UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington
D.C. 20549





FORM
10-K




x ANNUAL REPORT UNDER
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934


For
the fiscal year ended December 31, 2008




o TRANSITION REPORT UNDER
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.


For the transition period from ___
until ___





Commission
File Number 000-22573





AXION
POWER INTERNATIONAL, INC.


(Exact
name of registrant as specified in its charter)





Delaware
                            
                            65-0774638(State
      or other jurisdiction of
                            
                            (I.R.S.
      Employerincorporation
      organization)
                            
                            Identification
      No.)3601
      Clover LaneNew
      Castle, Pennsylvania
                            
                            16105(Address
      of principal executive offices)
                            
                            (Zip
      Code)Registrant’s telephone number, including area code
                            (724)
      654-9300





Securities
Registered under Section 12(b) of the Act


None





Securities
Registered under Section 12(g) of the Act


Common
Stock, par value $.0001 per share




Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.


Yes  ̈  No x




Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.


Yes  ̈  No x




Indicate
by check mark whether the issuer (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12
months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes x No
 ̈




Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. x









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




Large
      accelerated filer  ̈
              Accelerated
      filer  ̈Non-accelerated
      filer  ̈
              Smaller
      reporting company x




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


Yes  ̈ No x




The
aggregate market value of the 8,361,836 shares of voting stock held by
non-affiliates of the registrant  based on the closing price on the
Over the Counter Bulletin Board on June 30, 2008 was $14,884,068.




Indicate
the number of shares outstanding of each of the registrant’s classes of common
stock, as of the latest practicable date.




Shares
      OutstandingTitle of Class
                March 24, 2009Common
      Stock
                26,417,437




DOCUMENTS
INCORPORATED BY REFERENCE




None







TABLE
OF CONTENTS




PART IItem 1.
                      Description of Business.
                      
                      
                      3Item 1A.
                      Risk Factors.
                      
                      
                      11Item 2.
                      Properties.
                      
                      
                      20Item 3.
                      Legal Proceedings.
                      
                      
                      20Item 4.
                      Submission of Matters to a Vote of Security
      Holders.
                      
                      
                      22PART II
                      
                      
                      
                      24Item 5.
                      Market for Registrant’s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Securities.
                      
                      
                      24Item 7.
                      Management’s Discussion and Analysis of Financial Conditions
      and Results of Operations.
                      
                      
                      28Item 8.
                      Financial Statements and Supplementary
    Data.
                      
                      
                      38Item 9.
                      Changes in and Disagreements With Accountants on Accounting
      and Financial Disclosure.
                      
                      
                      85Item 9A.
                      Controls and Procedures.
                      
                      
                      85PART III
                      
                      
                      
                      88Item 10.
                      Directors, Executive Officers and Corporate
      Governance.
                      
                      
                      88Item 11.
                      Executive Compensation.
                      
                      
                      88Item 12.
                      Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters.
                      
                      
                      88Item 13.
                      Certain Relationships and Related Transactions, and
      Director Independence.
                      
                      
                      89Item 14.
                      Principal Accounting Fees and Services.
                      
                      
                      89PART IV
                      
                      
                      
                      89Item 15.
                      Exhibits.
                      
                      
                      89


1


Cautionary
Note Regarding Forward-Looking Information




This
Report on Form 10-K, in particular Part II Item 7 “Management’s Discussion and
Analysis of Financial Condition and Results of Operations,” contains certain
“forward-looking statements” within the meaning of Section 27A of the Securities
Act of 1933, as amended (the “Securities Act”), and Section 21E of the
Securities Exchange Act of 1934, as amended (the “Exchange Act”). These
forward-looking statements represent our expectations, beliefs, intentions or
strategies concerning future events, including, but not limited to, any
statements regarding our assumptions about financial performance; the
continuation of historical trends; the sufficiency of our cash balances for
future liquidity and capital resource needs; the expected impact of changes in
accounting policies on our results of operations, financial condition or cash
flows; anticipated problems and our plans for future operations; and the economy
in general or the future of the electrical storage device industry, all of which
were subject to various risks and uncertainties.




When used
in this Report on Form 10- K and other reports, statements, and information we
have filed with the Securities and Exchange Commission (the “Commission” or
“SEC”), in our press releases, presentations to securities analysts or
investors, in oral statements made by or with the approval of an executive
officer, the words or phrases “believes,” “may,” “will,” “expects,” “should,”
“continue,” “anticipates,” “intends,” “will likely result,” “estimates,”
“projects” or similar expressions and variations thereof are intended to
identify such forward-looking statements. However, any statements contained in
this Report on Form 10-K that are not statements of historical fact may be
deemed to be forward-looking statements. We caution that these statements by
their nature involve risks and uncertainties, certain of which are beyond our
control, and actual results may differ materially depending on a variety of
important factors, including, but not limited to, such factors as the following.
With regard to the risks the Company may face, we advise you to carefully
consider the following risks and uncertainties:




·
            we
      have incurred net losses since inception, and we may not be able to
      generate sufficient revenue and gross margin in the future to achieve or
      sustain profitability;




·
            our
      planned level of operations depends upon increased revenues
      or additional financing;




·
            we
      may be unable to enforce or defend our ownership of proprietary
      technology;




·
            we
      have never manufactured carbon electrode assemblies in large commercial
      quantities;




·
            we
      may be unable to develop a cost effective alternative to conventional lead
      electrodes;




·
            our
      technology may be rendered obsolete as a result of technological changes
      in the battery industry or other storage
  technologies;




·
            we
      may not be able to establish reliable supply channels for the raw
      materials and components that will be used in our commercial proprietary
      lead/carbon (“PbC®”) batteries;




·
            other
      manufacturers may not be able to modify established lead-acid battery
      manufacturing processes to replicate our processes to accommodate
      differences between their products and our commercial PbCTM battery
      technology;




·
            we
      will have limited market opportunities based on our anticipated
      manufacturing capacity;




·
            our
      shareholders may suffer significant dilution in the event that our
      outstanding convertible securities, warrants and options are ever
      exercised;




·
            we
      depend on key personnel and our business may be severely disrupted if we
      lose the services of our key executives and
  employees;




·
            our
      revenues may suffer if general economic conditions worsen, remain in the
      current adverse state and/or do not improve in a timely manner;
      and




·
            we
      are subject to stringent environmental
  regulation.


2




PART I




Item 1   Description of Business




Our
Corporate History




Axion
Power Corporation (APC) was formed in September 2003 to acquire and develop
certain innovative battery technology. Since inception, APC has been engaged in
Research and Development (R&D) of the new technology for the production of
PbC batteries. On December 31, 2003, APC engaged in a reverse acquisition with
Tamboril Cigar Company, a public shell company, whereby APC became a
wholly-owned subsidiary of Tamboril and the shareholders of Axion obtained a 95%
ownership in the surviving entity. Tamboril was originally incorporated in
Delaware in January 1997, operated a wholesale cigar business until December
1998 and was an inactive public shell thereafter until December 2003. Tamboril
changed its name to Axion Power International, Inc. (API) following the reverse
acquisition.




Since
inception, our operations have been financed by a small group of individuals
with little to no revenue generated from operations. As a result, trading in our
common stock has been sporadic, volumes have been low, and the market price has
been volatile. We believe that a successful transition from R&D to
manufacturing, and therefore marketing and selling our proprietary products,
will improve our cash balances and market profile and may result in a more
active trading market for our stock. However, we can provide no guarantees that
our transition efforts will be successful.




The
Battery Industry




There are
two principal types of lead acid batteries; flooded batteries and valve
regulated lead acid (“VRLA”). The choice of battery depends mainly on the
specific application that the battery serves. Typical standby or stationary
applications use VRLA batteries due to their inherent advantages including spill
proof design, low maintenance, compact form, low self-discharge and high
performance. On the other hand, applications like industrial equipment, traction
and railroad applications are better served by the flooded lead acid battery
types due to their superior performance in continuous deep discharge
applications and at high operating temperatures, among other features.
Technology within the lead-acid battery industry has remained relatively stable
for the last 30 years, and an industry-wide lack of innovation has generally
restrained growth into new applications and emerging markets.




Alternative
energy applications like wind and solar power require an energy storage solution
that combines low cost and long deep discharge cycle life. Lead-acid
batteries are currently one of the gold standards in large-scale power storage
applications, but the short cycle-life of lead acid chemistry at deep discharge
levels is a primary inhibitor to growth. Due primarily to the cycle-life
limitations of lead acid batteries, a number of battery manufacturers are
experimenting with alternative battery technologies that are far more expensive
to implement, but offer substantial cycle-life advantages.




The North
American lead acid battery industry is mature with a few leading vendors that
have a global presence and a larger number of smaller regional and local vendors
that cater to the needs of the North American market. The first tier companies
that have a global presence include EnerSys, Exide Technologies, Johnson
Controls and FIAMM. The second tier companies that cater mainly to the North
American Markets include, among others, East Penn Manufacturing, C&D
Technologies, GS Batteries, Crown Batteries, Trojan Battery and Eagle Picher
Technologies. The user segments that rely on lead acid batteries include
automotive applications, standby applications ranging from uninterruptible power
supplies to telecommunication applications, limited power storage for wind and
solar systems and motive power for heavy-duty equipment and railroad
applications.




3


Our
Business
  We are a
development stage company that has invested five years and approximately $14.0
million in R&D expense to develop a patented energy storage device that uses
carbon electrode assemblies to replace the lead-based negative electrodes found
in conventional lead-acid batteries. Our PbC energy storage device is a
battery-supercapacitor hybrid that combines the simplicity of lead-acid
batteries with the fast recharge rate and longer cycle life of supercapacitors,
resulting in a relatively low-cost device that has versatility of design that
will allow differing iterations to deliver maximum power; maximum energy; or a
range of balances between the two.
  Our
PbCTM
technology is protected by six issued U.S. patents, nine pending U.S. patent
applications and other proprietary features and structures. The resulting
devices are technically sophisticated and yet simple in design. The carbon
electrode assemblies are fabricated from readily available raw materials using,
for the most part, standard industrial processes and techniques. The electrodes
are then assembled into PbC batteries that can employ the same cases, covers,
positive electrodes, separators and electrolyte as conventional lead-acid
batteries, and can be assembled with the same equipment and manufacturing
methods used throughout the world for manufacturing conventional lead-acid
batteries. PbC batteries use significantly less lead than standard lead-acid
batteries with a comparable size, and the lead, plastics and acid employed are
routinely and profitably recycled at existing recycling facilities around the
world, which makes the PbC battery extremely environmentally friendly and far
more so than most  competing  battery
technologies.
  In
February 2007, our PbC technology received the Frost & Sullivan Technology
Innovation Award for the best development in the field of lead acid batteries
for 2006.
  We
believe that for large-scale deep-discharge energy storage systems (10 kWh or
greater), our PbC devices may prove to offer the lowest total cost of ownership
solution available in comparison to alternative battery storage technologies. As
ongoing development work on our technologies progress, we believe that further
cost reductions and performance gains will be likely.
  We
believe our advanced battery technologies are uniquely situated to answer the
current challenges facing the conventional lead-acid battery and that industry
as a whole. While we explore the various potential applications for our PbC
technology, our battery manufacturing plant in New Castle, Pennsylvania provides
us with both an excellent R&D facility and a near perfect pilot production
plant in which to produce our advanced energy storage devices. This plant allows
us to manufacture our PbC carbon electrodes in limited quantity and to assemble
our new energy storage batteries for laboratory testing and for small scale
demonstration projects. In manufacturing this battery assembly using
conventional lead acid battery production equipment, we provide proof to our
future PbC carbon negative electrode customers that our product is suitable to
immediate use in their factories.
  The PbC
battery production is limited at this time by our inability to make the carbon
electrodes in large numbers. As part of our plan to transition from pilot
production of PbC electrodes to commercial manufacturing we entered into a
letter agreement in the fourth quarter of 2008 for a sublease agreement for a
second facility in New Castle, Pennsylvania that provides us with an additional
54,000 square feet of production, R&D and office space. It is anticipated
that this facility will be used primarily to produce our PbC electrode
assemblies. In addition, this transition will require that we:
  ·         refine
our planned fabrication methods for carbon electrode assemblies;
  ·         demonstrate
the feasibility of manufacturing our PbC device, and our other technologies,
using standard techniques and equipment;
  ·         demonstrate
and document the performance of our products in key applications;
and
  ·         respond
appropriately to anticipated and unanticipated technical and manufacturing
challenges.
  Our
battery plant has a permitted manufacturing capacity of 3,000 lead-acid and or
PbC batteries per day and so we currently have excess battery manufacturing
capacity that we are able to dedicate to production of high margin specialty
batteries that are required in relatively small numbers for direct sales and to
also perform toll manufacturing for one of the largest lead-acid battery
manufacturers in North America. We continue efforts to increase our sales of
such batteries and have hired personnel to further that end.




4


We plan
to develop our lead carbon technology for use in a variety of applications
including:




·
            motive
      power applications;




·
            stationary
      power applications;




·
            hybrid
      electric vehicle applications; and




·
            military
      applications.




We
believe demand for cost-effective energy storage systems produced using our PbCTM
technology will grow rapidly. We also believe our technologies can be among the
leaders in the high performance battery market. We believe our competitive
advantages will include:




·
              Cost effectiveness: Due
      to an extended cycle life and relatively low production
    costs


·
            Ease of integration:
      Our planned carbon electrode assemblies will be designed to replace
      the standard lead negative electrodes in conventional lead-acid batteries.
      In some applications that require fixed voltage operations, voltage
      conversion may be needed;




·
            Superior flexibility:
      By changing the number, geometry and arrangement of the electrode
      assemblies, we expect to be able to configure our devices to favor either
      maximum energy storage or maximum power delivery;
  and




·
            Reduced lead content:
      Depending on the energy, power and cycling requirements of a particular
      application, our fully recyclable device will use substantially less lead
      than conventional lead acid
batteries.




We
anticipate our ability to establish and maintain a competitive position will be
dependent on several factors, including:




·
            the
      availability of raw materials and key
  components;





·
            our
      ability to design and manufacture commercial carbon electrode
      assemblies;




·
            our
      ability to establish and operate facilities that can fabricate electrode
      assemblies and commercially manufacture our PbC device with consistent
      quality at a predictable cost;




·
            our
      ability to establish and expand a customer
base;




·
            our
      ability to execute and perform on any future strategic distribution
      agreements with tier one and/or tier two battery
      manufacturers;




·
            our
      ability to compete against established and emerging battery and other
      storage technologies;·
            general
      worldwide economic conditions;




·
            the
      market for batteries in general;
and




·
            our
      ability to retain key personnel.




Our
objective is to become an industry leader in low cost, high performance energy
storage systems. We plan to achieve this objective by pursuing the following
core strategies:




·
            Platform technology business
      model. We plan to implement a platform technology business model
      where we will focus on developing and manufacturing carbon electrode
      assemblies that we can offer for sale to established battery manufacturers
      who want to use our PbC carbon electrode products in their
      batteries.




5





·
            Leverage relationships with
      thought leaders. We are engaged in discussions with industry
      consortia, research institutions and other thought leaders in the fields
      of utility applications, hybrid electric vehicles and automotive fuel cell
      technology. As we develop our relationships in the field of energy
      research, we believe the opportunities for government funding and
      consortia participation will expand rapidly, and improve our access to
      potential suppliers and customers.




·
            Leverage relationships with
      battery manufacturers. Our business model is based on the premise
      that we can most effectively address the needs of the market by selling
      electrode assemblies to established  lead-acid battery manufacturers
      who want to add advanced battery technology to their existing product
      lines. This business model should allow us to leverage the business
      abilities, manufacturing facilities and distribution networks of
      established manufacturers, in order to reduce our time to market and
      increase our potential market
penetration.




·
            Build a recognized
      brand. We believe strong brand name recognition is important to
      increase product awareness and to effectively penetrate the mass market.
      We intend to differentiate our brand by emphasizing our combination of
      high performance and low total cost of ownership per storage
      cycle.




·
            Secondary focus on emerging
      markets. Emerging markets for hybrid electric vehicles and
      conventional utility applications are becoming increasingly attractive. We
      are actively evaluating the potential for using our lead carbon technology
      products in these emerging markets.




·
            Maintain our technical
      advantage and reduce manufacturing costs. We intend to maintain our
      technical advantage by continuing to invest in R&D to improve the
      performance of our PbC devices and other technologies and to continue to
      lower our manufacturing costs.




The
battery industry is mature, capital intensive, heavily regulated, highly
competitive and averse to product performance risks associated with radical
departures from established technology and, with the severe decline in worldwide
automobile sales, currently experiencing unprecedented cutbacks. Additionally,
due to the nature of the industry, we do not believe we will be able to make a
credible entry into the battery market until we have proven the advantages of
our PbC device technology in demonstration projects with end users. Therefore,
our business plan contemplates two discrete phases: the Development Phase
(including prototype and demonstration) and the Commercialization
Phase.




Development
Phase. During the Development Phase, we  are focusing on
producing small quantities of commercial prototypes in our own manufacturing
facilities. These commercial prototypes will serve as the foundation for a
series of paid demonstration projects with established end users. If the
projects are successful and end user testing validates the advantages of our PbC
device technology under real-world operating conditions, it will be easier to
proceed to the full commercialization phase. In general, our development path in
each identified target market will include the following:




·
            Prototype
      manufacturing. We are finalizing design work and manufacturing
      methods for our commercial prototype PbC carbon electrodes. These
      electrode assemblies will be the key component in the on site
      manufacturing of our PbC batteries.





·
            Demonstration projects.
      When we have developed and bench tested our commercial prototype PbC
      devices for a particular target market, we will negotiate additional
      demonstration projects for each of the intended applications. In some of
      the larger projects we may partner with a larger battery manufacturer in
      order to provide the required quantity of PbCTM devices. Our goal is
      to document the superior performance of our products in real-world
      applications.




6





·
            Commercial production.
      When we have developed sufficient data to support a decision to commence
      full scale production of a product or product line, we intend to use our
      New Castle Pennsylvania facility until we reach our maximum permitted
      capacity, after which we plan to pursue strategic relationships with other
      battery manufacturers that are willing to manufacture co-branded
      commercial PbC products. Those products will contain our proprietary
      negative electrode assembly, which we will continue to manufacture at our
      New Castle facility and build our brand
  recognition.




Our
planned demonstration projects are not expected to generate sufficient gross
profit to offset our expected operating costs. Accordingly, we do not expect to
attain profitability during the demonstration phase. If we enter into a
commercialization relationship for a specific product or product line, we
believe our margins may improve based on efficiencies of scale. However, there
is no assurance that the commercialization of products for one or more market
segments will generate sufficient revenue to offset our anticipated R&D and
other operating expenses and yield a profit.




Commercialization
Phase.During the commercialization phase, we intend to implement a
platform technology business model where we will develop and manufacture the PbC
carbon electrode assemblies that are unique to our PbC batteries. In addition to
using these assemblies in our batteries, we eventually intend to sell our
propriatary assemblies to other established battery manufacturers who are
seeking to market more advanced batteries. We believe a platform
technology business model will reduce our time to market, allow us to rely on
the established business abilities of existing manufacturers and forge a strong
brand identity for our PbC products, while allowing us to focus on a narrow band
of value-added activities that should minimize our investment and
maximize our profitability.




Until we
complete our planned demonstration projects, our negotiation position with
respect to manufacturing relationships with established battery manufacturers
may be impaired. Even if our planned demonstration projects are successful, we
may be unable to negotiate manufacturing relationships on terms acceptable to
us. If we decide to manufacture and distribute a line of commercial battery
products ourselves, rather than sell carbon electrode assemblies to established
battery manufacturers, our time to market and our anticipated capital costs may
increase dramatically.




We plan
to initially focus on high-value market segments where the total cost of
ownership is the primary determining factor in product selection. We believe our
commercial PbC device will be most appealing where longer life, high
performance, and low maintenance are fully valued.




Acquisition
of Our PbC Device Technology




We
incorporated APC in September 2003, for the purpose of acquiring rights to a
lead carbon technology, that we have since named PbC, from C&T, the original
owner of the patents. The founders of APC were passive stockholders of Mega-C
Power Corp. (“Mega-C”), which from 2001 until mid 2003 held a limited,
nonexclusive license to market products utilizing the lead carbon technology
that we currently own and have since expanded upon. In February 2003, the
Ontario Securities Commission began an investigation into Mega-C’s stock sales
that terminated Mega-C’s ability to finance its operations and continue in
business. The founders of APC had collectively invested approximately $3.9
million in Mega-C and were facing a total loss of this investment when Mega-C
was unable to continue in business. In connection with the organization of APC,
the founders invested approximately $1.4 million dollars.




In late
December 2003, Tamboril had 1,875,000 shares outstanding. After evaluating the
lead carbon technology and APC, Tamboril’s management negotiated a series of
related transactions that included:




·
            a
      reverse acquisition between Tamboril and
APC;




·
            the
      establishment of the Mega-C Trust for the stated purpose of preserving the
      potential equitable rights of Mega-C’s creditors and stockholders while
      potentially insulating APC and Tamboril from the litigation risks
      associated with the activities of Mega-C and its promoters;
      and




7





·
            a
      purchase of the PbC device technology from
  C&T.





Of the
10,739,500 common shares that Tamboril issued for the outstanding securities of
APC, 7,327,500 shares, or approximately 58% of our post-transaction
capitalization, were deposited in the Mega-C Trust. The remaining 3,412,000
shares were distributed among APC’s stockholders. After the closing, APC’s
stockholders, C&T’s stockholders and the Mega-C Trust owned 95% of our
stock. For financial reporting purposes, APC was deemed to be the accounting
acquirer of Tamboril, followed by a recapitalization.





Our
Patents and Intellectual Property




We own
six issued U.S. patents and have nine patent applications pending at the date of
this report covering various aspects of our PbC technologies. There is no
assurance that any of the pending patent applications will ultimately be
granted. Our issued patents are:




·
            U.S.
      Patent No. 6,466,429 (expires May 2021) - Electric double layer
      capacitor;




·
            U.S.
      Patent No. 6,628,504 (expires May 2021) - Electric double layer
      capacitor;




·
            U.S.
      Patent No. 6,706,079 (expires May 2022) - Method of formation and charge
      of the negative polarizable carbon electrode in an electric double layer
      capacitor;




·
            U.S.
      Patent No. 7,006,346 (expires April 2024) - Positive Electrode of an
      electric double layer capacitor;




·
            U.S.
      Patent No. 7,110,242 (expires February 2021) - Electrode for electric
      double layer capacitor and method of fabrication thereof;
    and




·
            U.S.
      Patent No. 7,119,047 (expires February 2021) - Modified activated carbon
      for carbon for capacitor electrodes and method of fabrication
      thereof.





We have
no duty to pay any royalties or license fees with respect to the
commercialization of our PbC device technology, and we are not subject to any
field of use restrictions. We believe our patents and patent applications, along
with our trade secrets, know-how and other intellectual property, will be
critical to our success.




Our
ability to compete effectively with other companies will depend on our ability
to maintain and protect the PbC device intellectual property and technology. We
plan to file additional patent applications in the future. However, the degree
of protection offered by our existing patents or the likelihood that our future
applications will be granted is uncertain. Competitors in both the United States
and foreign countries, many of which have substantially greater resources and
have made substantial investment in competing technologies, may have, or may
apply for and obtain patents that will prevent, limit or interfere with our
ability to make and sell products based on our PbC device technology.
Competitors may also intentionally infringe on our patents. The prosecution and
defense of patent litigation is both costly and time-consuming, even if the
outcome is favorable to us. An adverse outcome in the defense of a patent
infringement suit could subject us to significant liabilities to third parties.
Although third parties have not asserted any infringement claims against us,
there is no assurance that third parties will not assert such claims in the
future.




8


We also
rely on trade secrets, know-how and other unpatented technology, and there is no
assurance that others will not independently develop the same or similar
technology or obtain unauthorized access to our trade secrets, know-how and
other unpatented technology. To protect our rights in these areas, we require
all employees, consultants, advisors and collaborators to enter into strict
confidentiality agreements. These agreements may not provide meaningful
protection for our unpatented technology in the event of an unauthorized use,
misappropriation or disclosure. While we have attempted to protect the
unpatented proprietary technology that we develop or acquire, and will continue
to attempt to protect future proprietary technology through patents, copyrights
and trade secrets, we believe that our success will depend, to a large extent,
upon continued innovation and technological expertise.




We may
license technology from third parties. Our proposed products are still in the
development stage, and we may need to license additional technologies to
optimize the performance of our products. We may not be able to license these
technologies on commercially reasonable terms or at all. In addition, we may
fail to successfully integrate any licensed technology into our proposed
products. Our inability to obtain any necessary licenses could delay our product
development and testing until alternative technologies can be identified,
licensed and integrated.




In
general, the level of protection afforded by a patent is directly proportional
to the ability of the patent owner to protect and enforce his rights through
legal action. Since our financial resources are limited, and patent litigation
can be both expensive and time consuming, there can be no assurance that we will
be able to successfully prosecute an infringement claim in the event that a
competitor develops a technology or introduces a product that infringes on one
or more of our patents or patent applications. There can be no assurance that
our competitors will not independently develop other technologies that render
our proposed products obsolete. In general, we believe the best protection of
our proprietary technology will come from market position, technical innovation,
speed-to-market and product performance. There is no assurance that we will
realize any benefit from our intellectual property rights.




Our
Competition




We plan
to compete with a number of established competitors in the battery and
supercapacitor industry, including:




·Maxwell
                · Enersys·Energy
      Conversion Devices
                ·Exide·Panasonic
                ·Japan
      Storage Battery




·Nippon-Chemicon
            ·Ness




In
addition, many universities, research institutions and other companies are
developing advanced energy storage technologies including:




·
            symmetric
      supercapacitors;




·
            asymmetric
      supercapacitors with organic
electrolytes;




·
            nickel
      metal hydride batteries;




·
            lithium
      ion batteries; and




·
            other
      advanced lead-acid devices and




·
              flow
      batteries


Other
business entities are developing advanced energy production technologies like
fuel cells, solar cells and windmills which may use our products, or, in some
cases, compete with our products. Since some of our competitors are developing
technologies that may ultimately have costs similar to, or lower than, our
projected costs, there can be no assurance we will be able to compete
effectively.




9





Most of
our potential competitors have longer operating histories, greater name
recognition, access to larger customer bases and significantly greater
financial, sales and marketing, manufacturing, distribution, technical and other
resources than us. As a result, they may be able to respond more quickly to
changing customer demands or to devote greater resources to the development,
promotion and sales of their products than we.




Our
competitors with more diversified product offerings may be better positioned to
withstand changing market conditions. Some of our competitors own, partner with,
have longer term or stronger relationships with suppliers of raw materials and
components, which could result in them being able to obtain raw materials on a
more favorable basis than us. It is possible that new competitors or alliances
among existing competitors could emerge and rapidly acquire significant market
share, which would harm our business.




The
development of technology, equipment and manufacturing techniques and the
operation of a facility for the automated production of rechargeable batteries
requires large capital expenditures. In order to minimize our capital investment
in manufacturing facilities and establish strong brand name recognition for our
products, our overall strategy is to negotiate strategic alliances and other
production agreements with established battery manufacturers that want to add a
high-performance co-branded products to their existing product lines. There can
be no assurance, however, that our platform technology business model will
succeed in the battery industry.




Raw
Materials




During
the research stage, we used readily available raw materials, off-the-shelf
components manufactured by others and hand-made components fabricated by our
staff. As we begin manufacturing in commercial quantities, we will need to
establish reliable supply channels for commercial quantities of raw materials
and components. We believe established suppliers of raw materials and components
will be able to satisfy our requirements on a timely basis. However we do not
have any long-term supply contracts and the unavailability of necessary raw
materials or components could delay the production of our products and adversely
impact our results of operations.




Lead is
the primary raw material in lead-acid batteries and currently accounts for
approximately 80% of our raw material and component costs in the specialty
conventional lead-acid batteries we now manufacture. Lead prices have fluctuated
dramatically over the last two years, similar to other industrial grade
commodity metals. Our PbC technology will require substantially less lead than
conventional batteries, providing a distinct competitive cost advantage if lead
prices increase above historical averages.





Environmental
Protection




Lead is a
toxic material that is a primary raw material in our PbC batteries. We also use,
generate and discharge other toxic, volatile and hazardous chemicals and wastes
in our research, development and manufacturing activities. We comply with
federal, state and local laws and regulations regarding pollution control and
environmental protection. Under some statutes and regulations, a government
agency, or other parties, may seek to recover response costs from operators of
property where releases of hazardous substances have occurred or are ongoing,
even if the operator was not responsible for such release or otherwise at fault.
In addition, more stringent laws and regulations may be adopted in the future,
and the costs of complying with those laws and regulations could be substantial.
If we fail to control the use of, or to adequately restrict the discharge of,
hazardous substances, we could be subject to significant monetary damages and
fines, or forced to suspend certain operations. In January of 2009, our facility
was tested and found to be in compliance with emission standards as established
by new federal guidelines in accordance with the Clean Air Act – Title
III.




10


Our
Research and Development





We engage
in extensive R&D for the purpose of improving our PbC technology and our
proposed products. Our goal is to increase efficiency and reduce costs in order
to maximize our competitive advantage. Our R&D organization works closely
with our engineering team, our suppliers and potential customers to improve our
product design and lower manufacturing costs. During the years ended December
31, 2008 and 2007, we spent $4.0 million and $2.2 million respectively on
R&D, and $14.0 million since inception. While our limited financial
resources and short operating history make it difficult for us to estimate our
future expenditures, we expect to incur R&D expenditures of consistent
magnitude for the foreseeable future.




Our
Employees




We
presently employ a staff of 50, including an 11 member scientific and
engineering team, and 26 people who are involved principally in manufacturing.
We are not subject to any collective bargaining agreements, and we believe we
have a good relationship with our employees.




Description
of Properties




In April
of 2008 we signed a new lease that added to our existing space at our
manufacturing plant in New Castle, Pennsylvania. The new lease calls for a
monthly payment of $16,142 with an initial term of two years which commenced in
April 2008. The lease includes two successive five-year renewal options, with
future rent to be negotiated at a commercially reasonable rate. The battery
manufacturing facility includes approximately 70,438 square feet of floor space,
including 7,859 square feet of office, locker, lab and lunch area, 46,931 square
feet of manufacturing space, 1,488 square feet of dedicated lab space, 9,200
square feet of storage buildings and 5,000 square feet of basement area. In
addition to the monthly rental, we are obligated to pay all required maintenance
costs, taxes and special assessments, maintain public liability insurance, and
maintain fire and casualty insurance for an amount equal to 100% of the
replacement value of the leased premises. Our battery manufacturing operations
at this facility are conducted through a wholly owned subsidiary named Axion
Power Battery Manufacturing, Inc. Management believes our property is in good
condition.





In
December 2008, we signed a letter agreement to sublease from a current tenant,
on a month-to-month basis, a building consisting of 54,000 square feet, also
located in New Castle, Pennsylvania. This space provides 48,000 of combined
manufacturing and warehouse space and 6,000 square feet of combined office and
R&D space. This letter agreement is effective through December 31, 2010. We
can enter into a sales agreement at any time during the sublease letter
agreement. Rental for this space is $19,300 per month.  In addition to
the monthly rent, we are obligated to pay all required maintenance costs, taxes
and special assessments, maintain public liability insurance, and maintain fire
and casualty insurance for an amount equal to 100% of the replacement value of
the leased premises.  We intend to conduct our PbC carbon electrode
manufacturing and R&D operations from this facility.





Item 1A  Risk Factors





Risks
related to our business




We
are a development stage company and our business and prospects are extremely
difficult to evaluate.





Since our
inception in September 2003, the majority of our resources have been dedicated
to our R&D efforts and we have only recently begun to transition into the
very early stages of commercial PbC prototype production. We do not have a
stable operating history that you can rely on in connection with your evaluation
of our business and our future business prospects. Our business and prospects
must be carefully considered in light of the limited history of PbC technology
and the many business risks, uncertainties and difficulties that are typically
encountered by development stage companies that have sporadic revenues and are
committed to focusing on research, development and product testing for an
indeterminate period of time. Some of the principal risks and difficulties we
have and expect to continue to encounter include, but are not limited to, our
ability to:





·
            Raise
      the necessary capital to finance our business until we can sell products
      on a full-scale and profitable
basis;




11





·
            Maintain
      effective control over the cost of our research, development and product
      testing activities;




·
            Develop
      cost effective manufacturing methods for essential components of our
      proposed products;




·
            Improve
      the performance of our commercial prototype
  batteries;




·
            Successfully
      transition from our laboratory research and pilot production efforts to
      commercial manufacturing and sales of our battery
      technologies;




·
            Adapt
      and successfully execute our rapidly evolving and inherently unpredictable
      business plan;




·
            Implement
      and improve operational, financial and management control systems and
      processes;




·
            License
      complementary technologies if necessary and successfully defend our
      intellectual property rights against potential
  claims;




·
            Respond
      effectively to competitive developments and changing market
      conditions;




·
            Continue
      to attract, retain and motivate qualified personnel;
  and




·
            Manage
      each of the other risks set forth
below.




Because
of our limited operating history and our relatively recent transition into the
production of prototype PbC devices that we are relying on to become our core
revenue generating products, we have limited insight into trends and conditions
that may exist or might emerge and affect our business. There is no assurance
that our business strategy will be successful or that we will successfully
address the risks identified in this report.





We
have incurred net losses from inception and do not expect to introduce our first
commercial PbC products for 9 to 12 months.





From our
inception we have incurred net losses and expect to continue to incur
substantial and possibly increasing losses for the foreseeable future as we
increase our spending to finance the development of and production methods for
our PbC devices, our administrative activities, and the costs associated with
being a public company. Our operating losses have had, and will continue to
have, an adverse impact on our working capital, total assets and stockholders’
equity. For the year ended December 31, 2008, we had a net loss of approximately
$10.6 million, a net loss of $14.3 million for the year ended December 31,
2007 and cumulative losses from inception (September 18, 2003) to December, 2008
of $49.1 million. Our PbC technology has not reached a point where we can mass
produce batteries based on the technology, and we will not be in a position to
commercialize such products until we complete the design development,
manufacturing process development and pre-market testing activities. We
believe the development and testing process will require a minimum of an
additional 9 to 12 months. There can be no assurance that our development and
testing activities will be successful or that our proposed products will achieve
market acceptance or be sold in sufficient quantities and at prices necessary to
make them commercially viable. If we do not realize sufficient revenue to
achieve profitability, our business could be harmed.






Our
revenues may suffer if general economic conditions continue to
worsen.




Our
revenues and our ability to generate earnings are affected by the general
economic factors that are adversely impacting the global economy, such as lack
of liquidity in the capital markets, reduced demand for consumer and industrial
products, excessive inflation, currency fluctuations, increased commodity prices
and employment levels, resulting in a temporary or longer-term overall decline
in demand for our products. This trend has already commenced with excess supply
beginning to build up in the industries in which we operate. Therefore, any
prolonged significant downturn or recession in the United States or Canada is
expected to have a material adverse effect on our business, results of
operations and financial condition.


12




Our
business will not succeed if we are unable to raise additional
capital.





Our
management believes our current financial resources will support operations
through 2009. We will not be able to continue our operations at planned levels
of effort beyond that time frame without increased revenues, receipt of awarded
grant proceeds or additional financing. We cannot assure you that any
additional capital will be available to us on favorable terms, or at all. If we
are unable to generate sufficient revenues or obtain additional
capital when needed, our research, development and testing activities will be
materially and adversely affected, and we may be unable to take advantage of
future opportunities or respond to competitive pressures. Any inability to
generate revenue or raise capital when we require it would seriously harm our
business.





We
are currently involved in litigation.





We are
currently involved in other litigation as described in this Annual Report on
Form 10-K. There are no assurances that we will prevail on any litigation to
which we are a party and, if we do prevail, at what cost in terms of financial
and personnel resources, as well as on what terms.





We
are in breach of certain registration rights.




As of
March 24, 2009, we have outstanding obligations to register approximately
3,755,500 shares of common stock held by the Mega-C Trust, and 750,000 shares
held by the Mega-C liquidation trust, in addition we have outstanding
obligations to register approximately 1,106,217 shares of common stock that may
be issued upon conversion of our 8% Cumulative Convertible Senior Preferred
Stock, 7,809,033 shares of common stock that may be issued upon conversion of
our Series A Convertible Preferred Stock, and an additional 1,870,690 shares of
common stock issuable upon the exercise of certain of our outstanding options,
and an additional 14,228,772 shares of common stock issuable upon the exercise
of certain of our outstanding warrants. We are still in breach of all of our
obligations to register these shares. There are no liquidated damages stipulated
for our failure to register such shares; however, the holders of these
securities may still elect to pursue remedies against the Company for our
failure to meet these registration obligations and, as a result, our business
operations, or our ability to raise additional capital in the future, may be
adversely affected.





As
we sell our products, we may become the subject of product liability
claims.





Due to
the hazardous nature of many of the key materials used in the manufacturing of
batteries, the producers of such products may be exposed to a greater number of
product liability claims, including possible environmental claims. We currently
have product liability insurance up to $1,000,000 per occurrence and $5,000,000
in the aggregate to protect us against the risk that in the future a product
liability claim or product recall could materially and adversely affect our
business operations. Inability to obtain sufficient insurance coverage at an
acceptable cost or otherwise to protect against potential product liability
claims could prevent or inhibit the commercialization of our product. We cannot
assure you that as we continue distribution of our products that we will be able
to obtain or maintain adequate coverage on acceptable terms, or that such
insurance will provide adequate coverage against all potential claims. Even if
we maintain adequate insurance, any successful claim could materially and
adversely affect our reputation and prospects, and divert management’s time and
attention. If we are sued for any injury allegedly caused by our future products
our liability could exceed our total assets and our ability to pay such
liability.




13


Our
products contain hazardous materials including lead.




Lead is a
toxic material that is a primary raw material in our batteries. We also use,
generate and discharge other toxic, volatile and hazardous chemicals and wastes
in our research, development and manufacturing activities. We are required to
comply with federal, state and local laws and regulations regarding pollution
control and environmental protection. Under some statutes and regulations, a
government agency, or other parties, may seek to recover response costs from
operators of property where releases of hazardous substances have occurred or
are ongoing, even if the operator was not responsible for such release or
otherwise at fault. In addition, more stringent laws and regulations may be
adopted in the future, and the costs of complying with those laws and
regulations could be substantial. If we fail to control the use of, or
inadequately restrict the discharge of, hazardous substances, we could be
subject to significant monetary damages and fines, or be forced to suspend
certain operations.  In January of 2009, our facility was tested and
found to be in compliance with emission standards as established by new federal
guidelines in accordance with the Clean Air Act – Title III.





We
are subject to stringent environmental regulation.





We use or
generate certain hazardous substances in our research and manufacturing
facilities. We do not carry environmental impairment insurance. We believe that
all permits and licenses required for the operation of our business are in
place. Although we do not know of any material environmental, safety or health
problems in our property or processes, there can be no assurance that problems
will not develop in the future which could have a material adverse effect on our
business, results of operation, or financial condition.  In January of
2009, our facility was tested and found to be in compliance with emission
standards as established by new federal guidelines in accordance with the Clean
Air Act – Title III.





The
growth we seek is substantial and challenging to achieve and
maintain.





The
realization of our business objectives will require substantial future growth.
Even in the event we are able to complete the development of our prototypes,
introduce our products to the market and grow our business, we expect that rapid
growth will significantly challenge our managerial, operational and financial
resources. We must continue to prepare for our growth, if any, through
appropriate systems and controls. We must also establish, train and manage a
much larger work force, which will again require advance planning. If we do not
prepare for and manage the growth of our business effectively, our potential for
success could be materially and adversely affected.





Being
a public company increases our administrative costs significantly.





As a
public company, we incur significant legal, accounting and other expenses that
would not be incurred by a comparable private company. Commission rules and
regulations have made some activities more time consuming and expensive and
require us to implement corporate governance and internal control procedures
that are not typical for development stage companies. We also incur a variety of
internal and external costs associated with the preparation, filing and
distribution of the periodic public reports and proxy statements required by the
Securities Exchange Act of 1934, as amended. During the year ended December 31,
2008, we spent approximately $930,000for public accounting
and compliance. Of this amount, approximately $455,000 was incurred in relation
to prior years filing requirements, approximately $105,000 for legal opinions
and other SEC related matters, and approximately $370,000 for 2008 filings
including the S-1 registration statement. We do not anticipate these costs to be
at these same levels for 2009. We expect Commission rules and regulations to
continue to make it more difficult and expensive for us to attract and retain
qualified directors and executive officers.





We
depend on key personnel, and our business may be severely disrupted if we lose
the services of our key executives and employees.





Our
business is dependent upon the knowledge and experience of our key scientists,
engineers and executive officers. Given the competitive nature of our industry,
there is the risk that one or more of our key scientists or engineers will
resign their positions, which could have a disruptive impact on our operations.
If any of our key scientists, engineers or executive officers do not continue in
their present positions, we may not be able to easily replace them and our
business may be severely disrupted. If any of these individuals joins a
competitor or forms a competing company, we could lose important know-how and
experience and incur substantial expense to recruit and train suitable
replacements. Currently, all of our key employees have employment contracts
which have remaining terms of at least 12 months and non-compete provisions that
extend an additional 24 months.


14




Our
certificate of incorporation and by-laws provide for indemnification and
exculpation of our officers and directors.





Our
certificate of incorporation provides for indemnification of our officers,
directors and employees to the fullest extent permitted by Delaware law. It also
provides exculpation of our directors for monetary damages arising from breach
of their fiduciary duties in cases that do not involve fraud or willful
misconduct. The Commission has advised that it believes that indemnification for
liabilities arising under the securities laws is against public policy as
expressed in the securities laws and is therefore unenforceable.





We
have limited manufacturing experience which may translate into substantial cost
overruns in manufacturing and marketing our products.





As we
transition into the commercial production of our prototype devices, we may
experience substantial cost overruns in manufacturing and marketing our PbC
technologies, and may not have sufficient capital in the future to successfully
complete such tasks. In addition, we may not be able to manufacture or market
our products because of industry conditions, general economic conditions, and/or
competition from potential manufacturers and distributors. Either of these
inabilities could cause us to abandon our current business plan and may cause
our operations to eventually fail.




Risks
related to our PbCTM technology





We
need to improve the performance of our commercial prototypes to achieve large
scale production.





Our
commercial prototypes do not satisfy all of our performance expectations, and we
need to continue to improve various aspects of our PbC technology as we move
forward with larger scale production of our commercial prototypes. There is no
assurance that we will be able to resolve the known technical issues. Future
testing of our prototypes may reveal additional technical issues that are not
currently recognized as obstacles. If we cannot improve the performance of our
prototypes in a timely manner, we may be forced to redesign or delay the large
scale production of commercial prototypes or possibly cause us to abandon our
product development efforts altogether.





We
cannot begin full-scale commercial production of our PbC technology for 9 to 12
months.





We will
not be able to begin full commercial production of our PbC energy storage
devices until we complete our current testing operations, our planned
application evaluation and our planned product development. We believe our
commercialization path will require a minimum of 9 to 12 months. Even if our
prototype development operations are successful, there can be no assurance that
we will be able to establish and maintain our facilities and relationships for
the manufacturing, distribution and sale of our PbC batteries and other
technologies or that any future products will achieve market acceptance and be
sold in sufficient quantities and at prices necessary to make them commercially
successful. Even if our proposed products are commercially successful, there can
be no assurance that we will realize enough revenue and gross margin from the
sale of products to achieve profitability.





We
do not have any long term vendor contracts.





We
currently purchase the raw materials for our carbon electrodes and a variety of
other components from third parties. We then fabricate our carbon electrodes and
build our prototypes in-house. We do not have any long-term contracts with
suppliers of raw materials and components, and our current suppliers may be
unable to satisfy our future requirements on a timely basis. Moreover, the price
of purchased raw materials and components could fluctuate significantly due to
circumstances beyond our control. If our current suppliers are unable to satisfy
our long-term requirements on a timely basis, we may be required to seek
alternative sources for necessary materials and components or redesign our
proposed products to accommodate available substitutes.


15





We
do not have extensive manufacturing experience.





We do not
have extensive manufacturing experience with respect to manufacturing our
commercial prototypes in quantities required to achieve our operational goals,
and there is no assurance that we will be able to retain a qualified
manufacturing staff or effectively manage the manufacturing of our proposed
products when we are ready to do so.





We
will be a small player in an intensely competitive market and may be unable to
compete.





The
lead-acid battery industry is large, intensely competitive and resistant to
technological change. If our product development efforts are successful, we will
have to compete or enter into strategic relationships with well-established
companies that are much larger and have greater financial capital and other
resources than we do. We may be unable to convince end users that products based
on our PbC technology are superior to available alternatives. Moreover, if
competitors introduce similar products, they may have a greater ability to
withstand price competition and finance their marketing programs. There is no
assurance that we will be able to compete effectively.





To
the extent we enter into strategic relationships, we will be dependent upon our
partners.





Some of
our products are not intended for direct sale to end users and our business
strategy will likely require us to enter into strategic relationships with
manufacturers of other power industry equipment that use batteries and other
energy storage devices as important components of their finished products. The
agreements governing any future strategic relationships are unlikely to provide
us with control over the activities of any strategic relationship we negotiate
and our future partners, if any, could retain the right to terminate the
strategic relationship at their option. Our future partners will have
significant discretion in determining the efforts and level of resources that
they dedicate to our products and may be unwilling or unable to fulfill their
obligations to us. In addition, our future partners may develop and
commercialize, either alone or with others, products that are similar to or
competitive with the products that we intend to produce.





Risks
relating to our intellectual property





We
may rely on licenses for our PbC technology, which may affect our continued
operations with respect thereto.





Although
this is a remote possibility, as we develop our PbC technology, we may need to
license additional technologies to optimize the performance of our products. We
may not be able to license these technologies on commercially reasonable terms
or at all. In addition, we may fail to successfully integrate any licensed
technology into our proposed products. Our inability to obtain any necessary
licenses could delay our product development and testing until alternative
technologies can be identified, licensed and integrated. The inability to obtain
any necessary third-party licenses could cause us to abandon a particular
development path, which could seriously harm our business, financial position
and results of our operations.





If
we are unable to protect our proprietary technology and preserve our trade
secrets, we will increase our vulnerability to competitors which could
materially adversely impact our ability to remain in business.





Our
ability to successfully commercialize our products will depend, in large
measure, on our ability to protect those products and our technology with
domestic and foreign patents. We will also need to continue to preserve our
trade secrets. The issuance of a patent is not conclusive as to its validity or
as to the enforceable scope of the claims of the patent. The patent positions of
technology companies, including us, are uncertain and involve complex legal and
factual issues.




16


We cannot
assure you that our patents will prevent other companies from developing similar
products or products which produce benefits substantially the same as our
products, or that other companies will not be issued patents that may prevent
the sale of our products or require us to pay significant licensing fees in
order to market our products. Accordingly, if our patent applications are not
approved or, even if approved, if such patents are circumvented or not upheld in
a court of law, our ability to competitively exploit our patented products and
technologies may be significantly reduced. Additionally, the coverage claimed in
a patent application can be significantly reduced before the patent is
issued.




From time
to time, we may need to obtain licenses to patents and other proprietary rights
held by third parties in order to develop, manufacture and market our products.
If we are unable to timely obtain these licenses on commercially reasonable
terms, our ability to commercially exploit such products may be inhibited or
prevented. Additionally, we cannot assure investors that any of our products or
technology will be patentable or that any future patents we obtain will give us
an exclusive position in the subject matter claimed by those patents.
Furthermore, we cannot assure investors that our pending patent applications
will result in issued patents, that patent protection will be secured for any
particular technology, or that our issued patents will be valid or enforceable
or provide us with meaningful protection.





If
we are required to engage in expensive and lengthy litigation to enforce our
intellectual property rights, the costs of such litigation could be material to
our results of operations, financial condition and liquidity and, if we are
unsuccessful, the results of such litigation could materially adversely impact
our entire business.





We may
find it necessary to initiate litigation to enforce our patent rights, to
protect our trade secrets or know-how or to determine the scope and validity of
the proprietary rights of others. We plan to aggressively defend our proprietary
technology and any issued patents if funding is available to do so. Litigation
concerning patents, trademarks, copyrights and proprietary technologies can
often be time-consuming and expensive and, as with litigation generally, the
outcome is inherently uncertain.





Although
we have entered into invention assignment agreements with our employees and with
certain advisors, if those employees or advisors develop inventions or processes
independently which may relate to products or technology under development by
us, disputes may also arise about the ownership of those inventions or
processes. Time-consuming and costly litigation could be necessary to enforce
and determine the scope of our rights under these agreements.





We also
rely on confidentiality agreements with our strategic partners, customers,
suppliers, employees and consultants to protect our trade secrets and
proprietary know-how. We may be required to commence litigation to enforce such
agreements, and it is certainly possible that we will not have adequate remedies
for breaches of our confidentiality agreements.




Other
companies may claim that our technology infringes on their intellectual property
or proprietary rights and commence legal proceedings against us which could be
time-consuming and expensive and could result in our being prohibited from
developing, marketing, selling or distributing our products.





Because
of the complex and difficult legal and factual questions that relate to patent
positions in our industry, we cannot assure you that our products or technology
will not be found to infringe upon the intellectual property or proprietary
rights of others. Third parties may claim that our products or technology
infringe on their patents, copyrights, trademarks or other proprietary rights
and demand that we cease development or marketing of those products or
technology or pay license fees. We may not be able to avoid costly patent
infringement litigation, which will divert the attention of management away from
the development of new products and the operation of our business. We cannot
assure investors that we would prevail in any such litigation. If we are found
to have infringed on a third party's intellectual property rights, we may be
liable for money damages, encounter significant delays in bringing products to
market or be precluded from manufacturing particular products or using
particular technology.





Other
parties may challenge certain of our foreign patent applications. If such
parties are successful in opposing our foreign patent applications, we may not
gain the protection afforded by those patent applications in particular
jurisdictions and may face additional proceedings with respect to similar
patents in other jurisdictions, as well as related patents. The loss of patent
protection in one jurisdiction may influence our ability to maintain patent
protection for the same technology in another jurisdiction.


17





New
technology may lead to our competitors developing superior products which would
reduce demand for our products.





Research
into the electrochemical applications for carbon nanotechnology and other
storage technologies is proceeding at a rapid pace, and many private and public
companies and research institutions are actively engaged in the development of
new battery technologies based on carbon nanotubes, nanostructured carbon
materials and other non-carbon materials. These new technologies may, if
successfully developed, offer significant performance or price advantages when
compared with our technologies. There is no assurance that our existing patents
or our pending and proposed patent applications will offer meaningful protection
if a competitor develops a novel product based on a new technology.





Risks
relating to our common stock





The number of shares of common stock
we are obligated to register could depress our stock
price.





Effective
August 5, 2008, we registered 2,782,837 shares of our common stock for resale by
certain Selling Stockholders. These shares represent approximately 7.1% of
our capitalization assuming the exercise of certain warrants and options
and conversion of preferred stock. The sale of a significant number of these
shares may cause the market price of our common stock to decline.





We
have issued a large number of convertible securities, warrants and options that
may increase, perhaps significantly, the number of common shares
outstanding.





We had
26,417,437 shares of common stock outstanding at December 31, 2008, and (a) our
Series A Convertible Preferred Stock is presently convertible into 7,809,033
shares of common stock, (b) our shares of Cumulative Convertible Senior
Preferred Stock are presently convertible into 1,106,217 shares of common stock,
(c) we have warrants outstanding that, if exercised, would generate proceeds of
$41,715,303 and cause us to issue up to an additional 14,228,772 shares of
common stock and (d) we have options to purchase common stock that, if
exercised, would generate proceeds of $11,221,886 and result in the issuance of
an additional 2,819,940 shares of common stock.





We
have provided and intend to continue offering compensation packages to our
management and employees that emphasize equity-based compensation.





As a key
component of our growth strategy, we have provided and intend to continue
offering compensation packages to our management and employees that emphasize
equity-based compensation. In particular:





·
            Our
      incentive stock plan authorized incentive awards for up to 2,000,000
      shares of our common stock; we have issued incentive awards for an
      aggregate of 782,950 shares at the date of this report; and we have the
      power to issue incentive awards for an additional 1,217,050 shares without
      stockholder approval;




·
            Our
      independent directors’ stock option plan authorized options for up to
      500,000 shares of our common stock; we have issued options for an
      aggregate of 349,155 shares at the date of this report; and have the power
      to issue options for an additional 150,845 shares without stockholder
      approval;




·
            We
      have issued contractual options for an aggregate of 1,943,000 shares of
      our common stock, of which 1,503,000 are currently outstanding, to
      executive officers under the terms of their employment agreements with us
      ; and




18





·
            We
      have issued contractual options for an aggregate of 1,144,700 shares of
      our common stock, of which 945,400 are currently outstanding, to certain
      employees, attorneys and consultants under the terms of their agreements
      with us.




We will
be required to account for the fair market value of equity compensation awards
as operating expenses. As our business matures and expands, we expect to incur
increasing amounts of non-cash compensation expense, which may materially and
adversely affect our future operating results.





We
may issue stock to finance acquisitions.





We may
wish to acquire complementary technologies, additional facilities and other
assets. Whenever possible, we will try to use our stock as an acquisition
currency in order to conserve our available cash for operations, but use of
stock as an acquisition currency will also dilute the ownership of then current
existing stockholders. Future acquisitions may give rise to substantial charges
for the impairment of goodwill and other intangible assets that would materially
and adversely affect our reported operating results. Any future acquisitions
will involve numerous business and financial risks, including:





·
            difficulties
      in integrating new operations, technologies, products and
      staff;




·
            diversion
      of management attention from other business concerns;
  and




·
            cost
      and availability of acquisition
financing.




We will
need to be able to successfully integrate any businesses we may acquire in the
future, and the failure to do so could have a material adverse effect on our
business, results of operations and financial condition.





Because
of factors unique to us, the market price of our common stock is likely to be
volatile.





Because
of the relatively small number of shares currently available for resale, the
large number of shares that we have registered and will register in the future
on behalf of Quercus Trust, the development stage of our business and numerous
other factors, the trading price of our common stock has been and is likely to
continue to be highly volatile. In addition, actual or anticipated variations in
our quarterly operating results; the introduction of new products by
competitors; changes in competitive conditions or trends in the battery
industry; changes in governmental regulation and changes in securities analysts’
estimates of our future performance or that of our competitors or our industry
in general, could adversely affect our future stock price. Investors should not
purchase our shares if they are unable to suffer a complete loss of their
investment.





Our
stock price may not stabilize at current levels.





Our stock
is quoted on the OTCBB. Since trading in our common stock began in January 2004,
trading has been sporadic, trading volumes have been low and the market price
has been volatile. The closing price reported as of March 24, 2009 [the latest
practicable date] was $0.90 per share. Current quotations are not necessarily a
reliable indicator of value and there is no assurance that the market price of
our stock will stabilize at or near current levels.





Our
common stock is subject to the “penny stock” rules.





Rule
3a51-1 promulgated under the Securities Exchange Act of 1934, as amended,
defines a “penny stock” as any equity security that is not listed on a national
securities exchange or the Nasdaq system and has a bid price of less than $5 per
share. We presently are subject to the penny stock rules. Our market price has
been highly volatile since trading in our common stock began in January 2004 and
there is no assurance that the penny stock rules will not continue to apply to
our shares for an indefinite period of time. Before effecting a transaction that
is subject to the penny stock rules, a broker-dealer must make a decision
respecting the suitability of the purchaser; deliver certain disclosure
materials to the purchaser and receive the purchaser’s written approval of the
transaction. Because of these restrictions, most broker-dealers refrain from
effecting transactions in penny stocks and many actively discourage their
clients from purchasing penny stocks. Therefore, both the ability of
broker-dealers to recommend our common stock and the ability of our stockholders
to sell their shares in the secondary market could be adversely affected by the
penny stock rules.


19





Item 2  Properties





In April
of 2008, we signed a new lease that added to our existing space at our
manufacturing plant in New Castle, Pennsylvania. The new lease calls for a
monthly payment of $16,142 with an initial term of two years beginning April
2008. The lease includes two successive five-year renewal options, with future
rent to be negotiated at a commercially reasonable rate. The battery
manufacturing facility includes approximately 70,438 square feet of floor space,
including 7,859 square feet of office, locker, lab and lunch area, 46,931 square
feet of manufacturing space, 1,488 square feet of dedicated lab space, 9,200
square feet of storage buildings and 5,000 square feet of basement area. In
addition to the monthly rental, we are obligated to pay all required maintenance
costs, taxes and special assessments, maintain public liability insurance, and
maintain fire and casualty insurance for an amount equal to 100% of the
replacement value of the leased premises. Our battery manufacturing operations
at this facility are conducted through a wholly owned subsidiary named Axion
Power Battery Manufacturing, Inc. Our management believes our property is in
good condition.





In
December 2008, we signed a letter agreement to sublease from a current tenant on
a month-to-month basis a building consisting of 54,000 square feet in New
Castle, Pennsylvania. This space provides 48,000 of combined manufacturing and
warehouse space and 6,000 square feet of combined office and R&D space. This
letter agreement is effective through December 31, 2010. We can enter into a
sales agreement at any time during the sublease letter agreement.  The
rent is $19,300 on a monthly basis.  In addition to the monthly rent,
we are obligated to pay all required maintenance costs, taxes and special
assessments, maintain public liability insurance, and maintain fire and casualty
insurance for an amount equal to 100% of the replacement value of the leased
premises.  We intend to conduct our PbC and R&D operations from
this facility.





Item 3  Legal Proceedings





TaylorLitigation




On
February 10, 2004, Lewis “Chip” Taylor, Chip Taylor in Trust, Jared Taylor,
Elgin Investments, Inc. and Mega-C Technologies, Inc. (collectively the “Taylor
Group”) filed a lawsuit in the Ontario Superior Court of Justice Commercial List
(Case No. 04-CL-5317) that named Tamboril, APC, and others as defendants (the
“Taylor Litigation”). As discussed more fully below, by virtue of an order
entered on February 11, 2008 by the Bankruptcy Court in the Mega-C bankruptcy
case, this action against us is subject to the permanent injunction of the
confirmed Chapter 11 Plan of Mega-C.




In
February 2005, the Bankruptcy Court stayed the Taylor Litigation pending
resolution of Mega-C’s Chapter 11 bankruptcy case. On December 12, 2005, we
entered into a settlement agreement with Mega-C, through its Chapter 11 Trustee,
and various others that was approved by an order entered in the bankruptcy case
on February 1, 2006 and which became fully effective when the Court confirmed
Mega-C’s Chapter 11 Plan of Reorganization in an order entered on November 8,
2006. The details of the settlement agreement and the current state of the
Taylor Group's litigation are discussed below.




Bankruptcy
Court Litigation




In April
2004, we filed an involuntary Chapter 11 petition against Mega-C in the U.S.
Bankruptcy Court for the District of Nevada (Case No. 04-50962-gwz). In March
2005, the Bankruptcy Court appointed William M. Noall (“Noall”) to serve as
Chapter 11 Trustee for the Mega-C case. On June 7, 2005, the Chapter 11 Trustee
commenced an adversary proceeding against Sally Fonner (“Fonner”), the trustee
of the Mega-C Trust (Adversary Proceeding No. 05-05042-gwz), demanding, among
other things, the turnover of at least 7,327,500 shares held by the Mega-C Trust
as property of the bankruptcy estate. On July 27, 2005, we commenced an
adversary proceeding against Noall and Fonner (Adversary Proceeding No.
05-05082-gwz).


20


Settlement
Agreement




On
December 12, 2005, we entered into the Settlement Agreement with Mega-C,
represented by Chapter 11 Trustee Noall, and the Mega-C Trust, represented by
its trustee Fonner.




The
Settlement Agreement was approved by the Bankruptcy Court after a hearing in an
order dated February 1, 2006. Certain terms were subject to confirmation and
effectiveness of Mega-C’s Chapter 11 plan of reorganization. On November 8,
2006, the Bankruptcy Court entered an order confirming the Chapter 11 plan. The
confirmed Chapter 11 plan was subsequently substantially consummated on November
21, 2006. The Settlement Agreement was fully incorporated in the confirmed
Chapter 11 plan. The plan is fully effective and substantially consummated.
Accordingly, all pending and potential disputes between the parties have been
resolved.





The
litigation settlement and releases provided by the Chapter 11 plan are now
binding on Mega-C, the Chapter 11 trustee, the Taylor Group and all other
parties described in the plan of reorganization. In an order entered on February
11, 2008, the Bankruptcy Court granted our motion for partial summary judgment,
holding that the alleged “oral” agreement creating rights or interests in the
Technology in favor of the Taylor Group never existed and, even if it had, the
Taylor Group transferred any such rights to the Debtor which were then
transferred to us by the confirmed Chapter 11 plan. The Bankruptcy Court held
that the Taylor Group has no interest in or rights to the Technology. The
Bankruptcy Court held that the only rights the Taylor Group has are as putative
creditors or Stockholders of Mega-C and that any attempts to claim an interest
in or contest our title to the technology are contrary to the permanent
injunction of the Chapter 11 plan. The Bankruptcy Court held that the Taylor
Litigation against us is barred by the permanent injunction of the confirmed
Chapter 11 plan.




In orders
entered on June 9, 2008, the Bankruptcy Court mandated that the Taylor Group
litigation against us be dismissed. On June 18, 2008, the Taylor Group filed a
notice of appeal from these orders. The Taylor Group signed a pleading
consenting to dismiss us from the Taylor Group litigation in Canada.
 On June 27, 2008, we filed a notice of cross-appeal from the Bankruptcy
Court’s orders denying our request for sanctions and our request to hold the
Taylors in contempt of court for their failure to comply with the permanent
injunction of the confirmed chapter 11 plan.  The Taylors’ appeal and our
cross-appeal are have been dismissed as interlocutory by the Bankruptcy
Appellate Panel for lack of jurisdiction.  On February 10, 2009, the
Taylors filed a second motion to vacate the February 11, 2008 order granting
summary judgment in our favor.  We believe this second motion lacks any
basis in the facts or the law and we intend to vigorously oppose that motion,
which is currently set for hearing in April 2009 in Bankruptcy
Court.




In
connection with a related adversary proceeding in the Bankruptcy Court, the
Liquidation Trustee and the Taylors entered into a settlement agreement
whereby, among other things, the Taylors agreed to withdraw virtually all of
their claims in the Mega C bankruptcy case, dismiss their appeals from the
confirmation order and dismiss their appeal from the settlement
agreement.    The Taylors’ appeals from the confirmation order
and from the settlement agreement have now been dismissed.  The Ninth
Circuit recently dismissed the appeal from the Settlement Agreement by a group
identifying themselves as the “Unaffiliated Shareholders,.” The Ninth
Circuit awarded double costs on appeal to the Company.  The
Unaffiliated Shareholders’ appeal from the Confirmation Order was also recently
dismissed.  As a result, all appeals from the Settlement Agreement and the
Confirmation Order have been resolved in the Company’s favor.





By virtue
of the confirmed Chapter 11 plan, all of the Mega-C’s right, title and interest,
if any, in the technology was transferred to us. By virtue of the February 11,
2008 orders of the Bankruptcy Court, the Taylor Group has no interest in or
rights to the technology.


21





Contingent
Shares




We agreed
to sell 1,000,000 shares of common stock to a foreign partnership, Mercatus
& Partners Limited at a price of $2.50 per share as part of a group of
comparable transactions where the purchaser planned to contribute a portfolio of
small public company securities to a pair of offshore funds in exchange for fund
units, and then use the fund units as security for bank financing that would be
used to pay for the underlying securities. Contrary to the terms and conditions
of our agreement, the foreign partnership was in possession of a stock
certificate representing these 1,000,000 shares; however, completion of the
transaction was contingent upon receipt of the proceeds from the foreign
partnership, which were not received. The 1,000,000 shares were recovered on
December 4, 2007 and forwarded to Continental Stock Transfer Agency for
cancellation, which took place that same month.




In
connection with the offering described above, four holders of warrants to
purchase shares of our common stock agreed to exercise their warrants to
purchase, in the aggregate, 301,700 shares of common stock (the “Incompletely
Exercised Warrant Shares”) for the purpose of selling them to the foreign
partnership in a transaction that was substantially similar to the one we
entered into with the same foreign partnership. These shares were to be issued
to the foreign partnership upon receipt of payment, which was in turn contingent
upon the foreign partnership tendering the payment of the purchase price for
these shares. Contrary to the terms and conditions of their agreements, the
foreign partnership transferred the shares to two of its creditors who both hold
the shares as holders-in-due-course.  We are pursuing the partnership and
the custodians of the stock for the monetary value of the stock. We retained
counsel to cause the parties who have possession of the Incompletely Exercised
Warrant shares to return the shares absent payment and commenced litigation
soon thereafter.




On or
about March 24, 2009, we were awarded judgment by default against the
partnership and an individual defendant for $1,499,100 plus accrued and unpaid
interest thereon. The net result to the Company will be a cash infusion of
approximately $1,000,000.  Like most judgments, there is no guarantee the
Company will be able to fully collect on this amount.




Peter
Roston Litigation




A prior
Chief Financial Officer, Mr. Peter Roston, filed a lawsuit to recover the full
amount of compensation and benefits that would have been paid to him through the
initial term of his employment for alleged breaches in his employment agreement
after he was discharged for cause by us in December 2006. We determined the
range of potential loss to be CAD $250,000 to CAD $275,000.  Arbitration
proceedings for this matter began in April 2008 and a settlement was reached in
October 2008.  By agreement, the terms of the settlement are confidential,
although the settlement amount is substantially below the range of potential
losses and are not material to Axion’s financial position.




Cypress
Avenue Partners, LLC




On May 8,
2008, Cypress Avenue Partners, LLC (“Cypress”), filed a complaint against us and
several others in the United States District Court for the Northern District of
California. The complaint alleges, among other things, that Cypress entered into
a contract with us under which Cypress was to act as a finder and was entitled
to certain remuneration which it was not paid. Cypress claims it is entitled to
purchase 200,000 shares of our common stock and is owed $900,000, representing a
five percent placement fee on the amount of $18 million which reflects the
closing of all rounds of Quercus financing. We denied any obligation to pay the
cash placement fee to Cypress under the terms of an October 2006 letter
agreement between us and Cypress. We filed a Motion to Dismiss the Complaint on
June 30, 2008. The Motion to Dismiss was granted by Order dated August 4, 2008,
and Defendant’s Motion by Plaintiff to reconsider was denied on August 11,
2008.  The Cypress Avenue Partners, LLClitigation was
settled on November 7, 2008, with the exchange of general releases and certain
consideration, which is not deemed to be material.





Item 4  Submission of Matters to a Vote of Security
Holders





On
November 12, 2008, we held an Annual Meeting of Shareholders.  At the
Annual Meeting, the following matters were put forth to a vote of our
shareholders, and passed with the following numbers of shares voted for, against
or withheld as set forth:


22





After
review and tabulation by class of stock, the ballots and proxies cast for and
against the reelection of each of the five current directors of the Company, who
were candidates for reelection:





Holders
of common stock and our Series A Preferred Stock, voting together as a class (on
an as-converted basis), were entitled to elect four members of our board at the
2008 Annual Meeting.





Dr. Igor
Filipenko, M.D.:





For:
                          
                          
                          31,983,028Against:
                          
                          
                          5,579Abstain:
                          
                          
                          50,200





Robert G.
Averill:





For:
                        
                        
                        31,988,207Against:
                        
                        
                        400Abstain:
                        
                        
                        50,200




Thomas
Granville:





For:
                        
                        
                        31,988,207Against:
                        
                        
                        50,400Abstain:
                        
                        
                        200





Michael
Kishinevsky:





For:
                        
                        
                        31,983,928Against:
                        
                        
                        4,679Abstain:
                        
                        
                        50,200





Holders
of our Senior Preferred Stock were entitled to elect one member of our
board.





Dr.
Howard K. Schmidt, Ph.D.:





For:
                          
                          
                          757,520Against:
                          
                          
                          -Abstain:
                          
                          
                          -





Furthermore,
the following director’s terms of office as a director continued after the
meeting: Glenn Patterson, Stanley A. Hirschman and Walker
Wainwright.





A
majority of the shares entitled to vote at the shareholder meeting were voted by
general proxy in favor of ratification of Rotenberg & Co., LLP as the
Corporation’s independent auditors.





After
review and tabulation, the ballots and proxies cast for and against the
amendment to the Corporation’s Certificate of Incorporation to increase
authorized shares:





For:
                        
                        
                        31,352,000Against:
                        
                        
                        761,466Abstain:
                        
                        
                        682,859


23





PART II





Item 5    Market for Registrant’s Common Equity,
Related Stockholder Matters and Issuer Purchases of Securities





Market
information




At the
start of the year ended December 31, 2007, our stock was trading on the OTC Pink
Sheets under the symbol AXPW.PK.  On July 3, 2008, our stock resumed
trading on the OTCBB under the symbol “AXPW”.Trading in our stock has
historically been sporadic, trading volumes have been low, and the market price
has been volatile.




The
following table shows the range of high and low bid prices for our common stock
as reported by the OTC Pink Sheets and the OTC Bulletin Board, as the case may
be, for each quarter since the beginning of 2007. The quotations reflect
inter-dealer prices, without retail markup, markdown or commission and may not
represent actual transactions.





Period
                  
                  High
                  
                  
                  LowFirst
      Quarter 2007
                  
                  $
                  4.05
                  
                  
                  $
                  2.25Second
      Quarter 2007
                  
                  $
                  3.30
                  
                  
                  $
                  2.50Third
      Quarter 2007
                  
                  $
                  3.10
                  
                  
                  $
                  2.20Fourth
      Quarter 2007
                  
                  $
                  2.50
                  
                  
                  $
                  2.00First
      Quarter 2008
                  
                  $
                  2.74
                  
                  
                  $
                  1.85Second
      Quarter 2008
                  
                  $
                  2.50
                  
                  
                  $
                  1.15Third
      Quarter 2008
                  
                  $
                  2.05
                  
                  
                  $
                  1.30Fourth
      Quarter 2008
                  
                  $
                  1.72
                  
                  
                  $
                  1.01




On March
24, 2009, the sale price for our common stock as reported on the OTCBB was $0.90
per share.




Securities
outstanding and holders of record




On March
24, 2009 there were approximately 395 record holders of our common
stock.




Dividend
Policy




We have
not paid and do not expect to pay dividends on our common stock. Any future
decision to pay dividends on our common stock will be at the discretion of our
board and will depend upon, among other factors, our results of operations,
financial condition, capital requirements and contractual
restrictions.





Information
respecting equity compensation plans




Summary Equity Compensation
Plan Information The following table provides summary information on our
equity compensation plans as of December 31, 2008.


24





Plan category:
                        
                        Number of shares
                          issuable on exercise of
                          outstanding options
                        
                        Weighted average
                          exercise price of
                          outstanding options
                        
                        Number of shares
                          available for future
                          issuance under equity
                          compensation plansEquity compensation plans approvedby
      stockholders2004
      Incentive Stock Plan
                        
                        51,950
                        
                        $
                        3.48
                        
                        1,217,0502004
      Directors’ Option Plan
                        
                        319,590
                        
                        $
                        2.05
                        
                        150,845Equity
      compensation plans not approved by stockholdersContract
      options held by officers
                        
                        1,503,000
                        
                        $
                        4.26Contract
      options held by employees, consultants and attorneys
                        
                        945,955
                        
                        $
                        4.22Total
      equity awards
                        
                        2,819,940
                        
                        $
                        3.98




The
Company has two stockholder approved equity compensation plans and occasionally
enters into employment and other contracts that provide for equity compensation
arrangements other than those contemplated by the stockholder approved plans.
The following sections summarize the Company’s equity compensation
arrangements.




Equity
Incentives Plans Not Approved by Stockholders: The Company issued
629,300, 228,000 and 789,500 stock purchase options in the fiscal years ended
December 31, 2006, 2007 and 2008, respectively, to officers, employees,
attorneys and consultants in connection with contractual agreements that do not
reduce the shares available under the shareholder’s approved plans. The
following paragraphs summarize these contractual stock options.




In
January 2004, members of the law firm of Fefer, Petersen & Cie, general
corporate counsel (of which one member was a director of the Company at the
time) were granted two-year contractual options to purchase 189,300 shares of
common stock at a price of $2.00 per share as partial compensation for services
rendered, valued at $68,296. These members also received 116,700 warrants as
consideration of pre-merger Tamboril debt). In August 2004, $1.00 of the
exercise price of the total 306,000 options and warrants owned by these members
was considered paid in advance in consideration of unbilled legal services
provided by the firm. The Company recorded $306,000 related to this reduction.
All of the warrants and options were exercised in the fourth quarter of 2005,
however, $306,000 of the amount is included in stock subscription receivable as
of December 31, 2005 and was received in 2006.




In July
2004, the President and Chief Operating Officer of the Company, Charles
Mazzacato, was granted a contractual option to purchase 240,000 shares of common
stock at a price of $4.00 per share. This option vests on a monthly basis at the
rate of 60,000 shares per year commencing July 31, 2005 and is exercisable for
five years after each vesting date. The market value of the Company stock at the
date of grant was greater than the exercise price which resulted in a total
intrinsic value of $180,000. In accordance with APB 25 the Company expensed the
intrinsic value over the vesting period which resulted in expense of $18,750 and
$45,000 during the years ended December 31, 2004 and 2005, respectively. On
January 1, 2006, the Company adopted the provisions of FASB 123R as discussed
below and recorded compensation of $124,364 during the year ended December 31,
2006. During the year ended December 31, 2006 the options were forfeited as a
result of his termination of employment from the Company in 2006.




In July
2004, the Chief Financial Officer of the Company, Peter Roston, was granted a
contractual option to purchase 200,000 shares of common stock at a price of
$4.00 per share. This option will vest on a monthly basis at the rate of 50,000
shares per year commencing July 31, 2005 and is exercisable for five years after
each vesting date. The market value of the Company stock at the date of grant
was greater than the exercise price which resulted in a total intrinsic value of
$150,000. In accordance with APB 25 the Company has expensed the intrinsic value
over the vesting period which resulted in expense of $15,625 and $37,500 during
the years ended December 31, 2004 and 2005, respectively. On January 1, 2006,
the Company adopted the provisions of FASB 123R as discussed below and recorded
compensation of $138,182 during the year ended December 31, 2006. During the
year ended December 31, 2006 the options were forfeited as a result of his
termination of employment from the Company in 2006.


25




In April
2005, the Chief Executive Officer of the Company, Thomas Granville, was granted
a contractual option to purchase 180,000 shares of common stock at a price of
$2.50 per share. This option vests at the rate of 7,500 shares per month
commencing May 1, 2005 and is exercisable for five years after each vesting
date. The market value of the Company stock at the date of grant was less than
the exercise price which resulted in no intrinsic value in accordance with APB
25. On January 1, 2006, the Company adopted the provisions of FASB 123R as
discussed below and recorded compensation of $112,500 during the year ended
December 31, 2006.




In April
2005, a European financial advisor was granted a contractual option to purchase
30,000 shares of common stock at a price of $2.50 per share. Options for an
aggregate of 20,000 shares vested during the year ended December 31, 2005 and
will be exercisable for five years. On December 31, 2005, a total of 10,000
unvested options were forfeited when the advisory agreement was terminated. The
options were valued at $35,998 using the Black-Scholes-Merton option pricing
model and included as expense in 2005.




In
September 2005, the Chief Technical Officer of the Company, Edward Buiel, was
granted a contractual option to purchase 90,000 shares of common stock at a
price of $4.00 per share. This option vests at the rate of 2,500 shares per
month commencing October 2005 and is exercisable for five years after each
vesting date. The market value of the Company stock at the date of grant was
less than the exercise price which resulted in no intrinsic value in accordance
with APB 25. On January 1, 2006, the Company adopted the provisions of FASB 123R
as discussed below and recorded compensation of $68,100 during the year ended
December 31, 2006.




In
February 2006, the Chief Executive Officer of the Company, Thomas Granville, was
granted an option to purchase 500,000 shares of common stock at an exercise
price of $6.00. Of this total 300,000 options vested immediately and the balance
is expected to vest, subject to the attainment of certain specified objectives,
over the next one to three years. These options are valued at $300,187 utilizing
the Black-Scholes-Merton option pricing model with $259,027 of compensation
recorded in 2006.




In
February 2006, the Chief Technical Officer of the Company, Edward Buiel, was
granted an option to purchase 35,000 shares of common stock at an exercise price
of $6.00. Of this total 10,000 options vested immediately and the balance is
expected to vest, subject to the attainment of certain specified objectives,
over the next two to three years. These options are valued at $20,994 utilizing
the Black-Scholes-Merton option pricing model with $13,330 of compensation
recorded in 2006.




In
February 2006, members and affiliates of the law firm of Fefer, Petersen &
Cie, general corporate counsel (of which one member was a director of the
Company at the time) were granted an option to purchase 360,000 shares of common
stock at an exercise price of $6.00. Of this total 240,000 options vested
immediately and the balance will vest at the rate of 10,000 shares per month
during the year ended December 31, 2006. These options are valued at $193,449
utilizing the Black-Scholes-Merton option pricing model and are recorded as
legal expense in 2006.




In
February 2006, the external bankruptcy counsel of the Company, Cecilia
Rosenauer, was granted an option to purchase 15,000 shares of common stock at an
exercise price of $6.00. The options vested on the effective date of Mega-C’s
Chapter 11 plan of reorganization, which took place in November 2006. These
options are valued at $2,483 utilizing the Black-Scholes-Merton option pricing
model and are recorded as legal expense in 2006.




In March
2006, two employees were granted options to purchase a total of 24,000 shares of
common stock at an exercise price of $4.00 and $6.00. The options vest at a rate
of 2,500 per month over the first 6 months and 1,500 per month thereafter. The
options are exercisable through March 2009. These options are valued at $28,257
utilizing the Black-Scholes-Merton option pricing model with $24,408 of
compensation recorded in 2006.


26




In
December 2006, the Chief Technical Officer of the Company, Edward Buiel, was
granted a contractual option to purchase an additional 100,000 shares of our
common stock at a price of $3.75 per share. A total of 50,000 options will vest
on December 29, 2009 and the remaining 50,000 will vest on December 29,
2010. The options will be exercisable for a period of six years from the
vesting date. These options are valued at $267,372, utilizing the
Black-Scholes-Merton option pricing model with $6,481 of compensation recorded
in 2006.





In
February 2006, a consultant, Trey Fecteau, was granted an option to purchase
97,000 shares of common stock at an exercise price of $4.00. The options vested
upon completion of contractual services in December 2006. The options are
exercisable through December 2009. These options are valued at $150,702
utilizing the Black-Scholes-Merton option pricing model. This amount reduced the
proceeds of the Series A Preferred Stock offering in 2006.




In
January 2007, Walker Wainwright, a director of the Company, was granted an
option to purchase 40,000 shares of common stock at an exercise price of $5.00
as compensation for services related to due diligence, negotiation and sale of
the 2006 Series A Preferred Stock offering. These three-year options were
immediately vested on the date of grant, and are valued at $52,230 utilizing the
Black-Scholes-Merton option pricing model and are recorded as offering costs in
2007.




In August
2007, the Company’s Chief Financial Officer, Andrew Carr Conway, Jr., was
granted a contractual option to purchase 80,000 shares of common stock at an
exercise price of $4.50. 20,000 vest immediately upon contract inception and the
remainder vest at a rate of 10,000 per month over the life of his six-month
employment contract. These two-year options are valued at $37,356 utilizing the
Black-Scholes-Merton option pricing model with $24,904 recorded as compensation
in 2007.




In
December 2007, the Company’s Vice-President of Manufacturing Engineering, Robert
Nelson, was granted a contractual option to purchase 108,000 shares of common
stock at an exercise price of $5.00. The options vest at a rate of 3,000 per
month over a three year period, but are being amortized over the term of his two
year employment contract. These five-year options are valued at $108,504
utilizing the Black-Scholes-Merton option pricing model with $4,521 recorded as
compensation in 2007.





In March
2008, the Company’s Chief Financial Officer, Andrew Carr Conway, Jr., was
granted a contractual option to purchase 30,000 shares of common stock at an
exercise price of $4.50. 10,000 options vested immediately upon grant and are
exercisable through December 2009, and the remaining 20,000 options vested in
May 2008 and are exercisable through May 2010.These options are valued at
$15,600 utilizing the Black-Scholes-Merton option pricing model with $15,600
recorded as compensation in 2008.





In June
2008, the Company’s Chief Financial Officer, Andrew Carr Conway, Jr., was
granted a contractual option to purchase 10,000 shares of common stock at an
exercise price of $4.50. These options vested in June 2008. These options are
valued at $5,200 utilizing the Black-Scholes-Merton option pricing model and
recorded as compensation in 2008.





In June
2008, the following Equity Awards were issued as part of a restructuring of key
employee contracts that was designed to provide for the long term stability of
the Company:





(i) Our
Chief Executive Officer, Thomas Granville, was granted a contractual option to
purchase an additional 90,000 shares of our common stock at a price of $2.50 per
share. The options vest prorated over the 24-month term of his contract, and are
exercisable for a period of five years from the vesting date. These options are
valued at $79,872, utilizing the Black-Scholes-Merton option pricing model with
$23,296 of compensation recorded in 2008.


27





(ii) Our
Chief Technical Officer, Edward Buiel, was granted a contractual option to
purchase an additional 100,000 shares of our common stock at a price of $2.50
per share. The options cliff vest on May 31, 2011, and are exercisable for a
period of five years from the vesting date. These options are valued at $95,436,
utilizing the Black-Scholes-Merton option pricing model with $18,557 of
compensation recorded in 2008.





(iii) Our
Chief Financial Officer, Donald Hillier, was granted an option to purchase
180,000 shares of our common stock. The exercise price of the option is $2.50
per share, and the option vests at the rate of 5,000 shares per month through
the term of the Employment Agreement and are exercisable for a period of 5 years
from the vesting date. These options are valued at $179,244, utilizing the
Black-Scholes-Merton option pricing model with $34,853 of compensation recorded
in 2008.





Three
employees were granted contractual options to purchase an additional 200,000
shares of our common stock at a price of $2.50 per share. 5,000 of these options
vested in June upon execution of the employment contracts, with the balance
cliff vesting on June 15, 2011, and are exercisable for a period of three years
from the vesting date. These options are valued at $165,041, utilizing the
Black-Scholes-Merton option pricing model with $34,222 of compensation recorded
in 2008.





Seven
employees were granted contractual options to purchase an additional 179,500
shares of our common stock at a price of $2.50 per share. 43,500 of these
options vested in December upon execution of the employment contracts, with the
balance vesting through the term of the employment agreement and are exercisable
for a period of three years from the vesting date. These options are valued at
$36,171, utilizing the Black-Scholes-Merton option pricing model with $5,330 of
compensation recorded in 2008.








Item 7   Management’s Discussion and Analysis of Financial
Condition and Results of Operations





The
following discussion should be read in conjunction with the consolidated
financial statements and the related notes that are set forth in our financial
statements elsewhere in this annual report.




Overview




We are a
development stage company that was formed in September 2003 to acquire and
develop certain innovative battery technology. Since inception, APC has been
engaged in R&D of the new technology for the production of lead-acid-carbon
energy storage devices that we refer to as our proprietary lead/carbon (“PbC”)
devices. As of December 31, 2003, APC engaged in a reverse acquisition with
Tamboril, a public shell company. Tamboril was originally incorporated in
Delaware in January 1997, operated a wholesale cigar business until December
1998 and was an inactive public shell thereafter until December 2003. The
information presented herein relates to the operations of APC, the accounting
acquirer. Tamboril, the legal acquirer, changed its name to Axion Power
International, Inc. We formed a new corporation, Axion Power Battery
Manufacturing Inc., which purchased the foreclosed assets of a failed battery
manufacturing plant and now conducts our manufacture of specialty
batteries.





At
December 31, 2008, we have incurred cumulative net losses of approximately $49.1
million applicable to the common shareholder. This includes approximately $2.1
million in interest of which $1.3 million relates to discount on notes. We have
an additional $13.6 million in accumulated preferred stock dividends.We had approximately
$6.9 million in current assets and $1.5 million in current liabilities at
December 31, 2008, which left a net working capital surplus of approximately
$5.4 million. As discussed below, we received an aggregate amount of $16.5
million, net of offering costs, in long term equity financing on January 14,
2008, April 7, 2008, and June 30, 2008 from Quercus Trust. Management believes
those funds will support operations through 2009.





On July
3, 2008 we moved from the Pink Sheets back to the OTCBB. We lost our OTCBB
listing and moved to the Pink Sheets in October of 2006 when our filings became
delinquent due to the restatements of our financial statements for the years
2003, 2004 and 2005. Our financial reporting became current at the beginning of
the second quarter of 2008, and it is our intention to remain current on a going
forward basis.


28




During
the third quarter of 2008, we fabricated several different types of lead acid
batteries to prepare for the testing of those products by another company under
a purchase order. At the end of September 2008, we were released to begin
production on three of eleven items covered by the order. On November 3,
2008, the Company received the first purchase order in what will be
a series of "confirming purchase orders and delivery
releases" pursuant to the original agreement. We have devoted time and
financial resources to upgrading, and where necessary replacing, existing
battery manufacturing equipment as part of our long range business plan. In the
future, a large portion of this upgraded equipment will be used to manufacture
our proprietary PbC lead carbon product. The Quercus Trust investment of $4
million in April allowed us to move this upgrade forward. Likewise the Quercus
$10 million investment that we received on June 30th has
allowed us to continue to pursue automated fabrication equipment, which will be
used in the manufacture of the PbC carbon electrode device in commercialization
quantities.




Key
Performance Indicators




Because
of our early stage of development the usual financial measures are not
particularly relevant or helpful in the assessment of company
operations.





We do not
use non-financial measures to evaluate our performance other than the degree of
success of our R&D and demonstration projects. Our demonstration projects
entail extended periods of time to assess our energy devices over multiple
charge and deep discharge cycles. Further, the results of our demonstration
projects do not lend themselves to simple measurement and
presentation.





The
single most significant financial metric for us is the adequacy of working
capital in order to continue to fund our research and development efforts.
Capital is also necessary to fund the equipment and methods required to progress
from demonstration projects to a state of prepared readiness for commercial
deployment. We believe we can maintain operations and fund R&D through 2009
without further capital infusions.





We
believe we need to continue to characterize and perfect our products in house
and through a limited number of demonstration projects before moving into mass
production. While the results of this work are promising to date, we cannot
assure you that the products will be successful in their present design or that
further research and development will not be needed. The successful completion
of present and future characterization and demonstration projects are critical
to the development and acceptance of our technology.





We must
devise methodologies to manufacture our energy storage devices in commercial
quantities. While we have assembled an engineering team that we believe can
accomplish this goal, and are adding to it as we go forward, there is no
assurance that we will be able to successfully mass produce our
product.




If we
successfully complete our characterization and demonstration projects, we must
present sufficiently compelling evidence to prospective users of energy storage
devices in order to persuade them to purchase our technology.




Material
Trends and Uncertainties




We will
continue to require substantial funds for R&D. Even with adequate funding
there is no assurance our new technology can be successfully commercialized.
While we intend to continue to manufacture specialty batteries and commence
contract manufacturing there is no assurance of profits or whether those profits
will be sufficient to sustain us as we continue to develop our new
technology.


29





Recent
Financing Activities




Bridge Loan FinancingIn November of 2007 we structured short term secured bridge loan
arrangements in increments of $100,000 (the "Bridge Loans") with certain of our
directors, officers and significant investors, such loans to bear interest at
the rate of 14% and were secured by all of our assets, including our
intellectual property and all of the equipment and inventory assets of our
wholly-owned subsidiary, Axion Power Battery Manufacturing Inc. Total funding
received under the Bridge Loans was approximately $2,640,000, of which $100,000
was received in 2008.





The
Bridge Loans had an original maturity date of March 31, 2008, with three
extensions of the maturity date at the option of the Company, with higher
interest rates to apply to each such extension. On March 31, 2008, we sent
notice to the investors of our intention to extend the loan until April 30,
2008. In accordance with the option terms contained in the loan agreement, three
of the investors chose to convert a total of $328,984 into equity under the same
terms offered to Quercus. One of these investors later rescinded his election,
opting for repayment. This resulted in a net conversion of $276,484 into equity
under the same terms offered to Quercus. The extension entitled the remaining
investors to earn an additional 1% extension fee based on the original loan
amount and interest at the annual rate of 15%. On April 29, 2008, we sent notice
to the investors of our intention to extend the loan until May 31, 2008. The
extension entitled investors to earn an additional 1% extension fee based on the
original loan amount and interest at the annual rate of 16%.  On May 29,
2008, a related party converted $4,200 of his Bridge Loan into equity under the
same terms offered to Quercus, with the balance repaid under the terms of the
note for the Bridge Loan. On May 30, 2008, we sent notice to the
remaining investors of our intention to extend the Loans until June 30,
2008. The interest rate during the extension period increased to 18% with an
extension fee equal to 2% of the original loan and an extension fee of 2% of the
original loan was paid to the holders of the Bridge Loans. A loan origination
fee was paid equal to 8% of the original principal amount of the Loan. The
origination fee decreased by one-half percent each week after December 15, 2007
until the loan closed on January 7, 2008. Warrants exercisable at $2.35 until
December 31, 2012 are included. For each $100,000 increment of the Bridge Loan,
the investors were issued warrants as follows: 3,405 warrants upon
occurrence of the secured bridge loan: 851 additional warrants upon the
extension of the loan to April 30, 2008; 1,276 additional warrants upon
extension of the loan to May 31, 2008 and 2,128 additional warrants upon
extension of the loan to June 30, 2008. Typical anti-dilution provisions apply
to the warrants as do piggyback registration rights.




On June
30, 2008, a director, exercising his rights to convert under the same terms
converted $800,000 of indebtedness under the Bridge Loans into 380,952 shares of
common stock and warrants to purchase 380,952 shares of common stock at an
exercise price of $2.60 per share, such warrants will expire on June 29, 2013.
The remaining balance due, $1,235,028, of indebtedness from the Bridge Loans was
repaid as of July 1, 2008 with a portion of the proceeds from the Final Quercus
Investment (as described below). The Bridge Loans have been fully repaid or
converted, and there is no remaining indebtedness under these
instruments.





The Quercus InvestmentOn
January 14, 2008, we entered into the Securities Purchase Agreement with
Quercus, pursuant to which we agreed to issue to Quercus up to 8,571,429 shares
of our common stock, together with a five year common stock purchase warrants
that will entitle the holder to purchase up to 10,000,000 additional shares of
our common stock.




At the
initial closing on January 14, 2008, Quercus invested $4.0 million in exchange
for 1,904,762 shares and warrants to purchase an additional 2,857,143 shares at
an exercise price of $2.60 per share. At the second closing on April 17, 2008,
Quercus invested an additional $4.0 million in exchange for 1,904,762 shares of
our common stock and warrant to purchase an additional 2,380,953 shares of at an
exercise price of $2.60 per share.


30





On June
30, 2008, the Company completed the third and final tranche of the Quercus
investment, whereby Quercus invested $10.0 million in exchange for 4,761,905
shares of our common stock and warrants to purchase an additional 4,761,905
shares of stock at an exercise price of $2.60 per share. All of the warrants
issued to Quercus expire by June 29, 2013. A portion of the proceeds of the June
30, 2008 financing were used to retire the remainder of the $2,640,000 December
2007 Bridge Loan that the Company had previously entered into. By June 30,
certain of the bridge lenders had converted $1,080,684 into 514,611 shares of
common stock and warrants to purchase 580,940 shares of common stock at an
exercise price of $2.60 per share. The warrant expires on June 29, 2013 and the
entire conversion was under the same terms as the Quercus investment. As a
result of conversion and repayment, the December 2007 Bridge Loans have been
completely retired, extinguishing all indebtedness under those instruments as of
July 1, 2008





The
warrants contain conventional full ratchet anti-dilution provisions for
adjustment of the exercise price in the event we issue additional shares of our
common stock or securities convertible into common stock (subject to certain
specified exclusions) at a price less than $1.00 per share.





Grant
Activities




On
October 6, 2008, the Company received notice that it was the recipient of a
federal grant for the development of new lightweight, high-powered batteries for
use in vehicles operated by the U.S. Marine Corps. The first year, of an
anticipated ongoing three year grant, provides $1,200,000 to us for the project.
In December of 2006 and January of 2007, the Company presented its unique
technology to branches of the Armed Forces. In February of 2007, after receiving
a letter of support from the Office of Naval Research, the Company submitted a
proposal to the Department of Defense. The proposal to further study the
applicability of the Company’s PbC technology for use in military assault
vehicles was sponsored by a U.S. Congressman. The grant was not approved in the
2008 federal budget, but was resubmitted and approved in the 2009 budget, and
the Company received formal notice on October 6, 2008. The
potential three year $5,000,000 grant has an initial year funding of
$1,200,000 expected to be received in 2009. Under the grant program, the Company
and the Navy and Marine Corps will study the feasibility of utilizing one of the
Company's PbC products in their assault and silent watch vehicles.  The
next phase is the joint development and testing of the product, which is
expected to be lighter in weight and more powerful in discharge than some of the
existing products in use.





On February 5, 2009, the Company
received a pair of grants from the Advanced Lead-Acid Battery Consortium, the
leading industry association made up in part by the largest companies supplying
the world’s battery market. The pair of grants totals approximately $380,000 and
will help support research into two key areas. (1) The first grant seeks to
identify the mechanism by which the optimum specification of carbon, when
included in the negative active material of a valve-regulated lead-acid battery,
provides protection against accumulation of lead sulfate during high-rate
partial-state-of-charge operation. (2) The second grant seeks simply to
characterize Axion’s proprietary PbCTM battery in hybrid electric vehicle (HEV)
type duty-cycle testing. The grants are administered through the Durham,
NC-based International Lead Zinc Research Organization acting on behalf of the
ALABC. The research work is expected to be completed in 2009.





On
February 9, 2009, the Company received notice that it is the recipient a grant
from the Pennsylvania Alternative Fuels Incentive Grant program. The $800,000
first-year grant, which was announced by Governor Edward Rendell on January
29th, is part of Pennsylvania’s overall effort to invest in businesses that are
creating important and innovative clean energy and bio-fuels technologies. The
award proceeds will be used to demonstrate the advantages the Axion proprietary
PbC battery technology provides in a variety of electric vehicle types
including: hybrids (HEVs), such as the popular Toyota
Prius;  “plug-ins” (PHEVs)  used in commuter, delivery and
other vehicles; and in electric vehicles (EV’s) and converted (from combustion
engine operation) EV’s. The grant proceeds are expected to be received in
2009.





A summary
of awarded grants expected to be received in 2009 are summarized as
follows:





DOD
      Office of Naval Research
                  
                  $
                  1,200,000ALABC
                  
                  
                  380,000PA
      Alternative Fuels Incentive Grant Program
                  
                  
                  800,000$
                  2,380,000


31





Results
of Operations




The
comparative data below presents our results of operations for the year ended
December 31, 2007 and 2008. While certain of the data is not strictly comparable
because some line items are positive and some negative, the provided percentages
demonstrate the relative significance of the individual line items and also the
relative changes from year to year.





·
            Our primary operations in our
      current development stage consist of research and development efforts for
      advanced battery applications and PbC carbon electrode devices. Revenues
      are for specialty collector and racing car, uninterruptable power supply
      (UPS) and flooded batteries  sold to customers. Cost of goods
      sold represent the  raw materials, components, labor and
      manufacturing overhead absorbed in producing batteries sold to
      customers.





·
            Selling, general and
      administrative expenses include substantial non-recurring legal, auditing,
      accounting and other costs associated with becoming current with our
      public filings, investor and public relations, registration and litigation
      costs and also one time employee costs in relation to restructuring of
      employment agreements.





·
            Research &
      development expenses are incurred to design, develop and test advanced
      batteries and an energy storage product based on our patented lead carbon
      technology (PbC).These costs include engineering and research and development
      employee labor and expenses, materials and components consumed in
      production for pilot products, demonstration projects, testing and
      prototypes. These costs also include manufacturing costs incurred for
      research and development activities including the creation, testing and
      improvement of plant production processes needed for production of our
      proprietary technologies.





·
            Interest expense was incurred for
      the bridge loan financing offered during the fourth quarter of 2007. The
      bridge loans were retired as of July 1,
  2008.





Years EndedDecember 31,Statements of Operations
                  
                  2008
                  
                  
                  % of net
                    loss
                  
                  
                  2007
                  
                  
                  % of
                    net lossRevenues
                  
                  $
                  679,559
                  
                  
                  
                  
                  
                  $
                  533,911Cost
      of goods sold
                  
                  
                  368,922
                  
                  
                  
                  
                  
                  
                  283,357Gross  profit
                  
                  
                  310,637
                  
                  
                  
                  -2.9
                  %
                  
                  
                  250,554
                  
                  
                  
                  -1.7
                  %ExpensesSelling,
      general & administrative
                  
                  
                  4,846,189
                  
                  
                  
                  45.6
                  %
                  
                  
                  3,720,632
                  
                  
                  
                  26.0
                  %Research
      & development
                  
                  
                  3,960,909
                  
                  
                  
                  37.3
                  %
                  
                  
                  2,155,873
                  
                  
                  
                  15.1
                  %Interest
      expense - related party
                  
                  
                  1,137,436
                  
                  
                  
                  10.7
                  %
                  
                  
                  276,651
                  
                  
                  
                  1.9
                  %Derivative
      revaluation
                  
                  
                  (2,844
                  )
                  
                  
                  0.0
                  %
                  
                  
                  (72,236
                  )
                  
                  
                  -0.5
                  %Interest
      & other income, net
                  
                  
                  (57,224
                  )
                  
                  
                  -0.5
                  %
                  
                  
                  (47,708
                  )
                  
                  
                  -0.3
                  %Net
      loss before income taxes
                  
                  
                  (9,573,829
                  )
                  
                  
                  90.2
                  %
                  
                  
                  (5,782,658
                  )
                  
                  
                  40.5
                  %Income
      Taxes Expense (Benefit)
                  
                  
                  (79,170
                  )
                  
                  
                  -0.7
                  %
                  
                  
                  83,469
                  
                  
                  
                  0.6
                  %Deficit
      accumulated during development stage
                  
                  
                  (9,494,659
                  )
                  
                  
                  89.5
                  %
                  
                  
                  (5,886,127
                  )
                  
                  
                  41.1
                  %Less
      preferred stock dividends and beneficial conversion
feature
                  
                  
                  (1,117,699
                  )
                  
                  
                  10.5
                  %
                  
                  
                  (8,417,955
                  )
                  
                  
                  58.9
                  %Net
      loss applicable to common shareholders
                  
                  $
                  (10,612,358
                  )
                  
                  
                  100.0
                  %
                  
                  $
                  (14,284,082
                  )
                  
                  
                  100.0
                  %Basic
      and diluted net loss per share
                  
                  $
                  (0.46
                  )
                  
                  
                  
                  
                  
                  $
                  (0.88
                  )Weighted
      average common shares outstanding
                  
                  
                  22,826,187
                  
                  
                  
                  
                  
                  
                  
                  16,247,299


32





Summary
of Consolidated Results for the Year Ended December 31, 2008 compared with the
Year Ended December 31, 2007




Revenue




Revenues
for year ended December 31, 2008 were approximately $0.7 million compared to
revenues of approximately $0.5 million for the same period in 2007. This
represents an increase of 27% in revenues reported during 2008 over the same
period in 2007. This increase is primarily due to another year of exposure,
especially in the race car and classic car industries, increased sales of
uninterruptable power supply (UPS) batteries and the sale of flooded lead-acid
batteries to a large battery manufacturer under our manufacturing subcontract
agreement.  We have one customer that accounted for approximately 10%
of revenue or the year ended December 31, 2008 and another customer accounted
for 12.5% of revenue for the same period in 2007.  Our relatively low
revenue is indicative of our predominant development stage
activities.





Cost
of Goods Sold




Costs of
goods sold represent costs for batteries sold to customers and include various
raw materials with lead being the most prominent and costly.  We also
use components such as plastic battery cases and covers as well as separators
and acid.    The cost of lead during 2008 decreased from the
historical highs of 2007 similar to other industrial-grade metals partially as a
result of the global economic slowdown.  We also incur manufacturing
labor and overhead costs as well as costs for packaging and
shipping.  Costs of goods sold increased by approximately $.10 million
for the year ended December 31, 2008, as compared to the same time period last
year.  2008 costs are 30% higher than that the 2007 respective period
consistent with our increase in revenue.





Selling,
General & Administrative Expenses




Selling,
general and administrative expenses include compensation for employees and
contractors, legal and accounting fees, and costs incurred for investor
relations and activities associated with fund raising and shareholder awareness.
Selling, general and administrative costs for year ended December 31, 2008 were
approximately $4.8 million compared to $3.7 million, respectively, for the same
period in 2007. This represents a 30% increase in spending over the same period
during 2007. Cost increases are primarily due to substantial non-recurring
legal, auditing, accounting and other costs associated with becoming current
with our public filings, investor and public relations, registration and
litigation costs and also one-time employee costs with respect to restructuring
of employment agreements.


33





Research
& Development Expenses




Research
and development expenses include compensation for employees and contractors, as
well as small test equipment, supplies and overhead. These costs also include
manufacturing employee compensation, manufacturing facility and overhead costs
attributed to research and development activities. Research and development also
includes prototype production and testing costs. Research and development
expenses for the year ended December 31, 2008 were approximately $4.0 million
compared to $2.2 million for the same periods in 2007, representing an increase
in spending of 46% as compared to the same period in 2007. The increase is due
to increased costs associated with additional efforts incurred to design,
develop and test advanced batteries and energy storage products based on our
patented lead carbon battery(PbC)
including  manufacturing activities to prepare the plant for
future PbC production, pilot product production and demonstration project
production activities. In 2008, we increased our R&D staff by approximately
50% and signed them to long term contracts. We also restructured existing
R&D employment contracts to ensure long term continuity. The expense of all
of these measures is reflected in the increased R&D expenditures for
2008.




Interest
Expense - Related Party




Interest
expense – related party represents interest costs incurred primarily for the
bridge loan financing offered during the fourth quarter of 2007. Related party
interest expense includes the coupon value of interest on debt, as well as the
debt discount on detachable warrants and origination fees.  Expenses
incurred during the year ended December 31, 2008 were approximately $1.14
million as compared to $.28 million, for the same period in 2007. Whereas 2007
financing was sustained through the issuance of the Series A preferred offering,
2007 did not have a comparable level of interest expense as was recognized
during 2008. The 2007 bridge loans were completely retired as of July 1, 2008.





Derivative
Revaluation




Derivative
revaluations are recognized whenever the Company incurs a liability to issue an
equity instrument. The instrument is revalued quarterly until the point in time
that the liability is settled.  Derivative revaluation expense for the
year ended December 31, 2008 resulted in a credit of $(.003) million compared
with a credit of $(.072) million for the same period ended in
2007.  During 2007, the Company funded its capital needs with debt
that offered detachable warrants. These warrants were not settled until March
2008, at which point the Company’s stock values were lower, giving rise to the
nominal credit in 2008.  There are no new obligations as of December
31, 2008.




Net Loss





For the
fiscal year ended December 31, 2008, our net loss before income taxes increased
$3.8 million, or 65%, to $9.6 million on revenue of $.7 million, from an
operating loss of approximately $5.8 million on revenue of $.6million for the
fiscal year ended December 31, 2007. As discussed above, the factors primarily
affecting this increase in operating loss were increased selling, general and
administrative costs, increased research and development costs and increased
interest expense of related party debt.




The net
loss applicable to common shareholders of $10.6 million for the year ended
December 31, 2008 compared to a loss of $14.3 million for the year ended
December 31, 2007 reflects a decrease of approximately 26%. The loss includes
non-cash charges related to preferred stock dividends and beneficial conversion
feature of $1.1 million in 2008 compared with $8.4 million in
2007.


34





Liquidity
and Capital Resources




Our
primary source of liquidity has historically been cash generated from issuances
of our equity or debt securities. From inception through fiscal year ended
December 31, 2008, we generated insignificant revenue from operations. We
believe we had sufficient funds on December 31, 2008 to conduct our
operations through 2009, which were primarily the result of the closings of
financing with the Quercus Trust. If we do not significantly increase our
revenues, obtain additional government grants or raise more money through sale
of equity during 2009 we will likely be unable to implement our business plan,
fund our liquidity needs or even continue our operations after this period. Any
equity or debt financings, if available at all, may be on terms which are not
favorable to us and, in the case of equity financings, most likely will result
in dilution to our stockholders.





Cash,
Cash Equivalents, Short Term Investments and Working Capital





At
December 31, 2008, we had approximately $3.1 million of cash and cash
equivalents compared to approximately $0.7 million at December 31,
2007.  At December 31, 2008 working capital was $5.4 million compared
to a working capital deficit of $(2.9) million at December 31, 2007. Cash
equivalents consist of short-term liquid investments with original maturities of
no more than three months and are readily convertible into cash and consisted of
the following at December 31, 2008:





Coupon /
                              Yield
                            
                            Maturity
                            
                            December 31,
                              2008United
      States Treasury Bills
                            
                            
                            
                            
                            Feb-09
                            
                            $
                            999,840Fidelity
      Institutional Money Market
                            
                            
                            2.08
                            %
                            n/a
                            
                            $
                            1,756,105




At December 31, 2008, we had the
following short term investments of $2,193,920 consisting of short-term liquid
investments with original maturities that exceed three months at December 31,
2008:





Coupon /
                                Yield
                              
                              MaturityCertificate
      of Deposit, Pacific Capital
                              
                              
                              2.9
                              %
                              Mar-09
                              
                              $
                              97,000Certificate
      of Deposit, Wachovia MTG FSB
                              
                              
                              2.9
                              %
                              Mar-09
                              
                              $
                              97,000United
      States Treasury Bills
                              
                              
                              
                              
                              Feb
      -09
                              
                              $
                              1,999,920





Cash
Flows from Operating Activities




Net cash
used in operations for the year ended December 31, 2008 was $(8.9) million. Cash
used in operations for this same period ended December 31, 2007 was
approximately $(3.7) million. The use of cash in operations is reflective of the
net loss before income taxes at this developmental stage of the business. The
cash used in operations for the year ended December 31, 2008 is also reflective
of the growth of inventories.


35




Cash
Flows from Investing Activities




Net cash
used in investing activities for the year ended December 31, 2008 was $(3.6)
million compared to $(1.2) million for the same period ended December 31,
2007.  Cash used by investing activities for the year ended December
31, 2008 was used to purchase short-term investments and for the purchase of
equipment for both production and research and development for both years ended
December 31, 2008 and 2007.




Cash
Flows from Financing Activities




Net cash
provided by financing activities for the year ended December 31, 2008 was
approximately $15.0 million compared to $2.0 million for the same period ended
December 31, 2007. Financing activities for the year ended December 31, 2008
consisted of $16.5 million from the issuance of common stock and the repayment
of $1.5 million for retirement of the 2007 bridge loans during 2008. 
Financing activities for the year ended December 31, 2007 consisted of $1.6
million received from the bridge loan financing and $.4 million from the
issuance of preferred stock.





Significant
Financing Arrangements




December 2007 Secured Bridge
Loan Transaction:  In December 2007, we offered certain of our
directors, officers, and significant investors the opportunity to participate in
a short term bridge loan arrangement in increments of $100,000, each such loan
to bear interest at 14% and to be secured by all of our assets, including our
intellectual property assets and the assets of Axion Power Battery Manufacturing
Inc.  Total funding received under the secured bridge loan as of
December 31, 2007 amounted to $2,540,000, with additional funding of $100,000
received in January of 2008.  $516,000 was repaid through June 2008
along with $60,000 of interest; the balance of the proceeds was used to fund
ongoing operations.  As of July 1, 2008, the Bridge Loans have been
fully repaid or converted, and there is no remaining indebtedness under these
instruments.




The Quercus
Investment: On January 14, 2008, we entered into the Securities Purchase
Agreement with Quercus Trust, pursuant to which we agreed to issue to Quercus up
to 8,571,429 shares of our common stock, together with a five-year common stock
purchase warrants that will entitle the holder to purchase up to 10,000,000
additional shares of our common stock.




At the
initial closing on January 14, 2008, Quercus invested $4.0 million in exchange
for 1,904,762 shares and warrants to purchase an additional 2,857,143 shares at
an exercise price of $2.60 per share. At the second closing on April 17, 2008,
Quercus invested an additional $4.0 million in exchange for 1,904,762 shares of
our common stock and warrant to purchase an additional 2,380,953 shares of at an
exercise price of $2.60 per share.





On June
30, 2008, the Company completed the third and final tranche of the Quercus
investment, whereby Quercus invested $10.0 million in exchange for 4,761,905
shares of our common stock and warrants to purchase an additional 4,761,905
shares of stock at an exercise price of $2.60 per share. All of the warrants
issued to Quercus expire by June 29, 2013. A portion of the proceeds of the June
30, 2008 financing were used to retire the remainder of the $2,640,000 December
2007 Bridge Loan that the Company had previously entered into. Prior to June 30,
certain of the bridge lenders had converted $280,684 into 133,659 shares of
common stock and warrants to purchase 199,988 shares of common stock at an
exercise price of $2.60 per share. On June 30, 2008, one of the Company’s
directors converted $800,000 of Bridge Loan indebtedness into 380,952 shares of
common stock and a warrant to purchase 380,952 shares at an exercise price of
$2.60 per share. The warrant expires on June 29, 2013 and the entire conversion
was under the same terms as the Quercus investment. As a result of conversion
and repayment, the December 2007 Bridge Loans have been completely retired,
extinguishing all indebtedness under those instruments.


36





The
warrants contain conventional anti-dilution provisions for adjustment of the
exercise price in the event we issue additional shares of our common stock or
securities convertible into common stock (subject to certain specified
exclusions) at a price less than $1.00 per share.





Critical
Accounting Policies, Judgments and Estimates




The
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” section of this annual report discusses our financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States (“GAAP”). To prepare these financial statements,
we must make estimates and assumptions that affect the reported amounts of
assets and liabilities. These estimates also affect our reported revenues and
expenses. On an ongoing basis, management evaluates its estimates and judgment,
including those related to revenue recognition, accrued expenses, financing
operations and contingencies and litigation. Management bases its estimates and
judgment on historical experience and on various other factors that are believed
to be reasonable under the circumstances, the results of which form the basis
for making judgments about the carrying value of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. The following represents a
summary of our critical accounting policies, defined as those policies that we
believe are the most important to the portrayal of our financial condition and
results of operations and that require management’s most difficult, subjective
or complex judgments, often as a result of the need to make estimates about the
effects of matters that are inherently uncertain.




Use of Estimates: The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statement and the reported amounts of revenues and expenses during the reporting
period. Actual results could differ from the estimates.




Principles of Consolidation:The consolidated financial statements include the accounts of the
Company, and its wholly owned subsidiaries, Axion Power Battery Manufacturing,
Inc., APC and C&T. All significant inter-company balances and transactions
have been eliminated in consolidation.




Revenue Recognition:The
Company recognizes revenue upon transfer of title at the time of shipment
(F.O.B. shipping point), when all significant contractual obligations have been
satisfied, the price is fixed or determinable and collection is reasonably
assured.




Stock-Based Compensation:
Prior to January 1, 2006, the Company accounted for stock option awards in
accordance with the recognition and measurement provisions of APB 25 and related
interpretations, as permitted by Statement of Financial Accounting Standard No.
123, “Accounting for
Stock-Based Compensation,” (“SFAS 123”). Under APB 25, compensation cost
for stock options issued to employees was measured as the excess, if any, of the
fair value of the Company’s stock at the date of grant over the exercise price
of the option granted. Compensation cost was recognized for stock options, if
any, ratably over the vesting period. As permitted by SFAS 123, the Company
reported pro-forma disclosures presenting results and earnings as if the Company
had used the fair value recognition provisions of SFAS 123 in the Notes to the
Consolidated Financial Statements.




Effective
January 1, 2006, the Company adopted SFAS 123R using the modified prospective
transition method. See footnote captioned “Equity Compensation” for further
detail on the impact of SFAS 123R to the Company’s consolidated financial
statements.




Stock-based
compensation related to non-employees is recognized as compensation expense in
the accompanying consolidated statements of operations and is based on the fair
value of the services received or the fair value of the equity instruments
issued, whichever is more readily determinable. The Company’s accounting policy
for equity instruments issued to consultants and vendors in exchange for goods
and services follows the provisions of EITF 96-18, “Accounting for Equity Instruments
That are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services” and EITF 00-18, “Accounting Recognition for Certain
Transactions Involving Equity Instruments granted to Other Than
Employees.” The measurement date for the fair value of the equity
instruments issued is determined at the earlier of (1) the date at which a
commitment for performance by the consultant or vendor is reached or (2) the
date at which the consultant or vendor’s performance is complete. In the case of
equity instruments issued to consultants, the fair value of the equity
instrument is recognized over the term of the consulting
agreement.


37





Research and Development:R&D costs are recorded in accordance with FASB No. 2, “Accounting for Research and
Development Costs,” which requires that costs incurred in R&D
activities covering basic scientific research and the application of scientific
advances to the development of new and improved products and their uses be
expensed as incurred. The policy of expensing the costs of R&D activities
relate to (1) in-house work conducted by the Company, (2) costs incurred in
connection with contracts that outsource R&D to third party developers and
(3) costs incurred in connection with the acquisition of intellectual property
that is properly classified as in-process R&D. All R&D costs have been
expensed.




Off Balance Sheet
Arrangements. We do not have any off-balance sheet arrangements that
have, or are reasonably likely to have, an effect on our financial condition,
financial statements, revenues or expenses.




Item 8   Financial Statements and Supplementary
Data





REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




To the
Board of Directors and Stockholders of


Axion
Power International, Inc.




We have
audited the accompanying consolidated balance sheets of Axion Power
International, Inc. as of December 31, 2008 and 2007, and the related
consolidated statements of operations, cash flows, and changes in stockholders’
equity and comprehensive income for the years then ended and for the period
since inception (September 18, 2003) through December 31, 2008. Axion Power
International Inc.’s management is responsible for these consolidated financial
statements. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement. The company
is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting. Our audit included consideration of
internal control over financial reporting as a basis for designing audit
procedures that are appropriate in the circumstances, but not for the purpose of
expressing an opinion on the effectiveness of the company’s internal control
over financial reporting. Accordingly, we express no such opinion. An audit also
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the consolidated financial statements, assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall consolidated financial statement presentation. We believe
that our audits provide a reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Axion Power International,
Inc. as of December 31, 2008 and 2007, and the results of its operations and its
cash flows for the years then ended and for the period since inception
(September 18, 2003) through December 31, 2008 in conformity with accounting
principles generally accepted in the United States of America.





/s/
      Rotenberg & Co., LLPRotenberg
      & Co., LLPRochester,
      New YorkMarch
      24, 2009


38





AXION
POWER INTERNATIONAL, INC


CONSOLIDATED
BALANCE SHEETS


(A
Development Stage Company)





December 31, 2008
                  
                  
                  December 31, 2007ASSETSCurrent
      Assets:Cash
      and cash equivalents
                  
                  $
                  3,124,168
                  
                  
                  $
                  671,244Short-term
      investments
                  
                  
                  2,193,920
                  
                  
                  
                  -Accounts
      receivable
                  
                  
                  128,035
                  
                  
                  
                  133,646Other
      receivables
                  
                  
                  64,456
                  
                  
                  
                  341,801Inventory
                  
                  
                  1,269,515
                  
                  
                  
                  375,635Prepaid
      expenses
                  
                  
                  78,989
                  
                  
                  
                  82,102Total
      current assets
                  
                  
                  6,859,083
                  
                  
                  
                  1,604,428Property
      & equipment, net
                  
                  
                  3,274,183
                  
                  
                  
                  2,119,252Other
      receivables, non-current
                  
                  
                  28,388
                  
                  
                  
                  -TOTAL
      ASSETS
                  
                  $
                  10,161,654
                  
                  
                  $
                  3,723,680LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      Liabilities:Accounts
      payable
                  
                  $
                  1,324,287
                  
                  
                  $
                  1,573,436Other
      current liabilities
                  
                  
                  162,580
                  
                  
                  
                  583,591Notes
      payable to related parties
                  
                  
                  -
                  
                  
                  
                  2,259,826Liability
      to issue equity instrument
                  
                  
                  -
                  
                  
                  
                  106,183Total
      current liabilities
                  
                  
                  1,486,867
                  
                  
                  
                  4,523,036Deferred
      revenue
                  
                  
                  751,096
                  
                  
                  
                  840,945Total
      liabilities
                  
                  
                  2,237,963
                  
                  
                  
                  5,363,981Stockholders'
      Equity:Convertible
      preferred stock-12,500,000 shares authorized.    Senior
      preferred – 1,000,000 shares designated
                    .    137,500
      issued and outstanding (137,500 in 2007)
                  
                  
                  1,656,735
                  
                  
                  
                  1,515,376.   
      Series A preferred – 2,000,000 shares designated
                    .    718,997
      shares issued and outstanding (822,997 in 2007)
                  
                  
                  9,440,359
                  
                  
                  
                  9,802,894Common
      stock-100,000,000 shares authorized $0.0001 par value 26,417,437 issued
      & outstanding (16,498,298 in 2007)
                  
                  
                  2,641
                  
                  
                  
                  1,625Additional
      paid in capital
                  
                  
                  46,184,287
                  
                  
                  
                  25,768,331Deficit
      accumulated during development stage
                  
                  
                  (49,111,062
                  )
                  
                  
                  (38,498,704
                  )Cumulative
      foreign currency translation adjustment
                  
                  
                  (249,269
                  )
                  
                  
                  (229,823
                  )Total
      Stockholders' Equity
                  
                  
                  7,923,691
                  
                  
                  
                  (1,640,301
                  )TOTAL
      LIABILITIES & STOCKHOLDERS' EQUITY
                  
                  $
                  10,161,654
                  
                  
                  $
                  3,723,680





The
Accompanying Notes are an Integral Part of the Financial
Statements


39





AXION
POWER INTERNATIONAL, INC


CONSOLIDATED
STATEMENTS OF OPERATIONS


(A
Development Stage Company)





Years Ended
                  
                  
                  InceptionDecember 31,
                  
                  
                  (9/18/2003) to2008
                  
                  
                  2007
                  
                  
                  December 31, 2008Revenues
                  
                  $
                  679,559
                  
                  
                  $
                  533,911
                  
                  
                  $
                  1,488,847Costs
      of goods sold
                  
                  
                  368,922
                  
                  
                  
                  283,357
                  
                  
                  
                  1,210,262Gross
      profit
                  
                  
                  310.637
                  
                  
                  
                  250.554
                  
                  
                  
                  278.585ExpensesSelling,
      general & administrative
                  
                  
                  4,846,189
                  
                  
                  
                  3,720,632
                  
                  
                  
                  18,015,381Research
      & development
                  
                  
                  3,960,909
                  
                  
                  
                  2,155,873
                  
                  
                  
                  13,951,670Impairment
      of assets
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,391,485Interest
      expense - related party
                  
                  
                  1,137,436
                  
                  
                  
                  276,651
                  
                  
                  
                  2,151,923Derivative
      revaluation
                  
                  
                  (2,844
                  )
                  
                  
                  (72,236
                  )
                  
                  
                  362,508Mega
      C Trust Share Augmentation (Return)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  400,000Interest
      & other income, net
                  
                  
                  (57,224
                  )
                  
                  
                  (47,708
                  )
                  
                  
                  (534,152
                  )Net
      loss before income taxes
                  
                  
                  (9,573,829
                  )
                  
                  
                  (5,782,658
                  )
                  
                  
                  (35,460,230
                  )Income
      Taxes Expense (Benefit)
                  
                  
                  (79,170
                  )
                  
                  
                  83,469
                  
                  
                  
                  4,299Deficit
      accumulated during development stage
                  
                  
                  (9,494,659
                  )
                  
                  
                  (5,886,127
                  )
                  
                  
                  (35,464,529
                  )Less
      preferred stock dividends and beneficial conversion
feature
                  
                  
                  (1,117,699
                  )
                  
                  
                  (8,417,955
                  )
                  
                  
                  (13,646,533
                  )Net
      loss applicable to common shareholders
                  
                  $
                  (10,612,358
                  )
                  
                  $
                  (14,284,082
                  )
                  
                  $
                  (49,111,062
                  )Basic
      and diluted net loss per share
                  
                  $
                  (0.46
                  )
                  
                  $
                  (0.88
                  )
                  
                  $
                  (3.11
                  )Weighted
      average common shares outstanding
                  
                  
                  22,826,187
                  
                  
                  
                  16,247,299
                  
                  
                  
                  15,776,245





The
Accompanying Notes are an Integral Part of the Financial
Statements


40





AXION
POWER INTERNATIONAL, INC


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(A
Development Stage Company)





Years
      Ended
                    
                    
                    InceptionDecember 31,
                    
                    
                    (9/18/2003) to2008
                    
                    
                    2007
                    
                    
                    12/31/2008Cash
      Flows from Operating Activities:Deficit
      accumulated during development stage
                    
                    $
                    (9,494,659
                    )
                    
                    $
                    (5,866,127
                    )
                    
                    $
                    (35,464,529
                    )Adjustments
      required to reconcile deficit accumulated during development stage to cash
      flows used by operating activitiesDepreciation
                    
                    
                    189,804
                    
                    
                    
                    176,196
                    
                    
                    
                    543,286Impairment
      of assets
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,391,486Non-cash
      interest expense
                    
                    
                    868,211
                    
                    
                    
                    224,536
                    
                    
                    
                    1,830,583Derivative
      revaluations
                    
                    
                    (2,844
                    )
                    
                    
                    (72,236
                    )
                    
                    
                    362,508Equity
      instruments issued for services
                    
                    
                    861,705
                    
                    
                    
                    478,113
                    
                    
                    
                    4,350,499Mega
      C Trust Share Augmentation (Return)
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    400,000Changes
      in Operating Assets & LiabilitiesAccounts
      receivable
                    
                    
                    5,612
                    
                    
                    
                    (88,639
                    )
                    
                    
                    (134,905
                    )Other
      receivables
                    
                    
                    277,345
                    
                    
                    
                    87,233
                    
                    
                    
                    (42,496
                    )Prepaid
      expenses
                    
                    
                    3,113
                    
                    
                    
                    10,478
                    
                    
                    
                    (76,401
                    )Inventory
                    
                    
                    (893,879
                    )
                    
                    
                    (108,449
                    )
                    
                    
                    (1,269,514
                    )Accounts
      payable
                    
                    
                    (249,149
                    )
                    
                    
                    661,969
                    
                    
                    
                    2,978,931Other
      current liabilities
                    
                    
                    (421,009
                    )
                    
                    
                    (252,500
                    )
                    
                    
                    183,712Deferred
      revenue and other
                    
                    
                    (2,370
                    )
                    
                    
                    840,945
                    
                    
                    
                    838,575Liability
      to issue equity instruments
                    
                    
                    -
                    
                    
                    
                    178,419
                    
                    
                    
                    178,419Net
      cash used by operating activities
                    
                    
                    (8,858,120
                    )
                    
                    
                    (3,730,062
                    )
                    
                    
                    (23,929,846
                    )Cash
      Flows from Investing ActivitiesShort
      term investments
                    
                    
                    (2,193,920
                    )
                    
                    
                    -
                    
                    
                    
                    (2,193,920
                    )Long
      term notes, net
                    
                    
                    (28,388
                    )
                    
                    
                    -
                    
                    
                    
                    (1,245,404
                    )Purchase
      of property & equipment
                    
                    
                    (1,432,213
                    )
                    
                    
                    (1,250,643
                    )
                    
                    
                    (3,814,180
                    )Investment
      in intangible assets
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (167,888
                    )Net
      cash used by investing activities
                    
                    
                    (3,654,521
                    )
                    
                    
                    (1,250,643
                    )
                    
                    
                    (7,421,392
                    )Cash
      Flow from Financing ActivitiesProceeds
      from related party debt, net
                    
                    
                    (1,483,485
                    )
                    
                    
                    1,630,032
                    
                    
                    
                    5,179,771Proceeds
      from sale of common stock; net of costs
                    
                    
                    16,468,500
                    
                    
                    
                    -
                    
                    
                    
                    20,185,905Proceeds
      from exercise of warrants
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,655,500Proceeds
      from sale of preferred stock, net of costs
                    
                    
                    -
                    
                    
                    
                    390,500
                    
                    
                    
                    7,472,181Net
      cash provided by financing activities
                    
                    
                    14,985,015
                    
                    
                    
                    2,020,532
                    
                    
                    
                    34,493,357Net
      Change in Cash and Cash Equivalents
                    
                    
                    2,472,374
                    
                    
                    
                    (2,960,173
                    )
                    
                    
                    3,142,119Effect
      of Exchange Rate on Cash
                    
                    
                    (19,450
                    )
                    
                    
                    21,137
                    
                    
                    
                    (17,951
                    )Cash
      and Cash Equivalents - Beginning
                    
                    
                    671,244
                    
                    
                    
                    3,610,280
                    
                    
                    
                    -Cash
      and Cash Equivalents - Ending
                    
                    $
                    3,124,168
                    
                    
                    $
                    671,244
                    
                    
                    $
                    3,124,168





The
Accompanying Notes are an Integral Part of the Financial
Statements


41





Axion
Power International, Inc.


Consolidated
Statement of Stockholders' Equity (Deficit)


For
Periods Ended December 31, 2003; 2004; 2005; 2006; 2007; 2008


(A
Development Stage Company)





Preferred
                                                                                
                                                                                
                                                                                Common
                                                                                
                                                                                
                                                                                Deficit
                                                                                  Accumulated
                                                                                  During
                                                                                
                                                                                
                                                                                Other
                                                                                  Comprehensive
                                                                                  Income
                                                                                  Cumulative
                                                                                
                                                                                
                                                                                Total
                                                                                  Stockholders'Shares
                                                                                
                                                                                
                                                                                Senior
                                                                                  Preferred
                                                                                
                                                                                
                                                                                Series A
                                                                                  Preferred
                                                                                
                                                                                
                                                                                Shares
                                                                                
                                                                                
                                                                                Common
                                                                                  Stock Amount
                                                                                
                                                                                
                                                                                Additional Paid-
                                                                                  In Capital
                                                                                
                                                                                
                                                                                Subscriptions
                                                                                  Receivable
                                                                                
                                                                                
                                                                                Development
                                                                                  Stage
                                                                                
                                                                                
                                                                                Translation
                                                                                  Adjustments
                                                                                
                                                                                
                                                                                Equity
                                                                                  (Deficit)Inception
      September 18, 2003
                                                                                
                                                                                
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                0
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                0Shares
      to founders upon formulation of APC
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                1,360,000
                                                                                
                                                                                
                                                                                
                                                                                137
                                                                                
                                                                                
                                                                                
                                                                                (137
                                                                                )
                                                                                
                                                                                
                                                                                0
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0Stock
      based compensation
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                170,000
                                                                                
                                                                                
                                                                                
                                                                                17
                                                                                
                                                                                
                                                                                
                                                                                48,936
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                48,953Conversion
      of debt to equity
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                1,108,335
                                                                                
                                                                                
                                                                                
                                                                                111
                                                                                
                                                                                
                                                                                
                                                                                1,449,889
                                                                                
                                                                                
                                                                                
                                                                                (350,000
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                1,100,001Debt
      Discount from convertible debt
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                86,402
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                86,402Unamortized
      discount on convertible debt
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (77,188
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (77,188
                                                                                )Fair
      value of options issued as loan inducements
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                15,574
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                15,574Shared
      issued during Recapitalization-
      Shares issued to Mega-C trust
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                6,147,483
                                                                                
                                                                                
                                                                                
                                                                                615
                                                                                
                                                                                
                                                                                
                                                                                (615
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0-
      Equity acquired in recapitalization
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                1,875,000
                                                                                
                                                                                
                                                                                
                                                                                188
                                                                                
                                                                                
                                                                                
                                                                                (188
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0Net
      Loss December 31, 2003
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (3,097,030
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (3,097,030
                                                                                )Other
      Comprehensive income (loss):Foreign
      Currency Translation Adjustment
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (56,547
                                                                                )
                                                                                
                                                                                
                                                                                (56,547
                                                                                )Comprehensive
      loss
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (3,153,577
                                                                                )Balance
      at December 31, 2003
                                                                                
                                                                                
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                0
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                10,660,818
                                                                                
                                                                                
                                                                                $
                                                                                1,067
                                                                                
                                                                                
                                                                                $
                                                                                1,522,674
                                                                                
                                                                                
                                                                                $
                                                                                (350,000
                                                                                )
                                                                                
                                                                                $
                                                                                (3,097,030
                                                                                )
                                                                                
                                                                                $
                                                                                (56,547
                                                                                )
                                                                                
                                                                                $
                                                                                (1,979,836
                                                                                )Shares
      issued to founders
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                445,000
                                                                                
                                                                                
                                                                                
                                                                                45
                                                                                
                                                                                
                                                                                
                                                                                (45
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0Augmentation
      shares issued to Mega-C trust
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                180,000
                                                                                
                                                                                
                                                                                
                                                                                18
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0Conversion
      of debt
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                283,333
                                                                                
                                                                                
                                                                                
                                                                                28
                                                                                
                                                                                
                                                                                
                                                                                451,813
                                                                                
                                                                                
                                                                                
                                                                                350,000
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                801,841Warrants
      in consideration for technology purchased
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                563,872
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                563,872Common
      stock offering - net of cost
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                823,800
                                                                                
                                                                                
                                                                                
                                                                                81
                                                                                
                                                                                
                                                                                
                                                                                1,607,053
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                1,607,134Proceeds
      from exercise of warrants
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                475,200
                                                                                
                                                                                
                                                                                
                                                                                48
                                                                                
                                                                                
                                                                                
                                                                                867,972
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                868,020Liability
      converted as partial prepayment on options
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                306,000
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                306,000Stock
      based compensation
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                45,000
                                                                                
                                                                                
                                                                                
                                                                                5
                                                                                
                                                                                
                                                                                
                                                                                191,738
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                191,742Fraction
      Shares Issued Upon Reverse Spilt
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                48,782
                                                                                
                                                                                
                                                                                
                                                                                5
                                                                                
                                                                                
                                                                                
                                                                                (5
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0Net
      Loss December 31, 2004
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (3,653,637
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (3,653,637
                                                                                )Other
      Comprehensive income (loss):Foreign
      Currency Translation Adjustment
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (74,245
                                                                                )
                                                                                
                                                                                
                                                                                (74,245
                                                                                )Comprehensive
      loss
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (3,727,882
                                                                                )Balance
      at December 31, 2004
                                                                                
                                                                                
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                0
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                12,961,933
                                                                                
                                                                                
                                                                                $
                                                                                1,296
                                                                                
                                                                                
                                                                                $
                                                                                5,511,054
                                                                                
                                                                                
                                                                                $
                                                                                0
                                                                                
                                                                                
                                                                                $
                                                                                (6,750,667
                                                                                )
                                                                                
                                                                                $
                                                                                (130,792
                                                                                )
                                                                                
                                                                                $
                                                                                (1,369,109
                                                                                )Proceeds
      From Exercise of Warrants & Options
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                853,665
                                                                                
                                                                                
                                                                                
                                                                                85
                                                                                
                                                                                
                                                                                
                                                                                1,283,395
                                                                                
                                                                                
                                                                                
                                                                                (496,000
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                787,480Common
      Stock Offering Proceeds
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                600,000
                                                                                
                                                                                
                                                                                
                                                                                60
                                                                                
                                                                                
                                                                                
                                                                                1,171,310
                                                                                
                                                                                
                                                                                
                                                                                (200,000
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                971,370Preferred
      Stock Offering proceeds
                                                                                
                                                                                
                                                                                385,000
                                                                                
                                                                                
                                                                                
                                                                                3,754,110
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (25,000
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                3,729,110Conversion
      of preferred to common
                                                                                
                                                                                
                                                                                (245,000
                                                                                )
                                                                                
                                                                                
                                                                                (2,475,407
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                1,470,000
                                                                                
                                                                                
                                                                                
                                                                                147
                                                                                
                                                                                
                                                                                
                                                                                2,475,260
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0Stock
      issued for services
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                500,000
                                                                                
                                                                                
                                                                                
                                                                                50
                                                                                
                                                                                
                                                                                
                                                                                1,524,950
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                1,525,000Fair
      Value of Options for Non-Employee Services
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                237,568
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                237,568Employee
      incentive share grants
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                219,000
                                                                                
                                                                                
                                                                                
                                                                                22
                                                                                
                                                                                
                                                                                
                                                                                647,480
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                647,502Impact
      of beneficial conversion feature
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                3,099,156
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (3,099,156
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0Preferred
      Stock Dividends
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                176,194
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (176,194
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                0Net
      Loss December 31, 2005
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (6,325,113
                                                                                )
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                
                                                                                (6,325,113
                                                                                )


42





Other
      Comprehensive income (loss):Foreign
      Currency Translation Adjustment
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (24,780
                            )
                            
                            
                            (24,780
                            )Comprehensive
      loss
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (6,349,893
                            )Balance
      at December 31, 2005
                            
                            
                            140,000
                            
                            
                            $
                            1,454,897
                            
                            
                            
                            
                            
                            
                            
                            16,604,598
                            
                            
                            $
                            1,661
                            
                            
                            $
                            15,950,173
                            
                            
                            $
                            (721,000
                            )
                            
                            $
                            (16,351,130
                            )
                            
                            $
                            (155,572
                            )
                            
                            $
                            179,028Preferred
      Series A Proceeds
                            
                            
                            782,997
                            
                            
                            
                            
                            
                            
                            
                            7,571,768
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            7,571,768Preferred  -
      Dividends
                            
                            
                            
                            
                            
                            
                            119,092
                            
                            
                            
                            103,101
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (222,193
                            )
                            
                            
                            
                            
                            
                            
                            0Senior
      Preferred Cancellation
                            
                            
                            (2,500
                            )
                            
                            
                            (25,000
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            25,000
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            0Common
      Stock Offering Proceeds
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            80,000
                            
                            
                            
                            8
                            
                            
                            
                            199,992
                            
                            
                            
                            696,000
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            896,000Proceeds
      from exercise of warrants
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            56,700
                            
                            
                            
                            6
                            
                            
                            
                            113,394
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            113,400Employee
      incentive share grants
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            6,000
                            
                            
                            
                            1
                            
                            
                            
                            23,999
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            24,000Augmentation
      shares issued to Mega-C trust
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (500,000
                            )
                            
                            
                            (50
                            )
                            
                            
                            (1,124,950
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (1,125,000
                            )Stock
      based compensation
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            1,241,231
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            1,241,231Fair
      value of warrants with related party debt
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            885,126
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            885,126Modification
      of preexisting warrants
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            392,811
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            392,811Fair
      value warrants issued for services
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            86,848
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            86,848Beneficial
      conversion feature on related party debt
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            95,752
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            95,752Beneficial
      conversion feature  on Preferred Stock
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (6,096,634
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            6,709,970
                            
                            
                            
                            
                            
                            
                            
                            (613,336
                            )
                            
                            
                            
                            
                            
                            
                            0Net
      Loss December 31, 2006
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (7,027,963
                            )
                            
                            
                            
                            
                            
                            
                            (7,027,963
                            )Other
      Comprehensive income (loss):
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            0Foreign
      Currency Translation Adjustment
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (95,387
                            )
                            
                            
                            (95,387
                            )Comprehensive
      loss
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (7,123,350
                            )Balance
      at December 31, 2006
                            
                            
                            920,497
                            
                            
                            $
                            1,548,989
                            
                            
                            $
                            1,578,235
                            
                            
                            
                            16,247,298
                            
                            
                            
                            1,625
                            
                            
                            
                            24,574,346
                            
                            
                            
                            -
                            
                            
                            
                            (24,214,622
                            )
                            
                            
                            (250,959
                            )
                            
                            $
                            3,237,614Preferred
      Series A Proceeds
                            
                            
                            40,000
                            
                            
                            
                            
                            
                            
                            
                            337,270
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            337,270Preferred  -
      Dividends
                            
                            
                            
                            
                            
                            
                            130,566
                            
                            
                            
                            1,790,755
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (1,921,321
                            )
                            
                            
                            
                            
                            
                            
                            0Employee
      incentive share grants
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            1,000
                            
                            
                            
                            0
                            
                            
                            
                            315,950
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            315,950Stock
      based compensation
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            215,393
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            215,393Fair
      value of warrants with related party debt
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            98,463
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            98,463Modification
      of preexisting warrants
                            
                            
                            
                            
                            
                            
                            (164,179
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            164,179
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            0Beneficial
      conversion feature  on Preferred Stock
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            6,096,634
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            400,000
                            
                            
                            
                            
                            
                            
                            
                            (6,496,634
                            )
                            
                            
                            
                            
                            
                            
                            0Net
      Loss December 31, 2007
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (5,866,127
                            )
                            
                            
                            
                            
                            
                            
                            (5,866,127
                            )Other
      Comprehensive income (loss):
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            0Foreign
      Currency Translation Adjustment
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            21,136
                            
                            
                            
                            21,136Comprehensive
      loss
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (5,844,991
                            )Balance
      at December 31, 2007
                            
                            
                            960,497
                            
                            
                            $
                            1,515,376
                            
                            
                            $
                            9,802,894
                            
                            
                            
                            16,248,298
                            
                            
                            $
                            1,625
                            
                            
                            $
                            25,768,331
                            
                            
                            $
                            0
                            
                            
                            $
                            (38,498,704
                            )
                            
                            $
                            (229,823
                            )
                            
                            $
                            (1,640,301
                            )


43





Preferred  -
      Dividends
                    
                    
                    
                    
                    
                    
                    141,359
                    
                    
                    
                    976,340
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (1,117,699
                    )
                    
                    
                    
                    
                    
                    
                    0Preferred
      Converted into Common Stock
                    
                    
                    (104,000
                    )
                    
                    
                    
                    
                    
                    
                    (1,338,875
                    )
                    
                    
                    1,071,099
                    
                    
                    
                    107
                    
                    
                    
                    1,338,768
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    0Bridge
      Loans Converted into Common Stock
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    514,611
                    
                    
                    
                    51
                    
                    
                    
                    1,080,633
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,080,684Proceeds
      from Quercus Trust-net of costs
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    8,571,429
                    
                    
                    
                    857
                    
                    
                    
                    15,273,908
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    15,274,765Employee
      incentive share grants
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    12,000
                    
                    
                    
                    1
                    
                    
                    
                    435,725
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    435,726Stock
      based compensation
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    425,979
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    425,979Fair
      value of warrants with related party debt
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    667,208
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    667,208Fair
      value warrants issued for services
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,193,735
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    1,193,735Net
      Loss December 31, 2008
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (9,494,659
                    )
                    
                    
                    
                    
                    
                    
                    (9,494,659
                    )Other
      Comprehensive income (loss):
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    0Foreign
      Currency Translation Adjustment
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (19,446
                    )
                    
                    
                    (19,446
                    )Comprehensive
      loss
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    (9,551,990
                    )Balance
      at December 31, 2008
                    
                    
                    856,497
                    
                    
                    $
                    1,656,735
                    
                    
                    $
                    9,440,359
                    
                    
                    
                    26,417,437
                    
                    
                    $
                    2,641
                    
                    
                    $
                    46,184,287
                    
                    
                    $
                    0
                    
                    
                    $
                    (49,111,062
                    )
                    
                    $
                    (249,269
                    )
                    
                    $
                    7,923,691





The
Accompanying Notes are an Integral Part of the Financial
Statements


44


AXION
POWER INTERNATIONAL, INC.




NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




(A
DEVELOPMENT STAGE COMPANY)




Note 1 — Organization and Operations




These
consolidated financial statements of Axion Power International, Inc., a Delaware
corporation (API), include the operations of its wholly owned subsidiaries;
Axion Power Battery Manufacturing, Inc (APB), Axion Power Corporation, a
Canadian Federal corporation (“APC”), and C & T Co. Inc., an Ontario
corporation (“C&T”) (collectively, the Company).




Axion is
developing innovative battery/energy storage device technology. The Company
continues its research and development and has entered the testing phase of its
unique battery designs. Development activities, testing and prototype
manufacturing is performed at the Company’s manufacturing facility. The Company
also manufactures on a limited basis specialty batteries for
resale.




Note
2 —Accounting Policies




Use of
Estimates:The preparation of
financial statements in conformity with accounting principles generally accepted
in the United States of America requires management to make estimates and
assumptions that affect reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statement and the reported amounts of revenues and expenses during the reporting
period. Actual results could differ from the estimates.




Principles of
Consolidation:The consolidated financial statements include the accounts of Axion, and
its wholly owned subsidiaries, APB, APC and C&T (collectively, the Company).
All significant inter-company balances and transactions have been eliminated in
consolidation.




Basis of
Presentation:The
financial statements have been presented in a “development stage” format in
accordance with the provisions of Statement of Financial Accounting Standards
(FASB) No. 7, Accounting and
Reporting by Development Stage Enterprises. Since inception, the
Company’s primary activities have been raising capital, obtaining financing,
developing Axion’s energy storage technology and testing its proposed
products.




Segment
Reporting:Management has determined that the Company is organized,
managed and internally reported as one business segment. Segments are determined
based on differences in products, internal reporting and how operational
decisions are made.




Foreign Currency
Translation: The accounts of APC
and C&T are measured using the Canadian dollar as the functional currency
for all the periods presented in the financial statements. The translation from
Canadian dollars to U.S. dollars is performed for the balance sheet accounts
using current exchange rates in effect at each of the balance sheet dates, and
for the revenue and expense accounts using the average rate in effect during the
periods. The resulting translation adjustments are recorded as a component of
accumulated other comprehensive income (loss) within stockholders’ equity. Gains
or losses resulting from transactions denominated in currencies other than the
functional currency are included in the results of operations as incurred. The
gains or losses arising from the inter-company loan denominated in U.S. dollars
are directly reflected in other comprehensive income, as the amounts are not
expected to be repaid in the foreseeable future.




Comprehensive
Income:The Company follows FASB No. 130, “Reporting Comprehensive
Income.” Comprehensive income, as defined by Statement 130, is the change
in equity of a business enterprise during a reporting period from transactions
and other events and circumstances from non-owner sources. In addition to the
Company’s net loss, the change in equity components under comprehensive income
include the foreign currency translation adjustment.


45


Fair Value of
Financial Instruments:FASB No. 107, "Disclosures about Fair Value of
Financial Instruments," requires disclosure of fair value information
about certain financial instruments, including, but not limited to, cash and
cash equivalents, accounts receivable, refundable tax credits, prepaid expenses,
accounts payable, accrued expenses, notes payable to related parties and
convertible debt-related securities. Fair value estimates discussed herein are
based upon certain market assumptions and pertinent information available to
management as of December 31, 2008 and 2007. The carrying value of the balance
sheet financial instruments included in the Company’s consolidated financial
statements approximated their fair values.




On
January 1, 2008, the Company adopted FASB Statement No. 157, “Fair
Value Measurements” (SFAS No. 157) which defines fair value, establishes a
framework for measuring fair value, and requires additional disclosures about
fair value measurements. The criterion that is set forth in SFAS No. 157 is
applicable to fair value measurement where it is permitted or required under
other accounting pronouncements.


SFAS
No. 157 defines fair value as the exit price, which is the price that would
be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date. The fair value
measurement is based on inputs of observable and unobservable market data that a
market participant would use in pricing the asset or liability. The use of
observable inputs is maximized where available and the use of unobservable
inputs is minimized for fair value measurement. As a means to illustrate the
inputs used, SFAS No. 157 establishes a three-tier fair value hierarchy
that prioritizes inputs to valuation techniques used for fair value
measurement.





·
            Level
      1 consists of observable market data in an active market for identical
      assets or liabilities.


·
            Level
      2 consists of observable market data, other than that included in Level 1,
      that is either directly or indirectly
  observable.


·
            Level
      3 consists of unobservable market data. The input may reflect the
      assumptions of the Company of what a market participant would use in
      pricing an asset or liability. If there is little available market data,
      then the Company’s own assumptions are the best available
      information.





In
the case of multiple inputs being used in a fair value measurement, the lowest
level input that is significant to the fair value measurement represents the
level in the fair value hierarchy in which the fair value measurement is
reported.





Cash and Cash
Equivalents:For financial statement
presentation purposes, the Company considers those short-term, highly liquid
investments with original maturities of three months or less to be cash or cash
equivalents.




Concentration of
Credit Risk:The Company’s cash and cash equivalents are on deposit with
banks. Only a portion of the cash and cash equivalents would be covered by
deposit insurance and the uninsured balances are substantially greater than the
insured amounts. Although cash and cash equivalent balances exceed insured
deposit amounts, management does not anticipate non-performance by the
banks.




Accounts
Receivable:The Company records its accounts receivable at the original
invoice amount less an allowance for doubtful accounts. An account receivable is
considered to be past due if any portion of the receivable balance is
outstanding beyond its scheduled due date. On a quarterly basis, the Company
evaluates its accounts receivable and establishes an allowance for doubtful
accounts and established an allowance for doubtful accounts for specific
accounts that are considered at risk as to collection. When a customer account
is considered to be uncollectible it is written off against the related
allowance. . No interest is accrued on past due accounts
receivable.




Inventory:
Inventory is recorded at the lower of cost or market value, and adjusted as
appropriate for decreases in valuation and obsolescence. Adjustments to the
valuation and obsolescence reserves are made after analyzing market conditions,
current and projected sales activity, inventory costs and inventory balances to
determine appropriate reserve levels. As of December 31, 2008, no reserve for
obsolescence was deemed necessary. Cost is determined using the first-in
first-out (FIFO) method. Many components and raw materials we purchase have
minimum order quantities. As of December 31, 2008, inventory costs of $1,270,000
consisted of $354,000 of finished goods, $344,000 of work-in-process and
$572,000 of raw materials. These amounts include $535,000 of finished batteries,
work-in-process and raw materials for our manufacturing subcontract. As of
December 31, 2007 inventory costs of $376,000 consisted of  $302,000
of raw materials,  $55,000 of work-in-process and $19,000 of finished
goods.




46




Property and
Equipment:Property and equipment
are recorded at cost. Depreciation is computed using the straight line method
over the estimated useful lives of the assets, ranging from 3 to 22
years.


Expenditures
for renewals and betterments are capitalized. Expenditures for minor items,
repairs and maintenance are charged to operations as incurred. Gain or loss upon
sale or retirement due to obsolescence is reflected in the operating results in
the period the event takes place.




Impairment or
Disposal of Long-Lived Assets:The Company adopted the provisions of FASB
No. 144 (FASB 144), “Accounting for the Impairment or
Disposal of Long-lived Assets.” This standard requires, among other
things, that long-lived assets be reviewed for potential impairment whenever
events or circumstances indicate that the carrying amounts may not be
recoverable. The assessment of possible impairment is based on the ability to
recover the carrying value of the asset from the expected future pre-tax cash
flows (undiscounted and without interest charges) of the related operations. If
these expected cash flows are less than the carrying value of such asset, an
impairment loss is recognized for the difference between estimated fair value
and carrying value. The primary measure of fair value is based on discounted
cash flows. The measurement of impairment requires management to make estimates
of these cash flows related to long-lived assets, as well as other fair value
determinations. There were no impairments recognized for years ended December
31, 2008 and 2007.





Revenue
Recognition: The Company recognizes revenue upon transfer of title at the
time of shipment (F.O.B. shipping point), when all significant contractual
obligations have been satisfied, the price is fixed or determinable, and
collectability is reasonably assured.




Shipping and
Handling Costs: All shipping and handling costs charged to customers are
recorded as Net Sales and all related expenses are included in Cost of Sales.
Shipping and handling costs not billed to customers are included in selling,
general and administrative expense.




Stock-Based
Compensation: Prior to January 1, 2006, the Company accounted for stock
option awards in accordance with the recognition and measurement provisions of
Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to
Employees,(APB 25)” and related
interpretations, as permitted by Statement of Financial Accounting Standard No.
123, “Accounting for
Stock-Based Compensation”, (SFAS 123). Under APB 25, compensation cost
for stock options issued to employees was measured as the excess, if any, of the
fair value of the Company’s stock at the date of grant over the exercise price
of the option granted. Compensation cost was recognized for stock options, if
any, ratably over the vesting period. As permitted by SFAS 123, the Company
reported pro-forma disclosures presenting results and earnings as if the Company
had used the fair value recognition provisions of SFAS 123 in the Notes to the
Consolidated Financial Statements.




Effective
January 1, 2006, the Company adopted the provisions of Statement of Financial
Accounting Standards No. 123 (revised 2004), “Share-Based Payment”, (SFAS
123(R)) using the modified prospective transition method. See footnote captioned
“Equity Compensation” for further detail on the impact of SFAS 123(R) to the
Company’s consolidated financial statements.




Stock-based
compensation related to non-employees is recognized as compensation expense in
the accompanying consolidated statements of operations and is based on the fair
value of the services received or the fair value of the equity instruments
issued, whichever is more readily determinable.The Company’s accounting
policy for equity instruments issued to consultants and vendors in exchange for
goods and services follows the provisions of EITF 96-18, “Accounting for Equity Instruments
That are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services” and EITF 00-18, “Accounting Recognition for Certain
Transactions Involving Equity Instruments granted to Other Than Employees.”The measurement date for the fair value of the equity instruments issued
is determined at the earlier of (i) the date at which a commitment for
performance by the consultant or vendor is reached or (ii) the date at which the
consultant or vendor’s performance is complete. In the case of equity
instruments issued to consultants, the fair value of the equity instrument is
recognized over the term of the consulting agreement.




47




Research and
Development:Research and development costs are recorded in accordance with FASB No,
2, “Accounting for Research
and Development Costs,” which requires that costs incurred in research
and development activities covering basic scientific research and the
application of scientific advances to the development of new and improved
products and their uses be expensed as incurred. The policy of expensing the
costs of research and development activities relate to (i) in-house work
conducted by the Company; (ii) costs incurred in connection with contracts
that outsource research and development to third party developers; and
(iii) costs incurred in connection with the acquisition of intellectual
property that is properly classified as in-process research and development. All
research and development costs have been expensed.




Income
Taxes: Deferred income taxes are recorded in accordance with FASB No.
109, “Accounting for Income
Taxes,” or FASB 109, and deferred tax assets and liabilities are
determined based on the differences between financial reporting and the tax
basis of assets and liabilities using the tax rates and laws in effect when the
differences are expected to reverse. FASB 109 provides for the recognition of
deferred tax assets if realization of such assets is more likely than not to
occur. Realization of net deferred tax assets is dependent upon generating
sufficient taxable income in future years in appropriate tax jurisdictions to
realize benefit from the reversal of temporary differences and from net
operating loss, or NOL, carryforwards. The Company has determined it more likely
than not that the deferred tax asset resulting from these timing differences
will not materialize and have provided a valuation allowance against the entire
net deferred tax asset. Management will continue to evaluate the realizability
of the deferred tax asset and its related valuation allowance. If the assessment
of the deferred tax assets or the corresponding valuation allowance were to
change, the Company would record the related adjustment to income during the
period in which the determination is made. The tax rate may also vary based on
actual results and the mix of income or loss in domestic and foreign tax
jurisdictions in which operations take place.




Refundable
tax credits are recorded, to the extent receipt is assured, in the year that
they are earned and included in other income.




The
provision for taxes represents corporate-level franchise taxes which may be
based on assets, equity, capital stock or a variation thereof.




Recent
Accounting Pronouncements:




In
February 2007, Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities-Including an Amendment of FASB Statement No.
115,” (FASB 159), was issued. This standard allows a company to
irrevocably elect fair value as the initial and subsequent measurement attribute
for certain financial assets and financial liabilities on a contract-by-contract
basis, with changes in fair value recognized in earnings. The provisions of this
standard are effective as of the beginning of our fiscal year 2008, with early
adoption permitted. The adoption of FASB No. 159 did not have a material impact
on the Company’s consolidated financial position, results of operation, or cash
flows.




In
December 2007, the FASB issued SFAS No. 141(R), Business Combinations and
SFAS No. 160, Accounting
and Reporting of Noncontrolling Interest in Consolidated Financial Statements,
an amendment of ARB No. 51. These new standards will significantly
change the accounting for and reporting of business combinations and
non-controlling (minority) interests in consolidated financial statements.
Statement Nos. 141(R) and 160 are required to be adopted simultaneously and
are effective for the first annual reporting period beginning on or after
December 15, 2008. Earlier adoption is prohibited. The Company is currently
evaluating the impact of adopting SFAS Nos. 141(R) and SFAS 160 on its
consolidated financial statements.




48




In March
2008, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standard (“SFAS”) No. 161, "Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB Statement No.
133”.  SFAS 161 requires enhanced disclosures about an entity’s
derivative and hedging activities.  SFAS 161 is effective for
financial statements issued for fiscal years and interim periods beginning after
November 15, 2008 with early application encouraged.  As such, the
Company is required to adopt these provisions at the beginning of the fiscal
year ended December 31, 2009.  The Company is currently evaluating the
impact of SFAS 161 on its consolidated financial statements but does not expect
it to have a material effect.





In May
2008, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standard (“SFAS”) No. 162, "The Hierarchy of Generally Accepted
Accounting Principles”.  SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles (GAAP) in
the United States.  SFAS 162 is effective 60 days following the SEC’s
approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted
Accounting Principles. The Company is currently evaluating the impact of SFAS
162 on its consolidated financial statements but does not expect it to have a
material effect.





In May
2008, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standard (“SFAS”) No. 163, "Accounting for Financial Guarantee
Insurance Contracts—an interpretation of FASB Statement No. 60" (“SFAS
163”).  SFAS 163 interprets Statement 60 and amends existing
accounting pronouncements to clarify their application to the financial
guarantee insurance contracts included within the scope of that
Statement.  SFAS 163 is effective for financial statements issued for
fiscal years beginning after December 15, 2008, and all interim periods within
those fiscal years.  As such, the Company is required to adopt these
provisions at the beginning of the fiscal year ended December 31,
2009.  The Company is currently evaluating the impact of SFAS 163 on
its consolidated financial statements but does not expect it to have a material
effect.




Reclassifications




Certain
reclassifications have been made to the 2007 financial statement presentation to
correspond to the current year’s presentation. Total equity and net income
are unchanged due to these reclassifications.





Note 3 -           Grant Revenue




Grants from
Commonwealth of Pennsylvania: On April 30, 2007, the Company was awarded
a series of retroactive grants from the Commonwealth of Pennsylvania with an
aggregate value of $1.2 million. Grants for $900,000 were specifically
designated for equipment purchases and the remaining $300,000 for job training
and tax credits. The $150,000 Opportunity Grant Program grant requires the
Company to hire 86 full-time employees by March 31, 2009, spend a total of
$6,492,300 of non-public funds as part of the company’s operating expenses and
equipment purchases by March 31, 2009 and maintain an operation in Neshannock
Township through March 31, 2011. Failure to meet these goals could result in a
partial return of the $150,000 grant allocation. During the year ended December
31, 2007, the Company recognized amounts related to these grants for the
purchase of equipment. The Company records equipment grants as other receivables
and deferred revenue based on qualifying equipment purchases that are billed to
the Commonwealth for reimbursement at a rate of 75% of the amount paid by the
Company. Deferred revenue is amortized into income over the estimated useful
life of the related equipment. As of December 31, 2008, deferred revenue was
$751,096. During the year 2008, $89,849 of income was recorded for the
amortization of deferred revenue. As of December 31, 2007, other receivables
included $239,861 and deferred revenue of $840,945 was recorded for equipment
grants. During the year ended December 31, 2007, $662,000 of cash was received
and $60,916 of income was recorded for the amortization of the deferred
revenue.




49




Note 4
-           Fair Value
Measures




The
Company has determined the fair value of certain assets through application of
SFAS No. 157, Fair Value
Measurements.




Fair
value of assets and liabilities measured at December 31, 2008 are as
follows:




Fair Value Measurements at
Reporting Date Using:




Quoted Prices In Active MarketsforFair Value
                            
                            
                            Identical Assets/Liabilities (Level1)December
      31, 2008:Available-for-sale
      securitiesCertificates
      of Deposit
                            
                            $
                            194,000
                            
                            
                            $
                            194,000United
      States Treasury Bills
                            
                            $
                            1,999,920
                            
                            
                            $
                            1,999,920




The
Company did not hold any securities for the year ended December 31,
2007.




There
were no gains or losses (realized and unrealized) included in earnings for the
periods reported in investment income.




Financial
assets and liabilities valued using level 1 inputs are based on unadjusted
quoted market prices within active market.




Note
5 — Property and Equipment




A summary
of property and equipment at December 31, 2008 and 2007is as
follows:





Estimated
                                      usefullife
                                    
                                    
                                    2008
                                    
                                    
                                    2007Asset
      deposit
                                    
                                    
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    -Leasehold
      improvements
                                    
                                    10
                                    
                                    
                                    
                                    105,888
                                    
                                    
                                    
                                    92,525Machinery
      & equipment
                                    
                                    3-22 years
                                    
                                    
                                    
                                    3,801,600
                                    
                                    
                                    
                                    2,382,749Less
      accumulated depreciation
                                    
                                    
                                    
                                    
                                    
                                    
                                    633,305
                                    
                                    
                                    
                                    356,022Net
                                    
                                    
                                    
                                    
                                    
                                    $
                                    3,274,183
                                    
                                    
                                    $
                                    2,119,252




Note
6 - Related Party Debt Financing





2007
Activity:




The
Company issued a total of 270,000 warrants against the 2006 loan agreement
executed with Mr. Averill during 2006 and has an obligation to issue an
additional 230,000 warrants from these loans through the November 2007 date of
extinguishment. In November 2007, the 2006 loan was subsequently extinguished in
exchange for the security provided under the Secured Bridge Loan program offered
during the fourth quarter of 2007. (See discussion of this loan under the
caption “Secured Bridge Loan Financing” below).




50




In August
2007, Mr. Averill loaned the Company an additional $460,000 earning interest at
a coupon rate of 12% per annum. The debt matures in two parts, with the $230,000
payable no later than September 30, 2007 and the final balance to be paid no
later than December 31, 2007. As additional consideration for this loan, Mr.
Averill is to receive a 3-year warrant to purchase 30,000 shares of common stock
upon loan inception, an additional 2,000 warrants for each business day between
the loan inception date and first repayment date, with the number of warrants
pegged to the first repayment not to exceed 42,000 warrants, and an additional
1,000 warrants for each business day between the date of first repayment and
second repayment date, with the number of warrants pegged to the second
repayment not to exceed 64,000 warrants. The Company repaid Mr. Averill $115,000
on September 28, 2007, from which he is to receive the maximum number of
warrants pegged to the first repayment date. On November 27, 2007 this loan was
subsequently extinguished in exchange for the security provided under the
Secured Bridge Loan program offered during the fourth quarter of 2007. The
Company has an obligation to issue an additional 64,000 warrants from these
loans through the November 27, 2007 extinguishment date. (See discussion of this
loan under the caption “Secured Bridge Loan Financing” below).




On
November 1, 2007, the Company borrowed an additional $267,900 from Robert
Averill. This amount was invested in anticipation of the Secured Bridge Loan
discussed below, earning interest at 14% per annum.




On
November 27, 2007, Mr. Averill and the Company entered into an agreement to
convert all outstanding debt obligations due and owing to Mr. Averill, into
obligations under the Secured Bridge Loan discussed below, extinguishing the
security interest Mr. Averill had in all of the assets of Axion Power Battery,
Inc. in exchange for the security provided under the Secured Bridge Loan. At the
time this indebtedness was converted, the Company owed Mr. Averill outstanding
principal plus interest amounting to $1,111,910 together with new borrowings of
$544,090 and $144,000 of loan origination fees recognized as a note discount,
resulting in Mr. Averill holding a note for $1,800,000 under the Secured Bridge
Loan financing. The loan has an original maturity of March 31, 2008, bears an
initial interest rate of 14% per annum, and is jointly secured, along with all
other investors in the Secured Bridge Loan, by all the assets including
intellectual property assets of the Company and its subsidiaries. As additional
consideration for this loan, Mr. Averill is to receive a warrant to purchase
61,290 shares of common stock. The warrants are exercisable for a period of five
years from loan inception at a price of $2.35 per share.




Mr.
Averill’s loan obligations specifically state that the warrant will be dated
three years from date of issue. Whereas none of these warrants were issued
during 2007, the expiration date on his warrants relating to both the 2006
carryover and the 2007 was not determined until 2008. In conjunction with this
loan obligation carried over from 2007, the Company satisfied the remainder of
its obligation to issue 366,000 warrants to Mr. Averill. Because of the delay in
processing, these 3 year warrants, exercisable at a price of $6.00, were issued
with an expiration date of March 31, 2011. Due to lower stock prices at the time
of modification, the modification of these instruments resulted in a net
decrease in fair value of these instruments.




In
October 2007, Igor Filipenko, a member of the Board of
Directors,  loaned the Company $115,000 under substantially the same
agreement as Mr. Averill’s loan agreement of August 2007. Mr. Filipenko earns
interest at a coupon rate of 12% per annum with a scheduled maturity of December
31, 2007. As additional consideration for this loan, Mr. Filipenko is to receive
a 3-year warrant to purchase 5,250 shares of common stock upon loan inception,
and an additional 500 warrants for each business day between the loan inception
date and repayment date. The number of warrants pegged to repayment is not to
exceed 26,500 warrants.  At the end of 2007, the Company had an
obligation to issue an additional 31,750 warrants from this loan upon
extinguishment on December 17, 2007. In conjunction with this loan obligation
carried over from 2007, the Company satisfied the remainder of its obligation to
issue 31,750 warrants to Mr. Filipenko. Because of the delay in processing,
these 3 year warrants, exercisable at a price of $6.00, were issued with an
expiration date of March 31, 2011. Due to lower stock prices at the time of
modification, the modification of these instruments resulted in a net decrease
in fair value of these instruments.  (See discussion of this loan under the
caption “Secured Bridge Loan Financing” below). (See discussion of this loan
under the caption “Secured Bridge Loan Financing” below).




51




In
December 2007, Mr. Filipenko elected to participate in the fourth quarter
short-term bridge loan arrangement whereby he converted his October loan of
$115,000, contributed an additional $92,000 in cash, and received a note
discount of $18,000 reflecting loan origination fees, resulting in Mr. Filipenko
holding a note for $225,000 under the Secured Bridge Loan. The loan has an
original maturity of March 31, 2008, bears an initial interest rate of 14% per
annum, and is jointly secured, along with all other investors in the Secured
Bridge Loan, by all the assets including intellectual property assets of the
Company and its subsidiaries. As additional consideration for this loan, Mr.
Filipenko is to receive a warrant to purchase 7,661 shares of common stock. The
warrants are exercisable for a period of five years from loan inception at a
price of $2.35 per share. (See discussion of this loan under the caption
“Secured Bridge Loan Financing” below).




In
December 2007, Glenn Patterson (HAP), a member of the Board of Directors,
contributed $92,000 in cash and received a note discount of $8,000 reflecting
loan origination fees by participating in the fourth quarter short-term bridge
loan arrangement offered by the Company. The loan has an original maturity of
March 31, 2008, bears an initial interest rate of 14% per annum, and is jointly
secured, along with all other investors in the Secured Bridge Loan, by all the
assets including intellectual property assets of the Company and its
subsidiaries. As additional consideration for this loan, Mr. Patterson is to
receive a warrant to purchase 3,405 shares of common stock. The warrants are
exercisable for a period of five years from loan inception at a price of $2.35
per share. (See discussion of this loan under the caption “Secured Bridge Loan
Financing” below).





2008
Activity:





The 2007
Bridge Loans had an original maturity date of March 31, 2008, with three
extensions of the maturity date at the option of the Company, with higher
interest rates to apply to each such extension.





On May
29, 2008, Glenn Patterson (HAP) converted $4,200 of his Bridge Loan into equity
under the same terms offered to Quercus discussed in Item 7 “Recent Financing
Activities” , with the $95,800 in principal repaid under the terms of the note
for the Bridge Loan. Mr. Patterson received 4,627 warrants valued at $3,990
utilizing the Black-Scholes-Merton option pricing model.





On June 30, 2008, Igor Filipenko was
repaid $225,000 in principal under the terms of the note for the Bridge
Loan.  Mr. Filipenko received 9,148 warrants valued at $9,768
utilizing the Black-Scholes-Merton option pricing model.





On June
30, 2008, Robert Averill, converted $800,000 under the same terms offered to
Quercus discussed in Item 7 “Recent Financing Activities”, with the $1,000,000
in principal repaid  on July 1, 2008 under the terms of the note for
the Bridge Loan.  Mr. Averill received 457,542 warrants valued at
$342,748 utilizing the Black-Scholes-Merton option pricing model.




Options and
Warrants: The loan agreements disclosed above provided for the aggregate
issuance of 484,278 common stock purchase warrants, with only 86,528 having been
issued as of December 31, 2007. We satisfied our obligation to issue the
remainder of 397,750 warrants in March 2008 by issue to two of our
directors.  As of December 31, 2007, the warrants due under these
agreements had been valued at 276,882 and recorded as a note discount. Note
discount of $154,201 had been amortized during the year ended December 31, 2007,
of which $152,884 relates to the warrant obligations under these 2007 loans.
$289,075 of unamortized debt discount relating to the 2007 obligations was
amortized during the 1st quarter
of 2008.  Because of the delay in processing, these 3 year warrants,
exercisable at a price of $6.00, the settlement warrants were issued with an
expiration date of March 31, 2011. Due to lower stock prices at the time of
modification, the modification of these instruments resulted in a net decrease
in fair value of these instruments. Decreases in fair value of embedded options
resulting from a modification should not be recognized and accordingly are not
reflected on the Company’s financial statements.




52




Secured Bridge
Loan Financing:In December 2007 the
Company offered certain of its directors, officers, and significant investors
the opportunity to participate in a short-term bridge loan arrangement in
increments of $100,000, each such loan to bear interest at 14% and to be secured
by all of the assets, including the intellectual property assets of Axion Power
International and Axion Power Battery Manufacturing Inc. (the “Secured Bridge
Loan”). Elections to participate must have been made no later than January 7,
2008, and if fully subscribed, the Secured Bridge Loan could result in up to
$3,000,000 in short-term funding for the Company.





Total
funding received under the Secured Bridge Loan as of December 31, 2007 amounted
to $2,541,216, with additional funding of $100,000 in January of 2008.
$2,125,000 was funded by three members of the Board of Directors, with the
balance funded by four accredited investors.





The
Bridge Loans had an original maturity date of March 31, 2008, with three
extensions of the maturity date at the option of the Company, with higher
interest rates to apply to each such extension. On March 31, 2008, we sent
notice to the investors of our intention to extend the loan until April 30,
2008. In accordance with the option terms contained in the loan agreement, three
of the investors chose to convert a total of $328,984 into equity under the same
terms offered to Quercus. One of these investors later rescinded his election,
opting for repayment. This resulted in a net conversion of $276,484 into equity
under the same terms offered to Quercus. The extension entitled the remaining
investors to earn an additional 1% extension fee based on the original loan
amount and interest at the annual rate of 15%. On April 29, 2008, we sent notice
to the investors of our intention to extend the loan until May 31, 2008. The
extension entitles investors to earn an additional 1% extension fee based on the
original loan amount and interest at the annual rate of 16%.  On May 29,
2008, a related party converted $4,200 of his Bridge Loan into equity under the
same terms offered to Quercus, with the balance repaid under the terms of the
note for the Bridge Loan. On May 30, 2008, we sent notice to the
remaining investors of our intentions to extend the loan until June 30,
2008. The interest rate during the extension period increased to 18% with an
extension fee equal to 2% of the original loan and an extension fee of 2% of the
original loan was paid to the holders of the Bridge Loans. A loan origination
fee was paid equal to 8% of the original loan. The origination fee decreased by
one-half percent each week after December 15, 2007 until the loan closed on
January 7, 2008. Warrants exercisable at $2.35 until December 31, 2012 are
included. For each $100,000 increment of the Bridge Loan, the
investors were issued warrants as follows: 3,405 warrants upon occurrence
of the secured bridge loan: 851 additional warrants upon the extension of the
loan to April 30, 2008; 1,276 additional warrants upon extension of the loan to
May 31, 2008 and 2,128 additional warrants upon extension of the loan to June
30, 2008. Typical anti-dilution provisions apply to the warrants as do piggyback
registration rights.





On June
30, 2008, a director, exercising his rights to convert under the same terms
converted $800,000 of indebtedness under the Bridge Loans into 380,952 shares of
common stock and warrants to purchase 380,952 shares of common stock at an
exercise price of $2.60 per share, such warrants will expire on June 29, 2013.
The remaining balance due, $1,235,028, of indebtedness from the Bridge Loans was
repaid on July  1, 2008 with a portion of the proceeds from the
Final Quercus Investment (as described below). The Bridge Loans have been fully
repaid or converted, and there is no remaining indebtedness under these
instruments.





Interest
Expense:Interest expense recognized for the year ended
December 31, 2008 in connection with certain notes payable to related parties
amounted to $1,137,485.  Of this total $277,045 relates to the
interest coupon and $860,443 to the amortization of note discount associated
with loan origination fees and detachable warrants.   The amounts
reported as interest expense-related party on the income statement include
payments to four accredited investors with certain associations to related
parties. Interest expense recognized for the year ended December 31, 2007 in
connection with these notes and related liabilities amounted to $276,651, of
which $117,058 relates to the amortization of the note discount for warrants
granted, $37,143 relates to the amortization of note discount reflected by the
Secured Bridge Loan’s origination fees, and the remainder relates to the stated
interest rate on the outstanding balance. In December 2007, loan origination
fees of $202,216 were recognized as note discounts related to funding received
in the fourth quarter on the Secured Bridge Loan. In January 2008, $7,500 in
origination fees were recognized as a note discount in connection with an
additional $92,500 of cash received for these notes. These note discounts are
being amortized as interest expense over the life of the respective
notes.




53




Note
7— Stockholders' Equity




Authorized
Capitalization: The Company’s authorized capitalization includes
100,000,000 shares of common stock and 12,500,000 shares of preferred stock.
This represents an increase in the number of authorized common shares from
50,000,000 pursuant to the Shareholder meeting vote on November 12,
2008.




Common
Stock:  At December 31, 2008, 26,417,437 shares of common stock were
issued and outstanding. The holders of common stock are entitled to one vote for
each share held of record on all matters to be voted on by stockholders. There
is no cumulative voting with respect to the election of directors, with the
result that the holders of more than 50% of the shares voted for the election of
directors can elect all of the directors. Holders of common stock are entitled
to receive dividends when and if declared by the board out of funds legally
available. In the event of liquidation, dissolution or winding up, the common
stockholders are entitled to share ratably in all assets remaining available for
distribution to them after payment of liabilities and after provision has been
made for each class of stock, if any, having preference over the common stock.
The common stockholders have no conversion, preemptive or other subscription
rights and there are no redemption provisions applicable to the common stock.
All of the outstanding shares of common stock are fully paid and
non-assessable.




Preferred
Stock: The Company’s certificate of incorporation authorizes the
issuance of 12,500,000 shares of blank check preferred stock. The Company’s
board of directors has the power to establish the designation, rights and
preferences of any preferred stock. Accordingly, the board of directors has the
power, without stockholder approval, to issue preferred stock with dividend,
liquidation, conversion, voting or other rights that could adversely affect the
voting power or other rights of the holders of common stock.





At
December 31, 2008, 137,500 shares of 8% Cumulative Convertible Senior Preferred
stock were issued and outstanding, and 718,997 shares of Series A Convertible
Preferred stock were issued and outstanding.




Equity
Transactions –period ended December 31, 2003




APC and
Tamboril Cigar Company (Tamboril, now Axion) reverse acquisition:In
December 2003 Tamboril entered into a reverse acquisition agreement with APC.
Under the terms of the agreement, all outstanding securities of APC were
acquired by Tamboril in exchange for newly issued stock. Upon consummation of
the transaction, the former stockholders of APC owned the majority of Tamboril’s
outstanding shares and controlled Tamboril’s Board of Directors. Accordingly,
the acquisition of APC by Tamboril was structured as a reverse acquisition under
which Tamboril was the legal acquirer in the transaction and APC was the
accounting acquirer. The transaction was treated as a recapitalization of APC
for accounting purposes. Tamboril had no material assets or liabilities and
1,875,000 common shares outstanding on December 31, 2003 when it entered into a
reverse acquisition with shareholders of APC. The historical financial
statements presented prior to December 31, 2003 represent those of APC since its
inception on September 18, 2003. The transactions of Tamboril are included
beginning January 1, 2004. Subsequently, Tamboril changed its name to Axion
Power International, Inc.




Prior to
the reverse acquisition, APC issued rights to its founders for 1,360,000 shares
of APC common stock as additional shares for money contributed through the
purchase of convertible debt. Accordingly, there was no expense recorded related
to these issuances of these shares. However, there was one founder that did not
contribute funds in which APC valued the 170,000 shares issued as expense for
services rendered during the period ending December 31, 2003 amounting to
$48,953 based on the value of the shares received for the funds contributed by
the other founders. The founders purchased convertible debt from APC for
$1,450,000 of which $350,000 was not collected until 2004 which is included as a
subscription receivable as of December 31, 2003. These convertible debt
instruments were converted prior to the merger in which 1,108,335 shares of APC
common stock were issued as consideration for $1,450,000 of convertible debt and
$92,761 in unamortized debt discount attributable to detachable
warrants.




54




The
following transactions were completed in conjunction with the original
closings:




·
            Tamboril
      had 1,875,000 shares of common stock outstanding at December 31, 2003
      which is reflected as equity acquired in the
    recapitalization.





·
            Tamboril
      settled $484,123 in pre-merger accrued related party compensation debt
      through the issuance of 233,400 warrants. No corresponding expense was
      recorded on the Company’s records because the debt was included on the
      legal acquirer’s (Tamboril’s) records prior to the reverse
      acquisition.





·
            Tamboril
      issued 9,785,818 common shares (prior to the return of 1,000,000 shares
      from The Trust for the Benefit of the Shareholders of Mega-C Power Corp in
      the fiscal year ended December 31, 2006, as disclosed in the note
      captioned “Subsequent Events”) and 608,600 warrants to APC’s stockholders
      in exchange for a substantial controlling interest in APC. This includes
      the common shares issued to the founders, common shares and warrants
      issued in conjunction with the convertible notes, and shares issued to the
      Mega C Trust.





·
            As
      part of the above described transaction, APC shareholders, who had rights
      to the stock agreed to have 7,147,483 shares of Tamboril shares to be
      issued to the Trust and APC shareholders retained the remaining shares. As
      a result of the November 21, 2006 Mega C Chapter 11 plan of
      reorganization, the Trust was required to return 1,000,000 shares of the
      common stock distributed to the Trust noted above for cancellation by the
      Company. The Company retroactively adjusted the return of the shares
      against the shares issued to the Trust resulting in 6,147,483 net shares
      issued to the Trust at December 31,
2003.





·
            The
      original reverse acquisition was amended on January 9, 2004. See
      discussion of the amendment under the explanation of the equity 2004
      below.





Equity
Transactions –period ended December 31, 2004




APC and
Tamboril Cigar Company (Tamboril, now Axion) reverse acquisition:Prior
to the second part of the reverse acquisition on January 9, 2004, the Company
adjusted the original shares issued to the founders by issuing rights to an
additional 445,000 shares to the founders and 180,000 shares to the Trust. Since
there was no additional service or money contributed there was no expense
recorded related to the additional shares issued. Also, the Company issued
45,000 shares to the CEO which amounted to $72,000 valued at the pink sheet bid
price on the date of grant. Certain related parties purchased convertible debt
from APC for $400,000. The $400,000 of convertible debt purchased during 2004
and the remaining $50,000 of convertible debt outstanding at December 31, 2003
was converted into 283,333 shares of APC common stock during 2004.




2004
Private Placements:During
the year ended December 31, 2004, the Company sold 823,800 shares of common
stock and 463,100 warrants for net cash proceeds of $1,607,134. The Company also
received $868,020 in cash proceeds from the exercise of 475,200 outstanding
common stock purchase warrants. The Company issued 48,782 shares of common stock
for rounding purposes in conjunction with the 2004 one-for-sixteen reverse stock
split.




Equity
Transactions –Year ended December 31, 2005




Augmentation
of Trust and Trust Settlement: In February 2005, the Company issued
500,000 shares of common stock to The Trust for the Benefit of the Shareholders
of Mega-C Power Corp. For accounting and financial reporting purposes, the stock
issuance transaction was valued at $1,525,000, which represents the value of the
shares on the date of issuance. This amount was charged to operating expenses
during the year ended December 31, 2005. There were 500,000 shares returned to
the Company for cancellation in November 2006 in connection with the bankruptcy
court confirmation of the settlement (see note captioned “Mega-C Power Corp
(Mega-C), Mega-CTrust (the Trust), The
Taylor Litigation”). Those shares were effectively the return of the 500,000
shares issued to the Trust in February, 2005. The return of those shares was
recorded as a reversal of the expense at fair value on the date of return in
2006 in the amount of $1,125,000 and has been subsequently cancelled. In
addition, under the bankruptcy court confirmation of the settlement, the Trust
corpus was reduced another 1,000,000 shares, which were returned to the Company
and cancelled. The return in 2006 was the result of a negotiated settlement and
there are no contingencies surrounding the Trust shares in 2005. This
cancellation was considered a retroactive adjustment to the shares issued in the
2003 reverse acquisition.




55




2005
Private Placement of Senior Preferred: In February 2005, the board of
directors designated 1,000,000 shares of preferred stock as 8% Cumulative
Convertible Senior Preferred Stock (the “senior preferred”). The Company sold
385,000 shares of senior preferred at a price of $10 per share. The net proceeds
of the offering included $2,754,110 in cash and $1,000,000 in liability
conversion (see Note captioned “Transactions with a Related Party (C&T)”).
At December 31, 2005, $25,000 of this amount was included in stock subscription
receivable that was subsequently reversed in 2006 when the amount was deemed
uncollectible. The senior preferred offering originally required the sale of a
minimum of 500,000 shares ($5,000,000) before the offering proceeds would be
available to the Company. The purchasers of the senior preferred ultimately
waived this minimum offering condition. The preferred stock has liquidation
preference equal to the stated value on the payment date before any payment or
distribution is made to the holders of common stock.




So long
as any senior preferred shares are outstanding, the Company cannot (i) issue any
series of stock having rights senior to or on parity with the senior preferred
(ii) amend, alter or repeal any provision of its Certificate of Incorporation or
bylaws to adversely affect the relative rights, preferences, qualifications,
limitations or restrictions of the senior preferred, or (iii) effect a
reclassification of the senior preferred without the consent of the holders of a
two-thirds majority of the outstanding shares. The Company is not authorized to
issue any additional shares of senior preferred.




To
provide for immediate cash needs during the offering period, the Company agreed
to issue warrants to any purchaser of senior preferred who agreed to loan the
Company the amount of the share proceeds until the $5 million minimum
subscription was reached. In connection therewith, the purchasers of $565,000 of
senior preferred agreed to release their subscription payments notwithstanding
the minimum subscription and other restrictions in the associated private
placement memorandum. As a result, the Company issued 282,500 warrants to those
purchasers. By March 2005, the $5 million minimum was still not met and the
Company agreed to issue 228,500 additional warrants to the purchasers of
$2,285,000 of senior preferred who agreed to waive the minimum subscription
requirement. The foregoing warrants are exercisable at a price of $2 per share,
and were to expire on March 21, 2007.Because the warrants
were detachable, granted in connection with the offering, immediately vested,
and exercisable at a price that was less than the reported fair market value of
the underlying common stock on the date of grant, the proceeds of the offering
were allocated between the senior preferred and the warrants based on the
relative fair value of each instrument. The assumed value of the senior
preferred was determined based on the fair value of the underlying common shares
and the fair value of the warrants was valued using the Black-Scholes-Merton
option pricing model. The proceeds allocated to the senior preferred amounted to
$3,440,268. The effective conversion price of the senior preferred was at a
price lower than the market price of the common stock at the date of the
issuance, resulting in a non-cash beneficial conversion feature of $2,315,482.
This beneficial conversion feature was immediately recognized as additional
non-cash dividends. On March 9, 2007 the Board of Directors unanimously agreed
to extend the life 476,000 $2.00 warrants issued in March 2005 to purchasers who
subscribed to the Senior Preferred private placement offering.





Holders
of senior preferred have the right to convert their shares into common stock at
any time, at an original conversion price of $2.00. The Company was required to
register the underlying shares by April 30, 2005. The shares were not registered
until June 2005 and as a result the conversion price was reduced to $1.86 per
share. This reduction in the conversion price resulted in an additional
beneficial conversion feature, valued at the fair value of the additional common
shares issuable as a result of the reduced conversion price, amounting to
$433,228.




56




Holders
of senior preferred are entitled to anti-dilution protection for certain
subsequent events, including the issuance of equity or debt securities that may
be converted into common stock at a conversion price that is less than the
conversion price of the senior preferred. As discussed in the note captioned
“Subsequent Events,” the Company sold approximately 823,000 shares of Series A
Preferred Stock that is convertible at a price of $1.25 per share. This stock
sale triggered the anti-dilution provisions of the senior preferred stock and
giving effect to all required adjustments, the adjusted conversion price of the
senior preferred is now $1.68 per share as of December 31, 2006.




In
September 2005, the Company offered all holders of preferred stock an early
conversion incentive that was approximately equivalent to one year’s anticipated
dividends on the preferred stock. While each share of senior preferred was
convertible into 5.5 shares of common stock when the Company offered the early
conversion incentive, 6 shares of common stock were issued for each share of
senior preferred converted during the incentive period. A total of 245,000
shares were converted. The fair value of the additional common shares issued as
a result of this inducement was recorded as a preferred dividend, amounting to
$350,446.




The total
of the beneficial conversion feature and conversion inducement for the year
ended December 31, 2005 that is included in preferred dividends on the
accompanying statement of operations amounted to $3,099,156. The Company
analyzed the embedded derivative conversion feature and the free standing
warrants issued in connection with the senior preferred and determined that the
instruments are equity instruments and accordingly, are not accounted for as
derivatives, requiring fair value accounting at each reporting
period.




Holders
of senior preferred are entitled to receive dividends at the annual rate of 8%.
Dividends are payable quarterly on the last day of March, June, September and
December of each year. Dividends are cumulative from the date of issuance and
payable to holders of record. In order to conserve available resources, the
Company did not pay cash dividends on the senior preferred in any quarter where
the Company reported a net loss. Any accrued dividends that are not paid in cash
will be added to the stated value of the senior preferred. Dividends accrued and
added to the stated value of the senior preferred during the year ended December
31, 2006 and 2005 amounted to $119,092 and $176,194, respectively.




The
senior preferred is redeemable by the Company under certain conditions unless
the holders elect to exercise their conversion rights prior to the redemption
date. Twenty percent of the senior preferred will become redeemable when the
market price of the Company’s common stock exceeds $6.00 per share for at least
30 trading days within any period of 45 consecutive trading days. Thereafter, an
additional twenty percent of the senior preferred will become redeemable for
each $1.00 increase in the stabilized market price of the Company’s common
stock. In connection with any proposed redemption of senior preferred, the
Company will give each holder not less than 30 days notice of its intention to
redeem a portion of the shares.





2005
Private Placement of Common Stock: Common stock private placement
activities during the year ended December 31, 2005 were as follows:




·
            The
      Company sold 600,000 units, each consisting of one share of common stock
      and a two-year warrant exercisable at $4.00 for a purchase price of $2.00
      per unit, or $1,200,000, before offering costs. As of December 31, 2005,
      $200,000 is included in stock subscriptions receivable, which was received
      in 2006.





·
            A
      director exercised 446,000 - $1 warrants/options and 25,000 - $2 options
      with a total exercise price of $496,000. The stock was issued and included
      in stock subscriptions receivable as of December 31, 2005. As of June 19,
      2006, the full amount has
  been settled.





·
            Other
      holders exercised 382,665 options & warrants with an aggregate
      exercise price of $787,395.




57




Equity
Transactions –Year ended December 31, 2006




Augmentation
of Trust and Trust Settlement: See above 2005 transactions and the
discussion in the note captioned “Mega-C Power Corp (Mega-C),Mega-CTrust (the Trust),
TheTaylor
Litigation” for disclosures about shares issued to the Trust, returned from the
Trust in November 2006 and the accounting for those shares.




Senior
Preferred: During 2006, a subscription for senior preferred shares was
cancelled, reducing the balance by 2,500 shares or $25,000. The senior preferred
had an initial stated value of $10.00 per share. Accrued dividends that are not
paid in cash within 10 days of a payment date will automatically be added to the
stated value and the stated value, as adjusted, will be used for all future
dividend and conversion calculations. The following table summarizes the
earnings through 2008 and the expected future stated value of the senior
preferred at the end of each quarter through December 31, 2009.




Quarter
                          Ended
                        
                        Adjusted Stated
                          Value
                        
                        Quarter
                          Ended
                        
                        Adjusted Stated
                          Value31-Mar-08
                        
                        $
                        12.72
                        
                        31-Mar-09
                        
                        $
                        13.7730-Jun-08
                        
                        $
                        12.97
                        
                        30-Jun-09
                        
                        $
                        14.0430-Sep-08
                        
                        $
                        13.23
                        
                        30-Sep-09
                        
                        $
                        14.3231-Dec-08
                        
                        $
                        13.50
                        
                        31-Dec-09
                        
                        $
                        14.61




2006 Private
Placement of Series A Preferred Stock:On October 18, 2006, the
Company’s board of directors designated, from the Company’s total authorized
12,500,000 shares, a new series of preferred stock consisting of up to 2,000,000
shares designated Series A Convertible Preferred Stock (the “series A
preferred”). During the fourth quarter of 2006, the Company sold an aggregate of
782,997 shares of series A preferred at a price of $10 per share for net
proceeds of $7,722,470 including $4,352,500 in cash and $3,369,970 in liability
conversion. In connection with the private placement, the Company incurred total
offering expenses of $258,202, of which $107,500 was paid in cash, while the
remainder was paid through the issuance of options to acquire shares of the
Company’s common stock.




Under the
terms of this new series of preferred stock, no more than 1,000,000 shares may
be sold for cash and the remaining shares must be reserved for (i) issuance
upon exercise of the conversion rights of holders of secured and unsecured
short-term debt and (ii) to pay in-kind dividends on the series A
preferred. So long as any series A preferred shares are outstanding, the Company
cannot (i) issue any series of stock having rights senior to or on parity with
the series A preferred (ii) amend, alter or repeal any provision of its
Certificate of Incorporation or bylaws to adversely affect the relative rights,
preferences, qualifications, limitations or restrictions of the series A
preferred (iii) effect a reclassification of the series A preferred or (iv)
issue any additional shares of series A preferred, each without the consent of
the holders of a two-thirds majority of the outstanding shares. The holders of
series A preferred have no pre-emptive rights with respect to any other
securities of the Company and a liquidation preference equal to the stated value
on the payment date before any payment or distribution is made to the holders of
common stock.





Beginning
on April 23, 2007, the shares of series A preferred shall be convertible at the
option of the holders of record at an initial conversion price of $1.25 per
share. Holders of series A preferred are entitled to anti-dilution protection
for certain subsequent events, including the issuance of equity or debt
securities that may be converted into common stock at a conversion price that is
less than the conversion price of the series A preferred resulting in a
reduction in the conversion price of the series A preferred. No such other
securities have been issued through the date of this report which would require
the reduction of the conversion price of the series A preferred. In addition,
the effective conversion price of the series A preferred was at a price lower
than the market price of the common stock at the respective dates of issuance in
the fourth quarter of 2006, resulting in an aggregate non-cash beneficial
conversion feature of $6,709,970 recognized as additional non-cash dividends on
a straight line basis, which did not differ materially from the effective
interest method, from the respective dates of issuance of the series A preferred
in the fourth quarter of 2006 through the first date these shares are
convertible on April 23, 2007. As a result, $613,336 was recognized as
additional non-cash dividends in the fourth quarter of 2006 with the remaining
amount recognized in 2007. In addition, if all holders of the series A preferred
were to have exercised their conversion rights at their respective dates of
subscription, these holders would have received an additional $5,597,970 in fair
value in excess of the proceeds paid for their subscriptions to the series A
preferred. The Company further analyzed the embedded conversion feature and
determined that it is properly classified as an equity instrument and
accordingly, is not accounted for as a derivative, requiring fair value
accounting at each reporting period.




58




Holders
of the shares of series A preferred shall receive dividends at the annual rate
of 10% of the stated value of the series A preferred so long as the Company is
current with respect to its reporting obligations under the Securities Exchange
Act of 1934 on any dividend payment date. Dividends are payable quarterly on the
last day of March, June, September and December in each year. Dividends are
cumulative from the date of issuance and payable to holders of record. Any
accrued dividends that are not paid in cash will be added to the stated value of
the series A preferred.




Because
the Company was not current with respect to its reporting obligations through
December 31, 2007, the series A preferred annual dividend rate increased to 20%
of the stated value. All but one of the series A preferred shareholders elected
to reinvest their preferred dividends back into series A preferred shares. As of
December 31, 2006, $103,101 of dividends has been accrued, including $97,896 in
non-cash and $5,205 in cash dividends. No cash dividends have been paid with
respect to the series A preferred shares. Non-cash dividends have increased the
value of the series A preferred shares by $0.13 to a stated value of $10.13 as
of December 31, 2006.




The
series A preferred had an initial stated value of $10.00 per share. Non-cash
dividends are automatically added to the stated value and the stated value, as
adjusted, will be used for all future dividend and conversion calculations. The
following table summarizes the earnings through 2008 and the expected future
stated value of the series A preferred at the end of each quarter through
December 31, 2009.




Quarter
                      Ended
                    
                    Adjusted Stated
                      Value
                    
                    Quarter
                      Ended
                    
                    Adjusted Stated
                      Value31-Mar-08
                    
                    $
                    12.61
                    
                    31-Mar-09
                    
                    $
                    13.9230-Jun-08
                    
                    $
                    12.93
                    
                    30-Jun-09
                    
                    $
                    14.2630-Sep-08
                    
                    $
                    13.25
                    
                    30-Sep-09
                    
                    $
                    14.6231-Dec-08
                    
                    $
                    13.58
                    
                    31-Dec-09
                    
                    $
                    14.99




The
series A preferred is redeemable by the Company under certain conditions unless
the holders elect to exercise their conversion rights prior to the redemption
date. Twenty percent of the series A preferred will become redeemable when the
market price of the Company’s common stock exceeds $5.00 per share for at least
30 trading days within any period of 45 consecutive trading days. Thereafter, an
additional twenty percent of the series A preferred will become redeemable for
each $2.50 increase in the stabilized market price of the Company’s common
stock. In connection with any proposed redemption of series A preferred, the
Company will give each holder not less than 30 days notice of its intention to
redeem a portion of the shares.





Common
Stock & Private Placements.  The common stock transactions
during the year ended December 31, 2006 are as follow:




·
            Two
      unaffiliated individual accredited investors purchased a total of 80,000
      units for a purchase price of $2.50 per unit or $200,000.   Each unit
      consists of one share of common stock and one common stock purchase
      warrant with an exercise price of $4.00 per share. The warrants are
      exercisable up until the first anniversary of the effective date of the
      common stock registration statement and were valued at $26,354 on the date
      of issuance




59




·
            The
      Company’s chief executive officer exercised his $2.00 warrants to purchase
      56,700 shares for $113,400





·
            The
      Company’s Chief Technical Officer received 6,000 unrestricted shares,
      valued at $24,000, pursuant to his 2005 employment contract and an
      additional 250,000 restricted shares, valued at $937,500, pursuant to his
      2006 employment contract. The 250,000 shares will become fully vested on
      December 28, 2009. The expense related to these shares will be recognized
      over this three-year requisite service period and the shares will be
      considered issued and outstanding upon
vesting.




Subscriptions
Receivable: The balance sheet as of December 31, 2005 reflected $721,000
in subscriptions receivable. During the year ended December 31, 2006, the
Company received subscription payments of $588,900, settled $107,100 against
open invoices for legal services, and cancelled the unsettled balance of the
subscription receivable for preferred stock amounting to $25,000,




Warrants:741,613 warrants were
issued to related parties in conjunction with the financing of debt issued
during 2006. See the “Related Party” footnote within ‘Debt Financing “above. In
April, 2006, the Company’s chief executive officer exercised his $2.00 warrants
to purchase 56,700 shares for $113,400. In October 2006,
200,000 3-year warrants were issued in payment for consulting services. These
$3.00 warrants valued at $74,437 are scheduled to expire in October 2009. In
December 2006, a former director of the Company received 9,000 $6.00 warrants
valued at $12,411, and are scheduled to expire December 29, 2010. Additionally,
80,000 warrants were issued to accredited investors in connection with a private
placement of units comprised of one share of the Company’s common stock and one
stock purchase warrant, as discussed above.




On June
9, 2006 the Board of Directors extended the life of 1,562,900 warrants issued to
the original shareholders of C&T along with 91,700 capital warrants issued
to Sally Fonner in recognition of the Company’s difficulty in establishing a
public trading market for its common stock. These $2 warrants scheduled to
expire in 2006 and early 2007 were modified to a December 31, 2007 expiration.
The warrants, valued at $521,642 prior to the extension, were revalued at the
date of modification using the Black-Scholes-Merton option-pricing model. The
incremental expense in 2006 resulting from the revaluations was recorded into
R&D ($342,131) and SG&A ($50,680).




Equity
Transactions –Year ended December 31, 2007





Senior
Preferred: At December 31, 2007, 137,500 shares of 8% Cumulative
Convertible Senior Preferred stock were issued and outstanding. As of December
31, 2007 $425,852 in dividends has been accrued to cover the Company’s
obligations with regard to the 8% Cumulative Convertible Senior Preferred stock.
No cash dividends have been paid with respect to these shares. Non-cash
dividends have increased the value of the Senior Preferred shares by $2.72 to a
stated value of $12.72 per share.




Series A
Preferred: 782,997 shares of Series A Preferred were issued during 2006.
In January 2007, the Company sold 40,000 additional shares of Series A Preferred
to accredited investors for gross cash proceeds of $400,000. On the date of
issuance, the effective conversion price of the Series A Preferred was at a
price lower than the market price of the common stock resulting in a non-cash
beneficial conversion feature of $400,000 recognized as additional non-cash
dividends on a straight line basis through the first date these shares are
convertible, being April 23, 2007. This straight line calculation did not differ
materially from the effective yield method. With the 2007 subscription, the
aggregate non-cash beneficial conversion feature attributable to the Series A
Preferred shares is valued at $7,109,970. $613,336 was recognized as additional
non-cash dividends in the fourth quarter of 2006, with the remaining balance of
$6,496,634 recognized as additional non-cash dividends during the year ending
December 31, 2007. Beginning on April 23, 2007, the shares of Series A Preferred
became convertible at the option of the holders of record at an initial
conversion of $1.25 per share. The conversion price is subject to adjustment if
Axion issues any shares less than the then existing conversion
price.




60




The
holders of the shares of Series A Preferred receive dividends at the annual rate
of 20% of the Stated Value of the Series A Preferred so long as the Company is
behind with respect to its reporting obligations under the Securities Exchange
Act of 1934 on any dividend payment date. Once the company is current with
respect to these reporting obligations, the dividend rate will be reduced to an
annual rate of 10% of the Stated Value. As of December 31, 2007, $1,893,855 in
dividends has been accrued. No cash dividends have been paid with respect to the
Series A Preferred shares. Non-cash dividends have increased the value of Series
A Preferred shares by $3.46 to a stated value of $13.46 per share. As of
December 31, 2007, 822,997 shares of Series A Convertible Preferred stock were
issued and outstanding.




Equity
Transactions –Year ended December 31, 2008





Senior
Preferred: At December 31, 2008, 137,500 shares of 8% Cumulative
Convertible Senior Preferred stock were issued and outstanding. As of December
31, 2008, $567,181 in dividends has been accrued to cover the Company’s
obligations with regard to the 8% Cumulative Convertible Senior Preferred stock.
No cash dividends have been paid with respect to these shares. Non-cash
dividends have increased the value of the Senior Preferred shares by $3.50 to a
stated value of $13.50 per share.




Series A
Preferred: With the Company becoming current with respect to its
reporting obligations under the Securities Exchange Act of 1934, the dividend
rate on its Series A Preferred reduced to an annual rate of 10% of the Stated
Value. During the year ended December 31, 2008, 104,000 Series A Preferred
shares along with accrued dividends of $298,875 were converted into 1,071,099
common shares. As of December 31, 2008, $2,571,321in dividends have been
accrued. No cash dividends have been paid with respect to the Series A Preferred
shares. Non-cash dividends have increased the value of Series A Preferred shares
by $3.58 to a stated value of $13.58 per share. As of December 31, 2008, 718,997
shares of Series A Convertible Preferred stock were issued and
outstanding.





Common Stock
Issuances:The
following table represents per share issuances of common stock from inception
through December 31, 2008, pursuant to FASB No. 7, “Development Stage
Enterprises”:




2003Description:
                                            
                                            Date
                                            
                                            Shares
                                            
                                            Per share
                                              valuation
                                            
                                            Business reason:Shares
      issued to founders
                                            
                                            9/18/2003
                                            
                                            
                                            1,360,000
                                            
                                            $
                                            0.00
                                            
                                            
                                            original
      capitalization-no contributed capitalAPC
      Founder
                                            
                                            9/18/2003
                                            
                                            
                                            170,000
                                            
                                            $
                                            0.29
                                            
                                            
                                            services
      rendered with respect to formationSeed
      debt financing
                                            
                                            12/31/2003
                                            
                                            
                                            500,000
                                            
                                            $
                                            1.00
                                            
                                            
                                            conversion
      of debt and accrued interest to common stockSeries
      I convertible debt
                                            
                                            12/31/2003
                                            
                                            
                                            533,334
                                            
                                            $
                                            1.50
                                            
                                            
                                            conversion
      of debt and accrued interest to common stockSeries
      II convertible debt
                                            
                                            12/31/2003
                                            
                                            
                                            75,000
                                            
                                            $
                                            2.00
                                            
                                            
                                            conversion
      of debt and accrued interest to common stockMega-C
      Trust
                                            
                                            12/31/2003
                                            
                                            
                                            6,147,484
                                            
                                            $
                                            0.00
                                            
                                            
                                            In
      lieu of shares issuable to foundersTamboril
      shareholders
                                            
                                            12/31/2003
                                            
                                            
                                            1,875,000
                                            
                                            $
                                            0.00
                                            
                                            
                                            recapitalization
      measured at fair market value of Tamboril assets2003
      Totals
                                            
                                            
                                            
                                            
                                            10,660,818
                                            
                                            $
                                            0.14




61




2004Description:
                                                                
                                                                Date
                                                                
                                                                Shares
                                                                
                                                                Per share
                                                                  valuation
                                                                
                                                                Business reason:Shares
      issued to founders
                                                                
                                                                1/9/2004
                                                                
                                                                
                                                                445,000
                                                                
                                                                $
                                                                0.00
                                                                
                                                                
                                                                In
      lieu of shares issuable to foundersMega-C
      Trust
                                                                
                                                                1/9/2004
                                                                
                                                                
                                                                180,000
                                                                
                                                                $
                                                                0.00
                                                                
                                                                
                                                                adjustment
      is shares issuable to foundersOfficer
                                                                
                                                                1/9/2004
                                                                
                                                                
                                                                45,000
                                                                
                                                                $
                                                                1.60
                                                                
                                                                
                                                                services
      rendered by former officerSeries
      I convertible debt-Igor Filipenko
                                                                
                                                                1/9/2004
                                                                
                                                                
                                                                50,000
                                                                
                                                                $
                                                                1.00
                                                                
                                                                
                                                                conversion
      of debt and accrued interest to common stockSeries
      II convertible debt-Turitella
                                                                
                                                                1/9/2004
                                                                
                                                                
                                                                133,333
                                                                
                                                                $
                                                                1.50
                                                                
                                                                
                                                                conversion
      of debt and accrued interest to common stockSeries
      III convertible debt-Turitella
                                                                
                                                                1/9/2004
                                                                
                                                                
                                                                100,000
                                                                
                                                                $
                                                                2.00
                                                                
                                                                
                                                                conversion
      of debt and accrued interest to common stockSeries
      II common stock offering
                                                                
                                                                2/1/2004
                                                                
                                                                
                                                                175,000
                                                                
                                                                $
                                                                2.00
                                                                
                                                                
                                                                common
      stock & warrants issued for cashSeries
      III common stock offering
                                                                
                                                                3/31/2004
                                                                
                                                                
                                                                288,100
                                                                
                                                                $
                                                                3.00
                                                                
                                                                
                                                                common
      stock & warrants issued for cashExercise
      of Series I warrants
                                                                
                                                                various
                                                                
                                                                
                                                                316,700
                                                                
                                                                $
                                                                1.50
                                                                
                                                                
                                                                warrants
      exercised pursuant to original termsExercise
      of Series II warrants
                                                                
                                                                various
                                                                
                                                                
                                                                125,000
                                                                
                                                                $
                                                                2.28
                                                                
                                                                
                                                                warrants
      exercised pursuant to original termsExercise
      of Series II warrants
                                                                
                                                                various
                                                                
                                                                
                                                                33,500
                                                                
                                                                $
                                                                3.23
                                                                
                                                                
                                                                warrants
      exercised pursuant to original termsNovember
      emergency funding
                                                                
                                                                11/1/2004
                                                                
                                                                
                                                                314,000
                                                                
                                                                $
                                                                1.50
                                                                
                                                                
                                                                common
      stock & warrants issued for cashDecember
      emergency funding
                                                                
                                                                12/1/2004
                                                                
                                                                
                                                                46,700
                                                                
                                                                $
                                                                1.50
                                                                
                                                                
                                                                common
      stock & warrants issued for cashFractional
      shareholders
                                                                
                                                                12/31/2004
                                                                
                                                                
                                                                48,782
                                                                
                                                                $
                                                                0.00
                                                                
                                                                
                                                                shares
      issued due to reverse split rounding formula2004
      Totals
                                                                
                                                                
                                                                
                                                                
                                                                2,301,115
                                                                
                                                                $
                                                                1.37




62




2005Description:
                                                
                                                Date
                                                
                                                Shares
                                                
                                                Per share
                                                  valuation
                                                
                                                Business reason:Mega-C
      Trust
                                                
                                                2/28/2005
                                                
                                                
                                                500,000
                                                
                                                $
                                                3.05
                                                
                                                
                                                Trust
      augmentationBanca
      di Unionale
                                                
                                                3/18/2005
                                                
                                                
                                                30,000
                                                
                                                $
                                                2.00
                                                
                                                
                                                conversion
      of Preferred and accrued dividendsBanca
      di Unionale
                                                
                                                4/20/2005
                                                
                                                
                                                20,000
                                                
                                                $
                                                2.00
                                                
                                                
                                                conversion
      of Preferred and accrued dividendsC&T
      employees
                                                
                                                4/1/2005
                                                
                                                
                                                219,000
                                                
                                                $
                                                2.50
                                                
                                                
                                                employee
      incentive share grants7
      individuals
                                                
                                                6/10/2005
                                                
                                                
                                                29,565
                                                
                                                $
                                                3.57
                                                
                                                
                                                Exercise
      of Director options3
      individuals
                                                
                                                7/11/2005
                                                
                                                
                                                190,000
                                                
                                                $
                                                1.58
                                                
                                                
                                                conversion
      of Preferred and accrued dividendsBanca
      di Unionale
                                                
                                                7/11/2005
                                                
                                                
                                                10,000
                                                
                                                $
                                                1.60
                                                
                                                
                                                exercise
      of preferred warrants3
      individuals
                                                
                                                8/28/2005
                                                
                                                
                                                150,000
                                                
                                                $
                                                1.67
                                                
                                                
                                                conversion
      of Preferred and accrued dividendsJames
      Smith
                                                
                                                9/7/2005
                                                
                                                
                                                30,000
                                                
                                                $
                                                1.67
                                                
                                                
                                                conversion
      of Preferred and accrued dividends2
      individuals
                                                
                                                9/28/2005
                                                
                                                
                                                1,050,000
                                                
                                                $
                                                1.69
                                                
                                                
                                                conversion
      of Preferred and accrued dividends2
      individuals
                                                
                                                various
                                                
                                                
                                                226,900
                                                
                                                $
                                                1.79
                                                
                                                
                                                exercise
      of Series I warrants3
      individuals
                                                
                                                various
                                                
                                                
                                                91,200
                                                
                                                $
                                                2.40
                                                
                                                
                                                exercise
      of Series III warrants2
      individuals
                                                
                                                various
                                                
                                                
                                                25,000
                                                
                                                $
                                                1.60
                                                
                                                
                                                exercise
      of Preferred warrantsOfficer
                                                
                                                10/20/2005
                                                
                                                
                                                446,000
                                                
                                                $
                                                1.00
                                                
                                                
                                                exercise
      of warrants and optionsOfficer
                                                
                                                10/20/2005
                                                
                                                
                                                25,000
                                                
                                                $
                                                2.00
                                                
                                                
                                                exercise
      of warrants6
      individuals
                                                
                                                12/1/2005
                                                
                                                
                                                600,000
                                                
                                                $
                                                2.00
                                                
                                                
                                                common
      stock and warrants2005
      Totals
                                                
                                                
                                                
                                                
                                                3,642,665
                                                
                                                $
                                                1.94




63




20062
      individuals
                                        
                                        4/21/06
                                        
                                        
                                        80,000
                                        
                                        
                                        2.50
                                        
                                        
                                        Common
      stock and warrants issued for cashOfficer
                                        
                                        4/21/06
                                        
                                        
                                        56,700
                                        
                                        
                                        2.00
                                        
                                        
                                        Exercise
      of non-plan incentive option granted to CEOOfficer
                                        
                                        4/21/06
                                        
                                        
                                        6,000
                                        
                                        
                                        4.00
                                        
                                        
                                        Unrestricted
      share grant to CTOMega-C
      Trust
                                        
                                        11/28/06
                                        
                                        
                                        (500,000
                                        )
                                        
                                        2.25
                                        
                                        
                                        Return
      of shares per settlement agreement2006
      Totals
                                        
                                        
                                        
                                        
                                        (357,300
                                        )
                                        $
                                        2.20





2007Officer
                                        
                                        12/01/07
                                        
                                        
                                        1,000
                                        
                                        
                                        2.30
                                        
                                        
                                        Unrestricted
      share grant to VP Mfg Engineering2007
      Totals
                                        
                                        
                                        
                                        
                                        1,000
                                        
                                        $
                                        2.30





2008





Officer
                                                                                                                                          
                                                                                                                                          01/01/08-12/01/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          12,000
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          1.85
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Unrestricted
      share grant to VP Mfg EngineeringQuercus
      Trust
                                                                                                                                          
                                                                                                                                          1/14/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          1,904,762
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          2.15
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Common
      stock and warrants issued for cashIndividual
                                                                                                                                          
                                                                                                                                          3/31/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          106,659
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          2.30
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Conversion
      of bridge loan and accrued interestQuercus
      Trust
                                                                                                                                          
                                                                                                                                          4/08/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          1,904,762
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          2.25
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Common
      stock and warrants issued for cashIndividual
                                                                                                                                          
                                                                                                                                          4/21/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          25,000
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          2.30
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Conversion
      of bridge loan and accrued interestIndividual
                                                                                                                                          
                                                                                                                                          5/06/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          508,512
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          2.10
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Conversion
      of Series A Preferred Shares and accrued dividendsDirector
                                                                                                                                          
                                                                                                                                          5/29/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          2,000
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          2.10
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Conversion
      of bridge loan and accrued interestQuercus
      Trust
                                                                                                                                          
                                                                                                                                          6/30/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          4,761,905
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          1.78
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Common
      stock and warrants issued for cashDirector
                                                                                                                                          
                                                                                                                                          6/30/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          380,952
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          1.78
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Conversion
      of bridge loan and accrued interestIndividual
                                                                                                                                          
                                                                                                                                          8/20/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          520,787
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          1.79
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Conversion
      of Series A Preferred Shares and accrued dividendsIndividual
                                                                                                                                          
                                                                                                                                          9/11/08
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          41,800
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          1.75
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          Conversion
      of Series A Preferred Shares and accrued dividends2008
      Totals
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          10,169,139
                                                                                                                                          
                                                                                                                                          
                                                                                                                                          $
                                                                                                                                          1.94




64




Warrants: The
following table provides summary information on warrants outstanding as of
December 31, 2008.. The table provides summary information on the various
warrants issued by the Company in private placement transactions; the warrants
exercised to date; the warrants that are presently exercisableand the current exercise
prices of such warrants.




2008
                  
                  
                  2007Shares
                  
                  
                  Weighted Average
                    Exercise price
                  
                  
                  Shares
                  
                  
                  Weighted Average
                    Exercise priceWarrants
      outstanding January 1
                  
                  
                  2,588,391
                  
                  
                  $
                  4.39
                  
                  
                  
                  3,761,213
                  
                  
                  $
                  3.21Granted
      during year
                  
                  
                  12,163,881
                  
                  
                  
                  2.6
                  
                  
                  
                  484,278
                  
                  
                  $
                  5.35Exercised
                  
                  
                  -
                  
                  
                  
                  0.00
                  
                  
                  
                  -
                  
                  
                  
                  0.00Lapsed
                  
                  
                  (473,500
                  )
                  
                  
                  2.00
                  
                  
                  
                  (1,657,100
                  )
                  
                  $
                  2.00Outstanding
      at December 31
                  
                  
                  14,278,772
                  
                  
                  $
                  2.94
                  
                  
                  
                  2,588,391
                  
                  
                  $
                  4.39Weighted
      average years remaining
                  
                  
                  3.9
                  
                  
                  
                  
                  
                  
                  
                  2.10





On March
9, 2007 the Board of Directors unanimously agreed to extend the life 476,000
$2.00 warrants issued in March 2005 to purchasers who subscribed to the Senior
Preferred private placement offering. These warrants, originally scheduled to
expire on March 17, 2007 were modified to March 17, 2008, so that the holders of
these warrants would have a reasonable opportunity to realize the benefit of
their original bargain.  The warrants, valued at $381,832 prior to the
extension, were revalued at the date of modification using the
Black-Scholes-Merton option-pricing model. The incremental expense resulting
from the revaluations was recorded as preferred dividends during the first
quarter of 2007 in the amount of $164,179.




Registration
Rights




General:
The Company filed a resale registration statement for the shares of common stock
held by the Mega-C Trust. See the discussion in the note titled “Mega-C Power
(Mega-C), Mega-C Trust (the Trust), The Taylor Litigation.”




Senior
Preferred: The
Company registered the resale of the shares of common stock issuable upon
conversion of the senior preferred and was required to maintain an effective
registration statement until September 18, 2006, the 18-month anniversary of the
closing date of the preferred stock offering. In the event that the current
registration statement was subsequently terminated, withdrawn or suspended for a
period of more than 10 days, then the conversion price of the senior preferred
was to be decreased by an initial delay adjustment of three percent (3%), plus
an additional delay adjustment of two percent (2%) for every thirty day period
(or portion thereof) that the underlying common stock is not subject to and
included in an effective registration statement. The holders of senior
preferred, or common stock issued upon conversion thereof, also have certain
piggy-back registration rights with respect to future offerings. The
registration statement included Axion’s Financial Statements for the period
ended June 30, 2005 and the financial statements became out of date. Axion did
not terminate, withdraw or suspend the registration statement. The Company
believes that the financial statements going out of date is not enough to
reactivate the registration delay provisions of the Senior Preferred
Stock.




Series A
Preferred: The
Company is required to file a registration statement within 180 days after the
initial closing of the offering and use its best efforts to maintain its
effectiveness for two years subsequent to the date it is declared effective. If,
at any time after the issuance of the series A preferred, the Company files a
registration statement for a proposed public offering of common stock, then
holders of the series A preferred will be able to participate in that offering
as selling shareholders.




65




Warrants: The Company has registered
the resale of the shares of common stock issuable upon exercise of all warrants
that were issued and outstanding in June 2005 and is required to maintain an
effective registration statement until the expiration dates of the warrants. It
is also obligated to file a resale registration statement for the warrants
issued after June 2005. The recently issued warrants generally provide that they
will be exercisable for terms of two to three years after the effective date of
the required registration statements. However there are no cash penalties or
exercise price adjustments associated with registration delays.




During
2006 and 2007, as a response to substantial unanticipated registration delays,
the Company extended the expiration dates of certain warrants that were issued
in 2003, 2004 and 2005. Under the extensions, which presently expire in December
2007 and March 2008, the Company has retained the right to redeem the warrants
at a price of $.01 per warrant if the underlying stock has been included in an
effective registration statement under the Securities Act and has traded at an
average bid price of $4 per share or more for at least 30 days before the call
for redemption. The accounting treatment for the modifications is discussed
above.





Note
8 - Equity Compensation




In
December 2004, the Financial Accounting Standards Board issued FASB 123R, “Share-Based Payment” (FASB
123R). FASB 123R supersedes FASB 123, “Accounting for Stock Based
Compensation,” and Accounting Principles Board Opinion 25, “Accounting for Stock Issued to
Employees” (APB 25) and its related implementation guidance. On January
1, 2006, the Company adopted the provisions of FASB 123R using the modified
prospective transition method. Under this method, compensation expense is
recorded for all stock based awards granted after the date of adoption and for
the unvested portion of previously granted awards that remain outstanding as of
the beginning of the adoption. Prior periods have not been restated for the
effects of FASB 123R. Under FASB 123R, employee-compensation expense related to
stock based payments are recorded over the requisite service period based on the
grant date fair value of the awards.




Prior to
the adoption of FASB 123R, the Company accounted for employee stock options
using the intrinsic value method in accordance with APB 25. Accordingly, no
compensation expense was recognized for stock options issued to employees as
long as the exercise price was greater than or equal to the market value of the
common stock at the date of grant. In accordance with FASB 123, the Company
disclosed the summary of pro forma effects to reported net loss as if the
Company had elected to recognize compensation costs based on the fair value of
the awards at the grant date.




The
Company’s accounting policy for equity instruments issued to consultants and
vendors in exchange for goods and services follows the provisions of EITF 96-18,
“Accounting for Equity
Instruments That are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services” and EITF 00-18 “Accounting
Recognition for Certain Transactions Involving Equity Instruments Granted to
Other Than Employees.” The measurement date for fair value of the equity
instruments is determined by the earlier of (i) the date at which commitment for
performance by the vendor or consultant is reached or (ii) the date at which the
consultant or vendor’s performance is complete. In the case of equity
instruments issued to consultants, the fair value of the equity instrument is
recognized over the term of the consulting agreement.




The
compensation cost that has been charged against income for options granted under
the plans was $425,979 for the year ended December 31, 2008. The impact of these
expenses to basic and diluted loss per share was approximately $0.02 per share
during the year. For stock options issued as non-qualified stock options, a tax
deduction is not allowed until the options are exercised. The amount of this
deduction will be the difference between the fair value of the Company’s common
stock and the exercise price at the date of exercise. Accordingly, there is a
deferred tax asset recorded for the tax effect of the financial statement
expense recorded. The tax effect of the income tax deduction in excess of the
financial statement expense will be recorded as an increase to additional
paid-in capital. Due to the uncertainty of the Company’s ability to generate
sufficient taxable income in the future to utilize the tax benefits of the
options granted, the Company has recorded a valuation allowance to reduce gross
deferred tax assets to zero. As a result, for the year ended December 31, 2008,
there is no income tax expense impact from recording the fair value of options
granted. There is no tax deduction allowed by the Company for incentive stock
options.




66




The
Company has two stockholder approved equity compensation plans and occasionally
enters into employment and other contracts that provide for equity compensation
arrangements other than those contemplated by the stockholder approved plans.
The following sections summarize the Company’s equity compensation
arrangements.




Incentive Stock
Plan Approved by Stockholders: The Company’s stockholders have adopted an
incentive stock plan for the benefit of its employees, consultants and advisors.
Under the terms of the original plan, the Company was authorized to grant
incentive awards for up to 1,000,000 shares of common stock. At the Company’s
2005 annual meeting, its shareholders increased the authorization under the
incentive stock plan to 2,000,000 shares.




The
incentive stock plan authorizes a variety of awards including incentive stock
options, non-qualified stock options, shares of restricted stock, shares of
phantom stock and stock bonuses. In addition, the plan authorizes the payment of
cash bonuses when a participant is required to recognize income for federal
income tax purposes because of the vesting of shares of restricted stock or the
grant of a stock bonus.





The plan
authorizes the grant of incentive awards to full-time employees of the Company
who are not eligible to receive awards under the terms of their employment
contract or another specialty plan. The plan also authorizes the grant of
incentive awards to directors who are not eligible to participate in the
Company’s outside directors’ stock option plan, independent agents, consultants
and advisors who have contributed to the Company’s success.




The
compensation committee administers the plan. The committee has absolute
discretion to decide which employees, consultants and advisors will receive
incentive awards, the type of award to be granted and the number of shares
covered by the award. The committee also determines the exercise prices,
expiration dates and other features of awards.




The
exercise price of incentive stock options must be equal to the fair market value
of such shares on the date of the grant or, in the case of incentive stock
options granted to the holder of more than 10% of the Company’s common stock, at
least 110% of the fair market value of such shares on the date of the grant. The
maximum exercise period for incentive stock options is ten years from the date
of grant, or five years in the case of an individual who owns more than 10% of
the Company’s common stock. The aggregate fair market value determined at the
date of the option grant, of shares with respect to which incentive stock
options are exercisable for the first time by the holder of the option during
any calendar year, shall not exceed $100,000.




The
following awards have been granted under the Plan since its
inception:




In
February 2004, Igor Filipenko, a Director of the Company, was granted options to
purchase 6,300 shares of common stock at a price of $3.20 per share. In June
2004, Mr. Filipenko was granted options to purchase 10,800 shares of common
stock at a price of $5.60 per share. The options are fully vested and may be
exercised at any time during the five-year period commencing one year after the
date of grant. The market value of the Company stock at the date of grant was
less than the exercise price; therefore there was no intrinsic value in
accordance with APB 25. Options for 7,200 shares were cancelled in April 2005
after Mr. Filipenko was issued additional options in March 2005 as part of the
offering to the former employees of C&T discussed below.




In
February 2004, John Petersen, a Director of the Company (and general corporate
counsel), and Kirk Tierney, each were granted options to purchase 6,300 shares
of common stock at a price of $3.20 per share. In June 2004, Messrs. Petersen
and Tierney were each granted options to purchase 3,600 shares of common stock
at a price of $5.60 per share. The options are fully vested and may be exercised
at any time during the five-year period commencing one year after the date of
grant. The market value of the Company stock at the date of grants was less than
the exercise price; therefore there was no intrinsic value in accordance with
APB 25.




67




In
February 2004, an advisor to the board was granted an option to purchase 6,300
shares of common stock at a price of $3.20 per share as compensation for
services. In June 2004, Mr. the advisor was granted options to purchase 3,600
shares of common stock at a price of $5.60 per share. The options are fully
vested and may be exercised at any time during the five-year period commencing
one year after the date of grant. The options were valued at $17,067 using the
Black-Scholes-Merton option pricing model and were included as expense in
2004.




In
November 2004, the Company’s President and Chief Operating Officer, Charles
Mazacatto, was granted options to purchase 6,250 shares of common stock at an
exercise price of $3.20. This option vested in 2004 and is exercisable until
November 2010. The market value of the Company stock at the date of grant was
less than the exercise price; therefore there was no intrinsic value in
accordance with APB 25.




In March
2005, the compensation committee authorized stock bonuses to the former
employees of C&T for an aggregate of 219,000 shares of common stock. These
stock grants are fully vested and unrestricted, subject to compliance with the
Company’s insider trading policies. The fair value of these shares, as
determined by the Company’s stock price on the date of grant, amounted to
$565,202 and was recorded as compensation during the year ended December 31,
2005.




In April
2005, the former employees of C&T were granted options to purchase an
aggregate of 744,500 shares of common stock at an exercise price of $2.50. These
options vest at a rate of 20% per year beginning in April 2006. The market value
of the Company stock at the date of grant was less than the exercise price which
resulted in no intrinsic value in accordance with APB 25. On January 1, 2006,
the Company adopted the provisions of FASB 123R as noted above which resulted in
the Company recording compensation expense of $86,954 during the year ended
December 31, 2006. Various options lapsed when several individuals terminated
their employment with the Company in 2005 and 2006. During the years ended
December 31, 2005 and 2006, an aggregate of 157,700 and 454,000 options,
respectively, forfeited unvested as a result of these terminations.





In
September 2005, the compensation committee awarded 6,000 shares of restricted
common stock to the Company’s Chief Technical Officer, Edward Buiel, pursuant to
his 2005 employment agreement, which were valued at $24,000 on the date of grant
and became fully vested in April 2006. The Company recorded $8,000 and $16,000
of compensation in 2005 and 2006, respectively, related to this
award.




In
December 2006, the Company issued 250,000 shares of restricted common stock to
the Company’s Chief Technical Officer, Edward Buiel, pursuant to his 2006
employment agreement, which were valued at $937,500 on the date of grant and
will become fully vested on December 2009. The Company will recognize this as
compensation over the requisite service period. No compensation expense was
recorded for the year ended December 31, 2006.




In
December 2007, the Company’s Vice-President of Manufacturing Engineering, Robert
Nelson, was granted 36,000 shares of restricted common stock pursuant to his
2007 employment agreement which were valued at $82,800 on the date of grant. The
shares vest at a rate of 1,000 shares per month, with provision for immediate
vesting based on significant changes in the relative ownership of the company.
The Company will recognize this as compensation over the 2 year employment
contract, with $3,450 of compensation expense recorded for the year ended
December 31, 2007.





In June
2008, the Company issued 80,000 shares of restricted common stock to the
Company’s Chief Technical Officer, Edward Buiel, pursuant to his 2008 employment
agreement, which were valued at $143,500 on the date of grant. 30,000 will vest
on December 29, 2009, and 50,000 will vest on May 31, 2011. The Company will
recognize this as compensation over the requisite service period. $35,063 in
compensation expense was recorded for the year ended December 31,
2008.




68




In June
2008, the Company issued 90,000 shares of restricted common stock to the
Company’s Chief Financial Officer, Donald Hillier, pursuant to his 2008
employment agreement, which were valued at $166,500 on the date of grant, which
will vest in equal 30,000 share amounts on June 16 of each of 2009,
2010 and 2011.  The Company will recognize this as compensation over the
requisite service period. $30,062 in compensation expense was recorded for the
year ended December 31, 2008.





In June
2008, the Company issued 50,000 shares of restricted common stock to an
employee, pursuant to his 2008 employment agreement, which were valued at
$92.500 on the date of grant, which cliff vest on June 15, 2011.  The
Company will recognize this as compensation over the requisite service period.
$16,701 in compensation expense was recorded for the year ended December 31,
2008.




Outside
Directors' Stock Option Plan Approved by Stockholders: The Company’s
stockholders have adopted an outside directors' stock option plan for the
benefit of its non-employee directors in order to encourage their continued
service as directors. Under the terms of the original plan, the Company was
authorized to grant incentive awards for up to 125,000 shares of common stock.
At the 2005 annual meeting, the Company’s shareholders increased the
authorization under the incentive stock plan to 500,000 shares.




Each
eligible director who is, on or after the effective date, appointed to fill a
vacancy on the Board or elected to serve as a member of the Board may
participate in the plan. Each eligible director shall automatically be granted
an option to purchase the maximum number of shares having an aggregate fair
market value on the date of grant of twenty thousand dollars ($20,000). The
option price of the stock subject to each option is required to be the fair
market value of the stock on its date of grant. Options generally expire on the
fifth anniversary of the date of grant. Any option granted under the plan shall
become exercisable in full on the first anniversary of the date of grant,
provided that the eligible director has not voluntarily resigned or been removed
"for cause" as a member of the Board of Directors on or prior to the first
anniversary of the date of grant (qualified option). Any qualified option shall
remain exercisable after its first anniversary regardless of whether the
optionee continues to serve as a member of the Board.




The
following awards have been granted under the Plan since its
inception:




During
the year ended December 31, 2004, the Company issued 54,000 5-year options to
four of its directors vesting in one year from the date of issuance. The market
value of the Company stock at the date of grant was less than the exercise price
which resulted in no intrinsic value in accordance with APB 25. During the year
ended December 31, 2005, these directors waived an aggregate of $105,542 in
accrued compensation as full payment of the exercise price of 29,565 options. An
additional 14,400 options were forfeited in 2005.




During
the year ended December 31, 2005, the Company issued 70,000 5-year options to
five of its directors vesting 1/3 per year over three years from the date of
grant. The market value of the Company stock at the date of grant was less than
the exercise price which resulted in no intrinsic value in accordance with APB
25. On January 1, 2006, the Company adopted the provisions of FASB 123R as noted
above and recorded compensation of $41,024 during the year ended December 31,
2006.




During
the year ended December 31, 2006, the Company issued 60,000 5-year options to
two of its directors vesting 1/3 per year over the next three years. These
options are exercisable at a price of $2 per share, expiring five years from
vest date and are valued at $71,680 utilizing the Black-Scholes-Merton option
pricing model, of which $20,230 was expensed in 2006.





During
the year ended December 31, 2008, the Company issued 179,555 5-year options to
five of its directors. Of this amount 5,555 with an exercise price of $3.60 per
share vested in November 2008 and the remainder vest 1/3 per year over the next
three years. These options are exercisable at a price of $1.38 per share,
expiring five years from vest date and are valued at $130,150 utilizing the
Black-Scholes-Merton option pricing model, of which $16,230 was expensed in
2008.




69




Non-plan Equity
Incentives Not Approved by Stockholders: The Company has
issued 789,500, 228,000, 1,131,000, 300,000 and 629,300 stock purchase options
in the fiscal years ended December 31, 2008, 2007, 2006, 2005 and 2004,
respectively, to officers, employees, attorneys and consultants in connection
with contractual agreements that do not reduce the shares available under the
shareholder’s approved plans. The following paragraphs summarize these
contractual stock options.




In
January 2004, members of the law firm of Fefer, Petersen & Cie, general
corporate counsel (of which one member was a director of the Company at the
time) were granted two-year contractual options to purchase 189,300 shares of
common stock at a price of $2.00 per share as partial compensation for services
rendered, valued at $68,296. As represented in the note captioned “Stockholder’s
Equity”, these members also received 116,700 warrants as consideration of
pre-merger Tamboril debt (the amount cited in “Stockholder’s Equity” is actually
233,400 because another party received the same number of warrants for a total
of 233,400 warrants). In August 2004, $1.00 of the exercise price of the total
306,000 options and warrants owned by these members was considered paid in
advance in consideration of unbilled legal services provided by the firm. The
Company recorded $306,000 related to this reduction. All of the warrants and
options were exercised in the fourth quarter of 2005, however; $306,000 of the
amount is included in stock subscription receivable as of December 31, 2005 and
was received in 2006.




In July
2004, the Company’s President and Chief Operating Officer, Charles Mazzacato,
was granted a contractual option to purchase 240,000 shares of common stock at a
price of $4.00 per share. This option vests on a monthly basis at the rate of
60,000 shares per year commencing July 31, 2005 and is exercisable for five
years after each vesting date. The market value of the Company stock at the date
of grant was greater than the exercise price which resulted in a total intrinsic
value of $180,000. In accordance with APB 25 the Company expensed the intrinsic
value over the vesting period which resulted in expense of $18,750 and $45,000
during the years ended December 31, 2004 and 2005, respectively. On January 1,
2006, the Company adopted the provisions of FASB 123R as noted above and
recorded compensation of $124,364 during the year ended December 31, 2006.
During the year ended December 31, 2006 the options were forfeited as a result
of his termination of employment from the Company in 2006.




In July
2004, the Company’s Chief Financial Officer, Peter Roston, was granted a
contractual option to purchase 200,000 shares of common stock at a price of
$4.00 per share. This option will vest on a monthly basis at the rate of 50,000
shares per year commencing July 31, 2005 and is exercisable for five years after
each vesting date. The market value of the Company stock at the date of grant
was greater than the exercise price which resulted in a total intrinsic value of
$150,000. In accordance with APB 25 the Company has expensed the intrinsic value
over the vesting period which resulted in expense of $15,625 and $37,500 during
the years ended December 31, 2004 and 2005, respectively. On January 1, 2006,
the Company adopted the provisions of FASB 123R as noted above and recorded
compensation of $138,182 during the year ended December 31, 2006. During the
year ended December 31, 2006 the options were forfeited as a result of his
termination of employment from the Company in 2006.




In April
2005, the Company’s Chief Executive Officer, Thomas Granville, was granted a
contractual option to purchase 180,000 shares of common stock at a price of
$2.50 per share. This option vests at the rate of 7,500 shares per month
commencing May 1, 2005 and is exercisable for five years after each vesting
date. The market value of the Company stock at the date of grant was less than
the exercise price which resulted in no intrinsic value in accordance with APB
25. On January 1, 2006, the Company adopted the provisions of FASB 123R as noted
above and recorded compensation of $112,500 during the year ended December 31,
2006.




In April
2005, a European financial advisor was granted a contractual option to purchase
30,000 shares of common stock at a price of $2.50 per share. Options for an
aggregate of 20,000 shares vested during the year ended December 31, 2005 and
will be exercisable for two years. On December 31, 2005, a total of 10,000
unvested options were forfeited when the advisory agreement was terminated. The
options were valued at $35,998 using the Black-Scholes-Merton option pricing
model and included as expense in 2005.




70





In
September 2005, the Company’s Chief Technical Officer, Edward Buiel, was granted
a contractual option to purchase 90,000 shares of common stock at a price of
$4.00 per share. This option vests at the rate of 2,500 shares per month
commencing October 2005 and is exercisable for five years after each vesting
date. The market value of the Company stock at the date of grant was less than
the exercise price which resulted in no intrinsic value in accordance with APB
25. On January 1, 2006, the Company adopted the provisions of FASB 123R as noted
above and recorded compensation of $68,100 during the year ended December 31,
2006.





In
February 2006, the Company’s Chief Executive Officer, Thomas Granville, was
granted an option to purchase 500,000 shares of common stock at an exercise
price of $6.00. Of this total 300,000 options vested immediately and the balance
is expected to vest, subject to the attainment of certain specified objectives,
over the next one to three years. These options are valued at $300,187 utilizing
the Black-Scholes-Merton option pricing model with $259,027 of compensation
recorded in 2006.




In
February 2006, the Company’s, Chief Technical Officer, Edward Buiel, was granted
an option to purchase 35,000 shares of common stock at an exercise price of
$6.00. Of this total 10,000 options vested immediately and the balance is
expected to vest, subject to the attainment of certain specified objectives,
over the next two to three years. These options are valued at $20,994 utilizing
the Black-Scholes-Merton option pricing model with $13,330 of compensation
recorded in 2006.




In
February 2006, members and affiliates of the law firm of Fefer, Petersen &
Cie, general corporate counsel (of which one member was a director of the
Company at the time) were granted an option to purchase 360,000 shares of common
stock at an exercise price of $6.00. Of this total 240,000 options vested
immediately and the balance will vest at the rate of 10,000 shares per month
during the year ended December 31, 2006. These options are valued at $193,449
utilizing the Black-Scholes-Merton option pricing model and are recorded as
legal expense in 2006.




In
February 2006, the Company’s external bankruptcy counsel, Cecilia Rosenauer, was
granted an option to purchase 15,000 shares of common stock at an exercise price
of $6.00. The options vested on the effective date of Mega-C’s Chapter 11 plan
of reorganization, which took place in November 2006. These options are valued
at $2,483 utilizing the Black-Scholes-Merton option pricing model and are
recorded as legal expense in 2006.




In March
2006, two employees were granted options to purchase a total of 24,000 shares of
common stock at an exercise price of $4.00 and $6.00. The options vest at a rate
of 2,500 per month over the first 6 months and 1,500 per month thereafter. These
options are valued at $28,257 utilizing the Black-Scholes-Merton option pricing
model with $24,408 of compensation recorded in 2006.




In
December 2006, the Company’s Chief Technical Officer, Edward Buiel, was granted
a contractual option to purchase an additional 100,000 shares of our common
stock at a price of $3.75 per share. A total of 50,000 options will vest on
December 29, 2009 and the remaining 50,000 will vest on December 29,
2010. The options will be exercisable for a period of six years from the
vesting date. These options are valued at $267,372, utilizing the
Black-Scholes-Merton option pricing model with $6,481 of compensation recorded
in 2006.




In
February 2006, a consultant, Trey Fecteau, was granted an option to purchase
97,000 shares of common stock at an exercise price of $4.00. The options vested
upon completion of contractual services in December 2006. These options are
valued at $150,702 utilizing the Black-Scholes-Merton option pricing model. This
amount reduced the proceeds of the Series A Preferred Stock offering in
2006.




In
January 2007, Walker Wainwright, a director of the Company, was granted an
option to purchase 40,000 shares of common stock at an exercise price of $5.00
as compensation for services related to due diligence, negotiation and sale of
the 2006 Series A Preferred Stock offering. These three-year options were
immediately vested on the date of grant, and are valued at $52,230 utilizing the
Black-Scholes-Merton option pricing model and are recorded as offering costs in
2007.


71


In August
2007, the Company’s Chief Financial Officer, Andrew Carr Conway, Jr., was
granted a contractual option to purchase 80,000 shares of common stock at an
exercise price of $4.50. 20,000 vested immediately upon contract inception and
the remainder vest at a rate of 10,000 per month over the life of his six-month
employment contract. These two-year options are valued at $37,356 utilizing the
Black-Scholes-Merton option pricing model with $24,904 recorded as compensation
in 2007.




In
December 2007, the Company’s Vice-President of Manufacturing Engineering, Robert
Nelson, was granted a contractual option to purchase 108,000 shares of common
stock at an exercise price of $5.00. The options vest at a rate of 3,000 per
month over a three year period, but are being amortized over the term of his two
year employment contract. These five-year options are valued at $108,504
utilizing the Black-Scholes-Merton option pricing model with $4,521 recorded as
compensation in 2007.




In March
and June 2008, the Company’s Chief Financial Officer, Andrew Carr Conway, Jr.,
was granted a contractual option to purchase 40,000 shares of common stock at an
exercise price of $4.50. All of these options were vested by June 2008. These
options are valued at $20,625 utilizing the Black-Scholes-Merton option pricing
model with $20,625 recorded as compensation in 2008.





Our Chief
Executive Officer, Thomas Granville, was granted a contractual option to
purchase an additional 90,000 shares of our common stock at a price of $2.50 per
share. The options vest prorated over the 24-month term of his contract, and are
exercisable for a period of five years from the vesting date. These options are
valued at $79,872, utilizing the Black-Scholes-Merton option pricing model with
$23,296 of compensation expected to be recorded in 2008.





Our Chief
Technical Officer, Edward Buiel, was granted a contractual option to purchase an
additional 100,000 shares of our common stock at a price of $2.50 per share. The
options cliff vest on May 31, 2011, and are exercisable for a period of five
years from the vesting date. These options are valued at $95,436, utilizing the
Black-Scholes-Merton option pricing model with $18,557 of compensation expected
to be recorded in 2008.





Our
Chief Financial Officer, Donald Hillier, was granted an option to purchase
180,000 shares of our common stock. The exercise price of the option is $2.50
per share and the option vests at the rate of 5,000 shares per month through the
term of the Employment Agreement and are exercisable for a period of 5 years
from the vesting date. These options are valued at $179,244, utilizing the
Black-Scholes-Merton option pricing model with $34,853 of compensation expected
to be recorded in 2008.





Three
employees were granted contractual options to purchase an additional 200,000
shares of our common stock at a price of $2.50 per share. 5,000 of these options
vested in June upon execution of the employment contracts, with the balance
cliff vesting on June 15, 2011, and are exercisable for a period of three years
from the vesting date. These options are valued at $165,041, utilizing the
Black-Scholes-Merton option pricing model with $34,222 of compensation expected
to be recorded in 2008.





Seven
employees were granted contractual options to purchase an additional 179,500
shares of our common stock at a price of $2.50 per share. 43,500 of these
options vested in December upon execution of the employment contracts, with the
balance vesting over the life of these contracts and are exercisable for a
period of three years from the vesting date. These options are valued at
$36,171, utilizing the Black-Scholes-Merton option pricing model with $5,330 of
compensation recorded in 2008.





The
Company uses the Black-Scholes-Merton Option Pricing Model to estimate the fair
value of awards on the measurement date using the weighted average assumptions
noted in the following table:




Year
                
                Interest Rate
                
                Dividend Yield
                
                Expected Volatility
                
                Expected Life2004
                
                
                3.8%
                
                0.0%
                
                
                59.1%
                
                60
      months2005
                
                
                4.0%
                
                0.0%
                
                
                52.0%
                
                100
      months2006
                
                
                4.7%
                
                0.0%
                
                
                53.6%
                
                45
      months2007
                
                
                3.9%
                
                0.0%
                
                
                54.4%
                
                62
      months2008
                
                
                2.8%
                
                0.0%
                
                
                51.4%
                
                58
      months




72





Expected
volatilities are calculated based on the historical volatility of the Company’s
stock since its listing on the public markets. Management has determined that it
cannot reasonably estimate a forfeiture rate given the insufficient amount of
time and activity of share option exercise and employee termination patterns.
The expected life of options represents the period of time that options granted
are expected to be outstanding was determined using the contractual term. The
risk-free interest rate for periods within the expected life of the option is
based on the interest rate for a similar time period of a U.S. Treasury note in
effort on the date of the grant.




The
following table provides consolidated summary information on the Company’s
equity compensation plans for the years ended December 31 2004, 2005, 2006, 2007
and 2008.




2004Weighted AverageAll Plan & Non-
                                Plan Compensatory Options
                              
                              Number of
                                Options
                              
                              
                              Exercise
                              
                              
                              Fair Value
                              
                              Remaining
                                Life (years)
                              
                              Aggregate
                                Intrinsic
                                ValueOptions outstanding
      at December 31,2003
                              
                              
                              
                              -
                              
                              
                              $
                              0.00
                              
                              
                              $
                              $0.00Granted
                              
                              
                              
                              736,350
                              
                              
                              $
                              3.53
                              
                              
                              $
                              $2.87Exercised
                              
                              
                              
                              -
                              
                              
                              $
                              0.00
                              
                              
                              $
                              $0.00Forfeited
      or lapsed
                              
                              
                              
                              -
                              
                              
                              $
                              0.00
                              
                              
                              $
                              $0.00Options
      outstanding at December 31,2004
                              
                              
                              
                              736,350
                              
                              
                              $
                              3.53
                              
                              
                              $
                              $2.87
                              
                              
                              
                              6.34




2005Weighted AverageAll Plan & Non-
                            Plan Compensatory Options
                          
                          Number of
                            Options
                          
                          
                          Exercise
                          
                          
                          Fair Value
                          
                          Remaining
                            Life (years)
                          
                          Aggregate
                            Intrinsic
                            ValueOptions
      outstanding at December 31,2004
                          
                          
                          
                          736,350
                          
                          
                          $
                          3.53
                          
                          
                          $
                          $2.87Granted
                          
                          
                          
                          1,254,500
                          
                          
                          $
                          2.48
                          
                          
                          $
                          $1.34Exercised
                          
                          
                          
                          (358,865
                          )
                          
                          $
                          1.65
                          
                          
                          $
                          $2.32Forfeited
      or lapsed
                          
                          
                          
                          (182,100
                          )
                          
                          $
                          3.04
                          
                          
                          $
                          $1.44Options
      outstanding at December 31,2005
                          
                          
                          
                          1,449,885
                          
                          
                          $
                          3.12
                          
                          
                          $
                          $1.86
                          
                          
                          
                          7.73




2006Weighted AverageAll Plan & Non-
                    Plan Compensatory Options
                  
                  Number of
                    Options
                  
                  
                  Exercise
                  
                  
                  Fair Value
                  
                  
                  Remaining
                    Life (years)
                  
                  
                  Aggregate
                    Intrinsic
                    ValueOptions
      outstanding at December 31,2005
                  
                  
                  1,449,885
                  
                  
                  $
                  3.12
                  
                  
                  $
                  1.86Granted
                  
                  
                  1,191,000
                  
                  
                  $
                  5.42
                  
                  
                  $
                  0.82Exercised
                  
                  
                  -
                  
                  
                  $
                  0.00
                  
                  
                  $
                  0.00Forfeited
      or lapsed
                  
                  
                  (894,000
                  )
                  
                  $
                  3.24
                  
                  
                  $
                  1.94Options
      outstanding at December 31,2006
                  
                  
                  1,746,885
                  
                  
                  $
                  4.62
                  
                  
                  $
                  1.05
                  
                  
                  
                  3.70
                  
                  
                  $
                  634,903Options
      exercisable at December 31,2006
                  
                  
                  1,192,385
                  
                  
                  $
                  5.11
                  
                  
                  $
                  0.97
                  
                  
                  
                  2.90
                  
                  
                  $
                  254,903




73





2007Weighted AverageAll Plan & Non-Plan Compensatory
                    Options
                  
                  Number of
                    Options
                  
                  
                  Exercise
                  
                  
                  Fair Value
                  
                  
                  Remaining
                    Life
                    (years)
                  
                  
                  Aggregate
                    Intrinsic
                    ValueOptions
      outstanding at December 31,2006
                  
                  
                  1,746,885
                  
                  
                  $
                  4.65
                  
                  
                  $
                  1.03Granted
                  
                  
                  228,000
                  
                  
                  $
                  4.82
                  
                  
                  $
                  0.87Exercised
                  
                  
                  -
                  
                  
                  $
                  0.00
                  
                  
                  $
                  0.00Forfeited
      or lapsed
                  
                  
                  (124,000
                  )
                  
                  $
                  2.50
                  
                  
                  $
                  1.14Options
      outstanding at December 31,2007
                  
                  
                  1,850,885
                  
                  
                  $
                  4.81
                  
                  
                  $
                  1.00
                  
                  
                  
                  1.5
                  
                  
                  $
                  18,000Options
      exercisable at December 31,2007
                  
                  
                  1,442,385
                  
                  
                  $
                  4.88
                  
                  
                  $
                  0.93
                  
                  
                  
                  2.0
                  
                  
                  $
                  6,000





2008Weighted AverageAll Plan & Non-Plan Compensatory
                    Options
                  
                  Number of
                    Options
                  
                  
                  Exercise
                  
                  
                  Fair Value
                  
                  
                  Remaining
                    Life
                    (years)
                  
                  
                  Aggregate
                    Intrinsic
                    ValueOptions
      outstanding at December 31,2007
                  
                  
                  1,850,885
                  
                  
                  $
                  4.81
                  
                  
                  $
                  1.00Granted
                  
                  
                  969,055
                  
                  
                  $
                  2.38
                  
                  
                  $
                  0.73Exercised
                  
                  
                  -
                  
                  
                  $
                  0.00
                  
                  
                  $
                  0.00Forfeited
      or lapsed
                  
                  
                  -
                  
                  
                  $
                  0.00
                  
                  
                  $
                  0.00Options
      outstanding at December 31,2008
                  
                  
                  2,819,940
                  
                  
                  $
                  3.98
                  
                  
                  $
                  0.91
                  
                  
                  
                  3.1
                  
                  
                  $
                  0Options
      exercisable at December 31,2008
                  
                  
                  1,831,690
                  
                  
                  $
                  4.75
                  
                  
                  $
                  0.90
                  
                  
                  
                  1.4
                  
                  
                  $
                  0




The
following table summarizes the status of the Company’s non-vested options under
the stock option plans:





All non-vested stock options as of December 31, 2008
                  
                  Shares
                  
                  
                  Fair ValueOptions
      subject to future vesting at December 31,2007
                  
                  
                  408,500
                  
                  
                  $
                  1.25Options
      granted
                  
                  
                  969,055
                  
                  
                  $
                  0.73Options
      forfeited or lapsed
                  
                  
                  -
                  
                  
                  $
                  0.00Options
      vested
                  
                  
                  (389,305
                  )
                  
                  $
                  .77Options
      subject to future vesting at December 31,2008
                  
                  
                  988,250
                  
                  
                  $
                  .93





As of
December 31, 2008, there was $714,192 of unrecognized compensation related to
non-vested options granted under the plans. The Company expects to recognize the
cost over a weighted average period of 1.6 years. The total fair value of
options vested during the year ended December 31, 2008 was $300,061 ($236,054
during the year ended December 31, 2007).




Note 9—Earnings/Loss Per
Share




Basic
earnings per share is computed by dividing income available to common
shareholders (the numerator) by the weighted-average number of common shares
outstanding (the denominator) for the period. Diluted earnings per share is
computed by assuming that any dilutive convertible securities outstanding were
converted, with related preferred stock dividend requirements and outstanding
common shares adjusted accordingly. It also assumes that outstanding common
shares were increased by shares issuable upon exercise of those stock options
for which market price exceeds the exercise price, less shares which could have
been purchased by us with the related proceeds. In periods of losses, diluted
loss per share is computed on the same basis as basic loss per share as the
inclusion of any other potential shares outstanding would be
anti-dilutive.





Had the
Company recorded income applicable to common shareholders for the periods ended
December 31, 2003, 2004, 2005, 2006,2007 and 2008, weighted-average number of
common shares outstanding would have increased by 785,897, 1,386,612, 2,970,730,
2,135,938, 8,975,643 and 9,566,738, respectively, for the fiscal years,
reflecting the addition of dilutive securities in the calculation of diluted
earnings per share. The increase in weighted average common shares for the
cumulative period (September 18, 2003 to December 31, 2008) is 4,542,647
shares.


74





Note
10 — Income Taxes Expense (Benefit)




Following
is a summary of the components giving rise to the income tax expense (benefit)
for the periods ended December 31, 2008 and 2007.




Currently
      payable:
                                        
                                        2008
                                        
                                        
                                        2007Federal
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        -State
                                        
                                        
                                        (79,170
                                        )
                                        
                                        $
                                        83,469Foreign
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Total
      currently payable
                                        
                                        
                                        (79,170
                                        )
                                        
                                        $
                                        83,469Deferred:Federal
                                        
                                        
                                        2,477,000
                                        
                                        
                                        
                                        1,817,000-State
                                        
                                        
                                        821,000
                                        
                                        
                                        
                                        537,000Foreign
                                        
                                        
                                        (404,000
                                        )
                                        
                                        
                                        446,000Total
      deferred
                                        
                                        
                                        2,894,000
                                        
                                        
                                        
                                        2,800,000Less
      increase in allowance
                                        
                                        
                                        (2,894,000
                                        )
                                        
                                        
                                        (2,800,000
                                        )Net
      deferred
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Total
      income tax expense (recovery)
                                        
                                        $
                                        (79,170
                                        )
                                        
                                        $
                                        $83,469




Individual
components giving rise to the deferred tax asset are as follows:




2008
                
                
                2007Future
      tax benefit arising from net operating loss carry forwards
                
                $
                7,927,000
                
                
                $
                5,977,000Future
      tax benefit arising from available tax credits
                
                
                734,000
                
                
                
                1,026,000Future
      tax benefit arising from options/warrants issued for
    Services
                
                
                775,000
                
                
                
                602,000Other
                
                
                37,000
                
                
                
                98,000Total
                
                
                9,473,000
                
                
                
                7,703,000Less
      valuation allowance
                
                
                (9,473,000
                )
                
                
                (7,703,000
                )Net
      deferred
                
                $
                -
                
                
                $
                -





The
components of pretax net loss are as follows:




2008
                  
                  
                  2007United
      States
                  
                  $
                  (9,538,115
                  )
                  
                  $
                  (5,776,191
                  )Foreign
                  
                  
                  (35,714
                  )
                  
                  
                  (6,457
                  )$
                  (9,573,829
                  )
                  
                  $
                  (5,782,658
                  )




The
Company has net operating loss carryforwards of approximately $17,725,000 and
$2,800,000 available to reduce future income taxes in United States and Canada,
respectively. The United States carryforwards expire at various dates between
2024 and 2028. The Canadian carryforwards expire at various dates between 2010
and 2028. The Company also has generated Canadian tax credits related to
research and development activities. A portion of this credit, amounting to
approximately $58,000 is refundable and has been presented as such in the
accompanying balance sheet. The remaining credit, amounting to $734,000, is
available to offset future taxable income in Canada and expires at various dates
between 2024 and 2026. The Company has adopted FASB 109 which provides for the
recognition of a deferred tax asset based upon the value certain items will have
on future income taxes and management's estimate of the probability of the
realization of these tax benefits. The Company has determined it more likely
than not that these timing differences will not materialize and have provided a
valuation allowance against the entire net deferred tax asset. The utilization
of NOL and tax credit carryforwards from Tamboril prior to the reorganization
may be subject to a substantial annual limitation due to the ownership change
limitations provided by the Internal Revenue Code of 1986, as amended and
similar state provisions. Accordingly, these amounts have not been included in
the gross deferred tax asset number above. In addition, due to equity
transactions that have occurred subsequent to the reorganization with Tamboril,
the utilization of NOL carryforwards may be subject to further change in control
limitations that generally restricts the utilization of the NOL per
year.


75




The
reconciliation of the United States statutory federal income rate and the
effective income tax rate in the accompanying consolidated statements of
operations is as follows:




2008
                                    
                                    
                                    2007Statutory
      U.S. federal income tax rate
                                    
                                    
                                    (34.0
                                    )%
                                    
                                    
                                    (34.0
                                    )%State
      taxes, net
                                    
                                    
                                    (5.5
                                    )%
                                    
                                    
                                    (6.4
                                    )%Equity
      based compensation
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1.0
                                    %Foreign
      tax credits
                                    
                                    
                                    1.9
                                    %
                                    
                                    
                                    0.0
                                    %Foreign
      currency fluctuation
                                    
                                    
                                    2.5
                                    %
                                    
                                    
                                    0.0
                                    %Other
                                    
                                    
                                    4.6
                                    %
                                    
                                    
                                    1.7
                                    %Change
      in valuation allowance
                                    
                                    
                                    30.5
                                    %
                                    
                                    
                                    37.7
                                    %Effective
      income tax rate
                                    
                                    
                                    0.0
                                    %
                                    
                                    
                                    0.0
                                    %




The
Company adopted the provisions of FASB Interpretation No. 48,Accounting
for Uncertainty in Income Taxes,on
January 1, 2008.As the result of the implementation of the FASB
interpretation No. 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes -
An Interpretation of FASB Statement
No. 109, the Company recognized no material adjustments to unrecognized
tax benefits. At the adoption date of January 1, 2008 and as of December 31, 2008, the
Company has no unrecognized tax benefits.





By
statute, tax years ending December 31, 2007 through 2004 remain open to
examination by the
major taxing jurisdictions to which the Company is subject.





Note
11 — Related Party Transactions




Trust for the
Benefit of the Shareholders of Mega-C Power Corp: The Trustee for The
Trust for the Benefit of the Shareholders of Mega-C Power Corp. served as an
officer of one of our consolidated companies in 2004. See discussion of the
transactions with the trust in the note captioned “Mega-C Power Corp (Mega-C),
Mega-C Trust (the Trust), The Taylor Litigation”




Transactions with
C&T:A current board member of the Company is the former majority
shareholder of C&T prior to the acquisition by the Company. See the note
captioned “Transactions with Related (C&T)” for disclosure of transactions
with C&T prior to and in connection with the acquisition.




Related party
notes payable: During the years ending December 31, 2008 and December 31,
2007, the Company borrowed certain amounts from related parties; certain of
these borrowings were extinguished through the issuance of the Company’s Series
A Preferred Stock in 2006 and through the issuance of the Secured Bridge
Financing during the fourth quarter of 2007. Refer to Notes captioned “Related
Party Debt Financing” and “Stockholders’ Equity” for discussion on these
matters.




Series A
Preferred stock sales -The Company raised capital in a preferred stock
offering during the year ended December 31, 2006, discussed further in the note
captioned “Stockholder’s Equity,” of which $3,829,970 related to transactions
with board members and their family members.




Legal
fees: John Petersen was a director of the Company until January 15, 2007,
and a partner in the law firm of Fefer, Petersen & Cie, which serves as the
Company’s legal counsel. During the year ended December 31, 2006, fees incurred
for services amounted to $287,463, including $49,352 related to the value of
options vesting. This amount is offset by a credit of $64,943 for the change in
value of equity instruments accrued in the fourth quarter of 2005 with a
measurement date in the first quarter of 2006.


76


Warrants:
In January 2007, Walker Wainwright, a director of the Company, was granted an
option to purchase 40,000 shares of common stock at an exercise price of $5.00
as compensation for services related to due diligence, negotiation and sale of
the 2006 Series A Preferred Stock offering. These three-year options were
immediately vested on the date of grant, and are valued at $52,230 utilizing the
Black-Scholes-Merton option pricing model and are recorded as offering costs in
2007.




Note 12-
Significant Non-Cash Transactions




The
following table provides summary information on our significant non-cash
investing and financing transactions during the twelve-month periods ended
December 31, 2008 and 2007.




2008
                  
                  
                  2007Preferred
      Dividends attributable to warrant modifications
                  
                  $
                  -
                  
                  
                  $
                  164,179Dividend
      accrued to preferred stock – Senior
                  
                  $
                  141,359
                  
                  
                  $
                  130,566Dividend
      accrued to preferred stock – Series A
                  
                  $
                  976,341
                  
                  
                  $
                  1,790,755Beneficial
      conversion feature on preferred stock
                  
                  $
                  -
                  
                  
                  $
                  6,496,634Preferred
      converted to common stock
                  
                  $
                  1,338,875
                  
                  
                  $Warrants
      issued for commission on sale of stock
                  
                  $
                  1,193,735
                  
                  
                  $Interest
      converted to common stock
                  
                  $
                  7,768
                  
                  
                  $Origination
      fees issued with related party note
                  
                  $
                  7,500
                  
                  
                  $Notes
      payable converted to common stock
                  
                  $
                  1,072,916
                  
                  
                  $Conversion
      of Interest and fees into debt instrument
                  
                  $
                  -
                  
                  
                  $
                  74,573Satisfaction
      of 2005 Liability to issue stock
                  
                  $
                  103,340
                  
                  
                  $Warrants
      issued for commission on sale of preferred
                  
                  $
                  -
                  
                  
                  $
                  53,230Fair
      value of warrants issued with related party note
                  
                  $
                  563,868
                  
                  
                  $
                  276,882




Cash
payments for interest during the year ended 2008 were $269.274. There were only
minor cash payments for interest in 2007 and no payments of income taxes during
the years ended 2008 and 2007.




Note 13 — Mega-C Power Corp (Mega-C),Mega-C Trust (the Trust), The Taylor
Litigation




Mega-C Power Corp
Business and Trust rationale:Mega-C Power Corporation was a Nevada
corporation that previously held limited and non-exclusive license rights to the
technology that APC licensed from C&T and that the Company purchased from
C&T [as discussed in the note captioned “Transactions with a related party
(C&T]. Mega-C had ceased substantive operations as a result of the
investigation of the promoters and management by the Ontario Securities
Commission (OSC) in the spring of 2003 and was placed into an involuntary
bankruptcy in April, 2004, as further described below.




77


Trust
Creation: The Trust was created on December 31, 2003, in connection with
a reverse acquisition between APC and the Company, through its public shell then
known as Tamboril Cigar Company, in response to the potential perceived equities
of the Mega-C shareholders and risks of the situation. APC’s founders believed
that the investors in Mega-C might be able to assert a variety of equitable
claims to the energy storage technology the Company acquired from C&T. The
Trust document required that when the Trust made its distribution, the
beneficiary released any claims against all parties. Therefore, while Axion had
no control over the Trust, its mandates were believed to be an effective way to
eliminate conflicting claims to the technology. The Company’s founders were also
shareholders in Mega-C for the most part.




Trust
corpus: The original corpus of the Trust was 7,327,500 shares of the
common stock that APC’s shareholders had rights to in connection with the
reverse acquisition on December 31, 2003. In connection with the execution of
the Amended and Restated Trust Agreement in February 2005, which formally
recognized the jurisdiction of the bankruptcy court on all matters, Axion issued
500,000 additional shares to the Trust. There was no contingency surrounding the
issuance of these shares at that time. This issuance was intended to be Axion’s
contribution to the Trust to obtain clear title to the technology and resolve
all related matters and was charged to operating expense during the year ended
December 31, 2005. The stock issuance transaction was valued at $1,525,000,
which was the value of the shares on the date of issuance.





As a
result of the bankruptcy court’s confirmation of a Chapter 11 Plan and the
substantial consummation of the confirmed plan in November 2006 the settlement
disclosed below became effective and 1,500,000 shares were returned to the
Company for cancellation in 2006, of which 1,000,000 represented a retroactive
adjustment to the shares issued in the reverse acquisition in December 31, 2003
and 500,000 shares represented a return of the 2005 augmentation. The return in
2006 was the result of a negotiated settlement and there were no contingencies
surrounding the Trust shares in 2005 or 2006. The 500,000 shares recovered were
recorded as a reversal of the expense at fair value on the date of return in
2006 amounting to $1,125,000 and were promptly cancelled as were the 1,000,000
shares.




Trust
Operations: The Trust did not conduct any substantive operations because,
as described below, Mega-C was placed into involuntary bankruptcy shortly after
the Trust’s inception. As a result of the confirmation of Mega-C’s plan of
reorganization by an order entered on November 8, 2008 and the substantial
consummation of the confirmed plan on November 21, 2006, as described below, the
Trust is now governed by a court appointed Trustee along with a court appointed
Board from the Trust’s beneficiaries.




The Trust for the
Benefit of the Shareholders of Mega-C Power Corp.Analysis of
Consolidation: Under FASB Interpretation No. 46 (revised December 2003)
Consolidation of Variable
Interest Entities an interpretation of ARB No. 51, (FIN 46R), reporting
companies are required to consolidate a related variable interest entity (“VIE”)
when the reporting company is the “primary beneficiary” of that entity and holds
a variable interest in the VIE. The determination of whether a reporting company
is the primary beneficiary of a VIE ultimately stems from whether the reporting
entity will absorb a majority of the VIE’s anticipated losses or receive a
majority of the VIE’s anticipated gains.




Variable Interest
Entity:The Trust may be a variable interest entity because it has
required outside infusions of cash over its existence.




Variable
Interest:The Company analyzed its transactions with and relationship to
the Trust and concluded that it may have had a very small variable interest in
the Trust based on its obligation to perform the acts necessary to have the SEC
declare a registration statement effective. Further, Axion appeared to have had
a limited variable interest based on its obligation, pursuant to the
requirements in the Trust instrument that Axion pay Trust expenses until the
required registration statement was declared effective. However, in reality,
Axion never paid any significant Trust expenses for three reasons: (1) while the
Trust included a provision for payment of expenses, no significant expenses were
ever paid, (2) the Trust suspended operations on April 4, 2004 when Mega-C Power
Corp. entered bankruptcy; and (3) the explicit obligation the Company had to pay
certain expenses of the Trust ended on January 7, 2005 when the required
registration statement was declared effective. The Company’s relationship to and
transactions with the Trust, based on actual transactions, constituted a very
small variable interest, if any, compared to other entities who provided much
larger amounts of support to the Trust, for which the Company had no
responsibility. Further no shares were expected to be returned to Axion at the
time these assessments were made. The relative size of the variable interest is
relevant to the determination of the primary beneficiary, as discussed
below.


78


Primary
Beneficiary:Axion did not and will not absorb a majority of the Trust’s
anticipated losses or derive the benefit of a majority of the Trust’s gains, if
any, at any time. The primary beneficiary, at the time of assessment, based on
an assessment of what entity (entities) absorbs a majority of the entity’s
expected losses, receives a majority of its expected residual returns, or both,
as a result of holding variable interests, was the creditors and shareholders of
Mega-C Power Corp, as a group. These were the entities, as groups, who would be
affected by increases and decreases in the Trust’s primary asset, the Axion
stock. These two groups will also suffer a diminution in assets available for
distribution to them because of the expenses the Trust incurs. The increases and
decreases in the value of the Axion stock in the Trust will have no effect on
Axion. Axion may have had a very limited obligation in the first quarter of 2004
but few, if any, expenses were incurred by the Trust in that quarter. In the
second quarter, Mega-C Power Corp. entered bankruptcy and the Trust became
dormant and, effectively, under the jurisdiction of the Bankruptcy Court. Upon
registration of the Trust shares in January 2005 Axion’s obligation to the Trust
ended except as described below relative to possible registration of
shares.




Based on
the above, Axion was not the primary beneficiary and accordingly, Axion is not
required to consolidate the Trust. Axion’s relationship with the Trust ended
when the Bankruptcy Court in Reno confirmed the bankruptcy plan in 2006 except
as described below relative to possible registration of shares. (See “Settlement
Agreement” below)





Trust
Registration Rights: The Company registered
7,327,500 shares of common stock held by the Mega-C Trust by a registration
statement the SEC declared effective January 7, 2005.  Pursuant to the
confirmed Chapter 11 Plan (See footnote captioned “Subsequent Events”), as
referenced above, the Company may be required to register 5,700,000 of those
shares (the "Plan Funding Shares") which fund the Chapter 11 Plan.  The
Company filed a post-effective amendment relating to the resale or other
disposition of 1,627,500 shares, of which, 1 million represent a portion of the
Plan Funding Shares and 627,500 represent shares to pay expenses of the Trust.
In paragraph 1(d) of the Settlement Agreement, the Company further agreed to
file such additional registration statements or post-effective amendments as may
be necessary or desirable to facilitate or accommodate the sale or distribution
of 4,700,000 of those shares. The Settlement Agreement was incorporated and
approved in its entirety in paragraph 6.1 of the Second Amended Plan, which
further provided in paragraph 6.12 that the Second Amended Shareholder Trustee
and the Liquidation Trustee have the right and power to request that the Company
file such amendments to the registration statement for the Plan Funding
Shares.




Taylor
Litigation: On February 10, 2004, Lewis “Chip” Taylor, Chip Taylor in
Trust, Jared Taylor, Elgin Investments, Inc. and Mega-C Technologies, Inc.
(collectively the “Taylor Group”) filed a lawsuit in the Ontario Superior Court
of Justice Commercial List (Case No. 04-CL-5317) that named Tamboril, APC, Rene
Pardo, Marvin Winick, Kirk Tierney, Joseph Piccirilli, Ronald Bibace, Robert
Averill, James Smith, James Eagan, Thomas Granville, Joseph Souccar, Glenn W.
Patterson, Canadian Consultants Bureau Inc., Robert Appel, Harold Rosen, Igor
Filipenko, Valeri Shtemberg, Yuri Volfkovich, Pavel Shmatko, Michael
Kishinevsky, Mega-C Power Corporation (Nevada), Mega-C Power Corporation
(Ontario), C&T, Turitella Corporation, Gary Bouchard, Fogler Rubinoff LLP,
Netprofitetc Inc., 503124 Ontario Ltd., HAP Investments LLC, Infinity Group LLC,
James Keim, Benjamin Rubin and John Doe Corporation as defendants. Although the
complaint alleges a number of complex and intersecting causes of action, it
appears that with respect to the Company and certain of its directors, officers
and stockholders, the lawsuit alleged a conspiracy to damage the value of the
Taylor Group’s investment in Mega-C and deprive the Taylor Group of its alleged
interests in the technology based on an alleged “oral” agreement, as well as
damages of $250,000,000.




Based on
orders entered in the Bankruptcy Court on February 11, 2008, management believes
that this litigation against the Company is resolved, as set forth more fully in
the section entitled “Settlement Agreement and Confirmed Chapter 11
Plan.”




Mega-C Bankruptcy
Court Litigation:
As described above, shortly after the formation of the Trust, Lewis “Chip”
Taylor, Chip Taylor in Trust, Elgin Investments, Jared Taylor and Mega-C
Technologies filed suit against Axion and APC’s founders (the “Taylor
Litigation”). The Company, APC and Thomas Granville filed an involuntary Chapter
11 petition against Mega-C in the U.S. Bankruptcy Court for the District of
Nevada (Case No. BK-N-04-50962-gwz).


79


In
February 2005, the Bankruptcy Court stayed the Taylor Litigation pending
resolution of Mega-C’s Chapter 11 bankruptcy case. In March 2005, the Bankruptcy
Court appointed William M. Noall to serve as Chapter 11 Trustee for the Mega-C
case. On June 7, 2005, the Chapter 11 Trustee commenced an adversary proceeding
against Sally Fonner, the trustee of the Trust (Adversary Proceeding No.
05-05042-gwz), demanding, among other things, the turnover of at least 7,327,500
shares of the Company’s stock held by the Trust as property of the bankruptcy
estate.




On July
27, 2005, the Company commenced an adversary proceeding against the Chapter 11
Trustee and Ms. Fonner (Adversary Proceeding No. 05-05082-gwz) for the purpose
of obtaining a judicial determination that as of the petition
date:




·
            Mega-C's
      license to commercialize the technology was
    terminated;·
            Mega-C
      does not have any interest in the technology;·
            Mega-C
      did not transfer any property to the Company with the intent to damage or
      defraud any entity;·
            Mega-C
      did not transfer any property to the Company for less than reasonably
      equivalent value; and




·
            If
      the court ultimately decides that Mega-C has a valid legal interest in the
      technology, then the Company is entitled to terminate the Trust. Further,
      Axion amended its complaint in September 2005 to assert its legal right to
      have the Trustee of the Mega-C Trust hold the assets of the Trust for the
      benefit of the Company in the event the bankruptcy court were to grant the
      Chapter 11 Trustee's request for turnover of the Trust assets and to set
      aside the Trust. Among other things these theories made it necessary
      to name Sally A. Fonner as a defendant in the
    lawsuit.




Settlement
Agreement and Confirmed Chapter 11 Plan: On December 12, 2005, the
Company entered into a settlement agreement with Mega-C, represented by its
Chapter 11 Trustee William M. Noall ("Noall"), and the Trust, represented by its
trustee Sally A. Fonner ("Fonner"). Additional signatories to the settlement
agreement include: (a) the Company's subsidiaries APC and C&T; (b)
Fonner in both her capacity as Mega-C's sole officer and director and as trustee
of the Trust; (c) certain former stockholders of APC including Robert
Averill, Joe Piccirilli, Canadian Consultants Bureau Inc., James Smith, James
Eagan, Tom Granville, Joe Souccar, HAP Investments, LLC, Glenn Patterson, Igor
Filipenko, Ron Bibace, Kirk Tierney, Infinity Group, LLC, James Keim and
Turitella Corporation; (d) Paul Bancroft, and (e) certain former
stockholders of C&T including, Yuri Volkovich, Pavel Shmatko, Albert
Shtemberg, Edward Shtemberg, C&T Co., Inc. in Trust, Oksana Fylypenko,
Andriy Malitskiy, Valeri Shtemberg, Yuri Shtemberg, Victor Eshkenazi, Miraslav
E. Royz, and Rimma Shtemberg.




The
settlement agreement was approved by the Bankruptcy Court after a hearing in an
order dated February 1, 2006. Certain terms were subject to confirmation and
effectiveness of Mega-C's Chapter 11 plan of reorganization. On November 8,
2006, the Bankruptcy Court entered an order confirming the plan which was
subsequently substantially consummated on November 21, 2006. The settlement
agreement was fully incorporated in the confirmed Chapter 11 plan. At the date
of these financial statements, the plan is fully effective and substantially
consummated.  Accordingly, all pending and potential disputes between the
parties to the Settlement Agreement have been resolved. In summary, the
following steps have been accomplished:




·
            The
      Company has compromised and withdrawn  its notes receivable from
      Mega-C to an allowed unsecured claim of $100;·
            Mega-C
      has assigned all of its right, title and interest, if any, in the
      technology and any and all tangible and intangible personal property in
      the Company's possession to the Company;




80




·
                  The
      Trust has been restated and retained 4,700,000 shares that will be sold to
      pay creditor claims that remain unsatisfied from the Liquidation Trust
      described below, with the balance to be proportionately distributed to the
      holders of allowed equity interests in Mega-C in connection with the
      implementation of Mega-C's Chapter 11 plan. It is also the owner of
      685,002 share certificates which serve as collateral for loans paid to the
      newly created Liquidation Trust in the amount of
    $2,055,000;·
                  A
      newly created Liquidation Trust received the proceeds of loans in the
      amount of $2,055,000, secured by 685,002 shares and has legal title to
      314,998 shares that will be sold to pay creditor claims and Liquidation
      Trust expenses.·
                  The
      former trustee of the Trust has received 627,500 shares as compensation by
      the Trust through the effective date of Mega-C's plan; and·
                  The
      Trust surrendered 1,500,000 shares to the Company which were promptly
      cancelled as discussed under “Trust corpus”
  above.




The
litigation settlement and releases provided by the plan, which are as broad as
the law allows, are now binding on Mega-C, the Chapter 11 trustee, the Taylor
Group and all other parties described in the plan of reorganization. The plan
requires the Liquidation Trustee or the Second Amended Shareholders Trustee to
seek dismissals of the Taylor litigation to the extent the litigation asserts
derivative or other causes of action that belong to the Chapter 11 estate of
Mega-C.





While
certain aspects of the litigation discussed above are on appeal to the Ninth
Circuit Court of Appeals and to the United States District Court for the
District of Nevada, management believes the possibility of any adverse decision
to the Company to be remote.




In orders
entered on February 11, 2008, the Bankruptcy Court held that the alleged “oral”
agreement creating rights or interests in the Technology in favor of the Taylor
Group never existed and, even if it had, the Taylor Group transferred any such
rights to the Debtor which were then transferred to the Company by the confirmed
Chapter 11 Plan. The Bankruptcy Court held that the Taylor Group has no interest
in or rights to the Technology. The Bankruptcy Court held that the only rights
the Taylor Group has are as putative creditors or shareholders of Mega-C and
that any attempts to claim an interest in or contest the Company’s title to the
Technology are contrary to the permanent injunction of the Chapter 11
Plan.




Future Litigation
Costs:No amounts have been accrued in the accompanying balance sheet
related to future litigation costs. Protracted litigation or higher than
anticipated costs could significantly reduce available working capital and have
a material adverse impact on the company’s financial condition.




Notes
Receivable-Mega-C: The Company advanced funds to Mega-C over the years
from 2003 to 2005. The Company considered these notes impaired, by recording an
allowance for doubtful accounts, in an amount equal to the aggregate of the
advances, net of certain repayments, against the Mega-C advances as the advances
were made.




Because
of the uncollectibility of the Mega-C receivable, as confirmed by the above
described transactions and events, the Company recorded a recovery of notes
receivable previously written off in November of 2006 in the amount of $100 as
well as other assets received from Mega-C Power Corp. The other assets received,
primarily miscellaneous fixed assets, have been determined to be negligible in
value and no attempt has been made to secure an appraisal or record any amounts
for these assets. Most importantly, the confirmation of the plan of
reorganization conveyed all of Mega C’s right, title and interest, if any, in
the technology to the Company, thereby resolving a significant challenge to the
Company’s ownership of the technology.


81




Note
14 — Commitments and Contingencies and Significant Contracts




Facilities
During 2006 the Company closed the facilities in Woodbridge, Ontario and moved
to New Castle, Pennsylvania. The agreement provided for an initial term of two
years with two renewal terms of five years each. The monthly rent payable for
the initial term of the agreement was $10,000. During the two extension terms,
the rent was to be based on market rates as determined by negotiation between
the parties, or if the parties are unable to reach a mutually agreed rental
rate, by an independent appraisal process. In April of 2008, the company signed
a new lease that also added to our existing space at our manufacturing plant in
New Castle, Pennsylvania. The new lease calls for a monthly payment of $16,142
with an initial term of two (2) years beginning April 2008. In addition to the
monthly rental, APB is obligated to pay all required maintenance costs, taxes
and special assessments, maintain public liability insurance in the amount of $1
million, and maintain fire and casualty insurance for an amount equal to 100% of
the replacement value of the leased premises. Rent expense for this plant
amounted to approximately $202,000 and $135,800 for the years ended December 31,
2008 and 2007, respectively. Future commitments under the term of this lease
amount to $194,000 for 2009 and $48,000 in 2010.





In
December 2008, we signed a letter agreement to sublease from a current tenant on
a month-to-month basis a building consisting of 54,000 square feet in New
Castle, Pennsylvania. Monthly rental for this space is $19,300 on a monthly
basis, subject to an annual inflation adjustment in January of each
year.  In addition to the monthly rental, we are obligated to pay all
required maintenance costs, taxes and special assessments, maintain public
liability insurance, and maintain fire and casualty insurance for an amount
equal to 100% of the replacement value of the leased premises.  Rent
expense for this facility amounted to $53,000 for the year ended December 31,
2008. This month-to-month rental agreement continues until the earlier of (1)
purchase of the building by the Company or a third party; (2) termination of the
letter agreement by either party; or (3) December 31, 2010.





Employment
Agreements:We have entered into executive employment
agreements with Thomas Granville, Edward Buiel, Andrew Carr Conway, Jr., Robert
Nelson and Donald T. Hillier, however our agreement with Mr. Conway terminated
on July 4, 2008. These agreements generally require each executive to devote
substantially all of his business time to our affairs, establish standards of
conduct, prohibit competition with our company during their term, affirm our
rights respecting the ownership and disclosure of patents, trade secrets and
other confidential information, provide for the acts and events that would give
rise to termination of such agreements and provide express remedies for a breach
of the agreement. Each of our executives will participate, without cost, in our
standard employee benefit programs, including medical/hospitalization insurance
and group life insurance, as in effect from time to time. Each of the covered
executives will generally receive an automobile allowance and reimbursement for
all reasonable business expenses incurred by him on behalf of the Company in the
performance of his duties. The provisions of the individual agreements set forth
in the following table:




Name
                    Position
                    Date
                    Term
                    
                    Salary
                    
                    
                    Options
                    
                    
                    Price
                    
                    Vesting
                    
                    StockThomas Granville
      (1)
                    CEO
                    6/23/08
                    2-year
                    
                    $
                    324,000
                    
                    
                    
                    90,000
                    
                    
                    $
                    2.50
                    
                    Monthly
                    
                    
                    0Donald
      T.  Hillier (2)
                    CFO
                    6/18/08
                    3-year
                    
                    $
                    150,000
                    
                    
                    
                    180,000
                    
                    
                    $
                    2.50
                    
                    Monthly
                    
                    
                    90,000Dr.
      Edward Buiel (3)
                    VP
      and CTO
                    6/23/08
                    2-year
                    
                    $
                    180,000
                    
                    
                    
                    100,000
                    
                    
                    $
                    2.50
                    
                    05/31/10
                    
                    
                    80,000Andrew
      Carr Conway, Jr. (4)
                    Former
      CFO
                    8/31/07
                    6
      months
                    
                    $
                    180,000
                    
                    
                    
                    120,000
                    
                    
                    $
                    4.50
                    
                    Monthly
                    
                    
                    0Dr.
      Robert Nelson (5)
                    VP
      Mfg. Eng.
                    12/1/07
                    2-year
                    
                    $
                    132,000
                    
                    
                    
                    108,000
                    
                    
                    $
                    5.00
                    
                    Monthly
                    
                    
                    36,000




82





1.
            Thomas Granville. On
      June 23, 2008, we entered into an Executive Employment Agreement with
      Thomas Granville as Chief Executive Officer. Pursuant to this agreement,
      Mr. Granville receives a monthly base salary of $27,000 for the period
      commencing June 1, 2008, and terminating May 31, 2010. Mr. Granville’s
      base salary is subject to annual review, and such salary is subject to
      renegotiation on the basis of Mr. Granville’s and the Company’s
      performance. In addition, Mr. Granville received a signing bonus of
      $250,000, paid 50% within ten (10) days of the execution of the agreement
      and 50% upon receipt of the final $10,000,000 investment from the Quercus
      Trust. The Company also granted Mr. Granville an option to purchase 90,000
      shares of our common stock at a price of $2.50 per share at a vesting rate
      of 3,750 shares per month through the term of the agreement. Mr. Granville
      is eligible to participate in any executive compensation plans adopted by
      the shareholders of the Company and the Company's standard employee
      benefit programs.




2.
            Donald T.
       Hillier.  On June 18, 2008, we entered into an Executive
      Employment Agreement with Donald T. Hillier as Chief Financial
      Officer.  Pursuant to this agreement, Mr. Hillier receives a monthly
      base salary of $12,500 for the period commencing June 16, 2008, and
      terminating June 15, 2011.  Mr. Hillier's base salary is subject to
      review after six (6) months and then on an annual basis thereafter, and
      such salary is subject to renegotiation on the basis of Mr. Hillier's and
      the Company's performance.  The Company also granted to Mr.
      Hillier 90,000 shares of common stock which will vest in equal 30,000
      share amounts on June 16 of each of 2009, 2010 and 2011. 
      In addition, Mr. Hillier was granted an option to purchase 180,000 shares
      of common stock at a price of $2.50 per share at a vesting rate of
      5,000 shares per month through the term of the agreement.  Mr.
      Hillier is eligible to participate in any executive compensation plans
      adopted by the shareholders of the Company and the Company's standard
      employee benefit programs.




3.
            Edward Buiel, Ph.D. On
      June 23, 2008, we entered into an Executive Employment Agreement with Dr.
      Edward Buiel as Vice President and Chief Technology Officer. Pursuant to
      this agreement, Dr. Buiel receives a monthly salary of $15,000 for the
      period commencing June 1, 2008 and terminating May 31, 2010. Dr. Buiel’s
      base salary is subject to annual review, and such salary is subject to
      renegotiation on the basis of Dr. Buiel’s and the Company’s performance.
      In addition, Dr. Buiel received a signing bonus of $110,000, paid 90%
      within ten (10) days of the execution of the agreement and 10% upon the
      receipt of the final $10,000,000 investment from the Quercus
      Trust.  Also, if Dr. Buiel is still employed with the Company on
      June 1, 2011, he will receive a bonus of $50,000, notwithstanding any
      other bonus arrangement. The Company also reconfirmed Dr. Buiel’s option
      to purchase 100,000 shares of our common stock, which had been previously
      granted in his prior Executive Employment Agreement dated December 29,
      2006. These existing options remain exercisable at a price of $3.75 per
      share and shall vest 50% on December 29, 2009 and 50% on December 29, 2010
      assuming Dr. Buiel is still employed by the company on each of those
      respective dates. In addition, Dr. Buiel was granted an option to purchase
      100,000 shares of our common stock in recognition of the opportunity cost
      associated with the one year extension of his new Executive Employment
      Agreement. These options are exercisable at a price of $2.50 per share and
      shall vest on May 31, 2011. Dr Buiel was also granted 80,000shares of
      common stock, of which 30,000 vests on December 29, 2009, and 50,000 will
      vest on May 31, 2011.  Dr. Buiel is eligible to participate in
      any executive compensation plans adopted by the shareholders of the
      Company and the Company's standard employee benefit programs. Certain of
      these equity awards were awarded under Dr. Buiel’s 2006 employment
      agreement and the terms of such awards have been incorporated into his new
      Executive Employment Agreement.




4.
            Andrew C. Conway,
      Jr. Under the terms of his employment agreement effective
      August 2007, which had an original term of six months, Mr. Conway received
      an annualized salary of $180,000, bonuses as determined by the
      compensation committee and an option to purchase 10,000 shares of our
      common stock at a price of $4.50 per share for each month of service.
      30,000 options vested with the execution of the contract, and the balance
      vest periodically over the remainder of the contract. The contract
      automatically renewed for an additional six month term ending
      August 31, 2008. A total of 120,000 options were awarded under the
      extended contract. Mr. Conway served as the Company’s CFO through June
      2008, and his employment agreement terminated, as mutually agreed, on July
      4, 2008.




83





5.
            Dr. Robert F. Nelson.Under the terms of his employment agreement effective December
      2007, which has a term of two years, Dr. Nelson receives an annual salary
      of $132,000 and bonuses as determined by the compensation committee. In
      addition, Dr. Nelson receives an option to purchase 108,000 shares of our
      common stock at a price of $5.00 per share and 36,000 shares of restricted
      common stock, each that vest over three years from the effective date of
      his employment agreement.




We have
no retirement plans or other similar arrangements for any directors, executive
officers or employees.




Purchase
Orders




On
November 3, 2008, the Company received the first purchase order for toll
contract manufacturing of standard flooded lead acid batteries for a large North
American lead acid battery company. The initial three types of batteries covered
in this purchase order have successfully completed customer testing, and
shipment was expected to begin late in the fourth quarter. The initial purchase
order calls for the shipment of 92,250 batteries, spread fairly equally over 11
months, with a total aggregate base purchase price of $6,400,000. Raw materials
will have an agreed upon base price with regular adjustments (not less than
monthly) to account for market price fluctuations, which could cause
fluctuations in the final purchase invoice. Due to economic conditions caused by
the steep downturn in the economy, our customer was unable to accept product
based on their original delivery schedule, resulting in only 1,500 batteries
being shipped before the end of 2008. The Company, however, continued to make
product and store it at our facility. The customer has informed the Company that
it intends to honor its purchase order commitment, but in view of the current
economic conditions there is no guarantee it will be able to do so. In early
March 2009, the customer began taking delivery of the manufactured product and
has set up a schedule to accept all of the remaining manufactured inventory,
(approximately 13,500 batteries), by the end of April 2009.  All
existing production, and future production, will take place on an ancillary
"flooded battery line" so the production will not reduce capacity from the
Company’s development of its proprietary PbC technologies, which will utilize
the primary "AGM battery line" for production.




Note
15 — Subsequent Events




On February 5, 2009, the Company
received a pair of grants from the Advanced Lead-Acid Battery Consortium, the
leading industry association made up in part by the largest companies supplying
the world’s battery market. The pair of grants total approximately $380,000, and
will help support research into two key areas: (1) to identify the mechanism by
which the optimum specification of carbon, when included in the negative active
material of a valve-regulated lead-acid battery, provides protection against
accumulation of lead sulfate during high-rate partial-state-of-charge operation;
and (2) the second grant seeks simply to characterize Axion’s proprietary PbCTM
battery in hybrid electric vehicle (HEV) type duty-cycle testing. The grants are
administered through the Durham, NC-based International Lead Zinc Research
Organization acting on behalf of the ALABC. The research work is expected to be
completed in 2009.





On
February 9, 2009, the Company received notice that is the recipient a grant from
the Pennsylvania Alternative Fuels Incentive Grant program. The $800,000
first-year grant, which was announced by Governor Edward Rendell on January
29th, is part of the State’s overall effort to invest in businesses that are
creating important and innovative clean energy and bio-fuels technologies. The
award proceeds will be used to demonstrate the advantages the Axion proprietary
PbCTM battery technology provides in a variety of electric vehicle types
including: hybrids (HEVs), such as the popular Toyota
Prius;  “plug-ins” (PHEVs)  used in commuter, delivery and
other vehicles; and in electric vehicles (EV’s) and converted (from combustion
engine operation) EV’s. The grant proceeds are expected to be received in
2009.




84


Item 9.
            Changes in and Disagreements
      With Accountants on Accounting and Financial
      Disclosure.





None.




Item 9A.
            Controls and
      Procedures




Evaluation
of Disclosure Controls and Procedures




As of
December 31, 2008, management performed, with the participation of our Chief
Executive Officer and Chief Financial Officer, an evaluation of the
effectiveness of our disclosure controls and procedures as defined in Rules
13a-15(e) and 15d-15(e) of the Exchange Act. Our disclosure controls and
procedures are designed to ensure that information required to be disclosed in
the report we file or submit under the Exchange Act is recorded, processed,
summarized, and reported within the time periods specified in the SEC’s forms,
and that such information is accumulated and communicated to our management
including our Chief Executive Officer and our Chief Financial Officer, to allow
timely decisions regarding required disclosures. Based on the evaluation and the
identification of the material weaknesses in our internal control over financial
reporting described below, our Chief Executive Officer and our Chief Financial
Officer concluded that, as of December 31, 2008, our disclosure controls and
procedures were not effective.




Management’s
Report on Internal Control Over Financial Reporting




Management
is responsible for establishing and maintaining adequate internal control over
financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange
Act. Internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements in accordance with GAAP. Because of its
inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Also, projection of any evaluation of effectiveness to
future periods is subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.




Management
has conducted, with the participation of our Chief Executive Officer and our
Chief Financial Officer, an assessment, including testing of the effectiveness,
of our internal control over financial reporting as of December 31, 2008.
Management’s assessment of internal control over financial reporting was
conducted using the criteria in Internal Control over Financial
Reporting - Guidance for Smaller Public Companies issued by the Committee
of Sponsoring Organizations of the Treadway Commission
(“COSO”).




A
material weakness is a deficiency, or a combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of our annual or interim financial statements will
not be prevented or detected on a timely basis. In connection with our
management’s assessment of our internal control over financial reporting as
required under Section 404 of the Sarbanes-Oxley Act of 2002, we identified the
following material weaknesses in our internal control over financial reporting
as of December 31, 2008:




·
            We
      do not have documented job descriptions for each position in the Company.
      Performance appraisals have not been performed consistently on an annual
      basis and, as a result, our employees may not have a clear understanding
      of their responsibilities or performance compared to these
      responsibilities





·
            We
      have not maintained sufficient segregation of duties as evidenced
      by:




85





·
            Our
      Sales Manager approves the credit worthiness of new customers and also has
      the ability and responsibility for entering sales orders into our
      accounting system. Credit limit approval for new customers and sales order
      entry should not be performed by sales personnel.·
            Some
      of our employees have the ability to purchase and receive goods. The
      receipt of goods should be kept separate from the purchasing
      functions.




·
            Our
      accounting staff employees with payable responsibilities also have access
      to vendor maintenance controls. Access to vendor accounts should be kept
      separate from the accounts payable
functions.




·
            We
      have concluded that there were not effective financial reporting controls
      in the following areas that could lead to inaccurate financial
      reporting:




·
            All
      financial personnel have the ability to change account structures without
      approval.·
            General
      Ledger journal entries are not always approved prior to
    entry.


·
            Documented
      processes do not exist for several key processes such as a closing
      checklist, budget-to-actual analyses, balance sheet variation analysis,
      pro forma financial statements, and the usage of key
      spreadsheets.




·
            We
      have identified weaknesses in our inventory
  controls:




·
            Documented
      processes do not exist for several key inventory control processes
      including inventory adjustments, reserves for excess, defective and
      obsolete inventory, product shipments and the tracking and recording of
      in-transit inventory.·
            Inventory
      valuation processes are lacking or do not exist including costs to be
      expensed versus inventoried, standard cost changes, actual versus standard
      cost analysis and the accurate accumulation of total production
      costs.




·
            We
      do not have a closed loop monitoring process in place, to ensure that
      issues, improvement and other directed actions have been completed in a
      timely manner.





·
            We
      do not do criminal background checks on the board of directors and
      employees.




o
            Per
      the KPMG, Fraud Risk Management White Paper, “U.S. sentencing guidelines
      (amended, November 2004) for organizational defendants establish minimum
      compliance and ethics program requirements for organizations seeking to
      mitigate penalties for corporate misconduct. Specifically, the amended
      guidelines call on organizations to: (1) promote a culture that encourages
      ethical conduct and a commitment to compliance with the law (2) establish
      standards and procedures to prevent and detect criminal misconduct and (3)
      Use reasonable efforts and exercise due diligence to exclude individuals
      from positions of substantial authority who have engaged in illegal
      activities or other conduct inconsistent with an effective compliance and
      ethics program.”




·
            We
      have key financial, sales order processing, shipping and receiving
      processes that are used to operate our business on a daily basis that are
      not formally documented.





·
            We
      do not have formal guidelines for creating properly authorized levels for
      entering into agreements (i.e. purchase orders, non-disclosure agreements,
      sales and other contracts) or distributing cash (signing checks, creating
      authorizing wire transfers).




Because
of the material weaknesses noted above, management has concluded that we did not
maintain effective internal control over financial reporting as of December 31,
2008, based on Internal
Control over Financial Reporting - Guidance for Smaller Public Companies
issued by COSO.




86





Remediation
of Material Weaknesses in Internal Control over Financial Reporting




We are in
the process of implementing remediation efforts with respect to the material
weaknesses noted above as follows:




·
            We
      hired during March 2009 an experienced manager of Human Resources who will
      conduct employee training sessions and have all employees acknowledge key
      policies and sign the Code of
Conduct.




·
            We
      have documented job descriptions for most of our positions and we will
      conduct performance appraisals for each employee as required by their
      employment agreements.




·
            We
      have put in place a credit policy and assigned the accounting manager, who
      has extensive prior credit experience as being responsible for verifying
      the credit worthiness of new customers. Additionally, with the
      implementation of our new ERP system, sales order entry will be approved
      by a person outside sales before a shop order is processed.
    .





·
            We
      have hired an experienced purchasing manager and along with the
      implementation of our ERP system we are developing processes and
      procedures to separating purchasing from receipt of goods functions and
      restrict system access accordingly.




·
            We
      are implementing a new Enterprise Resource Planning (ERP) system and
      accounting system that will restrict access and add needed layers of
      approvals and internal audit processes. With this implementation employees
      with accounts payable responsibilities will not be able to unilaterally
      add, delete or change vendor
accounts.





·
            We
      are improving our financial reporting controls
  by:





o
            Establishing
      procedures for changing and maintaining account structures and system
      access accordingly.o
            Implemented
      a process to review all journal entries prior to entry into the General
      Ledger.o
            Documenting
      all key financial reporting processes.o
            Establishing
      an effective document control and retention procedure.o
            Establishing budgets and
      examining on a month to month basis budget versus actual
      variances.o
            Generation of detailed monthly
      Board of Director financial reports and discussion with the Board
      financial results.




·
            We
      are documenting along with the implementation of our ERP system all key
      inventory control processes, bills of materials, measurement and valuation
      processes, purchasing and production forecasts and inventory
      management.





·
            We
      are establishing a closed loop monitoring process. This process will
      include the documentation of outstanding actions, the responsible
      individuals, expected completion dates and the status of the progress of
      these actions. The document will be reviewed and updated on an ongoing
      basis.




87





·
            We
      are evaluating the use of criminal background checks for all new members
      of the board of directors, prior to their appointment. We are also
      evaluating the use of criminal background checks for all potential new
      hires.




·
            We
      will implement a process to document key business processes and procedures
      and make them accessible to all appropriate
  personnel.




·
            We
      are have documented authorization levels stating who is allowed to approve
      key transactions and at what level of
spending.




We
believe the foregoing efforts will enable us to improve our internal control
over financial reporting. Management is committed to continuing efforts aimed at
improving the design adequacy and operational effectiveness of its system of
internal controls. The remediation efforts noted above will be subject to our
internal control assessment, testing and evaluation process.




This
annual report does not include an attestation report of the company's registered
public accounting firm regarding internal control over financial reporting.
Management's report was not subject to attestation by the company's registered
public accounting firm pursuant to temporary rules of the Commission that permit
the company to provide only management's report in this quarterly
report.





PART III





Item 10  Directors, Executive Officers and Corporate
Governance





Information
with respect to our executive officers and directors and disclosure of
delinquent Form 3, 4 or 5 filers required by this item will be contained in the
Definitive Proxy Statement relating to our 2009 Annual Meeting of Stockholders;
said information is incorporated herein by reference.





Code
of business conduct and ethics




Our Board
of Directors has adopted a Code of Business Conduct and Ethics, which has been
distributed to all directors, officers, and employees and is given to new
employees at the time of hire. The Code of Business Conduct and Ethics contains
a number of provisions that apply principally to our President, Chief Financial
Officer and other key accounting and financial personnel. A copy of our Code of
Business Conduct and Ethics can be found under the “Investor Information”
section of our website at www.axionpower.com. We intend to
disclose any amendments or waivers of our Code of Business Conduct and Ethics on
our website.





Item 11  Executive Compensation





A
description of the compensation of our executive officers will be contained in
the Definitive Proxy Statement relating to our 2009 Annual Meeting of
Stockholders; said information is incorporated herein by reference.





Item 12  Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters





A
description of the security ownership of certain beneficial owners and
management will be contained in the Definitive Proxy Statement relating to our
2009 Annual Meeting of Stockholders; said information is incorporated herein by
reference.




88


Item 13  Certain Relationships and Related Transactions,
and Director Independence





A
description of certain relationships and related transactions with management
will be contained in the Definitive Proxy Statement relating to our 2009 Annual
Meeting of Stockholders; said information is incorporated herein by
reference.





Item 14  Principal Accounting Fees and
Services





A
description of principal accounting fees and services will be contained in the
Definitive Proxy Statement relating to our 2009 Annual Meeting of Stockholders;
said information is incorporated herein by reference.





PART IV





Item 15  Exhibits





2.1
                  
                  Reorganization
      Agreement (without exhibits) between Tamboril Cigar Company, Axion Power
      Corporation and certain stockholders of Axion Power Corporation dated
      December 31, 2003.
                  
                  (1)2.2
                  
                  First
      Addendum to the Reorganization Agreement between Tamboril Cigar Company,
      Axion Power Corporation and certain stockholders of Axion Power
      Corporation dated January 9, 2004.
                  
                  (1)3.1
                  
                  Amended
      and Restated Certificate of Incorporation of Tamboril Cigar Company dated
      February 13, 2001.
                  
                  (2)3.3
                  
                  Amendment
      to the Certificate of Incorporation of Tamboril Cigar Company dated
      June 4, 2004.
                  
                  (3)3.4
                  
                  Amendment
      to the Certificate of Incorporation of Axion Power International, Inc.
      dated June 4, 2004.
                  
                  (3)3.5
                  
                  Amended
      By-laws of Axion Power International, Inc. dated June 4,
    2004.
                  
                  (3)4.1
                  
                  Specimen
      Certificate for shares of Company’s $0.00001 par value common
      stock.
                  
                  (9)4.2
                  
                  Trust
      Agreement for the Benefit of the Shareholders of Mega-C Power Corporation
      dated December 31, 2003.
                  
                  (1)4.3
                  
                  Succession
      Agreement Pursuant to the Provisions of the Trust Agreement for the
      Benefit of the Shareholders of Mega-C Power Corporation dated March 25,
      2004.
                  
                  (4)4.4
                  
                  Form
      of Warrant Agreement for 1,796,300 capital warrants.
                  
                  (9)4.5
                  
                  Form
      of Warrant Agreement for 667,000 Series I investor
    warrants.
                  
                  (9)4.6
                  
                  Form
      of Warrant Agreement for 350,000 Series II investor
    warrants.
                  
                  (9)4.7
                  
                  Form
      of Warrant Agreement for 313,100 Series III investor
    warrants.
                  
                  (9)4.8
                  
                  Form
      of 8% Cumulative Convertible Senior Preferred Stock
      Certificate
                  
                  (D)4.9
                  
                  First
      Amended and Restated Trust Agreement for the Benefit of the Shareholders
      of Mega-C Power Corporation dated February 28, 2005.
                  
                  (11)4.10
                  
                  Second
      Amendment and Restated Trust Agreement for the Benefit of the Shareholders
      of Mega-C Power Corporation dated November 21, 2006
                  
                  (19)




89





4.11
                          
                          Certificate
      of Powers, Designations, Preferences and Rights of the 8% Convertible
      Senior Preferred Stock of Axion Power International, Inc. dated March 17,
      2005.
                          
                          (12)4.12
                          
                          Certificate
      of Powers, Designations, Preferences and Rights of the Series A
      Convertible Preferred Stock, Par Value $0.0001 Per Share, of Axion Power
      International, Inc. dated October 23, 2006.
                          
                          (13)4.13
                          
                          Amended
      Certificate of Powers, Designations, Preferences and Rights of the Series
      A Convertible Preferred Stock, Par Value $0.0001 Per Share, of Axion Power
      International, Inc. dated October 26, 2006.
                          
                          (13)9.1
                          
                          Agreement
      respecting the voting of certain shares beneficially owned by the Trust
      for the Benefit of the Shareholders of Mega-C Power
      Corporation.
                          
                          Includedin
                            Exhibit
                            4.210.1
                          
                          Development
      and License Agreement between Axion Power Corporation and
      C and T Co. Incorporated dated November 15,
2003.
                          
                          (1)10.2
                          
                          Letter
      Amendment to Development and License Agreement between Axion Power
      Corporation and C and T Co. Incorporated dated November 17,
      2003.
                          
                          (1)10.3
                          
                          Tamboril
      Cigar Co. Incentive Stock Plan dated January 8, 2004
                          
                          (A)10.4
                          
                          Tamboril
      Cigar co. Outside Directors Stock Option Plan dated February 2,
      2004
                          
                          (A)10.5
                          
                          Stock
      Purchase & Investment Representation Letter among John L. Petersen,
      Sally A. Fonner and C and T Co. Incorporated dated January 9,
      2004
                          
                          (1)10.6
                          
                          Letter
      Amendment to Development and License Agreement between Axion Power
      Corporation and C and T Co. Incorporated dated January 9,
      2004.
                          
                          (1)10.7
                          
                          First
      Amendment to Development and License Agreement between Axion Power
      Corporation and C and T Co. Incorporated dated as of January 9,
      2004.
                          
                          (5)10.8
                          
                          Definitive
      Incentive Stock Plan of Axion Power International, Inc. dated June 4,
      2004.
                          
                          (3)10.9
                          
                          Definitive
      Outside Directors’ Stock Option Plan of Axion Power International, Inc.
      dated June 4, 2004.
                          
                          (3)10.10
                          
                          Executive
      Employment Agreement of Charles Mazzacato.
                          
                          (9)10.11
                            
                            10.12
                          
                          Executive
      Employment Agreement of Peter Roston.
                            
                            Amended
      Retainer Agreement between the law firm of Fefer, Petersen & Cie dated
      March 31, 2005
                          
                          (9)
                            
                            (C)10.13
                          
                          Retainer
      Agreement dated January 2, 2004 between the law firm of Fefer, Petersen
      & Cie and Tamboril Cigar Company.
                          
                          (10)10.14
                          
                          Bankruptcy
      Settlement Agreement Between Axion Power International, Inc. and 
      Mega-C Power Corporation dated December, 2005
                          
                          (E)10.15
                          
                          Second
      Amendment to Development and License Agreement between Axion Power
      International, Inc. and C and T Co. Incorporated dated as of
      March 18, 2005.
                          
                          (12)




90





10.16
                
                Executive
      Employment Agreement of Thomas Granville dated June 23,
    2008.
                
                (20)10.17
                
                Loan
      agreement dated January 31, 2006 between Axion Battery Products, Inc. as
      borrower, Axion Power International, Inc. as accommodation party and
      Robert Averill as lender respecting a $1,000,000 purchase money and
      working capital loan.
                
                (14)10.18
                
                Security
      agreement dated January 31, 2006 between Axion Battery Products, Inc. as
      debtor and Robert Averill as secured party.
                
                (14)10.19
                
                Security
      agreement dated January 31, 2006 between Axion Power International, Inc.
      as debtor and Robert Averill as secured party.
                
                (14)10.20
                
                Promissory
      Note dated February 14, 2006 between Axion Battery Products, Inc. as maker
      and Robert Averill as payee.
                
                (14)10.21
                
                Form
      of Warrant Agreement between Axion Power International, Inc. and Robert
      Averill.
                
                (14)10.22
                
                Commercial
      Lease Agreement dated February 14, 2006 between Axion Battery Products,
      Inc. as lessee and Steven F. Hoye and Steven C. Warner as
      lessors.
                
                (14)10.23
                
                Asset
      Purchase Agreement dated February 10, 2006 between Axion Battery Products,
      Inc. as buyer and National City Bank of Pennsylvania as
      seller.
                
                (14)10.24
                
                Escrow
      Agreement dated February 14, 2006 between Axion Battery Products, Inc. and
      National City Bank of Pennsylvania as parties in interest and William E.
      Kelleher, Jr. and James D. Newell as escrow agents.
                
                (14)1.25
                
                Executive
      Employment Agreement of Edward Buiel dated June 23, 2008.
                
                (21)10.26
                
                Consulting
      Agreement, dated as of September 27, 2007, by and between Axion Power
      International, Inc. and Andrew Carr Conway, Jr.
                
                (16)10.27
                
                Amendment
      No. 1 to Consulting Agreement, dated as of October 31, 2007, by and
      between Axion Power International, Inc. and Andrew Carr Conway,
      Jr.
                
                (16)10.28
                
                Securities
      Purchase Agreement dated as of January 14, 2008, by and between Axion
      Power International, Inc. and Quercus Trust.
                
                (17)10.29
                
                Common
      Stock Purchase Warrant dated January 14, 2008, executed by Axion Power
      International, Inc.
                
                (17)10.30
                
                Executive
      Employment Agreement of Donald T. Hillier dated June 18,
    2008.
                
                (19)14.1
                
                Code
      of Business Conduct and Ethics
                
                (6)31.1
                
                Certification
      of Chief Executive Officer Pursuant to Rule 13a-14(a).31.2
                
                Certification
      of Chief Financial Officer Pursuant to Rule 13a-14(a).32.1
                
                Statement
      of Chief Executive Officer Pursuant to Section   1350 of Title 18 of
      the United States Code.32.2
                
                Statement
      of Chief Financial Officer Pursuant to Section   1350 of Title 18 of
      the United States Code.




91





(1)
            Incorporated
      by reference from our Current Report on Form 8-K dated January 15,
      2004.


(2)
            Incorporated
      by reference from our Current Report on Form 8-K dated February 5,
      2003.


(3)
            Incorporated
      by reference from our Current Report on Form 8-K dated June 7,
      2004.


(4)
            Incorporated
      by reference from our Current Report on Form 8-K dated April 13,
      2004.


(5)
            Incorporated
      by reference from our Form S-3 registration statement dated May 20,
      2004.


(6)
            Incorporated
      by reference from our Annual Report on Form 10-KSB dated March 30,
      2004


(7)
            Incorporated
      by reference from our Current Report on Form 8-K dated April 13,
      2003.


(8)
            Incorporated
      by reference from our Current Report on Form 8-K dated February 16,
      2004.


(9)
            Incorporated
      by reference from our Form S-1 registration statement dated September 2,
      2004.


(10)
            Incorporated
      by reference from our Form S-1 registration statement dated December 17,
      2004.


(11)
            Incorporated
      by reference from our Current Report on Form 8-K dated February 28,
      2005.


(12)
            Incorporated
      by reference from our Current Report on Form 8-K dated March 21,
      2005.


(13)
            Incorporated
      by reference from our Current Report on Form 8-K dated November 8,
      2006.


(14)
            Incorporated
      by reference from our Current Report on Form 8-K dated February 16,
      2006.


(15)
            Incorporated
      by reference from our Current Report on Form 8-K dated January 3,
      2007.


(16)
            Incorporated
      by reference from our Current Report on Form 8-K dated November 6,
      2007.


(17)
            Incorporated
      by reference from our Current Report on Form 8-K dated January 17,
      2008.


(18)
            Incorporated
      by reference from our Current Report on Form 8-K dated January 31,
      2008.


(19)
            Incorporated
      by reference from our Registration Statement on Form S-1 dated July 3,
      2008.


(20)
            Incorporated
      by reference from our Current Report on Form 8-K dated June 27,
      2008.


(21)
            Incorporated
      by reference from our Current Report on Form 8-K dated July 2,
      2008.





(A)
            Incorporated
      by reference from our Current Report on Form 8-K/A dated February 2,
      2004.


(B)
            Incorporated
      by reference from our Current Report on Form 8-K dated April 4,
      2005.


(C)
            Incorporated
      by reference from our Registration Statement on Form SB-2 dated April 26,
      2005.


(D)
            Incorporated
      by reference from our Current Report on Form 8-K dated December 13,
      2005.





Financial
Statements





Consolidated
Financial Statements for Axion Power International, Inc. for the fiscal years
ended December 31, 2007 and 2008, respectively as set forth in Item 8 of this
Annual Report on Form 10-K.




SIGNATURES




In
accordance with Section 13 or 15(d) of the Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.





AXION
      POWER INTERNATIONAL, INC.By:
                        /s/
      Thomas GranvilleThomas
      Granville, Chief Executive Officer and
                          DirectorDate:
      March 31, 2009By:
                        /s/
      Donald T. HillierDonald
      T. Hillier, Chief Financial OfficerDate:
      March 31,
2009




92


In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.




Signature
                                            
                                            Title
                                            
                                            Date/s/
      Stanley A. HirschmanStanley
      A. Hirschman
                                            
                                            Director
                                            
                                            March
      31, 2009/s/
      Robert G. AverillRobert
      G. Averill
                                            
                                            Director
                                            
                                            March
      31, 2009/s/
      Glenn PattersonGlenn
      Patterson
                                            
                                            Director
                                            
                                            March
      31, 2009/s/
      Michael KishinevskyMichael
      Kishinevsky
                                            
                                            Director
                                            
                                            March
      31, 2009/s/
      Igor FilipenkoIgor
      Filipenko
                                            
                                            Director
                                            
                                            March
      31, 2009/s/
      Howard K. SchmidtHoward
      K. Schmidt
                                            
                                            Director
                                            
                                            March
      31, 2009/s/
      D. Walker WainwrightD.
      Walker Wainwright
                                            
                                            Director
                                            
                                            March
      31,
2009




93