**FORM
      10-QSB**


**U.S.
      SECURITIES AND EXCHANGE COMMISSION**





**Washington,
      D.C. 20429**








(Mark
      One)


x
            QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
      EXCHANGE ACT OF 1934




For
      the
      quarterly period ended September 30, 2006





o  TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF


THE
      SECURITIES EXCHANGE ACT OF 1934





For
      the
      transition period from ___________________________ to
      ______________________________


Commission
      File Number 000-28947 .





**SpaceDev,
      Inc.**


(Exact
      name of small business issuer as specified in its charter)





Colorado
            84-1374613(State
                or other jurisdiction of
              incorporation
                or organization)
            (IRS
                Employer
              Identification
                No.)13855
                Stowe Drive, Poway, California 92064(Address
                of principal executive offices)





(Issuer's
      telephone number) (858)
      375-2000 .





____________________________________________________________________________________


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





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





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





State
      the
      number of shares outstanding of each of the issuer's classes of common equity,
      as of the latest practicable date: 29,507,191 **** shares
      of
      Issuer's voting common stock were outstanding on November 1, 2006.





Transitional
      Small Business Disclosure Format (check one): Yes o No x








**FORM
      10-QSB**




**FOR
      THE QUARTER ENDED SEPTEMBER 30, 2006**








**Index**
              **Page**PART
                  I -- FINANCIAL INFORMATION
              1ITEM
                  1. FINANCIAL STATEMENTS
              1Consolidated
                  Balance Sheets
              1Consolidated
                  Statements of Operations
              2Consolidated
                  Statements of Cash Flows
              3NOTES
                  TO CONSOLIDATED FINANCIAL
                  STATEMENTS
              5ITEM
                  2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF
                  OPERATION
              15Overview
              15Selection
                  of Significant Contracts
              17Results
                  of Operations
              19Liquidity
                  and Capital Resources
              27Critical
                  Accounting Standards
              28Recent
                  Accounting Pronouncements
              29Risk
                  Factors
              29ITEM
                  3. CONTROLS AND PROCEDURES
              41PART
                  II -- OTHER INFORMATION
              42ITEM
                  1. LEGAL PROCEEDINGS
              42ITEM
                  2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
              42ITEM
                  3. DEFAULTS UPON SENIOR SECURITIES
              42ITEM
                  4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
              42ITEM
                  5. OTHER INFORMATION
              42ITEM
                  6. EXHIBITS
              43SIGNATURES
              43





**PART
      I-- FINANCIAL INFORMATION**





**ITEM
      1.**  **FINANCIAL
      STATEMENTS**


**SpaceDev,
        Inc. and Subsidiaries**
 **Consolidated
        Balance Sheets**
 **(Unaudited)**


*At
                  September 30,*
              
              
              **2006**
              
              
              2005**Assets****Current
                  Assets**Cash
              
              **$**
              **3,693,612**
              
              $
              4,022,243Accounts
                  receivable
              
              
              **6,028,819**
              
              
              1,096,645Inventory
                  (Note 2(b))
              
              
              **3,528,229**
              
              
              10,412Raw
                  materials
              
              
              **273,559**
              
              
              -WIP:
                  costs in excess of billings (Note 2)
              
              
              **3,254,670**
              
              
              10,412Finished
                  goods
              
              
              **-**
              
              
              -Note
                  receivable (Note 5)
              
              
              **-**
              
              
              1,326,453Other
                  current assets (Note 6(a))
              
              
              **965,433**
              
              
              -**Total
                  Current Assets**
              
              
              **14,216,093**
              
              
              6,455,753**Fixed
                  Assets - Net**
              
              
              **3,712,149**
              
              
              822,980**Goodwill
                  (Note 5)**
              
              
              **12,246,362**
              
              
              -**Other
                  Assets (Note 6(b))**
              
              
              **323,063**
              
              
              64,469**Total
                  Assets**
              
              **$**
              **30,497,667**
              
              $
              7,343,202


**Liabilities
                  and Stockholders’ Equity****Current
                  Liabilities**Accounts
                  payable and accrued expenses
              
              **$**
              **2,439,832**
              
              $
              419,719Accrued
                  payroll, vacation and related taxes
              
              
              **1,421,800**
              
              
              350,145Billings
                  in excess of costs incurred (Note 2(a))
              
              
              **3,879,981**
              
              
              -Revolving
                  credit facility (Note 3(b))
              
              
              **1,926,853**Other
                  accrued liabilities (Note 2(a))
              
              
              **1,503,919**
              
              
              304,897**Total
                  Current Liabilities**
              
              
              **11,172,385**
              
              
              1,074,761**Capitalized
                  Lease Obligations, Less Current Maturities**
              
              
              **168,129**
              
              
              -**Deferred
                  Gain - Assets Held For Sale (Note 3(a))**
              
              
              **742,723**
              
              
              859,996**Other
                  Long Term Liabilities**
              
              
              **15,266**
              
              
              -**Total
                  Liabilities**
              
              
              **12,098,503**
              
              
              1,934,757**Commitments
                  and Contingencies****Stockholders’
                  Equity**Convertible
                  preferred stock, $.001 par value, 10,000,000shares
                  authorized, and 253,249 and 248,460 sharesissued
                  or outstanding, respectivelySeries
                  C Convertible preferred stock (Note 4(a))
              
              
              **248**
              
              
              248Series
                  D-1 Convertible preferred stock (Note 4 (b))
              
              
              **5**
              
              
              -Common
                  stock, $.0001 par value; 100,000,000 and 50,000,000 sharesauthorized,
                  and 29,485,036 and 22,319,156 shares issuedand
                  outstanding, respectively (Note 4)
              
              
              **2,948**
              
              
              2,231Additional
                  paid-in capital
              
              
              **33,365,995**
              
              
              20,091,408Accumulated
                  deficit
              
              
              **(14,970,032**
              **)**
              
              (14,685,442
              )**Total
                  Stockholders’ Equity**
              
              
              **18,399,164**
              
              
              5,408,445**Total
                  Liabilities and Stockholders’ Equity**
              
              **$**
              **30,497,667**
              
              $
              7,343,202


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




1


**SpaceDev,
      Inc. and Subsidiaries**


**Consolidated
      Statements of Operations**


**(Unaudited)**




*Three
                  Months Ended*
              
              *Nine
                  Months Ended**At
                  September 30,*
              
              
              2006
              
              %
              
              
              
              2005
              
              %
              
              
              
              2006
              
              %
              
              
              
              2005
              
              %**Net
                  Sales**
              
              **$**
              **7,006,347**
              
              **100.0**
              **%**
              
              $
              2,234,010
              
              100.0
              %
              
              **$**
              **22,812,290**
              
              **100.0**
              **%**
              
              $
              5,942,558
              
              100.0
              %**Total
                  Cost of Sales**
              
              
              **5,123,878**
              
              **73.1**
              **%**
              
              
              1,709,077
              
              76.5
              %
              
              
              **16,718,917**
              
              **73.3**
              **%**
              
              
              4,571,505
              
              76.9
              %**Gross
                  Margin**
              
              
              **1,882,469**
              
              **26.9**
              **%**
              
              
              524,933
              
              23.5
              %
              
              
              **6,093,373**
              
              **26.7**
              **%**
              
              
              1,371,053
              
              23.1
              %**Operating
                  Expenses**Marketing
                  and sales
              
              
              **524,701**
              
              **7.5**
              **%**
              
              
              188,655
              
              8.4
              %
              
              
              **1,859,396**
              
              **8.2**
              **%**
              
              
              493,344
              
              8.3
              %Research
                  and development
              
              
              **70,754**
              
              **1.0**
              **%**
              
              
              446
              
              0.0
              %
              
              
              **275,592**
              
              **1.2**
              **%**
              
              
              9,558
              
              0.2
              %General
                  and administrative
              
              
              **1,282,775**
              
              **18.3**
              **%**
              
              
              252,895
              
              11.3
              %
              
              
              **3,990,450**
              
              **17.5**
              **%**
              
              
              644,966
              
              10.9
              %**Total
                  Operating Expenses**
              
              
              **1,878,230**
              
              **26.8**
              **%**
              
              
              441,996
              
              19.8
              %
              
              
              **6,125,438**
              
              **26.9**
              **%**
              
              
              1,147,868
              
              19.3
              %**Income/(Loss)
                  from Operations**
              
              
              **4,239**
              
              **0.1**
              **%**
              
              
              82,937
              
              3.7
              %
              
              
              **(32,065**
              **)**
              **-0.1**
              **%**
              
              
              223,185
              
              3.8
              %**Non-Operating
                  Income/(Expense)**Interest
                  income
              
              
              **2,714**
              
              **0.0**
              **%**
              
              
              24,848
              
              1.1
              %
              
              
              **43,466**
              
              **0.2**
              **%**
              
              
              69,632
              
              1.2
              %Interest
                  expense
              
              
              **(7,842**
              **)**
              **-0.1**
              **%**
              
              
              (452
              )
              0.0
              %
              
              
              **(18,471**
              **)**
              **-0.1**
              **%**
              
              
              (2,283
              )
              0.0
              %Gain
                  on building sale (Note 3(a))
              
              
              **29,319**
              
              **0.4**
              **%**
              
              
              29,318
              
              1.3
              %
              
              
              **87,956**
              
              **0.4**
              **%**
              
              
              87,953
              
              1.5
              %Non-Cash
                  loan fee (Note 3(b))
              
              
              **(1,918**
              **)**
              **0.0**
              **%**
              
              
              -
              
              0.0
              %
              
              
              **(1,918**
              **)**
              **0.0**
              **%**
              
              
              (28,875
              )
              -0.5
              %**Total
                  Non-Operating Income**
              
              
              **22,273**
              
              **0.3**
              **%**
              
              
              53,714
              
              2.4
              %
              
              
              **111,033**
              
              **0.5**
              **%**
              
              
              126,427
              
              2.1
              %**Income
                  Before Taxes**
              
              
              **26,512**
              
              **0.4**
              **%**
              
              
              136,651
              
              6.1
              %
              
              
              **78,968**
              
              **0.3**
              **%**
              
              
              349,612
              
              5.9
              %**Income
                  tax provision**
              
              
              **5,055**
              
              **0.1**
              **%**
              
              
              400
              
              0.0
              %
              
              
              **14,290**
              
              **0.1**
              **%**
              
              
              1,200
              
              0.0
              %**Net
                  Income**
              
              **$**
              **21,457**
              
              **0.3**
              **%**
              
              $
              136,251
              
              6.1
              %
              
              **$**
              **64,678**
              
              **0.3**
              **%**
              
              $
              348,412
              
              5.9
              %**Net
                  Income**
              
              
              **21,457**
              
              
              
              
              
              136,251
              
              
              
              
              
              **64,678**
              
              
              
              
              
              348,412Less
                  Preferred Dividend Payments
              
              
              **(150,842**
              **)**
              
              
              
              
              (42,737
              )
              
              
              
              
              **(446,791**
              **)**
              
              
              
              
              (128,210
              )**Adjusted
                  Net Income (Loss) for EPS Calculation**
              
              
              **(129,385**
              **)**
              
              
              
              
              93,514
              
              
              
              
              
              **(382,113**
              **)**
              
              
              
              
              220,202**Net
                  Income Per Share:**
              
              **$**
              **(0.00**
              **)**
              
              
              
              $
              0.00
              
              
              
              
              **$**
              **(0.01**
              **)**
              
              
              
              $
              0.01Weighted-Average
                  Shares Outstanding
              
              
              **29,027,350**
              
              
              
              
              
              21,241,448
              
              
              
              
              
              **28,419,751**
              
              
              
              
              
              21,777,211**Fully
                  Diluted Net Income Per Share:**
              
              **$**
              **(0.00**
              **)**
              
              
              
              $
              0.00
              
              
              
              
              **$**
              **(0.01**
              **)**
              
              
              
              $
              0.01Fully
                  Diluted Weighted-Average Shares Outstanding
              
              
              **29,027,350**
              
              
              
              
              
              23,831,994
              
              
              
              
              
              **28,419,751**
              
              
              
              
              
              25,230,427*
                The following table shows how the Company's stock option expense
                would be
                allocated to all expenses.Cost
                  of sales
              
              **$**
              **10,287**
              
              
              
              
              **$**
              -
              
              
              
              
              **$**
              **10,287**
              
              
              
              
              **$**
              -Marketing
                  and sales
              
              
              **717**
              
              
              
              
              
              -
              
              
              
              
              
              **717**
              
              
              
              
              
              -Research
                  and development
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -
              
              
              
              
              
              -General
                  and administrative
              
              
              **(25,555**
              **)**
              
              
              
              
              -
              
              
              
              
              
              **90,138**
              
              
              
              
              
              -**$**
              **(14,551**
              **)**
              
              
              
              **$**
              -
              
              
              
              
              **$**
              **101,142**
              
              
              
              
              **$**
              -







2


**SpaceDev,Inc.
      and Subsidiaries**


**Consolidated
      Statements of Cash Flows**


**(Unaudited)**




*Nine-Months
                  Ending September 30,*
              
              
              **2006**
              
              
              2005**Cash
                  Flows From Operating Activities**Net
                  income
              
              **$**
              **64,678**
              
              $
              348,412Adjustments
                  to reconcile net income to net cashused
                  in operating activities:Depreciation
                  and amortization
              
              
              **613,166**
              
              
              108,265Gain
                  on disposal of building sale
              
              
              **(87,956**
              **)**
              
              (87,953
              )Stock
                  option expense
              
              
              **103,317**
              
              
              -Non-cash
                  loan fee
              
              
              **1,918**
              
              
              28,875Change
                  in operating assets and liabilities
              
              
              **(2,014,912**
              **)**
              
              (84,760
              )**Net
                  Cash (Used In) Provided By Operating Activities**
              
              
              **(1,319,788**
              **)**
              
              312,839**Cash
                  Flows From Investing Activities**Notes
                  receivable
              
              
              **-**
              
              
              (1,326,453
              )Other
                  assets, capitalized acquisition costs
              
              
              **(1,066,564**
              **)**
              
              -Purchases
                  of fixed assets
              
              
              **(1,163,743**
              **)**
              
              (651,864
              )**Net
                  Cash Used in Investing Activities**
              
              
              **(2,230,307**
              **)**
              
              (1,978,317
              )**Cash
                  Flows From Financing Activities**Principal
                  payments on notes payable
              
              
              **(4,675,832**
              **)**
              
              (27,330
              )Principal
                  payments on capitalized lease obligations
              
              
              **(20,789**
              **)**
              
              (2,774
              )Dividend
                  payments on Series C and Series D-1 Preferred
              
              
              **(352,894**
              **)**
              
              -Proceeds
                  from revolving credit facility
              
              
              **1,926,853**
              
              
              -Employee
                  stock purchase plan
              
              
              **122,086**
              
              
              48,343Other
                  assets, capitalized revolving credit facility costs
              
              
              **(175,000**
              **)**
              
              -Proceeds
                  from issuance of preferred stock
              
              
              **4,316,850**
              
              
              600,881Proceeds
                  from issuance of common stock
              
              
              **352,395**
              
              
              -**Net
                  Cash Provided by Financing Activities**
              
              
              **1,493,669**
              
              
              619,120**Net
                  Decrease in Cash**
              
              
              **(2,056,426**
              **)**
              
              (1,046,358
              )**Cash
                  at Beginning of Period**
              
              
              **5,750,038**
              
              
              5,068,601**Cash
                  at End of Period**
              
              **$**
              **3,693,612**
              
              $
              4,022,243








3


**SpaceDev,
      Inc. and Subsidiaries**


**Consolidated
      Statements of Cash Flows, Cont'd.**


**(Unaudited)**


*Nine-Months
                  Ending June 30,*
              
              
              **2006**
              
              
              2005**Supplemental
                  Disclosures of Cash Flow Information:**Cash
                  paid during the period for:Interest
              
              **$**
              **18,471**
              
              $
              2,283Taxes
              
              
              **21,000**
              
              
              1,600**Noncash
                  Investing and Financing Activities:**During
                  the nine-months ended September 30, 2006 the Company entered into
                  capital
                  leases in the amount ofapproximately
                  $184,000.During
                  the nine-months ended September 30, 2006 and 2005 the Company converted
                  $122,086 and $47,702of
                  employee stock purchase plan contributions into 104,845 and 34,040
                  shares
                  of common stock,respectively.During
                  the nine-months ended September 30, 2006 and 2005 the Company declared
                  dividends payableof
                  $127,297 and $128,057, repectively to the holders of its Series
                  C
                  preferred stock.During
                  the nine-months ended September 30, 2005 the Company paid dividends
                  valued
                  at$174,976
                  in the form of 113,621 shares of common stock to the holders of
                  its Series
                  C preferred stock.During
                  the nine-months ended September 30, 2006 the Company declared dividends
                  payableof
                  $331,922 to the holders of its Series D-1 preferred stock and paid
                  $211,551 of these dividends.During
                  the nine-months ended September 30, 2006 the Company issued 310,009
                  shares
                  of common stock andexpensed
                  $1,918 and accrued $348,082 to be spread over the next twelve months
                  in
                  non-cash loan fees forthe
                  addition expenses incurred under our new revolving credit facilty
                  with
                  Laurus Master Fund.


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





4


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**1.
      Basis of Presentation**





The
      accompanying consolidated financial statements of SpaceDev, Inc., a Colorado
      corporation ("the Company") include the accounts of the Company and its
      subsidiary, Starsys, Inc., a Colorado corporation, and its inactive subsidiaries
      SpaceDev Oklahoma, an Oklahoma corporation and Dream Chaser, Inc., a Delaware
      corporation. In the opinion of management, the consolidated financial statements
      reflect all normal and recurring adjustments, which are necessary for a fair
      presentation of the Company's financial position, results of operations and
      cash
      flows as of the dates and for the periods presented. The consolidated financial
      statements have been prepared in accordance with generally accepted accounting
      principles for interim financial information. Consequently, these statements
      do
      not include all disclosures normally required by generally accepted accounting
      principles of the United States of America for annual financial statements
      nor
      those normally made in an Annual Report on Form 10-KSB. Accordingly, reference
      should be made to the Company's Form 10-KSB filed on March 28, 2006 and other
      reports the Company filed with the U.S. Securities and Exchange Commission
      for
      additional disclosures, including a summary of the Company's accounting
      policies, which have been modified, as a result of the Company's acquisition
      of
      Starsys Research Corporation, to include a "percentage-of-completion" method
      of
      revenue recognition and inventory policies. The consolidated results of
      operations for the nine-months ended September 30, 2006 are not necessarily
      indicative of results that may be expected for the fiscal year ended December
      31, 2006 or any future period, and the Company makes no representations related
      thereto.





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      certain estimates and assumptions that affect the reported amounts of assets
      and
      liabilities, disclosures of contingent assets and liabilities and the results
      of
      operations during the reporting period. Actual results could differ materially
      from those estimates.





**2.
      Accounting Policies**





*(a)
      Revenue Recognition*





The
      Company's revenues for the nine-months ended September 30, 2006 were derived
      primarily from fixed price contracts and commercial sales of component and
      subsystem products that the Company acquired in its acquisition of Starsys
      along
      with some United States government cost plus fixed fee (CPFF) contracts, which
      is compared to primarily CPFF contracts for the same nine-month period in 2005.
      Revenues from the CPFF contracts during the first nine-months ended September
      30, 2006 and 2005 were recognized as expenses were incurred. Estimated contract
      profits are taken into earnings in proportion to revenues recorded. Time and
      material revenues are recognized as services are performed and costs incurred.
      Certain fixed price contracts were prepared according to the
      "percentage-of-completion" method of accounting for long-term contracts. The
      amount of revenues recognized is that portion of the total contract amount
      that
      the actual cost expended bears to the anticipated final total cost based on
      current estimates of cost to complete the project (cost-to-cost method).
      Recognition of profit commences on an individual project only when cost to
      complete the project can reasonably be estimated and after there has been some
      meaningful performance achieved on the project. Recognition of losses on
      projects are taken as soon as the loss is reasonably determinable and accrued
      on
      the balance sheet in other accrued liabilities. The current accrual for
      potential losses on existing projects represents approximately $855,000. As
      projects are completed, the accrual is adjusted as projects move toward
      completion and more accurate estimates are established. Changes in job
      performance, job conditions, and estimated profitability, including those
      arising from contract penalty provisions (when applicable), and final contract
      settlements may result in revisions to costs and income and are recognized
      in
      the period in which the revisions are determined. Contract costs include all
      direct material, direct labor and subcontractor costs, and other costs such
      as
      supplies, tools and travel which are specifically related to a particular
      contract. All other selling, general and administrative costs are expensed
      as
      incurred.




5


The
      Company is in contract discussions and re-negotiations with a major customer
      over a significant fixed price development contract under which the Company
      is
      seeking various forms of contract relief, amendments and changes. As a result,
      the Company did not recognize any revenue or profit/loss during the 2006 third
      quarter relating to that contract. The Company is actively pursuing contract
      modifications to cover significant cost, scope and requirements changes and
      overruns on this contract.  As the total value, time and further
      requirements of the contract is currently uncertain, the Company has chosen
      not
      to recognize additional revenue under the “percentage of completion” method
      of accounting.  All costs related to the contract incurred since June 30,
      2006 have been capitalized and are included in WIP (Work-In-Process), which
      includes cost in excess of billings.  A resolution is expected before the
      fiscal year end.





*(b)
      Inventory*





Inventory
      is valued based on the lower-of-cost-or-market method and is disbursed on a
      FIFO
      (First-In, First-Out) basis, unless required by customer contract to be
      distributed by specific identification for lot control purposes. Inventory
      includes raw material inventory, finished goods inventory and work-in-process
      inventory (which includes costs and estimated earnings in excess of billings
      on
      uncompleted contracts and which represents approximately $3.2 million at
      September 30, 2006). Actual results of contracts may differ from management's
      estimates and such differences could be material to the consolidated financial
      statements. Professional fees are billed to customers on a time and materials
      basis. Time and material revenues are recognized as services are performed
      and
      costs incurred.





*(c)
      Earnings Per Share*





For
      the
      three and nine months ended September 30, 2006, options to purchase
      approximately 12.9 million shares of common stock and warrants to issue
      approximately 2.8 million shares of common stock were excluded from the
      computation of diluted earnings per share as the exercise prices of these
      options and warrants were greater than the average market price of the common
      shares at September 30, 2006. We typically account for the effect of the
      convertible preferred shares in diluted earning per common share calculation
      using the "if converted" method. Under that method, the convertible Series
      C and
      D-1 Preferred Shares are assumed to be converted into common shares at
      conversion rates of $1.54 and $1.48, respectively. Diluted earnings (loss)
      per
      common share would have been anti-dilutive for the three and nine months ended
      September 30, 3006, if based on fully diluted shares adjusted to reflect the
      conversion of the preferred shares into approximately 4.8 million common
      shares.





For
      the
      three and nine months ended September 30, 2005, options to purchase 1.3 million
      shares of common stock were excluded from the computation of diluted earnings
      per share as the exercise prices of these options were greater than the average
      market price of the common shares. Diluted earnings (loss) per common share
      would have been anti-dilutive for the three months ended September 30, 3005,
      if
      based on fully diluted shares adjusted to reflect the conversion of the
      preferred shares into approximately 1.6 million common shares.





**3.
      Long Term Liabilities**





*a)
      Building and Deferred Gain.*





In
      January 2003, the Company sold its interest in its Poway, California
      headquarters facility. The transaction included the sale of the land and
      building. Net fixed assets were reduced by approximately $1.9 million and notes
      payable were reduced by approximately $2.4 million while a deferred gain was
      recorded. In conjunction with the sale, the Company entered into a lease
      agreement with the buyer to leaseback its facilities. The Company's then chief
      executive officer provided a guarantee for the leaseback, which guarantee is
      still in place. The gain on the sale of the facility was deferred and amortized
      in proportion to the gross rental charged to expense over the lease term.
      Deferred gain of $1,172,720 is being amortized at the rate of $117,272 per
      year
      for ten (10) years ending in January 2013. As of September 30, 2006, the
      deferred gain was $742,723. This amortization is included in the Company's
      non-operating income/(expenses) and totaled $87,956 and $87,953 for the
      nine-months ended September 30, 2006 and 2005, respectively. On September 14,
      2006, the building was sold again; however, the terms and conditions of the
      lease to the Company remained unchanged.




6


*b)
      Revolving Credit Facility.*





New
      Revolving Credit Facility .
      On
      September 29, 2006, the Company entered into a $5.0 million financing
      arrangement through Laurus Master Fund, Ltd. (“Laurus”). The financing is
      affected with a revolving note for up to $5.0 million, although the exact
      principal balance at any given time will depend on draws made by the Company
      on
      the Facility. The Company will be allowed to borrow against the Facility under
      an investment formula based on accounts receivable at an advance rate equal
      to
      90% of eligible receivables and the lesser of: (a) 50% of eligible inventory
      (calculated on the basis of the lower-of-cost-or-market, on a first-in-first-out
      basis); or, (b) $1.0 million, provided, however, that no more than $500,000
      of
      such eligible inventory may be in the form or work-in-process inventory. The
      balance on this revolving credit facility at September 30, 2006 was
      $1,926,853.





The
      facility bears interest at a rate equal to prime plus 2%. This rate will be
      increased or decreased on the date the Prime Rate is adjusted. Interest is
      payable monthly, commencing in October 2006. Interest is due on the first
      business day of each month through maturity. The term of the facility is
      scheduled to end on September 29, 2009. Laurus received 310,009 unregistered
      shares of the Company’s common stock valued at $350,000 at closing. The value of
      these shares was determined based on the $1.13 average trading price for the
      stock during the preceding ten (10) business days and the expense is being
      amortized daily over the first year of the note. The Company will issue
      additional restricted shares of its common stock worth, in the aggregate,
      $200,000, to Laurus on each anniversary date of the facility, if the facility
      remains in place. The pricing of these additional shares will be based on the
      applicable preceding ten (10) business day average trading price.





Laurus
      agreed that if and when it can resell the unregistered shares under Rule 144,
      its resale on any one day cannot exceed 10% of the daily trading volume. Laurus
      has piggyback registration rights subject to certain underwriters’ restrictions,
      but will not be entitled to demand registration of any of the shares received
      under the facility. The facility is not convertible into any class of our
      securities at any time during its term. In addition, Laurus is strictly
      prohibited from engaging in any short sales of the Company’s common stock during
      the term of the facility.





The
      facility is a secured debt, collateralized by substantially all of the Company's
      and its subsidiaries' assets. The facility contains certain default provisions.
      In the event of a default by the Company, the Company will be required to pay
      an
      additional fee per month until the default is cured. Laurus has the option
      of
      accelerating the entire principal balance and requiring the Company to pay
      a
      premium in the event of an uncured default.





The
      facility requires the Company to deposit all funds (other than certain
      refundable deposits) into a lockbox that will be swept on a daily basis to
      reduce any outstanding facility balance. Any funds in excess of any outstanding
      facility balance will be transferred to the Company on a daily basis.





The
      Company paid to certain persons designated by Laurus in the amount of $9,500
      for
      legal fees and expenses in structuring the facility, conducting due diligence
      and escrow fees. In addition, the Company paid a finder’s fee in the amount of
      $35,000 and paid Laurus a facility fee of 3.5%, or approximately $140,000,
      of
      the facility amount, which facility fee is being expensed over the life of
      the
      note.





Previous
      Revolving Credit Facility .
      On June
      3, 2003, the Company entered into a $1.0 million financing arrangement with
      Laurus in the form of a three-year Convertible Note secured by its assets
      subject to the amount of eligible accounts receivables. On August 25, 2004,
      after the initial $1.0 million was converted, the revolving credit facility
      was
      increased to $1.5 million. The net proceeds from the Convertible Notes were
      used
      for general working capital purposes. Advances on the Convertible Notes were
      repayable at the Company's option, in cash or through the issuance of the
      Company's shares of common stock. The Convertible Notes carried an interest
      rate
      of Wall Street Journal Prime plus 0.75% on any outstanding balance. In addition,
      the Company was required to pay a collateral management payment of 0.55% of
      the
      average aggregate outstanding balance during the month plus an unused line
      payment of 0.20% per annum. Availability of funds under the old revolving credit
      facility was based on the Company's accounts receivable. Laurus exercised its
      conversion rights from time-to-time on outstanding balances. Laurus converted
      an
      aggregate of $2.5 million of revolving debt into 3,406,417 shares of Company
      common stock during the term of the revolving credit facility. There was no
      outstanding balance on the revolving credit facility at September 30, 2005
      and
      there were no conversions during the first nine months of 2005 or during the
      first five months of 2006 until expiration. This
      revolving credit facility with Laurus expired on June 3, 2006 and the Company
      has since entered into a new revolving note with Laurus on September 29, 2006,
      as mentioned above.




7


In
      conjunction with the June 3, 2003 transaction, the Company paid Laurus a fee
      of
      $20,000 for the first year and was required to pay a continuation fee of $10,000
      each year thereafter. In addition, Laurus received a warrant to purchase 200,000
      shares of the Company's common stock for the initial $1 million revolving credit
      facility. The warrant exercise price was $0.63 per share for the purchase of
      up
      to 125,000 shares; $0.69 per share for the purchase of an additional 50,000
      shares; and $0.80 per share for the purchase of an additional 25,000 shares.
      The
      warrant exercise price may be paid in cash, in shares of the Company's common
      stock, or by a combination of both. The warrant expiration date is June 3,
      2008.
      In addition to the initial warrant, the Company issued two warrants: 1) to
      purchase 50,000 shares at an exercise price of $1.0625 per share, which warrant
      was exercised by Laurus on April 19, 2005; and, 2) to purchase 50,000 shares
      at
      an exercise price of $1.925 per share, which has an expiration date of August
      25, 2009.





**4.
      Stockholder's Equity - Preferred Stock, Common Stock, Warrants, and
      Options**





**Preferred
      Stock**





*a)
      Series C Preferred Stock.*





On
      August
      25, 2004, the Company issued 250,000 shares of its Series C Non-Redeemable
      Convertible Preferred Stock, par value $0.001 per share (the "Series C Preferred
      Shares"), to Laurus for an aggregate purchase price of $2.5 million or $10.00
      per share (the "Stated Value"). The Series C Preferred Shares are convertible
      into shares of the Company's common stock at a rate of $1.54 per share, and
      accrue quarterly, cumulative dividends at a rate of 6.85%. The first payment
      was
      due on January 1, 2005. As of September 30, 2006 and 2005, the Company declared
      dividends payable of approximately $127,000 and $128,000, respectively, to
      the
      holders of its Series C preferred stock. These dividends are payable in cash
      or
      shares of our common stock at the holder's option with the exception that
      dividends must be paid in shares of our common stock for up to 25% of the
      aggregate dollar trading volume if the fair market value of the Company's common
      stock for the 20-days preceding the conversion date exceeds 120% of the
      conversion rate. On January 11, 2005, $60,967 of accrued dividends were paid
      in
      the form of 39,589 shares of the Company's common stock. Also, on May 5, 2005,
      $56,301 of accrued dividends were paid in the form of 36,559 shares of the
      Company's common stock, on September 28, 2005, $57,708 of accrued dividends
      were
      paid in the form of 37,473 shares of the Company's common stock. Accrued
      dividends were paid in cash on April 1, 2006, in the amount of approximately
      $99,000, and on July 6, 2006 of approximately $42,000. On September 30, 2006,
      accrued but unpaid dividends were approximately $43,000. The Series C Preferred
      Shares are redeemable by the Company in whole or in part at any time after
      issuance for (a) 115% of the Stated Value if the average closing price of the
      common stock for the 22 days immediately preceding the date of conversion does
      not exceed $1.48 per share or (b) the Stated Value if the average closing price
      of our common stock for the 22 days immediately preceding the date of conversion
      exceeds $1.48 per share. The Series C Preferred Shares have a liquidation right
      equal to the Stated Value upon the Company's dissolution, liquidation or
      winding-up. The Series C Preferred Shares have no voting rights, except as
      required by law.





In
      conjunction with the Series C Preferred Shares, the Company issued a five-year
      common stock warrant to Laurus for the purchase of 487,000 shares of the
      Company's common stock at an exercise price of $1.77 per share.





*b)
      Series D-1 Preferred Stock.*





On
      January 12, 2006, the Company entered into a Securities Purchase Agreement
      with
      a limited number of institutional accredited investors, including Tailwind
      Capital, Bristol Capital Management, Nite Capital, Laurus and Omicron Capital, (which
      has since transferred their preferred shares to Portside Growth &
Opportunity Fund and Rockmore Investment Master Fund). On January 13, 2006,
      the
      Company issued and sold to these investors 5,150 shares of Series D-1 Amortizing
      Convertible Perpetual Preferred Stock, par value $0.001 per share, for an
      aggregate purchase price of $5.15 million, or $1,000 per share. As of September
      30, 2006, 4,789 shares of Series D-1 Amortizing Convertible Perpetual Preferred
      Stock remain outstanding and 361 shares of the Series D-1 Amortizing Convertible
      Perpetual Preferred Stock were repaid through voluntary amortization or
      converted to the Company’s common stock. In May 2006, 75 shares of
      the
      Series D-1 Amortizing Convertible Perpetual Preferred Stock were
      converted into 50,676 shares of the Company's common stock and 286 shares of
      the
      Series D-1 Amortizing Convertible Perpetual Preferred Stock have been repaid
      through voluntary amortization, as provided for in the Agreement. The Company
      also issued various warrants to these investors as described below. The Company
      paid cash fees and expenses of $119,209 to a finder for the introduction of
      potential investors in this financing, and paid $60,000 to the lead investor's
      counsel for legal expenses incurred in the transaction. The preferred shares
      are
      convertible into shares of the Company's common stock at a rate of $1.48 per
      share and accrue quarterly, cumulative dividends at a rate of LIBOR plus 4%
      on
      the first day of the applicable quarter. The first payment was due on April
      1,
      2006. As of September 30, 2006, the Company had paid approximately $212,000
      of
      accrued Series D-1 dividends in cash. On September 30, 2006, accrued but unpaid
      dividends were approximately $123,000.




8


Under
      the
      purchase agreement, from the date of the effectiveness of the initial
      registration statement filed pursuant to the registration rights agreement
      (February 15, 2006), until the one-year anniversary of that date, if: (1) on
      any
      trading day during such period the volume weighted average price of the
      Company's common stock for each of the twenty (20) trading days immediately
      prior to such date exceeds $1.63; and, (2) the average daily trading volume
      of
      the Company's common stock exceeds $100,000 on each of those days, then the
      Company has the option, subject to a number of additional conditions, to put
      to
      the investors "units" at $1,000 per unit for an aggregate purchase price of
      up
      to $2.0 million (or a lesser amount to the extent the preferred stock warrants
      issued at the initial closing of the financing, which are described below,
      have
      been exercised to purchase these units). Each "unit" consists of one share
      of
      Series D-1 Preferred Stock and a common stock warrant, which entitles the
      holders to purchase up to an aggregate of 440,829 shares of common stock at
      an
      exercise price of $1.51 and otherwise has the same terms as the warrants
      described in the following paragraph.





Certain
      warrants the Company issued to the Series D-1 investors at the closing entitle
      the investors to purchase up to an aggregate of 1,135,138 shares of the
      Company's common stock at an exercise price of $1.51 per share. The warrants
      are
      exercisable for five (5) years following the date of grant. The warrants have
      "ratchet" anti-dilution provisions reducing the warrant exercise price if the
      Company issues equity securities (other than in specified exempt transactions)
      at an effective price below the warrant exercise price to such lower exercise
      price.





The
      Company also issued certain other warrants to the Series D-1 investors at the
      closing (the "preferred stock warrants"). These warrants entitle the holder
      to
      purchase an aggregate number of 2,000 "units", which are identical to the
      "units" described above, at an exercise price of $1,000 per unit. The preferred
      stock warrants are exercisable from the effective date (i.e., February 15,
      2006)
      until the one-year anniversary of that date. If any units subject to the
      preferred stock warrants remain unsold after (1) their expiration date and
      (2)
      the exercise of the Company's put option, if applicable, and any holder of
      a
      preferred stock warrant issued in the financing has exercised the warrant in
      full, then the preferred stock warrant would supplementally grant that holder
      the right to purchase 440,829 shares of common stock, times the number of
      "units" which the holder's preferred stock warrant initially overlaid, with
      a
      strike price of $1.51 per share, and the warrant, as so supplemented, would
      have
      a five (5) year term from January 12, 2006 to January 11, 2011.





The
      purchase agreement contains a number of covenants by the Company, which
      include:





·
            A
                grant of preemptive rights to the investors to participate in future
                financings until January 12, 2007;





·
            An
                agreement not to effect any transaction involving the issuance of
                securities convertible, exercisable or exchangeable for the Company's
                common stock at a price per share or rate which may change over time,
                so
                long as any shares of Series D-1 Preferred Stock are
                outstanding.





In
      connection with this financing, Laurus consented to and waived certain
      contractual rights. The Company paid Laurus Capital Management, L.L.C., and
      the
      manager of Laurus, an
      amount
      of $87,000 in connection with Laurus' delivery of the consent and waiver, and
      paid $1,000 to Laurus' counsel for their related fees.





9


*c)
      Common Stock Options*





The
      Company adopted SFAS 123(R) to account for its stock-based compensation
      beginning January 1, 2006. Previously, the Company elected to account for its
      stock-based compensation plans under APB 25. The Company computed, for pro
      forma
      disclosure purposes, the value of all options granted during the nine months
      ended September 30, 2005 using the minimum value method as prescribed by SFAS
      123 and amended by SFAS 148. Under this method, the Company used the risk-free
      interest rate at the date of grant, the expected volatility, the expected
      dividend yield and the expected life of the options to determine the fair value
      of options granted. The risk-free interest rates ranged from 6.0% to 6.5%,
      expected volatility was 117%, the dividend yield was assumed to be zero, and
      the
      expected life of the options was assumed to be three to five years based on
      the
      average vesting period of options granted.





If
      the
      Company had accounted for its options in accordance with SFAS 123(R) in 2005,
      the total value of options granted during the nine month period ended September
      30, 2005 would have been amortized over the vesting period of the options.
      Thus,
      the Company's consolidated net income (loss) would have been as
      follows:




**Net
                    Income (Loss)**
                
                
                **2005**As
                    reported at September 30, 2005
                
                **$**
                **348,412**Add:
                    Stock based employee compensation expense included in reported
                    net income
                
                **$**
                **-**Deduct:
                    Stock based employee compensation expense determined under the
                    fair value
                    based method for all awards
                
                **$**
                **553,989**Pro
                    forma at September 30, 2005
                
                **$**
                **(205,577**
                **)****Net
                    Income (Loss) Per Share:**As
                    reported at September 30, 2005
                
                **$**
                **0.02**Pro
                    forma at September 30, 2005
                
                **$**
                **(0.01**
                **)**
 For
        the
        nine months ended September 30, 2006, the Company expensed approximately
        $101,000 of stock option expenses due to SFAS 123(R) in its financial
        statements.





**5.
      Goodwill**





On
      January 31, 2006, the Company acquired Starsys Research Corporation and in
      accordance with U.S. generally accepted accounting principles ,
      the
      merger was accounted for using the purchase method of accounting. Under the
      purchase method of accounting, the total estimated purchase price was allocated
      to Starsys' net tangible assets and identifiable intangible assets based on
      their fair values as of the date of completion of the merger. The excess of
      the
      purchase price over those fair values was recorded as goodwill. Goodwill is
      not
      amortized but is tested for impairment at least annually. The combined company
      will incur additional amortization expense based on the identifiable amortizable
      intangible assets acquired pursuant to the merger agreement and their relative
      useful lives. Additionally, to the extent the value of goodwill or identifiable
      intangible assets or other long-lived assets become impaired, the combined
      company may be required to record material charges relating to the impairment.
      The goodwill balance as of September 30, 2006 was approximately $12.2
      million.





10


The
      following is a schedule of the goodwill incurred in the Starsys
      acquisition.


Starsys
                  Total Assets
              
              $
              (7,851,494
              )Starsys
                  Total Liabilities
              
              
              13,054,140Cash
                  to Starsys Stockholders
              
              
              410,791Equity
                  to Starsys Stockholders
              
              
              5,576,846Fees
                  Associated with Acquisition
              
              
              1,056,079$
              12,246,362


On
      September 8, 2005, the Company made a secured loan in the principal amount
      of
      $1.2 million to Starsys Research Corporation. The loan accrued interest at
      8%
      per annum and matured on January 31, 2006 upon the closing of the acquisition.
      No principal or interest payments were made before maturity. The loan was
      secured by a security interest in all of the assets of Starsys, subject to
      an
      intercreditor agreement with Vectra Bank. In addition, Starsys had agreed to
      pay
      the Company a placement agent fee and to reimburse the Company expenses in
      the
      aggregate amount of $120,000. This amount was forgiven at the closing of the
      merger.




**6.
      Other Assets**





*a)
      Other Current Assets*




Other
      current assets consist of a variety of prepaid and other cash advances for
      items
      which are expected to occur within the next year. The following is a listing
      of
      items that constitute the Company’s other current assets at September 30,
      2006.




Other
                  Current Assets - September 30,
              
              
              2006Prepaid:Financing
                  Fees
              
              $
              522,763Computer
                  & Software
              
              
              198,768Rent
              
              
              40,103Insurance
              
              
              103,433Taxes
              
              
              20,406Other
                  Accuals
              
              
              79,960Total
                  Other Current Assets
              
              $
              965,433





*b)
      Other Assets*




Other
      assets consist of prepaid and other cash advances for items which are expected
      to occur at a date beyond twelve months into the future. The following is a
      listing of items that constitute the Company’s other assets at September 30,
      2006.




Other
                  Assets - September 30,
              
              
              2006Prepaid
                  Rent
              
              $
              188,130Deposits
              
              
              134,933Total
                  Other Assets
              
              $
              323,063




11


**7.
      New Accounting Pronouncements**





There
      were no recent Accounting Pronouncements that affected the Company during the
      nine months ended September 30, 2006. For past pronouncements, please refer
      the
      Company's Form 10-KSB filed on March 28, 2006.





**8.
      Change in Accounting Principle and Accounting for Share-Based
      Compensation**





The
      Company adopted Financial Accounting Standards Board (FASB) Statement of
      Financial Accounting Standards (SFAS) No. 123 (revised 2004) (123(R)) on January
      1, 2006. Upon the adoption of SFAS 123(R), compensation costs associated with
      share-based compensation and stock option awards will be recorded to expense
      over the requisite period(s) associated with the stock or options. Prior to
      the
      adoption of SFAS 123(R), the Company accounted for share-based compensation
      and
      stock option awards issued to employees, directors and officers under the
      recognition and measurement principles of Accounting Principles Board (APB)
      No.
      25, *Accounting
      for Stock Issued to Employees* ,
      and
      related interpretations. Generally, no share-based employee compensation expense
      was recognized for employee stock option grants, as all options granted had
      an
      exercise price equal to the fair market value of the underlying common stock
      at
      the date of grant. Similarly, no compensation expense had been recognized under
      the Company's 1999 Employee Stock Purchase Plan (ESPP).





**9.
      Unaudited Pro Forma Combined Consolidated Statements of
      Operations**





The
      following unaudited pro forma combining
      and combined statements of operations give effect to the merger of SpaceDev
      and
      Starsys using the purchase method of accounting, as required by Statement of
      Financial Accounting Standard No. 141, "Business Combinations." The Company
      acquired Starsys Research Corporation on January 31, 2006 and is the "accounting
      acquirer" for accounting purposes. Under this method of accounting, the combined
      company will allocate the purchase price to the fair value of assets of Starsys
      deemed to be acquired, including identifiable intangible assets and goodwill.
      The purchase price allocation is subject to revision when the combined company
      obtains additional information regarding asset valuation. The unaudited pro
      forma combined statements of operations are based on respective historical
      consolidated financial statements and the accompanying notes of the Company.




The
      unaudited pro forma combined statement of operations for the nine months ended
      September 30, 2006 assumes the merger took place on January 1, 2006. The
      unaudited pro forma combined statement of operations for the year ended December
      31, 2005 combines SpaceDev's historical statement of operations for the year
      ended December 31, 2005 with the Starsys historical statement of operations
      for
      the year ended December 31, 2005 assuming the merger took place on January
      1,
      2005. The unaudited pro forma combined statements of operations should be read
      in conjunction with the related notes included in this Form 10-QSB and the
      consolidated audited financial statements of SpaceDev. The unaudited pro forma
      combined statements of operations are not necessarily indicative of what the
      actual results of operations and financial position would have been had the
      merger taken place on January 1 of each period presented and do not indicate
      future results of operations.





12


**SpaceDev,
        Inc. and Subsidiaries**


**(Unaudited)**




***For
                  the Nine Months Ended******September
                  30, 2006*****Consolidated**
              
              
              **Pro
                  Forma Adjustments**
              
              
              **Consolidated
                  Pro Forma****Net
                  Sales**
              
              $
              24,649,426
              
              $
              (265,224
              )
              $
              24,384,202**Cost
                  of Sales ***
              
              $
              18,081,469
              
              
              (86,972
              )
              $
              17,994,497**Gross
                  Margin**
              
              
              6,567,957
              
              
              (178,253
              )
              $
              6,389,704**Operating
                  Expenses**Marketing
                  and sales expense
              
              
              2,093,230
              
              
              (178,253
              )
              
              1,914,978Research
                  and development
              
              
              270,310
              
              
              -
              
              
              270,310Stock
                  option expense *
              
              
              115,693
              
              
              -
              
              
              115,693General
                  and administrative
              
              
              4,300,929
              
              
              -
              
              
              4,300,929**Total
                  Operating Expenses ***
              
              
              6,664,469
              
              
              (178,253
              )
              
              6,486,216**Loss
                  from Operations**
              
              
              (96,512
              )
              
              -
              
              
              (96,512
              )**Non-Operating
                  Income**Interest
                  income
              
              
              71,772
              
              
              -
              
              
              71,772Interest
                  expense
              
              
              (40,954
              )
              
              -
              
              
              (40,954
              )Non-cash
                  interest expense
              
              
              (1,918
              )
              
              -
              
              
              (1,918
              )Gain
                  on Building Sale
              
              
              87,956
              
              
              -
              
              
              87,956**Total
                  Non-Operating Income/(Expense)**
              
              
              116,856
              
              
              -
              
              
              116,856**Income
                  Before Income Taxes**
              
              
              20,344
              
              
              -
              
              
              20,344Income
                  tax provision
              
              
              14,290
              
              
              -
              
              
              14,290**Net
                  Income**
              
              $
              6,054
              
              $
              -
              
              
              6,054*
                  The following table shows how the Company's stock option
                  expense would be allocated to all expenses.Cost
                  of Sales
              
              $
              10,287
              
              $
              -
              
              
              10,287Marketing
                  and sales
              
              
              717
              
              
              -
              
              
              717Research
                  and development
              
              
              -
              
              
              -
              
              
              -General
                  and administrative
              
              
              90,138
              
              
              -
              
              
              90,138$
              101,142
              
              $
              -
              
              
              101,142






13


**SpaceDev,
        Inc. and Subsidiaries**


**(Unaudited)**





***For
                  the year ended December 31, 2005*****Consolidated**
              
              
              **Adjustments**
              
              
              **Consolidated
                  Pro Forma****Net
                  Sales**
              
              $
              26,767,741
              
              $
              -
              
              $
              26,767,741**Cost
                  of sales**
              
              $
              21,627,078
              
              
              -
              
              
              21,627,078**Gross
                  Margin**
              
              
              5,140,663
              
              
              -
              
              
              5,140,663**Operating
                  Expenses**Marketing
                  and sales expense
              
              
              673,636
              
              
              -
              
              
              673,636Research
                  and development
              
              
              31,940
              
              
              -
              
              
              31,940General
                  and administrative
              
              
              7,082,709
              
              
              -
              
              
              7,082,709**Total
                  Operating Expenses**
              
              
              7,788,285
              
              
              -
              
              
              7,788,285**Income/(Loss)
                  from Operations**
              
              
              (2,647,622
              )
              
              -
              
              
              (2,647,622
              )**Non-Operating
                  Income/(Expense)**Interest
                  income
              
              
              105,840
              
              
              **-**
              
              
              105,840Rental
                  income
              
              
              88,146
              
              
              
              
              
              88,146Interest
                  expense
              
              
              (509,398
              )
              
              -
              
              
              (509,398
              )Gain
                  on building sale
              
              
              117,272
              
              
              -
              
              
              117,272Loan
                  fee - equity compensation
              
              
              (28,875
              )
              
              -
              
              
              (28,875
              )**Total
                  Non-Operating Income/(Expense)**
              
              
              (227,015
              )
              
              -
              
              
              (227,015
              )**Income/(Loss)
                  Before Income Taxes**
              
              
              (2,874,637
              )
              
              -
              
              
              (2,874,637
              )Income
                  tax provision
              
              
              1,600
              
              
              -
              
              
              1,600**Net
                  Income/(Loss)**
              
              $
              (2,876,237
              )
              $
              -
              
              
              (2,876,237
              )**Net
                  Income/(Loss) Per Share:**Net
                  Income/(Loss)
              
              $
              (0.08
              )
              
              
              
              $
              (0.08
              )Shares
                  Outstanding
              
              
              29,551,305
              
              
              4,836,696
              
              
              34,388,001





14


**10.
      Subsequent Events**





The
      Company is in contract discussions and re-negotiations with a major customer
      over a significant fixed price development contract under which the Company
      is
      seeking various forms of contract relief, amendments and changes. As a result,
      the Company did not recognize any revenue or profit/loss during the 2006 third
      quarter relating to that contract. The Company is actively pursuing contract
      modifications to cover significant cost, scope and requirements changes and
      overruns on this contract.  As the total value, time and further
      requirements of the contract is currently uncertain, the Company has chosen
      not
      to recognize additional revenue under the “percentage of completion” method
      of accounting.  All costs related to the contract incurred since June 30,
      2006 have been capitalized and are included in WIP (Work-In-Process), which
      includes cost in excess of billings.  A resolution is expected before the
      fiscal year end.








**ITEM
      2.**  **MANAGEMENT'S
      DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**




The
      following discussion should be read in conjunction with our consolidated
      financial statements and the notes thereto and the other financial information
      appearing elsewhere in this document. Readers are also urged to carefully review
      and consider the various disclosures made by us which attempt to advise
      interested parties of the factors which affect our business, including without
      limitation our fiscal year 2005 Form 10-KSB and quarterly Form 10-QSB filings.





In
      addition to historical information, the following discussion and other parts
      of
      this document may contain forward-looking statements. These statements relate
      to
      future events or our future financial performance. In some cases, you can
      identify forward-looking statements by terminology such as "may," "will,"
      "should," "expect," "plan," "anticipate," "believe," "estimate," "predict,"
      "potential," or "continue," the negative of such terms or other comparable
      terminology. These statements are only predictions. Although we believe that
      the
      expectations reflected in the forward-looking statements are reasonable, we
      cannot guarantee future results, levels of activity, performance or
      achievements. Moreover, neither we nor any other person assume responsibility
      for the accuracy and completeness of the forward-looking statements. Except
      as
      may be required by law, we undertake no obligation to publicly update any of
      the
      forward-looking statements after the date of this report to conform such
      statements to actual results or to changes in our expectations.





Actual
      results could differ materially from those anticipated by such forward-looking
      statements. Factors that could cause or contribute to such differences include,
      but are not limited to, those identified in the "Risk Factors" section
      herein.





**Overview**




We
      are
      engaged in the conception, design, development, manufacture, integration and
      operations of space technology systems, products and services. Our historic
      SpaceDev operations are currently focused on the commercial and military
      development of low-cost microsatellites, nanosatellites and related subsystems,
      hybrid rocket propulsion for space, launch and human flight vehicles as well
      as
      associated engineering and technical services primarily to government agencies,
      and specifically the Department of Defense. Our products and solutions are
      sold,
      mainly on a project basis, directly to these customers and include sophisticated
      micro- and nanosatellites, hybrid rocket-based launch vehicles, maneuvering
      and
      orbital transfer vehicles as well as safe sub-orbital and orbital hybrid
      rocket-based propulsion systems. Although we believe there will be a commercial
      market for our microsatellite and nanosatellite products and services in the
      long-term, the early adopters of this technology appears to be the military
      and
      our "products" are considered to be the outcome of specific projects. We are
      also developing commercial hybrid rocket motors for possible use in small launch
      vehicles, targets and sounding rockets and small high-performance space vehicles
      and subsystems for commercial customers.





15


We
      acquired Starsys Research Corporation on January 31, 2006 in a tax-free forward
      triangular merger, renamed the company Starsys, Inc., and now hold it as a
      wholly-owned subsidiary of SpaceDev. Starsys is engaged in the design and
      manufacture of mechanical and electromechanical subsystems and components for
      spacecraft. Starsys' subsystems enable critical spacecraft functions such as
      pointing solar arrays and communication antennas and restraining, deploying
      and
      actuating moving spacecraft components. Starsys manufactures a wide range of
      products that include bi-axis gimbals, flat plate gimbals, solar array pointing
      mechanisms, deployable booms, separation systems, thermal louvers, actuators,
      restraint devices and cover systems. Starsys' products are sold both as
      "off-the-shelf" catalog products, which represent previously qualified devices
      with spaceflight history, and as custom systems that are developed for specific
      applications. Starsys' products are typically sold directly to spacecraft
      manufacturers. Starsys' customer base is segregated into three major segments:
      (1) domestic and international commercial spacecraft (communication and
      imaging satellites), (2) civil spacecraft (NASA) that are primarily
      scientific in nature and (3) defense spacecraft that support the United
      States' military capability. Starsys also offers products to non-space
      customers, including aerospace, maritime, and industrial customers.




Starsys'
      engineering and manufacturing capabilities position the company to provide
      both
      mechanical and electromechanical subsystems for spacecraft. Starsys' strategy
      is
      to identify opportunities to develop products from custom mechanical and
      electromechanical subsystems. To extend the product life cycle, Starsys has
      developed and expanded a "product platforms" business model. Product platforms
      are subsystems for which non-recurring and development engineering have been
      completed and for which there is continued customer demand. Starsys' product
      offerings also currently include High Output Paraffin ("HOP") actuators, hinges,
      battery bypass switches, thermal louvers, bi-axial gimbals and solar array
      drives, among others. The product life cycle for this type of product within
      the
      space industry is approximately 15 years.




The
      acquisition of Starsys fundamentally changed our profile. Starsys is a mature
      operating company with 2005 revenues of approximately $18 million and 2005
      losses of approximately $3.4 million. We believe there are numerous potential
      synergies between the historic SpaceDev business and Starsys' business,
      including but not limited to providing SpaceDev with a production capability
      as
      its technologies migrate from advanced systems to products, access to quality
      facilities and a strong market of aerospace engineers, a diversification of
      customers and revenues, and the ability to bid on larger and more vertically
      integrated programs and projects.





In
      March
      2006, we submitted a proposal for the $500 million NASA Commercial Orbital
      Transportation Services (COTS) demonstration. COTS is a new NASA initiative
      designed to stimulate the commercial delivery of cargo and crew transportation
      to the International Space Station. More than 20 of the nation’s leading private
      spaceflight companies submitted proposals to compete in four specific service
      areas: external unpressurized cargo delivery and disposal; internal pressurized
      cargo delivery and disposal; internal pressurized cargo delivery, return and
      recovery; and, crew transportation. NASA plans to spend the $500 million on
      this
      program through 2010. In May 2006, we were selected as one of six finalists
      for
      award of the COTS program, which indicates our increasing stature and profile
      within our industry. We continue to demonstrate the viability of our approach
      for safe, rapid, affordable and advanced space services to NASA and the space
      community. Unfortunately, the contract was awarded in August 2006 to two other
      finalists, and although we generated a high level of interest in our proposal
      and a high level of visibility for SpaceDev within NASA, we incurred no direct
      return on the approximately $800,000 that we invested in proposal related costs,
      which costs were expensed during the first nine months of 2006.





Our
      historic SpaceDev business approach is to provide smaller spacecraft - generally
      250 kg (550 pounds) mass and less - and cleaner, safer hybrid propulsion systems
      to commercial, government, university and limited international customers.
      We
      are developing smaller spacecraft and miniaturized subsystems using proven,
      lower cost, high-quality off-the-shelf components. Our space products are
      modular and reproducible, which allows us to create affordable space solutions
      for our customers. By utilizing our innovative technology and experience, and
      space-qualifying commercial industry-standard hardware, software and interfaces,
      we provide increased reliability with reduced costs and risks.





We
      have
      been awarded, have successfully concluded or are successfully concluding
      contracts from such esteemed government, university and commercial customers
      as
      the Air Force Research Laboratory, Boeing, the California Space Authority,
      the
      Defense Advanced Research Projects Agency, NASA's Jet Propulsion Laboratory,
      Lockheed Martin, Lunar Enterprise Corporation, Malin Space Science Systems,
      the
      Missile Defense Agency (formerly the "Ballistic Missile Defense Organization"),
      the National Reconnaissance Office, Scaled Composites and the University of
      California at Berkeley via NASA.





16


During
      the first nine months of 2006, 46% of our net sales were generated from direct
      government contracts, 41% were generated from government-related work through
      subcontracts with others, and 13% were generated from commercial contracts.
      For
      the same nine month period in 2005, approximately 93% of our net sales were
      generated by government or government-related work. We will continue to seek
      both government and commercial business and anticipate that net sales from
      government sources will continue to represent in excess of 80% of our net sales
      for the next several years. Currently, we are focusing on the domestic United
      States government market, which we believe is only about one-half of the global
      government market for our technology, products and services. Although we are
      interested in exploring increased international revenue and contract
      opportunities, we are restricted by export control regulations, including
      International Traffic in Arms Regulations, which may limit our ability to
      develop market opportunities outside the United States on some of our products.





At
      this
      time, over 99% of our forecasted sales for 2006 are under contract or near
      contract award. We may not be able to win enough new business to achieve our
      forecasted growth projection or to maintain a positive cash flow position.
      During the first nine months of 2006 we submitted approximately 60 bids for
      government or commercial programs ranging from $25,000 to $350 million and
      continued our work with the United States Congress to identify directed funding
      for our programs.





**Selection
      of Significant Contracts**




In
      June
      2002, Starsys was awarded a contract from Northrop Grumman Space Technology
      for
      the design, development, assembly, and test of two configurations of flat plate
      gimbal drive assemblies. These gimbals are used to position six dish antenna’s
      and two nulling antenna systems for each of two spacecraft. Subsequent to this
      award, Northrop Grumman Space Technology modified this contract to include
      a
      third shipset bringing the total contract value to $7.05 million. In addition
      to
      eight flight unit deliveries per spacecraft, the program includes development
      and qualification hardware. This contract was awarded as a firm fixed price
      contract with the final delivery scheduled for March 2007. Revenues from
      February 1, 2006 (our acquisition date of Starsys) through June 30, 2006 totaled
      approximately $1.8 million. We did not recognize any revenue or profit/loss
      during the 2006 third quarter relating to this contract, since we are pursuing
      contract modifications to cover significant cost, scope and requirements changes
      and overruns.





On
      March
      31, 2004, we were awarded a five-year, cost-plus-fixed fee indefinite
      delivery/indefinite quantity contract for up to $43,362,271 to conduct a
      microsatellite distributed sensing experiment in support of the Advanced Systems
      Deputate of the Missile Defense Agency, which contract was originally awarded
      on
      March 31, 2004. The microsatellite distributed sensing experiment is now
      intended to analyze, design, develop, fabricate, integrate, test, operate and
      support a networked cluster of three formation-flying boost phase and midcourse
      tracking microsatellites to support national missile defense. This overall
      contract is proceeding under a phased approach. The first phase, executed under
      Task Order I for approximately $1.1 million was completed on September 30,
      2004
      and resulted in a general mission and microsatellite design. The second phase,
      executed under Task Order II for approximately $8.3 million was awarded in
      October 2004 and was originally expected to be completed by January 2006 but
      was
      extended at the request of the Missile Defense Agency with an increased funding
      of $1.5 million, and subsequently completed on March 31, 2006. Task Order II
      resulted in a detailed mission and microsatellite design, as exemplified by
      a
      successful Critical Design Review in March 2006. Task Order III, the first
      of
      several task orders expected during the third phase, was awarded to us on April
      1, 2006 for a total of approximately $1.5 million, which was later amended
      to
      approximately $2.5 million and ran through June 30, 2006. Task Order IV was
      awarded by the Missile Defense Agency in July 2006, with initial funding of
      approximately $4.0 million through November 30, 2006. We expect continued
      modifications to the current phase with additional task orders throughout 2006
      and 2007. In addition to the three networked microsats under our second Task
      Order, the $43 million contract also originally envisioned an option for a
      second cluster of three microsats using laser communication technology.  We
      were informed in 2005 that the Missile Defense Agency had re-routed the laser
      communications experiment to another program and that they would not be
      exercising their option for the additional microsats at that time; however,
      the
      contract vehicle remained at $43 million and left open the opportunity for
      some
      other purchase to take its place. The
      IDIQ
      (indefinite delivery, indefinite quantity) nature of the contract allows for
      replenishment of funds by MDA within the same contract vehicle, as work is
      performed and we recognize revenue. We estimated that the second cluster would
      have represented approximately $10 million of the $43.3 million contract, and
      we
      reduced our current backorder accordingly. However,
      due to changes in the scope of work and length of the contract, we currently
      believe that the contract total will be back to the original $43.3 million
      and
      the remaining unbilled contract backlog of approximately $28.1 million to be
      secure. We recognized approximately $15.2 million in revenue under this contract
      from inception through September 30, 2006.





17


In
      January 2005, Starsys was awarded a firm fixed price contract from Raytheon
      in
      Goleta, California for the design, development, manufacture, assembly and test
      of the Aerosol Polarimetry Sensor (APS), Scan Mirror Motor/Encoder Assembly
      (SMMA). The APS instrument is slated to fly on the NASA Glory mission featuring
      the Aerosol Polarimetry Sensor. The APS is also a prime candidate for a
      secondary payload on NPOESS. The SMMA consists of Starsys designed low ripple,
      precision brushless DC motor and optical encoder assembly. The program consists
      of a development unit, engineering unit, qualification / life test unit, and
      flight units. This contract was awarded as a cost plus, fixed fee contract
      at a
      value of $2.98 million and will conclude in December 2006. Revenues from
      February 1, 2006 (our acquisition date of Starsys) through September 30, 2006
      totaled approximately $1.5 million





On
      July
      18, 2005, we were awarded a subcontract to provide scientific, engineering,
      development and programmatic support to the development and demonstration of
      innovative SSA (space situational awareness) nanosatellite (<15kg)
      spacecraft. SSA is the ability to search, identify and monitor spacecrafts
      for
      the purpose of obtaining space superiority. The subcontract covers the
      conceptual/preliminary phase of development and includes all aspects of
      potential systems from the platforms and associated payloads to the links and
      nodes and ground support. The cost plus fixed fee subcontract resulted in
      revenues of approximately $120,000. We completed this subcontract in December
      2005. In January 2006, we submitted a proposal for the next phase subcontract
      and, in March 2006, we were awarded the subcontract in the amount of
      approximately $1.2 million and began work on this phase. Revenues from February
      1, 2006 (our acquisition date of Starsys) through September 30, 2006 totaled
      approximately $720,000.





In
      October 2005, Starsys was awarded a contract from General Dynamics C4 Systems
      to
      design and deliver an antenna pointing gimbal and control electronics for the
      GeoEye-1 program. The contract, valued at $2.0 milliom, was awarded and work
      has
      already begun on the antenna in anticipation of an on-time delivery to General
      Dynamics. The GeoEye-1 program is a next-generation, high-resolution commercial
      remote-sensing satellite scheduled for launch in early 2007. The Starsys antenna
      control system is uniquely designed to operate by greatly reducing motion,
      to
      the GeoEye-1 spacecraft while pictures are being taken and data is
      simultaneously transmitted to earth ground stations, through incorporation
      of a
      low disturbance designed micro-stepping actuator and actuator drive electronics
      (QuAD). Revenues from February 1, 2006 (our acquisition date of Starsys) through
      September 30, 2006 totaled approximately $1.4 million





On
      February 28, 2006, we were awarded two Boom Technology contracts for advance
      research and development of a self-deployed articulated boom for approximately
      $950,000 and a jack screw deployed boom for approximately $1.5 million by the
      Air Force Research Laboratory.  AFRL placed these contracts with Starsys
      which will leverage the significant technical talent and advances Starsys
      engineers have already made in this critical space technology. Revenues from
      February 1, 2006 (our acquisition date of Starsys) through September 30, 2006
      totaled approximately $1.4 million.





In
      June
      2006, Starsys was awarded a firm fixed price contract from Lockheed Martin
      Commercial Space Systems for the design, and fabrication of the antenna pointing
      gimbals onboard the US Navy’s, Mobile User Objective System. The initial award
      is for two flight shipsets and includes two standard A2100 5-meter antenna
      gimbal assemblies, four Ka-Band antenna gimbal assemblies and two 14-meter
      gimbal assemblies. Options are included for additional gimbals supporting three
      additional spacecraft. The contract will include the development and
      qualification of the Ka-Band and 14-meter gimbal designs in addition to the
      standard gimbals and solar array deployment hinges Starsys has previously
      provided for the A-2100 bus. Total contract value, with options exercised,
      exceeds $6.0 million. Revenues from February 1, 2006 (our acquisition date
      of
      Starsys) through September 30, 2006 totaled approximately $637,000.





18


In
      August
      2006, Starsys was awarded the solar array drive, antenna pointing actuators
      and
      gimbal control electronic assemblies for the Lunar Reconnaissance Orbiter
      program from NASA Goddard Space Flight Center and Swales Aerospace. The contract
      value is in excess of $6.3 million. The LRO mission is scheduled to launch
      in
      the fall of 2008 as part of NASA's Lunar Precursor and Robotic Program. The
      spacecraft requires two drive actuators to align the solar panels with the
      sun,
      and a two axis pointing mechanism to align the downlink antenna for
      communication with earth. Starsys is to provide these actuators for the
      spacecraft along with the electronics to control them. A total of seven
      actuators and five control electronics assemblies will be delivered under the
      contract. Revenues from February 1, 2006 (our acquisition date of Starsys)
      through September 30, 2006 totaled approximately $ 284,000.








**Results
      of Operations**




Please
      refer to the consolidated financial statements, which are a part of this report,
      for further information regarding the results of operations. Please note that
      due to our January 31, 2006 acquisition of Starsys, all 2006 comparisons to
      2005
      are of limited comparative value.





***Nine-Months
      Ended September 30, 2006 -vs.- Nine-Months Ended September 30,
      2005***





During
      the nine-months ending September 30, 2006, we had net sales of approximately
      $22.8 million as compared to net sales of approximately $5.9 million for the
      same nine month period in 2005. Sales increased primarily due to our acquisition
      of Starsys on January 31, 2006, which generated revenues from February 1, 2006
      through September 30, 2006 of approximately $14.2 million which include
      approximately $300,000 of inter-company sales. Sales also increased due to
      revenues of approximately $8.9 million from our historic SpaceDev business
      which
      consists of existing government contracts, including our contract with the
      Missile Defense Agency which generated revenues of approximately $6.7 million.
      For the nine-months ended September 30, 2006, revenue from government and
      government related work was approximately $20.0 million and revenue from
      commercial customers was approximately $2.8 million. Our government customers
      include but are not limited to the Missile Defense Agency, the Air Force
      Research Laboratory, NASA, and the U.S. Army. Our government related work
      customers include but are not limited to General Dynamics, Northrop Grumman
      and
      Raytheon. Commercial customers include Lockheed Martin and Sumitomo. Revenue
      for
      the nine-months ended September 30, 2005 primarily represented approximately
      $4.1 million of work on the Missile Defense Agency contract. Small Business
      Innovation Research contracts with the Air Force Research Laboratory represented
      sales of approximately $1.0 million in the nine-months ended September 30,
      2005
      while revenues from all other programs including our effort with Andrews Space
      totaled approximately $800,000.





For
      the
      nine-months ended September 30, 2006, we had costs of sales (direct and
      allocated costs associated with individual contracts) of approximately $16.7
      million, or 73.3% of net sales, as compared to approximately $4.6 million,
      or
      76.9% of net sales, during the same period in 2005. The increase in cost of
      sales and the improved gross margin percentage were both due to the higher
      margin contracts and products sold by Starsys. We continue to focus efforts
      on
      managing our growth including but not limited to recruiting new talented
      engineers, developing and acquiring project management skills and creating
      or
      expanding systems to assist in the efficient and effective management of our
      projects.





The
      Company is in contract discussions and re-negotiations with a major customer
      of
      Starsys over a significant fixed price development contract on which significant
      cost overruns occurred and under which the Company is seeking various forms
      of
      contract relief, amendments and changes. Pending the outcome of our ability
      to
      negotiate a contract modification, we have not included in our income statements
      any third quarter 2006 revenue, related cost of sales, or profit/loss on this
      contract. If we had included them, our reported 2006 revenues would have been
      higher and, if retroactive effect were give to the outcome of the negotiations,
      our reported 2006 net income/loss (and our EBITDA), would have been either
      higher or lower. The Company is actively pursuing contract modifications to
      cover these significant cost, scope and requirements changes and overruns on
      this contract.  As the total value, time and further requirements of the
      contract is currently uncertain, the Company has chosen not to recognize
      additional revenue under the “percentage of completion” method of
      accounting.  All revenues and costs related to the contract incurred since
      June 30, 2006 have been capitalized and are included in deferred revenue and
      WIP
      (Work-In-Process), which includes cost in excess of billings,
      respectively.  A resolution is expected before the fiscal year
      end.





19


We
      experienced an increase of approximately $4.9 million in operating expenses
      from
      approximately $1.1 million, or 19.3% of net sales, for the nine-month period
      ended September 30, 2005 to approximately $6.1 million, or 26.9% of net sales,
      for the nine-month period ended September 30, 2006. Operating expenses include
      general and administrative expenses, research and development expenses,
      marketing and sales expenses, and stock option expenses under SFAS
      123(R).


·
            General
                and administrative expenses increased approximately $3.3 million
                from
                approximately $645,000, or 10.9% of net sales, for the nine-months
                ended
                September 30, 2005 to approximately $4.0 million, or 17.5% of net
                sales,
                for the same nine-month period in 2006. This increase is attributed
                mainly
                to the acquisition of Starsys general and administrative costs and
                the
                addition of our new Chief Executive Officer. With the addition of
                our new
                Chief Executive Officer, Mr. Benson (formerly our Chief Executive
                Officer)
                became our Chief Technology Officer with most of his 2006 expenses
                being
                charged to research and development. Most of Mr. Benson’s expenses in 2005
                were charged to marketing and sales. In addition, we have created
                a
                corporate business management group and we expect to recognize some
                cost
                saving and efficiencies as the companies consolidate and eliminate
                redundancies in certain general and administrative functions.




·
            Research
                and development expenses increased to approximately $276,000, or
                1.2% of
                net sales, for the nine-months ended September 30, 2006, from
                approximately $9,600, or 0.2% of net sales, during the same period
                in
                2005. The total dollar value increased by approximately $266,000,
                mainly
                due to the creation of the Chief Technology Officer position at the
                end of
                2005, the reallocation of Mr. Benson’s expenses from marketing and sales
                to research and development and an investment in some new technologies.
                Most of our scientific work is performed under contracts and therefore
                is
                accounted for as costs of sales, rather than as R&D expense. On
                September 28, 2006, Mr. Benson****has
                stepped down from his role as Chief Technology Officer in order to
                launch
                a new independent venture, Benson Space Company, focused on the marketing
                of commercial space tourism.





·
            Marketing
                and sales expenses increased to approximately $1.9 million, or 8.2%
                of net
                sales, for the nine-months ended September 30, 2006, from approximately
                $493,000, or 8.3% of net sales, during the same period in 2005. The
                total
                dollar increase of approximately $1.4 million was mainly due to costs
                related to bidding a number of proposals, including approximately
                $800,000
                for our NASA COTS proposal, during the first nine-months of 2006
                as well
                as absorbing a larger marketing and sales organization as part of
                the
                merger with Starsys.





·
            Our
                stock option expense is based on a calculation using the minimum
                value
                method as prescribed by SFAS 123(R), otherwise known as the Black-Scholes
                method. Under this method, we used a risk-free interest rate at the
                date
                of grant, an expected volatility, an expected dividend yield and
                an
                expected life of the options to determine the fair value of options
                granted. The risk-free interest rate was estimated at 4.0%, expected
                volatility ranged from 86.7% to 89.1% at the time all options were
                granted, the dividend yield was assumed to be zero, and the expected
                life
                of the options was assumed to be three years based on the average
                vesting
                period of options granted. The total expense for the nine-months
                ended
                September 30, 2006 was approximately $101,000 as compared to no expense
                during the same period in 2005, as we adopted SFAS 123(R) on January
                1,
                2006.





Non-operating
      expense (income) consisted of interest expense, interest income, and deferred
      gain on the sale of our building, as well as other non-cash loan fees and
      expenses. Non-operating gain and income exceeded non-operating expenses
      beginning in 2005, and since then, we have recorded non-operating income.





·
            Interest
                expense for the nine-months ended September 30, 2006 and 2005 was
                approximately $18,000 and $2,000, respectively, as we incurred no
                interest
                expense on our former revolving credit facility, which had a zero
                balance
                for the nine-months ended September 30, 2006 and 2005. We have recently
                entered into a new revolving credit facility on September 29, 2006;
                however, the interest expense for the two days was insignificant.
                We
                generated interest income in the nine-months ended September 30,
                2006 and
                2005 of approximately $43,000 and $70,000, respectively, due to our
                cash
                management practices.





·
            We
                recognized approximately $88,000 of the deferred gain on the 2003
                sale of
                our Poway headquarters building during each of the nine-month periods
                ended September 30, 2006 and 2005, and we will continue to amortize
                the
                remaining deferred gain of approximately $743,000 into non-operating
                income over the remainder of the leaseback, which expires in January
                2013.





20


During
      the nine-months ended September 30, 2006, we generated net income of
      approximately $65,000, or 0.3% of net sales, despite recognizing over $101,000
      in non-cash charges related to expensing stock options under SFAS 123(R),
      compared to net income of approximately $348,000, or 5.9% of net sales, for
      the
      same nine-month period in 2005. During the nine-months ended September 30,
      2006,
      we incurred a positive EBITDA (earnings before interest, taxes depreciation
      and
      amortization) of approximately $682,000, or 3.0% of net sales, compared to
      a
      EBITDA of approximately $331,000, or 5.4% of net sales, for the nine-months
      ended September 30, 2005.





The
      following table reconciles Earnings Before Interest, Taxes, Depreciation and
      Amortization (EBITDA) to net income for the nine-months ended September 30,
      2006
      and 2005, respectively:





***For
                  the nine months ending***
              
              
              **September
                  30, 2006**
              
              
              September
                  30, 2005**(Unaudited)**
              
              
              (Unaudited)**Net
                  Income**
              
              ***$***
              ***64,678***
              
              $
              348,413Interest
                  Income
              
              
              ***(43,466***
              ***)***
              
              (69,631
              )Interest
                  Expense
              
              
              ***18,471***
              
              
              2,282Non-Cash
                  Interest Expense
              
              
              ***1,918***
              
              
              28,875Gain
                  on Building Sale
              
              
              ***(87,956***
              ***)***
              
              (87,954
              )Stock
                  Option Expense
              
              
              ***101,142***
              
              
              0Provision
                  for income taxes
              
              
              ***14,290***
              
              
              1,200Depreciation
                  and Amortization
              
              
              ***613,166***
              
              
              108,271**EBITDA
                  ***
              
              ***$***
              ***682,243***
              
              *$*
              *331,457*




EBITDA
      should not be considered as an alternative to net income (as an indicator of
      operating performance) or as an alternative to cash flow (as a measure of
      liquidity or ability to service debt obligations). We believe that EBITDA
      provides an important additional perspective on our operating results, our
      ability to service our long-term obligations, our ability to fund continuing
      growth, and our ability to continue as a going concern. Beginning in 2003
      through the current quarter in 2006, we showed continued progress in total
      revenue as well as in EBITDA.





21


The
      following charts illustrate our quarterly trend in total revenue as well as
      in
      EBITDA for the period from March 31, 2004 to September 30, 2006.














22


***For
                  the three months ending***
              
              
              3/31/04
              
              
              6/30/04
              
              
              9/30/04
              
              
              12/31/04
              
              
              3/31/05
              
              
              **6/30/05**
              
              
              **9/30/05**
              
              
              **12/31/05**
              
              
              **3/31/06**
              
              
              **6/30/06**
              
              
              **9/30/06**(Unaudited
              )
              
              (Unaudited
              )
              
              (Unaudited
              )
              
              (Unaudited
              )
              
              (Unaudited
              )
              
              **(Unaudited**
              **)**
              
              **(Unaudited**
              **)**
              
              **(Unaudited**
              **)**
              
              **(Unaudited**
              **)**
              
              **(Unaudited**
              **)**
              
              **(Unaudited**
              **)****Net
                  Income (Loss)**
              
              $
              (442,549
              )
              $
              (1,286,866
              )
              $
              (602,888
              )
              $
              (694,750
              )
              $
              101,223
              
              **$**
              **110,938**
              
              **$**
              **136,251**
              
              **$**
              **152,851**
              
              **$**
              **7,017**
              
              **$**
              **36,204**
              
              **$**
              **21,457**Interest
                  Income
              
              
              -
              
              
              -
              
              
              (5,619
              )
              
              (13,386
              )
              
              (7,960
              )
              
              **(36,824**
              **)**
              
              **(24,848**
              **)**
              
              **(36,208**
              **)**
              
              **(33,615**
              **)**
              
              **(7,137**
              **)**
              
              **(2,714**
              **)**Interest
                  Expense
              
              
              19,788
              
              
              19,736
              
              
              23,110
              
              
              (6,707
              )
              
              1,222
              
              
              **609**
              
              
              **452**
              
              
              **590**
              
              
              **5,283**
              
              
              **5,346**
              
              
              **7,842**Non-Cash
                  Interest Expense
              
              
              464,000
              
              
              1,329,313
              
              
              663,481
              
              
              797,636
              
              
              -
              
              
              **28,875**
              
              
              **-**
              
              
              **-**
              
              
              **-**
              
              
              **-**
              
              
              **1,918**Gain
                  on Building Sale
              
              
              (29,318
              )
              
              (29,318
              )
              
              (29,318
              )
              
              (29,318
              )
              
              (29,318
              )
              
              **(29,318**
              **)**
              
              **(29,318**
              **)**
              
              **(29,318**
              **)**
              
              **(29,318**
              **)**
              
              **(29,317**
              **)**
              
              **(29,316**
              **)**Stock
                  Option Expense
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              **-**
              
              
              **-**
              
              
              **-**
              
              
              **90,701**
              
              
              **24,992**
              
              
              **(14,551**
              **)**Provision
                  for income taxes
              
              
              -
              
              
              -
              
              
              -
              
              
              1,600
              
              
              400
              
              
              **400**
              
              
              **400**
              
              
              **400**
              
              
              **4,235**
              
              
              **5,000**
              
              
              **5,055**Depreciation
                  and Amortization
              
              
              15,954
              
              
              16,533
              
              
              22,749
              
              
              28,250
              
              
              29,061
              
              
              **35,077**
              
              
              **44,078**
              
              
              **83,708**
              
              
              **147,370**
              
              
              **225,130**
              
              
              **240,666****EBITDA**
              
              $
              27,874
              
              $
              49,398
              
              $
              71,515
              
              $
              83,325
              
              $
              94,628
              
              **$**
              **109,758**
              
              **$**
              **127,015**
              
              **$**
              **172,023**
              
              **$**
              **191,673**
              
              **$**
              **260,218**
              
              **$**
              **230,357**






On
      January 1, 2006, the Company adopted SFAS 123(R), which requires companies
      to
      measure an equity instrument based on the grant-date fair value of the award
      and
      expense the value. The Company uses the Black-Scholes pricing model to determine
      the fair value of its options on the measurement date. The cost is recognized
      over the requisite period (usually the vesting period). During the first nine
      months of 2006, the Company had stock option expense of approximately $101,000
      related to stock option awards coincident with the Starsys merger. Without
      the
      adoptions of SFAS 123(R), the Company's operating income, net income and net
      income per share would have been increased to the pro forma non-GAAP amounts
      indicated below:





23


**SpaceDev,
                  Inc. **and
                  Subsidiaries******Consolidated
                  Statements of Operations - Supplemental
                  Schedule***Three
                  Months Ended*
              
              
              
              *Nine
                  Months Ended**At
                  September 30,*
              
              
              2006
              %
              
              
              
              
              2005
              %
              
              
              
              
              
              2006
              %
              
              
              
              
              2005
              %**GAAP
                  Operating Income**
              
              **$**
              **4,239**
              
              
              **0.1**
              **%**
              $
              82,937
              
              
              1.4
              %
              
              **$**
              **(32,065**
              **)**
              
              **-0.1**
              **%**
              $
              223,185
              
              
              3.8
              %FAS
                  123(R) stock -based compensation
              
              
              **(14,551**
              **)**
              
              **-0.2**
              **%**
              
              -
              
              
              0.0
              %
              
              
              **101,142**
              
              
              **0.4**
              **%**
              
              -
              
              
              0.0
              %**Non-GAAP
                  Operating Income**
              
              
              **(10,312**
              **)**
              
              **-0.1**
              **%**
              
              82,937
              
              
              1.4
              %
              
              
              **69,077**
              
              
              **0.3**
              **%**
              
              223,185
              
              
              3.8
              %**Non-Operating
                  Income/(Expense)**Interest
                  income
              
              
              **2,714**
              
              
              **0.0**
              **%**
              
              24,848
              
              
              0.4
              %
              
              
              **43,466**
              
              
              **0.2**
              **%**
              
              69,632
              
              
              1.2
              %Interest
                  expense
              
              
              **(7,842**
              **)**
              
              **0.0**
              **%**
              
              (452
              )
              
              0.0
              %
              
              
              **(18,471**
              **)**
              
              **-0.1**
              **%**
              
              (2,283
              )
              
              0.0
              %Gain
                  on building sale
              
              
              **29,319**
              
              
              **0.1**
              **%**
              
              29,318
              
              
              0.5
              %
              
              
              **87,956**
              
              
              **0.4**
              **%**
              
              87,953
              
              
              1.5
              %Non-Cash
                  loan fee
              
              
              **(1,918**
              **)**
              
              **0.0**
              **%**
              
              0
              
              
              0.0
              %
              
              
              **(1,918**
              **)**
              
              **0.0**
              **%**
              
              (28,875
              )
              
              -0.5
              %**Total
                  Non-Operating Income**
              
              
              **22,273**
              
              
              **0.1**
              **%**
              
              53,714
              
              
              0.9
              %
              
              
              **111,033**
              
              
              **0.5**
              **%**
              
              126,427
              
              
              2.1
              %**Non-GAAP
                  Net Income Before Taxes**
              
              **$**
              **11,961**
              
              
              **0.1**
              **%**
              $
              136,651
              
              
              2.3
              %
              
              **$**
              **180,110**
              
              
              **0.8**
              **%**
              $
              349,612
              
              
              5.9
              %Income
                  tax provision
              
              
              **5,055**
              
              
              **0.0**
              **%**
              
              400
              
              
              0.0
              %
              
              
              **14,290**
              
              
              **0.1**
              **%**
              
              1,200
              
              
              0.0
              %**Non-GAAP
                  Net Income**
              
              **$**
              **6,906**
              
              
              **0.0**
              **%**
              $
              136,251
              
              
              2.3
              %
              
              **$**
              **165,820**
              
              
              **0.7**
              **%**
              $
              348,412
              
              
              5.9
              %**Non-GAAP
                  Net Income**
              
              
              **6,906**
              
              
              
              
              
              136,251
              
              
              
              
              
              
              **165,820**
              
              
              
              
              
              348,412Less
                  Preferred Dividend Payments
              
              
              **(150,842**
              **)**
              
              
              
              
              (42,737
              )
              
              
              
              
              
              **(446,791**
              **)**
              
              
              
              
              (128,210
              )**Adjusted
                  Net Income/(Loss) for EPS Calculation**
              
              
              **(143,936**
              **)**
              
              
              
              
              93,514
              
              
              
              
              
              
              **(280,971**
              **)**
              
              
              
              
              220,202**Non-GAAP
                  Net Income Per Share**
              
              **$**
              **(0.00**
              **)**
              
              
              
              $
              0.00
              
              
              
              
              
              **$**
              **(0.01**
              **)**
              
              
              
              $
              0.01Weighted-Average
                  Shares Outstanding
              
              
              **29,027,350**
              
              
              
              
              
              21,241,448
              
              
              
              
              
              
              **28,419,751**
              
              
              
              
              
              21,777,211**Fully
                  Diluted Non-GAAP Net Income Per Share:**
              
              **$**
              **(0.00**
              **)**
              
              
              
              $
              0.00
              
              
              
              
              
              **$**
              **(0.01**
              **)**
              
              
              
              $
              (0.01
              )Fully
                  Diluted Weighted-Average Shares Outstanding
              
              
              **29,027,350**
              
              
              
              
              
              23,831,994
              
              
              
              
              
              
              **28,419,751**
              
              
              
              
              
              25,230,427





The
      Company believes that evaluating its ongoing operating results with these
      non-GAAP measurements may be useful as a supplement to its standard GAAP
      financial measurement presentation. Accordingly, the Company has chosen certain
      non-GAAP financial information to evaluate its ongoing operations and for
      internal planning and forecasting purposes. The Company believes that non-GAAP
      financial measures should be considered in addition to, and not a substitute
      for, financial information prepared in accordance with GAAP. The Company
      presents such non-GAAP financial measures in reporting its financial results
      to
      provide additional and supplemental disclosure to evaluate operating results.
      Whenever the Company uses a non-GAAP financial measurement, it provides a
      reconciliation of the non-GAAP financial measure to the most closely applicable
      GAAP financial measurement.




***Three-Months
      Ended September, 2006 -vs.- Three-Months Ended September 30,
      2005***





In
      the
      three-months ended September 30, 2006, we had net sales of approximately $7.0
      million as compared to net sales of approximately $2.2 million for the same
      three month period in 2005. Sales increased primarily due to our acquisition
      of
      Starsys on January 31, 2006, which generated revenues for the third quarter
      of
      approximately $4.5 million. Sales also increased due to revenues for the third
      quarter of approximately $1.8 million from our historic SpaceDev business which
      consists of an existing contract with the Missile Defense Agency as well as
      other new and ongoing government business. For the three-months ended September
      30, 2006, revenue from government and government related work was approximately
      $5.9 million and revenue from commercial customers was approximately $1.1
      million. Revenue for the three-months ended September 30, 2005 primarily
      represented $1.4 million of work for the Missile Defense Agency contract. Small
      Business Innovation Research contracts with the Air Force Research Laboratory
      represented sales of approximately $800,000 in the three-months ended September
      30, 2005.





24


For
      the
      three-months ended September 30, 2006, we had costs of sales (direct and
      allocated costs associated with individual contracts) of approximately $5.1
      million, or 73.1% of net sales, as compared to approximately $1.7 million,
      or
      76.5% of net sales, during the same period in 2005. The increase in cost of
      sales and the improved gross margin percentage were both due to the higher
      margin contracts and products sold by Starsys. We continue to focus efforts
      on
      managing our growth including but not limited to recruiting new talented
      engineers, developing and acquiring project management skills and creating
      or
      expanding systems to assist in the efficient and effective management of our
      projects.





The
      Company is in contract discussions and re-negotiations with a major customer
      of
      Starsys over a significant fixed price development contract on which significant
      cost overruns occurred and under which the Company is seeking various forms
      of
      contract relief, amendments and changes. Pending the outcome of our ability
      to
      negotiate a contract modification, we have not included in our income statements
      any third quarter 2006 revenue, related cost of sales, or profit/loss on this
      contract. If we had included them, our reported third quarter 2006 revenues
      would have been higher and, if retroactive effect were give to the outcome
      of
      the negotiations, our reported third quarter 2006 net income/loss (and our
      EBITDA), would have been either higher or lower. The Company is actively
      pursuing contract modifications to cover these significant cost, scope and
      requirements changes and overruns on this contract.  As the total value,
      time and further requirements of the contract is currently uncertain, the
      Company has chosen not to recognize additional revenue under the “percentage
      of completion” method of accounting.  All revenues and costs related
      to the contract incurred since June 30, 2006 have been capitalized and are
      included in deferred revenue and WIP (Work-In-Process), which includes cost
      in
      excess of billings, respectively.  A resolution is expected before the
      fiscal year end.





We
      experienced an increase of approximately $1.4 million in operating expenses
      from
      approximately $442,000, or 19.8% of net sales, for the three-month period ended
      September 30, 2005 to approximately $1.9 million, or 26.8% of net sales, for
      the
      three-month period ended September 30, 2006. Operating expenses include general
      and administrative expenses, research and development expenses, marketing and
      sales expenses, and stock option expenses under SFAS 123(R).





·
            General
                and administrative expenses increased approximately $1.0 million
                from
                approximately $253,000, or 11.3% of net sales, for the three-months
                ended
                September 30, 2005 to approximately $1.3 million, or 18.3% of net
                sales,
                for the same three-month period in 2006. This increase is attributed
                mainly to the acquisition of Starsys general and administrative costs
                and
                the addition of our new Chief Executive Officer. With the addition
                of our
                new Chief Executive Officer, Mr. Benson (formerly our Chief Executive
                Officer) became our Chief Technology Officer with most of his third
                quarter 2006 expenses being charged to research and development.
                Most of
                Mr. Benson’s expenses in the third quarter of 2005 were charged to
                marketing and sales. In addition, we have created a corporate business
                management group and we expect to recognize some cost saving and
                efficiencies as the companies consolidate and eliminate redundancies
                in
                certain general and administrative functions.




·
            Research
                and development expenses increased to approximately $71,000 or 1.0%
                of net
                sales for the three-months ended September 30, 2006, from approximately
                $400, or 0.0% of net sales, during the same period in 2005. The total
                dollar value increased by approximately $70,000, mainly due to creation
                of
                the Chief Technology Officer position at the end of 2005, the reallocation
                of Mr. Benson’s expenses from marketing and sales to research and
                development and an investment in some new technologies. Most of our
                scientific work is performed under contracts and therefore is accounted
                for as costs of sales, rather than as R&D expense. On September 28,
                2006, Mr. Benson****has
                stepped down from his role as Chief Technology Officer in order to
                launch
                a new independent venture, Benson Space Company, focused on the marketing
                of commercial space tourism.




25


·
            Marketing
                and sales expenses increased to approximately $525,000, or 7.5% of
                net
                sales, for the three-months ended September 30, 2006, from approximately
                $189,000, or 8.4% of net sales, during the same period in 2005. The
                total
                dollar increase of approximately $336,000 was mainly due to costs
                related
                to bidding a number of proposals, including approximately $139,000
                for our
                NASA COTS proposal during the three months ended September 30, 2006
                as
                well as absorbing a larger marketing and sales organization as part
                of the
                merger with Starsys.





·
            Our
                stock option expense is based on a calculation using the minimum
                value
                method as prescribed by SFAS 123(R), otherwise known as the Black-Scholes
                method. Under this method, we used a risk-free interest rate at the
                date
                of grant, an expected volatility, an expected dividend yield and
                an
                expected life of the options to determine the fair value of options
                granted. The risk-free interest rate was estimated at 4.0%, expected
                volatility was 86.7%, the dividend yield was assumed to be zero,
                and the
                expected life of the options was assumed to be three years based
                on the
                average vesting period of options granted. The total expense for
                the
                three-months ended September 30, 2006 was approximately($15,000)
                as compared to no expense during the same period in 2005, as we adopted
                SFAS 123(R) on January 1, 2006. The credit was due to a recapture
                of
                expenses for conditional options where the conditions were not met.




Non-operating
      expense (income) consisted of interest expense, interest income, and deferred
      gain on the sale of our building, as well as other non-cash loan fees and
      expenses. Non-operating gain and income exceeded non-operating expenses
      beginning in 2005, and since then, we have recorded non-operating income.





·
            Interest
                expense for the three-months ended September 30, 2006 and 2005 was
                approximately $7,800 and $500, respectively. We generated interest
                income
                in the three-months ended September 30, 2006 and 2005 of approximately
                $2,700 and $25,000, respectively, as our funds available for investment
                declined.




·
            We
                recognized approximately $29,000 of the 2003 deferred gain on the
                sale of
                our Poway headquarters building during each of the three-months ending
                September 30, 2006 and 2005, and we will continue to amortize the
                remaining deferred gain of approximately $743,000 into non-operating
                income over the remainder of the leaseback, which expires in January
                2013.





During
      the three-months ended September 30, 2006, we experienced net income of
      approximately $21,000, or 0.3% of net sales, which includes a recapture of
      approximately $15,000 in non-cash charges related to expensing stock options
      under SFAS 123(R), compared to net income of approximately $136,000, or 6.1%
      of
      net sales, for the same three-month period in 2005. During the three-months
      ended September 30, 2006, we incurred a positive EBITDA (earnings before
      interest taxes depreciation and amortization) of approximately $230,000, or
      3.3%
      of net sales, compared to a EBITDA of approximately $127,000, or 5.7% of net
      sales, for the three-months ended September 30, 2005.





26


The
      following table reconciles EBITDA to net income for the three-months ended
      September 30, 2006 and 2005, respectively. The 2006 third quarter represents
      another consecutive quarter of positive EBITDA:





***For
                  the three months ending***
              
              
              **September
                  30, 2006**
              
              
              September
                  30, 2005**(Unaudited)**
              
              
              (Unaudited)**Net
                  Income**
              
              ***$***
              ***21,457***
              
              $
              136,251Interest
                  Income
              
              
              ***(2,714***
              ***)***
              
              (24,848
              )Interest
                  Expense
              
              
              ***7,842***
              
              
              452Non-Cash
                  Interest Expense
              
              
              ***1,918***
              
              
              -Gain
                  on Building Sale
              
              
              ***(29,319***
              ***)***
              
              (29,318
              )Stock
                  Option Expense
              
              
              ***(14,551***
              ***)***Provision
                  for income taxes
              
              
              ***5,055***
              
              
              400Depreciation
                  and Amortization
              
              
              ***240,666***
              
              
              44,078**EBITDA
                  ***
              
              ***$***
              ***230,354***
              
              *$*
              *127,015*


*
      Earnings Before Interest, Taxes, Depreciation and Amortization. We exclude
      stock
      option expense and non-cash loan fees from EBITDA as well. Not every company
      that reports EBITDA defines it in the same way.




EBITDA
      should not be considered as an alternative to net income (as an indicator of
      operating performance) or as an alternative to cash flow (as a measure of
      liquidity or ability to service debt obligations). We believe that EBITDA
      provides an important additional perspective on our operating results, our
      ability to service our long-term obligations, our ability to fund continuing
      growth, and our ability to continue as a going concern.





**Liquidity
      and Capital Resources**





***Cash
      Flows for Nine-Months Ended September 30, 2006 -vs.- Nine-Months Ended September
      30, 2005***





Net
      decrease in cash during the nine-months ended September 30, 2006 was
      approximately $2.1 million compared to a cash decrease of $1.0 million for
      the
      same nine-month period in 2005, primarily due to the acquisition of Starsys
      Research Corporation and related debt repayment and transaction costs. These
      items were partially offset by the sale of our Series D-1 Preferred Stock to
      a
      small group of institutional investors in January 2006. Net cash used in
      operating activities totaled approximately $1.3 million for the nine-months
      ended September 30, 2006, a decrease of approximately $1.6 million, as compared
      to approximately $313,000 provided by operating activities during the same
      nine-month period in 2005, primarily due to the need to use our cash resources
      to pay accounts payable and fund accounts receivable, which we assumed upon
      the
      acquisition of Starsys.





Net
      cash
      used in investing activities totaled approximately $2.2 million for the
      nine-months ended September 30, 2006, compared to approximately $2.0 million
      used in investing activities during the same nine-month period in 2005. The
      slight increase in cash used in investing activities is primarily due to our
      forgiving our $1.2 million loan to Starsys, which was insolvent at the time
      we
      acquired it, as well as an increase in the purchases of fixed assets. We had
      made this loan to Starsys during the third quarter of 2005.





Net
      cash
      provided by financing activities totaled approximately $1.5 million for the
      nine-months ended September 30, 2006, which is an increase of approximately
      $875,000 from the approximately $620,000 provided by financing activities during
      the same nine-months in 2005. This is primarily attributable to the sale of
      our
      Series D-1 Preferred Stock in January 2006, which was then used to fund the
      merger with Starsys and pay off secured debt, and to our new revolving credit
      facility that we opened in September 2006.




At
      September 30, 2006, our cash, which included cash reserves and cash available
      for investment, was approximately $3.7 million, as compared to approximately
      $4.0 million at September 30, 2005, a decrease of approximately $300,000.





27


As
      of
      September 30, 2006, our backlog of funded and non-funded business was
      approximately $50 million, compared to approximately $33 million as of September
      30, 2005.





As
      of
      September 30, 2006 there has been no material changes in the Company's
      utilization of net operating carryforwards or effective tax rate from those
      reported in our form 10-KSB annual report filed on March 28, 2006. 
Pursuant to Internal Revenue Code Section 382 and 383, our use of net operating
      loss and credit carry forwards may be limited as a result of the cumulative
      changes in the ownership of more than 50% over a three year period.





Our
      ability to increase cash generation from operations and thereby avoid a
      necessity to need to raise additional capital depends upon our ability to
      ultimately implement our business plan, which includes (but is not limited
      to)
      our ability to effectively integrate operations with Starsys, manage the
      uncertainties in the government budgeting process, implement cost controls
      and
      limit the possibility of further cost overruns on fixed-price contracts, and
      generate substantial new revenue from customers, including but not limited
      to,
      the Missile Defense Agency.





**Critical
      Accounting Standards**




Due
      to
      the acquisition of Starsys, our revenues transitioned in 2006 from being
      primarily cost plus fixed fee contracts, where revenues are recognized as costs
      are incurred and services are performed, to a combination of cost plus fixed
      fee
      contracts and fixed-price contracts, where revenues are recognized using the
      percentage-of-completion method of contract accounting based on the ratio of
      total costs incurred to total estimated costs. Losses on contracts are
      recognized when they become known and reasonably estimable (see the Notes to
      our
      Consolidated Financial Statements). Actual results of contracts may differ
      from
      management's estimates and such differences could be material to the
      consolidated financial statements. In
      addition, when the total value of a contract becomes uncertain (such as when
      a
      contract modification to reflect cost overruns is being negotiated), we may
      be
      unable to report further revenues on the contract under the
      percentage-of-completion method until the uncertainty is resolved.





Professional
      fees are billed to customers on a time-and-materials basis, a fixed-price basis
      or a per-transaction basis. Time-and-materials revenues are recognized as
      services are performed. Deferred revenue represents amounts collected from
      customers for services to be provided at a future date. Research and development
      costs are expensed as incurred.





In
      October 1995, the Financial Accounting Standards Board (FASB) issued Statement
      of Financial Accounting Standards (SFAS) No. 123, *Accounting
      for Stock-Based Compensation.* We
      adopted SFAS No. 123 in 1997. Through December 31, 2005, we have elected to
      measure compensation expense for our stock-based employee compensation plans
      using the intrinsic value method prescribed by APB Opinion No. 25, *Accounting
      for Stock Issued to Employees* and
      provided pro forma disclosures as if the fair value based method prescribed
      in
      SFAS No. 123 had been utilized. (See Note 4 to our Consolidated Financial
      Statements.)





SFAS
      No.
      148, *Accounting
      for Stock-Based Compensation - Transition and Disclosure* ,
      which
      amends SFAS No. 123, *Accounting
      for Stock-Based Compensation* ,
      was
      published by the FASB on December 31, 2002. The effective date of SFAS No.
      148
      was December 15, 2002. SFAS No. 123 prescribes a "fair value" methodology to
      measure the cost of stock options and other equity awards. Companies may elect
      either to recognize fair value stock-based compensation costs in their financial
      statements or to disclose the pro forma impact of those costs in the footnotes.
      Through December 31, 2005, we had chosen the latter approach.





In
      December 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based
      Payment* (SFAS
      123(R)), which replaces SFAS No. 123 and supersedes APB Opinion No. 25. SFAS
      123(R) requires all share-based payments to employees, including grants and
      vesting of employee stock options beginning January 1, 2006, to be recognized
      in
      the financial statements based on their fair values. In addition, the adoption
      of SFAS 123(R) requires additional accounting related to the income tax effects
      and additional disclosure regarding the cash flow effects resulting from
      share-based payment arrangements. SFAS 123(R) became effective January 1, 2006
      for calendar year companies. Accordingly, we implemented the revised standard
      in
      the first quarter of 2006. (See Note 4 to our consolidated financial statements
      for additional information.)





28


On
      December 20, 2005, in response to SFAS 123(R), our Board of Directors
      accelerated the vesting of all unvested stock options held by current employees,
      including executive officers, and members of the Board of Directors.





**Recent
      Accounting Pronouncements**




There
      were no recent Accounting Pronouncements that affected the Company during the
      third quarter of 2006. For past pronouncements, please refer to our Form 10-KSB
      filed on March 28, 2006.





**Risk
      Factors**




The
      following factors, among others, could cause actual results to differ materially
      from those contained in forward-looking statements made herein and presented
      elsewhere by management from time to time.





**Risks
      Related to** **our
      Company**





***SpaceDev
      and Starsys have experienced losses from operations in prior periods and have
      been required to seek additional financing to support their
      businesses.***





In
      prior
      years, both SpaceDev and Starsys have experienced operating losses and, in
      some
      periods, revenues from operations have not been sufficient to fund their
      respective operations. On a pro forma basis, the combined company would have
      had
      a net loss from operations of approximately $5.0 million for the year ended
      December 31, 2004 and $2.9 million for the year ended December 31, 2005,
      assuming the merger had occurred on January 1, 2004. Starsys was insolvent
      at
      the time we acquired it. The success of the combined company's business depends
      upon our ability to generate revenue from existing contracts, to execute
      programs cost-effectively, to attract and successfully complete additional
      government and commercial contracts, and possibly to obtain additional
      financing. The likelihood of our success must be considered in light of the
      expenses, difficulties and delays frequently encountered in connection with
      developing businesses, those historically encountered by us, and the competitive
      environment in which we operate.





***If
      we are unable to raise capital, we may be unable to fund operating cash
      shortfalls and future growth opportunities.***





In
      the
      past, both SpaceDev and Starsys have relied upon cash from financing activities
      to fund part of the cash requirements of their respective businesses. We may
      need additional financing to fund our projected operations or expansion plans.
      Additional financing may not be available to us on acceptable terms, or at
      all.
      Any financing may cause additional dilution to existing shareholders. Any debt
      financing or other issuance of securities senior to common stock likely will
      include financial and other covenants that will restrict our operating
      flexibility and our ability to pay dividends to common shareholders.





***Some
      of our government contracts, including our large Missile Defense Agency
      contract, are staged and we cannot guarantee that all stages of the contracts
      will be awarded to us.***





Some
      of
      our government contracts are phased contracts in which the customer may
      determine to terminate the contract between phases for any reason. Accordingly,
      the entire contract amount may not be realized by us. In the event that
      subsequent phases of some of our government contracts, including but not limited
      to the Missile Defense Agency contract, are not awarded to us, it could have
      a
      material adverse effect on our financial position and results of operations.





29


***We
      provide our products and services primarily through fixed-price and cost plus
      fixed fee contracts. Starsys has experienced significant losses on fixed-price
      contracts. Cost overruns may result in further losses and, if significant,
      could
      impair our liquidity position.***





Under
      fixed-price contracts, our customers pay us for work performed and products
      shipped without adjustment for the costs we incur in the process. Therefore,
      we
      generally bear all or a significant portion of the risk of losses as a result
      of
      increased costs on these contracts. Starsys has experienced significant cost
      overruns on development projects under its fixed-price contracts, resulting
      in
      estimated losses on uncompleted contracts of $2.7 million for Starsys' fiscal
      2004, and an additional $2.5 million for the twelve months ended December 31,
      2005. As of December 31, 2005, based on a formal evaluation process, Starsys
      reserved approximately $1.5 million for potential risks on these remaining
      development projects, which has been reduced to approximately $855,000 as of
      September 30, 2006. Fixed-price contracts may provide for sharing of unexpected
      costs incurred or savings realized within specified limits and may provide
      for
      adjustments in price depending on actual contract performance other than costs.
      We bear the entire risk of cost overruns in excess of the negotiated maximum
      amount of unexpected costs to be shared. Starsys experienced significant cost
      overruns on a sizable contract, particularly in the third quarter of 2006.
      We
      are attempting to negotiate with the customer for a contract modification which
      would defray some or all of the cost overruns, but there can be no assurance
      that this negotiation will be successful. Any significant overruns in the future
      could materially impair our liquidity and operations.





When
      contract provisions produce unfavorable results for us, or fixed price
      development contracts result in losses, we generally do not have the legal
      or
      economic leverage needed to easily obtain renegotiated terms.  Our
      customers generally would not fear any threat we might make to withhold future
      business, and our financial and business position make litigation an unfavorable
      option for us.  On the other hand, the reverse might be true of our
      customer, who tend to be large aerospace companies with significant
      resources.  For example, we are currently seeking to negotiate revisions to
      a major Starsys fixed-price contract on which we have experienced
      significant cost overruns, but there can be no assurance that our attempt to
      renegotiate will be successful.  In addition, United States government
      contracts are generally terminable for convenience by the customer, but we
      generally do not have a corresponding contractual right to terminate our
      important contracts for convenience.





Under *cost
      plus fixed fee contracts* ,
      we are
      reimbursed for allowable incurred costs plus a fee, which may be fixed or
      variable. There is no guarantee as to the amount of fee we will be awarded
      under
      a cost plus fixed fee contract with a variable fee. The price on a cost plus
      fixed fee reimbursable contract is based on allowable costs incurred, but
      generally is subject to contract funding limitations. Therefore, we could bear
      the amount of costs in excess of the funding limitation specified in the
      contract, and we may not be able to recover those cost overruns.





***If
      we fail to integrate our operations effectively, the combination of SpaceDev
      and
      Starsys will not realize all the potential benefits of the merger and may be
      counterproductive.***





The
      integration of SpaceDev and Starsys is ongoing and may be time consuming and
      expensive and may disrupt the combined company's operations if it is not
      completed in a timely and efficient manner. If this integration effort is not
      successful, the combined company's results of operations could be harmed. In
      addition, the combined company may not achieve anticipated synergies or other
      benefits of the merger. The combined company may encounter difficulties, costs
      and delays involved in integrating their operations, including but not limited
      to the following:




·
            failure
                to successfully manage relationships with customers and other important
                relationships;


·
            failure
                of customers to accept new services or to continue using the products
                and
                services of the combined company;


·
            difficulties
                in successfully integrating the management teams and employees of
                the two
                companies;


·
            potential
                incompatibility of business cultures;


·
            challenges
                encountered in managing larger, more geographically dispersed operations;


·
            the
                loss of key employees;


·
            diversion
                of the attention of management from other ongoing business concerns;


·
            potential
                incompatibilities of processes, technologies and systems;
                and


·
            potential
                difficulties integrating and harmonizing financial reporting
                systems.





30


If
      the
      combined company's operations do not meet the expectations of existing customers
      of either company, these customers may reduce the amount of business or cease
      doing business with the combined company altogether, which would harm the
      results of operations and financial condition of the combined company.





If
      the
      anticipated benefits of the merger are not realized or do not meet the
      expectations of financial or industry analysts, the market price of SpaceDev
      common stock may decline. This could occur if, among other reasons:


·
            the
                integration of the two companies is unsuccessful;


·
            the
                combined company does not achieve the expected benefits of the merger
                as
                quickly as anticipated or the costs of or operational difficulties
                arising
                from the merger are greater than anticipated;


·
            the
                combined company's financial results after the merger are not consistent
                with the expectations of management or financial or industry analysts;


·
            the
                anticipated operating and product synergies of the merger are not
                realized;


·
            the
                combined company experiences the loss of significant customers or
                employees as a result of the merger; or


·
            Starsys'
                business continues to incur major cost overruns or remains unprofitable
                for other reasons.





***We
      need to invest in Starsys to support its business
      recovery.***





Starsys
      was insolvent at the time of the merger and we have begun making
      post-acquisition cash investments into Starsys. As stated previously, SpaceDev
      and Starsys have experienced losses from operations in prior periods, requiring
      that we seek additional financing to support our businesses. Our operating
      plans
      assume revenue and cash growth from SpaceDev and Starsys. If we are unable
      to
      effectively integrate our new subsidiary, or if we are unable to create positive
      cash flow within SpaceDev or Starsys, our cash flow and operating results could
      be adversely affected.





***A
      substantial portion of our net sales are generated from government contracts,
      which makes us susceptible to the uncertainties inherent in the government
      budgeting process. In addition, many of our contracts can be terminated by
      the
      customer.***





Our
      concentration of government work makes us susceptible to government budget
      cuts
      and policy changes, which may impact the award of new contracts or future phases
      of existing contracts. Government budgets (both in general and as to space
      and
      defense projects) are subject to the prevailing political climate, which is
      subject to change at any time. Additionally, awarded contracts could be altered
      or terminated prior to the time we recognize our projected revenue. Many
      contracts are awarded in phases where future phases are not guaranteed to us.
      In
      addition, obtaining contracts and subcontracts from government agencies is
      challenging, and contracts often include provisions that are not standard in
      private commercial transactions. For example, government contracts
      may:





·
            include
                provisions that allow the government agency to terminate the contract
                without penalty under some circumstances;


·
            be
                subject to purchasing decisions of agencies that are subject to political
                influence;


·
            contain
                onerous procurement procedures; and


·
            be
                subject to cancellation if government funding becomes unavailable.





Securing
      government contracts can be a protracted process involving competitive bidding.
      In many cases, unsuccessful bidders may challenge contract awards, which can
      lead to increased costs, delays and possible loss of the contract for the
      winning bidder.





31


In
      addition, major contracts are often awarded to teams of companies. Therefore,
      our ability to win contracts may depend not only on our own merits, but also
      those of our bid team members. Also, if we do not lead the bid team as the
      prime
      contractor, we will have limited control over the contract bid and award
      processes.





Finally,
      prime contracts in our business may be large in dollar amount and critical
      to
      national interests. As a practical matter, smaller companies are at a
      disadvantage when competing to be awarded such contracts as the prime
      contractors, due to the customer perception that larger companies might be
      more
      stable.





***Our
      common shareholders will experience dilution if our preferred stock is converted
      or our outstanding warrants and options are
      exercised.***





As
      of
      September 30, 2006, we are obligated to issue 9,063,433 shares of SpaceDev
      common stock if all of our outstanding warrants are exercised and shares of
      preferred stock converted.  In addition, as of September 30, 2006, we had
      outstanding stock options to purchase an aggregate of 11,547,700 shares of
      SpaceDev common stock, of which 10,256,700 are currently vested.  The total
      number of shares, issuable upon the exercise or conversion of currently vested
      warrants, options and preferred stock (19,320,133 shares) represents
      approximately 66% of our issued and outstanding shares of common stock as of
      September 30, 2006.





***Our
      historic SpaceDev business' limited operating history and lack of experience
      in
      our new or proposed lines of business make it difficult to predict our future
      prospects.***





Although
      Starsys has an operating history of almost twenty years, SpaceDev’s historic
      business has a limited operating history and, as a result, our pro forma
      historical financial information is of limited value in projecting our future
      success in these markets. SpaceDev launched its first microsatellite, CHIPSat,
      in January 2003 and, in June, September and October, 2004, SpaceDev’s hybrid
      rocket technology was first utilized in connection with SpaceShipOne. We hope
      to
      sell an increasing percentage of SpaceDev's products and services in commercial
      markets, but virtually all of SpaceDev's historical work has been from
      government contracts and government-related work. Our microsatellites,
      nanosatellites and launch services may not achieve market acceptance, and our
      future prospects are therefore difficult to evaluate.





In
      addition to many other risks involving this effort, we recently announced our
      intention to enter the launch services market by providing a microsat bus,
      integration services, and a launch vehicle as a package. We will be dependent
      on
      the performance of Space Exploration Technologies, a small company with limited
      operating history which has not yet had a successful launch, for our first
      launch vehicle.





***We
      may not successfully or timely develop products.***





Many
      of
      our products and technologies are currently in various stages of development.
      Further development and testing of our products and technologies will be
      required to prove additional performance capability beyond current levels and
      to
      confirm commercial viability. Additionally, the final cost of development cannot
      be determined until development is complete. Most of our development work is
      in
      fact performed under contracts from our customers. Our ongoing and future
      product development will depend, in part, on the ability to timely complete
      our
      projects within estimated cost parameters and ultimately deploy the product
      in a
      cost-effective manner. In addition, Starsys has contracted to execute
      development programs under fixed price contracts. Under these contracts, even
      if
      our costs begin to exceed the amount to be paid by the customer under the
      contract, we are required to complete the contract without receiving any
      additional payments from the customer. It is difficult to predict accurately
      the
      total cost of executing these programs. If the costs to complete these programs
      significantly exceed the payments from the customers under the contracts, our
      results of operations will be harmed.





32


Our
      products and services are and will continue to be subject to significant
      technological change and innovation. Our success will generally depend on our
      ability to continue to conceive, design, manufacture and market new products
      and
      services on a cost-effective and timely basis. We anticipate that we will incur
      significant expenses in the design and initial manufacture and marketing of
      new
      products and services.




***The
      marketplace for our technology and products is
      uncertain.***





The
      demand for our technology, products and services is uncertain and we may not
      obtain a sufficient market share to sustain our business or to increase
      profitability. Our business plan assumes that near-term revenues will be
      generated largely from government contracts for microsatellites and
      electromechanical systems for spacecraft with a long-term commercial market
      developing for private manned and unmanned space exploration. Microsatellites
      and commercial space exploration are still relatively new concepts, and it
      is
      difficult to predict accurately the ultimate size of the market. In addition,
      we
      are developing new product areas such as large deployable structures, solar
      array drives, slip rings and precision scanning assemblies for spacecraft.
      Many
      of our products and services are new and unproven, and the true level of
      customer demand is uncertain. Lack of significant market acceptance of our
      products and services, delays in such acceptance, or failure of our markets
      to
      develop or grow could negatively affect our business, financial condition,
      and
      results of operations.





***Our
      operating results could fluctuate on a quarterly and annual basis, which could
      cause our stock price to fluctuate or decline.***





Our
      operating results may fluctuate from quarter-to-quarter and year-to-year for
      a
      variety of reasons, many of which are beyond our control. Factors that could
      affect our quarterly and annual operating results include those listed below
      as
      well as others listed in this "Risk Factors" section:





·
            we
                may not be awarded all stages of existing or future contracts;


·
            significant
                contracts may be awarded to our competitors rather than to
                us;


·
            the
                timing of new technological advances and product announcements or
                introductions by us and our competitors;


·
            changes
                in the terms of our arrangements with customers or suppliers;


·
            our
                current reliance on a few customers for a significant portion of
                our net
                sales;


·
            the
                failure of our key suppliers to perform as expected;


·
            general
                or particular political conditions that could affect spending for
                the
                products that we offer;


·
            changes
                in perception of the safety of space
                travel;


·
            delays
                or failures to satisfy our obligations under our contracts on a timely
                basis;


·
            the
                failure of our products to successfully launch or operate;


·
            the
                uncertain market for our technology and products;


·
            the
              availability and cost of raw materials and components for our products;
              and


·
            the
              potential loss of or inability to hire key personnel.





Our
      operating results may fall below the expectations of public market analysts
      or
      investors. In this event, our stock price could decline significantly.





In
      addition, our acquisition of Starsys may render period-to-period comparisons
      of
      our operating results not meaningful, but market investors may over-respond
      to
      such comparisons.





***We
      face significant competition and many of our competitors have greater resources
      than we do.***





We
      face
      significant competition for our government and commercial contracts. Many of
      our
      competitors have greater resources than we do and may be able to devote greater
      resources than us to research and development and marketing. Given the
      sophistication inherent in any space company's operations, larger competitors
      may have a significant advantage and may be able to more efficiently adapt
      and
      implement technological advances. In addition, larger and financially stronger
      corporations have advantages over us in obtaining space and defense contracts
      due to their superior marketing (lobbying) resources and the perception that
      they may be a better choice than smaller companies for mission-critical projects
      because of the higher likelihood that they will be able to continue in business
      for the necessary future period. Furthermore, it is possible that other domestic
      or foreign companies or governments, some with greater experience in the space
      industry and many with greater financial resources than we possess, could seek
      to produce products or services that compete with our products or services,
      including new mechanisms and electromechanical subsystems using new technology
      which could render our products less viable. Some of our foreign competitors
      currently benefit from, and others may benefit in the future from, subsidies
      from or other protective measures implemented by their home countries.





33


***Our
      products and services may not function well under certain conditions.***





Most
      of
      our products are technologically advanced and tested, but sometimes are not
      space qualified for performance under demanding operating conditions. Our
      products may not be successfully launched or operated, or perform as intended.
      Like most organizations that have launched satellite programs, we have
      experienced and in the future will likely experience some product and service
      failures, cost overruns, schedule delays, and other problems in connection
      with
      our products.





***Launch
      failures or delays could have serious adverse effects on our business.***





Launch
      failures or delays of our microsatellites could have serious adverse effects
      on
      our business. Microsatellite launches are subject to significant risks, the
      realization of which can cause disabling damage to or total loss of a
      microsatellite, as well as damage to our reputation among actual and potential
      customers. Delays in the launch could also adversely affect our net sales.
      Delays could be caused by a number of factors, including:





·
            designing,
                constructing, integrating, or testing the microsatellite, microsatellite
                components, or related ground
                systems;


·
            delays
                in receiving the license necessary to operate the microsatellite
                systems;


·
            delays
                in obtaining the customer's payload;


·
            delays
                related to the launch vehicle;


·
            weather;
                and


·
            other
                events beyond our control.





Delays
      and the perception of potential delay could negatively affect our marketing
      efforts and limit our ability to obtain new contracts and projects.





***Our
      U.S. government contracts are subject to audits that could result in a material
      adverse effect on our financial condition and results of operations if a
      material adjustment is required.***





The
      accuracy and appropriateness of our direct and indirect costs and expenses
      under
      our contracts with the U.S. government are subject to extensive regulation
      and
      audit by the Defense Contract Audit Agency, by other agencies of the U.S.
      government or by prime contractors. These entities have the right to audit
      our
      cost estimates and/or allowable cost allocations with respect to certain
      contracts. From time to time we may in the future be required to make
      adjustments and reimbursements as a result of these audits. Responding to
      governmental audits, inquiries or investigations may involve significant expense
      and divert management attention. Also, an adverse finding in any such audit,
      inquiry or investigation could involve contract termination, suspension, fines,
      injunctions or other sanctions.





***Our
      success depends on our ability to retain our key personnel. The December 20,
      2005 acceleration of vesting all outstanding stock options, in anticipation
      of
      the January 1, 2006 implementation of SFAS 123(R), reduced the effectiveness
      of
      the stock options as a retention device.***





34


Our
      success will be dependent upon the efforts of key members of our management
      and
      engineering team, including our chief executive officer, Mark N. Sirangelo,
      our
      president and chief financial officer, Richard B. Slansky, the managing director
      of SpaceDev, Scott Tibbitts, the president of Starsys, Inc., Robert Vacek,
      and
      certain other SpaceDev and Starsys personnel. The loss of any of these persons,
      or other key employees, including personnel with security clearances required
      for classified work and highly skilled technicians and engineers, could have
      a
      material adverse effect on us. Our future success is likely to depend
      substantially on our continued ability to attract and retain highly qualified
      personnel. The competition for such personnel is intense, and our inability
      to
      attract and retain such personnel could have a material adverse effect on us.
      At
      this time we do not maintain key man life insurance on any of our key
      personnel.





Our
      founder and former chief executive officer, James W. Benson, resigned as our
      chairman and chief technology officer in September 2006. The departure of a
      founder, who has helped to shape our culture and vision, is always a special
      challenge for an emerging company.





Historically,
      we have used vesting stock options to enhance our ability to retain key
      personnel. If the employee leaves us before the vesting period has been
      completed, the employee must forfeit any unvested portion of the stock options.
      In December 2005, in order to avoid adverse financial reporting effects in
      future years under SFAS 123(R), a new accounting standard, we eliminated all
      future vesting requirements on all of our 8,031,036 stock options then
      outstanding and in the hands of employees, officers, and directors. We continue
      to use vesting stock options as an incentive; however, as a result of SFAS
      123(R) and other issues, the number of options being granted has been reduced.





***If
      we grow but do not effectively manage the growth, our business could suffer
      as a
      result.***





Even
      if
      we are successful in obtaining new business, failure to manage the growth could
      adversely affect our operations. We may experience extended periods of very
      rapid growth, which could place a significant strain on our management,
      operating, financial and other resources. Our future performance will depend
      in
      part on our ability to manage growth effectively. We must develop management
      information systems, including operating, financial, and accounting systems,
      improve project management systems and processes and expand, train, and manage
      our workforce to keep pace with growth. Our inability to manage growth
      effectively could negatively affect results of operations and the ability to
      meet obligations as they come due.





***We
      may not address successfully the problems encountered in connection
      with*** ***potential future acquisitions.***





We
      expect
      to consider opportunities to acquire or make investments in other technologies,
      products and businesses that could enhance our capabilities, complement our
      current products or expand the breadth of our markets or customer base. We
      have
      limited experience in acquiring other businesses and technologies; the Starsys
      acquisition was our first major acquisition. Potential and completed
      acquisitions and strategic investments involve numerous risks,
      including:





·
            problems
                assimilating the purchased technologies, products or business
                operations;


·
            problems
                maintaining uniform standards, procedures, controls and policies;


·
            unanticipated
                costs associated with the acquisition;


·
            diversion
                of management's attention from our core business;


·
            adverse
                effects on existing business relationships with suppliers and customers;


·
            incompatibility
                of business cultures;


·
            risks
                associated with entering new markets in which we have no or limited
                prior
                experience;


·
            dilution
                of common stock and shareholder value as well as adverse changes
                in stock
                price.


·
            potential
                loss of key employees of acquired businesses; and


·
            increased
                legal and accounting costs as a result of the newly adopted rules
                and
                regulations related to the Sarbanes-Oxley Act of
                2002.




35


***If
      our key suppliers fail to perform as expected, our reputation may be damaged.
      We
      may experience delays, lose customers and experience declines in revenues,
      profitability, and cash flow.***





We
      purchase a significant percentage of our product components and subassemblies
      from third parties. If our subcontractors fail to perform as expected or
      encounter financial difficulties, we may have difficulty replacing them or
      identifying qualified replacements in a timely or cost effective manner. As
      a
      result, we may experience performance delays that could result in additional
      program costs, contract termination for default or damage to our customer
      relationships which may cause our revenues, profitability and cash flow to
      decline. In addition, negative publicity from any failure of one of our products
      or sub-systems as a result of a supplier failure could damage our reputation
      and
      prevent us from winning new contracts.





***Our
      limited insurance may not cover all risks inherent in our
      operations.***





We
      may
      find it difficult to insure certain risks involved in our operations, including
      our launch vehicle and satellite operations, accidental damage to high value
      customer hardware during the manufacturing process and damages to customer
      spacecraft caused by our products not working to specification. Insurance market
      conditions or factors outside of our control at the time insurance is purchased
      could cause premiums to be significantly higher than current estimates.
      Additionally, the U.S. Department of State has published regulations which
      could
      significantly affect the ability of brokers and underwriters to insure certain
      launches. These factors could cause other terms to be significantly less
      favorable than those currently available, may result in limits on amounts of
      coverage that we can obtain, or may prevent us from obtaining insurance at
      all.
      Furthermore, proceeds from insurance may not be sufficient to cover losses.





***Several
      years of low demand and overcapacity in the commercial satellite market have
      resulted in slow growth in demand for space products.***





The
      commercial satellite market has experienced pricing pressures due to excess
      capacity in the telecommunications industry and weakened demand over the past
      several years. Satellite demand, and thus subsystem and component orders, have
      also been impacted by the business difficulties encountered by the commercial
      satellite services industry. This has resulted in a reduction in the total
      market size in the near term. While the market appears to be making a recovery,
      growth in the demand for our products may be limited.





***Our
      competitive position may be seriously damaged if we cannot protect intellectual
      property rights in our technology.***





Our
      success, in part, depends on our ability to obtain and enforce intellectual
      property protection for our technology. We rely on a combination of patents,
      trade secrets and contracts to establish and protect our proprietary rights
      in
      our technology. However, we may not be able to prevent misappropriation of
      our
      intellectual property, and the agreements we enter into may not be enforceable.
      In addition, effective intellectual property protection may be
      unavailable or limited in some foreign countries.





There
      is
      no guarantee any patent will be issued on any patent application that we have
      filed or may file. Further, any patent that we may obtain will expire, and
      it is
      possible that it may be challenged, invalidated or
      circumvented.  If we do not secure and maintain patent protection
      for our technology and products, our competitive position will be significantly
      harmed because it will be much easier for competitors to sell products similar
      to ours. Alternatively, a competitor may independently develop or patent
      technologies that  design around
      our  patented technology.  In addition,  it
      is possible that any patent that we may obtain may not
      provide  adequate protection and our competitive position could
      be significantly harmed.





As
      we
      expand our product line or develop new uses for our products, these products
      or
      uses may be outside the scope of our current patent applications, issued
      patents,  and other intellectual property rights. In addition, if we
      develop new products or enhancements to existing products, there is no guarantee
      that we will be able to obtain patents to protect them. Even if we do receive
      patents for our existing or new products, these patents may not provide
      meaningful protection. In some countries outside of the United States, effective
      patent protection is not available. Moreover, some countries that do allow
      registration of patents do not provide meaningful redress for violations of
      patents. As a result, protecting intellectual property in these countries is
      difficult and our competitors may successfully sell products in those countries
      that have functions and features that infringe on our intellectual property.





36


We
      may
      initiate claims or litigation against third parties in the future for
      infringement of our proprietary rights or to determine the scope and validity
      of
      our proprietary rights or the proprietary rights of competitors. These claims
      could result in costly litigation and divert the efforts of our technical and
      management personnel. As a result, our operating results could suffer and our
      financial condition could be harmed, regardless of the outcome of the
      case.





***Claims
      by other companies that we infringe on their intellectual property or that
      patents on which we rely are invalid could adversely affect our
      business.***





From
      time
      to time, companies may assert patent, copyright and other intellectual
      proprietary rights against our products or products using our technologies
      or
      other technologies used in our industry. These claims may result in our
      involvement in litigation. We may not prevail in such litigation given the
      complex technical issues and inherent uncertainties in intellectual property
      litigation. If any of our products were found to infringe on another company's
      intellectual property rights, we could be required to redesign our products
      or
      license such rights and/or pay damages or other compensation to such other
      company. If we were unable to redesign our products or license such intellectual
      property rights used in our products, we could be prohibited from making and
      selling such products.





Other
      companies or entities also may commence actions seeking to establish the
      invalidity of our patents. In the event that one or more of our patents are
      challenged, a court may invalidate the patent or determine that the patent
      is
      not enforceable, which could harm our competitive position. If any of our key
      patents are invalidated, or if the scope of the claims in any of these patents
      is limited by court decision, we could be prevented from licensing the
      invalidated or limited portion of such patents. Even if such a patent challenge
      is not successful, it could be expensive and time consuming to address, divert
      management attention from our business and harm our reputation.





***We
      are subject to substantial regulation, some of which prohibits us to sell
      internationally. Any failure to comply with existing regulations, or increased
      levels of regulation, could have a material adverse effect on us.***




Our
      business activities are subject to substantial regulation by various agencies
      and departments of the United States government and, in certain circumstances,
      the governments of other countries. Several government agencies, including
      NASA
      and the U.S. Air Force, maintain Export Control Offices to ensure that any
      disclosure of scientific and technical information complies with the Export
      Administration Regulations and the International Traffic in Arms Regulations,
      or
      "ITAR." Exports of our products, services and technical information require
      either Technical Assistance Agreements, manufacturing license agreements or
      licenses from the U.S. Department of State depending on the level of technology
      being transferred. This includes recently published regulations restricting
      the
      ability of U.S.-based companies to complete offshore launches, or to export
      certain satellite components and technical data to any country outside the
      United States. The export of information with respect to ground-based sensors,
      detectors, high-speed computers, and national security and missile technology
      items are controlled by the Department of Commerce. Failure to comply with
      the
      ITAR and/or the Commerce Department regulations may subject guilty parties
      to
      fines of up to $1 million and/or up to 10 years imprisonment per
      violation.




In
      addition, the space industry has specific regulations with which we must comply.
      Command and telemetry frequency assignments for space missions are regulated
      internationally by the International Telecommunications Union, which we refer
      to
      as the ITU. In the United States, the Federal Communications Commission, which
      we refer to as the FCC, and the National Telecommunications Information Agency,
      which we refer to as NTIA, regulate command and telemetry frequency assignments.
      All launch vehicles that are launched from a launch site in the United States
      must pass certain launch range safety regulations that are administered by
      the
      U.S. Air Force. In addition, all commercial space launches that we would perform
      require a license from the Department of Transportation. Satellites that are
      launched must obtain approvals for command and frequency assignments. For
      international approvals, the FCC and NTIA obtain these approvals from the ITU.
      These regulations have been in place for a number of years to cover the large
      number of non-government commercial space missions that have been launched
      and
      put into orbit in the last 15 to 20 years. Any commercial deep space mission
      that we would perform would be subject to these regulations.





37


We
      are
      also subject to laws and regulations regulating the formation, administration
      and performance of, and accounting for, U.S. government contracts. With respect
      to such contracts, any failure to comply with applicable laws could result
      in
      contract termination, price or fee reductions, penalties, suspension or
      debarment from contracting with the U.S. government.





We
      are
      also required to obtain permits, licenses, and other authorizations under
      federal, state, local and foreign laws and regulations relating to the
      environment. Our failure to comply with applicable law or government
      regulations, including any of the above-mentioned regulations, could have
      serious adverse effects on our business.





***Our
      stock price has been and may continue to be volatile, which could result in
      substantial losses for investors purchasing shares of our common
      stock.***





The
      market prices of securities of technology-based companies like ours,
      particularly in industries (also like ours) where substantial value is ascribed
      to a hope for future increase in the size of the total market, are often highly
      volatile. The market price of our common stock has fluctuated significantly
      in
      the past. Our market price may continue to exhibit significant fluctuations
      in
      response to a variety of factors, many of which are beyond our control,
      including:





·
            deviations
                in our results of operations from
                estimates;


·
            changes
                in estimates of our financial
                performance;


·
            changes
                in our markets, including decreased government spending or the entry
                of
                new competitors;


·
            awards
                of significant contracts to competitors rather than to
                us;


·
            our
                inability to obtain financing necessary to operate our
                business;


·
            changes
                in technology;


·
            potential
                loss of key personnel;


·
            short
                selling;


·
            changes
                in market valuations of similar companies and of stocks
                generally;


·
            the
                Starsys merger;


·
            volume
                fluctuations generally, including resales by former Starsys stockholders
                or by Laurus; and,


·
            other
                factors listed above in "Our operating results could fluctuate on
                a
                quarterly and annual basis, which could cause our stock price to
                fluctuate
                or decline."





***Changes
      in stock option accounting rules may adversely affect our reported operating
      results prepared in accordance with generally accepted accounting principles,
      our stock price and our efforts in recruiting additional employees.***




Technology
      companies, in general, and our company in particular, depend upon and use broad
      based employee stock option programs to hire, incent and retain employees in
      a
      competitive marketplace. Through fiscal 2005, we did not recognize compensation
      expense for stock options issued to employees or directors, except in limited
      cases involving modifications of stock options, and we instead disclosed in
      the
      notes to our financial statements information about what such charges would
      be
      if they were expensed. An accounting standard setting body adopted SFAS 123(R),
      a new accounting standard that will require us to record equity-based
      compensation expense for stock options and employee stock purchase plan rights
      granted to employees based on the fair value of the equity instrument at the
      time of grant. We are now recording these expenses beginning with the first
      quarter of 2006. The change in accounting rules will lead to a decrease in
      reported earnings, if we have earnings, or an increased loss, if we do not
      have
      earnings. This may negatively impact our future stock price. If in order to
      protect reported earnings we cut back on the use of stock options, we could
      lose
      the advantage of a valuable incentivizing tool and could be placed at a
      competitive disadvantage by other potential employers who were more willing
      to
      grant stock options.





38


***The
      concentration of ownership of our common stock gives a few individuals
      significant control over important policy decisions and could delay or prevent
      changes in control.***





As
      of
      September 30, 2006, our executive officers and directors together beneficially
      owned approximately 47.95% of the issued and outstanding shares of our common
      stock. As a result, these persons could have the ability to exert significant
      influence over matters concerning us, including the election of directors,
      changes in the size and composition of the board of directors, and mergers
      and
      other business combinations involving us. In addition, through control of the
      board of directors and voting power, our officers and directors may be able
      to
      control certain decisions, including decisions regarding the qualification
      and
      appointment of officers, dividend policy, access to capital (including borrowing
      from third-party lenders and the issuance of additional equity securities),
      and
      the acquisition or disposition of our assets. In addition, the concentration
      of
      voting power in the hands of those individuals could have the effect of delaying
      or preventing a change in control of our company, even if the change in control
      would benefit our shareholders. A perception in the investment community of
      an
      anti-takeover environment at our company could cause investors to value our
      stock lower than in the absence of such a perception.





***We
      have not paid dividends on our common stock in the past and do not anticipate
      paying dividends on our common stock in the foreseeable
      future.***





We
      have
      not paid common stock dividends since our inception and do not anticipate paying
      dividends in the foreseeable future. Our current business plan provides for
      the
      reinvestment of earnings in an effort to complete development of our
      technologies and products, with the goal of increasing sales and long-term
      profitability and value. In addition, the terms of our preferred stock currently
      restrict, and any other credit or borrowing arrangements that we may enter
      into
      may in the future restrict or limit, our ability to pay common stock dividends
      to our shareholders.




***Our
      expansion into other new lines of business may divert management's attention
      from our existing operations and prove to be too
      costly.***





Our
      current business plan contemplates the migration of SpaceDev's technology from
      projects into products for microsatellites and hybrid rocket motors over the
      next several years. Our Starsys technology may migrate or expand into from
      a
      component business into a structures and/or subsystem business over the next
      several years. In the meantime, we are investigating other applications of
      our
      technology and other markets for our technologies and prospective products.
      Our
      expansion into new lines of business may be difficult for us to manage because
      they may involve different disciplines and require different expertise than
      our
      core business. Consequently, this expansion may divert management's time and
      attention away from our core business, and we may need to incur significant
      expenses in order to develop the expertise, and reputation we desire. Any
      revenues generated by new lines of business may not be significant enough to
      offset the expenditures required to enter such business, or provide the
      anticipated return on investment.





***We
      are subject to new corporate governance and internal control reporting
      requirements, and our costs related to compliance with, or our failure to comply
      with existing and future requirements could adversely affect our
      business.***





We
      face
      new corporate governance requirements under the Sarbanes-Oxley Act of 2002,
      as
      well as new rules and regulations subsequently adopted by the SEC, the Public
      Company Accounting Oversight Board and any stock exchange on which our stock
      may
      be listed in the future. These laws, rules and regulations, which are already
      known to be burdensome and costly, continue to evolve and may become
      increasingly stringent in the future. In particular, we will be required to
      include management and independent registered public accounting firm reports
      on
      internal controls as part of our annual report for the year ended
      December 31, 2007 pursuant to Section 404 of the Sarbanes-Oxley Act (unless
      an August 2006 SEC proposal to delay the auditor attestation requirement for
      one
      year for smaller companies is adopted). We are in the process of evaluating
      our
      control structure and processes to help ensure that we will be able to comply
      with Section 404 of the Sarbanes-Oxley Act. We cannot assure you that we will
      be
      able to fully comply with these laws, rules and regulations that address
      corporate governance, internal control reporting and similar matters. Failure
      to
      comply with these laws, rules and regulations could materially adversely affect
      our reputation, financial condition and the value of our
      securities.





39


***The
      terms of our outstanding shares of preferred stock, and any shares of preferred
      stock issued in the future, may reduce the value of your common stock.***





We
      have
      authorized to issue up to 10,000,000 shares of preferred stock in one or more
      series. We currently have outstanding 248,460 shares of our Series C Convertible
      Preferred Stock and 4,789 shares of our Series D-1 Preferred Stock. Our board
      of
      directors may determine the terms of future preferred stock offerings without
      further action by our shareholders. If we issue additional preferred stock,
      it
      could affect your rights or reduce the value of your common stock. In
      particular, specific rights granted to future holders of preferred stock could
      be used to restrict our ability to merge with or sell our assets to a third
      party. These terms may include voting rights, preferences as to dividends and
      liquidation, conversion and redemption rights, and sinking fund provisions.
      Our
      Series C Preferred Stock and Series D-1 Preferred Stock rank senior to the
      common stock with respect to dividends and liquidation and have other important
      preferred rights.





***Because
      our common stock is subject to the SEC's penny stock rules, broker-dealers
      may
      experience difficulty in completing customer transactions and trading activity
      in our securities may be adversely affected.***





Transactions
      in our common stock are currently subject to the "penny stock" rules promulgated
      under the Securities Exchange Act of 1934. Under these rules, broker-dealers
      who
      recommend our securities to persons other than institutional accredited
      investors must:





·
            make
                a special written suitability determination for the purchaser;


·
            receive
                the purchaser's written agreement to a transaction prior to
                sale;


·
            provide
                the purchaser with risk disclosure documents which identify certain
                risks
                associated with investing in "penny stocks" and which describe the
                market
                for these "penny stocks" as well as a purchaser's legal remedies;
                and


·
            obtain
                a signed and dated acknowledgment from the purchaser demonstrating
                that
                the purchaser has actually received the required risk disclosure
                document
                before a transaction in a "penny stock" can be completed.





As
      a
      result of these rules, broker-dealers may find it difficult to effectuate
      customer transactions and trading activity in our securities may be adversely
      affected. As a result, the market price of SpaceDev securities may be depressed,
      and you may find it more difficult to sell our securities.





***Our
      secured debt financing is expensive and onerous.***




On
      September 29, 2006, we entered into a secured revolving credit facility with
      Laurus.  Although the maximum size of the facility is $5,000,000, actual
      borrowings are limited by a formula based on our eligible accounts receivable
      and eligible inventory.  Our initial borrowing was approximately $1.9
      million.  We paid a loan fee at closing in the form of common stock valued
      at $350,000.  In addition, we will be required to pay Laurus additional
      loan fees in the form of common stock valued at $200,000 on each anniversary
      date of the facility, if the facility remains in place.  In addition, the
      outstanding balance on the facility bears interest at a floating rate of prime
      plus 200 basis points, and the maximum life of the facility is three years.
      Laurus has piggyback registration rights subject to certain underwriters’
restrictions. The facility is a secured debt, collateralized by substantially
      all of the Company's and its subsidiaries' assets. The facility contains certain
      default provisions. In the event of a default by the Company, the Company will
      be required to pay an additional fee per month until the default is cured.
      Laurus has the option of accelerating the entire principal balance and requiring
      the Company to pay a premium in the event of an uncured default. The Company
      paid to certain persons designated by Laurus in the amount of $9,500 for legal
      fees and expenses in structuring the facility, conducting due diligence and
      escrow fees. In addition, the Company paid a finder’s fee in the amount of
      $35,000 and paid Laurus a facility fee of 3.5%, or approximately $140,000,
      of
      the facility amount, which facility fee is being expensed over the life of
      the
      note.




40


Any
      further debt financing, if available at all when needed, might require
      further expensive and onerous financial terms, security provisions and
      restrictive covenants.  If we cannot repay or refinance our debt when it
      comes due, we would be materially adversely affected.




**ITEM
      3.**  **CONTROLS
      AND PROCEDURES**




Mark
      N.
      Sirangelo, our chief executive officer, and Richard B. Slansky, our chief
      financial officer, after evaluating the effectiveness of our disclosure controls
      and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Securities
      Exchange Act of 1934, as amended) have concluded that, as of September 30,
      2006,
      our disclosure controls and procedures are effective.


41


**PART
      II -- OTHER INFORMATION**





**ITEM
      1.**  **LEGAL
      PROCEEDINGS**


None.








**ITEM
      2.**  **UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**





On
      September 29, 2006, we entered into a $5.0 million financing arrangement with
      Laurus. The terms and conditions of the proposed financing, which acts as a
      revolving credit facility included the issuance of 310,009 shares of our
      restricted common stock at $1.13 per share valued at $350,000 at
      closing.





**ITEM
      3.**  **DEFAULTS
      UPON SENIOR SECURITIES**


None.








**ITEM
      4.**  **SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS**


The
      annual meeting of the shareholders of SpaceDev, Inc. was held at 13855 Stowe
      Drive, Poway, California 92064, on August 10, 2006, at 9:00 A.M. Out of a total
      of 28,877,702 shares outstanding on the date of record, June 19,
      2006 shares, or approximately 74%, were voted in person or by proxy. The
      following proposals were presented and passed by the amounts indicated
      below:





PROPOSAL
      1: To elect nine directors to hold office until the 2007 Annual Meeting of
      Stockholders:




**Issue**
            
            **For**
            **Against**
            **Abstain**Sirangelo,
                Mark
            Total
            21,215,854
            -
            166,094Benson,
                Jim
            Total
            21,197,185
            -
            184,763Slansky,
                Richard
            Total
            21,217,416
            -
            164,532Blake,
                Curt
            Total
            21,216,854
            -
            165,094Estes,
                Howell
            Total
            21,215,554
            -
            166,394Huntress,
                Wesley
            Total
            21,215,454
            -
            166,494McClendon,
                Scott
            Total
            21,214,359
            -
            167,589Tibbitts,
                Scott
            Total
            21,203,234
            -
            178,714Walker,
                Robert
            Total
            21,216,354
            -
            165,594





PROPOSAL
      2: To approve the appointment of PKF, Certified Public Accountants, as our
      independent public accountants for the fiscal year ending December 31,
      2006:





**Issue**
            
            **For**
            **Against**
            **Abstain**Accountants
            Total
            21,295,886
            49,148
            36,914





**ITEM
      5.**  **OTHER
      INFORMATION**




None.




42


**ITEM
      6.**  **EXHIBITS** ****





Exhibit
                No.
            Description
            Filed
                Herewith
            Incorporated
                by Reference
            Form
            Date
                Filed with SEC
            Exhibit
                No.10.1
            Secured
                Revolving Note issued to Laurus Master Fund, Ltd. dated September
                29,2006
            
            X
            8-K/A
            Oct.
                10, 2006
            99.110.2
            Security
                Agreement with Laurus Master Fund, Ltd. dated as of September
                29,2006
            
            X
            8-K/A
            Oct.
                10, 2006
            99.231.1
            Rule
                13a-14(a) certification of Chief Executive Officer
            X31.2
            Rule
                13a-14(a) certification of Chief Financial Officer
            X32.1
            Section
                1350/Rule 13a-14(b) certifications
            X














**SIGNATURES**








In
      accordance with the requirements of the Exchange Act, the Registrant caused
      this
      report to be signed on its behalf by the undersigned thereunto duly
      authorized.





**SpaceDev,
      Inc.**


Registrant








Dated:
      November 13, 2006  By:
      /s/ Mark N. Sirangelo


Mark
      N.
      Sirangelo


Chief
      Executive Officer











Dated:
      November 13, 2006  By:
      /s/ Richard B. Slansky


Richard
      B. Slansky


President
      & Chief Financial Officer








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