlegal counsel to ensure that the Board’s determinations are consistent with allrelevant securities and other laws and regulations regarding the definition of “independent,”including those set forth in the applicable listing standards of The NasdaqStock Market. Consistent with these considerations, and after review of allrelevant transactions or relationships between each director, or any of hisfamily members, and the Company, its senior management and its independentregistered public accounting firm, the Board has determined that Mr. Tate, Mr.Stehlik, and Mr. Zavoral are independent directors within the meaning of theapplicable listing standard of The Nasdaq Stock Market.

The Board ofDirectors of the Company has an Audit Committee composed of James L. Reissner,Robert L. Stehlik, James H. Zavoral, and Michael J. Tate.  The Audit Committee provides assistance tothe Board in satisfying its fiduciary responsibilities relating to theaccounting, auditing, operating and reporting practices of the Company. TheAudit Committee reviews the Company’s annual financial statements, theselection and work of the Company’s independent auditors and the adequacy ofinternal controls for compliance with corporate policies and directives. TheAudit Committee does not have a written charter.  Because Mr. Reissner is a former executiveofficer and is a principal shareholder of the Company, Mr. Reissner would notbe considered “independent” under the Securities and Exchange Commissiondefinition of that term.

The Board ofDirectors has reviewed the education, experience and other relevantqualifications of Mr. Tate and Mr. Stehlik and has determined that thesemembers meet the Securities and Exchange Commission definition of an “auditcommittee financial expert” and would also be considered “independent” underthe Securities and Exchange Commission definition of that term.

29

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The Board andAudit Committee have not yet established procedures for the handling ofcomplaints regarding accounting, internal accounting controls or auditingmatters.

The Board ofDirectors of the Company has a Compensation Committee composed of James L.Reissner, Richard F. McNamara, Robert L. Stehlik, James H. Zavoral, and MichaelJ. Tate.  The Compensation Committee doesnot have a written charter.  Because Mr.McNamara is a principal shareholder of the Company and Mr. Reissner is a formerexecutive officer and is a principal shareholder of the Company, Mr. McNamaraand Mr. Reissner would not be considered “independent” under the Securities andExchange Commission definition of that term. The Compensation Committee approves the performance goals and objectivesof the corporation, approves all salary, bonus, and long-term incentive awardsfor the Chief Executive Office, and other Officers and Directors of theCompany, approve the overall bonus pool for the Corporate Bonus Plan, reviewand approve changes in the corporation’s qualified benefit plans.

The Board ofDirectors of the Company has a Governance Committee composed of James L.Reissner, Robert L. Stehlik, James H. Zavoral, and Michael J. Tate.  The Governance Committee exercises generaloversight with respect to the governance of the Board of Directors.  The Committee reviews the qualifications ofand recommends to the Board of Directors proposed nominees for election to theBoard.  The Committee reviews annuallythe size and composition of the Board as a whole and recommends, if necessary,measures to be taken so that the Board reflects the appropriate balance ofknowledge, experience, skills, expertise, diversity and independence requiredfor the Board as a whole.  The Committeeis also responsible for evaluating and recommending to the Board corporategovernance practices applicable to the corporation and for leading the Board inits annual review of the Board’s performance.

**ITEM 13. EXHIBITS AND REPORTS ONFORM 8-K.**

**(a)           Exhibits**

The exhibits to this Report arelisted in the Exhibit Index on pages 51 to 54 of this Report.

**ITEM 14. PRINCIPAL ACCOUNTINGFEES AND SERVICES.**

***Audit-RelatedFees***

Audit fees billed to the Company by Virchow Krause& Company, LLP during the fiscal year ended December 31, 2006 and forreview of our quarterly report on Form 10-QSB and annual report on Form 10-KSBfor the same fiscal year totaled $68,000. Such fees during the fiscal year ended December 31, 2005 totaled$55,475.

***Tax Fees***

Tax fees billed to the Company by Virchow Krause &Company, LLP for tax-related services, provided during the fiscal year endedDecember 31, 2006 totaled****$4,300.  Such fees during the fiscal year endedDecember 31, 2005 totaled $13,050.

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***Financial Information SystemsDesign and Implementation Fees***

The Company did not engage Virchow Krause &Company, LLP to provide advice regarding financial information systems designand implementation during fiscal year 2006 or 2005.

***All Other Fees***

Fees billed to the Company by Virchow Krause &Company, LLP for all other non-audit or tax-related services, provided duringthe fiscal year ended December 31, 2006 totaled****$1,740.  Such fees during the fiscal year endedDecember 31, 2005 totaled $0.

**Audit Committee**

The audit committee meets prior to filing of anyQuarterly Report on Form 10-QSB or Annual Report on Form 10-KSB to approvethose filings.  In addition, the committee meets to discuss audit plansand anticipated fees for audit and tax work prior to the commencement of thatwork.  Approximately 100% of all fees paid to our independent auditors arepre-approved by the audit committee.

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**SIGNATURES**

In accordance with Section 13 or15(d) of the Exchange Act, the registrant caused this Report to be signed onits behalf by the undersigned, thereunto duly authorized.
| Dated: March 27, 2007 | MAGSTAR TECHNOLOGIES, INC.              |
|-----------------------|-----------------------------------------|
|                  |                                    |
|                  | /s/ Jon L. Reissner                     |   |
|                  | Jon L. Reissner                         |
|                  | President and Chief Executive  Officer. |
|                       |                                         |  |  |

 

Inaccordance with the Exchange Act, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated.
| Signature                  | ** ** | **Title**                             | ** ** | **Date**       |
|----------------------------|------------|---------------------------------------|------------|----------------|
| ** **                 | ** ** | ** **                            | ** ** | ** **     |
| /s/ Richard F. McNamara    |       | Chairman of the Board and             |       | March 27, 2007 |
| Richard F. McNamara        |       | Director                              |       |           |
|                       |       |                                  |       |           |
| /s/ James L. Reissner      |       | Director                              |       | March 27, 2007 |
|                       |       |                                  |       |           |
| /s/ Michael J. Tate        |       | Director                              |       | March 27, 2007 |
| Michael J. Tate            |       |                                  |       |           |
|                       |       |                                  |       |           |
| /s/ Robert L. Stehlik      |       | Director                              |       | March 27, 2007 |
| Robert L. Stehlik          |       |                                  |       |           |
|                       |       |                                  |       |           |
| /s/ James H. Zavoral       |       | Director                              |       | March 27, 2007 |
| James H. Zavoral           |       |                                  |       |           |
|                       |       |                                  |       |           |
| /s/ Jon L. Reissner        |       | Director, President and Chief         |       | March 27, 2007 |
|                       |       | Executive officer                     |       |           |
|                       |       |                                  |       |           |
| /s/ Joseph A. Petrich      |       | Treasurer and Chief Financial         |       | March 27, 2007 |
| Joseph A. Petrich          |       | Officer (Principal Financial Officer) |       |           |
|                       |       |                                  |       |           |
| /s/ Jacqueline R. Mitchell |       | Controller                            |       | March 27, 2007 |
| Jacqueline R. Mitchell     |       |                                  |       |           |

 

32

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

Audit Committee, Stockholders andBoard of Directors

MagStar Technologies, Inc.

Hopkins,Minnesota

We haveaudited the accompanying balance sheets of MagStar Technologies, Inc., as ofDecember 31, 2006 and 2005 and the related statements of operations,stockholders’ deficiency and cash flows for the years then ended.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

Weconducted our audits in accordance with auditing standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, anaudit of its internal control over financial reporting. Our audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of MagStar Technologies, Inc. as ofDecember 31, 2006 and 2005 and the results of its operations and cash flows forthe years then ended in conformity with U.S. generally accepted accountingprinciples.

Theaccompanying financial statements have been prepared assuming that the Companywill continue as a going concern.  Asdiscussed in Note 1 to the financial statements, the Company has sufferedrecurring losses from operations and its total liabilities exceed its totalassets.  This raises substantial doubtabout the Company’s ability to continue as a going concern.  Management’s plans in regard to these mattersare also described in Note 1.  Thefinancial statements do not include any adjustments that might result from theoutcome of this uncertainty.

Asdiscussed in note 2, on January 1, 2006, the Company adopted the provisions ofstatement of Financial Accounting Standards No. 123R, Share Based Payment.
|  |   | /s/ Virchow, Krause & Company, LLP |
|--|--------|----------------------------------------|

 

Minneapolis, Minnesota

March 7,2007

33

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MagStar Technologies,Inc.

Balance Sheets

At December 31, 2006 and 2005
| ** **                                                                                                                                                                  | ** ** | **2006**    | ** ** | **2005**    | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| **ASSETS**                                                                                                                                                                  | ** ** | ** **  |       |        |       |
| Current  Assets:                                                                                                                                                            |       |        |       |        |       |
| Cash                                                                                                                                                                        |       | $           | 91,681     |        | $          | 600 |   |
| Accounts receivable, net                                                                                                                                                    |       | 558,551     |       | 1,024,035   |       |
| Inventories                                                                                                                                                                 |       | 1,267,477   |       | 1,296,321   |       |
| Other current assets                                                                                                                                                        |       | 51,264      |       | 71,495      |       |
| Total current assets                                                                                                                                                        |       | 1,968,973   |       | 2,392,451   |       |
|                                                                                                                                                                        |       |        |       |        |       |
| Property, plant and equipment, net                                                                                                                                          |       | 184,315     |       | 96,511      |       |
| Patents                                                                                                                                                                     |       | 34,142      |       | 22,301      |       |
| Total assets                                                                                                                                                                |       | $           | 2,187,430  |        | $          | 2,511,263 |   |
|                                                                                                                                                                        |       |        |       |        |       |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIENCY**                                                                                                                           | ** ** | ** **  | ** ** | ** **  | ** ** |
| Current  Liabilities:                                                                                                                                                       |       |        |       |        |       |
| Senior debt                                                                                                                                                                 |       | $           | —     |        | $          | 519,649 |   |
| Capital lease obligations                                                                                                                                                   |       | —      |       | 48,137      |       |
| Checks issued in excess of cash in bank                                                                                                                                     |       | —      |       | 21,972      |       |
| Notes payable to related parties                                                                                                                                            |       | —      |       | 3,071,154   |       |
| Accounts payable                                                                                                                                                            |       | 491,302     |       | 596,267     |       |
| Accrued expenses                                                                                                                                                            |       | 393,211     |       | 408,655     |       |
| Deposits                                                                                                                                                                    |       | 166,332     |       | —      |       |
| Short term deferred gain on sale – leaseback equipment                                                                                                                 |       | 155,576     |       | 155,576     |       |
| Short term deferred gain on sale – leaseback building                                                                                                                  |       | 175,949     |       | 331,978     |       |
| Current portion of deferred rent                                                                                                                                            |       | —      |       | 243,530     |       |
| Total current liabilities                                                                                                                                                   |       | 1,382,370   |       | 5,396,918   |       |
|                                                                                                                                                                        |       |        |       |        |       |
| Long-Term Liabilities:                                                                                                                                                      |       |        |       |        |       |
| Notes payable to related parties                                                                                                                                            |       | 3,071,154   |       | —      |       |
| Deferred gain on sale – leaseback equipment, net of current portion                                                                                                    |       | —      |       | 155,576     |       |
| Deferred gain on sale – leaseback building, net of current portion                                                                                                     |       | 293,247     |       | 885,274     |       |
| Deferred rent, net of current portion                                                                                                                                       |       | —      |       | 581,413     |       |
| Deposits                                                                                                                                                                    |       | —      |       | 2,000       |       |
| Other liabilities                                                                                                                                                           |       | —      |       | 240         |       |
|                                                                                                                                                                        |       |        |       |        |       |
| Total liabilities                                                                                                                                                           |       | 4,746,771   |       | 7,021,421   |       |
|                                                                                                                                                                        |       |        |       |        |       |
| Stockholders’  Deficiency:                                                                                                                                             |       |        |       |        |       |
| Preferred  stock, par value $.1875 per share, authorized 2,500,000 shares; 1,000,000  issued and outstanding                                                                |       | 187,500     |       | 187,500     |       |
| Common  stock, par value $.1875 per share, authorized 30,000,000 shares; issued and  outstanding 9,137,223 and 9,130,723 shares at December 31, 2006 and December  31, 2005 |       | 1,713,229   |       | 1,712,011   |       |
| Additional  paid-in capital                                                                                                                                                 |       | 23,665,876  |       | 22,557,683  |       |
| Deferred  compensation                                                                                                                                                      |       | —      |       | (27,704     | )          |
| Accumulated  deficit                                                                                                                                                        |       | (28,125,946 | )          | (28,939,648 | )          |
|                                                                                                                                                                        |       |        |       |        |       |
| Total stockholders’ deficiency                                                                                                                                         |       | (2,559,341  | )          | (4,510,158  | )          |
| Total  liabilities and stockholders’ deficiency                                                                                                                        |       | $           | 2,187,430  |        | $          | 2,511,263 |   |

 

Theaccompanying notes are an integral part of the financial statements.

34

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MagStar Technologies,Inc.

Statements of Operations

For the years ended December 31, 2006 and 2005
| ** **                                                             | ** ** | **2006**   | ** ** | **2005**  | ** ** |
|------------------------------------------------------------------------|------------|------------|------------|-----------|------------|
|                                                                   |       |       |       |      |       |
| Net sales                                                              |       | $          | 9,983,086  |      | $          | 8,104,646 |   |
| Cost of sales                                                          |       | 7,710,100  |       | 6,552,155 |       |
|                                                                   |       |       |       |      |       |
| Gross profit                                                           |       | 2,272,986  |       | 1,552,491 |       |
|                                                                   |       |       |       |      |       |
| Selling, general and administrative expenses                           |       |       |       |      |       |
| Gains on sale – leasebacks                                        |       | (903,632   | )          | (487,554  | )          |
| Other selling, general and  administrative expenses                    |       | 2,255,906  |       | 1,705,336 |       |
|                                                                   |       |       |       |      |       |
| Total selling, general and  administrative expenses, net               |       | 1,352,274  |       | 1,217,782 |       |
|                                                                   |       |       |       |      |       |
| Operating income                                                       |       | 920,712    |       | 334,709   |       |
|                                                                   |       |       |       |      |       |
| Other income (expense):                                                |       |       |       |      |       |
| Interest expense                                                       |       | (122,616   | )          | (149,669  | )          |
| Other, net                                                             |       | 15,606     |       | 7,804     |       |
|                                                                   |       |       |       |      |       |
| Total other income (expense), net                                      |       | (107,010   | )          | (141,865  | )          |
|                                                                   |       |       |       |      |       |
| Net income                                                             |       | 813,702    |       | 192,844   |       |
|                                                                   |       |       |       |      |       |
| Deemed dividend on preferred stock                                     |       | 72,000     |       | 72,000    |       |
|                                                                   |       |       |       |      |       |
| Net income attributable to common shareholders                         |       | $          | 741,702    |      | $          | 120,844 |   |
|                                                                   |       |       |       |      |       |
| Net income per share attributable to common shareholders– basic   |       | $          | 0.08       |      | $          | 0.01 |   |
| Net income per share attributable to common shareholders– diluted |       | $          | 0.07       |      | $          | 0.01 |   |
|                                                                   |       |       |       |      |       |
| Weighted average common shares outstanding – basic                |       | 9,137,223  |       | 9,127,723 |       |
| Weighted  average common shares outstanding – diluted             |       | 10,504,893 |       | 9,888,323 |       |

 

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

35

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MagStar Technologies,Inc.

Statements ofStockholders’ Deficiency

For the years ended December 31, 2006 and 2005
| ** **                                                        | ** ** | **Series A  Preferred  Stock** | ** ** | **Common  Stock** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | ** **       | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------|------------|------------|------------|------------|------------|-------------|------------|------------------|------------|
| ** **                                                        | ** ** | ** **                          | ** ** | **Par**           | ** ** | ** ** | ** ** | **Par**    | ** ** | **Paid-in** | ** ** | **Deferred**     | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | **Shares**                          | ** ** | **Value**         | ** ** | **Shares** | ** ** | **Value**  | ** ** | **Capital** | ** ** | **Compensation** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| ** **                                                        | ** ** | ** **                          | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                              |       |                                |       |              |       |       |       |       | ** ** | ** **  |       |             |       |   |   |   |   |
| Balances, December 31, 2004                                       |       | 1,000,000                           |       | $                 | 187,500    |       | 9,040,173  |       | $          | 1,695,032   | ** ** | **$**            | 22,420,483 |   | $ | (78,000 | ) | $ | (29,132,492 | ) | $ | (4,907,477 | ) |
| Deferred compensation related to options issued to  non-employees |       |                                |       |              |       |       |       |       |       | 35,187      |       | (35,187          | )          |   |   | — |   |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Compensation expense on options related to  non-employees         |       |                                |       |              |       | 7,358      |       | 1,380      |       | 1,920       |       | 85,483           |       |   |   | 88,783 |   |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Forgiveness of related party debt and accrued  interest           |       |                                |       |              |       |       |       |       |       | 89,597      |       |             |       |   |   | 89,597 |   |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Conversion of long-term debt                                      |       |                                |       |              |       | 54,192     |       | 10,161     |       | 13,684      |       |             |       |   |   | 23,845 |   |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Exercise of options                                               |       |                                |       |              |       | 29,000     |       | 5,438      |       | (3,188      | )          |             |       |   |   | 2,250 |   |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Net income                                                        |       |                                |       |              |       |       |       |       |       |        |       |             |       | 192,844 |   | 192,844 |   |
| Balances, December 31, 2005                                       |       | 1,000,000                           |       | 187,500           |       | 9,130,725  |       | 1,712,011  |       | 22,557,683  |       | (27,704          | )          | $ | (28,939,648 | ) | $ | (4,510,158 | ) |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Adoption of SFAS 123R                                             |       |                                |       |              |       |       |       |       |       | (27,704     | )          | 27,704           |       |   |   | — |   |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Share based compensation                                          |       |                                |       |              |       |       |       |       |       | 99,459      |       |             |       |   |   | 99,459 |   |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Forgiveness of related party debt and accrued  interest           |       |                                |       |              |       |       |       |       |       | 1,034,926   |       |             |       |   |   | 1,034,926 |   |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Exercise of stock options                                         |       |                                |       |              |       | 6,500      |       | 1,218      |       | 1,512       |       |             |       |   |   | 2,730 |   |
|                                                              |       |                                |       |              |       |       |       |       |       |        |       |             |       |   |   |   |   |
| Net income                                                        |       |                                |       |              |       |       |       |       |       |        |       |             |       | 813,702 |   | 813,702 |   |
| Balances, December 31, 2006                                       |       | 1,000,000                           |       | $                 | 187,500    |       | 9,137,223  |       | $          | 1,713,229   | ** ** | **$**            | 23,665,876 |   | $ | — |   | $ | (28,125,946 | ) | $ | (2,559,341 | ) |

 

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

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MagStar Technologies,Inc.

Statements of Cash Flows

For the years ended December 31, 2006 and 2005
| ** **                                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Cash flows from operating activities:                                                         |       |     |       |     |       |
| Net income                                                                                    |       | $        | 813,702    |     | $          | 192,844 |   |
| Adjustments to reconcile net  income to net cash  provided by (used in) operating activities: |       |     |       |     |       |
|                                                                                          |       |     |       |     |       |
| Depreciation and amortization                                                                 |       | 42,833   |       | 18,037   |       |
| Forgiveness of accrued interest –  related party                                         |       | 92,134   |       | 89,597   |       |
| Gain on disposition of equipment                                                              |       | (15,106  | )          | —   |       |
| Gain on sale-leaseback equipment                                                              |       | (155,576 | )          | (155,576 | )          |
| Gain on sale-leaseback building                                                               |       | (748,056 | )          | (331,978 | )          |
|                                                                                          |       |     |       |     |       |
| Share based compensation                                                                      |       | 99,459   |       | 88,783   |       |
| Deferred equipment leases                                                                     |       | —   |       | 128,004  |       |
| Deferred rent                                                                                 |       | (57,761  | )          | 343,392  |       |
| Changes in operating assets and  liabilities:                                                 |       |     |       |     |       |
| Receivables                                                                                   |       | 465,484  |       | (440,634 | )          |
| Inventories                                                                                   |       | 28,844   |       | (121,450 | )          |
| Other current assets, prepaid  expenses                                                       |       | 20,231   |       | (6,858   | )          |
| Accounts payable                                                                              |       | 70,645   |       | 230,845  |       |
| Accrued expenses                                                                              |       | (15,444  | )          | 72,038   |       |
| Accounts payable, related parties                                                             |       | —   |       | (60,205  | )          |
| Other liabilities and deposits                                                                |       | 164,092  |       | (11,867  | )          |
|                                                                                          |       |     |       |     |       |
| Net cash provided by operating activities                                                     |       | 805,481  |       | 34,972   |       |
|                                                                                          |       |     |       |     |       |
| Cash flows from investing activities:                                                         |       |     |       |     |       |
| Purchase of equipment                                                                         |       | (129,711 | )          | (76,306  | )          |
| Proceeds from sales of equipment                                                              |       | 16,000   |       | —   |       |
| Payments for patents                                                                          |       | (13,661  | )          | (9,022   | )          |
|                                                                                          |       |     |       |     |       |
| Net cash (used in) investing activities                                                       |       | (127,372 | )          | (85,328  | )          |
|                                                                                          |       |     |       |     |       |
| Cash flows from financing activities:                                                         |       |     |       |     |       |
| Net (payments on) line of credit                                                              |       | (519,649 | )          | (188,814 | )          |
| Net borrowings note-payable –  related party                                             |       | —   |       | 325,000  |       |
| Checks in excess                                                                              |       | (21,972  | )          | (55,988  | )          |
| Proceeds from stock option  exercises                                                         |       | 2,730    |       | 2,250    |       |
| Payments of capital lease  obligations                                                        |       | (48,137  | )          | (31,992  | )          |
|                                                                                          |       |     |       |     |       |
| Net cash provided by (used in) financing activities                                           |       | (587,028 | )          | 50,456   |       |
| Net increase in cash                                                                          |       | 91,081   |       | 100      |       |
| Cash, beginning of year                                                                       |       | 600      |       | 500      |       |
|                                                                                          |       |     |       |     |       |
| Cash, end of period                                                                           |       | $        | 91,681     |     | $          | 600 |   |
|                                                                                          |       |     |       |     |       |
| Supplemental disclosures of cash flow information:                                            |       |     |       |     |       |
| Cash paid for interest                                                                        |       | $        | 44,449     |     | $          | 67,154 |   |
|                                                                                          |       |     |       |     |       |
| Noncash investing and financing activities:                                                   |       |     |       |     |       |
| Forgiveness of related party debt  and accrued interest recorded to paid-in-capital           |       | $        | 1,034,926  |     | $          | 89,597 |   |
| Conversion of long-term debt                                                                  |       | $        | —     |     | $          | 23,845 |   |

 

Theaccompanying notes are an integral part of the financial statements*.*

37

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**1.**                                                              Business Description and Conditions

**BusinessDescription**

MagStar Technologies,Inc. (“MagStar” or the “Company”) is a leading global provider of products,technologies, solutions, and services to businesses of all sizes.  Our offering includes:

·      QuickdrawConveyors

·      Spindlesand Motion Control

·      IndustrialCentrifuges

·      ContractManufacturing

MagStar is a publiclyowned company headquartered in Hopkins, Minnesota that trades over the counteron the Bulletin Board (“OTCBB”) under the symbol “MGST.” 

The Company was established in 1948 as Reuter Manufacturing, Inc., andspecialized in precision machining and assemblies.  In late 2000, the Company acquired the assetsof MagStar Technologies, Inc., a private high-energy magnet and magneticassembly company.  In early 2001, theCompany changed its name to MagStar Technologies, Inc.  In February 2001, the Company acquired theassets of Quickdraw Conveyors, a provider of conveyers and technology forfactory, laboratory and equipment automation.

TheCompany is a Minnesota corporation.  Theprincipal executive offices of the Company are located at 410 Eleventh AvenueSouth, Hopkins, Minnesota 55343.  TheCompany’s telephone number is (952) 935-6921.

**FinancialCondition and Management’s Plans**

The Company has net income of $813,702 for the year endedDecember 31, 2006 and has a working capital of $586,603 and stockholders’deficiency of $2,559,341 at December 31, 2006.

Management’s plans and objectives toimprove the financial condition of the Company are based on a strategy tobecome a technology leader in centrifuge and conveyor design and production bybeing a product focused company, growing sales, reducing debt, and accumulatingcash. 

Steady growth may be achieved by identifying theCompany’s core business, (centrifuges, spindles, and conveyors), seekingrelationships that move beyond the manufacturing of specific parts and into thepreparation of sub-assemblies and completed assemblies for its customers,developing a focus towards proprietary products and away from contractmanufacturing, and building long term, sustainable competitive advantages overcompetitors.  The Company seeks to becomeinvolved with its customers early in their development and design processallowing the Company to participate in the earlier, higher value added stage ofproduct development and to establish a closer working relationship with itscustomers. 

The Company intends to add new customers by applyingcentrifuge technology to a variety of filtering and separating applications,developing new spindle applications, and by growing and nurturing the conveyorbusiness. The Company intends to add new conveyor customers by expanding itsdistribution network, creating strategic alliances and new marketinginitiatives.  The Company seeks to pursuea course investing in market driven research and development that

38

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will lead to innovation and new value propositions inthe future, establishing a reputation and expertise for productdevelopment.  The Company seeks to beidentified as a centrifuge, spindle and conveyor manufacturer and intends tofocus on higher value added products that allow it to use its design,manufacturing and engineering capabilities.

Cash control, cost management, and marginpreservation are fundamental to the Company’s profitability. Any new corporatestrategies considered must be accountable to existing headcounts and capitalresources meaning the Company must resist strategies that require significantinflows of capital, unless capital can be prudently raised.   Other priorities include recapitalizing thebalance sheet, generating liquidity, monitoring and changing processes toincrease productivity and strategically adding key managers and operationalexpertise as a measured response as required in a prudent and responsiblemanner.  The Company also has excesscapacity.  Through mergers, acquisitionsand organic growth, it believes it can increase its revenues while incurringproportionally less additional overhead. By increasing productivity, improving cost control, reducing expensesand keeping expenses in proportion to the Company’s current sales level, theCompany intends to sustain positive cash flow.

 The Companydoes not expect capital needs in 2007 to exceed the capacity of its asset basedline of credit as allowable receivables and inventory borrowings are expectedto cover operating requirements.  Whilethe asset based line of credit expires in June 2007, the Company believes itwill be able to replace this facility. The Company believes that cash from operations and renewal of andadvances from its credit facility will provide enough liquidity for the next 12months of operations.

Therecan be no assurance that management will be able to accomplish all of the aboveplans and objectives or achieve the necessary improvements in its cash flowsand financial position to meet its obligations as they become due.  The Company’s ability to continue operationsis dependent on its ability to increase sales and maintain adequate margins onsales, as well as its ability to maintain its credit facilities.  In addition, if the Company is unable tomaintain sales from current levels and generate positive cash flows fromoperations, it would be unable to meet its debt service requirements and may beforced to cease operations or seek protection under U.S. bankruptcy laws. 

Accordingly,there can be no assurance that the Company will continue as a going concern inits current form.  The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

**2.**                                                              Significant Accounting Policies

**AccountsReceivable**

The Company extends unsecured credit to customers in thenormal course of business and believes all accounts receivable in excess of theallowance for doubtful accounts to be fully collectible.  If accounts receivable in excess of theprovided allowance is determined uncollectible, they are charged to expense inthe year that determination is made.  The Company does not accrue interest on trade accounts receivable.  Accounts receivable are due 30 days after theinvoice date.  Accounts receivable arewritten off only after all collection attempts have failed.

**Inventories**

Inventories are valued at the lower of cost or market withcost determined on a first-in, first-out basis.

39

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**Property, Plantand Equipment**

Property, plant and equipment arerecorded at cost.  Depreciation andamortization is provided for by the straight-line method based on the estimateduseful lives of the related assets. Useful lives ranged from 15 to 40 years forbuildings and building improvements and 5 to 7 years for machinery andequipment.  Expenditures for majorrenewals and betterments are capitalized, and expenditures for maintenance andrepairs are charged to operations as incurred. Upon retirement or other disposition of property, plant or equipment,the applicable cost and accumulated depreciation and amortization areeliminated from the accounts, and the resulting gain or loss is included inoperations unless the sale is subject to the Company leasing the property backfor a period of time.

**RevenueRecognition**

The Company’srevenue is recognized in accordance with generally accepted accountingprinciples as outlined in the SEC’s Staff Accounting Bulletin No. 104 “RevenueRecognition,” which requires that four basic criteria be met before revenue canbe recognized: (i) persuasive evidence of an arrangement exists; (ii) the priceis fixed or determinable; (iii) collectibility is reasonably assured; and (iv)product delivery has occurred or services have been rendered. The Companyrecognizes revenue as products are shipped. 

**Advertising**

Advertising costs are charged to operations whenincurred.  Advertising expense was$131,305 and $91,526 for the years ended December 31, 2006 and 2005,respectively.

**Shipping andHandling Costs**

Shipping and handling costs charged to customers have beenincluded in net sales.  Shipping andhandling costs incurred by the Company have been included in the cost of sales.

**Income Taxes**

The Company utilizes the asset and liability method ofaccounting for income taxes whereby deferred taxes are determined based on thetemporary difference between the financial statement and tax basis of assetsand liabilities using enacted tax rates in effect in the years in which thedifferences are expected to reverse. Valuation allowances are established when necessary to reduce deferredtax assets to the amount expected to be realized.  

**Financial Instruments**

The carrying amount for all financial instrumentsapproximates fair value. The carrying amounts for cash, accounts payable andaccrued liabilities approximate fair value because of the short maturity ofthese instruments. The fair value of lines of credit and related party debtapproximates the carrying amounts based upon the Company’s expected borrowingrate for debt with similar remaining maturities and comparable risk.

**Net Income (Loss) per CommonShare**

Basic net income (loss) per common share attributableto common shareholders is computed by dividing net income (loss) attributableto common shareholders by the weighted average number of common sharesoutstanding for the reporting period. Diluted net income (loss) per commonshare attributable to common shareholders is computed by dividing net income(loss) attributable to common shareholders by the sum of the weighted averagenumber of common shares outstanding plus all additional common stock that wouldhave been outstanding if potentially dilutive common shares related to commonshare equivalents (stock options, stock warrants, and convertible preferred shares)had been issued. 

40

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**Cash**

The Company deposits its cash in high credit qualityfinancial institutions. The balances, at times, may exceed federally insuredlimits.

**Stock-Based Compensation**

The Company has various types of stock-basedcompensation plans. These plans are administered by the compensation committeeof the Board of Directors, which selects persons to receive awards anddetermines the number of shares subject to each award and the terms,conditions, performance measures and other provisions of the award. Refer toNotes 8, 9 and 10 for additional information related to these stock-basedcompensation plans.

Effective January 1, 2006, the Company adoptedStatement No. 123R, Share-Based Payment (SFAS 123R), which requires companiesto measure and recognize compensation expense for all stock-based payments atfair value. SFAS 123R is being applied on the modified prospective basis.Prior to the adoption of SFAS 123R, the Company accounted for its stock-basedcompensation plans under the recognition and measurement principles ofAccounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issuedto Employees, and related interpretations, and accordingly, recognized nocompensation expense related to the stock-based plans.

Under the modified prospective approach, SFAS 123Rapplies to new awards and to awards that were outstanding on January 1, 2006that are subsequently modified, repurchased, cancelled or vest. Under themodified prospective approach, compensation cost recognized in 2006 includescompensation cost for all share-based payments granted prior to, but not yetvested on, January 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS 123R, and compensation cost for allshared-based payments granted subsequent to January 1, 2006, based on thegrant-date fair value estimated in accordance with the provisions of SFAS 123R.Prior periods were not restated to reflect the impact of adopting the newstandard.

As a result of adopting SFAS 123R on January 1, 2006,the net income and net income per share for the year ended December 31, 2006,were $76,588 and $0.01 lower, respectively, than if the Company had continuedto account for stock-based compensation under APB Opinion No. 25. 

41

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Prior to the adoption of SFAS 123R, we followed theintrinsic value method in accordance with APB 25 to account for our equitygrants.  Accordingly, no compensationexpense was recognized for stock purchase rights granted in connection with theissuance of stock options under our employee stock option plans.  The following table illustrates the effect onnet loss and net loss per share had the Company accounted for stock-basedcompensation in accordance with SFAS 123R for the years ended December 31, 2005:
|                                                                                                                                 | ** ** | **2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Net income  attributable to common stockholders, as reported                                                                    |       | $        | 120,844    |   |
|                                                                                                                            |       |     |       |
| Employee  compensation expense included in net income, net of forfeitures and related  tax effects                              |       | —   |       |
|                                                                                                                            |       |     |       |
| Stock-based  employee compensation expense determined under the fair value based method  for awards, net of related tax effects |       | (67,474  | )          |
|                                                                                                                            |       |     |       |
| Pro forma net  income                                                                                                           |       | $        | 53,370     |   |
|                                                                                                                            |       |     |       |
| Earnings per  share attributable to common shareholders:                                                                        |       |     |       |
| Basic—as  reported                                                                                                         |       | $        | 0.01       |   |
| Basic—pro forma                                                                                                            |       | $        | 0.01       |   |
|                                                                                                                            |       |     |       |
| Diluted—as reported                                                                                                        |       | $        | 0.01       |   |
| Diluted—pro forma                                                                                                          |       | $        | 0.01       |   |

 

42

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Options and warrants issued tonon-employees are recorded at fair value, as required by SFAS No. 123, usingthe Black Scholes pricing model and accounts for options issued tonon-employees in accordance with EITF 96-18 “Accounting For Equity InstrumentsThat Are Issued To Other Than Employees For Acquiring, Or In Conjunction WithSelling Goods Or Services.”  As such, theCompany expensed $88,783 during the year ended December 31, 2005.

The weighted average grant-date fairvalue of options granted during 2006 and 2005 was $0.40 and $0.28,respectively, which was determined using the Black-Scholes option pricing modelwith the following key assumptions:
| Assumptions                   | ** ** | **2006**          | ** ** | **2005**          | ** ** |
|-------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                    |       |              |       |              |       |
| Risk free interest rate range |       | 4.61  – 4.93 | %          | 4.05  – 4.36 | %          |
| Volatility range              |       | 41 –  49     | %          | 53 –  54     | %          |
| Expected lives (months)       |       | 12 –  120    |       | 96 –  120    |       |
| Expected  dividend yield      |       | 0                 | %          | 0                 | %          |

 

**Use ofEstimates**

The preparation of the Company’s financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting periods.  Actual results could differ from thoseestimates.

**Self-Funded Employee MedicalBenefits**

The Company participates in aself-insured employee health insurance plan administered by an outsideparty.  The Company is required to pay upto $30,000 of annual medical claims per participant and the Company’s maximumexposure per the plan is approximately $1,000,000.  The annual plan medical claims will varydepending upon the number of employees and their level of participation.

**Segment Reporting**

A****businesssegment is a distinguishable component of an enterprise that is engaged inproviding an individual product or service or a group of related products orservices and that is subject to risks and returns that are different from thoseof other business segments. The Company’s segments have similar economiccharacteristics and are similar in the nature of the products sold, type ofcustomers, methods used to distribute the Company’s products and regulatoryenvironment.  Management believes that the Company meets the criteria foraggregating its operating segments into a single reporting segment. 

**Impact of RecentAccounting Pronouncements**

**In September 2006, the SEC issued Staff Accounting BulletinNo. 108, “Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements” (SAB 108).SAB 108 provides interpretive guidance on how the effects of the carryoveror reversal of prior year misstatements should be considered in quantifying acurrent year misstatement. Under SAB 108, registrants should quantify errorsusing both a balance sheet and income statement approach (“dual approach”) andevaluate whether either approach results in a misstatement that is materialwhen all relevant quantitative and qualitative factors are considered. TheCompany adopted SAB 108 on December 31, 2006.**

43

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**In June 2006, the FASB issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes, an interpretation of FASB StatementNo. 109, Accounting for Income Taxes (“FIN 48”).  FIN 48 clarifies the accounting foruncertainty in income taxes recognized in a company’s financial statements inaccordance with FASB Statement No. 109. FIN 48 stipulates a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. FIN 48 also provides guidance onde-recognition, classification, and interest and penalties. The provisions ofFIN 48 are to be effective for fiscal years beginning after December 15,2006 and management is currently evaluating the impact, if any, that FIN 48will have on the results of operations or financial position.**

**3.**              Selected Balance Sheet Information
|                                                         | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| Accounts Receivable, net                                |       |                  |       |                  |       |
|                                                    |       |                  |       |                  |       |
| Accounts receivable                                     |       | $                     | 565,754    |                  | $          | 1,034,333 |   |
| Less allowances for doubtful accounts and sales returns |       | (7,203                | )          | (10,298               | )          |
|                                                    |       | $                     | 558,551    |                  | $          | 1,024,035 |   |
| Inventories                                             |       |                  |       |                  |       |
|                                                    |       |                  |       |                  |       |
| Raw materials, finished goods and supplies              |       | $                     | 1,095,372  |                  | $          | 794,890 |   |
| Work-in-process                                         |       | 172,105               |       | 501,431               |       |
|                                                    |       | $                     | 1,267,477  |                  | $          | 1,296,321 |   |
|                                                    |       |                  |       |                  |       |
| Property, Plant, and Equipment, Net                     |       |                  |       |                  |       |
|                                                    |       |                  |       |                  |       |
| Office equipment                                        |       | $                     | 93,586     |                  | $          | 82,537 |   |
| Machinery and equipment                                 |       | 633,424               |       | 528,005               |       |
| Equipment under capital lease obligations               |       | 298,599               |       | 298,599               |       |
| Capital tooling                                         |       | 48,785                |       | 38,015                |       |
|                                                    |       | 1,074,394             |       | 947,156               |       |
| Less accumulated depreciation                           |       | (890,079              | )          | (850,645              | )          |
|                                                    |       | $                     | 184,315    |                  | $          | 96,511 |   |
|                                                    |       |                  |       |                  |       |
| Accrued Expenses                                        |       |                  |       |                  |       |
|                                                    |       |                  |       |                  |       |
| Accrued vacation                                        |       | $                     | 115,721    |                  | $          | 118,957 |   |
| Accrued warranty reserve                                |       | 20,000                |       | 20,000                |       |
| Accrued wages and related payroll taxes                 |       | 122,419               |       | 126,981               |       |
| Accrued medical claims                                  |       | 40,000                |       | 40,000                |       |
| Accrued interest                                        |       | 1,113                 |       | 15,081                |       |
| Accrued profit sharing contribution                     |       | 21,915                |       | 16,603                |       |
| Other accrued expenses                                  |       | 72,043                |       | 71,033                |       |
|                                                    |       |                  |       |                  |       |
|                                                    |       | $                     | 393,211    |                  | $          | 408,655 |   |

 

44

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**WarrantyReserve**

The Company warrants its products for one, or fiveyears.  The reserve for warranty isincluded in accrued expenses and is computed by averaging the last four yearswarranty costs incurred.  The followingsummarizes the warranty transactions for the years ended December 31:
|                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|
| ** **                   |       |     |       |     |       |
| Balance at Beginning of Year |       | $        | 20,000     |     | $          | 73,693 |   |
| Claims Paid                  |       | (6,048   | )          | (3,693   | )          |
| Expense Provision            |       | 6,048    |       | —   |       |
| Reserve reduction            |       | —   |       | (50,000  | )(1)       |
|                         |       |     |       |     |       |
| Balance  at End of Year      |       | $        | 20,000     |     | $          | 20,000 |   |

 

----

(1)  The reductionrelates to improvements in actual warranty expense tracking.  

**3.**                                                              Senior Debt

Senior debt atDecember 31, 2006 and 2005 was $0 and $519,649, respectively.  The effective interest rate on theasset-based line of credit borrowings was 8.75% and 7.25% for the years endedDecember 31, 2006 and 2005, respectively. The line of credit is due on demand,and is payable in full on June 30, 2007.

On June 30, 2006, theCompany entered into its first amendment to the second amended and restatedsenior credit agreement consisting of an asset-based line of credit withavailability of up to $1,200,000, subject to aborrowing base limitation of 85% of the Company’s eligible accountsreceivable.  In addition the Company canborrow up to 40% of eligible raw materials and 30% of eligible finished goodsfor a one time 120-day period. The asset-based line of credit bears interest at the bank’s referencerate plus one-half percent and matures in June 2007.  At December 31, 2006, the effective rate was8.75% on the line of credit.

The creditfacility is collateralized by all of the Company’s assets, except for certainequipment obtained with purchase-money financing. The bank may at any timeapply the funds available in any Company bank account against the outstandingloan balances.  As of December 31, 2006,$0 was outstanding under the credit facilities. The line of credit is due on demand; accordingly, this amount has beenclassified as a current liability as of December 31, 2006 and 2005

45

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**5.**                                      Notes Payable, Related Parties

Notes payable, relatedparties at December 31, 2006 and 2005, consisted of the following:
|                                                                                                           | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Notes payable; related entity, due upon demand with interest at 3% subordinated to senior debt, unsecured |       | $         | 500,000    |      | $          | 500,000 |   |
| Note payable; related entity, due upon demand with interest at 3% subordinated to senior debt, unsecured  |       | 625,000   |       | 625,000   |       |
| Note payable; related entity, due upon demand with interest at 3% subordinated to senior debt, unsecured  |       | 1,946,154 |       | 1,946,154 |       |
|                                                                                                      |       | $         | 3,071,154  |      | $          | 3,071,154 |   |

 

Accruedinterest on these notes at December 31, 2006 and 2005 was $0 and $0,respectively, and interest expense for the years ended December 31, 2006 and2005 was $92,134 and $89,597, respectively. During the years ended December 31, 2006 and 2005 interest expensetotaling $92,134 and $89,597, respectively, was forgiven.  The accrued interest forgiven was recorded asadditional paid-in capital.  OnJune 30, 2006 the related parties agreed to extend the due dates of the notesto July 1, 2008.

**6.**                                      Capital Lease Obligations 

The Companyleased equipment under noncancelable leases classified as capital leases.  The balance, including accrued interest, waspaid in full in January 2006.

**7.**                                      Sale/Leaseback and Related Party Lease Obligations 

On March 21, 2001, the Company entered into two sale-leasebackagreements with Activar Properties (arelated party through common ownership) for equipment.  On February 25, 2003, the Company sold thebuilding to Hopkins Eleventh Avenue LLC (arelated party through common ownership) and entered into a sale-leasebackarrangement.  Since 2001, the leases havebeen modified with the most recent on July1, 2006.  The amended lease combined theformer building and equipment lease agreements into one lease.  The new lease term is month to month, withmonthly payments totaling $16,250.  Aspart of the new lease agreements, the related party agreed to forgive deferredrent totaling $942,792, which was recorded to additional paid in capital.

TheCompany has determined that the amended lease is in substance a term leasebased on the Company’s intent to continue to use the equipment and buildingunder the lease for an extended period of time. Since the Company now leases only a portion of the building, the Companyrecognized $494,094 of the deferred gain on sale-leaseback immediately intoincome for the portion of the building no longer leased.  The remaining gain on sale-leaseback relatedto the building as of July 1, 2006 totaling $557,169 will be amortized overthirty-eight months which is equal to the remaining life of the lease at thetime of the amendment. The gain on sale-leaseback of equipment will continue tobe amortized over the remaining life of the previous term which had eighteenmonths remaining as of July 1, 2006.  Rent expense on the leases was $213,319 and$343,392 for the years ended December 31, 2006 and 2005, respectively.

46

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Future deferred gains resulting from this lease are asfollows:
|                      | ** ** | **Equipment** | ** ** | **Building** | ** ** |
|----------------------|------------|---------------|------------|--------------|------------|
| 2007                 |       | $             | 155,576    |         | $          | 175,949 |   |
| 2008                 |       | —        |       | 175,949      |       |
| 2009                 |       | —        |       | 117,298      |       |
| Total deferred gains |       | $             | 155,576    |         | $          | 469,196 |   |

 

**8.**                                      Stockholders’ Deficiency

**Series APreferred Stock**

The Series A Preferred is convertible at any time, withoutthe payment of any additional consideration, into fully paid and nonassessableshares of common stock on a one for one basis subject to anti-dilution.  The Series A Preferred generally votes withthe common stock on matters submitted to the shareholders, with each share ofSeries A Preferred having that number of votes that is equal to the number ofwhole shares of common stock into which such share of Series A Preferred isthen convertible.

Holders of the Series A preferred stock are entitledto receive cumulative cash dividends, in preference to dividends payable oncommon stock, at the annual rate of 9% and share equally with the common stock,on an as-converted basis, in any dividends declared on the common stock.  Dividends in arrears totaled $504,000 and$432,000 at December 31, 2006 and 2005, respectively.  In the event of any liquidation, whethervoluntary or involuntary, the assets of the Company available for distributionto its shareholders shall be distributed equally among the holders of thecommon stock and the Series A preferred stock.

In connection with the private placement, the Company, theinvestors and certain individuals from the Company’s existing stockholders(collectively, the control group) entered into a voting agreement.  Among other provisions, the voting agreementrequires that the control group vote their shares to designate the investors asmembers of the Company’s Board of Directors. The voting agreement further requires the control group to vote asdirected by the investors on all matters, which are presented for a vote to theCompany’s stockholders.

**Stock OptionPlans**

The Company’s Stock Option Plans (the Plans) provide forgrants of stock options to employees and directors.  The number of common shares available forgrant pursuant to the Plans was 693,327 and 862,309 at December 31, 2006 and2005, respectively.  Options becomeexercisable over periods of up to four years from the date of grant and expire10 years from the date of grant.

47

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The followingsummarizes all option activity under the Plans:
| ** **                                | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted Average  Remaining  Contractual  Term (in  months)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------------|------------|------------|------------|----------------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------|------------|
| Options  outstanding at December 31, 2004 |       | 1,219,973  |       | $                                      | 0.68       |                                                                      |       |                            |       |   |
| Cancelled                                 |       | (10,282    | )          | $                                      | 0.45       |                                                                      |       |                            |       |   |
| Granted                                   |       | 253,000    |       | $                                      | 0.40       |                                                                      |       |                            |       |   |
| Exercised                                 |       | (29,000    | )          | $                                      | 0.08       |                                                                      |       |                            |       |   |
| Options  outstanding at December 31, 2005 |       | 1,433,691  |       | $                                      | 0.64       |                                                                      |       |                            |       |   |
| Cancelled                                 |       | (40,058    | )          | $                                      | 0.79       |                                                                      |       |                            |       |   |
| Granted                                   |       | 242,000    |       | $                                      | 0.65       |                                                                      |       |                            |       |   |
| Exercised                                 |       | (6,500     | )          | $                                      | 0.42       |                                                                      |       |                            |       |   |
| Options  outstanding at December 31, 2006 |       | 1,629,133  |       | $                                      | 0.72       |                                                                      | 78         |                            | $          | 153,204 |   |
| Options exercisable at December 31, 2006  |       | 1,418,461  |       | $                                      | 0.73       |                                                                      | 74         |                            | $          | 149,270 |   |

 

The total intrinsicvalue of stock options exercised in 2006 and 2005 was $2,470 and $11,250 respectively.  No tax benefit related to the exercise ofstock options was recorded due to the Company’s 100% valuation allowance on netdeferred tax assets.

At December 31,2006, there was $21,475 of total stock option compensation expense related tononvested awards not yet recognized, which is expected to be recognized overthe weighted average period of two years.

**Warrants**

At December 31, 2006, warrants to purchase 250,000 shares ofthe Company’s common stock at an exercise price of $0.25 per share.  The warrants expire in January 2012.

**9.**                                      Income Taxes

The following table sets forth the components of thetax-affected deferred tax assets at December 31, 2006 and 2005:
|                                                                        | ** ** | **2006**    | ** ** | **2005**    | ** ** |
|------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| Net operating losses available for carry forward (expire 2009 to 2023) |       | $           | 11,132,000 |        | $          | 10,856,000 |   |
|                                                                   |       |        |       |        |       |
| Other future deductible temporary differences, net                     |       | 400,000     |       | 1,049,000   |       |
|                                                                   |       |        |       |        |       |
| Net deferred tax asset before valuation allowance                      |       | 11,532,000  |       | 11,905,000  |       |
|                                                                   |       |        |       |        |       |
| Valuation allowance                                                    |       | (11,532,000 | )          | (11,905,000 | )          |
|                                                                   |       |        |       |        |       |
|                                                                   |       | $           | —     |        | $          | — |   |

 

48

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The Company has established a valuation allowance for anytax benefits for which management believes, based on the relative weight ofcurrently available evidence, that it is “more likely than not” that therelated net deferred tax asset will not be realized.  The Company has net operating losscarryforwards for federal income tax purposes of approximately$29,000,000.  Under the Internal RevenueCode, certain stock transactions, including sales of stock and the granting ofwarrants to purchase stock, may limit the amount of net operating loss carryforwards that may be utilized on an annual basis to offset taxable income infuture periods.

Reconciliation ofthe income tax computed at the federal statutory rate to the actual income taxprovision is as follows:
|                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                 |       |     |       |     |       |
| Income tax (benefit)                       |       | $        | 325,000    |     | $          | 77,000 |   |
| Deferred tax assets                        |       | (373,000 | )          | (84,000  | )          |
| Increase (decrease) in valuation allowance |       | 48,000   |       | 7,000    |       |
|                                       |       |     |       |     |       |
| Income tax provision                       |       | $        | —     |     | $          | — |   |

 

The Company usedthe effective tax rates of 34% federal and 6% state in computing income taxexpense (benefit).

**10.**                               Employee Benefit Plans

All employees who are at least 21 years of age and havecompleted six months of service and have worked at least 1,000 hours areeligible to participate in the Company’s 401(k) Retirement Savings Plan andProfit Sharing Plan.  The Company maymake 401(k) matching contributions and profit sharing contributions at thediscretion of the Board of Directors. The Company’s 401(k) matching contributions and profit sharingcontributions for the years ended December 31, 2006 and 2005 were $21,293and $17,000, respectively.

**11.**                               Significant Customer Information

The Company’s major customers accounted for the followingpercentages of net sales:
|            | ** ** | ** **           | ** ** | **2006**   | ** ** | ** ** | ** ** | **2005**   | ** ** | ** ** | ** ** |
|------------|------------|----------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** ** | ** ** | ** **           | ** ** | **Amount** | ** ** | **%**      | ** ** | **Amount** | ** ** | **%**      | ** ** |
|       |       |                 |       |       |       |       |       |       |       |       |       |
| Customer A |       | Net Sales            |       | $          | 4,283,009  |       | 43         | %          | $          | 3,373,257  |       | 42 | % |
|       |       | Accounts Receivable  |       | $          | 106,072    |       | 19         |       | $          | 376,806    |       | 37 |   |
|       |       |                 |       |       |       |       |       |       |       |       |       |
| Customer B |       | Net Sales            |       | $          | 1,222,046  |       | 12         | %          | $          | 1,039,926  |       | 13 |   |
|       |       | Accounts  Receivable |       | $          | 93,911     |       | 17         | %          | $          | 182,196    |       | 18 | % |

 

49

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12.                                 **Sublease on Building**

TheCompany subleased a portion of the building during 2006 and 2005.  The Company has netted sublease income aspart of cost of goods sold and general and administrative expenses on thestatement of operations.  Total subleaseincome was approximately $23,000 and $204,000 for the years ended December 31,2006 and 2005, respectively.  Thesublease expired during 2006.

50

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**MAGSTAR TECHNOLOGIES, INC.**

**EXHIBIT INDEXTO ANNUAL REPORT**

**ON FORM 10-KSB**

**For the Fiscal Year Ended December 31, 2006**
| Item No. | ** ** | **Item**                                                                                                                            | ** ** | **Method of Filing**                                                                                                                                       |
|----------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |       |                                                                                                                                |       |                                                                                                                                                       |
| 3.1      |       | Restated Articles of  Incorporation, As amended                                                                                     |       | Incorporated by reference to Exhibit  3.1 to the Company’s Annual Report on Form 10-KSB for the year ended  December 31, 2001 (File No. 0-1561)  |
|     |       |                                                                                                                                |       |                                                                                                                                                       |
| 3.2      |       | Amended Bylaws                                                                                                                      |       | Incorporated by reference to  Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the year ended  December 31, 1990 (File No. 0-1561)    |
|     |       |                                                                                                                                |       |                                                                                                                                                       |
| 4.1      |       | Form of the Company’s Common Stock Certificate                                                                                 |       | Incorporated by reference to  Exhibit 4.1 to the Company’s Annual Report on Form 10-K for the year ended  December 31, 1990 (File No. 0-1561)    |
|     |       |                                                                                                                                |       |                                                                                                                                                       |
| 4.2      |       | Voting Agreement, dated September  12, 2000, by and among the Company, certain shareholders and investors                           |       | Incorporated by reference to  Exhibit 10.2 to the Company’s Current Report on Form 8-K, dated October  24, 2000 (File No. 0-1561)                     |
|     |       |                                                                                                                                |       |                                                                                                                                                       |
| 10.1     |       | 1997 Non-Employee Director Stock Option Plan                                                                                        |       | Incorporated by reference to  Exhibit 10.8 to the Company’s Annual Report on Form 10-KSB for the year  ended December 31, 1997 (File No. 0-1561)      |
|     |       |                                                                                                                                |       |                                                                                                                                                       |
| 10.2     |       | 2001 Stock Option Plan                                                                                                              |       | Incorporated by reference to  Exhibit 10.6 to the Company’s Annual Report on Form 10-KSB for the year ended  December 31, 2001 (File No. 0-1561) |
|     |       |                                                                                                                                |       |                                                                                                                                                       |
| 10.3     |       | 2001 Stock Purchase Plan                                                                                                            |       | Incorporated by reference to  Exhibit 10.7 to the Company’s Annual Report on Form 10-KSB for the year ended  December 31, 2001 (File No. 0-1561) |
|     |       |                                                                                                                                |       |                                                                                                                                                       |
| 10.4     |       | Environmental and ADA  Indemnification Agreement, dated  December 3, 1997, between the Company  and US Bancorp National Association |       | Incorporated by reference to  Exhibit 10.7 to the Company’s Current Report on Form 8-K, dated  December 18, 1997 (File No. 0-1561)                    |
|     |       |                                                                                                                                |       |                                                                                                                                                       |
| 10.5     |       | Environmental Letter of  Undertaking, dated December 3, 1997,  between the Company and US Bancorp National Association              |       | Incorporated by reference to  Exhibit 10.8 to the Company’s Current Report on Form 8-K, dated  December 18, 1997 (File No. 0-1561)                    |

 

51

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| Item No. | ** ** | **Item**                                                                                                                                                                                                                  | ** ** | **Method of Filing**                                                                                                                                        |
|----------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |       |                                                                                                                                                                                                                      |       |                                                                                                                                                        |
| 10.6     |       | Securities Purchase Agreement,  dated October 10, 2000, by and among the Company and certain Investors                                                                                                                    |       | Incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K, dated October  24, 2000 (File No. 0-1561)                      |
|     |       |                                                                                                                                                                                                                      |       |                                                                                                                                                        |
| 10.7     |       | Amended and Restated Credit  Agreement dated October 10, 2000, by  and between the Company and US Bancorp  National Association                                                                                           |       | Incorporated by reference to  Exhibit 10.4 to the Company’s Current Report on Form 8-K, dated October  24, 2000 (File No. 0-1561)                      |
|     |       |                                                                                                                                                                                                                      |       |                                                                                                                                                        |
| 10.8     |       | Amended, Restated and Consolidated  Mortgage, Security Agreement, Assignment of Leases and Rents and Fixture  Financing Statement, dated October 10, 2000 by and between the Company and US  Bancorp National Association |       | Incorporated by reference to  Exhibit 10.5 to the Company’s Current Report on Form 8-K, dated October  24, 2000 (File No. 0-1561)                      |
|     |       |                                                                                                                                                                                                                      |       |                                                                                                                                                        |
| 10.9     |       | Security Agreement, dated October  10, 2000, by and between the Company and US Bancorp National Association                                                                                                               |       | Incorporated by reference to  Exhibit 10.6 to the Company’s Current Report on Form 8-K, dated October  24, 2000 (File No. 0-1561)                      |
|     |       |                                                                                                                                                                                                                      |       |                                                                                                                                                        |
| 10.10    |       | $6,800,000 Amended and Restated  Note, dated October 10, 2000, given by the Company to US Bancorp National Association                                                                                                    |       | Incorporated by reference to  Exhibit 10.7 to the Company’s Current Report on Form 8-K, dated October  24, 2000 (File No. 0-1561)                      |
|     |       |                                                                                                                                                                                                                      |       |                                                                                                                                                        |
| 10.11    |       | First Amendment to Amended and  Restated Credit Agreement, dated November 30, 2001, by and between the  Company and US Bancorp National Association                                                                       |       | Incorporated by reference to  Exhibit 10.15 to the Company’s Annual Report on Form 10-KSB for the year  ended December 31, 2001 (File No. 0-1561) |
|     |       |                                                                                                                                                                                                                      |       |                                                                                                                                                        |
| 10.12    |       | Asset Purchase Agreement,  Promissory Note and Equipment Lease by and between Reuter Manufacturing, Inc.  and MagStar Technologies, Inc. for the acquisition of certain assets at  December 1, 2000                       |       | Incorporated by reference to  Exhibit 10.20 to the Company’s Annual Report on Form 10-KSB, for the  year ended December 31, 2000 (File No. 0-1561)     |
|     |       |                                                                                                                                                                                                                      |       |                                                                                                                                                        |
| 10.13    |       | Bill of Sale and two Master  Equipment Leases, with attached exhibits and assignments, dated March 21,  2001 related to the sale-leaseback of equipment between the Company and  Activar Properties, Inc.                 |       | Incorporated by reference to  Exhibit 10.21 to the Company’s Quarterly Report on Form 10-Q, for the  quarter ended March 31, 2001 (File No. 0-1561)    |
|     |       |                                                                                                                                                                                                                      |       |                                                                                                                                                        |
| 10.14    |       | Promissory Note between the  Company and Activar Properties, Inc. related to the purchase of Quickdraw  Conveyor Systems, Inc. dated February 23, 2001                                                                    |       | Incorporated by reference to  Exhibit 10.22 to the Company’s Quarterly Report on Form 10-Q, for the  quarter ended March 31, 2001 (File No. 0-1561)    |

 

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| Item No.   | ** ** | **Item**                                                                                                             | ** ** | **Method of Filing**                                                                                                                                        |
|------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.15      |       | Option Amendment Agreement, dated  October 1, 2001 by and between Michael J. Tate and the Company                    |       | Incorporated by reference to  Exhibit 10.19 to the Company’s Annual Report on Form 10-KSB for the year ended  December 31, 2001 (File No. 0-1561) |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.16      |       | 12% Promissory Note dated January  21, 2002 issued to Richard F. McNamara                                            |       | Incorporated by reference to  Exhibit 10.20 to the Company’s Annual Report on Form 10-KSB for the year  ended December 31, 2001 (File No. 0-1561) |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.17      |       | Warrant for Purchase of Shares of  Common Stock of the Company dated January 21, 2002 issued to Richard F.  McNamara |       | Incorporated by reference to  Exhibit 10.21 to the Company’s Annual Report on Form 10-KSB for the year  ended December 31, 2001 (File No. 0-1561) |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.18      |       | Lease from Hopkins Eleventh  Avenue, LLC to the Company dated February 21, 2003                                      |       | Incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K, dated March  11, 2003 (File No. 0-1561)                        |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.19      |       | Promissory Note from Hopkins  Eleventh Ave LLC dated February 21, 2003                                               |       | Incorporated by reference to  Exhibit 10.2 to the Company’s Current Report on Form 8-K, dated March  11, 2003 (File No. 0-1561)                        |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.20      |       | Third Amendment to Amended and Restated  Credit Agreement dated as of September 30, 2003                             |       | Incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K, dated October 31,  2003 (File No. 0-1561)                      |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.21      |       | Fourth Amendment to Amended and  Restated Credit Agreement dated as of January 6, 2004                               |       | Incorporated by reference to  Exhibit 10.25 to the Company’s Annual Report on Form 10-KSB, dated December  31, 2003 (File No. 0-1561)                  |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.22      |       | Amended Equipment Lease Agreement  between Activar Properties, Inc. and the Company dated as of December 30,  2002   |       | Incorporated by reference to  Exhibit 10.26 to the Company’s Annual Report on Form 10-KSB, dated December  31, 2003 (File No. 0-1561)                  |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.23      |       | Fifth Amendment to Amended and  Restated Credit Agreement dated as of August 13, 2004                                |       | Incorporated by reference to  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-QSB, dated June 30,  2004 (File No. 0-1561)                    |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.24      |       | Second Amended and Restated Credit  Agreement dated as of June 30, 2005                                              |       | Incorporated by reference to Exhibit  10.1 to the Company’s Quarterly Report on Form 10-QSB, dated June 30, 2005  (File No. 0-1561)                    |
|       |       |                                                                                                                 |       |                                                                                                                                                        |
| 10.25      |       | First amendment to second amended  and restated senior credit agreement dated as of June 30, 2006                    |       | Incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed on June 30,  2006 (File No. 0-1561)                      |

 

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| Item No. | ** ** | **Item**                                                                                            | ** ** | **Method of Filing**                                                                                                                      |
|----------|------------|-----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|
|     |       |                                                                                                |       |                                                                                                                                      |
| 14.1     |       | Code of Ethics and Business  Conduct                                                                |       | Incorporated by reference to  Exhibit 14.1 to the Company’s Annual Report on Form 10-KSB, dated December  31, 2003 (File No. 0-1561) |
|     |       |                                                                                                |       |                                                                                                                                      |
| 14.2     |       | Code of Ethics for Senior  [Financial] Executives                                                   |       | Incorporated by reference to  Exhibit 14.2 to the Company’s Annual Report on Form 10-KSB, dated December  31, 2003 (File No. 0-1561) |
|     |       |                                                                                                |       |                                                                                                                                      |
| 23.1     |       | Consent of Independent Registered  Accounting Firm                                                  |       | Filed herewith electronically                                                                                                             |
|     |       |                                                                                                |       |                                                                                                                                      |
| 31.1     |       | Certification of President and  Chief Executive Officer                                             |       | Filed herewith electronically                                                                                                             |
|     |       |                                                                                                |       |                                                                                                                                      |
| 31.2     |       | Certification of Treasurer and  Chief Financial Officer                                             |       | Filed herewith electronically                                                                                                             |
|     |       |                                                                                                |       |                                                                                                                                      |
| 32.1     |       | Certification of Chief Executive  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |       | Filed herewith electronically                                                                                                             |
|     |       |                                                                                                |       |                                                                                                                                      |
| 32.2     |       | Certification of Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |       | Filed herewith electronically                                                                                                             |

 

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