Table of Contents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 
| **x** | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|--------------------------------------------------------------------------------------------------------|

 

**For the quarterly period ended September 30, 2009**

 

**OR**

 
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------------|

 

**For the transition period from                 to**

 

**Commission file number: 001-34463**

 

**A123 Systems, Inc.**

(Exactname of registrant as specified in its charter)

 

| **Delaware**                                                                                                  | ** ** | **04-3583876**                         |
|---------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|
| (State  or other jurisdiction of incorporation or  organization)                                              |       | (I.R.S.  Employer  Identification No.) |
|                                                                                                          |       |                                   |
| **A123 Systems, Inc.**

**Arsenal on the Charles**

**321 Arsenal Street**

**Watertown, Massachusetts** | ** ** | **02472**                              |
| (Address  of principal executive offices)                                                                     |       | (Zip  Code)                            |

 

**617-778-5700**

(Registrant’stelephone number, including area code)

 

 

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

 

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

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§232.405 of thischapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files). Yes o  No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act. (Check one):

 

| Large  accelerated filer  o                                              |   | Accelerated  filer  o         |
|-------------------------------------------------------------------------------|--------|------------------------------------|
|                                                                          |   |                               |
| Non-accelerated  filer  x  (Do not check if a smaller reporting company) |   | Smaller  reporting company  o |

 

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

 

As of November 9, 2009,there were 102,497,134 shares of the registrant’s Common Stock, par value $.001per share, outstanding.

 

 

 

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**A123 Systems, Inc.Quarterly Report on Form 10-QFor the Quarterly Period Ended September 30, 2009**

 

**INDEX**

 
| ** **                                                                                     | **PAGE**                                                             |
|------------------------------------------------------------------------------------------------|----------------------------------------------------------------------|
| ** **                                                                                     | **NUMBER**                                                           |
| **PART  I. FINANCIAL INFORMATION**                                                             | ** **                                                           |
|                                                                                           |                                                                 |
| ITEM 1: Financial Statements  (Unaudited)                                                      |                                                                 |
|                                                                                           | Condensed  Consolidated Balance Sheets                               | 1 |
|                                                                                           | Condensed  Consolidated Statements of Operations                     | 2 |
|                                                                                           | Condensed Consolidated Statements of Stockholders'  (Deficit) Equity | 3 |
|                                                                                           | Condensed Consolidated Statements of Cash Flows                      | 4 |
|                                                                                           | Notes to Condensed Consolidated Financial Statements                 | 5 |
|                                                                                           |                                                                 |
| ITEM 2: Management's Discussion and Analysis of  Financial Condition and Results of Operations | 19                                                                   |
| ITEM 3: Quantitative and Qualitative Disclosures about  Market Risk                            | 31                                                                   |
| ITEM 4: Controls and Procedures                                                                | 31                                                                   |
|                                                                                           |                                                                 |
| **PART  II. OTHER INFORMATION**                                                                | ** **                                                           |
| ITEM  1: Legal Proceedings                                                                     | 32                                                                   |
| ITEM  1A: Risk Factors                                                                         | 33                                                                   |
| ITEM 2: Unregistered Sales of Equity Securities and  Use of Proceeds                           | 54                                                                   |
| ITEM 4: Submission of Matters to a Vote of Security  Holders                                   | 55                                                                   |
| ITEM 6:  Exhibits                                                                              | 55                                                                   |
| Signatures                                                                                     | 56                                                                   |

 
| EX-31.1 CEO Certification pursuant to  Section 302 of the Sarbanes-Oxley Act |   |
|-----------------------------------------------------------------------------------|--------|
| EX-31.2 CFO Certification pursuant to  Section 302 of the Sarbanes-Oxley Act |   |
| EX-32.1 CEO Certification pursuant to  Section 906 of the Sarbanes-Oxley Act |   |
| EX-32.2 CFO Certification pursuant to  Section 906 of the Sarbanes-Oxley Act |   |

 

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Table of Contents

 

**Part I.Financial Information**

 

**Item 1.Financial Statements**

 

**A123Systems, Inc.Condensed Consolidated Balance Sheets**

**(Unaudited)(in thousands, except per share data)**

 
| ** **                                                                                                                                                                                                                                                                                      | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                      | ** ** | **2008**              | ** ** | **2009**               | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                      |       |                  |       |                   |       |
| Current assets:                                                                                                                                                                                                                                                                                 |       |                  |       |                   |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                                       |       | $                     | 70,510     |                   | $          | 494,068 |   |
| Restricted cash                                                                                                                                                                                                                                                                                 |       | 766                   |       | 1,711                  |       |
| Accounts receivable, net                                                                                                                                                                                                                                                                        |       | 17,735                |       | 16,131                 |       |
| Inventory                                                                                                                                                                                                                                                                                       |       | 35,724                |       | 38,094                 |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                       |       | 5,101                 |       | 2,847                  |       |
| Total current assets                                                                                                                                                                                                                                                                            |       | 129,836               |       | 552,851                |       |
|                                                                                                                                                                                                                                                                                            |       |                  |       |                   |       |
| Property, plant and equipment, net                                                                                                                                                                                                                                                              |       | 52,705                |       | 68,159                 |       |
| Goodwill                                                                                                                                                                                                                                                                                        |       | 9,581                 |       | 9,581                  |       |
| Intangible assets, net                                                                                                                                                                                                                                                                          |       | 2,389                 |       | 1,754                  |       |
| Deferred offering costs                                                                                                                                                                                                                                                                         |       | 4,532                 |       | —                 |       |
| Other assets                                                                                                                                                                                                                                                                                    |       | 9,701                 |       | 9,207                  |       |
| Restricted cash                                                                                                                                                                                                                                                                                 |       | 216                   |       | 223                    |       |
| Total assets                                                                                                                                                                                                                                                                                    |       | $                     | 208,960    |                   | $          | 641,775 |   |
|                                                                                                                                                                                                                                                                                            |       |                  |       |                   |       |
| **LIABILITIES, REDEEMABLE STOCK, AND  STOCKHOLDERS’ (DEFICIT) EQUITY**                                                                                                                                                                                                                     |       |                  |       |                   |       |
| Current liabilities:                                                                                                                                                                                                                                                                            |       |                  |       |                   |       |
| Revolving credit lines                                                                                                                                                                                                                                                                          |       | $                     | 8,000      |                   | $          | 8,000 |   |
| Current portion of long-term debt                                                                                                                                                                                                                                                               |       | 4,629                 |       | 6,600                  |       |
| Current portion of capital lease obligations                                                                                                                                                                                                                                                    |       | 393                   |       | 512                    |       |
| Accounts payable                                                                                                                                                                                                                                                                                |       | 19,471                |       | 16,273                 |       |
| Accrued expenses                                                                                                                                                                                                                                                                                |       | 14,381                |       | 14,472                 |       |
| Other current liabilities                                                                                                                                                                                                                                                                       |       | 405                   |       | 242                    |       |
| Deferred revenue                                                                                                                                                                                                                                                                                |       | 13,050                |       | 7,358                  |       |
| Deferred rent                                                                                                                                                                                                                                                                                   |       | 162                   |       | 79                     |       |
| Total current liabilities                                                                                                                                                                                                                                                                       |       | 60,491                |       | 53,536                 |       |
|                                                                                                                                                                                                                                                                                            |       |                  |       |                   |       |
| Long-term debt, net of current portion                                                                                                                                                                                                                                                          |       | 5,893                 |       | 8,752                  |       |
| Capital lease obligations, net of current portion                                                                                                                                                                                                                                               |       | 291                   |       | 228                    |       |
| Deferred revenue, net of current portion                                                                                                                                                                                                                                                        |       | 26,028                |       | 26,000                 |       |
| Deferred rent, net of current portion                                                                                                                                                                                                                                                           |       | 20                    |       | 413                    |       |
| Other long-term liabilities                                                                                                                                                                                                                                                                     |       | 1,390                 |       | 4,729                  |       |
| Preferred stock warrant liability                                                                                                                                                                                                                                                               |       | 950                   |       | —                 |       |
| Total liabilities                                                                                                                                                                                                                                                                               |       | 95,063                |       | 93,658                 |       |
|                                                                                                                                                                                                                                                                                            |       |                  |       |                   |       |
| Commitments and contingencies (Note 8)                                                                                                                                                                                                                                                          |       |                  |       |                   |       |
| Redeemable convertible preferred stock, $0.001 par  value - 46,798,184 and 0 shares authorized; 46,671,487 and 0 shares issued  and outstanding at December 31, 2008 and September 30, 2009,  respectively (liquidation and redemption value of up to $270,069 and $0,  respectively) |       | 234,954               |       | —                 |       |
| Redeemable common stock, $0.001 par value -  1,592,797 and 0 shares authorized; 1,592,797 and 0 shares issued and  outstanding at December 31, 2008 and September 30, 2009,  respectively                                                                                             |       | 11,500                |       | —                 |       |
| Stockholders’ (deficit) equity:                                                                                                                                                                                                                                                            |       |                  |       |                   |       |
| Series B-1 convertible preferred stock, $0.001  par value - 1,493,065 and 0 shares authorized; 1,493,065 and 0 shares issued  and outstanding at December 31, 2008 and September 30, 2009,  respectively                                                                         |       | 1                     |       | —                 |       |
| Preferred stock, $0.001 par value—0 and 5,000,000  shares authorized; 0 shares issued and outstanding at December 31, 2008  and September 30, 2009, respectively                                                                                                                 |       | —                |       | —                 |       |
| Common stock, $0.001 par value—115,000,000 and  250,000,000 shares authorized; 7,661,705 and 102,474,874 shares issued and  outstanding at December 31, 2008 and September 30, 2009,  respectively                                                                               |       | 8                     |       | 103                    |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                      |       | 19,649                |       | 764,922                |       |
| Accumulated deficit                                                                                                                                                                                                                                                                             |       | (152,889              | )          | (216,337               | )          |
| Accumulated other comprehensive loss                                                                                                                                                                                                                                                            |       | (197                  | )          | (823                   | )          |
| Total A123 Systems, Inc. stockholders’ (deficit)  equity                                                                                                                                                                                                                              |       | (133,428              | )          | 547,865                |       |
| Noncontrolling interest                                                                                                                                                                                                                                                                         |       | 871                   |       | 252                    |       |
| Total stockholders’ (deficit) equity                                                                                                                                                                                                                                                       |       | (132,557              | )          | 548,117                |       |
| Total liabilities, redeemable stock, and  stockholders’ (deficit) equity                                                                                                                                                                                                                   |       | $                     | 208,960    |                   | $          | 641,775 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

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**A123Systems, Inc.Condensed Consolidated Statements of Operations(Unaudited)**

**(inthousands, except per share data)**

 
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                   | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                                                   | ** ** | **2008**               | ** ** | **2009**              | ** ** | **2008** | ** ** | **2009** | ** ** |
| Revenue:                                                                     |       |                   |       |                  |       |   |   |   |   |
| Product                                                                      |       | $                      | 14,121     |                  | $          | 20,008 |   | $ | 32,136 |   | $ | 56,646 |   |
| Research and  development services                                           |       | 8,821                  |       | 3,589                 |       | 12,740 |   | 9,873 |   |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Total revenue                                                                |       | 22,942                 |       | 23,597                |       | 44,876 |   | 66,519 |   |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Cost of  revenue:                                                            |       |                   |       |                  |       |   |   |   |   |
| Product                                                                      |       | 16,841                 |       | 22,570                |       | 40,638 |   | 61,756 |   |
| Research and  development services                                           |       | 5,081                  |       | 2,902                 |       | 7,959 |   | 7,407 |   |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Total cost of  revenue                                                       |       | 21,922                 |       | 25,472                |       | 48,597 |   | 69,163 |   |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Gross profit  (loss)                                                         |       | 1,020                  |       | (1,875                | )          | (3,721 | ) | (2,644 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Operating  expenses:                                                         |       |                   |       |                  |       |   |   |   |   |
| Research and  development                                                    |       | 11,058                 |       | 13,136                |       | 26,152 |   | 35,950 |   |
| Sales and  marketing                                                         |       | 2,117                  |       | 1,852                 |       | 5,723 |   | 6,079 |   |
| General and  administrative                                                  |       | 6,322                  |       | 5,887                 |       | 15,153 |   | 18,339 |   |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Total operating  expenses                                                    |       | 19,497                 |       | 20,875                |       | 47,028 |   | 60,368 |   |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Operating loss                                                               |       | (18,477                | )          | (22,750               | )          | (50,749 | ) | (63,012 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Other income  (expense):                                                     |       |                   |       |                  |       |   |   |   |   |
| Interest income                                                              |       | 551                    |       | 35                    |       | 1,165 |   | 97 |   |
| Interest  expense                                                            |       | (154                   | )          | (348                  | )          | (561 | ) | (920 | ) |
| (Loss) gain on  foreign exchange                                             |       | (626                   | )          | 670                   |       | (550 | ) | 555 |   |
| Unrealized loss  on preferred stock warrant liability                        |       | (177                   | )          | (445                  | )          | (936 | ) | (515 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Other expense,  net                                                          |       | (406                   | )          | (88                   | )          | (882 | ) | (783 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Loss from  operations, before tax                                            |       | (18,883                | )          | (22,838               | )          | (51,631 | ) | (63,795 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Provision for  income taxes                                                  |       | 60                     |       | 53                    |       | 244 |   | 320 |   |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Net loss                                                                     |       | (18,943                | )          | (22,891               | )          | (51,875 | ) | (64,115 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Less: Net loss  (income) attributable to the noncontrolling interest         |       | (27                    | )          | 93                    |       | (90 | ) | 667 |   |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Net loss  attributable to A123 Systems, Inc.                                 |       | (18,970                | )          | (22,798               | )          | (51,965 | ) | (63,448 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Accretion to  preferred stock                                                |       | (11                    | )          | (17                   | )          | (31 | ) | (45 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Net loss attributable  A123 Systems, Inc. common stockholders                |       | $                      | (18,981    | )                     | $          | (22,815 | ) | $ | (51,996 | ) | $ | (63,493 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Net loss per  share attributable to common stockholders - basic and diluted: |       | $                      | (2.06      | )                     | $          | (1.78 | ) | $ | (5.92 | ) | $ | (6.06 | ) |
|                                                                         |       |                   |       |                  |       |   |   |   |   |
| Weighted  average number of common shares outstanding - basic and diluted:   |       | 9,203                  |       | 12,823                |       | 8,789 |   | 10,469 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

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**A123 Systems, Inc.**

**Condensed ConsolidatedStatement of Stockholders’ (Deficit) Equity**

**(Unaudited)**

**(in thousands, except pershare data)**

 
| ** **                                                                                                                                                | ** ** | **A123  Systems, Inc. stockholders’ (deficit) equity**   | ** ** | ** **                         | ** ** | ** **              | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|------------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                | ** ** | **Series B-1  Convertible Preferred Stock  $0.001 Par Value** | ** ** | **Common  Stock $0.001 Par Value** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** | **Noncontrolling** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                                                                                                | ** ** | **Shares**                                                         | ** ** | **Amount**                         | ** ** | **Shares**              | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Income  (Loss)** | ** ** | **(Deficit)  Equity** | ** ** | **Interest** | ** ** | **Loss** | ** ** |
|                                                                                                                                                      |       |                                                               |       |                               |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| BALANCE - January 1,  2008                                                                                                                           |       | 1,493                                                              |       | $                                  | 1          |                    | 6,587      |   | $ | 6 |   | $ | 9,681 |   | $ | (72,419 | ) | $ | 128 |   | $ | (62,603 | ) | $ | 997 |   |   |   |
| Accretion of redeemable  convertible preferred stock to redemption value                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | (31 | ) | — |   | — |   | (31 | ) | — |   |   |   |
| Stock-based compensation                                                                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | 3,377 |   | — |   | — |   | 3,377 |   | — |   |   |   |
| Issuance of common stock                                                                                                                                  |       | —                                                             |       | —                             |       | 1,065                   |       | 2 |   | 5,131 |   | — |   | — |   | 5,133 |   | — |   |   |   |
| Issuance of common stock  warrant                                                                                                                         |       | —                                                             |       | —                             |       | —                  |       | — |   | 366 |   | — |   | — |   | 366 |   | — |   |   |   |
| Comprehensive loss:                                                                                                                                       |       |                                                               |       |                               |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | — |   | (51,965 | ) | — |   | (51,965 | ) | 90 |   | $ | (51,875 | ) |
| Foreign currency  translation adjustment                                                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | — |   | — |   | (317 | ) | (317 | ) | (165 | ) | (482 | ) |
| Total comprehensive loss                                                                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | — |   | — |   | — |   | — |   | — |   | $ | (52,357 | ) |
|                                                                                                                                                      |       |                                                               |       |                               |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| BALANCE -  September 30, 2008                                                                                                                        |       | 1,493                                                              |       | $                                  | 1          |                    | 7,652      |   | $ | 8 |   | $ | 18,524 |   | $ | (124,384 | ) | $ | (189 | ) | $ | (106,040 | ) | $ | 922 |   |   |   |
|                                                                                                                                                      |       |                                                               |       |                               |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| BALANCE - January 1,  2009                                                                                                                           |       | 1,493                                                              |       | $                                  | 1          |                    | 7,652      |   | $ | 8 |   | $ | 19,649 |   | $ | (152,889 | ) | $ | (197 | ) | $ | (133,428 | ) | $ | 871 |   |   |   |
| Accretion of redeemable  convertible preferred stock to redemption value                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | (45 | ) | — |   | — |   | (45 | ) | — |   |   |   |
| Stock-based compensation                                                                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | 6,544 |   | — |   | — |   | 6,544 |   | — |   |   |   |
| Exercise of stock options                                                                                                                                 |       | —                                                             |       | —                             |       | 70                      |       | — |   | 71 |   | — |   | — |   | 71 |   | — |   |   |   |
| Common stock issued in  public offering, net of issuance costs (Note 3)                                                                                   |       |                                                               |       |                               |       | 31,727                  |       | 32 |   | 391,277 |   |   |   |   |   | 391,309 |   |   |   |   |   |
| Exercise of common stock  warrant                                                                                                                         |       | —                                                             |       | —                             |       | 49                      |       | — |   | — |   | — |   | — |   | — |   | — |   |   |   |
| Conversion of redeemable common  stock and convertible preferred stock to common stock and conversion of  preferred stock warrant to common stock warrant |       | (1,493                                                             | )          | (1                                 | )          | 62,967                  |       | 63 |   | 347,426 |   | — |   | — |   | 347,488 |   | — |   |   |   |
| Comprehensive loss:                                                                                                                                       |       |                                                               |       |                               |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | — |   | (63,448 | ) | — |   | (63,448 | ) | (667 | ) | $ | (64,115 | ) |
| Foreign currency  translation adjustment                                                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | — |   | — |   | (626 | ) | (626 | ) | 48 |   | (578 | ) |
| Total comprehensive loss                                                                                                                                  |       | —                                                             |       | —                             |       | —                  |       | — |   | — |   | — |   | — |   | — |   | — |   | $ | (64,693 | ) |
|                                                                                                                                                      |       |                                                               |       |                               |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| BALANCE -  September 30, 2009                                                                                                                        |       | —                                                             |       | $                                  | —     |                    | 102,465    |   | $ | 103 |   | $ | 764,922 |   | $ | (216,337 | ) | $ | (823 | ) | $ | 547,865 |   | $ | 252 |   |   |   |

 

See notes to unaudited condensed consolidatedfinancial statements.

 

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**A123 Systems, Inc.**

**Condensed Consolidated Statements ofCash Flows**

**(Unaudited)**

**(in thousands)**

** **
| ** **                                                                    | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                    | ** ** | **2008**                                 | ** ** | **2009** | ** ** |
| Cash flows from operating activities:                                         |       |                                     |       |   |   |
| Net loss                                                                      |       | $                                        | (51,875    | ) | $ | (64,115 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities:  |       |                                     |       |   |   |
| Depreciation and amortization                                                 |       | 5,718                                    |       | 10,207 |   |
| Noncash rent                                                                  |       | (94                                      | )          | 310 |   |
| Noncash foreign exchange loss on intercompany loan                            |       | 912                                      |       | (727 | ) |
| Unrealized loss on preferred stock warrant  liability                         |       | 936                                      |       | 515 |   |
| (Gain) loss on disposal of property and equipment                             |       | (84                                      | )          | 49 |   |
| Amortization of debt issuance costs and noncash  interest expense             |       | 120                                      |       | 65 |   |
| Stock-based compensation                                                      |       | 3,377                                    |       | 6,544 |   |
| Changes in current assets and liabilities, net of  acquisitions:              |       |                                     |       |   |   |
| Accounts receivable                                                           |       | (11,279                                  | )          | 1,418 |   |
| Inventory                                                                     |       | (10,107                                  | )          | (2,343 | ) |
| Prepaid expenses and other assets                                             |       | (9,489                                   | )          | 2,308 |   |
| Accounts payable                                                              |       | 8,662                                    |       | (5,650 | ) |
| Accrued expenses                                                              |       | 4,316                                    |       | (23 | ) |
| Deferred revenue                                                              |       | 13,861                                   |       | (5,634 | ) |
| Other liabilities                                                             |       | (40                                      | )          | 111 |   |
| Net cash used in operating activities                                         |       | (45,066                                  | )          | (56,965 | ) |
| Cash flows from investing activities:                                         |       |                                     |       |   |   |
| Decrease (increase) in restricted cash                                        |       | 262                                      |       | (976 | ) |
| Purchases of property, plant and equipment                                    |       | (19,922                                  | )          | (21,767 | ) |
| Net cash used in investing activities                                         |       | (19,660                                  | )          | (22,743 | ) |
| Cash flows from financing activities:                                         |       |                                     |       |   |   |
| Net proceeds from initial public offering of common  stock and issuance costs |       | (2,339                                   | )          | 397,281 |   |
| Proceeds from government grant                                                |       | —                                   |       | 3,000 |   |
| Proceeds from issuance of common stock                                        |       | 5,002                                    |       | — |   |
| Proceeds from exercise of stock options                                       |       | 131                                      |       | 71 |   |
| Advances under revolving credit lines                                         |       | 4,299                                    |       | — |   |
| Proceeds from issuance of long-term debt                                      |       | 1,589                                    |       | 8,584 |   |
| Payments on long-term debt                                                    |       | (3,610                                   | )          | (4,676 | ) |
| Payments on capital lease obligations                                         |       | (158                                     | )          | (517 | ) |
| Net proceeds from issuance of redeemable common  stock                        |       | 11,500                                   |       | — |   |
| Net proceeds from issuance of redeemable  convertible preferred stock         |       | 101,998                                  |       | 99,590 |   |
| Net cash provided by financing activities                                     |       | 118,412                                  |       | 503,333 |   |
| Effect of foreign exchange rates on cash and cash  equivalents                |       | (344                                     | )          | (67 | ) |
| Net increase in cash and cash equivalents                                     |       | 53,342                                   |       | 423,558 |   |
| Cash and cash equivalents at beginning of period                              |       | 23,359                                   |       | 70,510 |   |
| Cash and cash equivalents at end of period                                    |       | $                                        | 76,701     |   | $ | 494,068 |   |
| Supplemental cash flow information - cash paid for  interest                  |       | $                                        | 440        |   | $ | 883 |   |
| Noncash investing and financing activities:                                   |       |                                     |       |   |   |
| Issuance of a common stock warrant in settlement of  a liability              |       | $                                        | 366        |   | $ | — |   |
| Issuance of note for consulting services                                      |       | $                                        | —     |   | $ | 830 |   |
| Purchase of equipment under capital leases                                    |       | $                                        | 768        |   | $ | 572 |   |
| Equipment purchases included in accounts payable                              |       | $                                        | 2,227      |   | $ | 2,466 |   |
| Deferred offering costs included in accounts  payable and accrued expenses    |       | $                                        | 1,511      |   | $ | 2,207 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

4

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Table of Contents

 

**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

**1. Natureof the Business**

 

A123 Systems, Inc. (the‘‘Company’’) was incorporated in Delaware on October 19, 2001 and has itscorporate offices in Watertown, Massachusetts. The Company designs, develops,manufactures and sells advanced rechargeable lithium-ion batteries and batterysystems and provides research and development services to government agenciesand commercial customers.

 

**2. Summaryof Significant Accounting Polices**

 

***UnauditedInterim Financial Statements***—The accompanying condensed consolidated financial statements and therelated disclosures as of September 30, 2009 and for the three and ninemonths ended September 30, 2008 and 2009 are unaudited and have been preparedin accordance with accounting principles generally accepted in the UnitedStates of America (“GAAP”) and the applicable rules and regulations of theSecurities and Exchange Commission (‘‘SEC’’) for interim financial information.Accordingly, they do not include all of the information and notes required byGAAP for complete financial statements. These interim condensed consolidated financial statements should be readin conjunction with the consolidated financial statements and notes theretocontained in the Company’s Prospectus filed with the SEC on September 24,2009.  The December 31, 2008condensed consolidated balance sheet included herein was derived from theaudited financial statements as of that date, but does not include alldisclosures including notes required by GAAP for complete financial statements.

 

The unaudited interimcondensed consolidated financial statements have been prepared on the samebasis as the audited consolidated financial statements and, in the opinion ofmanagement, reflect all adjustments of a normal recurring nature considerednecessary to present fairly the Company’s financial position as of September 30,2009 and results of its operations for the three and nine months ended September 30,2008 and 2009, and its cash flows for the nine months ended September 30,2008 and 2009. The interim results for the three and nine months ended September 30,2009 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2009.

 

***Principlesof Consolidation***—Theaccompanying condensed consolidated financial statements include the accountsof the Company and its subsidiaries. All inter-company balances andtransactions have been eliminated in consolidation. The Company’s investment ina variable interest entity (‘‘VIE’’), of which the Company is the primarybeneficiary, is consolidated.

 

***Consolidation of VariableInterest Entity***—Atthe time of the Company’s acquisition of Enerland Co., Ltd (‘‘Enerland’’), anEnerland wholly-owned subsidiary had a pre-existing joint venture agreementwith a quasi governmental entity in the Peoples Republic of China (‘‘PRC’’),whereby the Enerland subsidiary holds a 45% interest in the joint venture. Thejointly-owned enterprise was established under the laws of the PRC tomanufacture components of rechargeable batteries. The joint venture enterpriseis a VIE with Enerland as its primary beneficiary. Accordingly, the Companyconsolidates the joint venture enterprise and accounts for the 55% ownership asa noncontrolling interest. The total assets of the joint venture enterpriserepresented less than 2% of the Company’s total consolidated assets as of December 31,2008.

 

***Use ofEstimates***—Thepreparation of condensed consolidated financial statements in conformity withGAAP requires management to make estimates and assumptions that affect thereported amounts of assets, liabilities, revenue, expense and relateddisclosures. The Company bases estimates and assumptions on historicalexperience and on various other factors that it believes to be reasonable underthe circumstances. The Company evaluates its estimates and assumptions on anongoing basis. The Company’s actual results may differ from these estimatesunder different assumptions or conditions.

 

***Foreign Currency Translationand Remeasurement***—TheCompany’s foreign operations are subject to exchange rate fluctuations andforeign currency transaction costs. The majority of the Company’s sales are denominated in U.S. dollars. For foreignoperations with the local currency as the functional currency, local currencydenominated assets and liabilities are translated at the period-end exchangerates, and sales, costs and expenses are translated at the average exchangerates during the period. Gains or losses resulting from foreign currencytranslation attributable to the Company are included as a component ofaccumulated other comprehensive income (loss) in the condensed consolidatedbalance sheets. For foreign operations with the U.S. dollar as the functionalcurrency, foreign currency denominated assets and liabilities are remeasured atthe period-end exchange rates and related gains or losses are reflected asother income (expense) in the condensed consolidated statement of operations,except for nonmonetary assets (e.g., inventories, and property, plant, andequipment) and related income statement accounts (e.g., cost of sales anddepreciation) which are remeasured at historical exchange rates. During thethree months ended September 30, 2008 and 2009, and during the nine monthsended September 30, 2008 and 2009, the Company recognized net (losses)gains of $(0.6) million, $0.7 million, $(0.6) million, and $0.6 millionrespectively.

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

***Cash and Cash Equivalents***—Cash equivalents include short-term, highly liquid instruments, whichconsist of money market accounts.  Themajority of cash and cash equivalents are maintained with major financialinstitutions in North America.  Depositswith these financial institutions may exceed the amount of insurance providedon such deposits; however, these deposits typically may be redeemed upon demandand, therefore, bear minimal risk.

 

***Restricted Cash andGovernment Grants***—Cash accounts with any type of restriction are classified as restricted cash.If the restriction is expected to be lifted in the next twelve months, therestricted cash account is classified as current.

 

The Company recognizesgovernment grants on the balance sheet initially as a liability and restrictedcash when the grant is received and that the Company will comply with theconditions attached to it.  Grant fundsare typically used for either capital expenditures or to fund research anddevelopment. Once the funds are used, the Company then amortizes the liabilityas a reduction of depreciation expense over the useful life of the asset or asa reduction of expenses as milestones are met over the term of the grant.

 

During 2008, the Company wasawarded a $10.0 million Center of Energy Excellence grant from the Stateof Michigan. The Company received $3.0 million in March 2009, and theremainder will be paid based on the achievement of certain milestones in theCompany’s Livonia, Michigan facility development such as the installation ofpurchased equipment and qualification of manufacturing processes.  As of September 30, 2009, the Company has used approximately$1.3 million of the funds related to this grant for deposits for equipment,and the remaining $1.7 million is included in restricted cash. The Companyhas complied and expects to continue to comply with all conditions attached tothe grant.

 

The Company has also beenoffered a loan from the State of Michigan for $4.0 million to support itsplanned expansion in Livonia, Michigan.  The loan would accrue interest ata rate of 1% and is payable over ten years. The loan agreement allows for the forgivenessof the loan either partially or in total based on the number of jobs created inthe State of Michigan prior to January 1, 2015. As of September 30,2009, the Company had not drawn down on the loan.

 

***Goodwill andIndefinite-Lived Intangible Assets***—Goodwill is comprised of the cost of business acquisitions in excessof the fair value assigned to the net tangible and identifiable intangibleassets acquired. Indefinite-lived intangible assets are not subject toamortization and consist of trademarks and trade names the Company has acquiredthrough business acquisitions. Goodwill and indefinite-lived intangible assetsare not amortized but are reviewed for impairment annually and more frequentlyif events or changes in circumstances indicate that the asset might beimpaired. If an impairment exists, a loss is recorded to write-down the valueof goodwill or indefinite-lived intangible assets to their implied fair value.The Company performed the annual impairment test for these assets as of October 1,2008. This test did not indicate an impairment. There have been no events since October 1, 2008 that would requirethe Company to perform an additional assessment of goodwill or indefinite-livedassets.

 

***Intangible Assets Subjectto Amortization***—TheCompany amortizes its intangible assets with definitive lives over theirestimated useful lives, which range from less than a year to 17 years, based onthe same pattern as the Company expects to receive the economic benefit fromthese assets.

 

***Impairment of Long-Lived Assets***—The Company’s long-lived assets includeproperty, plant and equipment and intangible assets subject to amortization(i.e., patented technology, contractual backlog, specially-trained workforceand customer relationships). The Company evaluates long-lived assets forrecoverability whenever events or changes in circumstances indicate that anasset may have been impaired. In evaluating an asset for recoverability, theCompany estimates the future cash flow expected to result from the use of theasset and eventual disposition. If the expected future undiscounted cash flowis less than the carrying amount of the asset, an impairment loss, equal to theexcess of the carrying amount over the fair value of the asset, is recognized.

 

***Segment, Geographic and SignificantCustomer Information***—Operatingsegments are defined as components of an enterprise about which discretefinancial information is available that is evaluated regularly by the chiefoperating decision maker, or decision making group, in making decisions on howto allocate resources and assess performance. The Company’s chief decisionmaker is the Chief Executive Officer. The Company’s chief decision makerreviews consolidated operating results to make decisions about allocatingresources and assessing performance for the entire Company. The Company viewsits operations and manages its business as one operating segment.

 

Information about theCompany’s operations in different geographic regions is presented in the tablesbelow (in thousands):

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 
| ** **                                                                | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                | ** ** | **2008**                                   | ** ** | **2009**                                  | ** ** | **2008** | ** ** | **2009** | ** ** |
| Geographic revenues (based on shipment destination or  services location) |       |                                       |       |                                      |       |   |   |   |   |
| United States                                                             |       | $                                          | 6,962      |                                      | $          | 10,116 |   | $ | 13,035 |   | $ | 32,711 |   |
| United Kingdom                                                            |       | 4,341                                      |       | 117                                       |       | 6,497 |   | 6,969 |   |
| Chile                                                                     |       | —                                     |       | 6,300                                     |       | — |   | 6,300 |   |
| China                                                                     |       | 8,932                                      |       | 2,039                                     |       | 17,678 |   | 5,132 |   |
| Mexico                                                                    |       | 184                                        |       | 143                                       |       | 563 |   | 3,879 |   |
| Germany                                                                   |       | 263                                        |       | 1,951                                     |       | 1,189 |   | 3,809 |   |
| Czech Republic                                                            |       | 174                                        |       | 2,181                                     |       | 410 |   | 2,734 |   |
| Austria                                                                   |       | —                                     |       | 201                                       |       | 4 |   | 1,232 |   |
| Korea                                                                     |       | 248                                        |       | 240                                       |       | 689 |   | 576 |   |
| Malaysia                                                                  |       | 946                                        |       | —                                    |       | 3,562 |   | 12 |   |
| Other                                                                     |       | 892                                        |       | 309                                       |       | 1,249 |   | 3,165 |   |
|                                                                      |       | $                                          | 22,942     |                                      | $          | 23,597 |   | $ | 44,876 |   | $ | 66,519 |   |

 
| ** **                                               | ** ** | **December 31, 2008** | ** ** | **September 30, 2009** | ** ** |
|----------------------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| Long-lived tangible assets (based on location of  asset) |       |                       |       |                        |       |
| China                                                    |       | $                          | 33,180     |                        | $          | 44,087 |   |
| United States                                            |       | 13,701                     |       | 18,292                      |       |
| Korea                                                    |       | 5,627                      |       | 5,780                       |       |
| Canada                                                   |       | 197                        |       | —                      |       |
|                                                     |       | $                          | 52,705     |                        | $          | 68,159 |   |

 

The Company groups itsrevenues into four revenue categories. Revenue for these categories is asfollows (in thousands):

 
| ** **                        | ** ** | ******Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                        | ** ** | **September 30,**     | ** ** | **September 30,** | ** ** |
| ** **                        | ** ** | **2008**                   | ** ** | **2009**               | ** ** | **2008** | ** ** | **2009** | ** ** |
| Transportation                    |       | $                          | 1,758      |                   | $          | 8,344 |   | $ | 2,296 |   | $ | 34,017 |   |
| Consumer                          |       | 12,363                     |       | 5,364                  |       | 29,840 |   | 16,329 |   |
| Electric grid                     |       | —                     |       | 6,300                  |       | — |   | 6,300 |   |
| Research and development services |       | 8,821                      |       | 3,589                  |       | 12,740 |   | 9,873 |   |
|                              |       | $                          | 22,942     |                   | $          | 23,597 |   | $ | 44,876 |   | $ | 66,519 |   |

 

***Revenue Recognition***—The Companyrecognizes revenue from the sale of products and delivery of research anddevelopment services, including governmental grants. Revenue is recognized whenall of the following criteria are met: persuasive evidence of an arrangement exists,delivery has occurred or services have been provided, the price to the buyer isfixed or determinable, and collectability is reasonably assured. If salesarrangements contain multiple elements, the Company evaluates the agreements todetermine if separate units of accounting exist within the arrangement. TheCompany has determined that as of September 30, 2009, all salesarrangements should be accounted for as a single unit of accounting.

 

*ProductRevenue*

 

Productrevenue is generally recognized upon transfer of title and risk of loss, whichis generally upon shipment, unless an acceptance period exists. In general, theCompany’s customary shipping terms are FOB shipping point or free carrier. Ininstances where customer acceptance of a product is required, revenue is eitherrecognized (i) upon shipment when the Company is able to demonstrate thatthe customer specific objective criteria have been met or (ii) upon theearlier of customer acceptance or expiration of the acceptance period.

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

TheCompany provides warranties for its products and records the estimated costs asa cost of revenue in the period the revenue is recorded. The Company’s standardwarranty period extends one to five years from the date of sale, depending onthe type of product purchased and its application. The warranties provide thatthe Company’s products will be free from defects in material and workmanshipand will, under normal use, conform to the specifications for the product. Thewarranties further provide that the Company will repair the product or providereplacement parts at no charge to the customer. When the Company is unable toreasonably determine its obligation for warranty of new products, revenue fromthe sale of the products is deferred until expiration of the warranty period oruntil such time as the warranty obligation can be reasonably estimated.

 

*Researchand Development Services Revenue*

 

Revenuefrom research and development services is recognized as the services areperformed consistent with the performance requirements of the contract usingthe proportional performance method. Where arrangements include milestones orgovernmental approval that impact the fees payable to the Company, revenue islimited to those amounts whereby collectability is reasonably assured. TheCompany recognizes revenue earned under time and materials contracts asservices are provided based upon actual costs incurred plus a contractuallyagreed-upon profit margin. The Company recognizes revenue from fixed-pricecontracts, using the proportional performance method based on the ratio ofcosts incurred to estimates of total expected project costs in order todetermine the amount of revenue earned to date. Project costs are based on thedirect salary and associated fringe benefits of the employees on the projectplus all direct expenses incurred to complete the project that are notreimbursed by the client. The proportional performance method is used sincereasonably dependable estimates of the revenues and costs applicable to variousstages of a contract can be made. These estimates are based on historicalexperience and deliverables identified in the contract and are indicative ofthe level of benefit provided to the Company’s clients. There are no costs thatare deferred and amortized over the contract term.

 

Researchand development revenue is derived from the execution of contracts awarded bythe U.S. federal government, other government agencies and commercialcustomers. The Company’s research anddevelopment arrangements with the federalgovernment or other government agencies typically require the Company toprovide pure research, in which the Company investigates design techniques onnew battery technologies. The Company’s research and development arrangementswith commercial customers consist of arrangements where the Company is paid toenhance or modify an existing product or to develop or jointly develop a newproduct to meet a customer’s specifications.

 

TheCompany’s research and development arrangements generally provide that allpre-existing or newly created intellectual property remains under the ownershipof the respective party, and that all jointly created intellectual property beowned by both parties without a duty to account for or pay royalties to theother party.

 

*OtherRevenue*

 

Feesto license the use of the Company’s proprietary and licensed technologies arerecognized only after both the license period has commenced and the technologyhas been delivered to the customer. Royalty revenue is recognized when itbecomes determinable and collectability is reasonably assured; otherwise theCompany recognizes revenue upon receipt of payment. To date, the Company hasnot recognized any license or royalty revenue.

 

***DeferredRevenue***—The Company records deferred revenue for product sales and researchand development services in several different circumstances. Thesecircumstances include when (i) the Company has delivered products orperformed services but other revenue recognition criteria have not beensatisfied, (ii) payments have been received in advance of products beingdelivered or services being performed and (iii) all other revenuerecognition criteria have been met, but the Company is not able to reasonablyestimate the warranty expense. Deferred revenue includes customer deposits andup-front fees associated with research and development arrangements. Deferredrevenue expected to be recognized as revenue more than one year subsequent tothe balance sheet date is classified as long-term deferred revenue. Deferredrevenue will vary depending on the timing and amount of cash receipts fromcustomers and can vary significantly depending on specific contractual terms.

 

OnNovember 17, 2008, the Company entered into an exclusive agreement tolicense certain of its technology in the field of consumer electronics devices(excluding power tools and certain other consumer products). In connection withthis license agreement, the Company has received and recorded as deferredrevenue an up-front license fee of $22.5 million, as well as an up-frontsupport fee of $2.5 million. The Company also expects to receive an additionallicense fee of $3.0 million following the completion of a support period. Inaddition, the agreement provides that the Company will be paid royalty fees onnet sales of licensed products that include its technology. The Company hasagreed to the terms of the license agreement that if, during a certain periodfollowing execution of the license agreement, the Company enters into anagreement with a third party that materially restricts the licensee’s rightsunder the license agreement or fails to provide the necessary support to enablethe licensee to practice the Company’s technology, then the Company may berequired to refund the licensee all license and support fees paid to cover thelicensee’s capital and other expenses

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

paidand/or committed by the licensee in reliance upon its rights under the licenseagreement. Revenue recognition will commence in two years, upon successfultransfer of technology know how to the customer. The license and support feewill be recognized on a straight line basis over the longer of the patent termor the expected customer relationship.

 

***Research and DevelopmentCosts***—Costsincurred in the research and development of the Company’s products are expensedas incurred and include salaries, third-party contractors, materials, andsupplies. Research and development costs directly associated with research anddevelopment services revenue are classified as cost of research and developmentservices. Additionally, a portion of research and development costs were offsetby cost-sharing funding. For the three months ended September 30, 2008 and2009, and for the nine monthsended September 30, 2008 and 2009, the research and development costs thatwere offset by cost-sharing funding was $0.6 million, $0.4 million, $3.4 million, and $2.0 million, respectively.

 

***Incom******e Taxes***—The Company accounts for income taxes inaccordance with the asset and liability method for accounting and reportingincome taxes. Deferred tax assets and liabilities are recognized based on temporarydifferences between the financial reporting and income tax bases of assets andliabilities using rates anticipated to be in effect when such temporarydifferences reverse. A valuation allowance against net deferred tax assets isrequired if, based upon the available evidence, it is more likely than not thatsome or all of the deferred tax assets will not be realized.  The Company provides reserves for potentialpayments of tax to various tax authorities related to uncertain tax positionsand other issues. Reserves are based on a determination of whether and how muchof a tax benefit taken by the Company in its tax filings or positions is morelikely than not to be realized following resolution of any potentialcontingencies present related to the tax benefit. Potential interest andpenalties associated with such uncertain tax positions are recorded as acomponent of income tax expense.

 

The Company provides forincome taxes in interim periods based upon the estimated effective tax ratesfor the full year.

 

***Fair Value of FinancialInstruments***—Thecarrying amount of cash, cash equivalents, restricted cash, accountsreceivable, accounts payable and accrued expenses approximates fair value dueto the short-term nature of these items. Management believes that the Company’sdebt obligations bear interest at rates which approximate prevailing marketrates for instruments with similar characteristics and, accordingly, thecarrying values for these instruments approximate fair value. At December 31,2008, the Company’s preferred stock warrant liability was carried at fairvalue.  Upon the closing of the Company’sinitial public offering on September 29, 2009, the preferred stockwarrants were converted to common stock warrants, and at September 30,2009 there is no outstanding preferred stock warrant liability.

 

Fair value is an exit price,representing the amount that would be received from the sale of an asset orpaid to transfer a liability in an orderly transaction between marketparticipants. As such, fair value is a market-based measurement that should bedetermined based on assumptions that market participants would use in pricingan asset or liability. As a basis for considering such assumptions, GAAPestablishes a three-tier value hierarchy, which prioritizes the inputs used inmeasuring fair value as follows: (Level 1) observable inputs such as quotedprices in active markets; (Level 2) inputs other than the quoted prices inactive markets that are observable either directly or indirectly; and (Level 3)unobservable inputs in which there is little or no market data, which requiresthe Company to develop its own assumptions. This hierarchy requires the Companyto use observable market data, when available, and to minimize the use ofunobservable inputs when determining fair value. On a recurring basis, theCompany measures certain financial assets and liabilities at fair value,including the Company’s cash equivalents.

 

The Company did not have anyitems that are measured at fair value on a non-recurring basis under thisrequirement for the nine months ended September 30, 2009 or 2008.

 

The following tables showassets and liabilities measured at fair value on a recurring basis as of December 31,2008 and September 30, 2009 and the input categories associated with thoseassets and liabilities (in thousands):

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 
| ** **              | ** ** | ** **                           | ** ** | **As of December 31, 2008**                                           | ** ** |
|-------------------------|------------|--------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **              | ** ** | **Fair Value at  December 31, 2008** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
|                    |       |                                 |       |                                                                  |       |   |   |   |   |
| Asset:                  |       |                                 |       |                                                                  |       |   |   |   |   |
| Money market funds      |       | $                                    | 61,580     |                                                                  | $          | — |   | $ | 61,580 |   | $ | — |   |
|                    |       |                                 |       |                                                                  |       |   |   |   |   |
| Liability:              |       |                                 |       |                                                                  |       |   |   |   |   |
| Preferred stock warrant |       | $                                    | 950        |                                                                  | $          | — |   | $ | — |   | $ | 950 |   |

 
| ** **         | ** ** | ** **                             | ** ** | **As of September 30, 2009**                                          | ** ** |
|--------------------|------------|----------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **         | ** ** | **Fair Value at   September 30, 2009** | ** ** | **Quoted Prices in  Active Markets for  Identical Assets  (Level 1)** | ** ** | **Significant Other  Observable  Inputs  (Level 2)** | ** ** | **Significant  Unobservable  Inputs  (Level 3)** | ** ** |
|               |       |                                   |       |                                                                  |       |   |   |   |   |
| Asset:             |       |                                   |       |                                                                  |       |   |   |   |   |
| Money market funds |       | $                                      | 484,314    |                                                                  | $          | 484,314 |   | $ | — |   | $ | — |   |
|                    |            |                                        |            |                                                                       |            |  |  |  |  |  |  |  |  |

 

The Company’s cashequivalents consist of money market funds that approximate their face value.The fair value of the preferred stock warrant liability was determined usingthe Black-Scholes option pricing model. The Company’s preferred stock warrants were converted to common stockwarrants as of September 29, 2009 in conjunction with the Company’s publicstock offering, and are now classified as equity awards.

 

The following table providesa roll-forward of the fair value of the preferred stock warrant liability,categorized as a Level 3 instrument, for the nine months ended September 30,2009 (in thousands):

 

**NineMonths Ended September 30, 2009**

 
| ** **                                                                           | ** ** | **Preferred Stock Warrant Liability** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
|                                                                                 |       |                                  |       |
| Balance, December 31, 2008                                                           |       | $                                     | 950        |   |
|                                                                                 |       |                                  |       |
| Unrealized loss included in other  income (expense)                                  |       | 515                                   |       |
| Conversion to common stock in  connection with the Company's initial public offering |       | (1,465                                | )          |
| Balance, September 30, 2009                                                          |       | $                                     | —     |   |

 

***Stock-Based Compensation***—Effective January 1, 2006, the Companyaccounts for all awards, including employee and director awards, by recognizingcompensation expense based on the fair value of share-based transactions in thefinancial statements on a prospective basis. This accounting applies to new awards and to awards modified,repurchased, or cancelled on or after January 1, 2006 and awards issued priorto January 1, 2006 continue to be accounted for in accordance with theaccounting originally applied. The Company recognizes compensation expense overthe vesting period using a ratable method (providing the minimum amount of compensation recordedis equal to the vested portion of the award, requiring a ratable method whennecessary) and classifies these amounts in the condensed consolidatedstatements of operations based on the department to which the related employeereports. The Company uses the Black-Scholes valuation model to calculate thefair value of stock options, utilizing various assumptions.

 

The Company records equityinstruments issued to non-employees as expense at their fair value over therelated service period and periodically revalues the equity instruments as theyvest.

 

***Net Loss Per Share***—Basic net loss per share is computed bydividing net loss by the weighted-average number of common shares outstandingduring the fiscal year. Diluted net loss per share is computed by dividing netloss by the weighted-average number of dilutive common shares outstandingduring the fiscal year. Dilutive shares outstanding are calculated by adding tothe weighted shares outstanding any potential (unissued) shares of common stockand warrants based on the treasury stock method.

 

The following potentiallydilutive securities were excluded from the calculation of diluted net loss pershare, as the effect would have been anti-dilutive, (in thousands):

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 
| ** **                                                   | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                   | ** ** | **2008**               | ** ** | **2009** | ** ** |
| Convertible preferred stock upon conversion to common  stock |       | 48,165                 |       | — |   |
| Warrants to purchase redeemable convertible  preferred stock |       | 126                    |       | — |   |
| Warrants to purchase common stock                            |       | 45                     |       | 112 |   |
| Options to purchase common stock                             |       | 8,215                  |       | 10,431 |   |
|                                                         |       | 56,551                 |       | 10,543 |   |

 

***New AccountingPronouncements***—InJune 2009, the FASB issued new accounting guidance which modifies theexisting quantitative guidance used in determining the primary beneficiary of avariable interest entity (“VIE”) by requiring entities to qualitatively assesswhether an enterprise is a primary beneficiary, based on whether the entity has(i) power over the significant activities of the VIE, and (ii) anobligation to absorb losses or the right to receive benefits that could bepotentially significant to the VIE.  Thisguidance becomes effective for all new and existing VIE’s on January 1,2010.  The Company is evaluating thepotential impact, if any, of the adoption of guidance on the Company’sconsolidated financial statements.

 

In October 2009, FASBissued an update to the existing criteria for separating consideration inmultiple-deliverable arrangements. This update is effective for arrangementsentered into in the fiscal years beginning on or after June 15, 2010,unless the vendor elects early application. The Company is currently evaluatingthe potential impact, if any, of the adoption of this update on the Company’sconsolidated financial statements.

 

**3. InitialPublic Offering**

 

On September 29, 2009,the Company closed its initial public offering of common stock (“IPO”) of32,407,576 shares of common stock at an offering price of $13.50 per share, ofwhich 31,727,075 shares were sold by the Company and 680,501 shares were soldby selling stockholders, resulting in net proceeds to the Company ofapproximately $391.3 million, after deducting underwriting discounts andoffering costs. Upon the closing of the IPO, the Company’s outstanding sharesof redeemable convertible preferred stock were automatically converted into61,374, 225 shares of common stock, the redemption rights of the Company’soutstanding shares of redeemable common stock terminated and these 1,592,797shares werereclassifiedto common stock, and the Company’s outstanding preferred stock warrants wereautomatically converted into common warrants to purchase a total of 126,696shares of common stock. The condensed consolidated financial statements,including share and per share amounts, include the effects of the IPO becauseit was completed prior to September 30, 2009.

 

Costs directly associatedwith the Company’s IPO were capitalized and recorded as deferred offering costsprior to the closing of the IPO. The Company filed its initial Form S-1with the SEC on August 8, 2008 and closed its IPO on September 29,2009. These costs have been recorded as a reduction of the proceeds received inarriving at the amount to be recorded in additional paid-in capital as of September 29,2009.  Deferred offering costs wereapproximately $4.5 million as of December 31, 2008.  On September 29, 2009, approximately$7.1 million of deferred offering costs were reclassified and recorded as areduction of the proceeds received through the IPO.

 

**4.Inventory**

 

Inventory consists of thefollowing (in thousands):

** **
| ** **      | ** ** | **December  31, 2008** | ** **   | **September  30, 2009** | ** ** |
|-----------------|------------|------------------------|--------------|-------------------------|------------|
|            |       |                   |         |                    |       |
| Raw materials   |       | $                      | 11,042       |                    | $          | 8,179 |   |
| Work-in-process |       | 19,207                 |         | 23,304                  |       |
| Finished goods  |       | 5,475                  |         | 6,611                   |       |
|            |       | $                      |  35,724 |                    | $          | 38,094 |   |

 

11

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Tableof Contents

 

**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

**5. Property, Plant and Equipment**

 

Property, plant andequipment consists of the following (in thousands):

 
| ** **                                     | ** ** | **December  31, 2008** | ** ** | **September  30, 2009** | ** ** |
|------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
|                                           |       |                   |       |                    |       |
| Computer equipment and software                |       | $                      | 4,765      |                    | $          | 6,781 |   |
| Furniture and fixtures                         |       | 977                    |       | 1,573                   |       |
| Machinery and equipment                        |       | 37,224                 |       | 60,163                  |       |
| Buildings                                      |       | 6,192                  |       | 6,891                   |       |
| Leasehold improvements                         |       | 7,017                  |       | 9,204                   |       |
| Automobiles                                    |       | 326                    |       | 376                     |       |
| Construction in progress                       |       | 9,759                  |       | 8,365                   |       |
|                                           |       |                   |       |                    |       |
| Property, plant and equipment, at cost         |       | 66,260                 |       | 93,353                  |       |
|                                           |       |                   |       |                    |       |
| Less accumulated depreciation and amortization |       | 13,555                 |       | 25,194                  |       |
|                                           |       |                   |       |                    |       |
| Property, plant and equipment, net             |       | $                      | 52,705     |                    | $          | 68,159 |   |

 

Plant and equipment undercapital lease consists of the following (in thousands):

 
| ** **                               | ** ** | **December 31, 2008** | ** ** | **September 30, 2009** | ** ** |
|------------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| Computer equipment and software, at cost |       | $                          | 1,052      |                        | $          | 1,549 |   |
| Less accumulated depreciation            |       | (345                       | )          | (728                        | )          |
| Computer equipment and software, net     |       | $                          | 707        |                        | $          | 821 |   |

 

Depreciation expense for thethree months ended September 30, 2008 and 2009 and for the nine monthsended September 30, 2008 and 2009 was $1.7 million, $3.1 million, $4.3million, and $8.4 million, respectively.

 

**6.****Intangible Assets**

 

Intangible assets consist ofthe following (in thousands):

 
| ** **                   | ** ** | ** **       | ** ** | **December 31,  2008** | ** ** | **September 30,  2009** | ** ** |
|------------------------------|------------|------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                   | ** ** | **Useful  Life** | ** ** | ** **                  | ** ** | **Accumulated**              | ** ** | ** ** | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| **Intangible Asset Class**   | ** ** | **(Years)**      | ** ** | **Gross**                   | ** ** | **Amortization**             | ** ** | **Net** | ** ** | **Gross** | ** ** | **Amortization** | ** ** | **Net** | ** ** |
|                         |       |             |       |                        |       |                         |       |   |   |   |   |   |   |   |   |
| Contractual  backlogs        |       | 1-3              |       | $                           | 497        |                         | $          | 497 |   | $ | — |   | $ | 497 |   | $ | 497 |   | $ | — |   |
| Customer  relationships      |       | 5-17             |       | 640                         |       | 177                          |       | 463 |   | 640 |   | 310 |   | 330 |   |
| Patented  technology         |       | 4-5              |       | 2,473                       |       | 1,200                        |       | 1,273 |   | 2,473 |   | 1,691 |   | 782 |   |
| Specialty-trained  workforce |       | 4                |       | 60                          |       | 29                           |       | 31 |   | 60 |   | 40 |   | 20 |   |
| Trademarks  and trade names  |       | Indefinite       |       | 622                         |       | —                       |       | 622 |   | 622 |   | — |   | 622 |   |
|                         |       |             |       |                        |       |                         |       |   |   |   |   |   |   |   |   |
|                         |       |             |       | $                           | 4,292      |                         | $          | 1,903 |   | $ | 2,389 |   | $ | 4,292 |   | $ | 2,538 |   | $ | 1,754 |   |

 

Amortization expense forintangible assets totaled $0.2 million and $0.3 million for three months ended September 30,2008 and 2009, respectively. Amortization expense for intangible assets totaled$0.7 million and $0.6 million for the nine months ended September 30, 2008and 2009, respectively. The remaining net book value of the intangible assetswill be amortized over a weighted-average period of approximately 2.6 years asof December 31, 2008.

 

**7. Accrued Expenses**

 

Accrued expenses consists ofthe following (in thousands):

 

12

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 
| ** **                                | ** ** | **December 31,  2008** | ** ** | **September 30,  2009** | ** ** |
|-------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
|                                      |       |                        |       |                         |       |
| Payroll and related benefits              |       | $                           | 3,663      |                         | $          | 4,069 |   |
| Legal, audit, tax and professional fees   |       | 1,831                       |       | 3,571                        |       |
| Product warranty                          |       | 1,813                       |       | 3,016                        |       |
| Manufacturing sub-contractors’ costs |       | 4,262                       |       | 1,396                        |       |
| Taxes                                     |       | 558                         |       | 423                          |       |
| Direct contract costs                     |       | 661                         |       | 461                          |       |
| Interest                                  |       | 75                          |       | 104                          |       |
| Other                                     |       | 1,518                       |       | 1,432                        |       |
|                                      |       |                        |       |                         |       |
| Total accrued expenses                    |       | $                           | 14,381     |                         | $          | 14,472 |   |

 

**8****. Commitments andContingencies**

 

***Litigation***—In November 2005,the Company received a letter asserting that it was infringing upon certainU.S. patents. In April 2006, the Company commenced an action in the UnitedStates District Court for the District of Massachusetts seeking a declaratoryjudgment that the patents in question were not infringed by the Company’sproducts and that the patents claiming to be infringed upon are invalid. On September 11,2006, a countersuit was filed against the Company and two of its businesspartners in the United States District Court for the Northern District of Texasalleging infringement of these patents. In October 2006 and January 2007,the U.S. Patent and Trademark Office (PTO) granted the Company’s request forreexamination of the two patents. In January and February 2007, thetwo suits were stayed pending the reexamination. The reexaminations of the twopatents were concluded on April 15, 2008 and May 12, 2009, respectively.The Company filed a motion to re-open the litigation in the United StatesDistrict Court for the District of Massachusetts on June 11, 2009. On September 28,2009, the Massachusetts court entered an order denying that motion, which theCompany appealed on October 27, 2009 to the United States Court of Appealsfor the Federal Circuit.  On July 22,2009, the Company was sent a proposed Second Amended Complaint which thecomplainants intend to seek leave to file with the Texas Court in light of thePTO’s reexaminations. The two suits continue to remain stayed at this time. TheCompany has agreed to indemnify two business partners for their legal costs indefending this litigation and any damages that may be awarded. The Company isunable to predict the outcome of this matter, and therefore no accrual has beenestablished for this contingency.

 

**9****. Product Warranties**

 

The Company provides for theestimated costs to fulfill customer warranty obligations upon the recognitionof the related revenue. While the Company engages in extensive product qualityprograms and processes, including actively monitoring and evaluating thequality of its component suppliers, the Company’s warranty obligation isaffected by product failure rates, utilization levels, material usage, andsupplier warranties on parts delivered to the Company. Should actual productfailure rates, utilization levels, material usage, or supplier warranties onparts differ from the Company’s estimates, revisions to the estimated warrantyliability would be required.

 

Product warranty activity,which is recorded in accrued expenses on the condensed consolidated balancesheets, as of December 31, 2008 and September 30, 2009 was as follows(in thousands):

 
| ** **                                             | ** ** | **Product  Warranty Liability** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | ** **                      | ** ** |
| Product warranty liability - December 31, 2008    |       | $                               | 1,813      |   |
|                                                   |       |                            |       |
| Accruals for new warranties issued (warranty  expense) |       | 1,417                           |       |
| Payments made (in cash or in kind)                     |       | (214                            | )          |
|                                                   |       |                            |       |
| Product warranty liability - September 30, 2009   |       | $                               | 3,016      |   |

 

**10. Income Taxes**

 

TheCompany provides for income taxes at the end of each interim period based onthe estimated effective tax rate for the full fiscal year. Cumulativeadjustments to the Company’s estimate are recorded in the interim period inwhich a change in the estimated annual effective rate is determined.  The Company’s provision for income taxes consists primarily of foreigntaxes.

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

As of December 31,2008, the Company has provided a liability of $0.6 million for uncertain taxpositions related to various foreign income tax matters which are classified asother long-term liabilities in the Company’s condensed consolidated balancesheets. The uncertain tax positions as of December 31, 2008 excludeinterest and penalties of $0.1 million which are classified as other long-termliabilities on the Company’s condensed consolidated balance sheets. Theseuncertain tax positions would impact the Company’s effective tax rate, ifrecognized. The Company does not expect that the amounts of uncertain taxpositions will change significantly within the next 12 months.

 

The Company recognizesinterest and penalties accrued related to uncertain tax positions in theprovision for income taxes. During the year ended December 31, 2008 andthe nine months ended September 30, 2009, the Company recognizedapproximately $0.1 million and $26,000 in penalties and interest, respectively.The Company had approximately $0.2 million for the payment of penalties andinterest accrued at September 30, 2009.

 

**11. Financing Arrangements**

 

**Long-TermDebt**—Long-term debt as of December 31, 2008 and September 30, 2009consists of the following (in thousands):

 
| ** **                         | ** ** | **December 31,  2008** | ** ** | **September 30,  2009** | ** ** |
|------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
|                               |       |                        |       |                         |       |
| Term loan                          |       | $                           | 8,547      |                         | $          | 13,544 |   |
| Enerland debt                      |       |                        |       |                         |       |
| Term loan 1                        |       | 104                         |       | —                       |       |
| Term loan 2                        |       | 1,192                       |       | 1,267                        |       |
| Technology funds loan              |       | 152                         |       | 113                          |       |
| Korean government loans            |       | 527                         |       | 428                          |       |
|                               |       |                        |       |                         |       |
| Total                              |       | 10,522                      |       | 15,352                       |       |
| Less amounts classified as current |       | 4,629                       |       | 6,600                        |       |
|                               |       |                        |       |                         |       |
| Long-term debt                     |       | $                           | 5,893      |                         | $          | 8,752 |   |

 

***Term Loan***—The Company holds a term loan agreement with a financial institutionthat is also a common shareholder. The Company has a term loan facility underthe term loan agreement for $3.0 million with minimum advances of $1.0 million.Each advance under this term loan facility is repayable over a 36-month periodand accrues interest at prime rate (3.25% at December 31, 2008 and September 30,2009) plus 2.5%. As of September 30, 2009, the Company has approximately$0.2 million outstanding under this term loan facility. The Company holds asecond term loan facility under the term loan agreement for $15.0 million withminimum advances of $0.5 million.  The second term loan facility isrepayable over a 36-month period and accrues interest at prime plus0.75%.  As of September 30, 2009, the Company has approximately $13.3million outstanding under this credit facility.

 

Theterm loan agreement requires the Company to comply with certain financialcovenants, which include a minimum liquidity ratio calculation. The term loanagreement is collateralized by substantially all assets of the Company,excluding intellectual property, property and equipment owned as of December 31,2005 and certain equipment located in China.

 

***Note Payable***—On April 17, 2009, the Company enteredinto a $0.8 million promissory note with a vendor for consulting servicesperformed. The promissory note was due by December 31, 2009 and accruedinterest at 4.0%. In the event that the Company completed certain financing orfunding arrangements or completed an IPO, the promissory note becameimmediately due and payable.  The Companyrepaid the note following the completion of the IPO in September 2009.

 

***Enerland debt***—The Company has the following outstandingobligations for its Enerland subsidiary:

 

·*Term loan 1* —Enerland entered into two secured loan agreements with a financial institutionwhich matured in September 2008 and June 2009 to borrow approximately$0.9 million.  The weighted averageinterest rate for the loans for 2008 was 4.47%. Enerland was provided with repayment guarantees from Kibo TechnologyFund, a Korean technical guarantee agency for small business, in relation tothese loan agreements.  The Term Loan 1was paid off during the nine months ended September 30, 2009.

 

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Table of Contents

 

**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

·*Term loan 2*—On March 5,2008, the Company entered into two loan agreements with a financial institutionin the amounts of $1.3 million and $0.3 million which mature in 2010. The loanshave a variable interest rate. The weighted average interest rate for the loansas of September 30, 2009 was 8.05%.

 

·*Technology funds loan*—TheCompany has a technology funds loan agreement amounting to $0.2 million with avariable interest rate. The weighted average interest rate for the loan as of September 30,2009 was 5.06%. The loan matures in August 2011.

 

·*Korean government loans*—Aspart of the Korean government’s initiative to promote and encourage the developmentof start-up companies in certain high technology industries, high technologystart-up companies with industry leading technology or products are eligiblefor government loans. Certain grants are refundable, depending on the successful development andcommercialization of the technology or products, and a company receiving suchgovernment grants is required to refund between 20% and 30% of the grantsreceived for such development.

 

**Revolving Credit Facilities**—The Company entered into a line of credit (“LOC”)for $8.0 million with a financial institution that is also a commonstockholder. The line of credit accrues interest at prime (3.25% at December 31,2008 and September 30, 2009).  Theoutstanding balance at December 31, 2008 and September 30, 2009 was$8.0 million. The LOC has a maturity date of September 24, 2010, and theCompany is required to comply with the same financial covenants required underthe Term Loan mentioned above.

 

**12. Stock Warrants**

 

The Company issued a warrantto purchase 67,000 shares of Series B Redeemable Convertible PreferredStock (‘‘Series B’’) at an exercise price of $2.08 per share. The warrantis immediately exercisable and expires in February 2012. The Companyestimated the initial fair value of the warrant as of the date of grant to be$0.1 million using the Black-Scholes option-pricing model and the followingassumptions: (i) risk-free interest rate of 4.19%, (ii) life of sevenyears, (iii) volatility of 100%, and (iv) no expected dividends.  Upon the closing of the Company’s IPO on September 29,2009, the preferred stock warrant was converted to a common stock warrant andthe fair value of the preferred warrant as of September 29, 2009,estimated to be $0.8 million using the Black-Scholes option pricing model, was reclassifiedto additional paid-in capital.

 

In connection with the TermLoan (see Note 11), the Company issued a warrant to purchase 59,000 shares of Series CRedeemable Convertible Preferred Stock (‘‘Series C’’) at an exercise priceof approximately $3.37 per share. The warrant is immediately exercisable andexpires in August 2013. The Company has estimated the initial fair valueof the warrant to be $0.1 million using the Black-Scholes option-pricing modeland the following assumptions: (i) risk-free interest rate of 4.9%, (ii) lifeof seven years, (iii) volatility of 70%, and (iv) no expecteddividends.  In conjunction with theCompany’s IPO, the warrant was converted to a common stock warrant and the fairvalue of the preferred stock warrant, estimated to be $0.7 million using theBlack-Scholes option pricing model, was reclassified to additional paid-incapital.  The warrant was exercised in September 2009under the cashless exercise option for 49,210 shares of common stock.

 

At December 31, 2008,the fair value of each of the above warrants using the Black-Scholesoption-pricing model and underlying assumptions used in the model were asfollows:

 
| ** **                       | ** ** | **December 31,  2008** | ** ** |
|----------------------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | **Series B  Warrant**  | ** ** | **Series C  Warrant** | ** ** |
| Warrant valuation (in thousands) |       | $                           | 514        |   | $ | 436 |   |
| Risk-free rate                   |       | 1.00                        | %          | 1.55 | % |
| Life (years)                     |       | 3.2                         |       | 4.6 |   |
| Volatility                       |       | 81                          | %          | 81 | % |
| Expected dividends               |       | —                      | %          | — | % |
|                                  |            |                             |            |  |  |  |  |

 

**13. Stock-Based Compensation**

 

The Board of Directors hasadopted, and the Company’s stockholders have approved, the A123 Systems, Inc.2001 Stock Incentive Plan (the ‘‘2001 Plan’’), which provides for the grant ofqualified incentive stock options and nonqualified stock options or otherawards to the Company’s employees, officers, directors, and outside consultantsto purchase up to an aggregate of 13,700,000 shares of the Company’s commonstock.

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

The stock options generallyvest over a four-year period and expire 10 years from the date of grant. Uponoption exercise, the Company issues shares of common stock. As of December 31,2008 and September 30, 2009, the Company had 625,000 and 330,000 stockoptions available for future grant under the 2001 Plan, respectively.

 

During 2009, the Company’sBoard of Directors approved the 2009 Stock Incentive Plan (the “2009 Plan”)which became effective on the closing of the IPO.  A total of 3,000,000 shares of Company’scommon stock, subject to increase on an annual basis, are reserved for futureissuance under the 2009 Plan.  Shares ofcommon stock reserved for issuance under the 2001 Plan that remain availablefor issuance immediately prior to closing of the IPO and any shares of commonstock subject to awards under the 2001 Plan that expire, terminate, or areotherwise forfeited, canceled or repurchased by the Company prior to beingfully exercised will be added to the number of shares available under the 2009Plan, up to a maximum of 500,000 shares. As of September 30, 2009, no grants have been made under the 2009Plan.

 

The following table presentsstock-based compensation expense included in the Company’s condensed consolidatedstatements of operations (in thousands):

 
| ** **                 | ** ** | **Three  Months Ended** | ** ** | **Nine  Months Ended** | ** ** |
|----------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                 | ** ** | **September 30,**  | ** ** | **September 30,** | ** ** |
| ** **                 | ** ** | **2008**                | ** ** | **2009**               | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                 | ** ** | ** **              | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of sales              |       | $                       | 133        |                   | $          | 412 |   | $ | 346 |   | $ | 1,159 |   |
| Research and development   |       | 608                     |       | 1,160                  |       | 1,902 |   | 3,100 |   |
| Sales and marketing        |       | 132                     |       | 259                    |       | 326 |   | 603 |   |
| General and administrative |       | 305                     |       | 679                    |       | 803 |   | 1,682 |   |
|                       |       |                    |       |                   |       |   |   |   |   |
| Total                      |       | $                       | 1,178      |                   | $          | 2,510 |   | $ | 3,377 |   | $ | 6,544 |   |

 

The Company has capitalizedan immaterial amount of stock-based compensation as a component of inventory.

 

The following tablesummarizes stock option activity for the nine months ended September 30,2009:

 
| ** **                                           | ** ** | **Shares**          | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------------------|------------|---------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **(In  thousands)** | ** ** | ** **                             | ** ** | ** **                                          | ** ** | **(In  thousands)**             | ** ** |
|                                                 |       |                |       |                                   |       |                                                |       |                            |       |
| Outstanding - January 1, 2009                   |       | 8,205               |       | $                                      | 4.30       |                                                | 7.73       |                            | $          | 38,594 |   |
|                                                 |       |                |       |                                   |       |                                                |       |                            |       |
| Granted                                              |       | 2,585               |       | 9.55                                   |       |                                                |       |                            |       |
| Exercised                                            |       | (70                 | )          | 1.01                                   |       |                                                |       |                            |       |
| Forfeited                                            |       | (289                | )          | 7.70                                   |       |                                                |       |                            |       |
|                                                 |       |                |       |                                   |       |                                                |       |                            |       |
| Outstanding - September 30, 2009                |       | 10,431              |       | $                                      | 5.53       |                                                | 7.58       |                            | 164,725    |   |
|                                                 |       |                |       |                                   |       |                                                |       |                            |       |
| Vested or expected to vest - December 31, 2008  |       | 7,499               |       | $                                      | 4.08       |                                                | 7.66       |                            | $          | 36,553 |   |
| Vested or expected to vest - September 30, 2009 |       | 9,750               |       | $                                      | 5.40       |                                                | 7.54       |                            | $          | 115,220 |   |
|                                                 |       |                |       |                                   |       |                                                |       |                            |       |
| Options exercisable - December 31, 2008         |       | 3,481               |       | $                                      | 1.52       |                                                | 6.78       |                            | $          | 24,839 |   |
| Options exercisable - September 30, 2009        |       | 5,213               |       | $                                      | 3.07       |                                                | 6.47       |                            | $          | 95,117 |   |

 

The Company has estimatedthe fair value of stock options granted to employees since January 1, 2006using the Black-Scholes option-pricing model. Options are granted with an exercise price equal to the fair value ofthe common stock as of the date of grant. Fair value of the common stock has been determined by the Board ofDirectors as the Company’s stock has historically not been publicallyquoted.   In addition, due to the Company’slimited historical data, the Company estimated the expected volatility of itscommon stock at the date of grant based on the historical volatility ofcomparable public companies over the option’s expected term. The Companycalculated the weighted average expected life of options using the simplifiedmethod as prescribed by the Stock Compensation Subtopic of the FASBCodification.  The assumed dividend yieldis based upon the Company’s expectation of not paying dividends in theforeseeable future. The risk-free rate is based on the U.S. Treasury yieldcurve in effect at the time of grant for maturities similar to the expectedterm. Compensation expense is amortized on a straight-line basis over therequisite service period of the options, which is generally four years.

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

The Black-Scholes model assumptionsfor the three months ended September 30, 2008 and 2009 and for the ninemonths ended September 30, 2008 and 2009 are as follows:

 
| ** **              | ** ** | **Three  Months Ended  September 30,** | ** ** | **Nine  Months Ended  September 30,** | ** ** |
|-------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **              | ** ** | **2008**                                    | ** ** | **2009**                                   | ** ** | **2008** | ** ** | **2009** | ** ** |
| Risk-free interest rate |       | 3.40                                        | %          | 3.03                                       | %          | 3.0 - 3.4 | % | 2.7 - 3.2 | % |
| Expected life           |       | 6.25 years                                  |       | 6.25 years                                 |       | 6.14 years |   | 6.25 years |   |
| Expected volatility     |       | 67                                          | %          | 73                                         | %          | 66 | % | 73 | % |
| Expected dividends      |       | 0                                           | %          | 0                                          | %          | 0 | % | 0 | % |

 

The weighted average grantdate fair value of options granted during the three months ended September 2008and 2009 and during the nine months ended September 30, 2008 and 2009 was$8.52, $6.71, $5.73, and $6.42, respectively. The intrinsic value of optionsexercised during the three months ended September 30, 2008 and 2009 andduring the nine months ended September 30, 2008 and 2009 was $1.0 million,$0.3 million, $3.6 million, and $0.6 million, respectively.

 

As of December 31,2008, there was approximately $16.0 million of total unrecognized compensationcost related to non-vested share-based compensation arrangements granted underthe 2001 Plan, which is expected to be recognized over a weighted-averageperiod of 3.73 years.

 

The Company received $33,000and $46,000 in cash from option exercises during the three months ended September 30,2008 and 2009, respectively and $131,000 and $71,000 in cash from optionexercises during the nine months ended September 30, 2008 and 2009,respectively.

 

During the nine months endedSeptember 30, 2008, the Company granted stock options to purchase 10,000shares of common stock to certain advisors (non-employees) of the Company inconsideration of services being performed. These options were fully vested upongrant, and the Company recognized $0.1 million of stock-based compensation expenserelated to these options during the nine months ended September 30, 2008.

 

The Company has estimatedthe fair value of options issued to non-employees using the Black-Scholesoption-pricing model with the following weighted-average assumptions:

 
| Risk-free interest rate |   | 4.60     | %      |
|-------------------------|--------|----------|--------|
| Expected life           |   | 10 years |   |
| Expected volatility     |   | 77.4     | %      |
| Expected dividends      |   | 0        | %      |

 

The assumptions used todetermine the fair value of the non-employee awards were derived in a similarmanner as described above for employee awards, except that the expected life ofnon-employee awards are the stated contractual terms and the Company did notassume any forfeitures. These stock options are subject to variable accountingover the service period, which is expected to be the vesting period, as themeasurement date for these non-employee stock options is the date when theservices have been completed. During the nine months ended September 30,2008, the Company recorded $14,000 of stock-based compensation expense relatedto these options. There was no compensation expense related to these optionsrecorded during the nine months ended September 30, 2009.

 

During the nine months endedSeptember 30, 2008, the Company issued five restricted stock awards for atotal of 24,000 shares of restricted common stock to certain advisors(non-employees) of the Company in consideration of services being performed.These awards were fully vested upon grant, and the Company recognized $0.3million of stock-based compensation expense related to these awards during thenine months ended September 30, 2008.

 

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**A123 Systems, Inc.**

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

**14. Stockholders’ Equity**

 

At September 30, 2009,the Company’s Board of Directors had the authority to issue 255,000,000 sharesof stock, of which 250,000,000 were designated as common stock, with a parvalue of $0.001, and 5,000,000 were designated as preferred stock, with a parvalue of $0.001 per share.

 

Prior to the closing of theCompany’s IPO, the Company had outstanding seven series of redeemableconvertible preferred stock and one series of convertible preferred stock, withvarious rights and preferences, outstanding. On September 29, 2009, in conjunction with the closing of theCompany’s IPO, all of the Company’s 59,026,778 outstanding preferred sharesautomaticallyconvertedon a one-for-one basis, except for Series E redeemable convertiblepreferred stock, which converted on a one-for-1.38 basis, into 61,374,225shares of common stock.  At September 30,2009, the Company had no preferred shares outstanding.

 

The redemption rights of theredeemable common stock terminated on September 29, 2009 in connectionwith the IPO.  At September 30,2009, the 1,592,797 shares previously classified as redeemable common stock areincluded in common stock on the condensed consolidated balance sheet.

 

**15. Subsequent Events**

 

The Company has evaluatedthe period from September 30, 2009, the date of the financial statements,through November 10, 2009, the date of the issuance and filing of thefinancial statements, and has determined that no material subsequent eventshave occurred that would affect the information presented in these financialstatements or require additional disclosure.

 

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**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

*Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with the unaudited condensedconsolidated financial statements and the related notes thereto includedelsewhere in this Quarterly Report on Form 10-Q and the auditedconsolidated financial statements and notes thereto and management’s discussionand analysis of financial condition and results of operations for the yearended December 31, 2008 included in our final prospectus dated September 23,2009 and filed with the Securities and Exchange Commission, or SEC. ThisQuarterly Report on Form 10-Q contains “forward-looking statements” withinthe meaning of Section 21E of the Securities Exchange Act of 1934, asamended, or the Exchange Act. These statements are often identified by the useof words such as “may,” “will,” “expect,” “believe,” “anticipate,” “intend,” “could,”“estimate,” or “continue,” and similar expressions or variations. Suchforward-looking statements are subject to risks, uncertainties and otherfactors that could cause actual results and the timing of certain events todiffer materially from future results expressed or implied by suchforward-looking statements. Factors that could cause or contribute to suchdifferences include, but are not limited to, those discussed in the sectiontitled “Risk Factors,” set forth in Part II, Item 1A of thisQuarterly Report on Form 10-Q and elsewhere in this Report. Theforward-looking statements in this Quarterly Report on Form 10-Q representour views as of the date of this Quarterly Report on Form 10-Q. Weanticipate that subsequent events and developments will cause our views tochange. However, while we may elect to update these forward-looking statementsat some point in the future, we have no current intention of doing so except tothe extent required by applicable law. You should, therefore, not rely on theseforward-looking statements as representing our views as of any date subsequentto the date of this Quarterly Report on Form 10-Q.*

 

**Overview**

 

Wedesign, develop, manufacture and sell advanced, rechargeable lithium-ionbatteries and battery systems. Our target markets are the transportation,electric grid services and consumer markets.

 

Wemarket and sell our products primarily through a direct sales force. In thetransportation market, we are focusing sales of our batteries and batterysystems to automotive manufacturers either directly or through tier 1suppliers. We work with automotive manufacturers directly to educate and informthem about the benefits of our technology for use in hybrid electric vehiclesor, HEVs, plug-in hybrid electric vehicles, PHEVs, and electric vehicles, EVs,and are engaged in design and development efforts with several automotivemanufacturers and tier 1 suppliers. At the same time, we work withtier 1 suppliers who are developing integrated solutions using ourbatteries. In the electric grid services market, our agreement with AES EnergyStorage, LLC, a unit of AES Corporation, was initiated directly by our salesforce. In the consumer market, our sales are made both directly and indirectlythrough distributors with key accounts managed by our sales personnel. We haveentered into an exclusive agreement to license certain of our technology in thefield of consumer electronic devices (excluding power tools and certain otherconsumer products) and expect to receive royalty fees on net sales of licensedproducts that include our technology. We expect to expand our sales presence inEurope and Asia as our business in those regions continues to grow. We expectinternational markets to provide increased opportunities for our products. Weopened our first European sales office in Germany in May 2009.

 

Oursales cycles vary by product and market segment. Most of our batteries andbattery systems typically undergo a lengthy development and qualificationperiod prior to commercial production. We expect that the total time fromcustomer introduction to commercial production will range from three to fiveyears depending on the specific product and market served. Our long andunpredictable sales cycles and the potential large size of battery supply anddevelopment contracts cause our period-to-period financial results to besusceptible to significant variability. Since most of our operating and capitalexpenses are incurred up-front based on the anticipated timing of estimateddesign wins and customer orders, the loss or delay of any such orders couldhave a material adverse effect on a period’s results. The variability in ourperiod-to-period results will also be driven by likely period-to-periodvariations in product mix and by the seasonality experienced by some of the endmarkets into which we sell our products.

 

Wehave been expanding our manufacturing capacity since inception, and we intendto further expand our manufacturing capacity by constructing more manufacturinglines. We intend to accelerate the expansion of our manufacturing capacitysubject to actual and anticipated future demand for our products and thereceipt of stimulus funds from the U.S. and state governments. We believe thatincreases in production capacity have had, and will continue to have, asignificant effect on our financial condition and results of operations. Wehave made and continue to make significant up-front investments in ourmanufacturing capacity, which negatively impact earnings and cash balances, butwe expect these investments will increase our revenue in the long term.

 

Ourresearch and development efforts are focused on developing new products andimproving the performance of existing products. We fund our research anddevelopment initiatives both from internal and external sources. As part of ourdevelopment

 

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strategy, certaincustomers fund or partially fund research and development efforts to design andcustomize batteries and battery systems for their specific application.

 

Wehave continued to experience significant losses since inception, as we havecontinued to invest significantly in anticipation of growth in our business. Inparticular, we have invested in product development and sales and marketing inorder to meet product requirements of our target markets and to secure designwins that may lead to strong revenue growth. We have also invested in theexpansion of our manufacturing capacity to meet anticipated demand and ourbattery systems capabilities to provide battery systems solutions to ourcustomers.  As our business grows, thekey factors to improving our financial performance will be revenue growth andrevenue diversification into the transportation and electric grid servicesmarkets. Our revenue growth and revenue diversification will depend on ourability to secure design wins in the transportation and electric grid servicesmarkets. Higher revenue will also impact gross profit positively as higherproduction volumes will provide for increased absorption of manufacturingoverhead and will reduce, on a percentage basis, the costs associated withincreasing our production capacity.

 

In August 2009, theU.S. government announced that we have been selected to receive a$249.1 million grant award under the Department of Energy, or DOE, BatteryInitiative to fund the construction of new lithium-ion battery manufacturingfacilities in Michigan. We are negotiating a loan under the $25 billionAdvanced Technology Vehicles Manufacturing Loan Program, or the ATVM Program,to support this manufacturing expansion. Based on the amount of our grant awardunder the DOE Battery Initiative and the guidelines associated with the ATVMProgram, we believe we will be permitted to borrow up to $233 millionunder the ATVM Program. Under the DOE Battery Initiative, we will be requiredto spend up to one dollar of our own funds for every incentive dollar wereceive, and we expect we will be required to spend one dollar of our own fundsfor every four dollars we borrow under the ATVM Program. The timing and theamount of any loan we may receive under the ATVM Program, as well as thespecific terms and conditions applicable to our grant award under the DOEBattery Initiative or any loan we may receive, are currently under discussion,and, once fully disclosed to us, are subject to change and negotiation with thefederal government.

 

On September 29, 2009, weclosed our initial public offering of common stock of 32,407,576 shares ofcommon stock at an offering price of $13.50 per share, of which 31,727,075shares were sold by the Company and 680,501 shares were sold by sellingstockholders, resulting in net proceeds of approximately $391.3 million afterdeducting underwriting discounts and offering costs.

 

**FinancialOperations Overview**

 

***Revenue***

 

Wederive revenue from product sales and research and development services.

 

*Product Revenue.*    Product revenue is derivedfrom the sale of our batteries and battery systems.  For the nine months ended September 30,2008 and 2009, product revenue represented 72% and 85% of our total revenues,respectively.

 

Asignificant portion of our revenue is generated from a limited number ofcustomers. Our four largest customers (BAE Systems, Black & Decker,Mercedes-Benz HighPerformanceEngines, and AES Energy Storage, LLC) accountedfor approximately 41% and 72% of our total revenue during the nine monthsended September 30, 2008 and 2009, respectively, and we expect that mostof our revenue will continue to come from a relatively small number ofcustomers for the foreseeable future. As we increase our focus on thetransportation and electric grid markets, BAE Systems and AES Energy Storagewill represent a more significant portion of our 2009 and 2010 revenue, and theloss of BAE Systems and AES Energy as customers could have a material adverseeffect on our short-term revenue. Black & Decker has historicallyrepresented a significant portion of our revenue; however, we expect revenuefrom Black & Decker to decline in future periods as we increase our focuson the transportation and electric grid markets and Black & Decker engagesadditional suppliers for its battery requirements. On November 2, 2009 Stanley Worksand Black & Decker announced that they have entered into a definitivemerger agreement. We do not yet know what impact, if any, this will have on ourcurrent relationship with Black & Decker. We do not anticipate receivingany more revenue in 2009 from Mercedes-Benz HighPerformanceEngines.

 

*Research and Development Services Revenue.*    Research anddevelopment services revenue is derived from contracts awarded by the U.S.federal government, other government agencies and commercial customers. Theseactivities range from pure research, in which we investigate design techniqueson new battery technologies at the request of a government agency or commercialcustomer, to custom development projects in which we are paid to enhance ormodify an existing product or develop a new product to meet a customer’sspecifications. We expect to continue to perform funded research anddevelopment work and to use the technology developed to advance our new productdevelopment efforts. We expect that revenue from research and developmentservices will vary period-to-period depending on the timing of cash paymentsreceived and, if applicable, the achievement of milestones. We expect thatresearch development services revenue will decrease as a percentage of ourtotal revenue due to the expected increase in product revenue.

 

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*Deferred Revenue.*    We record deferred revenue forproduct sales and research and development services in several differentcircumstances. These circumstances include: (i) the products have beendelivered or services have been performed, but other revenue recognitioncriteria have not been satisfied, (ii) payments have been received inadvance of products being delivered or services being performed and (iii) whenall other revenue recognition criteria have been met, but we are not able toreasonably estimate the warranty expense. Deferred revenue includes customerdeposits and up-front fees associated with research and developmentarrangements. Deferred revenue expected to be recognized as revenue more thanone year subsequent to the balance sheet date is classified as long-termdeferred revenue. Deferred revenue will vary depending on the timing and amountof cash receipts from customers and can vary significantly depending onspecific contractual terms. As a result, deferred revenue is likely to fluctuatefrom period-to-period. During 2008, we received and recorded as deferredrevenue a $25.0 million up-front payment in connection with our licenseagreement with Gillette. Under our exclusive license agreement with Gillette,Gillette paid us an up-front fee of $22.5 million and a support fee of$2.5 million. Gillette will also be required to pay us an additionallicense fee following the completion of a support period. In addition, theagreement requires Gillette to pay us royalty fees on net sales of productsthat include our technology. We have agreed with Gillette that if, during acertain period following execution of the license agreement, we enter into anagreement with a third party that materially restricts Gillette’s licenserights under the license agreement, then we may be required to refund toGillette all license and support fees paid to us by Gillette under the licenseagreement, plus, in certain cases, an additional amount to cover Gillette’scapital and other expenses paid and/or committed by Gillette in reliance uponits rights under the license agreement.

 

***Factors that May Affect Comparability***

 

*Public Company Expenses.* In September 2009,we completed an initial public offering of shares of our common stock.  As a result, we are subject to laws,regulations, and requirements that we were not required to comply with as aprivate company, including the Sarbanes-Oxley Act of 2002, other SECregulations and the requirements of the NASDAQ Global Market.  Compliance with these requirements requiresus to increase our general and administrative expenses in order to payconsultants, legal counsel and independent registered public accountants toassist us in, among other things, instituting and monitoring a morecomprehensive compliance and board governance function, establishing andmaintaining internal control over financial reporting in accordance with Section 404of the Sarbanes-Oxley Act of 2002 and preparing and distributing periodicpublic reports in compliance with our obligations under the federal securitieslaws.  In addition, as a public company,it is more expensive for us to obtain directors’ and officers’ liabilityinsurance.

 

***Cost of Revenue and Gross Profit***

 

Costof product revenue includes the cost of raw materials, labor and outside processingfees that are required for the development and manufacture of our products, aswell as manufacturing overhead costs, inventory obsolescence charges, warrantycosts and costs associated with increasing our production capacity. Rawmaterial costs, which are our most significant cost item over the past twoyears, have historically been stable, but increasing energy costs for some ofour materials are expected to increase this cost. This increase may bepartially offset by process innovation, dual sourcing of materials andincreased volume if we achieve better economies of scale. We incur costsassociated with unabsorbed manufacturing expenses prior to a factory operatingat normal operating capacity.  We expectthese unabsorbed manufacturing costs, which include certain personnel, rent,utilities, materials, testing and depreciation costs, to increase in absolutedollars and as a percentage of revenue in the near term.

 

Costof research and development services revenue includes the direct labor costs ofengineering resources committed to funded research and development contracts,as well as third-party consulting, and associated direct material costs.Additionally, we include overhead expenses such as occupancy costs associatedwith the project resources, engineering tools and supplies and programmanagement expense.

 

Ourgross profit as a percentage of revenue is affected by a number of factors,including the mix of products sold, customer diversification, the mix betweenproduct revenue and research and development services revenue, average sellingprices, foreign exchange rates, our actual manufacturing costs and costsassociated with increasing production capacity until full production isachieved. As we continue to grow and build out our manufacturing capacity, andas new product designs come into production, our gross profit will continue tofluctuate from period-to-period.

 

***Operating Expenses***

 

Operatingexpenses consist of research and development, sales and marketing and generaland administrative expenses. Personnel-related expenses comprise the mostsignificant component of these expenses. We expect to hire a significant numberof new

 

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employees in order tosupport our anticipated growth. In any particular period, the timing ofadditional hires could materially affect our operating expenses, both inabsolute dollars and as a percentage of revenue.

 

*Research and Development Expenses.*    Research anddevelopment expenses consist primarily of expenses for personnel engaged in thedevelopment of new products and the enhancement of existing products. Theseexpenses also consist of lab materials, quality assurance activities andfacilities costs and other related overhead. We expense all of our research anddevelopment costs as they are incurred. In the near term, we expect researchand development expenses to increase in large part due to personnel-relatedexpenses as we seek to hire additional employees, as well as contract-relatedexpenses as we continue to invest in the development of our products. Researchand development expense is reported net of any funding received under contractswith governmental agencies and commercial customers that are considered to becost sharing arrangements with no contractually committed deliverable.Accordingly, we expect that our research and development expenses will continueto increase in absolute dollars but decrease as a percentage of revenue in thelong term.

 

*Sales and Marketing Expenses.*    Sales and marketing expensesconsist primarily of personnel-related expenses, travel and other out-of-pocketexpenses for marketing programs, such as trade shows, industry conferences, marketingmaterials and corporate communications, and facilities costs and other relatedoverhead. We intend to hire additional sales personnel, initiate additionalmarketing programs and build additional relationships with resellers, systemsintegrators and strategic partners on a global basis. Accordingly, we expectthat our sales and marketing expenses will continue to increase in absolutedollars but decrease as a percentage of revenue in the long term.

 

*General and Administrative Expenses.*    General andadministrative expenses consist primarily of personnel-related expenses relatedto our executive, legal, finance, human resource and information technologyfunctions, as well as fees for professional services and allocated facilityoverhead expenses. Professional services consist principally of external legal,accounting, tax, audit and other consulting services. We expect general andadministrative expenses to increase as we incur additional costs related tooperating as a publicly-traded company, including increased audit and legalfees, costs of compliance with securities, corporate governance and otherregulations, investor relations expenses and higher insurance premiums,particularly those related to director and officer insurance. In addition, we expectto incur additional costs as we hire personnel and enhance our infrastructureto support the anticipated growth of our business.

 

*Other Income (Expense), Net.*    Other income (expense), netconsists primarily of interest income on cash balances, interest expense onborrowings, change in fair value of preferred stock warrants and foreigncurrency-related gains and losses. We have historically invested our cash inmoney market investments. Our interest income will vary each reporting perioddepending on our average cash balances during the period and the current levelof interest rates. Similarly, our foreign currency-related gains and losseswill also vary depending upon movements in underlying exchange rates.

 

*Provision for Income Taxes.*    Through the year ended December 31,2008, we incurred net losses since inception and have not recorded provisionsfor U.S. federal income taxes since the tax benefits of our net losses havebeen offset by valuation allowances.

 

Wehave recorded a tax provision for foreign taxes associated with our foreignsubsidiaries and state income taxes where our net operating loss deductions arelimited by statutes.

 

**WattHours Operating Metric**

 

Wemeasure our product shipments in watt hours, or Wh, which refers to theaggregate amount of energy that could be delivered in a single completedischarge by a battery. We calculate Wh for each of our battery models bymultiplying the battery’s amp hour, or Ah, storage capacity by the battery’svoltage rating. For example, our 26650 battery is a 2.3 Ah battery thatoperates at 3.3 V, resulting in a 7.6 Wh rating. We determine a battery’s Ahstorage capacity at a specific discharge rate and a specific depth ofdischarge. We do this by charging the battery to its top voltage and bydischarging it to zero capacity (2 volt charge level). The Wh metric allows usand our investors to measure our manufacturing capacity and shipments,regardless of battery voltages and Ah specifications, utilizing a uniform andconsistent metric.

 

**Certain Trends and Uncertainties**

 

The following represents a summary of certain trendsand uncertainties, which could have a significant impact on our financialcondition and results of operations. This summary is not intended to be acomplete list of potential trends and uncertainties that could

 

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impact ourbusiness in the long or short term. The summary, however, should be consideredalong with the factors identified in the section titled “*Risk Factors*” set forth in Part II,Item 1A of this Quarterly Report on Form 10-Q and elsewhere in thisreport.

 
|   | · | We  believe that our future revenues depend on our ability to develop, manufacture  and market products that improve upon existing battery technology and gain  market acceptance. If our battery technology is not adopted by our customers,  or if our battery technology does not meet industry requirements for power  and energy storage capacity in an efficient and safe design, our batteries  will not gain market acceptance;                                                                                                                    |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   | · | We  build our manufacturing capacity based on our projection of future  development and supply agreement wins. Increases in production capacity, have  had, and will continue to have, an effect on our financial condition and  results of operations. Our business revenues and profits will depend upon our  ability to enter into and complete development and supply agreements,  successfully complete these capacity expansion projects, achieve competitive  manufacturing yields and drive volume sales consistent with our demand  expectations; |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   | · | Our  revenues are expected to continue to come from a relatively small number of  customers for the foreseeable future. The loss of our most significant  customer or several of our smaller customers could materially harm our  business.                                                                                                                                                                                                                                                                                                                |

 

**CriticalAccounting Policies**

 

Our financial statements are prepared in accordancewith accounting principles generally accepted in the United States of America.The preparation of our financial statements and related disclosures requires usto make estimates, assumptions and judgments that affect the reported amount ofassets, liabilities, revenue, costs and expenses, and related disclosures. Webase our estimates and assumptions on historical experience and other factorsthat we believe to be reasonable under the circumstances. We evaluate ourestimates and assumptions on an ongoing basis. Our actual results may differfrom these estimates under different assumptions and conditions. Our mostcritical accounting policies are listed below.

 
| ·     | Revenue  recognition;                                   |
|------------|---------------------------------------------------------|
|       |                                                    |
| ·     | Product  warranty obligations;                          |
| ** ** | ** **                                              |
| ·     | Inventory;                                              |
|       |                                                    |
| ·     | Business  Combinations;                                 |
|       |                                                    |
| ·     | Impairment  of goodwill and acquired intangible assets; |
|       |                                                    |
| ·     | Impairment  of long-lived assets;                       |
|       |                                                    |
| ·     | Stock-based  compensation;                              |
|       |                                                    |
| ·     | Grants  to non-employees;                               |
|       |                                                    |
| ·     | Income  taxes                                           |

 

During the three and nine months ended September 30,2009, there were no significant changes in our critical accounting policies orestimates. See our prospectus filed on September 23, 2009 for additionalinformation about these critical accounting policies, as well as a descriptionof our other significant accounting policies.

 

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**Resultsof Consolidated Operations**

 

The following table sets forth selected condensedconsolidated statements of operations data for each of the periods (inthousands):

 
| ** **                                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                           | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                           | ** ** | **2008**               | ** ** | **2009**               | ** ** | **2008** | ** ** | **2009** | ** ** |
| ** **                                                           | ** ** | ** **             | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue:                                                             |       |                   |       |                   |       |   |   |   |   |
| Product                                                              |       | $                      | 14,121     |                   | $          | 20,008 |   | $ | 32,136 |   | $ | 56,646 |   |
| Research and development services                                    |       | 8,821                  |       | 3,589                  |       | 12,740 |   | 9,873 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Total revenue                                                        |       | 22,942                 |       | 23,597                 |       | 44,876 |   | 66,519 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Cost of revenue:                                                     |       |                   |       |                   |       |   |   |   |   |
| Product                                                              |       | 16,841                 |       | 22,570                 |       | 40,638 |   | 61,756 |   |
| Research and development services                                    |       | 5,081                  |       | 2,902                  |       | 7,959 |   | 7,407 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Total cost of revenue                                                |       | 21,922                 |       | 25,472                 |       | 48,597 |   | 69,163 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Gross profit (loss)                                                  |       | 1,020                  |       | (1,875                 | )          | (3,721 | ) | (2,644 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Operating expenses:                                                  |       |                   |       |                   |       |   |   |   |   |
| Research and development                                             |       | 11,058                 |       | 13,136                 |       | 26,152 |   | 35,950 |   |
| Sales and marketing                                                  |       | 2,117                  |       | 1,852                  |       | 5,723 |   | 6,079 |   |
| General and administrative                                           |       | 6,322                  |       | 5,887                  |       | 15,153 |   | 18,339 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Total operating expenses                                             |       | 19,497                 |       | 20,875                 |       | 47,028 |   | 60,368 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Operating loss                                                       |       | (18,477                | )          | (22,750                | )          | (50,749 | ) | (63,012 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Other income (expense):                                              |       |                   |       |                   |       |   |   |   |   |
| Interest income                                                      |       | 551                    |       | 35                     |       | 1,165 |   | 97 |   |
| Interest expense                                                     |       | (154                   | )          | (348                   | )          | (561 | ) | (920 | ) |
| (Loss) gain on foreign exchange                                      |       | (626                   | )          | 670                    |       | (550 | ) | 555 |   |
| Unrealized loss on preferred stock warrant liability                 |       | (177                   | )          | (445                   | )          | (936 | ) | (515 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Other expense, net                                                   |       | (406                   | )          | (88                    | )          | (882 | ) | (783 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Loss from operations, before tax                                     |       | (18,883                | )          | (22,838                | )          | (51,631 | ) | (63,795 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Provision for income taxes                                           |       | 60                     |       | 53                     |       | 244 |   | 320 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Net loss                                                             |       | (18,943                | )          | (22,891                | )          | (51,875 | ) | (64,115 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Less: Net (loss) income attributable to the noncontrolling  interest |       | (27                    | )          | 93                     |       | (90 | ) | 667 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Net loss attributable to A123 Systems, Inc.                     |       | (18,970                | )          | (22,798                | )          | (51,965 | ) | (63,448 | ) |
| Accretion to preferred stock                                         |       | (11                    | )          | (17                    | )          | (31 | ) | (45 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Net loss attributable A123 Systems, Inc. common  stockholders   |       | $                      | (18,981    | )                      | $          | (22,815 | ) | $ | (51,996 | ) | $ | (63,493 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| **Other Operating Data:**                                            |       |                   |       |                   |       |   |   |   |   |
| Shipments (in watt hours, or Wh)(in  thousands)                      |       | 16,202                 |       | 17,128                 |       | 31,625 |   | 44,791 |   |

 

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*Three Months Ended September 30,2008 and 2009*

 

**Revenue**

 
| ** **                        |   | **Three Months Ended September 30,** |       |
|-----------------------------------|--------|-------------------------------------------|------------|
| ** **                        |   | **2008**                                  | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** |   |
| ** **                        |   | **(Dollars in thousands)**                |       |
| **Revenue**                       |   |                                      |       |   |   |   |   |   |   |
| ** **                        |   |                                      |       |   |   |   |   |   |   |
| Product                           |   |                                      |       |   |   |   |   |   |   |
| Consumer                          |   | $                                         | 12,363     |   | $ | 5,364 |   | $ | (6,999 | ) | -56.6 | % |
| Transportation                    |   | 1,758                                     |       | 8,344 |   | 6,586 |   | 374.6 | % |
| Electric grid                     |   | —                                    |       | 6,300 |   | 6,300 |   | 100.0 | % |
|                              |   |                                      |       |   |   |   |   |   |   |
| Total Product                     |   | 14,121                                    |       | 20,008 |   | 5,887 |   | 41.7 | % |
| Research and development services |   | 8,821                                     |       | 3,589 |   | (5,232 | ) | -59.3 | % |
|                              |   |                                      |       |   |   |   |   |   |   |
| Total revenue                     |   | $                                         | 22,942     |   | $ | 23,597 |   | $ | 655 |   | 2.9 | % |

 

*Product Revenue.*The increase in product revenue wasprimarily due to an increase in sales to customers in the transportationindustry of $6.6 million and in the electric grid industry of $6.3 million.These increases were partially offset by a decrease of $5.8 million in sales toBlack & Decker and its affiliates and a decrease of $1.4 million insales generated by Enerland, which was attributable to the decline in demandfor our radio controlled products.  Salesto other consumer customers increased by $0.2 million.

 

*Research and Development Services Revenue.*Revenue relatedto government agency research contracts increased by $0.6 million, and revenuerelated to commercial projects decreased by $5.8 million. The increase ingovernment agency research contract revenue was due to new project awardgrants. The decrease in revenue from commercial projects was due to the timingof project milestones and revenue recognition on active projects.

 

**Cost of Revenue and Gross Profit (Loss)**

 
| ** **                        | ** ** | **Three Months Ended September 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **(Dollars in thousands)**                | ** ** |
| **Cost of revenue**               |       |                                      |       |   |   |   |   |   |   |
|                              |       |                                      |       |   |   |   |   |   |   |
| Product                           |       | $                                         | 16,841     |   | $ | 22,570 |   | $ | 5,729 |   | 34.0 | % |
| Research and development services |       | 5,081                                     |       | 2,902 |   | (2,179 | ) | -42.9 | % |
|                              |       |                                      |       |   |   |   |   |   |   |
| Total cost of revenue             |       | $                                         | 21,922     |   | $ | 25,472 |   | $ | 3,550 |   | 16.2 | % |
|                              |       |                                      |       |   |   |   |   |   |   |
| **Gross profit (loss)**           |       |                                      |       |   |   |   |   |   |   |
|                              |       |                                      |       |   |   |   |   |   |   |
| Product                           |       | $                                         | (2,720     | ) | $ | (2,562 | ) | $ | 158 |   | -5.8 | % |
| Research and development services |       | 3,740                                     |       | 687 |   | (3,053 | ) | -81.6 | % |
|                              |       |                                      |       |   |   |   |   |   |   |
| Total gross profit (loss)         |       | $                                         | 1,020      |   | $ | (1,875 | ) | $ | (2,895 | ) | -283.8 | % |

 

*Cost of Product Revenue*. The increase in cost of product revenuewas primarily due to the increase in product revenue.

 

*Cost of Research and Development Services Revenues*. The decrease in costs of research anddevelopment services revenue resulted from the decrease in research anddevelopment services revenues.

 

*Product Gross Profit (Loss).* We experienced a product gross lossduring the three months ended September 30, 2009, primarily due to lowfactory utilization. Our future gross profit will be affected by numerousfactors, including the build-out of our manufacturing capacity and the timingof the production of new product designs. For example, unabsorbed manufacturingexpenses were $5.2 million during the three months ended September 30,2009. As a result, our gross profit or loss will vary significantly fromperiod-to period going forward.

 

*Research and Development Gross Profit*. Research and development gross profitdecreased due to the decrease in research and development services revenue andthe timing of project milestones.

 

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**Operating Expenses**

 
| ** **                 | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **(Dollars in thousands)**                | ** ** |
| **Operating expenses**     |       |                                      |       |   |   |   |   |   |   |
| ** **                 |       |                                      |       |   |   |   |   |   |   |
| Research and development   |       | $                                         | 11,058     |   | $ | 13,136 |   | $ | 2,078 |   | 18.8 | % |
| Sales and marketing        |       | 2,117                                     |       | 1,852 |   | (265 | ) | -12.5 | % |
| General and administrative |       | 6,322                                     |       | 5,887 |   | (435 | ) | -6.9 | % |
|                       |       |                                      |       |   |   |   |   |   |   |
| Total operating expenses   |       | $                                         | 19,497     |   | $ | 20,875 |   | $ | 1,378 |   | 7.1 | % |

 

*Research and Development Expenses.* A portion of research and developmentexpenses was offset by cost-sharing funding. Our research and developmentexpenditures are summarized as follows:

 
| ** **                                       | ** ** | **Three Months Ended September 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)**                | ** ** |
| **Research and development expenditures**        |       |                                      |       |   |   |   |   |   |   |
|                                             |       |                                      |       |   |   |   |   |   |   |
| Aggregated research and development expenditures |       | $                                         | 11,698     |   | $ | 13,500 |   | $ | 1,802 |   | 15.4 | % |
| Research and development reimbursements          |       | 640                                       |       | 364 |   | (276 | ) | -43.1 | % |
|                                             |       |                                      |       |   |   |   |   |   |   |
| Research and development expenses                |       | $                                         | 11,058     |   | $ | 13,136 |   | $ | 2,078 |   | 18.8 | % |

 

The increase in research and development expenses forthe three months ended September 30, 2009 compared to the three monthsended September 30, 2008 was primarily attributable to an increase of $1.1million in personnel-related expenses associated with an increase in researchand development personnel who primarily focus on manufacturing processimprovement, material science chemistry and battery and battery systemstechnology, in addition to an increase in general product development and otherresearch and development expenses of $1.0 million. Research and developmentexpense as a percentage of revenue was 48% in the three months ended September 30,2008, compared to 56% in the three months ended September 30, 2009.

 

*Sales and Marketing Expenses.* The decrease in sales and marketingexpenses for the three months ended September 30, 2009 compared to thethree months ended September 30, 2008 was primarily attributable to adecrease of $0.3 million in marketing expenses related to trade shows, publicrelations, advertising, and other sales and marketing related expenses and adecrease of $0.1 million in travel expenses. These amounts were partially offset by an increase of $0.1 million inpersonnel-related expenses associated with an increase in sales and marketingpersonnel. Sales and marketing expense was 9% of revenue for the three monthsended September 30, 2008, compared to 8% for the three months ended September 30,2009.

 

*General and Administrative Expenses*. The decrease in general andadministrative expenses for the three months ended September 30, 2009compared to the three months ended September 30, 2008 was primarily due toa termination payment of $1.3 million related to an agreement with a customerwhich is included in the three months ended September 2008, a decrease intravel expenses of $0.1 million and a decrease in other general andadministrative expenses of $0.3 million. These amounts were partially offset by an increase in professional feesof $0.9 million and personnel-related expenses of $0.4 million. Professionalfees were higher compared to the three months ended September 30, 2008primarily due to legal and consulting fees associated with the applicationprocess of the Department of Energy’s ATVM loan and grant programs. General andadministrative expense was 28% of revenue for the three months ended September 30,2008, compared to 25% for the three months ended September 30, 2009.

 

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**Other Income (Expense), Net**

** **
| ** **                                           | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)**                | ** ** |
| **Other income (expense), net**                      |       |                                      |       |   |   |   |   |   |   |
|                                                 |       |                                      |       |   |   |   |   |   |   |
| Interest income                                      |       | $                                         | 551        |   | $ | 35 |   | $ | (516 | ) | -93.6 | % |
| Interest expense                                     |       | (154                                      | )          | (348 | ) | (194 | ) | 126.0 | % |
| (Loss) gain on foreign exchange                      |       | (626                                      | )          | 670 |   | 1,296 |   | -207.0 | % |
| Unrealized loss on preferred stock warrant liability |       | (177                                      | )          | (445 | ) | (268 | ) | 151.4 | % |
|                                                 |       |                                      |       |   |   |   |   |   |   |
| Total other expense, net                             |       | $                                         | (406       | ) | $ | (88 | ) | $ | 318 |   | -78.3 | % |

 

The decrease in interest income for the three monthsended September 30, 2009 was primarily due to lower prevailing interestrates combined with a greater use of money market funds to limit our exposureto loss and to preserve principle. The increase in interest expense wasprimarily due to the total debt outstanding and additional borrowings whichoccurred between September 30, 2008 and September 30, 2009. Theincrease in net foreign exchange gains for the three months ended September 30,2009 is due to the effect of currency exchange rate changes on transactionsthat are non U.S. dollar denominated and charged or credited to earnings. Theincrease in unrealized loss on preferred stock warrant liability was due to theincrease in the fair market value of our stock.

 

*Provision for Income Taxes.* The provision for income taxes for thethree months ended September 30, 2008 and 2009 was primarily related toforeign and state income taxes. We did not report a benefit for federal incometaxes in the condensed consolidated financial statements as the deferred taxasset generated from our net operating loss has been offset by a full valuationallowance because it is more likely than not that the tax benefits of the netoperating loss carry forward may not be realized.

 

*Nine Months Ended September 30,2008 and 2009*

 

**Revenue**

** **
| ** **                         | ** ** | **Nine Months Ended September  30,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|
| ** **                         | ** ** | **2008**                             | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)**           | ** ** |
| **Revenue**                        |       |                                 |       |   |   |   |   |   |   |
| ** **                         |       |                                 |       |   |   |   |   |   |   |
| Product                            |       |                                 |       |   |   |   |   |   |   |
| Consumer                           |       | $                                    | 29,840     |   | $ | 16,329 |   | $ | (13,511 | ) | -45.3 | % |
| Transportation                     |       | 2,296                                |       | 34,017 |   | 31,721 |   | 1381.6 | % |
| Electric  grid                     |       | —                               |       | 6,300 |   | 6,300 |   | 100.0 | % |
|                               |       |                                 |       |   |   |   |   |   |   |
| Total  Product                     |       | 32,136                               |       | 56,646 |   | 24,510 |   | 76.3 | % |
| Research  and development services |       | 12,740                               |       | 9,873 |   | (2,867 | ) | -22.5 | % |
|                               |       |                                 |       |   |   |   |   |   |   |
| Total  revenue                     |       | $                                    | 44,876     |   | $ | 66,519 |   | $ | 21,643 |   | 48.2 | % |

 

*Product Revenue.*The increase in product revenue wasprimarily due to an increase in sales to customers in the transportationindustry of $31.7 million and to the electric grid industry of $6.3 million.These increases were partially offset by a decrease of $11.3 million in salesto Black & Decker and its affiliates and a decrease of $5.5 million insales generated by Enerland, which was attributable to the decline in demandfor our radio controlled products.  Salesto other customers in the consumer industry increased by $3.3 million.

 

*Research and Development ServicesRevenue.*Revenuerelated to commercial projects decreased by $4.9 million.  The decrease in revenue from commercialprojects was due to the timing of project milestones and revenue recognition onactive projects.  This decrease waspartially offset by an increase in revenue related to government agency researchcontracts of $2.0 million. The increase in government agency research contractrevenue was due to new project award grants.

 

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**Cost of Revenue and Gross Profit (Loss)**

 
| ** **                        | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|
| ** **                        | ** ** | **2008**                                 | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **(Dollars in thousands)**               | ** ** |
| **Cost of revenue**               |       |                                     |       |   |   |   |   |   |   |
|                              |       |                                     |       |   |   |   |   |   |   |
| Product                           |       | $                                        | 40,638     |   | $ | 61,756 |   | $ | 21,118 |   | 52.0 | % |
| Research and development services |       | 7,959                                    |       | 7,407 |   | (552 | ) | -6.9 | % |
|                              |       |                                     |       |   |   |   |   |   |   |
| Total cost of revenue             |       | $                                        | 48,597     |   | $ | 69,163 |   | $ | 20,566 |   | 42.3 | % |
|                              |       |                                     |       |   |   |   |   |   |   |
| **Gross profit (loss)**           |       |                                     |       |   |   |   |   |   |   |
|                              |       |                                     |       |   |   |   |   |   |   |
| Product                           |       | $                                        | (8,502     | ) | $ | (5,110 | ) | $ | 3,392 |   | -39.9 | % |
| Research and development services |       | 4,781                                    |       | 2,466 |   | (2,315 | ) | -48.4 | % |
|                              |       |                                     |       |   |   |   |   |   |   |
| Total gross loss                  |       | $                                        | (3,721     | ) | $ | (2,644 | ) | $ | 1,077 |   | -28.9 | % |

 

*Cost of Product Revenue*. The increase in cost of product revenuewas primarily due to the increase in product revenue.

 

*Cost of Research and Development Services Revenues*. The decrease in costs of research anddevelopment services revenue resulted from the decrease in research anddevelopment services revenues.

 

*Product Gross Profit (Loss).* We experienced a product gross lossduring the nine months ended September 30, 2009, primarily due to lowfactory utilization. Our future gross profit will be affected by numerousfactors, including the build-out of our manufacturing capacity and the timingof the production of new product designs. For example, unabsorbed manufacturingexpenses were $16.5 million during the nine months ended September 30,2009. As a result, our gross profit or loss will vary significantly fromperiod-to period going forward.

 

*Research and Development Gross Profit*. Research and development gross profitdecreased due to the decrease in research and development services revenue andthe timing of project milestones.

 
| ** **                 | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------|------------|------------------------------------------|------------|
| ** **                 | ** ** | **2008**                                 | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                 | ** ** | **(Dollars in thousands)**               | ** ** |
| **Operating expenses**     |       |                                     |       |   |   |   |   |   |   |
|                       |       |                                     |       |   |   |   |   |   |   |
| Research and development   |       | $                                        | 26,152     |   | $ | 35,950 |   | $ | 9,798 |   | 37.5 | % |
| Sales and marketing        |       | 5,723                                    |       | 6,079 |   | 356 |   | 6.2 | % |
| General and administrative |       | 15,153                                   |       | 18,339 |   | 3,186 |   | 21.0 | % |
|                       |       |                                     |       |   |   |   |   |   |   |
| Total operating expenses   |       | $                                        | 47,028     |   | $ | 60,368 |   | $ | 13,340 |   | 28.4 | % |

 

*Research and Development Expenses.* A portion of research and developmentexpenses was offset by cost-sharing funding. Our research and developmentexpenditures are summarized as follows:

 
| ** **                                       | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                 | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)**               | ** ** |
| **Research and development expenditures**        | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                             |       |                                     |       |   |   |   |   |   |   |
| Aggregated research and development expenditures |       | $                                        | 29,542     |   | $ | 37,941 |   | $ | 8,399 |   | 28.4 | % |
| Research and development reimbursements          |       | 3,390                                    |       | 1,991 |   | (1,399 | ) | -41.3 | % |
|                                             |       |                                     |       |   |   |   |   |   |   |
| Research and development expenses                |       | $                                        | 26,152     |   | $ | 35,950 |   | $ | 9,798 |   | 37.5 | % |

 

The increase in research and development expenses forthe nine months ended September 30, 2009 compared to the nine months endedSeptember 30, 2008 was primarily attributable to an increase of $4.8million in personnel-related expenses associated with an increase in researchand development personnel who primarily focus on manufacturing processimprovement, material science chemistry and battery and battery systemstechnology, in addition to an increase in general product development and otherresearch and development expenses of $5.0 million. Research and developmentexpense as a percentage of revenue was 58% for the nine months ended September 30,2008, compared to 54% for the nine months ended September 30, 2009.

 

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*Sales and Marketing Expenses.* The increase in sales and marketingexpenses for the nine months ended September 30, 2009 compared to the ninemonths ended September 30, 2008 was primarily attributable to an increaseof $0.7 million in personnel-related expenses associated with an increase insales and marketing personnel. This amount was partially offset by a decrease inmarketing expenses related to trade shows, public relations, advertising andother sales and marketing related expenses by $0.3 million. Sales and marketingexpense was 13% of revenue for the nine months ended September 30, 2008,compared to 9% for the nine months ended September 30, 2009.

 

*General and Administrative Expenses*. The increase in general andadministrative expenses for the nine months ended September 30, 2009compared to the nine months ended September 30, 2008 was primarily due toan increase in personnel-related expenses of $1.8 million and professional feesof $3.0 million.  These amounts werepartially offset by a decrease due to a termination payment of $1.3 millionrelated to an agreement with a customer which is included in the nine monthsended September 2008 and a decrease in other general and administrativeexpenses of $0.3 million.Professional fees were higher compared to the ninemonths ended September 30, 2008 primarily due to legal and consulting feesassociated with the application process of the Department of Energy’s ATVM loanand grant programs. General and administrative expense was 34% of revenue forthe nine months ended September 30, 2008, compared to 28% for the ninemonths ended September 30, 2009.

 

**Other Income (Expense), Net**

 
| ** **                                           | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                 | ** ** | **2009** | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)**               | ** ** |
| **Other income (expense), net**                      |       |                                     |       |   |   |   |   |   |   |
| Interest income                                      |       | $                                        | 1,165      |   | $ | 97 |   | $ | (1,068 | ) | -91.7 | % |
| Interest expense                                     |       | (561                                     | )          | (920 | ) | (359 | ) | 64.0 | % |
| (Loss) gain on foreign exchange                      |       | (550                                     | )          | 555 |   | 1,105 |   | -200.9 | % |
| Unrealized loss on preferred stock warrant liability |       | (936                                     | )          | (515 | ) | 421 |   | -45.0 | % |
|                                                 |       |                                     |       |   |   |   |   |   |   |
| Total other expense, net                             |       | $                                        | (882       | ) | $ | (783 | ) | $ | 99 |   | -11.2 | % |

 

The decrease in interest income for the nine months endedSeptember 30, 2009 was primarily due to lower prevailing interest ratescombined with a greater use of money market funds to limit our exposure to lossand preserve principle. The increase in interest expense was primarily due tothe total debt outstanding and additional borrowings which occurred between September 30,2008 and September 30, 2009.  Theincrease in net foreign exchange gains for the nine months ended September 30,2009 is due to the effect of currency exchange rate changes on transactionsthat are non U.S. dollar denominated and charged or credited to earnings. Thedecrease in unrealized loss on preferred stock warrant liability was due to thedecrease in the fair market value of our stock during the nine months ended September 30,2008.

 

*Provision for Income Taxes.* The provision for income taxes for thenine months ended September 30, 2008 and 2009 was primarily related toforeign and state income taxes. We did not report a benefit for federal incometaxes in the condensed consolidated financial statements as the deferred taxasset generated from our net operating loss has been offset by a full valuationallowance because it is more likely than not that the tax benefits of the netoperating loss carry forward may not be realized.

 

**Liquidityand Capital Resources**

 

The following table sets forth the major sources anduses of cash for each of the periods set forth below (in thousands):

 
| ** **                                                     | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                     | ** ** | **2008**                                 | ** ** | **2009** | ** ** |
| ** **                                                     | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Net cash used in operating activities                          |       | $                                        | (45,066    | ) | $ | (56,965 | ) |
| Net cash used in investing activities                          |       | (19,660                                  | )          | (22,743 | ) |
| Net cash provided by financing activities                      |       | 118,412                                  |       | 503,333 |   |
| Effect of foreign exchange rates on cash and cash  equivalents |       | (344                                     | )          | (67 | ) |
| ** **                                                     | ** ** | ** **                               | ** ** | ** ** | ** ** |
| Net increase in cash and cash equivalents                      |       | $                                        | 53,342     |   | $ | 423,558 |   |

 

As of September 30, 2009, we had cash and cashequivalents of $494.1 million and accounts receivable of $16.1 million.  During the nine months ended September 30,2009, we received $99.9 million from the issuance of series F convertiblepreferred stock and net proceeds of $397.3 million from the initial publicoffering of our common stock.

 

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***Cash Flows From Operating Activities***

 

Operating activities used $57.0 million of net cashduring the nine months ended September 30, 2009. We incurred a net loss of$64.1 million in the nine months ended September 30, 2009, which includednon-cash share-based compensation expense of $6.5 million and depreciation andamortization of $10.2 million. Changes in asset and liability accounts used$9.8 million of net cash during the nine months ended September 30, 2009.

 

Operating activities used $45.1 million of net cashduring the nine months ended September 30, 2008. We incurred a net loss of$51.9 million in the nine months ended September 30, 2008, which includednon-cash share-based compensation expense of $3.4 million and depreciation andamortization of $5.7 million. Changes in asset and liability accounts used $4.1million of net cash during the nine months ended September 30, 2008.

 

We anticipate negative cashflow from operations in the near future as we continue to support theanticipated growth of our business.

 

***Cash Flows From Investing Activities***

 

Cash flows from investing activities primarily relateto capital expenditures to support our growth.

 

Cash used in investing activities totaled $22.7million during the nine months ended September 30, 2009 and consisted ofcapital expenditures of $21.8 million primarily related to the purchase ofmanufacturing equipment and an increase in restricted cash $1.0 million.

 

Cash used in investing activities totaled $19.7million during the nine months ended September 30, 2008 and consisted ofcapital expenditures of $19.9 million primarily related to the purchase ofmanufacturing equipment and a decrease in restricted cash generated $0.2million of cash.

 

We anticipate higher capital expenditure levels infuture periods as we continue to fund the expansion of our facilities tosupport the anticipated growth of our business.

 

***Cash Flows From Financing Activities***

 

Cash flows from financing activities totaled $503.3million during the nine months ended September 30, 2009 and included netproceeds from the initial public issuance of common stock of $397.3, proceedsof $99.6 million from the issuance of series F redeemable convertible preferredstock, proceeds from government grants of $3.0 million, and proceeds fromissuance of long-term debt of $8.6 million. These proceeds were partiallyoffset by repayments on long-term debt of $4.7 million, and repayments oncapital lease obligations of $0.5 million. In 2010, we expect financingactivities such as proceeds from grants, equity offerings and debt issuances tobe a significant source of cash.

 

Cash flows from financing activities totaled $118.4million during the nine months ended September 30, 2008 and includedproceeds of $102.0 million from the issuance of series E convertible preferredstock, $11.5 million from the issuance of redeemable common stock, proceeds of$5.0 million from the issuance of common stock, $1.6 million in proceeds fromthe issuance of long-term debt and $4.3 million from advances under credit lines.These proceeds were partially offset by repayments on long-term debt of $3.6million and deferred offering costs of $2.3 million.

 

**Off-BalanceSheet Arrangements**

 

We did not have during the periods presented, and wedo not currently have, any off-balance sheet arrangements, as defined under SECrules, such as relationships with unconsolidated entities or financialpartnerships, which are often referred to as structured finance or specialpurpose entities, established for the purpose of facilitating financingtransactions that are not required to be reflected on our balance sheet.

 

**ContractualObligations**

 

Our contractual obligations relate primarily toborrowings under long-term debt obligations, capital leases, operating leases,and purchase obligations which include agreements or purchase orders topurchase goods or services that are enforceable and legally binding.

 

In May 2009, we entered into a long-term leasefor a new facility in Livonia, Michigan. The lease is for 291,000 square feet and has an initial term of tenyears with two options to renew for five years each.  Our future minimum payments under this leaseare expected to be $14.2 million over the initial term.

 

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**ITEM****3. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

*Foreign Currency Exchange Risk.* As a result of our foreign operations,we have significant expenses, assets and liabilities that are denominated inforeign currencies. A significant number of our employees are located in Asia.Therefore, a substantial portion of our payroll as well as certain otheroperating expenses are paid in the China RMB and South Korean Won. Additionally,we purchase materials and components from suppliers in Asia. While we pay thesesuppliers in U.S. dollars, their costs are typically based upon the localcurrency of the country in which they operate. All of our revenues are receivedin U.S. dollars because our customer contracts generally provide that ourcustomers will pay us in U.S. dollars.

 

As a consequence, our gross profit, operating results,profitability and cash flows are adversely impacted when the dollar depreciatesrelative to other foreign currencies. We have a particularly significantcurrency rate exposure to changes in the exchange rate between the RMB and theU.S. dollar. For example, to the extent that we need to convert U.S. dollars tofund our operations, appreciation of the RMB against the U.S. dollar would havean adverse effect on the RMB amount we receive from the conversion.

 

We have not used any forward contracts or currencyborrowings to hedge our exposure to foreign currency exchange risk.

 

*Interest Rate Sensitivity.*We had cash and cash equivalents totaling$494.1 million as of September 30, 2009, and $70.5 million as of December 31,2008. Our exposure to interest rate risk primarily relates to the interestincome generated by excess cash invested in highly liquid investments withmaturities of three months or less from the original dates of purchase. Thecash and cash equivalents are held for working capital purposes. We have notused derivative financial instruments in our investment portfolio. We have notbeen exposed, nor do we anticipate being exposed, to material risks due tochanges in market interest rates. Declines in interest rates, however, willreduce future investment income. If overall interest rates had declined by upto 100 basis points during the year ended December 31, 2008 and the ninemonths ended September 30, 2009, our interest income would have decreasedby approximately $0.6 million and $0.1 million, respectively, assumingconsistent investment levels.

 

Interest rate risk also refers to our exposure to movementsin interest rates associated with our interest bearing liabilities. Theinterest bearing liabilities are denominated in U.S. dollars and the interestexpense is based on the prime interest rate plus an additional margin,depending on the respective lending institutions. If the prime rate hadincreased by 100 basis points during the year ended December 31, 2008 andthe nine months ended September 30, 2009, our interest expense would haveincreased by approximately $0.1, assuming consistent borrowing levels.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

*Evaluation of Disclosure Controlsand Procedures.*Our management, with the participation of our chief executive officer and chieffinancial officer, evaluated the effectiveness of our disclosure controls andprocedures as of September 30, 2009. The term “disclosure controls andprocedures,” as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act, means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theSEC’s rules and forms. Disclosure controls and procedures include, withoutlimitation, controls and procedures designed to ensure that informationrequired to be disclosed by a company in the reports that it files or submitsunder the Exchange Act is accumulated and communicated to the company’smanagement, including its principal executive and principal financial officers,as appropriate to allow timely decisions regarding required disclosure.Management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving theirobjectives and management necessarily applies its judgment in evaluating thecost-benefit relationship of possible controls and procedures. Based on theevaluation of our disclosure controls and procedures as of September 30,2009, our chief executive officer and chief financial officer concluded that,as of such date, our disclosure controls and procedures were effective at thereasonable assurance level.

 

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**PART II.OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

In 2005 and 2006, we received communications fromHydro-Quebec, a Canadian utility company, alleging that the cathode material ofour batteries infringes U.S. Patent No. 5,910,382 and U.S. Patent No. 6,514,640that had been granted to The University of Texas, or UT, and that relate tocertain electrode materials used in lithium-ion batteries. We refer to these patentsby the last three digits of the patent number. The ‘382 and ‘640 patentsinclude claims that claim to cover battery cathode material having a particularcrystal structure and chemical formula. We contend that our cathode materialhas a different crystal structure and chemical formula.

 

We believe that UT subsequently licensed the patentsto Hydro-Quebec, which in turn licensed the technology to companies that makeand sell electrode materials for batteries. On April 7, 2006, we commencedan action in the United States District Court for the District of Massachusettsseeking a declaratory judgment that our products do not infringe these patentsand that the patents are invalid. On September 8, 2006, we also requestedex parte reexamination of the two patents by the U.S. Patent &Trademark Office, or PTO, to determine whether the subject matter they claim ispatentable. The reexamination process does not result in findings ofinfringement. In order to have a patent reexamined, the party of interest mustsubmit prior art that raises a ‘‘substantial new question of patentability’’.If the PTO determines that there is a substantial new question ofpatentability, it will order a reexamination. In an ex parte reexamination, athird party requesting reexamination does not participate further in thereexamination proceedings. Once a reexamination is ordered, a new examiner isassigned to the case and the patent goes through another examination similar inprocedure to the examination it received leading up to the issuance of thepatent in the first instance. If any claims are rejected in light of the newquestions raised, then the patent owner can narrow or cancel the rejectedclaims to try to avoid rejection of the claims. The patent owner can alsosubmit new claims, provided they are not broader than the claims in theoriginal patent. Once the reexamination has been concluded and if any claimsare considered patentable, a ‘‘Certificate of Reexamination’’ is issued.

 

On September 11, 2006, Hydro-Quebec and UT commencedan action in the United States District Court for the Northern District ofTexas against us, one of our customers, Black & Decker, whom we haveagreed to indemnify, and one of our suppliers alleging infringement of the twopatents and, in a later amended complaint, false advertising. The plaintiffs’complaint alleges infringement of various claims of the ‘382 Patent and variousclaims of the ‘640 Patent and that we and Black & Decker have engagedin false advertising by making representations about the source and nature ofour technology. The complaint seeks injunctive relief, including againstmaking, using or selling any product containing the patented technology, actualdamages in an unspecified amount, increased and/or treble damages, interest, costsand attorney fees.

 

In October 2006 and January 2007, the PTOgranted our requests for reexamination of the two patents. In January and February 2007,the two litigations in Massachusetts and Texas were stayed pending the PTOreexaminations. Various motions to dismiss, filed by parties on both sides ofthe dispute, remain undecided.

 

During the reexamination, the PTO rejected all of theoriginal claims of the ‘382 Patent as unpatentable. UT then amended the claimsof the ‘382 Patent to make them narrower than the original claims in order todistinguish the claimed invention from the prior art and added two new andnarrower claims. The PTO determined that the narrower amended and new claims ofthe ‘382 Patent submitted during reexamination are patentable and concluded thereexamination of the ‘382 Patent. On April 15, 2008, the PTO issued areexamination certificate with the amended claims and the two new claims.During the reexamination of the ‘640 Patent, the PTO rejected all of theoriginal claims of the ‘640 Patent as unpatentable. UT then amended the claimsof the ‘640 Patent to make them narrower than the original claims in order todistinguish the claimed invention from the prior art.

 

On December 22, 2008, the parties jointlyrequested that the stay of the litigation continue pending resolution of thereexamination of the ‘640 Patent. On May 12, 2009, the PTO issued aReexamination Certificate for the ‘640 Patent with the amended narrower claims,thus removing the last condition for staying this litigation, although thelitigation currently remains stayed. As a result, while Hydro-Quebec and UT mayassert the narrower claims of the reexamination certificate against any allegedinfringer, including us, they are unable to continue to assert the original claimsof the ‘382 Patent and the ‘640 Patent against us. On June 11, 2009, wefiled a motion to reopen the lawsuit in Massachusetts pursuant to the court’sdeadline to file within 30 days of the conclusion of the PTO’s reexamination.On September 28, 2009, the Massachusetts court entered an order denyingthat motion, which we appealed on October 27, 2009 to the United StatesCourt of Appeals for the Federal Circuit. On July 22, 2009, Hydro-Quebec and UT sent us a proposed SecondAmended Complaint in the Texas litigation that they said they intend to seekleave to file in light of the PTO’s reexaminations.

 

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If either or both of the lawsuits are reactivated, weexpect that they could take as much as two years or more to reach trial, if atall. We believe that we do not infringe either UT patent, including the ‘382Patent and the ‘640 Patent following reexamination, and that we have othermeritorious defenses, and we intend to continue to vigorously defend ourproducts and intellectual property rights. The ‘382 and ‘640 Patents includeclaims that claim to cover battery cathode material having a particular crystalstructure and chemical formula, which Hydro-Quebec and UT claim our cathodematerial infringes. We believe, and contend in the lawsuits, that our cathodematerial has a different crystal structure and chemical formula that is notcovered by the ‘382 and ‘640 patents. However, due to the nature of thelitigation, we cannot determine the total expense or possible loss, if any,that may ultimately be incurred either in the context of a trial or as a resultof a negotiated settlement. Although Hydro-Quebec and UT have not specified intheir complaint the nature or extent of their damages, they have asked forinjunctive relief and we believe that they would likely seek substantialdamages that could involve both one-time payments and on-going amounts.Regardless of the ultimate outcome of the litigation, it could result insignificant legal expenses and diversion of time by our technical andmanagerial personnel. The results of these proceedings are uncertain, and therecan be no assurance that they will not have a material adverse effect on ourbusiness, operating results, and financial condition.

 

**Item 1A. Risk Factors**

 

*Ourbusiness is subject to numerous risks. We caution you that the followingimportant factors, among others, could cause our actual results to differmaterially from those expressed in forward-looking statements made by us or onour behalf in filings with the SEC, press releases, communications withinvestors and oral statements. Any or all of our forward-looking statements inthis Quarterly Report on**Form 10-Q**and in any other public statements we make may turnout to be wrong. They can be affected by inaccurate assumptions we might makeor by known or unknown risks and uncertainties. Many factors mentioned in thediscussion below will be important in determining future results. Consequently,no forward-looking statement can be guaranteed. Actual future results maydiffer materially from those anticipated in forward-looking statements. Weundertake no obligation to update any forward-looking statements, whether as aresult of new information, future events or otherwise. You are advised,however, to consult any further disclosure we make in our reports filed withthe SEC.*

 

**RisksRelated to Our Business**

 

***We have had a history of losses, and we may be unable to achieve orsustain profitability.***

 

We have never beenprofitable. We experienced net losses of $15.8 million for 2006, $31.0 millionfor******2007, $80.5million for 2008, and $64.1 million for the nine months ended September 30,2009. We expect we will******continueto incur net losses in 2009. We expect to incur significant future expenses aswe develop and******expand ourbusiness and our manufacturing capacity. In addition, as a public company, wewill incur******additionalsignificant legal, accounting and other expenses that we did not incur as aprivate company.******Theseincreased expenditures will make it harder for us to achieve and maintainfuture profitability. We******mayincur significant losses in the future for a number of reasons, including theother risks described in this******prospectus,and we may encounter unforeseen expenses, difficulties, complications, delaysand other******unknownevents. Accordingly, we may not be able to achieve or maintain profitability.

 

***We have yet to achieve positive cash flow, and our ability to generatepositive cash flow is uncertain.***

 

To rapidly develop andexpand our business, we have made significant up-front investments in our******manufacturing capacity andincurred research and development, sales and marketing and general and******administrative expenses. Inaddition, our growth has required a significant investment in working capital******over the last several years.We have had negative cash flow before financing activities of $29.1 million for2006, $56.1 million for 2007, $76.0 million for 2008, and $79.7 million for thenine months ended September 30,******2009.We anticipate that we will continue to have negative cash flow for theforeseeable future as we******continueto make significant future capital expenditures to expand our manufacturingcapacity and incur******increasedresearch and development, sales and marketing, and general and administrativeexpenses. Our******businesswill also require significant amounts of working capital to support our growth.Therefore, we may******needto raise additional capital from investors to achieve our expected growth, andwe may not achieve******sufficientrevenue growth to generate positive future cash flow. An inability to generatepositive cash flow******forthe foreseeable future or raise additional capital on reasonable terms may decreaseour long-term******viability.

 

***Our limited operating history makes it difficult to evaluate ourcurrent business and future prospects.***

 

We have been in existencesince 2001, but much of our growth has occurred in recent periods. Our limitedoperating history may make it difficult to evaluate our current business andour future prospects. We have encountered and will continue to encounter risksand difficulties frequently experienced by growing companies in rapidlychanging industries, including increasing expenses as we continue to grow ourbusiness. If we do not manage these risks successfully, our business will beharmed.

 

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In addition, we aretargeting new and emerging markets for our batteries and battery systems.However, historically, a significant portion of the products that we have soldare designed for the consumer tool market, which is a more mature market withdifferent growth prospects than our other target markets. Several of ourproducts are still under development, including a battery in prismatic formdesigned for use in the automotive industry, and the timing of the ultimaterelease, if any, of new production quality products is not determinable. Ourefforts to expand beyond our existing markets may never result in new productsthat achieve market acceptance, create additional revenue or become profitable.Therefore, our recent historical growth trajectory may not provide an accuraterepresentation of the market dynamics we may be exposed to in the future,making it difficult to evaluate our future prospects.

 

***The demand for batteries in the transportation and other marketsdepends on the continuation of current trends resulting from dependence onfossil fuels. Extended periods of low gasoline prices could adversely affectdemand for electric and hybrid electric vehicles.***

 

We believe that much of thepresent and projected demand for advanced batteries in the transportation andother markets results from recent increases in the cost of oil, the dependencyof the United States on oil from unstable or hostile countries, governmentregulations and economic incentives promoting fuel efficiency and alternateforms of energy, as well as the belief that climate change results in part fromthe burning of fossil fuels. If the cost of oil decreased significantly, theoutlook for the long-term supply of oil to the United States improved, thegovernment eliminated or modified its regulations or economic incentivesrelated to fuel efficiency and alternate forms of energy, or if there is achange in the perception that the burning of fossil fuels negatively impactsthe environment, the demand for our batteries could be reduced, and ourbusiness and revenue may be harmed.

 

Gasoline prices have beenextremely volatile, and this continuing volatility is expected to persist.Lower gasoline prices over extended periods of time may lower the perception ingovernment and the private sector that cheaper, more readily available energyalternatives should be developed and produced. If gasoline prices remain atdeflated levels for extended periods of time, the demand for hybrid andelectric vehicles may decrease, which would have a material adverse effect onour business.

 

***If we are unable to develop, manufacture and market products thatimprove upon existing battery technology and gain market acceptance, ourbusiness may be adversely affected. In addition, many factors outside of ourcontrol may affect the demand for our batteries and battery systems.***

 

We are researching,developing, manufacturing and selling lithium-ion batteries and batterysystems. The market for advanced rechargeable batteries is at a relativelyearly stage of development, and the extent to which our lithium-ion batterieswill be able to meet our customers’ requirements and achieve significant marketacceptance is uncertain. Rapid and ongoing changes in technology and productstandards could quickly render our products less competitive, or even obsoleteif we fail to continue to improve the performance of our battery chemistry andsystems. Other companies that are seeking to enhance traditional batterytechnologies have recently introduced or are developing batteries based onnickel metal-hydride, liquid lithium-ion and other emerging and potentialtechnologies. These competitors are engaged in significant development work onthese various battery systems. One or more new, higher energy rechargeablebattery technologies could be introduced which could be directly competitivewith, or superior to, our technology. The capabilities of many of thesecompeting technologies have improved over the past several years. Competingtechnologies that outperform our batteries could be developed and successfullyintroduced, and as a result, there is a risk that our products may not be ableto compete effectively in our target markets. If our battery technology is notadopted by our customers, or if our battery technology does not meet industryrequirements for power and energy storage capacity in an efficient and safedesign our batteries will not gain market acceptance.

 

In addition, the market forour products depends upon third parties creating or expanding markets for theirend-user products that utilize our batteries and battery systems. If suchend-user products are not developed, if we are unable to have our productsdesigned into these end user products, if the cost of these end-user productsis too high, or the market for such end-user products contracts or fails todevelop, the market for our batteries and battery systems would be expectedsimilarly to contract or collapse. Our customers operate in extremelycompetitive industries, and competition to supply their needs focuses ondelivering sufficient power and capacity in a cost, size and weight efficientpackage. The ability of our customers to adopt new battery technologies willdepend on many factors outside of our control. For example, in the automotiveindustry, we depend on our customers’ ability to develop HEV, PHEV and EVplatforms that gain broad appeal among end users.

 

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Many other factors outsideof our control may also affect the demand for our batteries and battery systemsand the viability of widespread adoption of advanced battery applications,including:

 

· performance and reliabilityof battery power products compared to conventional and other non-battery energysources and products;

 

· success of alternativebattery chemistries, such as nickel-based batteries, lead-acid batteries andconventional lithium-ion batteries and the success of other alternative energytechnologies, such as fuel cells and ultra capacitors;

 

· end-users’ perceptions ofadvanced batteries as relatively safe and reliable energy storage solutions,which could change over time if alternative battery chemistries prove unsafe orbecome the subject of significant product liability claims and negativepublicity is generated on the battery industry as a whole;

 

· cost-effectiveness of ourproducts compared to products powered by conventional energy sources andalternative battery chemistries;

 

· availability of governmentsubsidies and incentives to support the development of the battery powerindustry;

 

· fluctuations in economicand market conditions that affect the cost of energy stored by batteries, suchas increases or decreases in the prices of electricity;

 

· continued investment by thefederal government and our customers in the development of battery poweredapplications;

 

· heightened awareness ofenvironmental issues and concern about global warming and climate change; and

 

· regulation of energyindustries.

 

***Adverse business or financial conditions affecting the automobileindustry may have a material adverse effect on our development and marketingpartners and our battery business.***

 

Much of our business dependson and is directly affected by the general economic state of the United Statesand global automobile industry. The effect of the continued economicdifficulties of the major automobile manufacturers on our business is unclear.Two major auto manufacturers have filed for bankruptcy and one of our existingcustomers has entered into a debt restructuring process, and it is possiblethat more of these companies may encounter financial difficulties. The impactof any such financial difficulties on the automobile industry and its suppliersis unclear and difficult to predict. Possible effects could include reducedspending on alternative energy systems for automobiles, a delay in theintroduction of new, or the cancellation of new and existing, hybrid andelectric vehicles and programs, and a delay in the conversion of existingbatteries to lithium-ion batteries, each of which would have a material adverseeffect on our business.

 

We have entered intoagreements relating to joint design and development efforts with severalautomotive manufacturers and tier 1 suppliers regarding their HEV, PHEV and EVdevelopment efforts. Certain of these manufacturers and suppliers have inrecent years experienced static or reduced revenues, increased costs, netlosses, loss of market share, bankruptcy, labor issues and other business andfinancial challenges. The viability of the ‘‘Big Three’’ U.S. automanufacturers, particularly GM and Chrysler, remains unclear. As a result,these or other automotive manufacturers may discontinue or delay their plannedintroduction of HEVs, PHEVs or EVs as a result of adverse changes in theirfinancial condition or other factors. Automotive manufacturers may also seekalternative battery systems from other suppliers which may be morecost-effective or require fewer modifications in standard manufacturingprocesses than our products. We may also experience delays or losses withrespect to the collection of payments due from customers in the automotiveindustry experiencing financial difficulties. For example, one of our customers,Think Global, is experiencing financial difficulties. As a result, we recordedan allowance for bad debt of $1.3 million for the outstanding amounts due fromThink and recorded a $2.6 million charge for obsolete inventory related to thisprogram.

 

***We have experienced rapid growth in recent periods. If we fail tomanage our growth effectively, we may be unable to execute our business plan,maintain high levels of service or address competitive challenges adequately.***

 

We increased our number offull-time employees from 227 at December 31, 2006 to 1,689 at September 30,******2009, and our revenueincreased from $34.3 million in 2006 to $68.5 million in 2008. Our growth has******placed, and may continue toplace, a significant strain on our managerial, administrative, operational,******financial, informationtechnology and other resources. We intend to further expand our overallbusiness,******customerbase, headcount and operations both domestically and internationally. Expandinga global******organization andmanaging a geographically dispersed workforce will require substantialmanagement******effort andsignificant additional investment in

 

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our infrastructure. We will be required to continue to******improve our operational,financial and management controls and our reporting procedures and we may******not be able to do soeffectively. As such, we may be unable to manage our expenses effectively inthe******future, which maynegatively impact our operating results in any particular quarter.

 

***Because we build our manufacturing capacity based on our projection offuture design wins and supply agreements, our business revenue and profits willdepend upon our ability to enter into and complete these agreements,successfully complete these expansion projects, achieve competitivemanufacturing yields and drive volume sales consistent with our demandexpectations.***

 

In order to fulfill theanticipated demand for our products, we invest in capital expenditures inadvance of actual customer orders, based on estimates of future demand. We planto continue the expansion of our manufacturing capacity across multiple productlines. The build-up of our internal manufacturing capabilities exposes us tosignificant up-front fixed costs. If market demand for our products does notincrease as quickly as we have anticipated and align with our expandedmanufacturing capacity, or if we fail to enter into and complete projecteddevelopment and supply agreements, we may be unable to offset these costs andto achieve economies of scale, and our operating results may be adverselyaffected as a result of high operating expenses, reduced margins,underutilization of capacity and asset impairment charges. Alternatively, if weexperience demand for our products in excess of our estimates, our installedcapital equipment may be insufficient to support higher production volumes,which could harm our customer relationships and overall reputation. In addition,we may not be able to expand our workforce and operations in a timely manner,procure adequate resources, or locate suitable third-party suppliers, torespond effectively to changes in demand for our existing products or to thedemand for new products requested by our customers, and our current or futurebusiness could be materially and adversely affected. Our ability to meet suchexcess customer demand could also depend on our ability to raise additionalcapital and effectively scale our manufacturing operations.

 

We utilize standardmanufacturing equipment that we modify and customize in order to meet ourproduction needs. While this equipment may be available from various suppliers,its procurement requires long lead times. Therefore, we may experience delays,additional or unexpected costs and other adverse events in connection with ourcapacity expansion projects, including those associated with potential delaysin the procurement and customization of manufacturing equipment.

 

If we are unable to achieveand maintain satisfactory production yields and quality as we expand ourmanufacturing capabilities, our relationships with certain customers andoverall reputation may be harmed, and our sales could decrease.

 

***We may not be able to obtain, or to agree on acceptable terms andconditions for, all or a significant portion of the government grants, loansand other incentives for which we have applied and may in the future apply. Ourcustomers and potential customers applying for government grants, loans andother incentives may condition purchases of our products upon their receipt ofthese funds or delay purchases of our products until their receipt of thesefunds.***

 

We have applied for federaland state grants, loans and tax incentives under government programs designedto stimulate the economy and support the production of electric vehicles andadvanced battery technologies. Much of our planned domestic manufacturingcapacity expansion depends on receipt of these funds and other incentives, andthe failure to obtain these funds or other incentives could materially andadversely affect our ability to expand our manufacturing capacity and meetplanned production levels. We anticipate that in the future there will be newopportunities for us to apply for grants, loans and other incentives from theUnited States, state and foreign governments. Our ability to obtain funds orincentives from government sources is subject to the availability of fundsunder applicable government programs and approval of our applications toparticipate in such programs. The application process for these funds and otherincentives is and will be highly competitive. While we have been notified thatwe have been selected to receive a grant under the DOE Battery Initiative andhave received some state incentives, we cannot assure you that we will besuccessful in obtaining additional grants, loans and other incentives.Moreover, state incentives depend on the continued availability of state funds.With respect to the grant which we have been awarded and the grants, loans andother incentives we may be awarded, we may not be able to satisfy or continueto satisfy the requirements and milestones imposed by the granting authority asconditions to receipt of the funds or other incentives, the timing of thereceipt of the funds may not meet our needs and we nevertheless may be unableto successfully execute on our business plan. Moreover, not all of the termsand conditions associated with these incentive funds have been disclosed to us,and once disclosed, there may be terms and conditions with which we are unableto comply or which are commercially unacceptable to us. In addition, the DOEBattery initiative grant and any other federal government programs which maymake additional awards to us will require us to spend a portion of our ownfunds for every incentive dollar we receive or are permitted to borrow from thegovernment and will impose time limits during which we must use the fundsawarded to us. If we are unable to raise sufficient additional capital so thatwe are able to receive all of the amounts which have and may be awarded to usin a timely manner, our ability to expand our manufacturing capacity could bematerially adversely affected. In addition, less than expected actual andanticipated future demand for our products may cause us to slow the pace of theexpansion of our manufacturing

 

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capacity such that we are not able to use the government incentive fundsawarded or made available to us in the time periods required by the grantingauthorities.

 

Our customers and potentialcustomers applying for these government grants, loans and other incentives maycondition purchases of our products upon receipt of these funds or delaypurchases of our products until receipt of these funds, and if our customersand potential customers do not receive these funds or the receipt of thesefunds is significantly delayed, our results of operations could suffer.

 

***We rely on a limited number of customers for a significant portion ofour revenue, and the loss of our most significant or several of our smallercustomers could materially harm our business.***

 

A significant portion of ourrevenue is generated from a limited number of customers. During each of****the years ended December 31, 2007 and2008 and the nine months ended September 30, 2008 and 2009, Black &****Decker, together with its affiliates,represented 66%, 44%, 33%, and 18% of our revenue, respectively.****During the year ended December 31,2008 and the nine months ended September 30, 2009, revenue from****Mercedes-Benz HighPerformanceEnginesrepresented 12% and 10%, respectively, of our revenue. We****expect revenue from Black &Decker will decline in the remainder of 2009 and therefore represent a****smaller percentage of our revenue infuture quarters. On November 2, 2009, Stanley Works and Black &Decker announced that they have entered into a definitive merger agreement.  We do not yet know what impact, if any, thiswill have on our current relationship with Black & Decker.  In addition, we do not anticipate receivingany more****revenue in 2009 fromMercedes-Benz HighPerformanceEngines. For the nine months ended September 30,2009,****revenue from BAE Systemsrepresented 35% of our revenue. For the nine months ended September 30, 2009,revenue from AES Energy accounted for 9% of our revenue. Although thecomposition of our significant****customerswill vary from period to period, we expect that most of our revenue willcontinue, for the****foreseeablefuture, to come from a relatively small number of customers. In addition, ourcontracts with our****customers donot include long-term commitments or minimum volumes that ensure future salesof our****products. Consequently, ourfinancial results may fluctuate significantly from period-to-period based on****the actions of one or more significantcustomers. A customer may take actions that affect us for reasons****that we cannot anticipate or control, suchas reasons related to the customer’s financial condition, changes****in the customer’s business strategy oroperations, the introduction of alternative competing products, or as****the result of the perceived quality orcost-effectiveness of our products. Our agreements with these****customers may be cancelled if we fail tomeet certain product specifications or materially breach the****agreement or for other reasons outside ofour control. In addition, our customers may seek to renegotiate****the terms of current agreements orrenewals. The loss of or a reduction in sales or anticipated sales to our****most significant or several of our smallercustomers could have a material adverse effect on our business,****financial condition and results ofoperations.

 

***Our financial results may vary significantly from period-to-period dueto the long and unpredictable sales cycles for some of our products, theseasonality of certain end markets into which we sell our products, and changesin the mix of products we sell during a period, which may lead to volatility inour stock price.***

 

The size and timing of ourrevenue from sales to our customers is difficult to predict and is marketdependent. Our sales efforts often require us to educate our customers aboutthe use and benefits of our products, including their technical and performancecharacteristics. Customers typically undertake a significant evaluation processthat has in the past resulted in a lengthy sales cycle for us, typically manymonths. In some markets such as the transportation market, there is usually asignificant lag time between the design phase and commercial production. Wespend substantial amounts of time and money on our sales efforts and there isno assurance that these investments will produce any sales within expected timeframes or at all. Given the potentially large size of battery development andsupply contracts, the loss of or delay in the signing of a contract or acustomer order could reduce significantly our revenue in any period. Since mostof our operating and capital expenses are incurred based on the estimatednumber of design wins and their timing, they are difficult to adjust in theshort term. As a result, if our revenue falls below our expectations or isdelayed in any period, we may not be able to reduce proportionately ouroperating expenses or manufacturing costs for that period, and any reduction ofmanufacturing capacity could have long-term implications on our ability toaccommodate future demand.

 

Our profitability fromperiod-to-period may also vary significantly due to the mix of products that wesell in different periods. While we have sold most of our products to date intothe consumer market, as we expand our business we expect to sell new batteryand battery system products into other markets and for other applications.These products are likely to have different cost profiles and will be sold intomarkets governed by different business dynamics. Consequently, sales ofindividual products may not necessarily be consistent across periods, whichcould affect product mix and cause gross and operating profits to varysignificantly.

 

In addition, since ourbatteries and battery systems are incorporated into our customers’ products forsale into their respective end markets, our business is exposed to the seasonaldemand that may characterize some of our customers’ own product sales. Because

 

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many of our expenses are based on anticipated levels of annual revenue,our business and operating results could also suffer if we do not achieverevenue consistent with our expectations for this seasonal demand.

 

As a result of thesefactors, we believe that quarter-to-quarter comparisons of our operatingresults are not necessarily meaningful and that these comparisons cannot berelied upon as indicators of future performance. Moreover, our operatingresults may not meet expectations of equity research analysts or investors. Ifthis occurs, the trading price of our common stock could fall substantiallyeither suddenly or over time.

 

***Our principal competitors have, and any future competitors may have,greater financial and marketing resources than we do, and they may thereforedevelop batteries or other technologies similar or superior to ours orotherwise compete more successfully than we do.***

 

Competition in the batteryindustry is intense. The industry consists of major domestic and internationalcompanies, most of which have existing relationships in the markets into whichwe sell as well as financial, technical, marketing, sales, manufacturing,scaling capacity, distribution and other resources and name recognitionsubstantially greater than ours. These companies may develop batteries or othertechnologies that perform as well as or better than our batteries. We believethat our primary competitors are existing suppliers of cylindrical lithium-ion,nickel cadmium, nickel metal-hydride and in some cases, non-starting/lighting/ignitionlead-acid batteries. A number of our competitors have existing and evolvingrelationships with our target customers. For example, Bosch and Samsung formedLiMotive to focus on the development, production and marketing of lithium-ionbattery systems for application in hybrid and other electric vehicles, and DowChemical recently announced the establishment of a joint venture with KokamAmerica and others, pending receipt of government incentive funding, to build afacility in Michigan for the manufacture of lithium polymer batteries for usein HEVs and EVs. In addition, NEC and Nissan entered into a joint venture todevelop lithium-ion batteries in prismatic form, Sanyo and Volkswagen agreed todevelop lithium-ion batteries for HEVs, Sanyo already provides nickel metalhydride batteries for Ford and Honda, and Toyota and Panasonic are engaged in ajoint venture to make batteries for HEVs and EVs. In addition, we expect newcompetitors will enter the markets for our products in the future. Potentialcustomers may choose to do business with our more established competitors,because of their perception that our competitors are more stable, are morelikely to complete various projects, can scale operations more quickly, havegreater manufacturing capacity, are more likely to continue as a going concernand lend greater credibility to any joint venture. If we are unable to competesuccessfully against manufacturers of other batteries or technologies in any ofour targeted applications, our business could suffer, and we could lose or beunable to gain market share.

 

***If our products fail to perform as expected, we could lose existing andfuture business, and our ability to develop, market and sell our batteries andbattery systems could be harmed.***

 

Our products are complex andcould have unknown defects or errors, which may give rise to claims******against us, diminish ourbrand or divert our resources from other purposes. Despite testing, new and******existing products havecontained defects and errors and may in the future contain manufacturing ordesign******defects, errorsor performance problems when first introduced, when new versions orenhancements are******released,or even after these products have been used by our customers for a period oftime. These******problemscould result in expensive and time-consuming design modifications or warrantycharges, delays in******theintroduction of new products or enhancements, significant increases in ourservice and maintenance******costs,exposure to liability for damages, damaged customer relationships and harm toour reputation, any******ofwhich may adversely affect our business and our operating results.

 

Our success in thetransportation market depends, in part, on our ability to design, develop and******commercially manufacturelithium-ion batteries in prismatic form for use in HEVs, PHEVs and EVs******currently being developedand that may be developed in the future. The design and development of a******lithium-ion battery inprismatic form for use in the automotive industry is complex, expensive,******time-consuming and subjectto rigorous quality and performance requirements. If we are unable to design,******develop and commerciallymanufacture lithium-ion batteries in prismatic form that are accepted for usein******the automotiveindustry, our business and operating results may be adversely affected.

 

***In the past, we have identified material weaknesses in our internalcontrol over financial reporting and if we fail to remediate these weaknessesand maintain proper and effective internal controls, our ability to produceaccurate and timely financial statements could be impaired, which could harmour operating results, our ability to operate our business and investors’ viewsof us.***

 

Ensuring that we haveadequate internal financial and accounting controls and procedures in place sothat we can produce accurate financial statements on a timely basis is a costlyand time-consuming effort that needs to be evaluated frequently. In connectionwith our financial audits, we identified material weaknesses in our internalcontrol over financial reporting. A material weakness is defined

 

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as a deficiency, or combination of deficiencies, in internal control overfinancial reporting, such that there is a reasonable possibility that amaterial misstatement of the company’s annual or interim financial statementswill not be prevented or detected on a timely basis by the company’s internalcontrols. These material weaknesses were as follows:

 

· we did not have an adequatenumber of personnel in our accounting and finance department with sufficienttechnical accounting expertise and, as a result, we could not evaluate in atimely manner the accounting implications of our business transactions; and

 

· we did not design ormaintain effective operating and information technology controls over thefinancial statement close and reporting process in order to ensure the accurateand timely preparation of financial statements in accordance with accountingprinciples generally accepted in the United States, or GAAP.

 

We are in the process oftaking the necessary steps to remediate the material weaknesses that weidentified and have made enhancements to our control procedures; however, thematerial weaknesses will not be remediated until the necessary controls havebeen implemented and are operating effectively. We do not know the specifictime frame needed to fully remediate the material weaknesses identified.

 

We cannot assure you thatour efforts to fully remediate these internal control weaknesses will besuccessful or that similar material weaknesses will not recur.

 

Implementing any appropriatechanges to our internal controls may distract our officers and employees,entail substantial costs to implement new processes and modify our existingprocesses and take significant time to complete. Moreover, these changes do notguarantee that we will be effective in maintaining the adequacy of our internalcontrols, and any failure to maintain that adequacy, or consequent inability toproduce accurate financial statements on a timely basis, could increase ouroperating costs and harm our business. In addition, investors’ perceptions thatour internal controls are inadequate or that we are unable to produce accuratefinancial statements on a timely basis may harm our stock price and make itmore difficult for us to effectively market and sell our products to new andexisting customers. For a more detailed discussion of our material weaknesses,see “Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Internal Control Over Financial Reporting.”

 

***If our warranty expense estimates differ materially from our actualclaims, or if we are unable to estimate future warranty expense for new products,our business and financial results could be harmed.***

 

Our warranty for ourproducts ranges from one to five years from the date of sale, depending on thetype of product and its application. We expect that in the future some of ourwarranties will extend beyond five years. In the consumer market, we typicallyprovide a warranty against certain potential manufacturing defects, which maycause high-rates of self-discharge, inaccurate voltage, and other productirregularities. In the electric grid services and transportation markets, wemay also provide a warranty against a certain percentage decline in the initialpower and energy density specifications of a particular product. Since we beganselling our first products in the consumer market in the first quarter of 2006and in the transportation market in the first quarter of 2007, and we have onlyrecently shipped our first product in the electric grid services market, wehave a limited product history on which to base our warranty estimates. Becauseof the limited operating history of our batteries and battery systems, ourmanagement is required to make assumptions and to apply judgment regarding anumber of factors, including anticipated rate of warranty claims, thedurability and reliability of our products, and service delivery costs. Ourassumptions could prove to be materially different from the actual performanceof our batteries and battery systems, which could cause us to incur substantialexpense to repair or replace defective products in the future and may exceedexpected levels against which we have reserved. If our estimates proveincorrect, we could be required to accrue additional expenses from the time werealize our estimates are incorrect and also face a significant unplanned cashburden at the time our customers make a warranty claim, which could harm ouroperating results.

 

In addition, with our newproducts and products that remain under development, we will be required tobase our warranty estimates on historical experience of similar productstesting of our batteries and performance information learned during ourdevelopment activities with the customer. If we are unable to estimate futurewarranty costs for any new product, we will be required to defer recognizingrevenue for that product until we are able reasonably to estimate theassociated warranty expense. As a result, our financial results could varysignificantly from period-to-period.

 

***Product liability or other claims could cause us to incur losses ordamage our reputation.***

 

The risk of productliability claims and associated adverse publicity is inherent in thedevelopment,******manufacturing,marketing and sale of batteries and battery systems. Certain materials we usein our******batteries, aswell as our batteries and battery systems, could, if

 

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used improperly, cause injuries to others.******Improperly charging or discharging our batteries couldcause fires. Any accident involving our batteries or******other products could decrease or even eliminate demandfor our products. Because some of our batteries******are designed to be used in vehicles, and becausevehicle accidents can cause injury to persons and damage******to property, we are subject to a risk of claims forsuch injuries and damages. In addition, we could be******harmed by adverse publicity resulting from problems oraccidents caused by third party products that******incorporate our batteries. For example, our businessand operating results could be harmed by adverse******publicity resulting from injury to persons or damage toproperty caused by a defective electronic system on******a battery system manufactured by a third party thatincorporates our batteries.

 

Although we have productliability insurance for our products of up to an annual aggregate limit of******$102 million, this may beinadequate to cover all potential product liability claims. In addition, whilewe******often seek tolimit our product liability in our contracts, such limits may not beenforceable or may be******subjectto exceptions. Any product recall or lawsuit seeking significant monetarydamages either in excess******ofour coverage, or outside of our coverage, may have a material adverse affect onour business and******financialcondition. We may not be able to secure additional product liability insurancecoverage on******acceptableterms or at reasonable costs when needed. If we were to experience a largeinsured loss, it******mightexceed our coverage limits, or our insurance carriers could decline to furthercover us or raise our******insurancerates to unacceptable levels, any of which could impair our financial positionand results of******operations.A successful product liability claim against us could require us to pay asubstantial monetary******award.We cannot assure you that such claims will not be made in the future.

 

***We are subject to financial and reputational risks due to productrecalls resulting from product quality and liability issues.***

 

The risk of product recalls,and associated adverse publicity, is inherent in the development,manufacturing, marketing, and sale of batteries and battery systems. Ourproducts and the products of third parties in which our products are acomponent are becoming increasingly sophisticated and complicated as rapidadvancements in technologies occur, and as demand increases for lighter andmore powerful rechargeable batteries. At the same time, product quality andliability issues present significant risks. Product quality and liabilityissues may affect not only our own products but also the third-party productsin which our batteries and battery systems are a component. Our efforts and theefforts of our development partners to maintain product quality may not besuccessful, and if they are not, we may incur expenses in connection with, forexample, product recalls and lawsuits, and our brand image and reputation as aproducer of high-quality products may suffer. Any product recall or lawsuitseeking significant monetary damages could have a material adverse effect onour business and financial condition. A product recall could generatesubstantial negative publicity about our products and business, interfere withour manufacturing plans and product delivery obligations as we seek to replaceor repair affected products, and inhibit or prevent commercialization of otherfuture product candidates. Although we do have product liability insurance, wedo not have insurance to cover the costs associated with a product recall andthe expenses we would incur in connection with a product recall could have amaterial adverse affect on our operating results.

 

***We depend on third parties to deliver raw materials, parts, componentsand services in adequate quality and quantity in a timely manner and at areasonable price.***

 

Our manufacturing operationsdepend on obtaining raw materials, parts and components, manufacturingequipment and other supplies including services from reliable suppliers inadequate quality and quantity in a timely manner. It may be difficult for us tosubstitute one supplier for another, increase the number of suppliers or changeone component for another in a timely manner or at all due to the interruptionof supply or increased industry demand. This may adversely affect ouroperations. The prices of raw materials, parts and components and manufacturingequipment may increase due to changes in supply and demand. In addition,currency fluctuations and a weakening of the U.S. dollar against foreigncurrencies may adversely affect our purchasing power for raw materials, partsand components and manufacturing equipment from foreign suppliers.

 

We depend on sole sourcesuppliers or a limited number of suppliers for certain key raw materials andcomponent parts used in manufacturing and developing our products. We generallypurchase raw materials pursuant to purchase orders placed from time to time andhave no long-term contracts or other guaranteed supply arrangements with oursole or limited source suppliers. Therefore, our operating margins may beimpacted by price fluctuations in the commodities we use as raw materials inour batteries. As a result, our suppliers may not be able to meet ourrequirements relative to specifications and volumes for key raw materials, andwe may not be able to locate alternative sources of supply at an acceptablecost. In the past, we have experienced delays in product development due to thedelivery of raw materials from our suppliers that do not meet ourspecifications. In addition, if a sole source supplier ceased to continue toproduce a component with little or no notice to us, our business could beharmed. Any future inability to obtain high quality raw materials ormanufacturing equipment in sufficient quantities on competitive pricing termsand on a timely basis, due to global supply and demand or a dispute with asupplier, may delay battery production, impede our ability to fulfill existingor future purchase orders and harm our reputation and profitability.

 

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***Our failure toraise additional capital necessary to expand our operations and invest in ourproducts and manufacturing facilities could reduce our ability to competesuccessfully.***

 

Wemay require additional capital in the future and we may not be able to obtainadditional debt or******equityfinancing on favorable terms, if at all. If we raise additional equityfinancing, our stockholders may******experiencesignificant dilution of their ownership interests, and the per-share value ofour common stock******coulddecline. If we engage in debt financing, we may be required to accept termsthat restrict our ability to******incuradditional indebtedness and force us to maintain specified liquidity or otherratios. We are also******seekingfederal and state grants, loans and tax incentives some of which we intend touse to expand our******operations.We may not be successful in obtaining these funds or incentives. If we needadditional capital******andcannot raise or otherwise obtain it on acceptable terms, we may not be able to,among other things:

 

· develop or enhanceour products or introduce new products;

 

· continue to expandour development, sales and marketing and general and administrative organizationsand manufacturing operations;

 

· attract top-tiercompanies as customers or as our technology and product development partners;

 

· acquirecomplementary technologies, products or businesses;

 

· expand ouroperations, in the United States or internationally;

 

· expand andmaintain our manufacturing capacity;

 

· hire, train andretain employees; or

 

· respond tocompetitive pressures or unanticipated working capital requirements.

 

***Our inability to obtain federal and state government environmental permitsand approvals for our planned  U.S.manufacturing facilities could negatively impact our ability to obtain federaland state incentive funding and materially harm our business.***

 

Pursuant to applicable environmental and safety lawsand regulations, we are required to obtain and maintain certain governmentalpermits and approvals and to comply with applicable federal and stateenvironmental laws and regulations, including the National Environmental PolicyAct (NEPA), with respect to our planned U.S. manufacturing facilities.  Inparticular, NEPA requires the federal government (including the U.S. Departmentof Energy) to evaluate the environmental impacts associated with our plannedmanufacturing facilities, and to identify and evaluate potential alternativesto our facilities.   We are in theprocess of obtaining a determination under NEPA and obtaining other federal andstate environmental permits.   However, there is no guarantee thatrequired determinations, permits and approvals will ultimately be obtained; thefailure to complete the NEPA process with a Finding of No Significant Impact,or to obtain other required federal and state environmental permits, could havean adverse effect on our financial results and could also delay or prevent usfrom  obtaining matching fundreimbursement from the $249.1 million grant we were awarded under the DOEBattery Initiative, as well as funding under the DOE ATVM loan program.

 

If obtained, permits and approvals may be subject torevocation, modification or denial under certain circumstances.  Ouroperations or activities could result in administrative or private actions,revocation of required permits or licenses, or fines, penalties or damages,which could have an adverse effect on us.  In addition, environmental lawswill likely become more stringent over time, thereby requiring new capitalexpenditures and increases in operating costs.

 

***Our workingcapital requirements involve estimates based on demand expectations and maydecrease or increase beyond those currently anticipated, which could harm ouroperating results and financial condition.***

 

Inorder to fulfill the product delivery requirements of our customers, we planfor working capital needs in advance of customer orders. As a result, we baseour funding and inventory decisions on estimates of future demand. If demandfor our products does not increase as quickly as we have estimated or drops offsharply, our inventory and expenses could rise, and our business and operatingresults could suffer. Alternatively, if we experience sales in excess of ourestimates, our working capital needs may be higher than those currentlyanticipated. Our ability to meet this excess customer demand depends on ourability to arrange for additional financing for any ongoing working capitalshortages, since it is likely that cash flow from sales will lag behind theseinvestment requirements.

 

***Credit marketvolatility and illiquidity may affect our ability to raise capital to financeour operations, plant expansion and growth.***

 

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Thecredit markets have experienced extreme volatility during the last year, andworldwide credit markets have remained illiquid despite injections of capitalby the federal government and foreign governments. Despite the capitalinjections and government actions, banks and other lenders, such as equipmentleasing companies, have significantly increased credit requirements and reducedthe amounts available to borrowers. Companies with low credit ratings may nothave access to the debt markets until the liquidity improves, if at all. Ifcurrent credit market conditions do not improve, we may not be able to accessdebt or leasing markets to finance our plant expansion plans.

 

***We may be unableto successfully implement or manage our planned expansion of our domesticmanufacturing capability or realize the expected benefits of our plannedexpansion.***

 

Weexpect to aggressively expand our battery manufacturing capacity in the UnitedStates to meet expected demand for our product. Much of our planned domesticexpansion depends upon our receipt of sufficient federal and state incentivefunding. We may not receive the federal and state funding necessary for ourplanned expansion at all or on a timely basis. In addition, such funding couldbe subject to conditions that are commercially unacceptable to us or for whichwe are unable to comply. Even if we succeed in aggressively expanding ourdomestic manufacturing capacity, we may not have enough demand for our productsto justify the increased capacity.

 

Anysuch expansion will place a significant strain on our senior management teamand our financial and other resources. Our proposed expansion will expose us togreater overhead and support costs and other risks associated with themanufacture and commercialization of new products. Our ability to manage ourgrowth effectively will require us to continue to improve our operations and ourfinancial and management information systems and to train, motivate and manageour employees. Difficulties in effectively managing the budgeting, forecastingand other process control issues presented by such a rapid expansion could harmour business, prospects, results of operations and financial condition.

 

***We may not beable to successfully recruit and retain skilled employees, particularlyscientific, technical and management professionals.***

 

Webelieve that our future success will depend in large part on our ability toattract and retain highly******skilledtechnical, managerial and marketing personnel who are familiar with our keycustomers and******experiencedin the battery industry. We plan to continue to expand our work force bothdomestically and******internationally.Industry demand for such employees, especially employees with experience inbattery******chemistry andbattery manufacturing processes, however, exceeds the number of personnelavailable, and******thecompetition for attracting and retaining these employees is intense. Thiscompetition will intensify if******theadvanced battery market continues to grow, possibly requiring increases incompensation for current******employeesover time. We compete in the market for personnel against numerous companies,including******larger, moreestablished competitors who have significantly greater financial resources thanwe do and may******be in abetter financial position to offer higher compensation packages to attract andretain human capital.******Wecannot be certain that we will be successful in attracting and retaining theskilled personnel necessary******tooperate our business effectively in the future. Because of the highly technicalnature of our batteries and******batterysystems, the loss of any significant number of our existing engineering andproject management******personnelcould have a material adverse effect on our business and operating results.

 

***Our futuresuccess depends on our ability to retain key personnel.***

 

Oursuccess will depend to a significant extent on the continued services of our seniormanagement team, and in particular David Vieau, our chief executive officer,and Gilbert N. Riley, Jr., our chief technical officer. The loss orunavailability of either of these individuals could harm our ability to executeour business plan, maintain important business relationships and completecertain product development initiatives, which could harm our business. We donot have agreements requiring any of our senior management team to remain withour company. In addition, each of these individuals could terminate his or herrelationship with us at any time, and we may be unable to enforce anyapplicable employment or non-compete agreements.

 

***If we do notcontinue to form and maintain economic arrangements with original equipmentmanufacturers, or OEMs, to commercialize our products, our profitability couldbe impaired.***

 

Ourbusiness strategy requires us to integrate the design of our products intoproducts being developed by OEMs, and therefore to identify acceptable OEMs andenter into agreements with them. In addition, we will need to meet theirrequirements and specifications by developing and introducing new products andenhanced or modified versions of our existing products on a timely basis. OEMsoften require unique configurations or custom designs for batteries or batterysystems which must be developed and integrated into a

 

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productwell before the product is launched. This development process requires not onlysubstantial lead time between the commencement of design efforts for acustomized battery system and the commencement of volume shipments of thebattery systems to the customer, but also the cooperation and assistance of theOEMs in order to determine the requirements for each specific application.Technical problems may arise that affect the acceptance of our product by OEMs. Ifwe are unable to design and develop products that meet OEMs’ requirements, wemay lose opportunities to obtain purchase orders, and our reputation may bedamaged. In addition, we may not receive adequate assistance from OEMs tosuccessfully commercialize our products, which could impair our profitability.

 

***Declines in productprices may adversely affect our financial results.***

 

Ourbusiness is subject to intense price competition worldwide, which makes itdifficult for us to maintain product prices and achieve adequate profits. Suchintense price competition may adversely affect our ability to achieveprofitability, especially during periods of decreases in demand. In addition,because of their purchasing size, our larger automotive customers can influencemarket participants to compete on price terms. If we are not able to offsetpricing reductions resulting from these pressures by improved operatingefficiencies and reduced expenditures, those pricing reductions may have anadverse impact on our business.

 

***We are currentlyimplementing a new software platform. If these implementations are notsuccessful, our business and operations could be disrupted and our operatingresults could be harmed.***

 

Weare currently implementing new software platforms to assist us in themanagement of our business. The implementation of new software managementplatforms and the addition of these platforms at new locations, especiallyoverseas, require significant management time, support and cost. We expect theimplementation and enhancements of these platforms to continue across new andexisting sites worldwide. In addition, as our business continues to develop, weexpect to add and enhance existing management platforms in the areas offinancial, inventory control, engineering, and customer support and warrantymanagement. We cannot be sure that these platforms will be fully or effectivelyimplemented on a timely basis, if at all. If we do not successfully implementthis project, our operations may be disrupted and our operating expenses couldbe harmed. In addition, the new systems may not operate as we expect them to,and we may be required to expend significant resources to correct problems orfind alternative sources for performing these functions.

 

***Our inability toeffectively and quickly transfer, replicate and scale our new product manufacturingprocesses from low volume prototype production to high volume manufacturingfacilities, could adversely affect our results of operations.***

 

Underour manufacturing model, we develop and establish manufacturing processes andsystems for the low volume prototype production of our new products. As demandincreases for a product, we transfer these processes and systems to, andreplicate and scale these processes and systems in our high volumemanufacturing facilities. If we are unable to effectively and quickly transfer,replicate and scale these manufacturing processes and systems, we may be unableto meet our customers’ product quality and quantity requirements and lower ourcosts of goods sold and our results of operations could be adversely affected.

 

Inaddition, our costs of goods sold for some of our new products exceed thepurchase price for that product paid to us by our customers. If we are unableto decrease unit production costs for these products by increasing volumes,improving the manufacturing process, reducing transportation and handling costsor obtaining lower cost raw materials or component parts, we will not realize aprofit from these products and our business will be harmed.

 

***Problems in ourmanufacturing and assembly processes could limit our ability to producesufficient batteries to meet the demands of our customers.***

 

Regardlessof the process technology used, the manufacturing and assembly of safe,high-power batteries and battery systems is a highly complex process thatrequires extreme precision and quality control throughout a number ofproduction stages. Because we outsource the manufacturing and assembly of onebattery model and certain battery systems, we are unable to directly controldelivery schedules, quality assurance, manufacturing yields and productioncosts. Any defects in battery packaging, impurities in the electrode materialsused, contamination of the manufacturing environment, incorrect welding, excessmoisture, equipment failure or other difficulties in the manufacturing processcould cause batteries to be rejected, thereby reducing yields and affecting ourability to meet customer expectations.

 

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Aswe have scaled up our production capacity, we have experienced productionproblems that limited our ability to produce a sufficient number of batteriesto meet the demands of one of our customers in the consumer market. If these orother production problems recur and we are unable to resolve them in a timelyfashion, our business could suffer and our reputation may be harmed.

 

***Our failure tocost-effectively manufacture our batteries and battery systems in quantitieswhich satisfy our customers’ demand and product specifications and theirexpectations for product quality and reliable delivery could damage ourcustomer relationships and result in significant lost business opportunitiesfor us.***

 

Wemanufacture a substantial percentage of our products rather than relying uponthird-party outsourcing. To be successful, we must cost-effectively manufacturecommercial quantities of our complex batteries and battery systems that meetour customer specifications for quality and timely delivery. To facilitate thecommercialization of our products, we will need to further reduce ourmanufacturing costs, which we intend to do by working with manufacturingpartners and by improving our manufacturing and development operations in ourwholly-owned operations in China. We manufacture our batteries and assemble ourproducts in China, Korea, Massachusetts and Michigan. We depend on theperformance of our manufacturing partners, as well as our own manufacturingoperations, to manufacture and deliver our products to our customers. If we orany of our manufacturing partners are unable to manufacture products incommercial quantities on a timely and cost-effective basis, we could lose ourcustomers and be unable to attract future customers.

 

Inaddition, we have recently begun to shift most of our battery assembly and allof our battery system manufacturing from contract manufacturing to in-housemanufacturing, so our in-house experience with battery assembly and batterysystem manufacturing is limited.

 

***We may be unableto complete or integrate acquisitions effectively, which may adversely affectour growth, profitability and results of operations.***

 

Acquisitionsof businesses and assets have played a role in our growth. In the past fouryears, we have completed three acquisitions. However, we cannot be certain thatwe will be able to continue to identify attractive acquisition targets, obtainfinancing for acquisitions on satisfactory terms or successfully acquireidentified targets. Additionally, we may not be successful in integratingacquired businesses into our existing operations and achieving projectedsynergies. Competition for acquisition opportunities in the various industriesin which we operate may rise, thereby increasing our costs of making acquisitionsor causing us to refrain from making further acquisitions. These and otheracquisition-related factors could negatively and adversely impact our growth,profitability and results of operations.

 

***Laws regulatingthe manufacture or transportation of batteries may be enacted which couldresult in a delay in the production of our batteries or the imposition ofadditional costs that could harm our ability to be profitable.***

 

Lawsand regulations exist today, and additional laws and regulations may be enactedin the future, which impose environmental, health and safety controls on thestorage, use and disposal of certain chemicals and metals used in themanufacture of lithium-ion batteries. Complying with any laws or regulationscould require significant time and resources from our technical staff andpossible redesign of one or more of our products, which may result insubstantial expenditures and delays in the production of one or more of ourproducts, all of which could harm our business and reduce our futureprofitability. The transportation of lithium and lithium-ion batteries isregulated both domestically and internationally. Compliance with theseregulations, when applicable, increases the cost of producing and deliveringour products.

 

***We depend on contractswith the U.S. government and its agencies or on subcontracts with the U.S.government’s prime contractors for revenue and research grants to fund orpartially fund our research and development programs, and our failure to retaincurrent or obtain additional contracts could preclude us from achieving ouranticipated levels of revenue growth and profitability, increase our researchand development expenses and delay or halt certain research and developmentprograms.***

 

Ourability to develop and market some of our products depends upon maintaining ourU.S. government contract revenue and research grants obtained, which arerecorded as incremental revenue and an offset to our research and developmentexpenses, respectively. Many of our U.S. government contracts are fundedincrementally, with funding decisions made on an annual basis. Approximately2.8% of our total revenue and 26.3% of our research and development expensesduring the year ended December 31, 2008 were derived from governmentcontracts and subcontracts. Changes in government policies, priorities orprograms that result in budget reductions could cause the government to cancelexisting contracts or eliminate follow-on phases in the future which wouldseverely inhibit our ability to successfully complete the development andcommercialization of some of our products. In addition,

 

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therecan be no assurance that, once a government contract is completed, it will leadto follow-on contracts for additional research and development, prototype buildand test or production. Furthermore, there can be no assurance that our U.S.government contracts or subcontracts will not be terminated or suspended in thefuture. A reduction or cancellation of these contracts, or of our participationin these programs, would increase our research and development expenses, whichcould materially and adversely affect our results of operations and could delayor impair our ability to develop new technologies and products.

 

***If we are unableto develop manufacturing facilities for our products in the United States, wemay lose business opportunities and our customer relationships may suffer.***

 

Webelieve that developing manufacturing facilities for our products in the UnitedStates is important, in order to address national economic imperatives, such asjob creation, as well as to more efficiently address the needs of ourU.S.-based customers. This expansion depends upon our receiving federal andstate financial incentives, primarily in the form of direct grants and loans,to provide the necessary capital for facilities and equipment. If we are unableto obtain this government assistance on a timely basis and in the amountsrequested, we will not be able to scale our capacity meet current and futurecustomer demand for our products.

 

***Because of thefunding we receive from U.S. government entities and our government businessinitiatives, we are subject to U.S. federal government audits and otherregulation, and our failure to satisfy audit requirements or comply withapplicable regulations could subject us to material adjustments or penaltiesthat could negatively impact our business.***

 

Theaccuracy and appropriateness of our direct and indirect costs and expensesunder our contracts with the U.S. government are subject to extensiveregulation and audit by appropriate agencies of the U.S. government. Theseagencies have the right to challenge our cost estimates or allocations withrespect to any such contract. Additionally, substantial portions of thepayments to us under U.S. government contracts are provisional payments thatare subject to potential adjustment upon audit by such agencies. Adjustmentsthat result from inquiries or audits of our contracts could have a materialadverse impact on our financial condition or results of operations. Since ourinception, we have not experienced any material adjustments as a result of anyinquiries or audits, but there can be no assurance that our contracts will notbe subject to material adjustments in the future.

 

Aswe grow our government business, we may also need to comply with U.S. lawsregulating the export of our products, particularly in our government business.We cannot be certain of our ability to obtain any licenses required to exportour products or to receive authorization from the U.S. federal government forinternational sales or domestic sales to foreign persons. Moreover, the exportregimes and the governing policies applicable to our business are subject tochange. Our failure to comply with these and other applicable regulations, rules andapprovals could result in the imposition of penalties, the loss of ourgovernment contracts or our suspension or debarment from contracting with thefederal government generally, any of which would harm our business, financialcondition and results of operations.

 

***Our ability tosell our products to our direct, OEM and tier 1 supplier customers depends inpart on the quality of our engineering and customization capabilities, and ourfailure to offer high quality engineering support and services could have amaterial adverse effect on our sales and operating results.***

 

Ahigh level of support is critical for the successful marketing and sale of ourproducts. The sale of our batteries and battery systems is characterized bysignificant co-development and customization work in certain applications. Thisdevelopment process requires not only substantial lead time between thecommencement of design efforts for a customized battery system and thecommencement of volume shipments of the battery systems to the customer, butalso the cooperation and assistance of the OEMs to determine the requirementsfor each specific application. Once our products are designed into an OEM ortier 1 supplier customer’s products or systems, the OEM or tier 1 suppliercustomer depends on us to resolve issues relating to our products. If we do noteffectively assist our OEM or tier 1 supplier customers in customizing,integrating and deploying our products in their own systems or products, or ifwe do not succeed in helping them quickly resolve post-deployment issues andprovide effective ongoing technical support, our ability to sell our productswould be adversely affected.

 

Inaddition, while we have supply and co-development agreements with customerslocated in different regions of the world, we do not have a globallydistributed engineering support and services organization. Currently, any issueresolution related to our products, system deployment or integration ischanneled back to our energy solutions group in Hopkinton, Massachusetts andNovi, Michigan, from which engineers and support personnel are deployed. As wegrow our business with our existing customers and beyond the markets into whichwe currently sell our battery technologies, we may need to increase the size ofour engineering support teams and deploy them closer to our customers. Ourinability to deliver a consistent level of engineering support and overallservice as we expand our operations could have a material adverse effect on ourbusiness and operating results. Moreover, despite our internal

 

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qualitytesting, our products may contain manufacturing or design defects or exhibitperformance problems at any stage of their lifecycle. These problems couldresult in expensive and time-consuming design modifications and imposeadditional needs for engineering support and maintenance services as well assignificant warranty charges.

 

***Our past andfuture operations may lead to substantial environmental liability.***

 

Thehandling and use of some of the materials used in the development andmanufacture of our****products aresubject to federal, state and local environmental laws, as well asenvironmental laws in other****jurisdictionsin which we operate. Under applicable environmental laws, we may be jointly andseverally****liable with priorproperty owners for the treatment, cleanup, remediation and/or removal of anyhazardous****substances discovered atany property we use. In addition, courts or government agencies may impose****liability for, among other things, theimproper release, discharge, storage, use, disposal or transportation of****hazardous substances. If we incur anysignificant environmental liabilities, our ability to execute our****business plan and our financial conditionwould be harmed.

 

***Our facilitiesor operations could be damaged or adversely affected as a result of disastersor unpredictable events, including widespread public health problems.***

 

Ourheadquarters, including sales offices and research and development centers, islocated in****Massachusetts. We alsooperate manufacturing, logistics, sales and research and development facilitiesin****Michigan, China, Korea andCanada. If major disasters such as earthquakes, fires, floods, hurricanes,wars,****terrorist attacks, computerviruses, pandemics or other events occur, or our information system or****communications network breaks down oroperates improperly, our facilities may be seriously damaged, or****we may have to stop or delay productionand shipment of our products. We may incur expenses relating to****such damages. In addition, a renewedoutbreak of SARS, avian flu, swine flu or another widespread public****health problem in China or the UnitedStates could have a negative effect on our operations.

 

**RisksRelated to Intellectual Property**

 

***Third partieshave asserted that they own or control patents that are infringed by ourproducts.***

 

Weare presently involved in two related patent litigations with Hydro-Québecinvolving certain patents it has licensed from The University of Texas, or UT,related to electrode materials used in lithium-ion batteries. After discussionswith Hydro-Québec about the relevance of two of these patents to our products,we brought an action in the Federal District Court of Massachusetts seeking adeclaratory judgment that our products do not infringe these two UT patents. Inresponse, Hydro-Québec and the UT countersued us in the Federal Courts inTexas. Both cases are currently stayed pending re-examination of these patentsby the U.S. Patent Office. The re-examination of these patents is complete, butthe stay continues, although the litigation could resume at any time. For amore detailed discussion of our patent litigation, see Item 1 of Part II: “LegalProceedings.’’

 

Webelieve that we have valid non-infringement defenses against both of thesepatents and that at least one of the patents is invalid. If we were tochallenge the validity of any issued United States patent in court, we wouldneed to overcome a presumption of validity that attaches to every patent. Thisburden is high and would require us to present clear and convincing evidence asto the invalidity of the patent’s claims. There is no assurance that a courtwould find in our favor on infringement or validity and, if this case is notresolved in our favor, we may be required to pay substantial damages. Inaddition, an adverse ruling could cause us, and our customers, developmentpartners and licensees, to stop, modify or delay activities in the UnitedStates such as research, development, manufacturing and sales of products basedon technologies covered by these patents. We would need to develop products andtechnologies that design around these patents or obtain a license to theappropriate patent. There is no certainty that such design-arounds exist or ifthey exist that they would be commercially competitive, and there is nocertainty that a license from the appropriate parties could be obtained. Also,the mere existence, and the uncertainty with respect to the ultimate outcome,of this patent litigation or any other patent litigation that we may becomeinvolved with, could cause our current and potential customers, developmentpartners, the federal or state governments and licensees to stop, delay oravoid doing business with us or modify the extent to which they are willing todo business with us, and this loss or delay of business could harm ouroperating results and our ability to execute on our business plan.

 

***Other partiesmay also bring intellectual property infringement claims against us which wouldbe time-consuming and expensive to defend, and if any of our products orprocesses is found to be infringing, we may not be able to procure licenses touse patents necessary to our business at reasonable terms, if at all.***

 

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Oursuccess depends in part on avoiding the infringement of other parties’ patentsand proprietary rights. We may inadvertently infringe existing third-partypatents or third-party patents issued on existing patent applications. In theUnited States and most other countries, patent applications are published 18months after filing. As a result, there may be third-party pending patentapplications of which we are unaware, and which we may infringe once theyissue. These third parties could bring claims against us that, even if resolvedin our favor, could cause us to incur substantial expenses and, if resolvedagainst us, could cause us to pay substantial damages. Under some circumstancesin the United States, these damages could be triple the actual damages thepatent holder incurs. If we have supplied infringing products to third partiesfor marketing or licensed third parties to manufacture, use or marketinfringing products, we may be obligated to indemnify these third parties forany damages they may be required to pay to the patent holder and for any lossesthe third parties may sustain themselves as the result of lost sales or damagespaid to the patent holder. In addition, we may have, and may be required to,make representations as to our right to supply and/or license intellectualproperty and to our compliance with laws. Such representations are usuallysupported by indemnification provisions requiring us to defend our customersand otherwise make them whole if we license or supply products that infringe onthird party technologies or violate government regulations. Further, if apatent infringement suit were brought against us, we and our customers,development partners and licensees could be forced to stop or delay research,development, manufacturing or sales of products based on our technologies inthe country or countries covered by the patent we infringe, unless we canobtain a license from the patent holder. Such a license may not be available onacceptable terms, or at all, particularly if the third party is developing ormarketing a product competitive with products based on our technologies. Evenif we were able to obtain a license, the rights may be nonexclusive, whichwould give our competitors access to the same intellectual property.

 

Anysuccessful infringement action brought against us may also adversely affectmarketing of products based on our technologies in other markets not covered bythe infringement action. Furthermore, we may suffer adverse consequences from asuccessful infringement action against us even if the action is subsequentlyreversed on appeal, nullified through another action or resolved by settlementwith the patent holder. As a result, any infringement action against us wouldlikely harm our competitive position, be costly and require significant timeand attention of our key management and technical personnel.

 

***We may beinvolved in lawsuits to protect or enforce our patents, which could beexpensive and time consuming.***

 

Competitorsor others may infringe our patents. To counter infringement or unauthorizeduse, we may be required to file patent infringement claims, which can beexpensive and time-consuming. In addition, in an infringement proceeding, acourt may decide that a patent of ours is not valid or is unenforceable, or mayrefuse to stop the other party from using the technology at issue on thegrounds that our patents do not cover that technology. An adverse determinationof any litigation or defense proceedings could put one or more of our patentsat risk of being invalidated or interpreted narrowly and could put our patentapplications at risk of not issuing.

 

Interferenceproceedings brought by the United States Patent and Trademark Office may benecessary to determine the priority of inventions with respect to our patentapplications. Litigation or interference proceedings may fail and, even ifsuccessful, may result in substantial costs and be a distraction to ourmanagement. We may not be able to prevent misappropriation of our proprietaryrights, particularly in countries where the laws may not protect such rights asfully as in the United States.

 

Furthermore,because of the substantial amount of discovery required in connection withintellectual property litigation, there is a risk that some of our confidentialinformation could be compromised by disclosure. In addition, during the courseof this litigation, there could be public announcements of the results ofhearings, motions or other interim proceedings or developments. If securitiesanalysts or investors perceive these results to be negative, it could have asubstantial adverse effect on the price of our common stock.

 

Wemay not prevail in any litigation or interference proceeding in which we areinvolved. Even if we do prevail, these proceedings can be expensive anddistract our management.

 

***Our patentapplications may not result in issued patents, which may have a materialadverse effect on our ability to prevent others from commercially exploitingproducts similar to ours.***

 

Patentapplications in the United States are maintained in secrecy until the patentsare published or are issued. Since publication of discoveries in the scientificor patent literature tends to lag behind actual discoveries by several months,we cannot be certain that we are the first creator of inventions covered bypending patent applications or the first to file patent applications on theseinventions. We also cannot be certain that our pending patent applications willresult in issued patents or that any of our issued patents will affordprotection against a competitor. In addition, patent applications filed inforeign countries are subject to laws, rules and procedures that differfrom those of the United States, and thus we cannot be certain that foreignpatent applications related to issued U.S. patents will

 

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beissued. Furthermore, if these patent applications issue, some foreign countriesprovide significantly less effective patent enforcement than in the UnitedStates.

 

Thestatus of patents involves complex legal and factual questions and the breadthof claims allowed is uncertain. Accordingly, we cannot be certain that thepatent applications that we file will result in patents being issued, or thatour patents and any patents that may be issued to us in the near future willafford protection against competitors with similar technology. In addition,patents issued to us may be infringed upon or designed around by others andothers may obtain patents that we need to license or design around, either ofwhich would increase costs and may adversely affect our operations.

 

***Our patents andother protective measures may not adequately protect our proprietaryintellectual property.***

 

Weregard our intellectual property, particularly our proprietary rights in ourbattery and battery system technology, as critical to our success. We havereceived a number of patents, and filed other patent applications, for variousapplications and aspects of our technology or processes and other intellectualproperty. In addition, we generally enter into confidentiality and inventionagreements with our employees and consultants. Such patents and agreements andvarious other measures we take to protect our intellectual property from use byothers may not be effective for various reasons, including the following:

 

· our pending patentapplications may not be granted for various reasons, including the existence ofconflicting patents or defects in our applications;

 

· the patents wehave been granted may be challenged, invalidated or circumvented because of thepre-existence of similar patented or unpatented intellectual property rights orfor other reasons;

 

· parties to theconfidentiality and invention agreements may have such agreements declaredunenforceable or, even if the agreements are enforceable, may breach suchagreements;

 

· the costsassociated with enforcing patents, confidentiality and invention agreements orother intellectual property rights may make aggressive enforcement prohibitive;

 

· even if we enforceour rights aggressively, injunctions, fines and other penalties may beinsufficient to deter violations of our intellectual property rights; and

 

· other persons mayindependently develop proprietary information and techniques that arefunctionally equivalent or superior to our intellectual proprietary informationand techniques but do not breach our patented or unpatented proprietary rights.

 

***We may be unableto adequately prevent disclosure of trade secrets and other proprietaryinformation.***

 

Werely on trade secrets to protect our proprietary technologies, especially wherewe do not believe patent protection is appropriate or obtainable. However,trade secrets are difficult to protect. We rely in part on confidentialityagreements with our employees, contractors, consultants, outside scientificcollaborators and other advisors to protect our trade secrets and otherproprietary information. These agreements may not effectively preventdisclosure of confidential information and may not provide an adequate remedyin the event of unauthorized disclosure of confidential information. Inaddition, others may independently discover our trade secrets or independentlydevelop processes or products that are similar or identical to our tradesecrets, and courts outside the United States may be less willing to protecttrade secrets. Costly and time-consuming litigation could be necessary toenforce and determine the scope of our proprietary rights, and failure toobtain or maintain trade secret protection could adversely affect ourcompetitive business position.

 

**RisksAssociated With Doing Business Internationally and Specifically in China andKorea**

 

***Our substantialinternational operations subject us to a number of risks, including unfavorablepolitical, regulatory, labor and tax conditions.***

 

Wehave significant manufacturing facilities and operations in China and Koreathat are subject to the legal, political, regulatory and social requirementsand economic conditions in these jurisdictions. In addition, we expect to sella significant portion of our products to customers located outside the UnitedStates. Risks inherent to international operations and sales, include, but arenot limited to, the following:

 

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· difficulty inenforcing agreements, judgments and arbitration awards in foreign legalsystems;

 

· fluctuations inexchange rates may affect product demand and may adversely affect ourprofitability in U.S. dollars to the extent the cost of raw materials and laboris denominated in a foreign currency;

 

· impediments to theflow of foreign exchange capital payments and receipts due to exchange controlsinstituted by certain foreign governments and the fact that the localcurrencies of these countries are not freely convertible;

 

· inability toobtain, maintain or enforce intellectual property rights;

 

· changes in generaleconomic and political conditions;

 

· changes in foreigngovernment regulations and technical standards, including additional regulationof rechargeable batteries, power technology, or the transport of lithium orphosphate, which may reduce or eliminate our ability to sell or license incertain markets;

 

· requirements orpreferences of foreign nations for domestic products could reduce demand forour products;

 

· trade barrierssuch as export requirements, tariffs, taxes and other restrictions andexpenses, which could increase the prices of our products and make us lesscompetitive; and

 

· longer paymentcycles typically associated with international sales and potential difficultiesin collecting accounts receivable, which may reduce the future profitability offoreign sales.

 

Ourbusiness in foreign jurisdictions requires us to respond to rapid changes inmarket conditions in these countries. Our overall success as a global businessdepends on our ability to succeed in different legal, regulatory, economic,social and political situations and conditions. We may not be able to developand implement effective policies and strategies in each foreign jurisdictionwhere we do business. Also, each of the foregoing risks will likely take onincreased significance as we implement plans to expand foreign manufacturingoperations.

 

***Since many ofour products are manufactured in China, we own and lease manufacturingfacilities in China and the Chinese market is of growing importance for ourproducts, we face risks if China loses normal trade relations status with theUnited States or if US-China trade relations are otherwise adversely impacted.***

 

Wemanufacture and export our products from China and own and lease manufacturingfacilities in China. We may also sell our products in China in the future. Ourproducts sold in the United States have normal trade relations status and arecurrently not subject to United States import duties. As a result of oppositionto certain policies of the Chinese government and China’s growing tradesurpluses with the United States, there has been, and in the future may be,opposition to normal trade relations status with China. The United StatesCongress may also introduce China trade legislation targeting currencymanipulation, which may adversely affect our business in China. The loss ofnormal trade relations status for China, changes in current tariff structuresor adoption in the United States of other trade policies adverse to China, andany retaliatory measures that impact our products in the Chinese market, couldhave an adverse effect on our business.

 

Achange in exchange rates mandated by legislation could negatively impact thecost of imported raw materials and products.

 

Furthermore,our business and operations may be adversely affected by deterioration of thediplomatic and political relationships between the United States and China. Ifthe relationship between the United States and China were to materiallydeteriorate, it could negatively impact our ability to control our operationsand relationships in China, enforce any agreements we have with Chinesepartners or otherwise deal with any assets or investments we may have in China.

 

***Our ongoingmanufacturing operations in China are complex and having these remoteoperations may divert management’s attention, lead to disruptions inoperations, delay implementation of our business strategy and make it difficultto establish adequate management and financial controls in China. Our plans togrow our business to include sales to Chinese customers may necessitateadditional management attention to establishing and maintaining one or morejoint venture relationships with Chinese parties.***

 

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Currently,we have most of our manufacturing operations in China. We may not be able tofind or retain suitable employees in China and we may have to train personnelto perform necessary functions for our manufacturing, senior management anddevelopment operations. This may divert management’s attention, lead todisruptions in operations and delay implementation of our business strategy,all of which could negatively impact our profitability.

 

Chinahas only recently begun to adopt management and financial reporting conceptsand practices like those with which investors in the United States arefamiliar. We may have difficulty in hiring and retaining employees in China whohave the experience necessary to implement the kind of management and financialcontrols that are expected of a United States public company. If we cannotestablish and implement such controls, we may experience difficulty incollecting financial data and preparing financial statements, books of accountand corporate records and instituting business practices that meet U.S.standards.

 

Growingour business to include sales to Chinese customers may involve us entering intoa Chinese-foreign joint venture with a Chinese partner. A Chinese-foreign jointventure can be a complex business arrangement requiring substantial managementattention to the joint venture relationship. The joint venture will alsorequire capital contributions and due to China’s foreign exchange controls,uncertainty as to the ability to repatriate profits and principal out of China.

 

***Because of therelative weakness of the Chinese legal system in general, and the intellectualproperty regime in particular, we may not be able to enforce intellectualproperty rights in China.***

 

Thelegal regime protecting intellectual property rights in China is weak. Becausethe Chinese legal system in general, and the intellectual property regime inparticular, are relatively weak, it is often difficult to create and enforceintellectual property rights in China. Accordingly, we may not be able toeffectively protect our intellectual property rights in China.

 

***Enforcingagreements and laws in China is difficult and may be impossible because Chinadoes not have a comprehensive system of laws.***

 

Wedepend on our relationships with our Chinese manufacturing partners. In China,enforcement of contractual agreements may be sporadic, and implementation andinterpretation of laws may be inconsistent. The Chinese judiciary is relativelyinexperienced in interpreting agreements and enforcing China’s laws, leading toa higher than usual degree of uncertainty as to the outcome of any litigation.Even where adequate law exists in China, it may not be possible to obtain swiftand equitable enforcement of such law, or to obtain enforcement of a judgmentor an arbitration award by a court of another jurisdiction.

 

***The governmentof China may change or even reverse its policies of promoting private industryand foreign investment, in which case our assets and operations may be at risk.***

 

Ourexisting and planned operations in China are subject to risks related to thebusiness, economic and political conditions in China, which include thepossibility that the central government of China will change or even reverse itspolicies of promoting private industry and foreign investment in China. Thegovernment of China has exercised and continues to exercise substantial controlover virtually every section of the Chinese economy through regulation andstate ownership. Many of the current reforms which support private business inChina are of recent origin or provisional in nature. Other political, economicand social factors, such as political changes, changes in the rates of economicgrowth, unemployment or inflation, or in the disparities of per capita wealthamong citizens of China and between regions within China, could also lead tofurther readjustment of the government’s reform measures. It is not possible topredict whether the Chinese government will continue to be as supportive ofprivate business in China, nor is it possible to predict how any future reformswill affect our business. For example, if the government were to limit thenumber of foreign personnel who could work in the country, substantiallyincrease taxes on foreign businesses, eliminate export processing zones,restrict the transportation of goods in and out of the country, adopt policiesfavoring competitors or impose other restrictions on our operations, the impactmay be significant.

 

Significantly,a reversal of current liberalizations of foreign exchange controls by theChinese government could be disruptive and costly to our cross-borderoperations and our business as a whole.

 

***Businesspractices in China and Korea may entail greater risk and dependence upon thepersonal relationships of senior management than is common in North America,and therefore some of our agreements with other parties in China and Koreacould be difficult or impossible to enforce.***

 

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Thebusiness cultures of China and Korea are, in some respects, different from thebusiness cultures in Western countries and may present some difficulty for Westerninvestors reviewing contractual relationships among companies in China andKorea and evaluating the merits of an investment. Personal relationships amongbusiness principals of companies and business entities in China and Korea arevery significant in their business cultures. In some cases, because so muchreliance is based upon personal relationships, written contracts amongbusinesses in China and Korea may be less detailed and specific than iscommonly accepted for similar written agreements in Western countries. In somecases, material terms of an understanding are not contained in the writtenagreement but exist as oral agreements only. In other cases, the terms oftransactions which may involve material amounts of money are not documented atall. In addition, in contrast to Western business practices where a writtenagreement specifically defines the terms, rights and obligations of the partiesin a legally-binding and enforceable manner, the parties to a written agreementin China or Korea may view that agreement more as a starting point for anongoing business relationship which will evolve and require ongoingmodification. As a result, written agreements in China or Korea may appear tothe Western reader to look more like outline agreements that precede a formalwritten agreement. While these documents may appear incomplete or unenforceableto a Western reader, the parties to the agreement in China or Korea may feelthat they have a more complete understanding than is apparent to someone who isonly reading the written agreement without having attended the negotiations. Asa result, contractual arrangements in China and Korea may be more difficult toreview and understand.

 

***China hasintroduced sweeping reforms to its income tax, turnover tax and other tax lawsand regulations. Some of the changes increase the taxes foreign-invested andother businesses in China will incur on specific types of transactions as wellas arising from operations generally in China. Our earnings may be affected bytax adjustments to reflect such changes in the law.***

 

Pursuantto a comprehensive reform of China’s tax system that took effect on January 1,2008, income tax incentives granted to foreign-invested enterprises, andgeographically-based incentives, have largely been eliminated and have beenreplaced with incentives designed to encourage enterprises, domestic andforeign-invested alike, in selected industries. For example, dividends paid byforeign-invested enterprises to foreign shareholders are no longer exempt fromwithholding tax. A 10% withholding tax applies to dividends, although the rateis reduced to 5% by certain tax treaties. The tax holidays and tax reductionperiods and the reduced national income tax rate that foreign-investedenterprises engaged in production used to enjoy have also been removed. The taxincentives promised to our wholly foreign-owned subsidiaries located in exportprocessing zones at the time of inception will be phased-out by the end of2012. At that time, these subsidiaries and any new foreign-invested enterpriseswe might establish as part of our strategy to expand the market for ourproducts will no longer have income tax advantages over Chinese domesticbusinesses.

 

China’sturnover tax system consists of VAT, consumption tax and business tax. VAT isprimarily imposed on import and sales of goods and certain services, such asrepairing, processing and replacement. Export sales are exempt under VAT rules,and an exporter who incurs VAT on the purchase or manufacture of goods should beable to claim a refund from Chinese tax authorities. Depending on whether VATexport refund rates are raised or reduced for relevant goods, exporters mightbear part of the VAT they incurred in conjunction with producing the exportedgoods. To mitigate the effects of the global economic downturn on China’sexport industry, the PRC Ministry of Finance and the State Administration ofTaxation have raised VAT rebates on numerous exported labor-intensive andhigh-value-added products. However, the Chinese government may also lowerrebate rates in future in response to different economic and policy objectives.

 

Chinahas also introduced sweeping VAT policy reforms with effect from January 1,2009, which facilitate China’s shift from a production-based VAT scheme to aconsumption-based system. Generally, the new system reduces the total outputVAT of production enterprises as fixed-asset investment costs related toVAT-eligible output are no longer subject to VAT. However, our VAT costs willdepend on our ability to pass on input VAT to our local suppliers andcustomers. As the relevant VAT law and implementing regulations are new, theremay be a period of adjustment before any cost-savings are realized.

 

Businesstax is usually a fee of 3-5 percent levied on services—such as transport,construction, education, finance, and insurance—transfer of intangible assets,and sales of fixed assets, none of which are generally eligible for VAT. Newbusiness tax regulations, which took effect January 1, 2009, may imposebusiness on services exchanged among China- and foreign-based entities whichpreviously were not subject to business tax, and the potential overall impactis to increase the tax burden of cross-border service transactions.

 

Frequentchanges to China’s tax laws can result in uncertainty and unpredictability infinancial results of our operations in China. China’s tax laws are supplementedwith detailed implementation rules and circulars. However, theinterpretation of the rules may vary among local tax authorities.

 

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**RisksRelated to Ownership of Our Common Stock**

 

***We are incurringincreased costs and demands upon management as a result of complying with thelaws and regulations affecting public companies, which could harm our operatingresults.***

 

Asa public company, we are incurring significant additional legal, accounting andother expenses that we did not incur as a private company, including costsassociated with public company reporting requirements. We also have incurredand will incur costs associated with current corporate governance requirements,including requirements under Section 404 and other provisions of theSarbanes-Oxley Act, as well as rules implemented by the Securities andExchange Commission, or SEC, and the Nasdaq Global Market. The expensesincurred by public companies for reporting and corporate governance purposeshave increased dramatically in recent years. We expect these rules andregulations to substantially increase our legal and financial compliance costsand to make some activities more time-consuming and costly. We are unable tocurrently estimate these costs with any degree of certainty. We also expectthese new rules and regulations may make it more difficult and moreexpensive for us to obtain director and officer liability insurance, and we maybe required to accept reduced policy limits and coverage or incur substantiallyhigher costs to obtain the same or similar coverage previously available. As aresult, it may be more difficult for us to attract and retain qualifiedindividuals to serve on our board of directors or as our executive officers.

 

***An activetrading market for our common stock may not develop or be sustained, and youmay not be able to resell your shares at or above the price at which youpurchased them.***

 

We have a limited history asa public company.  An active trading market for our shares maynever develop or be sustained. In the absence of an active trading market forour common stock, investors may not be able to sell their common stock at orabove the price they paid or at the time that they would like to sell.

 

***Our stock pricemay be volatile.***

 

Themarket price of our common stock could be subject to significant fluctuations,and it may decline below the price at which you purchased it. Market prices forsecurities of early stage companies have historically been particularlyvolatile. As a result of this volatility, you may not be able to sell yourcommon stock at or above price you paid. Some of the factors that may cause themarket price of our common stock to fluctuate include:

 

· fluctuations inour quarterly financial results or the quarterly financial results of companiesperceived to be similar to us;

 

· fluctuations inour recorded revenue, even during periods of significant sales order activity;

 

· changes inestimates of our financial results or recommendations by securities analysts;

 

· failure of any ofour products to achieve or maintain market acceptance;

 

· product liabilityissues involving our products or our competitors’ products;

 

· changes in marketvaluations of similar companies;

 

· success ofcompetitive products or technologies;

 

· changes in ourcapital structure, such as future issuances of securities or the incurrence ofdebt;

 

· announcements byus or our competitors of significant services, contracts, acquisitions orstrategic alliances;

 

· developments orannouncements related to our application for government stimulus funds;

 

· regulatorydevelopments in the United States, foreign countries or both;

 

· litigationinvolving us, our general industry or both;

 

· additions ordepartures of key personnel;

 

· investors’ generalperception of us; and

 

· changes in generaleconomic, industry and market conditions.

 

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Inaddition, if the market for technology stocks or the stock market in generalexperiences a loss of investor confidence, the trading price of our commonstock could decline for reasons unrelated to our business, financial conditionor results of operations. If any of the foregoing occurs, it could cause ourstock price to fall and may expose us to class action lawsuits that, even ifunsuccessful, could be costly to defend and a distraction to management.

 

***A significantportion of our total outstanding shares may be sold into the public market inthe near future, which could cause the market price of our common stock to dropsignificantly, even if our business is doing well.***

 

Sales of a substantialnumber of shares of our common stock in the public market could occur at anytime after the expiration of the lock-up agreements our stockholders enteredinto with the underwriters of our initial public offering, or IPO. These sales,or the market perception that the holders of a large number of shares intend tosell shares, could reduce the market price of our common stock.  As of September 30, 2009,69,495,530 shares of common stock are subject to a 180-day contractuallock-up (which began on the closing of the IPO on September 29, 2009) withthe underwriters, and 218,304 shares of common stock are subject to a180-day contractual lock-up (which began on September 29, 2009) with us.These shares will be able to be sold, subject to any applicable volumelimitations under federal securities laws, after the earlier of the expirationof, or release from, the 180-day lock-up period. Morgan Stanley and Goldman,Sachs & Co., acting as co-representatives of the underwriters,may permit our officers, directors, employees and current stockholders who aresubject to the contractual lock-up to sell shares prior to the expiration ofthe lock-up agreements.

 

Inaddition, as of September 30, 2009, there were 10,430,980 sharessubject to outstanding options that will become eligible for sale in the publicmarket to the extent permitted by any applicable vesting requirements, thelock-up agreements and Rules 144 and 701 under the Securities Act of 1933,as amended. Moreover, holders of an aggregate of approximately102.5 million shares of our common stock as of September 30, 2009,have rights, subject to some conditions, to require us to file registrationstatements covering their shares and to include their shares in registrationstatements that we may file for ourselves or other stockholders. Holders of anaggregate of approximately 0.3 million additional shares of our commonstock as of September 30, 2009, have rights, subject to some conditions,to include their shares in registration statements that we may file forourselves or other stockholders. We also intend to register all shares ofcommon stock that we may issue under our equity incentive plans, including329,973 shares reserved for future issuance under our equity incentiveplans. Once we register and issue these shares, they can be freely sold in thepublic market upon issuance, subject to the lock-up agreements.

 

***If securities orindustry analysts do not publish or cease publishing research or reports aboutus, our business or our market, or if they change their recommendations regardingour stock adversely, our stock price and trading volume could decline.***

 

Thetrading market for our common stock will be influenced by the research andreports that industry or securities analysts may publish about us, ourbusiness, our market or our competitors. If any of the analysts who may coverus change their recommendation regarding our stock adversely, or provide morefavorable relative recommendations about our competitors, our stock price wouldlikely decline. If any analyst who may cover us were to cease coverage of ourcompany or fail to regularly publish reports on us, we could lose visibility inthe financial markets, which in turn could cause our stock price or tradingvolume to decline.

 

***Our managementwill have broad discretion over the use of our cash reserves, if any, and mightnot apply this cash in ways that increase the value of your investment.***

 

Ourmanagement will have broad discretion to use our cash reserves, if any, and youwill be relying on the judgment of our management regarding the application ofthis cash. Our management might not apply our cash in ways that increase thevalue of your investment. We expect to use our cash reserves for capitalexpenditures, including capital expenditures related to the expansion of our manufacturingcapacity in Michigan, working capital, and other general corporate purposes,which may in the future include investments in, or acquisitions of,complementary businesses, joint ventures, partnerships, services ortechnologies. Our management might not be able to yield a significant return,if any, on any investment of this cash. You will not have the opportunity toinfluence our decisions on how to use our cash reserves.

 

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***We do not expectto declare any dividends in the foreseeable future.***

 

Wedo not anticipate declaring any cash dividends to holders of our common stockin the foreseeable future. Consequently, investors may need to rely on sales oftheir common stock after price appreciation, which may never occur, as the onlyway to realize any future gains on their investment. Investors seeking cashdividends should not purchase our common stock.

 

***Anti-takeoverprovisions contained in our certificate of incorporation and bylaws, as well asprovisions of Delaware law, could impair a takeover attempt.***

 

Ourcertificate of incorporation, bylaws and Delaware law contain provisions thatcould have the effect of rendering more difficult or discouraging anacquisition deemed undesirable by our board of directors. Our corporategovernance documents include provisions:

 

· authorizing blankcheck preferred stock, which could be issued with voting, liquidation, dividendand other rights superior to our common stock;

 

· limiting theliability of, and providing indemnification to, our directors and officers;

 

· limiting the abilityof our stockholders to call and bring business before special meetings and totake action by written consent in lieu of a meeting;

 

· requiring advancenotice of stockholder proposals for business to be conducted at meetings of ourstockholders and for nominations of candidates for election to our board ofdirectors;

 

· controlling theprocedures for the conduct and scheduling of board of directors and stockholdermeetings;

 

· providing theboard of directors with the express power to postpone previously scheduledannual meetings and to cancel previously scheduled special meetings;

 

· establishing aclassified board of directors so that not all members of our board are electedat one time;

 

· limiting thedetermination of the number of directors on our board of directors and thefilling of vacancies or newly created seats on the board to our board ofdirectors then in office; and

 

· providing thatdirectors may be removed by stockholders only for cause.

 

Theseprovisions, alone or together, could delay hostile takeovers and changes incontrol of our company or changes in our management.

 

Asa Delaware corporation, we are also subject to provisions of Delaware law,including Section 203 of the Delaware General Corporation law, whichprevents some stockholders holding more than 15% of our outstanding commonstock from engaging in certain business combinations without approval of theholders of substantially all of our outstanding common stock. Any provision ofour amended and restated certificate of incorporation or bylaws or Delaware lawthat has the effect of delaying or deterring a change in control could limitthe opportunity for our stockholders to receive a premium for their shares ofour common stock, and could also affect the price that some investors arewilling to pay for our common stock.

 

**Item 2.Unregistered Sales of Equity Securities and Use of Proceeds**

 

(a) Sales ofUnregistered Securities

 

From the period beginning July 1,2009 through September 30, 2009, we have granted stock options to purchasean aggregate of 350,000 shares of our common stock, with exercise prices of$10.00 per share, to employees and directors pursuant to our 2001 stockincentive plan. An aggregate of 34,319 shares have been issued upon theexercise of stock options issued under our 2001 stock incentive plan, at aweighted-average exercise price of $1.35 per share, for an aggregateconsideration of $46,365 as of September 30, 2009.  The securities described in this paragraphwere issued pursuant to written compensatory plans or arrangements with ouremployees, directors and consultants in reliance on the exemptions provided byeither Section 4(2) of the Securities Act or Rule 701promulgated under Section 3(b) of the Securities Act.

 

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We issued an aggregate of49,210 shares of our common stock on September 28 and 30, 2009 to GoldHill Venture Lending 03, LP and SVB Financial Group upon the exercise ofwarrants at an exercise price of $3.37 per share.  These warrants were exercised on a “cashless”basis, as an aggregate of 10,120 of the shares subject to such warrants,representing aggregate consideration of $165,888, were forfeited as payment forthe shares issued.  The shares issuedupon exercise of such warrants were issued in reliance on the exemptionprovided by Section 4(2) of the Securities Act, and the recipients ofsuch shares represented their intentions to acquire the shares for investmentpurposes only and not with a view to, or for sale in connection with, anydistribution thereof.

 

All securities described inthis subsection (a) of this Item are deemed restricted securities forpurposes of the Securities Act. The instruments representing such issuedsecurities included appropriate legends setting forth that the securities hadnot been registered and the applicable restrictions on transfer.

 

(b) Use of Proceedsfrom Public Offering of Common Stock

 

On September 29, 2009,we closed our IPO, in which 32,407,576 shares of common stock were sold at aprice to the public of $13.50 per share. We sold 31,727,075 shares of ourcommon stock in the offering and selling stockholders sold 680,501 of theshares of common stock in the offering. The aggregate offering price for allshares sold in the offering, including shares sold by us and the sellingstockholders, was $437.5 million. The offer and sale of all of the shares inthe IPO were registered under the Securities Act pursuant to a registrationstatement on Form S-1 (File No. 333-152871), which was declaredeffective by the SEC on September 23, 2009, and a registration statementon Form S-1 (File No. 333-162090) filed pursuant to Rule 424(b) ofthe Securities Act.. The offering commenced as of September 23, 2009 anddid not terminate before all of the securities registered in the registrationstatement were sold. Morgan Stanley & Co. Incorporated and Goldman,Sachs, & Co. acted as co-representatives of the underwriters. Weraised approximately $391.3 million in net proceeds after deductingunderwriting discounts and commissions of $30.0 million and otherestimated offering costs of $7.1 million. No payments were made by us todirectors, officers or persons owning ten percent or more of our common stockor to their associates, or to our affiliates, other than payments in theordinary course of business to officers for salaries and to non-employeedirectors as compensation for board or board committee service, or as a resultof sales of shares of common stock by selling stockholders in theoffering.  There has been no materialchange in the planned use of proceeds from our IPO as described in our finalprospectus filed with the SEC pursuant to Rule 424(b).  From the effective date of the registrationstatement through September 30, 2009, we used approximately $0.8 millionof the net proceeds to repay a note payable with a vendor for consultingservices performed.  We have invested theremainder of the funds in a registered money market fund.

 

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

 

Effective July 16,2009, our stockholders approved by written consent pursuant to Section 228of the Delaware General Corporate Law, or Section 228, the filing of atwelfth amended and restated certificate of incorporation.  Holders of (a) more than 66 2/3% of ourthen outstanding redeemable convertible preferred stock, on an as-converted tocommon stock basis, (b) more than 66 2/3% of our then outstanding series Fconvertible preferred stock and (c) a majority of our then outstandingshares of capital stock, on an as-converted to common stock basis, approved theforegoing matter.

 

Effective September 8,2009, our stockholders approved by written consent pursuant to Section 228the filing of a thirteenth amended and restated certificate ofincorporation.  Holders of (a) morethan 66 2/3% of our then outstanding redeemable convertible preferred stock, onan as-converted basis, (b) more than 68% of our then outstanding series Econvertible preferred stock and (c) a majority of our then outstandingshares of capital stock, on an as-converted to common stock basis, approved theforegoing matter.

 

Effective September 8,2009, in connection with our IPO, our stockholders approved by written consentpursuant to Section 228 (i)  the filing, following the closing of ourIPO, of a restated certificate of incorporation, (ii) our 2009 stockincentive plan, (iii) the sales of shares by the selling stockholders inour IPO and (iv) the adoption and ratification of all actions taken andthings done by our incorporators, stockholders, directors and officers,including without limitation all elections of officers anddirectors.  Holders of (a) more than 66 2/3% of our thenoutstanding redeemable convertible preferred stock, (b) more than 66 2/3%of the holders of registered securities under the seventh amended and restatedinvestor rights agreement among us and certain of our stockholders and (c) amajority of our then outstanding shares of capital stock, on an as-converted tocommon stock basis, approved the foregoing matters.

 

**Item 6.Exhibits**

 

The exhibits listed in the Exhibit Indeximmediately preceding the exhibits are filed (other than exhibits 32.1 and32.2) as part of this Quarterly Report on Form 10-Q and such Exhibit Indexis incorporated herein by reference.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|                          | **A123  SYSTEMS, INC.** |
|-------------------------------|-------------------------|
|                          |                    |
| Date: November 10,  2009 | By:                     | /s/ David P. Vieau |
|                          |                    | David P. Vieau |
|                          |                    | Chief Executive Officer |
|                          |                    | (Principal Executive  Officer) |
|                          |                    |   |
|                          |                    |   |
| Date: November 10,  2009 | By:                     | /s/ Michael Rubino |
|                          |                    | Michael Rubino |
|                          |                    | Chief Financial Officer |
|                          |                    | (Principal Financial and  Accounting Officer) |

 

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*EXHIBITINDEX*

 

Listed and indexed below areall Exhibits filed as part of this report.

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                  |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                             |
| 31.1             |       | Certification of Chief Executive  Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by  Chief Executive Officer.                            |
|             |       |                                                                                                                                                             |
| 31.2             |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 by Chief Financial Officer.                            |
|             |       |                                                                                                                                                             |
| 32.1 +           |       | Certification pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, by Chief Executive Officer.  |
|             |       |                                                                                                                                                             |
| 32.2 +           |       | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002, by Chief Financial  Officer. |

 

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| + | This certification shall  not be deemed “filed” for purposes of Section 18 of the Securities  Exchange Act of 1934, or otherwise subject to the liability of that Section,  nor shall it be deemed to be incorporated by reference into any filing under  the Securities Act of 1933 or the Securities Exchange Act of 1934. |
|---|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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