<PAGE>

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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

                                   FORM 10-K

                       FOR ANNUAL AND TRANSITION REPORTS
                    PURSUANT TO SECTIONS 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

(Mark One)

[X]  FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTION 13 OR 15(d) OF THE
         SECURITIES EXCHANGE ACT OF 1934

                  For the fiscal year ended December 31, 2001

                                      OR

[_] 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 000-31533

                          PROTON ENERGY SYSTEMS, INC.
            (Exact name of Registrant as specified in its charter)

                      Delaware                 06-1461988
                   (State or Other          (I.R.S. Employer
                   Jurisdiction of         Identification No.)
                  Incorporation or
                    Organization)

                     50 INWOOD ROAD, ROCKY HILL, CT 06067
                   (Address of principal executive offices)

       Registrant's telephone number, including area code (860) 571-6533

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

                                     None

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

                         Common Stock, $.01 par value

   Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. YES [X]    NO [_]

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

   The aggregate market value of the voting stock held by non-affiliates of the
Registrant on March 21, 2002 was approximately $175,110,000 based on the price
of the last reported sale as reported by The Nasdaq Stock Market on March 21,
2002. The number of shares outstanding of the Registrant's Common Stock on
March 21, 2002, was 33,259,567.

                      DOCUMENTS INCORPORATED BY REFERENCE

   Portions of the registrant's definitive proxy statement in connection with
the annual meeting of the stockholders to be held on June 5, 2002 are
incorporated by reference in Part III hereof.

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                          Proton Energy Systems, Inc.

                                     INDEX


<TABLE>
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                                                                                                            Page
           Description                                                                                     Number
-          -----------                                                                                     ------
<C>        <S>                                                                                             <C>
PART I

Item 1     Description of Business........................................................................    1
Item 2     Properties.....................................................................................    8
Item 3     Legal Proceedings..............................................................................    9
Item 4     Submission of Matters to a Vote of Security Holders............................................    9

PART II

Item 5     Market for Registrant's Common Stock and Related Stockholder Matters...........................   11
Item 6     Selected Financial Data........................................................................   12
Item 7     Management's Discussion and Analysis of Financial
             Condition and Results of Operations..........................................................   13
Item 7A    Quantitative and Qualitative Disclosures About Market Risk.....................................   26
Item 8     Financial Statements and Supplementary Data....................................................   28
Item 9     Changes In and Disagreements with Accountants on Accounting and
             Financial Disclosure.........................................................................   47

PART III

Item 10    Directors and Executive Officers of the Registrant.............................................   47
Item 11    Executive Compensation.........................................................................   47
Item 12    Security Ownership of Certain Beneficial Owners And Management.................................   47
Item 13    Certain Relationships and Related Transactions.................................................   47

PART IV

Item 14    Exhibits, Financial Statement Schedules and Reports on Form 8-K................................   47

Signatures ...............................................................................................   50
</TABLE>

<PAGE>

  This report contains forward-looking statements for purposes of the safe
  harbor provisions under The Private Securities Litigation Reform Act of 1995.
  Statements contained herein that are not statements of historical fact may be
  deemed to be forward-looking information. Without limiting the foregoing,
  words such as "anticipates," "believes," "could," "estimate," "expect,"
  "intend," "may," "might," "should," "will," and "would" and other forms of
  these words or similar words are intended to identify forward-looking
  information. You should read these statements carefully, because Proton's
  actual results may differ materially from those indicated by these
  forward-looking statements as a result of various important factors. We
  disclaim any obligation to update these forward-looking statements. Our
  actual results could differ significantly from those anticipated in these
  forward looking statements as a result of certain factors, including those
  set forth below under "Legal Proceedings" "Management's Discussion and
  Analysis of Financial Condition and Results of Operations--Certain Factors
  That May Affect Future Results", and critical accounting policies set forth
  below under "Management's Discussion and Analysis of Financial Condition and
  Results of Operations--Critical Accounting Policies." You should also
  carefully review the risks outlined in other documents that we file from time
  to time with the Securities and Exchange Commission, including our Quarterly
  Reports on Form 10-Q that we file in 2002.

   PROTON(R), HOGEN(R), UNIGEN(R), FUELGEN(TM) are trademarks or registered
trademarks of Proton Energy Systems, Inc. Chrysalis(TM) is a trademark of
Matheson Tri-Gas, Inc. Other trademarks or service marks appearing in this
report are the property of their respective holders.

ITEM 1.  Description of Business

The Company

   We were founded in 1996 to design, develop and manufacture proton exchange
membrane, or PEM, electrochemical products. Our proprietary PEM technology is
embodied in two families of products: hydrogen generators and regenerative fuel
cell systems. Our hydrogen generators produce hydrogen from electricity and
water in a clean and efficient process. We are currently manufacturing and
delivering models of our hydrogen generators to customers for use in commercial
applications. Our regenerative fuel cell systems, which we are currently
developing, will combine our hydrogen generation technology with a fuel cell
power generator to create an energy device that is able to produce and store
the hydrogen fuel it can later use to generate electricity. By providing the
hydrogen fuel used by fuel cells, our core PEM electrolysis technology can
enable fuel cells to function not only as power generating devices, but also as
energy storage devices.

   We are designing our products to meet the needs of attractive near-term and
longer-term markets. Our hydrogen generators have been designed to address the
existing demand for on-site hydrogen gas generation in a variety of
manufacturing and laboratory applications which we believe will provide a
lower-cost, safer and more convenient alternative to conventionally delivered
hydrogen. In the longer term, as fuel cell markets develop, we believe our
hydrogen generators can be a key component of the hydrogen supply
infrastructure that will be needed to provide the hydrogen used by fuel cells
in transportation, stationary power generation and portable power generation
applications. We are developing our regenerative fuel cell systems to address
the demand for highly reliable backup power systems. In particular, the
increased use of computers, computer networks and communications networks, as
well as the increased use of sensitive electronics in manufacturing, are all
creating an increase in the demand for highly reliable backup power to avoid
the costs and lost revenue associated with power disruptions. In addition, we
believe that in the longer term our regenerative fuel cell systems may enable
renewable energy solutions by facilitating the storage of energy produced by
non-depleting, non-polluting energy sources, such as solar, wind and
hydroelectric power.

   We believe we are among the first companies to manufacture and deliver
systems incorporating PEM technology for use in commercial applications. We
delivered 35 of our HOGEN 40 style hydrogen generation units in 2001 to
domestic and international customers for use in industrial applications. Our
plan for 2002 is to expand production of HOGEN 40 units and deliver additional
units to domestic and international customers seeking alternatives to
conventionally delivered hydrogen.

                                      1

<PAGE>

   In other commercial applications, we delivered 68 Chrysalis hydrogen
generator units in 2001 under an exclusive agreement with Matheson Tri-Gas,
Inc., a leading supplier of laboratory gas, for use in laboratory applications.
The goal for 2002 is to expand our manufacturing capacity and deliver
additional units to Matheson under our agreement.

   In the longer term, we believe our PEM hydrogen generation technology will
be an important part of the infrastructure needed to provide hydrogen for fuel
cell vehicles. Our research and product development efforts include the
development of our FUELGEN, high-pressure hydrogen generator, capable of
providing hydrogen for a fuel cell vehicle. In December 2001, we reached an
agreement for a joint test and evaluation program with the TH!NK Group, an
enterprise of Ford Motor Company. Our plans are to begin field testing of
FUELGEN development units in the second half of 2002.

   We also intend to develop commercial applications for our UNIGEN
regenerative fuel cell technology. We built regenerative fuel cell systems in
2001 for both NASA and Marconi Inc. ("Marconi"), as well as for internal
research and product development programs.Our goal for 2002 is to manufacture
multiple demonstration regenerative fuel cell systems, and deliver them to
domestic and international customers for evaluation. These systems are being
designed to have the scale and technical attributes necessary to serve a broad
range of commercial applications.

   The development and commercialization of our hydrogen generators and
regenerative fuel cell systems has been and we anticipate will continue to be
supported by government and private development contracts. In October 2001, we
signed our largest contract to date worth up to $6.2 million with the Naval
Research Laboratory for advanced fuel cell technology development. Phase I of
this contract, worth $3.2 million, will provide initial technology development,
and has begun. The contract also includes a $3.0 million Phase II option under
which Proton could provide prototype fabrication and testing. We also signed a
3-year joint development agreement with the Sumitomo Corporation to develop,
sell and service PEM-based regenerative fuel cell and hydrogen generation
systems for the Japanese market, which include backup power, hydrogen
generation, load leveling/peak shaving, and renewable energy storage. We also
have ongoing development contracts in 2002 with the Connecticut Clean Energy
Fund, the Department of Energy and STM Power Inc.

   We plan to move our Company to a newly constructed 100,000 square foot
facility in Wallingford, CT during 2002 to accommodate the projected growth of
our business over the next several years. The building will consolidate all of
our corporate headquarters, manufacturing, research and product development
activities.

Products

  Hydrogen Generators

   Our HOGEN hydrogen generators convert water and electricity into high
purity, pressurized hydrogen gas, using PEM electrolysis. PEM electrolysis is a
process in which water is divided into its component elements to produce pure
hydrogen gas, with oxygen and heat as the only by-products. Users can connect
many of our hydrogen generators directly to existing water and electrical
sources, allowing them to be installed and used in a wide range of locations.

   We have shipped 35 commercial models of our HOGEN 40 style hydrogen
generators with 20 and 40 cubic feet per hour hydrogen production capacities,
and delivered a 380 cubic foot per hour capacity unit for demonstration. Our
HOGEN 40 units are freestanding, roughly the size of a household washing
machine, and are intended for indoor placement. Our HOGEN 380 is a larger
freestanding unit with a weatherized design for outdoor use. We intend to
increase production of our commercial HOGEN 40 products in 2002. We also intend
to deliver additional HOGEN 380 units for demonstration in 2002. We anticipate
expanding our family of hydrogen generation products into different output
capacities to better serve customer and application requirements.

   We have manufactured commercial hydrogen generators, marketed by Matheson
Tri-Gas, Inc. under the Chrysalis brand name, under a long-term agreement for
use in laboratory applications. These units are compact and designed to sit on
a laboratory countertop. We intend to increase production and product shipments
of these generators to Matheson in 2002.

                                      2

<PAGE>

   An important feature of our hydrogen production technology is the ability to
produce hydrogen at pressure without mechanical compression. Our current
commercial products produce hydrogen at between 150-200 psi. We have completed
the construction and commenced in-house testing of a full-scale 2000 psi, 20
standard cubic foot per hour prototype hydrogen gas generator. This multi-cell
system generates hydrogen pressure without a mechanical compressor using
solid-state compression within the electrochemical cell stack. Our proprietary
cell stack design has undergone continuous laboratory development since
mid-1999. Proton believes its high-pressure technology will be important in a
variety of applications and will continue its development in 2002.

   We have signed a 10-year agreement with STM Power Inc. for the exclusive
supply of high-pressure hydrogen replenishment systems for Stirling Cycle
Engines. These units are being developed to maintain the Stirling engine's
internal working pressure of greater than 2000 psi. Under an initial purchase
order relating to this agreement, Proton has begun product development work on
a high-pressure hydrogen replenishment system. We expect delivery of prototype
units in 2002.

   We are currently developing our FUELGEN high-pressure hydrogen generation
systems capable of supplying the hydrogen fueling needs of fuel cell vehicles
and other hydrogen power applications. Proton's FuelGen units are appropriately
scaled and designed to operate at typical gas station locations using ordinary
water and electricity. Proton has completed the initial assembly of its first
full scale FuelGen system and plans to begin demonstration unit testing in the
spring of 2002. Units are expected to be delivered to the TH!NK Group, an
enterprise of Ford Motor Company, and to the California Fuel Cell Partnership
later this year.

  Regenerative Fuel Cell Systems

   The UNIGEN regenerative fuel cell systems we are developing will integrate
PEM hydrogen generation technology with PEM fuel cell technology to create a
power generation device that produces hydrogen from water and electricity,
stores the hydrogen and later uses the hydrogen as fuel for the production of
electricity. In the hydrogen generation or electrolysis mode, the regenerative
fuel cell works exactly like a hydrogen generator, producing hydrogen at
pressures suitable for storage without compressors. In the power generation or
fuel cell mode, the process is reversed and the stored hydrogen is combined
with air to produce electricity instantaneously, efficiently and without any
harmful by-products. Our regenerative fuel cell architecture is capable of
using fuel cells produced by other developers and manufacturers to enable their
fuel cells to become energy storage devices.

   We have entered into a Joint Development Program with Marconi Communication
to further develop our regenerative fuel cell technology. Under a Memorandum of
Understanding, Proton and Marconi are jointly developing concepts, designs and
products incorporating Proton's technology for potential application in
Marconi's product lines.

   We also signed a 3-year joint development agreement with the Sumitomo
Corporation to develop, sell and service PEM-based regenerative fuel cell and
hydrogen generation systems for the Japanese market, which include backup
power, hydrogen generation, load leveling/peak shaving, and renewable energy
storage.

   We currently have ongoing research and financial assistance programs related
to our regenerative fuel cell systems and our hydrogen generation systems with
the United States Department of Energy ("DOE"), Naval Research Laboratory
("NRL"), and the Connecticut Clean Energy Fund for use in ongoing research and
development programs. The DOE program is focused on hydrogen generation and
storage from renewable energy sources. The NRL program is concentrated on fuel
cell technology development for use in advanced space propulsion and energy
systems. The Connecticut Clean Energy Fund program's purpose is to help
accelerate the commercialization of UNIGEN regenerative fuel cell products for
application in power quality markets.

                                      3

<PAGE>

Our Strategy

   Our objective is to be a leader in harnessing PEM technology for a number of
commercial applications. Our strategy for achieving this objective includes the
following elements:

  Leverage Technological Position

   In developing PEM technology, we have focused on two key areas: the
development of PEM hydrogen generators and the development of regenerative fuel
cell systems. We believe these technologies provide us with the opportunity to
develop innovative products that address attractive markets. In addition, our
technology is complementary to other fuel cell technologies and could enable
the commercial use of other fuel cell products, such as vehicular fuel cells,
by providing a hydrogen delivery infrastructure. For example, our hydrogen
generators could be deployed at refueling sites to provide hydrogen for fuel
cell vehicle fleets. As a result, we believe we are also well positioned to
benefit from further developments by other fuel cell developers and from
increases in demand for their fuel cell products. We intend to maintain our
technology leadership in PEM-based hydrogen generation and regenerative fuel
cell system technology by continuing to develop our core technology and
commercial manufacturing processes as well as improving the design and features
of our products.

  Focus on Near-Term Market Opportunities

   We believe we are among the first companies to manufacture and deliver
systems incorporating PEM technology for use in commercial applications. We
intend to focus on designing and marketing our products in the near term for
two primary markets: hydrogen generation for industrial applications and backup
power for communications network-related applications. We believe the
industrial gas market is an attractive market for us because it is well
developed and our hydrogen generator products offer cost and safety advantages
to users that currently rely on conventionally delivered hydrogen. We believe
the backup power market for the communications industry is also attractive
given its large size and the advantages our regenerative fuel cell systems are
being designed to offer over existing products. Our focus on near-term market
opportunities will continue to reinforce our emphasis on the commercial
application of PEM technology.

  Continue Focus on Cost Reduction

   Given our focus on commercial applications for PEM technology, manufacturing
improvements are a critical element of our product development and design
efforts. We intend to continue to focus on reducing the cost of manufacturing
our products. We will seek to reduce costs in part through the simplification
of our product designs, identification and use of lower cost materials and
components, development of long-term relationships with third-party component
and raw material suppliers and the construction of a larger-scale manufacturing
facility that will use higher volume, lean manufacturing processes and
techniques.

  Develop Key Strategic Relationships

   We are beginning to establish strategic relationships with leading companies
in our target markets. The strategic relationships we develop may include joint
development efforts and sales and marketing agreements. At present, we are in
various stages of discussions with potential partners, including industrial gas
suppliers and distributors, energy producers, backup power providers and
renewable energy companies. In seeking to develop strategic relationships, we
will focus on partners that can provide us with distribution channels for our
products and assist us in the design, development and manufacture of new
products. We believe that our demonstrated capabilities in PEM technology and
our focus on creating commercial applications make us an attractive potential
partner for many established companies seeking to gain access to fuel
cell-related technology.

   We have entered into a Joint Development Program with Marconi, a global
provider of advanced communications solutions. Under a Memorandum of
Understanding, Proton and Marconi have been jointly

                                      4

<PAGE>

developing concepts, designs and products incorporating Proton's UNIGEN(R)/
regenerative fuel cell technology for potential application to Marconi's
product lines. /

   We also signed a 3-year joint development agreement with the Sumitomo
Corporation to develop, sell and service PEM-based regenerative fuel cell and
hydrogen generation systems for the Japanese market, which include backup
power, hydrogen generation, load leveling/peak shaving, and renewable energy
storage.

   We have also reached an agreement for a joint test and evaluation program
with Ford's TH!NK Group. Under this agreement, Proton plans to deliver a
FuelGen(TM) high-pressure hydrogen refueling system to TH!NK in 2002. The
FuelGen(TM) system is designed to provide fuel for Ford's hydrogen-fueled fuel
cell and internal combustion vehicles. Proton will also assist TH!NK in the
installation, support and testing of the system.

  Position Our Technology for Longer-Term Opportunities

   We believe we are well positioned to take advantage of growth in the markets
for fuel cell applications and renewable energy technologies. If fuel cell
applications achieve commercial acceptance, our hydrogen generators can be a
key component of the hydrogen supply infrastructure that will be required. We
intend to work with leading energy and power companies to position our hydrogen
generators for automotive refueling applications. With respect to renewable
power, as developers of renewable technologies, especially wind and solar
power, achieve cost and performance improvements, the need to overcome the
inherent intermittent nature of renewable power will become even more
important. Accordingly, we plan to work with renewable energy companies to
explore and develop energy storage applications using our regenerative fuel
cell architecture.

Our Technology

  PEM-Based Hydrogen Generators

   Our hydrogen generators are electrochemical devices that convert water and
electricity into hydrogen gas using a process known as PEM electrolysis. The
core of a hydrogen generator is an electrolysis cell consisting of a solid
electrolyte proton exchange membrane. Catalyst material is bonded to both sides
of the membrane, forming two electrodes. To generate hydrogen, water is
introduced to one side of the membrane and voltage is applied to the
electrodes. This process divides the water into protons, electrons and oxygen.
The protons are drawn through the proton exchange membrane and recombined with
the electrons at the opposite side of the membrane to form hydrogen. The oxygen
is removed from the cells with the excess water flow. This process produces
hydrogen with a high level of purity and at significant pressures.

   A single electrolysis cell is typically integrated into a complete cell
assembly that includes flowfield structures that provide mechanical support,
conduct current and provide a means to introduce water and remove gases. These
cell assemblies are stacked and compressed between two end plates along with
other support components to form a complete cell stack. The hydrogen production
capability of a cell stack is approximately proportional to the area of each
cell, the number of cells in the stack and the electric current supplied.

  PEM-Based Fuel Cell Power Generators

   In our PEM fuel cell, which is very similar to our PEM electrolysis cell,
the opposite reactions occur. To generate electricity, hydrogen and air, or
oxygen, are introduced to opposite sides of the cell. The hydrogen passes over
an electrode structure adjacent to the proton exchange membrane, where it is
divided into its component protons and electrons. When the electrons are
separated from the protons, the electrons are conducted in the form of a usable
electric current. The protons travel through the proton exchange membrane and
recombine with the electrons and oxygen to produce water.

   To form a complete fuel cell stack, individual PEM fuel cells are stacked
and compressed between two end plates. The electrical power production
capability of a cell stack is approximately proportional to the area of each
cell and the number of cells in the stack.

                                      5

<PAGE>

   Our regenerative fuel cell systems incorporate the ability to support both
an electrolysis reaction and a fuel cell reaction. Our proprietary designs
operate in the electrolysis mode by using water and electricity to generate
hydrogen at elevated pressure and then reverses the process and consumes the
hydrogen with air to generate electricity. The resulting product functions like
a rechargeable battery in which hydrogen is produced through electrolysis,
stored and then used for power generation. Unlike one-way fuel cells, our
regenerative fuel cell systems use hydrogen produced through electrolysis
rather than extracted from hydrocarbon fuels, electricity can be produced at
room temperature, without lengthy start-up times or carbon-based emissions and
in areas where fossil fuels such as natural gas, propane or gasoline are not
available.

   Our regenerative fuel cell systems can be configured using one or two PEM
stacks. The one stack approach uses one of our proprietary designs, which
allows a single cell to operate in both the electrolysis mode and the fuel cell
mode. These reversible fuel cells are under development by Proton and may have
cost and weight advantages. Our two stack regenerative fuel cell systems are
configured by using separate cell stacks for the electrolysis and fuel cell
reaction. Proton currently manufactures its own electrolysis stacks for testing
in these systems. We are developing our own proprietary fuel cell stack, which
we intend to incorporate into these systems. We are also testing fuel cell
stacks from other fuel cell developers for potential incorporation into our
regenerative systems.

Research and Development

   A portion of our research and development has been funded by programs funded
by government contracts, and is classified as research and development expense
in our financial statements. For the years ended December 31, 2001, total
research and development expenses, including amounts received from NRL,
Connecticut Clean Energy Fund, DOE, NASA, other government agencies and private
entities, and amounts that have been self-funded, was $6.5 million. We expect
to receive funding in 2002 under our contracts from NRL, the Connecticut Clean
Energy Fund, DOE, and STM Power Inc.

Proprietary Technology

   We have developed proprietary technology relating to various aspects of our
electrolysis cells, regenerative fuel cell systems and related systems. These
include:

  .  membrane processing technology;

  .  electrolysis catalytic electrode formulation;

  .  reversible fuel cells;

  .  fuel cell stack designs

  .  high-pressure cell structures that simplify overall system implementation;
     and

  .  integrated system designs for both hydrogen generators and regenerative
     fuel cell systems.

Distribution and Marketing

   We plan to sell our hydrogen generators primarily through distribution
arrangements with third parties and also through a limited direct sales force.
Because small and medium-volume hydrogen users generally buy hydrogen from
industrial gas suppliers and distributors, we intend to focus our marketing
efforts on sales to these companies for resale to end-users. By focusing on
industrial gas suppliers and industrial gas equipment distributors, we intend
to maximize our sales by leveraging their established marketing, distribution
and service channels. We currently have a development, marketing and
distribution agreement with Matheson Tri-Gas, Inc. under which Matheson has
exclusive distribution rights for hydrogen generators for the laboratory market
bearing Matheson's Chrysalis trademark or other designated commercial names. In
addition, we have distribution

                                      6

<PAGE>

agreements with Diamond Lite S.A., Products of Technology LTD, and Fig Tree
Marketing, for distribution of our hydrogen generators in western and central
Europe, UK, Ireland and in the specialized field of meteorology. We intend to
establish additional sales and distribution arrangements with industrial gas
suppliers and distributors, as well as meteorology equipment providers and
original equipment manufacturers.

   As the market to supply hydrogen fuel for fuel cell vehicles develops, we
also plan, where possible, to focus on existing distribution channels. We
believe that existing energy suppliers are likely to begin supplying new forms
of automotive fuel as they come to market. Accordingly, we intend to establish
relationships with major oil companies to explore ways of supplying our
hydrogen generators for installation at local service stations. In addition, we
believe that automobile manufacturers providing introductory and fleet fuel
cell vehicles will be interested in our refueling technology and therefore we
will seek to establish relationships with these manufacturers.

   Currently, backup power equipment is sold by a few large manufacturers to
commercial end users through diverse reseller networks, including integrators
and qualified resellers. We plan to sell our backup power products to these
existing manufacturers, integrators and qualified resellers.

   In 2001, sales to each of Air Liquide America Corp., Diamond Lite SA,
Praxair Distribution, and The Bernd Group, Inc. accounted for more than 10% of
our product revenue.

Manufacturing

   We are currently manufacturing hydrogen generators at our facility in Rocky
Hill, Connecticut. Key aspects of this process include formulation of our
proprietary catalysts, deposition of the catalyst on the proton exchange
membrane and fabrication of cells into cell stacks. The balance of the
manufacturing process consists of integrating cell stacks into systems that
perform fluids and electrical management of the electrochemical process.

   We purchase raw proton exchange membrane material from Dupont, although we
have identified other companies we believe capable of providing suitable
membrane material. We purchase the other components used in our systems from
third-party suppliers. We regularly consult with our suppliers to evaluate ways
to lower the cost of other components or subassemblies while meeting the
performance needs of our products. In this regard, we have considered and will
continue to evaluate the option of having subassemblies that we currently
produce in-house produced to our specifications by others if lower costs can be
achieved. We anticipate moving all our manufacturing capacity in 2002 to our
new larger facility where we will continue to integrate and assemble our
products.

   In 2001, we successfully completed our annual ISO9001 audit and remain
registered. We believe that this registration, a quality assurance model for
companies that design, produce, install and service items as part of their
business will provide us with an advantage over competitors that are not
ISO9001 registered. In some cases, this registration is a condition of doing
business with our customers.

Intellectual Property

   We seek to maintain our technology leadership position by aggressively
protecting our intellectual property assets using patent, trade secret,
trademark and copyright law. Our protection of these assets has continued to
accelerate and we currently have five issued U.S. patents and one European
patent, covering aspects of our hydrogen generation equipment and electrolysis
cell designs. One U.S. patent covers a system that isolates the electrical
components from the hydrogen gas, eliminating the need for explosion-proof
equipment. We have over 75 U.S. and international patents pending, covering not
only our current electrolysis products, but technologies we have developed
related to fuel cells, backup and renewable power systems and hydrogen fueling
systems.

   In addition to our patented assets, our intellectual property position has
also grown to include manufacturing processes and know-how, which are enhancing
our next generation products and cost reduction efforts. We also seek to
protect our proprietary intellectual property in part through confidentiality
agreements with our strategic partners and employees. We cannot assure you that
these agreements will not be breached, that we will have adequate remedies for
any breach or that such persons or institutions will not assert rights to
intellectual property arising out of these relationships.

                                      7

<PAGE>

Competition
   Our hydrogen generators will compete with delivered hydrogen, and with
alternative equipment used to manufacture hydrogen-rich gas. Competitors in the
delivered hydrogen market include Air Liquide, Air Products and Chemicals,
Linde and Praxair. Our hydrogen generators will also compete with older
generations of electrolysis-based hydrogen generation equipment sold by Stuart
Energy Systems, Norsk Hydro, Teledyne-Brown and other companies. These systems
are generally larger in size, require manual operation and supervision, contain
hazardous liquid electrolyte and require the assistance of mechanical
compressors to produce hydrogen at pressure.

   In backup power applications, our products may compete against:

  .  battery-based, uninterruptible power supply systems, which are widely
     manufactured and used around the world;

  .  ultracapacitors, which store energy as an electrostatic charge;

  .  internal combustion engine generator sets;

  .  microturbines;

  .  superconducting energy storage systems, which store energy within a
     superconducting magnet kept at extremely low temperatures;

  .  flywheels, which store energy in the form of a continuously spinning
     wheel, the kinetic energy of which can be converted into electrical
     energy; and

  .  other fuel cells using alternative hydrogen supply applications.

   There are a number of companies located in the United States, Canada and
abroad that are developing PEM fuel cell technology. Although we believe these
companies are currently primarily targeting vehicular and residential
applications, they could decide to enter the hydrogen generation and backup
power markets we intend to address. We may also encounter competition from
companies that have developed or are developing fuel cells based on non-PEM
technology, as well as other distributed generation technologies.

   Many of our competitors have substantially greater financial, research and
development and marketing capabilities than we do. In addition, as the backup
power and hydrogen fuel markets develop, other large industrial companies may
enter these fields and compete with us.

Employees

   As of December 31, 2001, we had a total staff of approximately 115
employees, of which approximately 65 were engineers, scientists, and other
degreed professionals. We consider our relations with our employees to be
excellent.

ITEM 2.  Properties

   Our principal executive offices are located in Rocky Hill, Connecticut. We
currently lease two facilities totaling approximately 28,000 square feet that
house all of our research, product development, manufacturing and office
activities and staff.

   In 2001, we purchased approximately 44 acres of land located in Wallingford,
Connecticut to build our new facility. In December 2001, Technology Drive LLC,
a limited liability company wholly owned by us, entered into a $6,975,000 loan
agreement with a bank, in connection with the construction of the facility.
Under the terms of the loan, the business assets of Technology Drive LLC,
including the land and building, are subject to lien. The loan agreement is
structured as a one-year construction loan with monthly payments of interest
only until December 2002 at which time the loan converts to a seven-year term
note.

                                      8

<PAGE>

   Our new facility will total approximately 100,000 square feet and contain
all of our research, product development, manufacturing and office
activities.We expect to relocate our operations in mid-2002.

ITEM 3.  Legal Proceedings

   Between July 3, 2001 and August 29, 2001, four purported class action
lawsuits were filed in the United States District Court for the Southern
District of New York against the Company and several of its officers and
directors as well as against the underwriters who handled the September 28,
2000 initial public offering ("IPO") of common stock. All of the complaints
were filed allegedly on behalf of persons who purchased the Company's common
stock from September 28, 2000 through and including December 6, 2000. The
complaints are similar, and allege that the Company's IPO registration
statement and final prospectus contained material misrepresentations and/or
omissions related, in part, to excessive and undisclosed commissions allegedly
received by the underwriters from investors to whom the underwriters allegedly
allocated shares of the IPO.

   The Company believes it has meritorious defenses to the claims made in the
complaints and intends to contest the lawsuits vigorously. However, there can
be no assurance that we will be successful, and an adverse resolution of the
lawsuits could have a material adverse effect on our financial position and
results of operation in the period in which the lawsuits are resolved. The
Company is not presently able to reasonably estimate potential losses, if any,
related to the lawsuits. In addition, the costs to us of defending any
litigation or other proceeding, even if resolved in our favor, could be
substantial.

ITEM 4.  Submission of Matters to a Vote of Security Holders

   Not applicable.

Executive Officers and Directors

   Our executive officers and directors, and their ages as of December 31,
2001, are as follows:

<TABLE>
<CAPTION>
Name                       Age Title
----                       --- -----
<C>                        <C> <S>
Walter W. Schroeder....... 53  President, chief executive officer and director
Robert J. Friedland....... 36  Senior vice president of products and manufacturing
Trent M. Molter........... 39  Senior vice president of technology and
                               new business and director
Lawrence C. Moulthrop, Jr. 45  Vice president of product development
William F. Smith.......... 50  Vice president of programs and new business
David E. Wolff............ 44  Vice president of sales and marketing
John A. Glidden........... 38  Vice president of finance
Robert W. Shaw, Jr........ 60  Chairman of the board of directors
Richard A. Aube........... 33  Director
Gerald B. Ostroski........ 60  Director
Philip R. Sharp........... 59  Director
</TABLE>

   Walter W. Schroeder, one of our founders, has served as our president and
chief executive officer, and as a director, since our founding in August 1996.
From 1991 to August 1996, Mr. Schroeder served as an officer of AES Corp., an
independent power company. From 1986 to 1991, Mr. Schroeder was a vice
president in the investment banking division of Goldman Sachs & Co.
Mr. Schroeder holds BS and MS degrees from Massachusetts Institute of
Technology.

   Robert J. Friedland, one of our founders, has served as our senior vice
president of products and manufacturing since September 2001. From our founding
in August 1996 through September 2001, Mr. Friedland served as our vice
president of operations. From 1995 to August 1996, Mr. Friedland served as a

                                      9

<PAGE>

program operations manager for United Technologies Corporation, a diversified
aerospace and building systems company. Mr. Friedland holds a BS in mechanical
engineering from Syracuse University and an MBA from Rennselaer Polytechnic
Institute.

   Trent M. Molter, one of our founders, has served as our senior vice
president of technology and new business since September 2001 and as a director
since 1997. From our founding in August 1996 through September 2001, Mr. Molter
served as our vice president of engineering and technology. From 1984 to August
1996, Mr. Molter served as an advanced technology engineer and a project
manager in PEM products for United Technologies. Mr. Molter holds a BS in
chemical engineering from Clarkson University and an MS in metallurgy from
Rennselaer Polytechnic Institute.

   Lawrence C. Moulthrop, Jr., one of our founders, has served as our vice
president of product development since our founding in August 1996. From 1994
to August 1996, Mr. Moulthrop served as the PEM technology engineering manager
for United Technologies. From 1984 to 1994, Mr. Moulthrop served in various
other PEM engineering positions for United Technologies. Mr. Moulthrop holds a
BS in chemical engineering from the University of New Hampshire.

   William F. Smith, one of our founders, has served as our vice president of
programs and new business since September 2001. From our founding in August
1996 through September 2001, Mr. Smith served as our vice president of business
development. From 1986 to August 1996, Mr. Smith served as a business
development program manager for United Technologies. Mr. Smith holds a BA in
physics from the University of Connecticut and an MBA from the University of
Massachusetts.

   David E. Wolff has served as our vice president of sales and marketing since
March 1999. From 1992 to March 1999, Mr. Wolff served in various capacities for
MG Industries, a subsidiary of the Messer Group, a supplier of industrial gas.
From 1979 to 1992 Mr. Wolff served in various sales positions for Air Products
and Chemicals. Mr. Wolff holds an AB in engineering science from Dartmouth
College.

   John A. Glidden has served as our vice president of finance since November
1997. From July 1996 to November 1997, Mr. Glidden served as a financial
manager for United Technologies. From 1987 to July 1996, Mr. Glidden served as
a senior financial planning analyst for United Technologies. Mr. Glidden holds
a BS in business administration from Central Connecticut State University and
an MS in international management from Rensselaer Polytechnic Institute.

   Robert W. Shaw, Jr. has served as our chairman of the board of directors
since our founding in August 1996. Dr. Shaw has served as president of Arete
Corporation, a private investment firm, since March 1997. From 1983 to 1997,
Dr. Shaw served as president of Arete Ventures, Inc., a private investment firm
he founded to invest in the fields of modular/dispersed power generation,
renewable power generation and specialty materials. Prior to that time, Dr.
Shaw was a senior vice president and director of Booz Allen & Hamilton, a
consulting firm, where he founded the firm's energy division. Dr. Shaw holds
BEP and MS degrees from Cornell University, an MPA from American University and
a PhD in applied physics from Stanford University. He serves as a director of
Evergreen Solar, Inc., a public company which makes photovoltaic products, and
of CellTech Power, Inc., H2Gen Innovations, Inc. and Northern Power Systems,
Inc., each a private power technology company.

   Richard A. Aube has served as a director since April 2000. Mr. Aube is
currently a general partner of The Beacon Group Energy Funds, a private
investment firm and affiliate of J.P. Morgan Partners.Prior to that time,
Mr. Aube was an investment banker in the natural resources group at Morgan
Stanley & Co. Incorporated. Mr. Aube holds a BA from Dartmouth College. He
serves as a director of Capstone Turbine Corporation, a public company which
makes microturbine generation systems, and of STM Power Inc. and Powercell
Corporation, each a private power technology company.

                                      10

<PAGE>

   Gerald B. Ostroski has served as a director since February 1999.
Mr. Ostroski has served as vice president of Minnesota Power, Inc. since
January 1982. Since 1991, Mr. Ostroski has also served as president of
Minnesota Power's Synertec subsidiary and currently serves as a director or
officer of several other Minnesota Power subsidiaries. Mr. Ostroski is a
registered professional engineer, licensed in Minnesota and North Dakota.
Mr. Ostroski holds a BSEE from the University of Wisconsin.

   Philip R. Sharp has served as a director since March 1999. Dr. Sharp has
served as a lecturer at the John F. Kennedy School of Government of Harvard
University since February 1995. From July 1995 to February 1998, Dr. Sharp also
served as director of Harvard University's Institute of Politics, and is
currently a member of the Institute's senior advisory board. From 1975 to 1995,
Dr. Sharp served as a member of the United States House of Representatives,
representing the second district of Indiana. He was a member of the House
Energy and Commerce Committee and the Interior Committee. Dr. Sharp also
chaired the Subcommittee on Fossil and Synthetic Fuels and the Energy and Power
Subcommittee. Dr. Sharp holds a BSFS in foreign service and a PhD in government
from Georgetown University. He serves as a director of Cinergy Corp. and New
England Power Co.

   Each executive officer serves at the discretion of the board of directors
and holds office until his successor is elected and qualified or until his
earlier resignation or removal. There are no family relationships among any of
our directors or executive officers.

                                    PART II

ITEM 5.  Market for Registrant's Common Stock and Related Stockholder Matters

   The range of high and low sales prices per share of our Common Stock as
reported on The NASDAQ National Market under the symbol PRTN since our initial
public offering is shown below:

                             Proton Energy Systems

           Support for Item 5--Market for Registrant's Common Stock

<TABLE>
<CAPTION>
               Year and Quarter                       High   Low
               ----------------                      ------ -----
               <S>                                   <C>    <C>
               2001
               First Quarter........................ $16.50 $6.13
               Second Quarter.......................  15.12  6.67
               Third Quarter........................  11.98  4.39
               Fourth Quarter.......................   9.00  4.00

               2000
               Fourth Quarter (from October 2, 2000) $33.25 $5.25
</TABLE>

   We have never declared or paid any cash dividends on our common stock and
currently intend to retain any future earnings for the future operation and
expansion of our business. Accordingly, we do not anticipate that any cash
dividends will be declared or paid on our common stock in the foreseeable
future.

   As of March 20, 2002 there were approximately 14,100 stockholders of record.

  Use of Proceeds

   The effective date of the Securities Act registration statement for which
the use of proceeds information is being disclosed was September 28, 2000, and
the Commission file number assigned to the registration statement is 333-39748.
After deducting underwriting discounts and commissions and offering expenses,
our net proceeds from the Offering were approximately $125.8 million. The net
proceeds have been allocated for general

                                      11

<PAGE>

corporate purposes and capital expenditures, including purchase of equipment
for and leasehold improvements to our planned manufacturing facility, and the
possible acquisition of businesses, products or technologies that are
complementary to our business. As of December 31, 2001, approximately $11.4
million of the net proceeds of the offering had been used to fund operations
and purchase fixed assets. The remaining net proceeds are invested in U.S.
Government and Agency securities. In October 2001, we loaned $275,000 of the
proceeds to Mr. Schroeder, who is president and a director of the company. No
other portion of the proceeds were paid directly or indirectly to any director,
officer or general partner of us or our associates, persons owning ten percent
or more of any class of our equity securities, or an affiliate of us.

   The data set forth below should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
our financial statements and notes thereto included elsewhere in this report.

ITEM 6.  Selected Financial Data

   The data set forth below should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
our financial statements and notes thereto included elsewhere in this report.

<TABLE>
<CAPTION>
                                                                   Year Ended December 31,
                                                        ---------------------------------------------
                                                          2001      2000     1999     1998     1997
                                                        --------  --------  -------  -------  -------
                                                            (in thousands, except per share data)
<S>                                                     <C>       <C>       <C>      <C>      <C>
Statement of Operations Data:
Revenue:
   Contract revenue.................................... $  1,215  $    644  $   934  $    --  $    --
   Product revenue.....................................    1,753        56       --       --       --
                                                        --------  --------  -------  -------  -------
       Total revenue...................................    2,968       700      934       --       --
Costs and expenses:
   Costs of contract revenue...........................    1,001       396      355      377       --
   Costs of production.................................    2,534       248      154       --       --
   Research and development............................    6,500     3,227    2,182    1,323      963
   General and administrative..........................    6,950     4,518    1,705      950      735
                                                        --------  --------  -------  -------  -------
                                                          16,985     8,389    4,396    2,650    1,698
   Loss from operations................................  (14,017)   (7,689)  (3,462)  (2,650)  (1,698)
   Interest income (expense), net......................    8,950     4,199      172      (31)      28
   Gain on sale of marketable securities...............      113        --       --       --       --
                                                        --------  --------  -------  -------  -------
   Net loss............................................   (4,954)   (3,490)  (3,290)  (2,681)  (1,670)
   Deemed preferred dividends and accretion............       --   (52,691)    (899)    (441)    (160)
                                                        --------  --------  -------  -------  -------
   Net loss attributable to common stockholders........   (4,954)  (56,181)  (4,189)  (3,122)  (1,830)
                                                        ========  ========  =======  =======  =======
Basic and diluted net loss per share attributable to
  common stockholders.................................. $  (0.15) $  (5.92) $ (2.20) $ (1.64) $ (0.96)
                                                        ========  ========  =======  =======  =======
Shares used in computing basic and diluted net loss per
  share attributable to common stockholders............   33,161     9,484    1,900    1,900    1,900
                                                        ========  ========  =======  =======  =======
Balance Sheet Data:
Cash, cash equivalents and marketable securities....... $167,220  $174,749  $ 3,131  $ 3,228  $ 2,990
Working capital........................................  169,253   176,856    3,225    3,274    2,925
Total assets...........................................  181,868   180,752    5,000    4,870    3,664
Current liabilities....................................    4,675     2,445      921      792      129
Long-term liabilities..................................    1,166        --       --       --       --
Mandatorily redeemable convertible preferred stock.....       --        --   13,136    9,237    5,571
Total stockholders' equity (deficit)...................  176,027   178,307   (9,057)  (5,159)  (2,036)
</TABLE>

                                      12

<PAGE>

ITEM 7.  Management's Discussion and Analysis of Financial Condition and
Results of Operations

   You should read the following discussion and analysis in conjunction with
our financial statements and the related notes included elsewhere in this
report. This discussion and analysis contains forward-looking statements that
involve risks and uncertainties. Our actual results may differ materially from
those anticipated in these forward-looking statements as a result of several
factors, including, but not limited to, those set forth under "Certain Factors
That May Affect Future Results" and elsewhere in this report.

Overview

   We were founded in 1996 to design, develop and manufacture PEM
electrochemical products for commercial applications. Our proprietary PEM
technology is incorporated in two families of products: hydrogen generators, of
which we are currently manufacturing and delivering commercial models to
customers, and regenerative fuel cell systems, which we are currently
developing. Since our inception, we have funded our operations through private
financings that raised approximately $61.6 million, including $50.1 million
raised in a private financing in April 2000, and an initial public offering in
October 2000 which raised net proceeds of approximately $125.8 million.

   The following significant events occurred in 2001:

  .  We signed an agreement with Ford's TH!NK Group for a joint test and
     evaluation program of Proton's FUELGEN high-pressure hydrogen refueling
     system.

  .  We signed an agreement with the Connecticut Clean Energy Fund providing
     $1.5 million to accelerate commercial deployment of our UNIGEN(R) fuel
     cell product family

  .  We signed a contract worth up to $6.2 million with the Naval Research
     Laboratory.

  .  We signed a ten-year agreement with STM Power, Inc. for the exclusive
     supply of high-pressure hydrogen replenishment systems for Stirling Cycle
     Engines.

  .  In the fourth quarter of 2001 we determined that we had adequate
     information and experience to begin recognizing product revenue related to
     sales of HOGEN 40 units upon shipment. We delivered 19 additional HOGEN 40
     series units in the fourth quarter for a total of 35 units shipped in 2001.

  .  During 2001, we began to generate significant revenue from our principal
     operations. As a result, we no longer consider ourselves to be a
     development stage enterprise.

  .  We strengthened our intellectual property position by bringing to 77 our
     total portfolio of U.S. and foreign patant filings. To date, 5 U.S.
     patents have been issued.

  .  We broke ground on a new 100,000 square foot manufacturing, product
     development and research facility.

   We have generated cumulative losses since our inception, and as of December
31, 2001 our accumulated deficit was $67.0 million, of which $50.7 million is
attributable to deemed preferred dividends and accretion and $16.3 million is
attributable to net losses. We expect to continue to make significant
investments in new product design and development for the foreseeable future.
We believe that our success is dependent on increasing our customer base,
developing products that leverage our proprietary technology, and maintaining a
proper alignment between our cost structure and our revenue goals. We expect to
incur operating losses in 2002 and for the next several years and cannot
predict when we will become profitable, if ever.

Critical Accounting Policies

   Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared by us in accordance with accounting principles generally accepted
in the United States of America. The preparation of these financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenue and expenses, and

                                      13

<PAGE>

disclosure of contingent assets and liabilities. Our estimates include those
related to revenue recognition, investments, income taxes, depreciable lives of
equipment, and contingency accruals. We base our estimates on historical
experience and on various other assumptions that we believe to be reasonable
under the circumstances. Actual results may differ from these estimates under
different assumptions or conditions. For a complete description of our
accounting policies, see Note 2 to our consolidated financial statements
included in this Form 10-K.

   Our critical accounting policies include the following:

  Revenue Recognition--Product Revenue

   We began delivering late-stage development models of our hydrogen generators
to customers in 1999; revenue on such transactions has generally been deferred
until the expiration of the product warranty period. In the fourth quarter of
2001, we determined that we had adequate product warranty information and
experience to begin recognizing product revenue related to sales of HOGEN 40
units upon shipment. As a result, we recognized previously deferred HOGEN 40
series revenue of $754,000 in the fourth quarter 2001. The Company will
continue to defer revenue on shipments of its Chrysalis and HOGEN 380 hydrogen
products until such units are past the product warranty period or until the
Company has adequate warranty history. As of December 31, 2001, we have
deferred revenue of approximately $884,000 related to hydrogen generators,
other than HOGEN 40 units, we have delivered. In the future, we expect to
derive the majority of our revenue from the sale of the hydrogen generator and
regenerative fuel cell system products we may develop.

  Revenue Recognition--Contract Revenue

   We derive contract revenue from customer-sponsored research and development
contracts related to our PEM technology. For those contracts which do not
require us to meet specific obligations, we recognize contract revenue
utilizing the percentage-of-completion method, which is based on the
relationship of costs incurred to total estimated contract costs. For those
research and development contracts which require us to meet specified
obligations, including delivery and acceptance obligations, amounts advanced to
us pursuant to the contracts are recognized as contract liabilities until such
obligations are met. Once the obligations are met, the amounts are recognized
as contract revenue. From inception through December 31, 2001, we have
recognized approximately $2.8 million in contract revenue from research and
development funding under arrangements with both government and private
sources. Under these contracts, we have delivered HOGEN hydrogen generators and
demonstration regenerative fuel cell systems.

  Warranty Costs

   Our warranty policy is limited to replacement parts and services and expires
one year from date of shipment. Estimated warranty obligations are provided for
as costs of production in the period in which the related revenue is
recognized. Our warranty obligation may be materially affected by product
failure rates and other costs incurred in correcting a product failure. Should
actual product failure rates or other related costs differ from our estimates,
revisions to the estimated warranty liability would be required.

  Inventory

   Inventory is recorded at the lower of cost or market value. This requires us
to write-down our inventory for estimated obsolescence equal to the difference
between the cost of inventory and the estimated market value to reflect
assumptions about future demand and market conditions. If future demand and
market conditions are less favorable than anticipated, additional inventory
write-downs may be required.

  Stock-Based Compensation

   We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees," (APB 25) and related interpretations, as clarified by
FASB Interpretation No. 44, "Accounting for Certain

                                      14

<PAGE>

Transactions Involving Stock Compensation," in accounting for our stock option
plan and stock awards with the disclosure provisions of Statement of Financial
Accounting Standards No. 123 "Accounting for Stock-Based Compensation" (SFAS
123). Under APB 25, compensation expense is computed to the extent that the
fair market value of the underlying stock on the date of grant exceeds the
exercise price of the employee stock option or stock award. Compensation so
computed is then recognized over the vesting period. We account for equity
instruments issued to non-employees in accordance with SFAS 123 and the
consensus in Emerging Issues Task Force ("EITF") 96-18. These pronouncements
require the fair value of equity instruments given as consideration for
services rendered be recognized as a non-cash charge to income over the shorter
of the vesting or service period. The equity instruments must be revalued on
each subsequent reporting date until performance is complete with a cumulative
catch-up adjustment recognized for any changes in their fair value. In the
event that we are required to record compensation expense that is currently
only being disclosed under SFAS 123, an adjustment to decrease net income in
such period would result.

  Deferred Tax Asset Valuation Allowance

   We provide a full valuation allowance against our net deferred tax assets
as, based on the weight of available evidence, it is more likely than not that
some or all of the net deferred tax assets will not be realized. In the event
that we determine in the future that we will be able to realize our deferred
tax assets in excess of their carrying amounts, an adjustment to the valuation
allowance would increase net income in the period such determination was made.

  Related Party Transactions

   From time to time, we may enter into transactions with parties that have
relationships with our officers or directors. Such transactions are reviewed by
the Board of Directors and are subject to the prior approval of members of the
Board of Directors who do not have a personal interest in the applicable
transaction. We disclose all material transactions that, in our judgment,
constitute related party transactions.

Results of Operations

  Comparison of Years 2001 and 2000

   Contract revenue.  Contract revenue increased from $644,000 in 2000 to $1.2
million in 2001. This increase was due to research and development activity
related to regenerative fuel cell systems under the DOE contract, as well as
activity under the NRL contract entered into in the fourth quarter of 2001. In
the future, we expect contract revenue from government sponsored research and
development contracts to decrease as a percentage of total revenues.

   Product revenue.  Product revenue increased from $56,000 in 2000 to $1.8
million in 2001. In 2000, product revenue was recognized only upon expiration
of the product warranty and includes revenue for product rentals. In 2001,
HOGEN 40 product revenues began to be recognized upon shipment in the fourth
quarter. The revenue in 2001 accordingly represents previously deferred HOGEN
40 revenue within the warranty period, fourth quarter HOGEN 40 revenue, product
rental revenue, and spare parts revenue.

   Costs of contract revenue.  Costs of contract revenue increased from
$396,000 in 2000 to $1.0 million in 2001. The increase in 2001 reflects
increased costs incurred under our DOE contract compared with 2000 as well as
costs incurred under the new NRL contract.

   Costs of production.  Costs of production increased from $248,000 in 2000 to
$2.5 million in 2001. The amounts in 2000 and 2001 reflect costs associated
with manufacturing and delivering our hydrogen generators in excess of the
corresponding sales price as well as warranty costs on units in the field. Cost
of production could increase if warranty experience deteriorates. In addition,
in 2001, cost of production also includes approximately $1.7 million of
previously deferred cost recognized concurrent with the recognition of revenue.

                                      15

<PAGE>

   To date, under our initial order, we have recognized costs in excess of our
contracted sales price with Matheson Tri-Gas, Inc. in the amount of $394,000.
We expect to continue to incur costs in excess of our sales price under our
contract with Matheson Tri-Gas, Inc. until we are able to reduce the costs of
production on these units through refinements in our production process.

   Under the Matheson Tri-Gas contract, Matheson has the exclusive right to
sell our hydrogen generators if it meets minimum purchase requirements
specified in the contract. No minimum purchase requirements are applicable to
Matheson prior to December 31, 2001. For periods after December 31, 2001, the
contract currently provides that Matheson must purchase 1,000 units per year if
it wishes to maintain exclusivity; however, the Company and Matheson are
currently in negotiation regarding quantity and price adjustments for 2002.
Under the contract, we have the right to increase prices on the units once
annually by providing six months notice, subject to either party's right to
terminate the contract if agreement on price increases is not reached. We
anticipate that the terms of the contract may be revised as commercial
development is completed. Any future recognition of losses by us under this
contract will depend on the number of orders placed by Matheson and the extent
to which our cost per unit exceeds the sale price per unit.

   Research and development expenses.  Research and development expenses
increased from $3.2 million in 2000 to $6.5 million in 2001. The increase was
due to an increase in our research and development activities related to our
PEM technology in our regenerative fuel cell systems and our hydrogen
generators. These research and development activities primarily related to
increased salaries and benefits for our growing research and development staff.
We expect our research and development expenses to continue to increase in the
future.

   General and administrative expenses.  General and administrative expenses
increased from $4.5 million in 2000 to $7.0 million in 2001. This increase
reflects an increase in salaries and benefits of $731,000, as a result of an
increase in the number of employees, an increase in accounting and legal
expenses of $400,000, an increase of $346,000 in investor relations expenses,
an increase of $142,000 in educational and training related expenses, and an
increase of $110,000 for non-cash compensation expense associated with stock
option grants.

   Interest income (expense), net.   Interest income increased from $4.2
million in 2000 to $8.9 million in 2001. The increase was driven by higher
average cash and marketable securities balances during 2001 resulting from the
proceeds of the issuance of our series C convertible preferred stock in April
2000 and initial public offering in October 2000.

Results of Operations

  Comparison of Years 2000 and 1999

   Contract revenue.   Contract revenue decreased from $934,000 in 1999 to
$644,000 in 2000. This decrease was due to research and development activity
related to regenerative fuel cell systems under the NASA and DOE contracts as
well as the completion of the Electric Power Research Institute (EPRI) contract
in 1999. In the future, we expect contract revenue from government sponsored
research and development contracts to decrease as a percentage of total
revenues once we begin to recognize revenue from product sales.

   Product revenue.   Product revenue increased from $0 in 1999 to $56,000 in
2000. The amount in 2000 relates to revenue recognized upon expiration of the
product warranty and for product rentals.

   Costs of contract revenue.   Costs of contract revenue increased from
$355,000 in 1999 to $396,000 in 2000. The amount in 1999 reflects costs
incurred on the first phase of both our DOE and NASA contracts and on our EPRI
contract, for which contract revenue was deferred until specific obligations
were met in the fourth quarter of 1999. The amount in 2000 reflects costs
incurred under the second phase of both our DOE and NASA contracts.

                                      16

<PAGE>

   Costs of production.   Costs of production increased from $154,000 in 1999
to $248,000 in 2000. The amount in 1999 reflects costs associated with
manufacturing and delivering our hydrogen generators in excess of the
corresponding sales price. The amount in 2000 reflects costs associated with
manufacturing and delivering our hydrogen generators in excess of the
corresponding sales price as well as warranty costs on units in the field.

   Research and development expenses.  Research and development expenses
increased from $2.2 million in 1999 to $3.2 million in 2000. The increase was
due to an increase in our research and development activities related to our
PEM technology in our regenerative fuel cell systems and our hydrogen
generators. These research and development activities primarily related to
increased salaries and benefits for our growing research and development staff.

   General and administrative expenses.   General and administrative expenses
increased from $1.7 million in 1999 to $4.5 million in 2000. This increase
reflects an increase in salaries and benefits of $1,052,000, as a result of an
increase in the number of employees, an increase in legal expenses of $410,000,
primarily for patent application costs, an increase in recruiting and
relocation of $119,000 and an increase of $353,000 of non-cash compensation
expense associated with stock option grants.

   Interest income (expense), net.   Interest income increased from $172,000 in
1999 to $4.2 million in 2000. The increase resulted from increased cash and
marketable securities as a result of investing the proceeds from the issuance
of our series C convertible preferred stock and initial public offering.

Liquidity and Capital Resources

   Since our inception in August 1996 through December 2001, we have financed
our operations through the series A, A-1, B, B-1 and C convertible preferred
stock issuances and our initial public offering that, in total, raised
approximately $187.4 million. As of December 31, 2001, we had $167.2 million in
cash, cash equivalents and marketable securities.

   In December 2001, Technology Drive LLC, a limited liability company wholly
owned by us, entered into a $6,975,000 loan agreement with a major financial
institution, in connection with the construction of the Company's new facility
in Wallingford, Connecticut. At December 31, 2001, $1.2 million is outstanding
under this agreement. Under the terms of the loan, the business assets of
Technology Drive LLC, including the land and building, are subject to lien. The
loan agreement is structured as a one-year construction loan with monthly
payments of interest only until December 2002 at which time the loan converts
to a seven-year term note. The term note amortizes based upon a fifteen-year
schedule with a final lump sum payment due at the maturity date of December 31,
2009. The note is guaranteed by us and bears interest at the one month LIBOR
plus 2.375% (4.42% at December 31, 2001). In connection with the construction
of our new Wallingford facility, we entered into a sales and use tax exemption
program with the Connecticut Development Authority. As part of that program, we
have $420,910 of restricted cash in escrow.

   At December 31, 2001, we were committed under operating leases for our
current facilities extending through June 2004. Minimum lease payments under
the noncancelable leases at December 31, 2001 are as follows: 2002: $303,484;
2003: $228,721; and 2004: $114,361.

   In 2001, the Company entered into an agreement with the Connecticut Clean
Energy Fund ("CCEF"). The agreement provides the Company with up to $1.5
million of funding to accelerate commercial deployment of the UNIGEN product.
At such time as revenues from UNIGEN products reach $25 million annually the
Company is required to repay CCEF 110% of the amounts advanced by them under
the agreement. However, prior to the achievement of milestones described in
this agreement, these funds are subject to repayment provisions based upon the
occurrence of certain events. These events include a failure to maintain a
Connecticut presence, the purchase of a controlling interest in the Company by
a third party, the sale of substantially all of the Company's assets, the
consolidation or merger of the Company with a third party, or the granting of
the exclusive license to a

                                      17

<PAGE>

third party to manufacture or use the UNIGEN product line. Because of these
repayment provisions, the Company record funds received as liabilities until it
achieves the contract milestones. At December 31, 2001, $200,000 had been
received and is recorded in customer advances.

   Cash used in operating activities was $2.9 million for the year ended
December 31, 2001 and was primarily attributable to our net loss and increases
in inventory, offset by increases in accounts payable and accrued expenses.
Cash used in operating activities was $4.8 million in 2000 and was primarily
attributable to our net loss and increases in inventory and other current
assets, offset by increases in deferred revenue, accounts payable and accrued
expenses.

   Cash provided by investing activities was $2.3 million for the year ended
December 31, 2001 and was primarily attributable to proceeds from the maturity
of marketable securities offset by purchases of marketable securities and fixed
assets. Cash used in investing activities was $171.0 million in 2000 and was
primarily attributable to purchases of marketable securities offset by
maturities of marketable securities.

   Cash provided by financing activities was $1.1 million for the year ended
December 31, 2001 and was primarily attributable to borrowings under our
construction loan. Cash provided by financing activities was $176.5 million in
2000 and was attributable to the receipt of the proceeds from the sale of
series C convertible preferred stock and our initial public offering.

   We anticipate that our cash and marketable securities on hand as of December
31, 2001 will be adequate to fund our operations, working capital and capital
expenditure requirements for at least the next 12 months. We have purchased
approximately 44 acres of land in Wallingford, CT to build our new
manufacturing facility and we expect to begin relocating our operations by
mid-2002. We expect to spend approximately $7-9 million over the next 9-12
months in connection with this facility. To date through December 31, 2001, we
have spent approximately $5.4 million in connection with the facility,
primarily related to the land purchase and costs to prepare the land for
construction. Over the next 12 months, we expect to continue to fund the
production of our hydrogen generators and to continue our research and
development activities on our regenerative fuel cell systems. We cannot assure
you that we will not require additional financing to fund our operations or
that, if required, any further financing will be available to us on acceptable
terms, or at all. If sufficient funds are not available, we may be required to
delay, reduce or eliminate some of our research and development or
manufacturing programs. The terms of any additional financing may require us to
relinquish rights to our technologies or potential products or other assets.

Certain Factors That May Affect Future Results

  Our future success is uncertain because we have a limited operating history.

   We face many risks and uncertainties. If we are unsuccessful in addressing
these risks and uncertainties, we may be unable to generate revenue and grow
our company. We were formed in 1996 to research and develop PEM electrochemical
products. We began shipping late-stage development models of our hydrogen
generators in 1999 and have not yet manufactured commercial regenerative fuel
cell systems. Accordingly, there is only a limited basis upon which you can
evaluate our business and prospects and our future success is uncertain. You
should consider the challenges, expenses, delays and other difficulties
typically involved in the establishment of a new business, including the
continued development of our products, development of fully functioning
manufacturing operations, refinement of processes and components for our
commercial products, recruitment of qualified personnel, and achievement of
market acceptance for our products.

  We have incurred, and expect to continue to incur, substantial losses, and we
  may never become profitable.

   We have incurred substantial losses since we were founded and we anticipate
we will continue to incur substantial losses in the future. As of December 31,
2001, we had an accumulated deficit of approximately $67 million. In 2001, we
experienced increased cash burn and increased our headcount significantly. We
cannot

                                      18

<PAGE>

predict when we will operate profitably, if ever. We expect to continue to
incur increased expenses related to research and development activities,
expansion of our manufacturing facilities and general administrative functions.
As a result, we anticipate that we will continue to incur losses until we can
cost-effectively produce and sell our hydrogen generators and regenerative fuel
cell systems in substantial quantities. Even if we do achieve profitability, we
may be unable to sustain or increase our profitability in the future.

  If we fail to retain our key personnel and attract and retain additional
  qualified personnel, we may be unable to develop our products and generate
  revenue.

   Our success depends upon the continued service of our executive officers and
other key employees such as manufacturing and research and development
personnel. The loss of any of our executive officers or key employees,
especially Walter W. Schroeder, president and chief executive officer, Trent M.
Molter, senior vice president of technology and new business, Robert J.
Friedland, senior vice president of products and manufacturing, and Lawrence C.
Moulthrop, Jr., vice president of product development, could impair our ability
to pursue our growth strategy and slow our product development processes. We do
not have employment agreements with any of our key executives. Furthermore, we
must continue to hire large numbers of highly qualified individuals, including
researchers, engineers and manufacturing professionals.Competition for these
individuals is intense, and we may not be able to attract, assimilate or retain
additional highly qualified personnel in the future.

  We may not be able to generate revenue in the future if we do not complete
  the development of our regenerative fuel cell systems.

   Our regenerative fuel cell systems are still in the development stage. We do
not know when or whether we will successfully complete research and development
of commercial regenerative fuel cell systems. If we are unable to develop
commercial regenerative fuel cell systems, we may not be able to generate
future revenue and we may not recover the losses we have incurred in attempting
to develop these products. If we experience delays in meeting our development
milestones or if our regenerative fuel cell systems exhibit technical defects
or cannot meet cost or performance goals, including output, useful life and
reliability goals, potential purchasers of our products may decline to purchase
them or choose alternative technologies. We may be unable to make the
substantial technological advances necessary to produce commercial regenerative
fuel cell systems that provide the features and performance specifications
required by customers at a competitive price. For example, we must identify
improved hydrogen storage technologies and fuel cell module structures. If we
are unable to successfully complete these development activities, we may be
unable to commercially market our products. In some cases, we are attempting to
expedite our development efforts by utilizing third parties for important
engineering work. These third parties include vendors of hydrogen storage,
purification systems, power supply and control components. If these third
parties are unable to successfully complete their development activities on our
behalf, we may be unable to commercially market our products.

  We will not be able to grow our business if we do not achieve widespread
  commercial acceptance of our hydrogen generators in the market for delivered
  hydrogen.

   We intend to market our hydrogen generators to small- and medium-volume
users of delivered hydrogen. Our business depends on the widespread commercial
acceptance of our hydrogen generators and we may be unable to grow our business
if our targeted customers do not purchase substantial numbers of our hydrogen
generators. Our targeted customers, or the distributors who we intend to use to
market to these customers, may not purchase our hydrogen generators at all or
in sufficient quantities to support the growth of our business. Our hydrogen
generators will require our target customers to make a substantial initial
investment, currently ranging from approximately $40,000 to $200,000 per unit
for our HOGEN models. Our method of supplying hydrogen by producing it on-site
using PEM electrolysis represents a significant departure from conventional
means of supplying hydrogen to end users. PEM electrolysis is a new and
unproven technology in the markets we are targeting, and we do not know if our
targeted customers will accept our product. In addition, we have just begun to
demonstrate that we can supply hydrogen to our targeted customers at a lower
cost than conventionally delivered hydrogen.

                                      19

<PAGE>

  The success of our hydrogen generators as a fuel source for PEM fuel cells
  depends upon the development of a mass market for PEM fuel cells, and we may
  not be able to generate revenue in the future if this market does not develop.

   We also intend to market our hydrogen generators for use as fuel generators
for PEM fuel cells in a variety of applications, in particular fuel cell
vehicles. If a mass market for PEM fuel cells fails to develop or develops more
slowly than we anticipate, we may be unable to generate revenue in the future
and recover the losses we will have incurred in the development of our hydrogen
generators. PEM fuel cells represent an emerging commercial market, and we do
not know whether end-users will want to use them. The development of a mass
market for PEM fuel cells may be affected by many factors outside of our
control, including

  .  the emergence of newer, more competitive technologies;

  .  the cost competitiveness of PEM fuel cells compared to existing and new
     technologies

  .  the future cost of hydrogen;

  .  regulatory requirements;

  .  consumer perceptions of the safety, reliability and functionality of PEM
     fuel cells; and

  .  consumer willingness to try a new product.

   In addition, the sole market for vehicular PEM fuel cells is and will
continue to be car, bus and other vehicle manufacturers. Automobile
manufacturers' interest in vehicular PEM fuel cells has been driven in large
part by environmental laws and regulations concerning vehicle emission
requirements that have been enacted in California and some northeastern states.
If these laws and regulations are not kept in force or do not become widely
adopted, the demand for vehicular PEM fuel cells may be limited. Further,
automobile manufacturers may be able to use other technologies to meet their
regulatory requirements, such as batteries, low emission internal combustion
engines and hybrid internal combustion/battery engines. Even if automobile
manufacturers decide to develop vehicles powered by PEM fuel cells, it may be
many years before substantial numbers of vehicles powered by PEM fuel cell
systems are manufactured. Further, there are several other technologies that
may be used to generate hydrogen, such as hydrocarbon reforming, and there
remains a strong possibility that our means of generating hydrogen will not be
used to supply fuel to fuel cells.

  We may be unable to increase our revenue in the future if the use of
  renewable energy does not increase.

   We anticipate that one of the primary uses of our regenerative fuel cell
systems will be for storing energy produced by renewable power sources, such as
solar, wind and hydroelectric power. If the demand for renewable energy
develops more slowly than we anticipate, our ability to sell our regenerative
fuel cell systems could be impaired and we may be unable to grow our business.
The market for renewable energy is still in an early stage of development and
the demand for renewable energy will remain limited until the cost of producing
energy from renewable sources is substantially reduced. Power from renewable
energy sources currently costs significantly more than power derived from
nonrenewable sources, such as coal and oil. The growth of the renewable energy
market will be dependent on many factors that are outside of our control, such
as the emergence of new, more cost-effective power technologies and products,
and domestic and international regulatory requirements.

  We expect to incur significant expenses in expanding our manufacturing
  facilities and production and we may not be successful in these efforts.

   We will be expanding our manufacturing facilities in anticipation of
increased demand for our products. If this demand does not materialize, we will
not generate sufficient revenue to offset the costs of developing and operating
these facilities, which could increase our losses and prevent us from growing
our business.We expect to expand our production and may experience delays or
problems in our expected expansion that could compromise our ability to
increase our sales and grow our business. Factors that could delay or prevent
our expected production expansion include:

  .  the inability to purchase parts or components in adequate quantities or
     sufficient quality;

                                      20

<PAGE>

  .  the cost of raw materials;

  .  the failure to increase our assembly and test operations;

  .  the failure to hire and train additional manufacturing personnel; and

  .  the failure to develop and implement manufacturing processes and equipment.

  If we fail to successfully manufacture our products in commercial quantities,
  we may not be able to increase our revenue.

   To be financially successful, we will have to manufacture our products in
commercial quantities at acceptable costs while also preserving the quality
levels achieved in manufacturing these products in limited quantities. This
presents a number of technological and engineering challenges for us. We may
not be successful in developing product designs and manufacturing processes
that permit us to manufacture our hydrogen generators and regenerative fuel
cell systems in commercial quantities at commercially acceptable costs while
preserving quality. Currently, we sell some of our products for less than it
costs us to produce them. In addition, we will incur significant start-up costs
and may experience unforeseen delays and expenses in our product design and
manufacturing efforts. If the commercialization of our products is delayed,
potential purchasers may also decline to purchase them or choose alternative
technologies, both of which could impair our ability to generate revenue in the
future.

  If our suppliers do not supply us with a sufficient amount and quality of
  components at acceptable prices, we may not be able to manufacture our
  products commercially.

   Although we generally attempt to use standard components for our products,
the proton exchange membrane material and hydrogen purification system used in
our products are currently available only from limited sources. Also, we may be
unable to purchase components of adequate quality or that meet our cost
requirements. In addition, to the extent these components are proprietary
products of our suppliers, or the processes used by our suppliers to
manufacture these components are proprietary, we may be unable to obtain
comparable components from alternative suppliers. We may experience delays in
production of our products and our business and financial results would suffer
if we fail to identify alternate suppliers, or if our supply is interrupted or
reduced or there is a significant increase in cost.

   In addition, platinum is a key component of our PEM fuel cells. Platinum is
a scarce natural resource and we are dependent upon a sufficient supply of this
commodity. We may not be able to produce commercial products, or the cost of
producing our products may significantly increase, if there are any shortages
in the supply of platinum.

  We may be unable to sell our products and generate revenue if we fail to
  establish distribution relationships.

   Because we intend to sell our products primarily through third-party
distributors, the financial benefits to us of commercializing our products will
be dependent on the efforts of others. We intend to enter into additional
distribution agreements or other collaborative relationships to market and sell
our products. If we are unable to enter into additional distribution
agreements, or if our third-party distributors do not successfully market and
sell our products, we may be unable to generate revenue and grow our business.
We may seek to establish relationships with third-party distributors who also
indirectly compete with us. For example, we have targeted industrial gas
suppliers as potential distributors of our hydrogen generators. Because
industrial gas suppliers currently sell hydrogen in delivered form, adoption by
their customers of our hydrogen generation products could cause them to
experience declining demand for delivered hydrogen. For this reason, industrial
gas suppliers may be reluctant to become distributors of our hydrogen
generators. In addition, our third-party distributors may require us to provide
volume price discounts and other allowances, or customize our products, either
of which could reduce the potential profitability of these relationships.


                                      21

<PAGE>

  We have historically focused on research and development activities and have
  limited experience in marketing, selling and servicing our products.

   We have primarily focused on the research and development of our hydrogen
generators and regenerative fuel cell systems. Consequently, our management
team has limited experience directing the commercialization efforts that are
essential to our future success. To date, we only have limited experience
marketing, selling and servicing our hydrogen generators, and no experience
marketing, selling or servicing our regenerative fuel cell systems.
Furthermore, there are very few people anywhere who have significant experience
marketing, selling or servicing PEM electrochemical products. We will have to
expand our marketing and sales organization and will have to create a
maintenance and support capability. We may not be successful in our efforts to
market and service our products, which would compromise our ability to increase
our revenue.

  Our plans to market, distribute and service our products internationally
  subject our business to additional risks, which could prevent us from growing
  our business.

   We intend to market, distribute and service our products internationally and
we may derive a significant portion of our revenue from international sales. If
we fail to successfully sell our products internationally, our ability to
increase our future revenue and grow our business would be impaired. We have
limited experience developing, and limited experience manufacturing, our
products to comply with the commercial and legal requirements of international
markets. Our success in those markets will depend on our ability to secure
relationships with foreign resellers and our ability to manufacture products
that meet foreign regulatory and commercial requirements. In addition, our
planned international operations may be subject to a variety of additional
risks, including:

  .  difficulties in collecting international accounts receivable;

  .  increased costs associated with maintaining international marketing
     efforts;

  .  compliance with U.S. Department of Commerce export controls;

  .  increases in duty rates;

  .  the introduction of non-tariff trade barriers;

  .  fluctuations in currency exchange rates;

  .  political and economic instability; and

  .  difficulties in enforcing intellectual property rights.

  We currently face and will continue to face significant competition, which
  could cause us to lose sales or render our products uncompetitive or obsolete.

   The markets for delivered hydrogen and reliable backup power are highly
competitive. There are a number of companies located in the United States,
Canada and abroad that deliver hydrogen, sell hydrogen generation equipment or
are developing PEM fuel cell technology. Many of these companies have
substantially greater resources than we do. Each of these companies has the
potential to capture market share in the markets we intend to address, which
could cause us to lose sales and prevent us from growing our business. New
developments in technology may also delay or prevent the development or sale of
some or all of our products or make our products uncompetitive or obsolete. If
this were to occur, we would not be able to generate sufficient revenue to
offset the cost of developing our hydrogen generators and regenerative fuel
cell systems.

   Our regenerative fuel cell systems are one of a number of power technology
products being developed today to provide high quality, highly reliable backup
power to the existing electric transmission system, or grid. These products
include advanced batteries, ultracapacitors, microturbines, flywheels, internal
combustion generator sets, superconducting magnetic energy storage devices and
other fuel cells using alternative hydrogen supply applications. Improvements
are also being made to the existing electric grid. Technological advances in
power

                                      22

<PAGE>

technology products and improvements in the electric grid may reduce the
attractiveness of our regenerative fuel cell systems.

   As the markets for PEM fuel-cell related products, on-site hydrogen
generation and backup power develop, other large industrial companies may enter
these fields and compete with us. These large industrial companies may have the
research and development, manufacturing, marketing and sales resources
necessary to commercialize hydrogen generators and regenerative fuel cell
systems more quickly and effectively than we do.

  We depend on our intellectual property and our failure to protect it could
  enable competitors to market products with similar features that may reduce
  demand for our products.

   If we are unable to protect our intellectual property, our competitors could
use our intellectual property to market products similar to our products, which
could reduce demand for our products. Our success depends substantially upon
the internally developed technology that is incorporated in our products. We
may be unable to prevent unauthorized parties from attempting to copy or
otherwise obtain and use our products or technology. Policing unauthorized use
of our technology is difficult, and we may not be able to prevent
misappropriation of our technology, particularly in foreign countries where the
laws may not protect our intellectual property as fully as those in the United
States. Others may circumvent the trade secrets, trademarks and copyrights that
we own and any of the U.S. patents or foreign patents owned by us or
subsequently issued to us may be invalidated, circumvented, challenged or
rendered unenforceable. In addition, we may not be issued any patents as a
result of our pending and future patent applications, and any patents we are
issued may not have the breadth of claim coverage sought by us.

   Most of our intellectual property is not covered by any patent or patent
application. We seek to protect this proprietary intellectual property, which
includes intellectual property that may not be patented or patentable, in part
by confidentiality agreements with our distributors and employees. These
agreements afford only limited protection and may not provide us with adequate
remedies for any breach or prevent other persons or institutions from asserting
rights to intellectual property arising out of these relationships.

  We could incur substantial costs defending our intellectual property from
  infringement by others.

   Unauthorized parties may attempt to copy aspects of our products or to
obtain and use our proprietary information. Litigation may be necessary to
enforce our intellectual property rights, to protect our trade secrets and to
determine the validity and scope of the proprietary rights of others. Any
litigation could result in substantial costs and diversion of resources with no
assurance of success.

  We could incur substantial costs defending against claims that our products
  infringe on the proprietary rights of others.

   The patent situation in the field of PEM fuel cell technology is complex. A
large number of patents, including overlapping patents, relating to this
technology have been granted worldwide. We are aware of patents in the fuel
cell architecture field held by potential competitors and other third parties,
including Ballard Power Systems, General Motors, Giner, H-Power, Oronzio deNora
Impianti Electrochemical, Packard Instrument, Plug Power, Shinko Pantec,
Siemens, Toyota, United Technologies and Whatman. Third parties could claim
infringement by us with respect to these patents or other patents or
proprietary rights, and we cannot assure you that we would prevail in any such
proceeding.

   In addition, some of our employees are parties to assignment of invention
and nondisclosure agreements with their former employers. These agreements
generally grant the former employer rights to technology developed by the
employee while employed by the former employer and prohibit disclosure of that
technology or other employer information to third parties. We cannot assure you
that such employers will not assert claims against us or our employees alleging
a breach of those agreements or other violations of their proprietary rights or
alleging rights to inventions by our employees, or that we would prevail in any
such proceeding.

                                      23

<PAGE>

   Any infringement claim against us, whether meritorious or not, could:

  .  be time-consuming;

  .  result in costly litigation or arbitration and diversion of technical and
     management personnel; or

  .  require us to develop non-infringing technology or to enter into royalty
     or licensing agreements.

   We might not be successful in developing non-infringing technologies.
Royalty or licensing agreements, if required, may not be available on terms
acceptable to us, or at all, and could significantly harm our business and
operating results. A successful claim of infringement against us or our failure
or inability to license the infringed or similar technology could require us to
pay substantial damages and could harm our business because we would not be
able to sell the affected product without redeveloping it or incurring
significant additional expense. In addition, to the extent we agree to
indemnify customers or other third parties against infringement of the
intellectual property rights of others, a claim of infringement could require
us to incur substantial time, effort and expense to indemnify these customers
and third parties and could disrupt or terminate their ability to use, market
or sell our products.

  We may not be able to control our warranty exposure, which could increase our
  expenses.

   Any significant incurrence of warranty expense could increase our costs. In
addition, any warranty disclaimers we use may not effectively limit our
liability.

  We may be exposed to lawsuits and other claims if our products malfunction,
  which could increase our expenses, harm our reputation and prevent us from
  growing our business.

   Any liability for damages resulting from malfunctions of our products could
be substantial and could increase our expenses and prevent us from growing our
business. In particular, hydrogen is a flammable gas and can pose safety risks
if not handled properly. In addition, our products may require modifications to
operate properly under extreme temperatures. Potential customers will also rely
upon our products for critical needs, such as backup power. A malfunction of
our products could result in tort or warranty claims. In addition, a
well-publicized actual or perceived problem could adversely affect the market's
perception of our products. This could result in a decline in demand for our
products, which would reduce our revenue and harm our business.

  Future government regulation may impair our ability to market and sell our
  products.

   Our products are potentially subject to federal, local and foreign laws and
regulations governing, among other things, emissions to air as well as laws
relating to occupational health and safety. We may incur substantial costs or
liabilities in complying with governmental regulations. Our potential customers
must also comply with numerous laws and regulations, which could affect their
interest in our products. We could incur potentially significant expenditures
in complying with environmental and health and safety laws, regulations and
requirements that may be adopted or imposed in the future.

  We anticipate undergoing a period of rapid growth and our failure to manage
  this growth could harm our business.

   We anticipate undergoing a period of rapid growth in the number of our
employees and the scope of our operations. We intend to introduce new products,
increase our production capacity and develop additional distributor
relationships. Rapid expansion would likely place a significant strain on our
senior management team and other resources. In addition, we may be required to
hire additional senior management personnel. Our ability to manage growth will
depend in part on our ability to continue to enhance our operating, financial
and management information systems. Our personnel, systems and controls may be
unable to support our growth.

  We may not be able to obtain sufficient funds to grow our business.

   We have regularly needed to raise funds in order to operate our business and
believe we may need to raise additional funds to achieve full commercialization
of some or all of our products. If we are unable to raise

                                      24

<PAGE>

additional funds when needed, our ability to operate and grow our business
could be impaired. We do not know whether we will be able to secure additional
funding or funding on terms acceptable to us. Our ability to obtain additional
funding will be subject to a number of factors, including market conditions,
our operating performance and investor sentiment. These factors may make the
timing, amount, terms and conditions of additional funding unattractive to us.
If we issue additional equity securities, existing stockholders may experience
dilution or be subordinated to any rights, preferences or privileges granted to
the new equity holders.

  Our revenue and operating results may fluctuate significantly as a result of
  factors outside of our control, which could cause the market price of our
  common stock to decline.

   We expect our revenue and operating results to vary significantly from
quarter to quarter. As a result, quarterly comparisons of our financial results
are not necessarily meaningful and you should not rely on them as an indication
of our future performance. In addition, due to our stage of development, we
cannot predict our future revenue or results of operations accurately. As a
consequence, our operating results may fall below the expectations of
securities analysts and investors, which could cause the price of our common
stock to decline. Factors that may affect our operating results include:

  .  the status of development of our technology, products and manufacturing
     capabilities;

  .  the cost of our raw materials and key components;

  .  the introduction, timing and market acceptance of new products introduced
     by us or our competitors;

  .  the development of our strategic relationships and distribution channels;

  .  general economic conditions, which can affect our customers' capital
     investments and the length of our sales cycle;

  .  the development of vehicular PEM fuel cells and renewable energy markets;
     and

  .  government regulation.

   We expect to make significant investments in all areas of our business,
particularly in research and product development and in expanding our
manufacturing capability. Because the investments associated with these
activities are relatively fixed in the short-term, we may be unable to adjust
our spending quickly enough to offset any unexpected shortfall in our revenue
growth. In addition, because we are in the very early stages of selling our
products and have a limited number of customers, we expect our order flow to be
uneven from period to period.

  Our stock price is likely to be highly volatile and may result in substantial
  losses for investors purchasing shares.

   The market price of our common stock is likely to be highly volatile. The
stock market in general, and the market for technology-related stocks in
particular, has been highly volatile. As a result, investors in our common
stock may experience a decrease in the value of their common stock regardless
of our operating performance or prospects. Our common stock may not trade at
the same levels as other technology-related stocks and technology-related
stocks in general may not sustain their current market prices. In addition, an
active public market for our securities may not be sustained.

   The trading price of our common stock could be subject to wide fluctuations
in response to:

  .  our perceived prospects;

  .  variations in our operating results and achievement of key business
     targets;

  .  changes in securities analysts' recommendations or earnings estimates;

  .  differences between our reported results and those expected by investors
     and securities analysts;


                                      25

<PAGE>

  .  announcements of new products by us or our competitors;

  .  market reaction to any acquisition, joint venture or strategic investments
     announced by us or our competitors; and

  .  general economic or stock market conditions unrelated to our operating
     performance.

   In the past, securities class action litigation has often been instituted
against companies following periods of volatility in their stock price. This
type of litigation could result in substantial costs and divert our
management's attention and resources.

  Our executive officers, directors and their affiliates hold a large
  percentage of our stock and their interests may differ from other
  stockholders.

   Our directors, executive officers and individuals or entities affiliated
with our directors as a group beneficially own approximately twenty five
percent of our outstanding common stock. If these stockholders choose to act or
vote together, they will have the power to significantly influence the election
of our directors, and the approval of any other action requiring the approval
of our stockholders, including any amendments to our certificate of
incorporation and mergers or sales of substantially all of our assets. In
addition, without the consent of these stockholders, we could be prevented from
entering into transactions that could be beneficial to us or our other
stockholders. Also, third parties could be discouraged from making a tender
offer or bid to acquire us at a price per share that is above the then-current
market price.

  The provisions of our charter documents and Delaware law could inhibit a
  takeover that stockholders may consider favorable and diminish the voting
  rights of the holders of our common stock.

   There are provisions in our certificate of incorporation and by-laws that
make it more difficult for a third party to acquire, or attempt to acquire,
control of Proton, even if a change in control was considered favorable by our
stockholders. For example, our board of directors has the authority to issue up
to 5,000,000 shares of preferred stock. The board of directors can fix the
price, rights, preferences, privileges and restrictions of the preferred stock
without any further vote or action by our stockholders. The issuance of shares
of preferred stock may delay or prevent a change in control transaction. As a
result, the market price of our common stock and the voting and other rights of
our stockholders may be adversely affected. The issuance of shares of preferred
stock may result in the loss of voting control to other stockholders.

   Our charter documents contain other provisions that could have an
anti-takeover effect, including:

  .  only one of the three classes of directors is elected each year;

  .  stockholders have limited ability to remove directors;

  .  stockholders cannot take actions by written consent;

  .  stockholders cannot call a special meeting of stockholders; and

  .  stockholders must give advance notice to nominate directors or submit
     proposals for consideration at stockholder meetings.

   In addition, we are subject to the anti-takeover provisions of Section 203
of the Delaware General Corporation Law, which regulates corporate
acquisitions. These provisions could discourage potential acquisition proposals
and could delay or prevent a change in control transaction. They could also
have the effect of discouraging others from making tender offers for our common
stock. These provisions may also prevent changes in our management.

ITEM 7A.  Quantitative and Qualitative Disclosures About Market Risk

   We hold marketable securities consisting of U.S. government obligations that
are held by two major banking institutions. We do not hold derivative financial
instruments. Interest rate risk is the major price risk facing our

                                      26

<PAGE>

investment portfolio. Such exposure can subject us to economic losses due to
changes in the level or volatility of interest rates. Generally, as interest
rates rise, prices for fixed income instruments will fall. As rates decline the
inverse is true. We attempt to mitigate this risk by investing in high quality
issues of short duration. We do not expect any material loss from our
marketable securities investments and believe that our potential interest rate
exposure is not material.

   The following table provides information about the Company's financial
instruments that are sensitive to changes in interest rates:

<TABLE>
<CAPTION>
                            Fair Value of Investments at Expected Maturity Date
                            --------------------------------------------------
                               2002         2003         2004        Total
                            -----------  -----------  ----------  ------------
 <S>                        <C>          <C>          <C>         <C>
 Investments
    Fixed Rate Investments. $88,839,638  $73,654,575  $2,888,788  $165,383,001
    Average Interest.......        5.98%        4.58%       4.70%         5.33%
</TABLE>

                                      27

<PAGE>

ITEM 8.  Financial Statements and Supplementary Data

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                                            Page
                                                                                            ----
<S>                                                                                         <C>
Report of Independent Accountants..........................................................  29
Consolidated Balance Sheets--December 31, 2001 and 2000....................................  30
Consolidated Statements of Operations for the Years ended December 31, 2001, 2000, and 1999  31
Consolidated Statements of Changes in Stockholders' Equity (Deficit) for the Years ended
  December 31, 2001, 2000, and 1999........................................................  32
Consolidated Statements of Cash Flows for the Years ended December 31, 2001, 2000, and 1999  33
Notes to Consolidated Financial Statements.................................................  34
</TABLE>

                                      28

<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and
Stockholders of Proton Energy Systems, Inc.:

   In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of stockholders' equity and of cash
flows present fairly, in all material respects, the financial position of
Proton Energy Systems, Inc. at December 31, 2001 and 2000 and the results of
its operations and its cash flows for each of the three years in the period
ended December 31, 2001 in conformity with accounting principles generally
accepted in the United States of America. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with auditing standards generally
accepted in the United States of America, which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

                                          PRICEWATERHOUSECOOPERS LLP

Hartford, Connecticut
February 14, 2002

                                      29

<PAGE>

                        Part II--FINANCIAL INFORMATION

                                    ITEM 1.
                             FINANCIAL STATEMENTS

                          PROTON ENERGY SYSTEMS, INC.

                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                              December 31,  December 31,
                                                                                  2001          2000
                                                                              ------------  ------------
<S>                                                                           <C>           <C>
                                   ASSETS
Current assets:
   Cash and cash equivalents................................................. $  1,836,899  $  1,360,127
   Marketable securities (Note 3)............................................  165,383,001   173,389,002
   Accounts receivable.......................................................    1,011,259       289,816
   Inventories and deferred costs (Note 4)...................................    3,143,164     1,649,674
   Related party note receivable (Note 11)...................................      110,801            --
   Other current assets......................................................    2,442,530     2,612,610
                                                                              ------------  ------------
       Total current assets..................................................  173,927,654   179,301,229
                                                                              ------------  ------------
Fixed assets, net (Note 5)...................................................    7,152,156     1,204,353
Related party note receivable, long term portion (Note 11)...................      133,475            --
Other assets, net............................................................      654,957       246,889
                                                                              ------------  ------------
       Total assets.......................................................... $181,868,242  $180,752,471
                                                                              ============  ============
                    LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable.......................................................... $    718,112  $    185,733
   Accrued expenses..........................................................      724,431       435,598
   Accrued construction costs................................................    1,603,640            --
   Accrued compensation......................................................      234,661       507,250
   Deferred revenue..........................................................      884,248     1,035,302
   Customer advances.........................................................      509,973       156,549
   Taxes payable.............................................................           --       125,000
                                                                              ------------  ------------
       Total current liabilities.............................................    4,675,065     2,445,432
                                                                              ------------  ------------
Long term liabilities:
   Construction loan (Note 6)................................................    1,166,000            --
                                                                              ------------  ------------
       Total liabilities.....................................................    5,841,065     2,445,432
                                                                              ------------  ------------
Commitments and contingencies (Note 9)
Stockholders' equity (Note 7):
   Preferred stock, undesignated, $.01 par value per share; 5,000,000 shares
     authorized, no shares issued or outstanding.............................           --            --
   Common stock, $.01 par value; 100,000,000 shares authorized; 33,228,495
     and 33,088,043 shares issued and outstanding, respectively..............      332,285       330,880
   Additional paid-in capital................................................  242,034,880   242,092,743
   Unearned compensation.....................................................   (1,447,629)   (2,374,361)
   Accumulated other comprehensive income (Note 3)...........................    2,092,949       289,000
   Accumulated deficit.......................................................  (66,985,308)  (62,031,223)
                                                                              ------------  ------------
       Total stockholders' equity............................................  176,027,177   178,307,039
                                                                              ------------  ------------
       Total liabilities and stockholders' equity............................ $181,868,242  $180,752,471
                                                                              ============  ============
</TABLE>

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

                                      30

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                      Year Ended December 31,
                                                              ---------------------------------------
                                                                  2001          2000         1999
                                                              ------------  ------------  -----------
<S>                                                           <C>           <C>           <C>
Contract revenue............................................. $  1,215,465  $    644,253  $   933,512
Product revenue..............................................    1,752,556        55,950           --
                                                              ------------  ------------  -----------
       Total revenues........................................    2,968,021       700,203      933,512

Costs and expenses:
   Costs of contract revenue.................................    1,001,306       396,169      354,532
   Costs of production.......................................    2,533,841       247,692      154,000
   Research and development..................................    6,500,129     3,227,421    2,181,548
   General and administrative................................    6,950,296     4,517,511    1,705,369
                                                              ------------  ------------  -----------
       Total costs and expenses..............................   16,985,572     8,388,793    4,395,449
                                                              ------------  ------------  -----------
Loss from operations.........................................  (14,017,551)   (7,688,590)  (3,461,937)
Interest income, net.........................................    8,949,996     4,198,865      172,227
Gain on sale of marketable securities........................      113,470            --           --
                                                              ------------  ------------  -----------
Net loss.....................................................   (4,954,085)   (3,489,725)  (3,289,710)
Deemed preferred dividends and accretion.....................           --   (52,691,154)    (899,000)
                                                              ------------  ------------  -----------
Net loss attributable to common stockholders................. $ (4,954,085) $(56,180,879) $(4,188,710)
                                                              ============  ============  ===========
Basic and diluted net loss per share attributable to common
  stockholders............................................... $      (0.15) $      (5.92) $     (2.20)
                                                              ============  ============  ===========
Shares used in computing basic and diluted net loss per share
  attributable to common stockholders........................   33,161,301     9,483,738    1,900,000
                                                              ============  ============  ===========
</TABLE>


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

                                      31

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

      CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)

<TABLE>
<CAPTION>
                                                                                   Accumulated                    Total
                                      Common Stock      Additional                    Other                   Stockholders'
                                   -------------------   Paid-In       Unearned   Comprehensive Accumulated      Equity
                                     Shares    Amount    Capital     Compensation    Income       Deficit       (Deficit)
                                   ---------- -------- ------------  ------------ ------------- ------------  -------------
<S>                                <C>        <C>      <C>           <C>          <C>           <C>           <C>
Balance at December 31, 1998......  1,900,000 $ 19,000 $         --  $        --   $       --   $ (5,177,634) $ (5,158,634)
Unearned compensation related to
 stock option grants..............         --       --    1,099,281   (1,099,281)          --             --            --
Amortization of unearned
 compensation.....................         --       --           --      290,460           --             --       290,460
Accretion.........................         --       --     (899,000)          --           --             --      (899,000)
Net loss..........................         --       --           --           --           --     (3,289,710)   (3,289,710)
                                   ---------- -------- ------------  -----------   ----------   ------------  ------------
Balance at December 31, 1999......  1,900,000   19,000      200,281     (808,821)          --     (8,467,344)   (9,056,884)
Issuance of common stock..........  8,051,950   80,519  125,768,765           --           --             --   125,849,284
Conversion of preferred stock into
 common stock..................... 22,659,093  226,591   65,862,596           --           --             --    66,089,187
Issuance of common stock upon
 exercise of warrants.............    424,689    4,247      586,111           --           --             --       590,358
Issuance of common stock upon
 exercises of stock options.......     52,311      523        8,483           --           --             --         9,006
Unearned compensation related to
 stock option grants..............         --       --    2,161,427   (2,161,427)          --             --            --
Amortization of unearned
 compensation.....................         --       --           --      595,887           --             --       595,887
Deemed preferred dividends and
 accretion........................         --       --   47,457,155           --           --    (50,074,154)   (2,616,999)
Issuance of stock option awards...         --       --       47,925           --           --             --        47,925
Change in unrealized gain on
 marketable securities (Note 3)...         --       --           --           --      289,000             --       289,000
Net loss..........................         --       --           --           --           --     (3,489,725)   (3,489,725)
                                   ---------- -------- ------------  -----------   ----------   ------------  ------------
Balance at December 31, 2000...... 33,088,043  330,880  242,092,743   (2,374,361)     289,000    (62,031,223)  178,307,039
Issuance of common stock..........     13,829      138       67,397           --           --             --        67,535
Issuance of common stock upon
 exercises of stock options.......    126,623    1,267       25,142           --           --             --        26,409
Unearned compensation related to
 stock option grants..............         --       --     (172,452)     172,452           --             --            --
Amortization of unearned
 compensation.....................         --       --           --      754,280           --             --       754,280
Issuance of stock option awards...         --       --       22,050           --           --             --        22,050
Change in unrealized gain on
 marketable securities (Note 3)...         --       --           --           --    1,803,949             --     1,803,949
Net loss..........................         --       --           --           --           --     (4,954,085)   (4,954,085)
                                   ---------- -------- ------------  -----------   ----------   ------------  ------------
Balance at December 31, 2001...... 33,228,495 $332,285 $242,034,880  $(1,447,629)  $2,092,949   $(66,985,308) $176,027,177
                                   ========== ======== ============  ===========   ==========   ============  ============
</TABLE>

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

                                      32

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                Year Ended December 31,
                                                       -----------------------------------------
                                                           2001           2000          1999
                                                       -------------  -------------  -----------
<S>                                                    <C>            <C>            <C>
Cash flows from operating activities:
 Net loss............................................. $  (4,954,085) $  (3,489,725) $(3,289,710)
 Adjustments to reconcile net loss to net cash used in
   operations:
   Depreciation and amortization......................       541,472        296,292      164,588
   Amortization of premiums (discounts) on securities.       691,935       (251,000)          --
   Non-cash stock-based expense.......................       776,330        791,924      395,460
   Loss on disposal of assets.........................        54,879             --           --
   Changes in operating assets and liabilities:
     Accounts receivable..............................      (721,443)      (277,299)      12,483
     Inventories and deferred costs...................    (1,493,490)      (707,447)    (189,508)
     Other current assets.............................       170,080     (2,551,462)      (1,495)
     Other assets.....................................      (203,904)      (240,590)          --
     Accounts payable and accrued expenses............     2,152,263        845,822      172,503
     Income taxes payable.............................      (125,000)       125,000           --
     Deferred revenue and contract advances...........       202,370        703,369     (147,488)
                                                       -------------  -------------  -----------
       Net cash used in operating activities..........    (2,908,593)    (4,755,116)  (2,883,167)
                                                       -------------  -------------  -----------
Cash flows from investing activities:
 Purchases of fixed assets............................    (6,542,005)      (653,271)    (214,446)
 Purchases of marketable securities...................  (189,599,533)  (179,210,023)  (2,550,000)
 Proceeds from maturities and sales of marketable
   securities.........................................   198,717,548      8,911,021    2,750,000
 Issuance of related party note.......................      (275,000)            --           --
 Proceeds from repayment of related party note........        30,724             --           --
                                                       -------------  -------------  -----------
       Net cash provided by (used in) investing
        activities....................................     2,331,734   (170,952,273)     (14,446)
                                                       -------------  -------------  -----------
Cash flows from financing activities:
 Borrowings from long term debt.......................     1,166,000             --           --
 Payment of long term debt origination costs..........      (206,313)
 Proceeds from sale of common stock, net..............        67,535    125,849,284           --
 Proceeds from exercise of stock options..............        26,409          9,006           --
 Proceeds from exercise of warrants...................            --        590,358           --
 Proceeds from issuance of mandatorily redeemable
   convertible preferred stock and warrants...........            --     50,038,159    3,000,000
                                                       -------------  -------------  -----------
       Net cash provided by financing activities......     1,053,631    176,486,807    3,000,000
                                                       -------------  -------------  -----------
Net increase in cash..................................       476,772        779,418      102,387
Cash and cash equivalents at beginning of period......     1,360,127        580,709      478,322
                                                       -------------  -------------  -----------
Cash and cash equivalents at end of period............ $   1,836,899  $   1,360,127  $   580,709
                                                       =============  =============  ===========
</TABLE>

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

                                      33

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  Formation and Operations of the Company

   Proton Energy Systems, Inc. (the "Company") was incorporated in Delaware on
August 16, 1996 to design, develop and manufacture proton exchange membrane
("PEM") electrochemical products. The Company employs PEM electrochemical
products in hydrogen generation and power generating and storage devices for
use in a variety of commercial applications. The Company manufactures products
for the domestic and international industrial gas market and operates in a
single segment. Through 2000, the Company was considered a development stage
company, as defined in Statement of Financial Accounting Standards ("SFAS") No.
7, "Accounting and Reporting by Development Stage Enterprises". During 2001,
the Company began to generate significant revenue from its principal
operations. As a result, the Company is no longer considered to be a
development stage enterprise.

2.  Summary of Significant Accounting Policies

   Significant accounting policies followed in the preparation of these
financial statements are as follows:

  Principles of Consolidation

   The consolidated financial statements include the accounts of Proton Energy
Systems, Inc. and its wholly owned limited liability company, Technology Drive
LLC, after elimination of significant intercompany transactions.

  Use of Estimates

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

  Revenue Recognition

   The Company generates revenue from two principal sources: product sales and
long-term contracts. In 1999, the Company began delivering hydrogen generators
under commercial agreements. Revenue and costs on such delivered units were
deferred until the expiration of the product warranty period. In the fourth
quarter of 2001, the Company determined that it had adequate product warranty
information and experience to begin recognizing product revenue related to
sales of HOGEN 40 units upon shipment. As a result, the Company recognized
previously deferred revenue of $754,000. The Company will continue to defer
revenue on shipments of its Chrysalis and HOGEN 380 hydrogen products until
such units are past the product warranty period or until the Company has
adequate warranty history. The Company had deferred product revenue of $884,248
and $1,035,302 as of December 31, 2001 and 2000 respectively.

   The Company receives payments under customer-sponsored research and
development contracts related to our PEM technology and regenerative fuel cell
systems development. For those research and development contracts that require
the Company to meet specific obligations as defined in the agreements
(including delivery and acceptance of units), amounts advanced pursuant to the
contracts are recognized as liabilities until such obligations are met. Once
the obligations are met, the amounts are recognized as contract revenue. For
those research and development contracts which do not require the Company to
meet specific obligations, the Company recognizes contract revenue utilizing
the percentage-of-completion method, which is based on the relationship of
costs incurred to total estimated contract costs. As of December 31, 2001, four
research and development contracts were in place pursuant to which the Company
had received $509,973 of customer advances. As of December 31, 2000, the
Company had received $156,549 of such advances under two contracts.

                                      34

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Shipping and Handling Costs

   Costs incurred in the shipping and handling of customers' goods are included
in general and administrative expenses.

  Cash and Cash Equivalents

   The Company considers all highly liquid investments purchased with original
maturity dates of three months or less as of the purchase date to be cash
equivalents. The Company invests excess cash primarily in a money market
account at a major banking institution, which is subject to credit and market
risk.

  Restricted Cash

   In connection with the construction of its new Wallingford facility, the
Company entered into a sales and use tax exemption program with the Connecticut
Development Authority. As part of that program, the Company was required to
place $420,910 of cash in escrow. This restricted cash is classified in the
balance sheet under "other assets."

  Marketable Securities

   The Company classifies its entire investment portfolio as available for sale
as defined in SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities." At December 31, 2001, the Company's investment portfolio
consisted of U.S. government and agency securities that are held by two major
banking institutions.

   Securities are carried at fair value with the unrealized gains and losses
reported as a separate component of stockholders' equity. The specific
identification method was used to determine cost in computing the unrealized
gain or loss.

  Comprehensive Income (Loss)

   Comprehensive income (loss) is defined as changes in equity other than
transactions resulting from investments by owners and distributions to owners.
The Company's comprehensive loss for the years ended December 31, 2001 and
December 31, 2000, consisted of reported net loss and unrealized gains on
marketable securities and totaled $3,122,019 and $55,891,879, respectively. The
Company's comprehensive loss for the year ended December 31, 1999 was the same
as its net loss.

  Inventory

   Inventory is recorded at the lower of cost or market value. Cost is
determined by the first-in, first-out method.

  Fixed Assets

   Fixed assets are stated at cost and are depreciated using the straight-line
method over the following estimated useful lives by asset category:

<TABLE>
<CAPTION>
Asset Category                           Estimated Useful Life
--------------                           ---------------------
<S>                                      <C>
Machinery and equipment................. 7 years
Leasehold improvements.................. Shorter of remaining life of lease or 7 years
Office furniture, fixtures and equipment 3-5 years
</TABLE>

                                      35

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   When assets are sold or retired, the related cost and accumulated
depreciation are removed from their respective accounts and any resulting gain
or loss is included in income. The Company periodically reviews the carrying
value of its fixed assets to assess recoverability based upon the expectation
of non-discounted future cash flows.

  Research and Development

   Research and development costs are expensed as incurred.

  Warranty Costs

   The Company's warranty policy is limited to replacement parts and services
and expires one year from date of shipment. Estimated warranty obligations are
provided for as costs of production in the period in which the related revenue
is recognized.

  Income Taxes

   The Company uses the asset and liability method of accounting for income
taxes. Under this method, deferred tax assets and liabilities are recognized
for the expected future tax consequences of temporary differences between the
carrying amounts and the tax basis of assets and liabilities. A valuation
allowance is established against net deferred tax assets if, based on the
weight of available evidence, it is more likely than not that some or all of
the net deferred tax assets will not be realized.

  Concentration of Risks

   Concentration of credit risk exists with respect to cash and cash
equivalents, investments and vendors. The Company maintains its cash and cash
equivalents and investments with high quality financial institutions. In
addition, certain critical product components are only available from one
source for which the source maintains proprietary rights.

   For the years ended December 31, 2001 and 2000, contract revenue from
government-sponsored agencies accounted for approximately 41% and 92% of total
revenue, respectively. At December 31, 2001 and 2000, accounts receivable from
government-sponsored agencies accounted for approximately 45% and 65% of total
accounts receivable, respectively.

   For the year ended December 31, 2001, four customers comprised 54% of
product revenue.

  Loss per Share

   Basic EPS is calculated by dividing income or loss attributable to common
stockholders by the weighted average common shares outstanding. Diluted EPS is
calculated by adjusting weighted average common shares outstanding by assuming
conversion of all potentially dilutive shares. In periods of net loss as
recorded, no effect is given to potentially dilutive securities, since the
effect would be antidilutive.

  Stock-Based Compensation

   The Company applies Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees," (APB 25) and related interpretations, as
clarified by FASB Interpretation No. 44, "Accounting for Certain Transactions
Involving Stock Compensation," in accounting for its stock option plan and
stock awards

                                      36

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

with the disclosure provisions of Statement of Financial Accounting Standards
No. 123 "Accounting for Stock-Based Compensation" (SFAS 123). Under APB 25,
compensation expense is computed to the extent that the fair market value of
the underlying stock on the date of grant exceeds the exercise price of the
employee stock option or stock award. Compensation so computed is then
recognized over the vesting period. The Company accounts for equity instruments
issued to non-employees in accordance with SFAS 123 and the consensus in
Emerging Issues Task Force ("EITF") 96-18. These pronouncements require the
fair value of equity instruments given as consideration for services rendered
be recognized as a non-cash charge to income over the shorter of the vesting or
service period. The equity instruments must be revalued on each subsequent
reporting date until performance is complete with a cumulative catch-up
adjustment recognized for any changes in their fair value.

  Recent Accounting Pronouncements

   In July 2001, the Financial Accounting Standards Board issued SFAS 141,
"Business Combinations" ("SFAS 141") and SFAS 142, "Goodwill and other
Intangible Assets" ("SFAS 142"). SFAS 141 applies to all business combinations
initiated after June 30, 2001, and requires these business combinations to be
accounted for using the purchase method of accounting. SFAS 142 applies to all
goodwill and intangibles acquired in a business combination. Under SFAS 142,
all goodwill, including goodwill acquired before initial application of the
standard, will not be amortized but will be tested for impairment within six
months of adoption of the statement, and at least annually thereafter.
Intangible assets other than goodwill will be amortized over their useful lives
and reviewed for impairment in accordance with SFAS 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of."
SFAS 142 is effective for fiscal years beginning after December 15, 2001, and
must be adopted as of the beginning of a fiscal year. The adoption of these
standards in 2002 is not expected to have an impact on the Company's financial
condition or results of operations.

   In June 2001, the Financial Accounting Standards Board issued SFAS 143,
"Accounting for Asset Retirement Obligations" ("SFAS 143"). SFAS 143 addresses
financial accounting and reporting obligations associated with the retirement
of tangible long-lived assets and the associated asset retirement costs. SFAS
143 is effective for fiscal years beginning after June 15, 2002. The adoption
of this standard in 2003 is not expected to have an impact on the Company's
financial condition or results of operations.

   In August 2001, the Financial Accounting Standards Board issued SFAS 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144").
SFAS 144 addresses financial accounting and reporting for the impairment or
disposal of long-lived assets. SFAS 144 is effective for fiscal years beginning
after December 15, 2001. The adoption of this standard in 2002 is not expected
to have a material impact on the Company's financial condition or results of
operations.

  Reclassifications

   Certain reclassifications have been made to the 2000 financial statements to
conform to the 2001 presentation.

                                      37

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


3.  MARKETABLE SECURITIES

   The following tables summarize investments:

<TABLE>
<CAPTION>
                                             Gross      Gross
                               Amortized   Unrealized Unrealized
                                 Cost        Gains      Losses    Fair Value
                              ------------ ---------- ---------- ------------
   <S>                        <C>          <C>        <C>        <C>
   December 31, 2001
   U.S. government securities $163,290,052 $2,129,649  $(36,700) $165,383,001
                              ------------ ----------  --------  ------------
                              $163,290,052 $2,129,649  $(36,700) $165,383,001
                              ============ ==========  ========  ============

                                             Gross      Gross
                               Amortized   Unrealized Unrealized
                                 Cost        Gains      Losses    Fair Value
                              ------------ ---------- ---------- ------------
   December 31, 2000
   U.S. government securities $173,100,002 $  294,000  $ (5,000) $173,389,002
                              ------------ ----------  --------  ------------
                              $173,100,002 $  294,000  $ (5,000) $173,389,002
                              ============ ==========  ========  ============
</TABLE>

   As of December 31, 2001 and 2000, the approximate fair values of marketable
securities by maturity date are as follows:

<TABLE>
<CAPTION>
                                       2001         2000
                                   ------------ ------------ -
                <S>                <C>          <C>          <C>
                Less than one year $ 88,839,638 $165,102,600
                One to five years.   76,543,363    8,286,402
                                   ------------ ------------ -
                                   $165,383,001 $173,389,002
                                   ============ ============ =
</TABLE>

   Securities are carried at fair value with the unrealized gains/losses
reported as a separate component of stockholders' equity. Proceeds from the
sale of a security in 2001 totaled $15,546,432. The cost was determined using
the specific identification method and the resulting realized gain was
$113,470. The net unrealized gain from marketable securities was $2,092,949 and
$289,000 at December 31, 2001 and 2000, respectively.

4.  INVENTORIES AND DEFERRED COSTS

   Inventories and deferred costs are as follows:

<TABLE>
<CAPTION>
                                         December 31,
                                     ---------------------
                                        2001       2000
                                     ---------- ----------
                     <S>             <C>        <C>
                     Raw materials.. $1,177,126 $  545,583
                     Work in process    534,809    133,315
                     Finished goods.  1,431,229    970,776
                                     ---------- ----------
                                     $3,143,164 $1,649,674
                                     ========== ==========
</TABLE>

   Deferred costs of $716,358 and $970,776 are included in finished goods as of
December 31, 2001 and 2000 respectively. These costs of production have been
deferred until the Company recognizes the related product revenue.

                                      38

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


5.  FIXED ASSETS

<TABLE>
<CAPTION>
                                                      December 31,
                                                -----------------------
                                                   2001         2000
                                                -----------  ----------
       <S>                                      <C>          <C>
       Machinery and equipment................. $ 1,046,546  $  805,229
       Leasehold improvements..................     368,225     280,705
       Office furniture, fixtures and equipment   1,376,101     738,090
       Construction in process.................   5,450,275      12,585
                                                -----------  ----------
                                                $ 8,241,147  $1,836,609
       Less: accumulated depreciation..........  (1,088,991)   (632,256)
                                                -----------  ----------
                                                  7,152,156   1,204,353
                                                ===========  ==========
</TABLE>

   Construction in process is primarily comprised of the land purchased for
construction of the new facility, costs to prepare the land for construction,
and building construction costs. Depreciation expense was $539,323, $296,292,
and $164,588 for the years ended December 31, 2001, 2000 and 1999, respectively.

6.  DEBT

   In December 2001, Technology Drive LLC, a limited liability company wholly
owned by us, entered into a $6,975,000 loan agreement with a major financial
institution, in connection with the construction of the Company's new facility
in Wallingford, Connecticut. Under the terms of the loan, the business assets
of Technology Drive LLC, including the land and building, are subject to lien.
The loan agreement is structured as a one-year construction loan with monthly
payments of interest only until December 2002 at which time the loan converts
to a seven-year term note. The term note amortizes based upon a fifteen-year
schedule with a final lump sum payment due at the maturity date of December 31,
2009. The note is guaranteed by Proton Energy Systems, Inc., the managing
member of Technology Drive LLC and bears interest at the one month LIBOR plus
2.375% (4.42% at December 31, 2001).

   At December 31, 2001, $1,166,000 is outstanding under the note and is
classified as long-term debt. The Company is required to comply with certain
covenants including the maintenance of adequate insurance coverage and a
liquidity covenant requiring the Company to maintain cash and marketable
securities of not less than $20 million.

   In connection with the loan facility, the Company incurred approximately
$206,000 of loan origination costs. These costs are being amortized over the
term of the loan.

7.  CAPITAL STRUCTURE

  Mandatorily Redeemable Preferred Stock

   Since inception, the Company has issued Series A, A-1, B, B-1 and C
Convertible Preferred Stock ("Preferred Stock"). All of the series of Preferred
Stock had similar conversion rights, voting rights, dividend rights,
liquidation preferences and redemption rights.

   In April 2000, the Company issued 14,306,901 shares of Series C Preferred
Stock for $3.50 per share for gross proceeds of approximately $50.1 million.
Concurrent with the issuance of the Series C Preferred Stock, the Company
recorded a beneficial conversion charge. The beneficial conversion charge was
calculated in accordance with the consensus in EITF 98-5, "Accounting for
Convertible Securities with Beneficial Conversion

                                      39

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Features or Contingently Adjustable Conversion Ratios," and represents the
difference between the Series C Preferred Stock price and the deemed fair
market value of the Company's common stock into which the Series C Preferred
Stock was immediately convertible, limited to the total Series C Preferred
Stock proceeds. Accordingly, a deemed preferred dividend of approximately $50.1
million as of the issuance date has been recognized as a charge to accumulated
deficit and net loss attributable to common stockholders, and as an increase to
additional paid-in capital.

   In May 2000, the Company issued 103,163 shares of Series A-1 Preferred Stock
to a service provider for services rendered. For the years ended December 31,
2000 and 1999, the Company incurred approximately $148,000 and $105,000,
respectively, in expense for services rendered.

   In October 2000, 424,689 shares of Series B Preferred Stock were issued as a
result of the exercise and conversion of warrants to acquire Series B Preferred
Stock. Of the 441,959 then outstanding warrants, 295,179 warrants were
exercised for cash and 146,780 were converted to 129,510 shares of Series B
Preferred stock.

   Holders of the Series A, Series A-1, Series B, Series B-1 and Series C
mandatorily redeemable preferred stock had redemption rights equal to the
original purchase price plus dividends at 8% per annum (compounded annually)
for each year in which dividends were not declared and paid. Until the date of
conversion, as noted above, such dividends had not been declared or paid and
were being accreted annually to the carrying value of the Preferred Stock from
additional paid-in capital or accumulated deficit if additional paid-in capital
were not available. The Company recognized $2,616,999 and $899,000 in accretion
for the years ended December 31, 2000 and 1999, respectively.

   All outstanding shares of Series A, Series A-1, Series B, Series B-1 and
Series C mandatorily redeemable preferred stock automatically converted into
22,659,093 shares of common stock on a one for one basis, upon the closing of
the Company's initial public offering of common stock in October 2000.

  Preferred Stock

   In June 2000, the Company created a class of 5,000,000 authorized but
undesignated shares of preferred stock, par value $.01.

  Common Stock

   The Company has authorized 100,000,000 shares of common stock, par value
$.01 per share. The Company issued 1,900,000 shares of common stock upon
incorporation. Of the 1,900,000 issued shares, 1,400,000 shares were issued to
the Company's founders, subject to a vesting schedule. At December 31, 2001,
the shares were fully vested.

   In connection with a February 1998 customer-sponsored research and
development contract, the Company issued a warrant to purchase 50,000 shares of
the Company's common stock at a purchase price of $1.10 per share. At December
31, 2001, the warrant was fully exercisable and expires in February 2008.

   In October 2000, the Company completed an initial public offering of
8,050,000 shares of common stock at an offering price of $17.00 per share,
including 1,050,000 shares pursuant to the underwriters' exercise of their
over-allotment option. The Company received proceeds of $125.8 million, which
was net of $11 million of expenses and underwriting discounts relating to the
issuance and distribution of the securities. Upon the closing of the offering,
all of the Company's then outstanding preferred stock automatically converted
into common stock on a one-for-one basis.

                                      40

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


8.  EMPLOYEE BENEFIT AND STOCK OPTION PLANS

  Stock Option Plan

   The Company has two stock option plans: the 1996 Stock Option Plan (the
"1996 Plan") and the 2000 Stock Option Plan (the "2000 Plan"). The Company has
reserved a total of 7,700,000 shares of common stock for issuance under the
1996 and 2000 Plans. Together the Plans provide for the grants of non-qualified
and incentive stock options, restricted stock awards and other stock-based
awards to its employees, officers, directors, consultants and advisors. As
determined by the Board of Directors, options are generally granted at the fair
market value of the common stock at the time of grant. However, the Board of
Directors has determined that the exercise price for each incentive stock
option shall not be less than the fair market value of the Common Stock at the
time the incentive stock option is granted. Options generally vest ratably over
four years and expire ten years from the date of grant.

   A summary of stock option activity for the years ended December 31, 2001,
2000 and 1999 under the Plans is as follows:


<TABLE>
<CAPTION>
                                                                         Weighted
                                                                         Average
                                                                         Exercise
                                                               Shares     Price
                                                              ---------  --------
<S>                                                           <C>        <C>
Outstanding at January 1, 1999 (107,050 shares exercisable)..   374,201   $ 0.13
Granted......................................................   667,040     0.28
Cancelled or forfeited.......................................    (5,000)    0.35
                                                              ---------
Outstanding at December 31, 1999 (246,225 shares exercisable) 1,036,241     0.23
Granted...................................................... 1,811,871    11.86
Exercised....................................................   (52,311)    0.17
Cancelled or forfeited.......................................   (32,791)    0.17
                                                              ---------
Outstanding at December 31, 2000 (424,508 shares exercisable) 2,763,010     7.85
Granted......................................................   595,579     7.73
Exercised....................................................  (126,623)    0.21
Cancelled or forfeited.......................................   (63,105)    5.53
                                                              ---------
Outstanding at December 31, 2001 (829,801 shares exercisable) 3,168,861   $ 8.18
                                                              =========
</TABLE>

   In connection with the grant of certain stock options to employees during
2000 and 1999, the Company recorded unearned stock compensation representing
the difference between the deemed fair market value of the common stock on the
date of grant and the exercise price. Compensation related to options that vest
over time was recorded as unearned compensation, a component of stockholders'
equity (deficit), and is being amortized over the vesting periods of the
related options. During the years ended December 31, 2001, 2000 and 1999, the
Company recorded non-cash compensation expense relating to these options
totaling $716,319, $577,226 and $290,460, respectively. At December 31, 2001
and 2000, the unearned compensation balance is $1,408,045 and $2,249,702,
respectively.

                                      41

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table summarizes additional information about stock options
outstanding at December 31, 2001:

<TABLE>
<CAPTION>
                                  Options Outstanding            Options Exercisable
                         ------------------------------------- ------------------------
                                           Weighted
                             Number        Average    Weighted     Number      Weighted
                           Outstanding    Remaining   Average    Exercisable   Average
                         at December 31, Contractual  Exercise at December 31, Exercise
Range of Exercise Prices      2001       Life (years)  Price        2001        Price
------------------------ --------------- ------------ -------- --------------- --------
<S>                      <C>             <C>          <C>      <C>             <C>
     $  .11-$  .15......      444,589        6.35      $ 0.14      377,589      $ 0.14
        .35-    .50.....      469,520        7.34        0.38      188,945        0.37
       2.00-  6.00......      493,212        8.70        5.82      108,050        5.88
       6.35- 10.31......      484,379        9.78        7.72        9,050        9.36
      10.75- 15.25......      443,661        8.99       11.05        5,500       12.80
      16.88- 17.00......      833,000        8.51       17.00      140,542       17.00
      24.13- 24.13......          500        8.79       24.13          125       24.13
                            ---------        ----      ------      -------      ------
                            3,168,861        8.33      $ 8.18      829,801      $ 3.98
                            =========                              =======
</TABLE>

   The fair value of each option grant is estimated on the date of grant using
the minimum value option-pricing model through December 31, 1999, and the Black
Scholes option-pricing model from January 1, 2000 through December 31, 2001,
with the following assumptions:

<TABLE>
<CAPTION>
                                     2001        2000        1999
                                  ----------- ----------- -----------
          <S>                     <C>         <C>         <C>
          Risk free interest rate 4.57%-5.39% 5.17%-6.68% 4.82%-6.48%
          Expected dividend yield    None        None        None
          Expected life of option   5 years     5 years     6 years
          Expected volatility....    100%        100%         0%
</TABLE>
   The weighted average fair value of options granted during 2001, 2000 and
1999 was $5.93, $9.17 and $1.81, respectively.

   If compensation expense had been recognized based on the fair value of
options at their grant date, in accordance with SFAS No. 123, "Accounting for
Stock-Based Compensation," the net loss for the years ended December 31, 2001,
2000 and 1999 would have been as follows:
<TABLE>
<CAPTION>
                                                     2001          2000         1999
                                                  -----------  ------------  -----------
<S>                                               <C>          <C>           <C>
Net loss attributable to common stockholders:
   As reported................................... $(4,954,085) $(56,180,879) $(4,188,710)
   Pro forma under SFAS 123......................  (9,780,706)  (57,588,581)  (4,439,118)
Basic and diluted net loss per share attributable
  to common shareholders:
   As reported................................... $      (.15) $      (5.92) $     (2.20)
   Pro forma under SFAS 123......................        (.29)        (6.07)       (2.34)
</TABLE>

   The above pro forma results are not necessarily indicative of future results.

   During the years ended December 31, 2001 and 2000, the Company granted fully
vested, non-qualified stock options with a ten-year term, to non-employees to
purchase 3,000 and 5,500 shares of common stock, respectively. The Company
recognized compensation expense based on the fair value of these options of
$22,050 and $47,925 for the years ended December 31, 2001 and 2000,
respectively.

                                      42

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   In September 2000, the Company granted non-qualified stock options to a
non-employee to purchase 15,000 shares that vest over four years and expire at
the end of ten years. Accounting for these options require that they be
revalued on each subsequent reporting date until performance is complete or
vesting occurs with a cumulative catch-up adjustment recognized for any changes
in fair value. Compensation related to these options was recorded as unearned
compensation, a component of stockholders' deficit, and is being amortized over
the vesting periods of the related options. As of December 31, 2001, 3,750
options have vested with a fair value of $14,888 or $3.97 per share. The
remaining unvested options have an estimated fair value of $81,338 or $7.23 per
share. The Company's results of operations for the years ended December 31,
2001 and 2000 include a non-cash charge of $37,961 and $18,661 respectively,
for the amortization of the fair value of these options. At December 31, 2001
and 2000, the unearned compensation balance is $39,584 and $124,659,
respectively. The Company's future results of operations could be materially
impacted by a change in valuation of these unvested stock options as a result
of future increases or decreases in the price of the Company's common stock.

   The fair value of each non-employee option grant is estimated using the
Black Scholes option-pricing model with the following assumptions:

<TABLE>
<CAPTION>
                                           2001        2000
                                        ----------- -----------
                <S>                     <C>         <C>
                Risk free interest rate 4.50%-5.46% 5.12%-6.21%
                Expected dividend yield    None        None
                Expected life of option 5-10 years  5-10 years
                Expected volatility....    100%        100%
</TABLE>

  2000 Employee Stock Purchase Plan

   In June 2000, the Company adopted the 2000 Employee Stock Purchase Plan. A
total of 250,000 shares of common stock have been reserved for issuance under
this plan. Eligible employees may purchase common stock pursuant to payroll
deductions at a price equal to 85% of the lower of the fair market value of the
common stock at the beginning or end of each three-month offering
period.Employee contributions are limited to 10% of an employee's eligible
compensation not to exceed amounts allowed by the Internal Revenue Code. As of
December 31, 2001 and 2000, 15,779 and 1,950 shares of common stock were issued
for proceeds of $84,940 and $17,404, respectively. As of December 31, 2001,
234,221 shares are available for future issuance.

  401(k) Plan

   In 1997, the Company established a 401(k) plan covering substantially all of
its employees, subject to certain eligibility requirements. Participants have
the option of contributing up to 15% of their annual compensation. In January
2002, the Company adopted a 50% match of employee contributions up to 6% of
compensation.

9.  COMMITMENTS AND CONTINGENCIES

  Development, Marketing and Distribution Agreements

   In November 1999, the Company entered into an agreement with Matheson
Tri-Gas, Inc. to develop, market and distribute hydrogen generators to be used
solely in laboratory applications. This agreement grants the distributor
worldwide exclusivity to the commercial sale of this product during the
fifteen-year term of the contract as long as the distributor meets minimum
purchases, as defined in the agreement. The Company retains the right to modify
the contract once annually by providing six months notice. The Company recorded
a loss of approximately $273,000 and $122,000 for orders received and delivered
under this contract for the years ended December 31, 2001 and 2000,
respectively. Any future loss recognition is contingent on the distributor
placing additional orders and the Company's cost per unit exceeding the related
sale price per unit.

                                      43

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   In 2001, the Company entered into an agreement with the Connecticut Clean
Energy Fund ("CCEF"). The agreement provides the Company with up to $1.5
million of funding to accelerate commercial deployment of the UNIGEN product.
At such time as revenues from UNIGEN products reach $25 million annually the
Company is required to repay CCEF 110% of the amounts advanced by them under
the agreement. However, prior to the achievement of milestones described in
this agreement, these funds are subject to repayment provisions based upon the
occurrence of certain events. These events include a failure to maintain a
Connecticut presence, the purchase of a controlling interest in the Company by
a third party, the sale of substantially all of the Company's assets, the
consolidation or merger of the Company with a third party, or the granting of
the exclusive license to a third party to manufacture or use the UNIGEN product
line. Because of these repayment provisions, the Company record funds received
as liabilities until it achieves the contract milestones. At December 31, 2001,
$200,000 had been received and is recorded in customer advances.

  Legal Proceedings

   Between July 3, 2001 and August 29, 2001, four purported class action
lawsuits were filed in the United States District Court for the Southern
District of New York against the Company and several of its officers and
directors as well as against the underwriters who handled the September 28,
2000 initial public offering ("IPO") of common stock. All of the complaints
were filed allegedly on behalf of persons who purchased the Company's common
stock from September 28, 2000 through and including December 6, 2000. The
complaints are similar, and allege that the Company's IPO registration
statement and final prospectus contained material misrepresentations and/or
omissions related, in part, to excessive and undisclosed commissions allegedly
received by the underwriters from investors to whom the underwriters allegedly
allocated shares of the IPO.

   The Company believes it has meritorious defenses to the claims made in the
complaints and intends to contest the lawsuits vigorously. However, there can
be no assurance that we will be successful, and an adverse resolution of the
lawsuits could have a material adverse effect on our financial position and
results of operation in the period in which the lawsuits are resolved. The
Company is not presently able to reasonably estimate potential losses, if any,
related to the lawsuits. In addition, the costs to us of defending any
litigation or other proceeding, even if resolved in our favor, could be
substantial.

  Operating Leases

   At December 31, 2001, the Company was committed under operating leases for
its facilities extending through June 2004. The Company also rents certain
office equipment under operating leases.

   Rent expense under the non-cancelable operating leases was approximately
$363,000, $197,000, and $118,000 for the years ended December 31, 2001, 2000
and 1999, respectively.

   Minimum lease payments under the noncancelable leases at December 31, 2001
are as follows:

<TABLE>
                <S>                                     <C>
                2002................................... $303,484
                2003...................................  228,721
                2004...................................  114,361
                                                        --------
                Total minimum obligations.............. $646,566
                                                        ========
</TABLE>

                                      44

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


10.  INCOME TAXES

   The Company's gross deferred tax assets and liabilities were as follows:

<TABLE>
<CAPTION>
                                                          December 31,
                                                    ------------------------
                                                       2001         2000
                                                    -----------  -----------
  <S>                                               <C>          <C>
  Gross deferred tax assets:
     Net operating loss carryforwards.............. $ 5,701,000  $ 3,873,000
     Deferred revenue..............................     344,000      495,000
     Accrued expenses..............................     151,000      229,000
     Research and development tax credits..........      48,000      385,000
     Other.........................................      92,000       41,000
                                                    -----------  -----------
                                                      6,336,000    5,023,000
                                                    -----------  -----------
  Gross deferred tax liabilities:
     Depreciation..................................      84,000       97,000
     Unrealized gain on marketable securities......     815,000      113,000
     Deferred costs................................     279,000      403,000
                                                    -----------  -----------
                                                      1,178,000      613,000
                                                    -----------  -----------

     Net deferred tax asset........................   5,158,000    4,410,000
     Less: valuation allowance.....................  (5,158,000)  (4,410,000)
                                                    -----------  -----------
                                                    $        --  $        --
                                                    ===========  ===========
</TABLE>

   At December 31, 2001, the Company had approximately $14.6 million of federal
net operating loss carryforwards that expire beginning in the year 2011 through
2021 and approximately $14.9 million of state net operating loss carryforwards
that expire beginning in the year 2001 through 2021.

   The amount of the net operating loss and research and development tax credit
carryforwards that may be utilized annually to offset future taxable income and
tax liability is limited as a result of certain ownership changes pursuant to
Section 382 of the Internal Revenue Code.

11.  RELATED PARTIES

   In October 2001, the Company loaned $275,000 to Walter W. Schroeder, the
President and Chief Executive Officer of the Company and a director. The loan
has a two year term and is payable in monthly installments of $10,000 each with
a final payment due at maturity. The loan, which accrues interest at the prime
rate (4.75% at December 31, 2001) contains no penalty for early repayment. At
December 31, 2001, the balance of the loan was $244,276, which is recorded in
related party note receivable.

   In 2001, the Company entered into a contract with STM to develop and deliver
hydrogen generators (see Note 9). Richard A. Aube, a member of the Company's
Board of Directors, is also a member of STM's Board of Directors.

                                      45

<PAGE>

                          PROTON ENERGY SYSTEMS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


12.  SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

   The following tables set forth certain unaudited quarterly statement of
operations data for the eight quarters ended December 31, 2001. This data has
been derived from unaudited financial statements that, in our opinion, include
all adjustments, consisting only of normal recurring adjustments, necessary for
a fair presentation of such information when read in conjunction with our
consolidated financial statements and related notes appearing elsewhere in this
Form 10-K. The operating results for any quarter are not necessarily indicative
of results for any future period.

<TABLE>
<CAPTION>
                                                                           2001 Quarters
                                                            -------------------------------------------
                                                              First        Second     Third    Fourth*
                                                             -------      --------   -------  -------
                                                            Amounts in 000s except for per share amount
<S>                                                         <C>          <C>        <C>       <C>
Revenues................................................... $   239      $    555   $   364   $ 1,810
Cost and expenses..........................................   3,082         4,037     4,162     5,704
Loss from operations.......................................  (2,843)       (3,482)   (3,798)   (3,894)
Net loss...................................................    (264)       (1,171)   (1,567)   (1,952)
Net loss attributable to common stockholders...............    (264)       (1,171)   (1,567)   (1,952)
Basic and diluted net loss per share attributable to common
  stockholders.............................................   (0.01)        (0.04)    (0.05)    (0.06)
                                                                           2000 Quarters
                                                            -------------------------------------------
                                                              First        Second     Third    Fourth
                                                             -------      --------   -------  -------
Revenues................................................... $    56      $    131   $   350   $   163
Costs and expenses.........................................   1,300         1,523     2,092     3,348
Loss from operations.......................................  (1,244)       (1,392)   (1,742)   (3,185)
Net loss...................................................  (1,210)         (744)   (1,014)     (522)
Net loss attributable to common stockholders...............  (1,470)      (51,914)   (2,275)     (522)
Basic and diluted net loss per share attributable to common
  stockholders.............................................   (0.77)       (27.30)    (1.18)    (0.02)
</TABLE>
--------
* See footnote 2 to the financial statements.

                                      46

<PAGE>

ITEM 9.  Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

   Not applicable.

                                   PART III

   Certain information required by Part III is omitted from this Annual Report
as we intend to file our definitive Proxy Statement for our Annual Meeting of
Stockholders to be held on June 5, 2002, pursuant to Regulation 14A of the
Securities Exchange Act of 1934, as amended, not later than 120 days after the
end of the fiscal year covered by this Report, and certain information included
in the Proxy Statement is incorporated herein by reference.

ITEM 10.  Directors of the Registrant

   (a) Executive Officers and Directors--The information in the section
entitled "Executive Officers and Directors of the Registrant" in Part I hereof
is incorporated herein by reference.

   (b) Directors--The information in the section entitled "Directors and
Nominees for Director" in the Proxy Statement is incorporated herein by
reference.

   The disclosure required by Item 405 of Regulation S-K is incorporated by
reference to the section entitled "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Proxy Statement.

ITEM 11.  Executive Compensation

   The information in the sections entitled "Compensation of Executive
Officers," "Compensation of Directors" and "Compensation Committee Interlocks
and Insider Participation" in the Proxy Statement is incorporated herein by
reference.

ITEM 12.  Security Ownership of Certain Beneficial Owners and Management

   The information in the section entitled "Security Ownership of Certain
Beneficial Owners and Management" in the Proxy Statement is incorporated herein
by reference.

ITEM 13.  Certain Relationships and Related Transactions

   The information in the section entitled "Certain Transactions" and
"Compensation Committe Interlocks and Insider Participation" in the Proxy
Statement is incorporated herein by reference.

                                    PART IV

ITEM 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K

   (a) Documents filed as part of Form 10-K

1.  Financial Statements

   The financial statements of the Company have been included in Item 8 of this
report:

  .  Balance Sheets as of December 31, 2001 and 2000.

  .  Statements of Operations for each of the three years ended December 31,
     2001, 2000 and 1999.

  .  Statements of Changes in Stockholders' Equity (Deficit) for each of the
     three years ended December 31, 2001, 2000 and 1999.

  .  Statements of Cash Flows for each of the three years ended December 31,
     2001, 2000 and 1999.

  .  Notes to Consolidated Financial Statements.

2.  Financial Statement Schedules

   All financial statement schedules have been omitted since they are either
not required or the information required is included in the financial
statements or the notes thereto.

                                      47

<PAGE>

3.  Exhibit Listing

<TABLE>
<CAPTION>
Exhibit  Description
-------  -----------
<C>      <S>

1.1*     Third Amended and Restated Certificate of Incorporation of the Registrant

1.2*     Amended and Restated By-Laws of the Registrant

4.1*     Specimen common stock certificate

4.2*     See Exhibits 3.1 and 3.2 for provisions of the Certificate of Incorporation and By-Laws of the
           Registrant defining the rights of holders of common stock of the Registrant

10.1*    1996 Stock Option Plan

10.2*    2000 Stock Incentive Plan

10.3*    2000 Employee Stock Purchase Plan

10.4*    Development, Marketing and Distribution Agreement, dated November 10, 1999, between the
           Registrant and Matheson Tri-Gas, Inc.

10.5*    Distribution Agreement, dated November 24, 1999, between the Registrant and Diamond Lite
           Limited

10.6*    Lease, dated as of May 27, 1997, between the Registrant and 50 Inwood Road Limited Partnership,
           as amended on January 29, 1998, March 1, 1999, and April 9, 1999 and December 4, 2000.

10.7*    Series C Preferred Stock Purchase Agreement, dated April 12, 2000, among the Registrant and
           certain stockholders

10.8*    Form of Series B Preferred Stock Purchase Warrant

10.9*    Common Stock Purchase Warrant, dated February 1998, issued to the Electric Power Research
           Institute

10.11*   Contract with the U.S. Department of Energy, dated May 21, 1998

10.12*   Form of Indemnification Agreement with directors and executive officers

10.13**  Lease, dated as of January 1, 2001, between the Registrant and the Connecticut Student Loan
           Foundation

10.14**  Purchase and Sale Agreement, dated as of March 8, 2001, between the Registrant and Wallingford
           Land, L.L.C

10.15**  Agreement, dated as of March 8, 2001, between the Registrant, Medway Associates Limited
           Partnership and Wallingford Land, L.L.C.

10.16**  Amendment dated December 4, 2000 to Lease, dated as of May 27, 1997, between Registrant and
           50 Inwood Road Limited Partnership.

10.17*** Secured Promissory Note, dated October 4, 2001, between the Registrant and Walter W.
           Schroeder.

10.18    Construction Loan Agreement dated as of December 7, 2001 between Technology Drive, LLC, a
           wholly owned limited liability company of the Registrant, and Webster Bank.

10.19    Construction Mortgage Note dated as of December 7, 2001 between Technology Drive, LLC, a
           wholly owned limited liability company of the Registrant, and Webster Bank.

10.20    Open-End Construction Mortgage Deed and Security Agreement dated as of December 7, 2001
           between Technology Drive, LLC, a wholly owned limited liability company of the Registrant,
           and Webster Bank.
</TABLE>

                                      48

<PAGE>

<TABLE>
<CAPTION>
Exhibit Description
------- -----------
<C>     <S>

10.21   Guaranty Agreement dated as of December 7, 2001 between the Registrant and Webster Bank.

23.1    Consent of PricewaterhouseCoopers LLP
</TABLE>
--------
  * Incorporated herein by reference to the identically numbered exhibit of the
    Company's registration statement on Form S-1, SEC File No. 333-39748.
 ** Incorporated herein by reference to the identically numbered exhibit of the
    Company's Form 10-K for the fiscal year ended December 31, 2000, SEC File
    No. 000-31533.
*** Incorporated herein by reference to the identically numbered exhibit of the
    Company's Form 10-Q for the quarter ended September 30, 2001, SEC File No.
    000-31533.

   (b) Reports on Form 8-K

   No reports on Form 8-K were filed by the Registrant during the quarter ended
December 31, 2001.


                                      49

<PAGE>

                                  SIGNATURES

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

                                          PROTON ENERGY SYTEMS, INC.

                                                /S/  WALTER W. SCHROEDER
                                          --------------------------------------
                                             Walter W. Schroeder, President

   Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons, on behalf of the
registrant and in the capacities and on the dates indicated.

          Signature                     Capacity                 Date
          ---------                     --------                 ----
  /S/  WALTER W. SCHROEDER    Chief Executive               March 29, 2002
-----------------------------   Officer, President and
     Walter W. Schroeder        Director (Principal
                                executive officer)
  /S/  ROBERT W. SHAW, JR.    Chairman of the Board         March 29, 2002
-----------------------------
     Robert W. Shaw, Jr.
     /S/   RICHARD AUBE       Director                      March 29, 2002
-----------------------------
        Richard Aube
    /S/   TRENT M. MOLTER     Senior Vice President of      March 29, 2002
-----------------------------   Technology and New Business
       Trent M. Molter          and Director
   /S/  GERALD B. OSTROSKI    Director                      March 29, 2002
-----------------------------
     Gerald B. Ostroski
    /S/  PHILIP R. SHARP      Director                      March 29, 2002
-----------------------------
       Philip R. Sharp
    /S/  JOHN A. GLIDDEN      Vice President of             March 29, 2002
-----------------------------   Finance (Principal
       John A. Glidden          financial and accounting
                                officer)

                                      50