<PAGE>

                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                   FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934

For the quarterly period ended     June 30, 2001
                               -------------------------------------------------

                                      or

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934

For the transition period from _____________________ to ________________________

Commission file number: ________________________________________________________

                              ACTIVE POWER, INC.
--------------------------------------------------------------------------------
            (Exact name of registrant as specified in its charter)

          Delaware                                        74-2961657
--------------------------------------------------------------------------------
  (State or other jurisdiction              (I.R.S. Employer Identification No.)
of incorporation or organization)

11525 Stonehollow Dr.,  Suite 110,  Austin, Texas                      78758
--------------------------------------------------------------------------------
(Address of principal executive offices)                             (Zip Code)

                                (512) 836-6464
--------------------------------------------------------------------------------
             (Registrant's telephone number, including area code)

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

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

                     APPLICABLE ONLY TO CORPORATE ISSUERS:

 Indicate the number of shares outstanding of each of the issuer's classes of
               common stock, as of the latest practicable date.
The number of shares of common stock as of June 30, 2001 was 39,932,734 with a
                        par value of $.001 per share .
--------------------------------------------------------------------------------
<PAGE>

                              ACTIVE POWER, INC.
                                     INDEX
<TABLE>
<S>                                                                                                <C>
 PART I - FINANCIAL INFORMATION..................................................................   1
  Item 1. Financial Statements...................................................................   1
     BALANCE SHEETS..............................................................................   1
     STATEMENT OF OPERATIONS.....................................................................   2
     STATEMENT OF CASH FLOWS.....................................................................   3
     Notes to Financial Statements...............................................................   4
  Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..   5
     Liquidity and Capital Resources.............................................................   8
     Quantitative and Qualitative Disclosures About Market Risk..................................   9
     Risk Factors That May Affect Future Results.................................................  10
 PART II - OTHER INFORMATION.....................................................................  18
  Item 1.  Legal Proceedings.....................................................................  18
  Item 2. Changes in Securities and Use of Proceeds..............................................  18
  Item 3. Defaults Upon Senior Securities........................................................  18
  Item 4. Submission of Matters to a Vote of Security Holders....................................  18
  Item 5. Other Information......................................................................  18
  Item 6. Exhibits and Reports on Form 8-K.......................................................  18
</TABLE>
<PAGE>

PART I - FINANCIAL INFORMATION

     Item 1. Financial Statements

                              ACTIVE POWER, INC.
                                BALANCE SHEETS

                                (in thousands)

<TABLE>
<CAPTION>
                                                            June 30,    December 31,
                                                              2001          2000
                                                              ----          ----
                                                          (unaudited)
<S>                                                       <C>           <C>
ASSETS

Current assets:
        Cash and cash equivalents                          $ 84,091         $ 92,720
        Short-term investments                               20,498           42,541
        Accounts receivable, net                              5,265            1,934
        Inventories, net                                      4,570            2,343
        Prepaid expenses and other                              948            1,177
                                                           --------         --------
              Total current assets                          115,372          140,715
Property and equipment, net                                   8,494            4,469
Long-term investments                                        26,487           10,948
                                                           --------         --------
              Total assets                                 $150,353         $156,132
                                                           ========         ========

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
        Accounts payable                                   $  5,696         $  2,133
        Accrued expenses                                      2,709            1,610
                                                           --------         --------
              Total current liabilities                       8,405            3,743

Stockholders' equity:
        1992 preferred stock                                      -                -
        Common stock                                             40               39
        Treasury stock                                           (2)              (2)
        Deferred stock compensation                          (4,530)          (7,519)
        Additional paid-in capital                          212,734          212,601
        Accumulated deficit                                 (66,294)         (52,730)
                                                           --------         --------
              Total stockholders' equity                    141,948          152,389
                                                           --------         --------
              Total liabilities and stockholders' equity   $150,353         $156,132
                                                           ========         ========
</TABLE>

See accompanying notes

                                       1
<PAGE>

                              ACTIVE POWER, INC.
                            STATEMENT OF OPERATIONS

              (in thousands, except share and per share amounts)
                                  (unaudited)

<TABLE>
<CAPTION>
                                                            Three Months                 Six Months
                                                           Ended June 30,              Ended June 30,
                                                           --------------              ---------------
                                                         2001            2000        2001           2000
                                                         ----            ----        ----           ----
<S>                                                  <C>           <C>           <C>              <C>
Product revenue                                      $     6,732   $       679   $    11,839    $       861
Cost of goods sold                                         7,272         1,176        13,785          1,697
                                                     -----------   -----------   -----------    -----------
Product margin (loss)                                       (540)         (497)       (1,946)          (836)

Operating expenses:
Research and development                                   4,015         2,195         7,559          3,658
Selling, general and administrative                        2,922         1,463         5,663          2,560
Amortization of deferred stock compensation                  985         1,859         2,271          3,140
                                                     -----------   -----------   -----------    -----------
Total operating expenses                                   7,922         5,517        15,493          9,358
                                                     -----------   -----------   -----------    -----------
Operating loss                                            (8,462)       (6,014)      (17,439)       (10,194)

Interest income (expense)                                  1,663           325         3,901            690
Change in fair value of warrants with
       redemption rights                                       -          (520)            -         (1,562)
Other income (expense)                                       (50)            -           (26)             -
                                                     -----------   -----------   -----------    -----------

Net loss                                             $    (6,849)  $    (6,209)  $   (13,564)   $   (11,066)
Preferred stock dividends and accretion                        -        (8,179)            -        (15,410)
                                                     -----------   -----------   -----------    -----------
Net loss to common shareholders                      $    (6,849)  $   (14,388)  $   (13,564)   $   (26,476)
                                                     ===========   ===========   ===========    ===========

Net loss per share - basic and diluted               $     (0.17)  $     (1.26)  $     (0.35)   $     (2.41)
Shares used in computing net loss per share,
       basic and diluted                              39,508,193    11,418,380    39,222,367     10,983,192
</TABLE>

See accompanying notes

                                       2
<PAGE>

                              ACTIVE POWER, INC.
                            STATEMENT OF CASH FLOWS

                                (in thousands)

<TABLE>
<CAPTION>
                                                                  Six Months Ended June 30,
                                                                  ------------------------
                                                                  2001                2000
                                                                  ----                ----
                                                                  (unaudited)   (unaudited)
<S>                                                           <C>                <C>
Operating activities
Net loss                                                          $ (13,564)     $ (11,066)
 Adjustment to reconcile net loss to cash used in
 operating activities:
 Depreciation expense                                                 1,039            362
 Amortization of deferred stock compensation                          2,272          3,140
 Change in fair value of warrants with redemption rights                  -          1,562
 Changes in operating assets and liabilities:
  Accounts receivable, net                                           (3,331)          (158)
  Inventories, net                                                   (2,227)          (950)
  Prepaid expenses and other assets                                    (381)          (459)
  Accounts payable                                                    3,563            787
  Accrued expenses                                                    1,099            127
  Other non-current liabilities                                           -             (7)
                                                                  ---------      ---------
Net cash used in operating activities                               (11,530)        (6,662)

Investing activities
Purchases of property and equipment                                  (5,064)        (2,212)
Net maturity (purchase) of investments                                6,504        (14,873)
                                                                  ---------      ---------
Net cash provided by (used in) investing activities                   1,440        (17,085)

Financing activities
Proceeds from issuance of common stock, net of issuance costs           894            383
Proceeds from exercise of warrants                                      567             30
Payments on notes payable                                                 -            (55)
                                                                  ---------      ---------
Net cash provided by financing activities                             1,461            358
                                                                  ---------      ---------
Increase in cash and cash equivalents                                (8,629)       (23,389)
Cash and cash equivalents, beginning of period                       92,720         24,856
                                                                  ---------      ---------
Cash and cash equivalents, end of period                          $  84,091      $   1,467
                                                                  =========      =========
</TABLE>
     See accompanying notes.

                                       3
<PAGE>

                              Active Power, Inc.
                         Notes to Financial Statements

                                  (unaudited)

1.  Organization

    Active Power, Inc. was founded in 1992 as Magnetic Bearing Technologies,
Inc. for the purpose of developing and commercializing advances in the field of
electromechanics. In the early years, Active Power devoted efforts principally
to research and development, pursuing patent protection for intellectual
property, successful production of initial prototypes, raising capital and
pursuing markets for our flywheel-based power quality and storage products. In
2000 and 2001, the size and scope of our operations expanded considerably. We
raised our level of new product development, increased our manufacturing
capabilities and capacity, and added resources in sales and service to
strengthen our distribution channels.

2.  Basis of Presentation

    The accompanying unaudited interim financial statements have been prepared
pursuant to the rules and regulations of the Securities and Exchange Commission.
Accordingly, certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted. These financial statements should be
read in conjunction with the audited financial statements and accompanying notes
thereto included in our Annual Report on Form 10-K for the year ending December
31, 2000. In the opinion of management the financial statements include all
adjustments (consisting of normal recurring adjustments) necessary for a fair
presentation of the results for the periods presented. Results of operations for
any interim period are not necessarily indicative of results for any other
interim period or for the full year.

3.  Inventory

    Active Power states inventories at the lower of cost or replacement cost,
with cost being determined on a standard cost basis which does not differ
materially from actual cost.

    Inventories consist of the following:

                                         June 30,                 December 31,
                                           2001                       2000
                                       -----------              --------------
     Raw Materials                     $ 4,570,842              $    2,902,224
     Work in Progress                    1,486,160                     310,330
     Finished Goods                        121,409                       4,981
     Less Reserves                      (1,608,029)                   (874,867)
                                       -----------              --------------
                                       $ 4,570,382              $    2,342,668
                                       ===========              ==============

4.  Capital Structure

 The following table sets forth the computation of basic and diluted net loss
                                  per share:

                                                 Three Months      Six Months
                                                Ended June 30,    Ended June 30,
                                                --------------    --------------

                                       4
<PAGE>

<TABLE>
<CAPTION>
                                                                                 2001           2000           2001          2000
                                                                                 ----           ----           ----          ----
    <S>                                                                  <C>            <C>            <C>             <C>
     Net loss to common stockholders (thousands)                          $    (6,849)   $   (14,388)   $   (13,564)   $   (26,476)
     Basic and diluted:
          Weighted-average shares of common
               stock outstanding                                           39,727,715     11,864,128     39,495,352     11,374,608
          Weighted-average shares of common
               stock subject to repurchase                                   (219,522)      (445,748)      (272,985)      (391,416)
                                                                          -----------    -----------    -----------    -----------
     Shares used in computing basic and diluted
        net loss per share                                                 39,508,193     11,418,380     39,222,367     10,983,192
                                                                          ===========    ===========    ===========    ===========
     Basic and diluted net loss per share                                 $     (0.17)   $     (1.26)   $     (0.35)   $     (2.41)
                                                                          ===========    ===========    ===========    ===========
</TABLE>



     Item 2.  Management's Discussion and Analysis of Financial Condition and
Results of Operations

              The following discussion should be read in conjunction with the
     financial statements appearing elsewhere in this Quarterly Report on Form
     10-Q and within our Annual Report on Form 10-K for the year ending December
     31, 2000. This report contains forward-looking statements, within the
     meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
     Securities Exchange Act of 1934, that involve risks and uncertainties. Our
     actual results could differ materially from those anticipated in these
     forward-looking statements as a result of various factors, including those
     discussed below under the heading "Risk Factors," and other factors
     detailed in the Company's filings with the Securities and Exchange
     Commission, specifically our Form 10-K for the year ending December 31,
     2000.

     Overview

              We design, manufacture and market power quality products that
     provide the consistent, reliable electric power required by today's digital
     economy. We believe that we are the first company to commercialize a
     flywheel energy storage system that provides a highly reliable, low-cost
     and non-toxic replacement for lead-acid batteries used in conventional
     power quality installations. Leveraging our expertise in this technology
     and in conjunction with Caterpillar, the leading maker of engine generators
     for the power reliability market, we have developed a battery-free power
     quality system, which is marketed under the Caterpillar brand name (Cat
     UPS). Our products are sold for use in the facilities of companies in many
     different industries that all share a critical need for reliable, high-
     quality power, such as semiconductor manufacturers, hospitals, credit card
     processing centers, telecommunications providers, Internet service
     providers, electric utilities and broadcasters. As an extension of these
     existing product lines, we are developing a lower power fully integrated
     continuous power system, which we are calling the HIT 6 product. The
     initial target market for this product is the telecommunications industry.

              Since 1996, we have focused our efforts and financial resources
     primarily on the design and development of our CleanSource line of power
     quality products and on establishing effective OEM channels to market our
     products. As of June 30, 2001, we have generated an accumulated deficit of
     $66.3 million and expect to continue to sustain operating losses for the
     next several quarters. We initially funded our operations through sales of
     shares of our preferred stock, which resulted in gross proceeds of
     approximately $42.6 million. We believe the proceeds

                                       5
<PAGE>

     from our August 2000 initial public offering, approximately $138.4 million
     net of commissions and issuance costs, together with cash balances on hand
     prior to August 2000 will be sufficient to meet our capital requirements
     through at least the next 24 months. Our cash and investments position at
     June 30, 2001 was $131.1 million.

          Since our inception, a small number of customers have accounted for
     the majority of our annual sales. During 1999, our four largest customers
     accounted for 89% of our sales, with our largest customer, Caterpillar and
     its dealer network, accounting for 39%. In 2000 and the first six months of
     2001, our volume of business with Caterpillar and its dealer network grew
     substantially, accounting for 96% and 90%, respectively, of our revenue due
     to the commercial introduction of the CleanSource UPS product line. We
     expect to continue to be dependent on a few OEM customers, primarily
     Caterpillar, for the majority of our sales for the foreseeable future.

          With the commercial release of our second generation product line,
     CleanSource UPS, in May 2000 under the Caterpillar brand name, and a
     growing market demand for power quality equipment, the demand for our
     products has increased significantly. To prepare for this growth in demand
     and to position us for future growth, we have increased and expect to
     continue to increase the scale of our operations in the following ways:

          .    expand our manufacturing facilities and add manufacturing
               personnel to address anticipated increases in product demand;

          .    increase our personnel levels in product development and
               engineering to accelerate time to market on new products and
               enhance existing product lines; and

          .    add sales and marketing personnel to support our OEM customers.

          We believe that although these efforts will increase our operating
     expenses, they will also enable us to realize significant revenue growth.


     Results of Operations

          Product Revenue. Product revenue primarily consists of sales of our
     CleanSource power quality products.  We recognize revenue upon the transfer
     of title, which generally occurs upon shipment to our customers.  Sales
     increased $6.1 million, or 891%, to $6.7 million for the three months ended
     June 30, 2001 from $679,000 for the three months ended June 30, 2000. For
     the six months ended June 30, sales increased $11.0 million, or 1275%, to
     $11.8 million in 2001 from $861,000 in the same period of 2000.  Both of
     these increases were primarily attributable to a continued ramp up in the
     sales of our CleanSource UPS product line. In the six months ended June 30,
     2001, we sold 206 quarter-megawatt flywheel units, in comparison to the 19
     quarter-megawatt flywheel units sold in the same period of 2000. The
     majority of these units were sold to our CleanSource UPS distribution
     partner, Caterpillar.

          Cost of goods sold. Cost of goods sold includes the cost of component
     parts of our product that are sourced from suppliers, personnel, equipment
     and other costs associated with our assembly and test operations, shipping
     costs, and the costs of manufacturing support functions such as logistics
     and quality assurance. Cost of goods sold increased $6.1 million to

                                       6
<PAGE>

     to $7.3 million for the three months ended June 30, 2001 from $1.2 million
     for the three months ended June 30, 2000. For the six months ended June 30,
     cost of goods sold increased $12.1 million, or 712%, to $13.8 million in
     2001 from $1.7 million in the same period of 2000. In both periods product
     costs grew commensurate with the increase in sales and a scale up in our
     manufacturing operations. Although the absolute dollar amounts increased
     year over year, we achieved significant improvements in our gross margin as
     a percent of revenue in each period. For example, we improved our gross
     margin as a percent of sales by 19% between the first and second quarter of
     2001, and realized an improvement of 49% since the fourth quarter of 2000.
     These improvements are a result of supplier cost reductions associated with
     higher volume, changes in our supplier base, engineering design savings,
     and leverage gained from higher production volumes. This quarter's gross
     margins were also positively impacted by the high percentage of CAT UPS and
     product options, both of which carry higher margins than our CleanSource DC
     products. In anticipation of future demand for our products, we plan to
     significantly expand our manufacturing capacity by increasing both our
     manufacturing facilities and production personnel, which will increase our
     fixed manufacturing expense base. We believe gross margins will continue to
     improve over time as our product volumes increase, and we achieve greater
     economies of scale in production and in purchasing component parts, and
     introduce engineering design savings.

          Research and development. Research and development expense primarily
     consists of compensation and related costs of employees engaged in
     research, development and engineering activities, third party consulting
     and development activities, as well as an allocated portion of our
     occupancy costs. Research and development expense increased $1.8 million,
     or 83%, to $4.0 million for the three months ended June 30, 2001 from $2.2
     million for the three months ended June 30, 2000. For the six months ended
     June 30, research and development expense increased $3.9 million, or 107%,
     to $7.6 million in 2001 from $3.7 million in the same period of 2000.  The
     increase in research and development expense was primarily due to an
     increase in project development costs on our HIT 6 continuous power system,
     1.8 MVA CAT UPS and CleanSource 2 DC products.  We believe that research
     and development expense will continue to increase slightly during the
     remainder of 2001 as we continue to develop new products and enhance
     existing product lines, and then begin to flatten out in 2002 with the
     anticipated commercial launch of several products currently under
     development, including our HIT continuous power system.

          Selling, general and administrative. Selling, general and
     administrative expense is primarily comprised of compensation and other
     personnel costs for marketing, sales and administrative personnel, selling
     and marketing expenses, professional fees and reserves for bad debt and
     warranty.  Selling, general and administrative expense increased
     approximately $1.5 million, or 100%, to $2.9 million for the three months
     ended June 30, 2001 from $1.4 million for the three months ended June 30,
     2000.  For the six months ended June 30, selling, general and
     administrative expense increased $3.1 million, or 121%, to $5.7 million in
     2001 from $2.6 million in the same period of 2000.  The increase in
     selling, general and administrative expense was principally due to
     increased personnel in our sales and marketing organizations in order to
     support our main OEM channel partner's sales and service ramp up of the
     CleanSource UPS product line. We also incurred higher administrative costs
     associated with the added responsibilities and reporting requirements of a
     public company.  We believe our selling, general and administrative expense
     will continue to increase as we add sales, marketing and administrative
     personnel and costs to position us for future sales growth and to assist in
     the administration of an expanding work force.

                                       7
<PAGE>

          Amortization of deferred stock compensation. Deferred stock
     compensation reflects the difference between the exercise price of option
     grants to employees and the estimated fair value determined subsequently by
     us of our common stock at the date of grant. We are amortizing deferred
     stock compensation as an operating expense over the vesting periods of the
     applicable options, which resulted in amortization expense of approximately
     $1.0 million for the three months ended June 30, 2001 and $1.9 million for
     the three months ended June 30, 2000.  For the six months ended June 30,
     amortization expense was $2.3 million in 2001 and $3.1 million in the same
     period of 2000.  We expect amortization expense to decrease during the
     remainder of 2001 and beyond, as the options that were granted at exercise
     prices less than the estimated fair value determined subsequently by us
     become fully vested, and to a smaller extent as some employees to whom
     these options were granted leave the company and any unvested options are
     canceled.

          Interest income. Interest income increased $1.3 million to $1.7
     million for the three months ended June 30, 2001 from $325,000 for the
     three months ended June 30, 2000.  This is primarily due to the increase in
     our average cash and investments balance for the second quarter of 2001 of
     $134.0 million compared to an average cash and investments balance of $20.6
     million for the second quarter of 2000.  For the six months ended June 30,
     interest income increased $3.2 million, or 460%, to $3.9 million in 2001
     from approximately $700,000 in the same period of 2000.  The increase in
     our cash and investments balance is primarily associated with the
     approximately $138.4 million raised as part of our August 2000 initial
     public offering.  Our interest income in the second quarter of 2001
     declined compared to the first quarter of 2001 due to lower interest rates
     and a lower average cash and investments balance.  We believe interest
     income will continue to decline as cash consumed from operating and
     investing activities  results in lower average cash balances.

          Change in fair value of warrants.  Due to the redemption feature of
     warrants we had  outstanding in 1999 and 2000, we recorded a liability
     associated with the fair value of the warrants on the balance sheet and
     recorded changes in fair value of the warrants in expense.  We calculated
     the fair value of the warrants using a Black-Scholes pricing model. In
     2000, the fair value of the underlying common stock increased
     substantially, resulting in an increase in the warrant value and
     corresponding expense.  There was no expense recorded for the three months
     ended June 30, 2001, while we recorded $520,000 in expense for the second
     quarter of 2000.  For the six months ended June 30, there was no warrant
     expense recorded in 2001 and $1.6 million recorded in 2000.  We do not
     anticipate further warrant-related charges in the future.

     Liquidity and Capital Resources


          Our principal source of liquidity as of June 30, 2001 consisted of
     $131.1 million of cash, cash equivalents and investments.

          In August 2000, we completed a successful initial public offering,
     raising approximately  $138.4 million, net of commissions and issuance
     expenses.  This is in addition to our private financing efforts, including
     the sale of shares of our preferred stock, which resulted in gross proceeds
     of approximately $42.6 million, and $5.0 million in development funding
     received from Caterpillar in 1999.  During the six months ended June 30,
     2001, cash used by operating activities was $11.5 million, which compares
     to $6.7 million of cash used by operating activities for the six months
     ended June 30, 2000.  The cash usage in each of these periods was primarily

                                       8
<PAGE>

     attributable to our focus on the development of products and the expansion
     of our manufacturing operations and sales activities.

          Capital expenditures were $5.1 million for the six months ended June
     30, 2001 and $2.2 million for the six months ended June 30, 2000. The 2001
     increase in capital expenditures was primarily due to the build out of our
     new manufacturing facility, which will be operational sometime in the third
     quarter.  We expect to incur approximately $5.0 to $7.0 million in
     additional costs in 2001 primarily on the remaining build out of our new
     manufacturing facility, and for engineering test equipment, and general
     computer equipment and software.

          We believe our existing cash balance at June 30, 2001 will be
     sufficient to meet our capital requirements through at least the next 24
     months, although we might elect to seek additional funding prior to that
     time. Beyond the next 24 months, our capital requirements will depend on
     many factors, including the rate of sales growth, the market acceptance of
     our products, the rate of expansion of our sales and marketing activities,
     the rate of expansion of our manufacturing facilities, and the timing and
     extent of research and development projects. Although we are not a party to
     any agreement or letter of intent with respect to a potential acquisition,
     we may enter into acquisitions or strategic arrangements in the future
     which could also require us to seek additional equity or debt financing.

     Quantitative and Qualitative Disclosures About Market Risk


          Our interest income is sensitive to changes in the general level of
     U.S. interest rates, particularly because the majority of our investments
     are in short-term instruments. We believe that our investment policy is
     conservative, both in terms of the average maturity of investments that we
     allow and in terms of the credit quality of the investments we hold. We
     estimate that a 1% decrease in market interest rates would decrease our
     interest income by approximately $1.3 million.  Because of the short-term
     nature of the majority of our investments, we do not believe a 1% decline
     in interest rates would have a material effect on their fair value.

          We invest our cash in a variety of financial investments, including
     bank time deposits, taxable and tax-advantaged variable rate and fixed rate
     obligations of corporations, municipalities, and local, state and national
     government entities and agencies.  These investments are denominated in
     U.S. dollars.

                                       9
<PAGE>

     Risk Factors That May Affect Future Results


          In addition to the other information in this Form 10-Q, the following
     factors should be considered in evaluating Active Power and our business.
     These factors include, but are not limited to the potential for significant
     losses to continue; our inability to accurately predict revenue and budget
     for expenses for future periods; fluctuations in revenue and operating
     results; overall market performance; limited product lines; the inability
     to expand our distribution channels; our dependence on our relationship
     with Caterpillar; competition; delays in research and development;
     inventory risks; the inability to expand our manufacturing operations;
     risks of delay or poor execution from a variety of sources; limited
     resources; dependence upon key personnel; the inability to protect our
     intellectual property rights; potential future acquisitions; and the
     volatility of our stock price. The discussion below addresses some of these
     factors. Additional risks and uncertainties that we are unaware of or that
     we currently deem immaterial also may become important factors that affect
     us.


     We have incurred significant losses and anticipate losses for the next
     several quarters.

     We have incurred operating losses since our inception and expect to
     continue to incur losses for the next several quarters. As of June 30,
     2001, we had an accumulated deficit of $66.3 million. To date, our product
     revenue has been insignificant, and we have funded our operations
     principally through the sale of our stock. We will need to generate
     significant revenue to achieve profitability, and we cannot assure you that
     we will ever realize sufficient revenue to achieve profitability. We also
     expect to incur significant product development, sales and marketing and
     administrative expenses and, as a result, we expect to continue to incur
     losses.


     Due to our limited operating history and the uncertain market acceptance of
     our products, we may never achieve significant revenue and may have
     difficulty accurately predicting revenue for future periods and
     appropriately budgeting for expenses.

     We have generated a total of $18.6 million in product revenue since January
     1, 1998, and we have sold fewer than 380 CleanSource DC and CleanSource UPS
     products. We are uncertain whether our products will achieve market
     acceptance such that our revenues will increase or whether we will be able
     to achieve significant revenue. Therefore, we have a very limited ability
     to predict future revenue. Our limited operating experience, the uncertain
     market acceptance for our products, and other factors that are beyond our
     control make it difficult for us to accurately forecast our quarterly and
     annual revenue. However, we use our forecasted revenue to establish our
     expense budget. Most of our expenses are fixed in the short term or
     incurred in advance of anticipated revenue. As a result, we may not be able
     to decrease our expenses in a timely manner to offset any revenue
     shortfall. Further, we are expanding our staff and facilities and
     increasing our expense levels in anticipation of future revenue growth. If
     our revenue does not increase as anticipated, we will incur significant
     losses.

                                       10
<PAGE>

     Our business is subject to fluctuations in operating results, which could
     negatively impact the price of our stock.

     Our product revenue, expense and operating results have varied in the past
     and may fluctuate significantly in the future due to a variety of factors,
     many of which are outside of our control. These factors include, among
     others:

          .  the timing of orders from our customers and the possibility that
             these customers may change their order requirements with little or
             no advance notice to us;
          .  the rate of adoption of our flywheel-based energy storage system as
             an alternative to lead-acid batteries;
          .  the deferral of customer orders in anticipation of new products
             from us or other providers of power quality systems;
          .  the ongoing need for short-term power outage protection in
             traditional UPS systems;
          .  the uncertainty regarding the adoption of our current and future
             products, including our recently introduced CleanSource UPS product
             and our fully integrated CPS, which we expect to commercially
             introduce by the end of 2001; and
          .  the rate of growth of the markets for our products.


     Our business is dependent on the market for power quality products and the
     health of the overall economy, and if this market does not expand as we
     anticipate, if alternatives to our products are successful, or if a
     downturn in the economy limits capital spending, our business will suffer.

     The market for power quality products is rapidly evolving and it is
     difficult to predict its potential size or future growth rate. Most of the
     organizations that may purchase our products have invested substantial
     resources in their existing power systems and, as a result, may be
     reluctant or slow to adopt a new approach. Moreover, our products are
     alternatives to existing UPS and CPS systems and may never be accepted by
     our customers or may be made obsolete by other advances in power quality
     technologies. Improvements may also be made to the existing alternatives to
     our products that could render them less desirable or obsolete.
     Furthermore, our business depends on capital expenditures by organizations,
     which tend to decrease when the U.S. or global economy slows.


     We have limited product offerings, and our success depends on our ability
     to develop in a timely manner new and enhanced products that achieve market
     acceptance.

     We have only one principal product that has any significant operating
     history at customer sites, CleanSource DC, and we have only recently
     introduced our CleanSource UPS product. To grow our revenue, we must rely
     on Caterpillar to successfully market our CleanSource UPS product, and we
     must develop and introduce to market new products and product enhancements
     in a timely manner. Even if we are able to develop and commercially
     introduce new products and enhancements, they may not achieve market
     acceptance. This would substantially impair our revenue prospects.

                                       11
<PAGE>

     Failure to expand our distribution channels and manage our distribution
     relationships could impede our future growth.

     The future growth of our business will depend in part on our ability to
     expand our existing relationships with OEMs, to identify and develop
     additional channels for the distribution and sale of our products and to
     manage these relationships. As part of our growth strategy, we intend to
     expand our relationships with OEMs and to develop relationships with new
     OEMs. We will also look to identify and develop relationships with
     additional partners that could serve as distributors for our products. Our
     inability to successfully execute this strategy and to reduce our reliance
     on Caterpillar could impede our future growth.


     We are heavily dependent on our relationship with Caterpillar. If our
     relationship is unsuccessful, our business and revenue will suffer.

     If our relationship with Caterpillar is not successful, or if Caterpillar's
     distribution of our CleanSource UPS product is not successful, our business
     and revenue will suffer. Pursuant to a development agreement, Caterpillar
     provided us with $5.0 million in funding to support the development of our
     CleanSource UPS product. In exchange for this payment, Caterpillar received
     co-ownership of the proprietary rights in this product. Either we or
     Caterpillar may license to other entities the intellectual property that we
     jointly own without seeking the consent of the other and all licensing
     revenue generated by licensing this intellectual property will be solely
     retained by the licensing party. However, we may not license the joint
     intellectual property to specifically identified competitors of Caterpillar
     until January 1, 2005. Caterpillar may terminate this agreement at any time
     by giving us 90 days' advance written notice. We also have a distribution
     agreement with Caterpillar.  In 2000 and the first six months of 2001, our
     business level with Caterpillar and its dealer network accounted for 96%
     and 90% of our product revenue, respectively. Pursuant to the distribution
     agreement with Caterpillar, they are the exclusive distributor, subject to
     limited exceptions, of our CleanSource UPS product. Caterpillar is not
     obligated to purchase any CleanSource UPS units.


     We depend on a limited number of OEM customers for the vast majority of our
     revenue and service and support functions. The loss or significant
     reduction in orders, or the failure to provide adequate service and support
     to the end users of our products, from any key OEM customer, particularly
     Caterpillar, would significantly reduce our revenue.

     We rely on OEMs as a primary distribution channel because they are able to
     sell our products to a large number of end user organizations. We further
     rely on our OEMs to provide service and support to the end users of our
     products because they have the experience and personnel to perform such
     activities. We believe that the use of OEM channels will enable our
     products to achieve broad market penetration, while we devote a limited
     amount of our resources to sales, marketing and customer service and
     support. Our operating results in the foreseeable future will continue to
     depend on sales to a relatively small number of OEM customers, primarily
     Caterpillar. For example, in 2000 and the first six months of 2001, our
     volume of business with Caterpillar and its dealer accounted for 96% and
     90% of our revenue, respectively. Therefore, the loss of our key OEM
     customer, Caterpillar, or a significant reduction in sales to Caterpillar
     and its dealers, would significantly reduce our revenue. We also have
     granted Caterpillar semi-exclusive worldwide rights to distribute our
     CleanSource UPS product, provided that they meet

                                       12
<PAGE>

     minimum annual sales requirements. These restrictions will further increase
     our dependence upon Caterpillar. However, Caterpillar is not obligated to
     purchase any CleanSource UPS units under this agreement.


     We may have difficulty managing the expansion of our operations.

     We are undergoing rapid growth in the number of our employees, the size of
     our physical facilities and the scope of our operations. For example, we
     had 38 employees on January 1, 1998, 126 employees on June 30, 2000 and 213
     employees on June 30, 2001. Such rapid expansion is likely to place a
     significant strain on our senior management team and other resources. Our
     business, prospects, results of operations or financial condition could be
     harmed if we encounter difficulties in effectively managing the budgeting,
     forecasting and other process control issues presented by such a rapid
     expansion.


     We have no experience manufacturing our products in the quantities we
     expect to sell in the future.

     To be financially successful, we will have to manufacture our products in
     commercial quantities at acceptable costs while also preserving the quality
     levels achieved in manufacturing these products in more limited quantities.
     This presents a number of technological and engineering challenges for us.
     We cannot assure you that we will be successful in executing the planned
     expansion of our manufacturing activities. We have not previously
     manufactured our products in high volume. We do not know whether or when we
     will be able to develop efficient, low-cost manufacturing capability and
     processes that will enable us to meet the quality, price, engineering,
     design and product standards or production volumes required to successfully
     manufacture large quantities of our products. Even if we are successful in
     developing our manufacturing capability and processes, we do not know
     whether we will do so in time to meet our product commercialization
     schedule or to satisfy the requirements of our customers.


     Quality problems relating to one or more of our new or existing products
     could negatively impact the market's acceptance of our products and cause
     us to miss our revenue goals.

     Because of the nature of the power quality and reliability market, quality
     problems attributable to the CleanSource DC or CleanSource UPS product
     lines could significantly affect the market's perception of our technology
     and slow their acceptance.  This would substantially impair our revenue
     prospects.  Moreover, quality problems for our product lines could cause us
     to delay or cease shipments of products, or recall products, thus impairing
     our revenue or cost targets.


     We are subject to increased inventory risks and costs because we outsource
     the manufacturing of components of our products in advance of binding
     commitments from our customers to purchase our products.

     To assure the availability of our products to our OEM customers, we
     outsource the manufacturing of components prior to the receipt of purchase
     orders from OEM customers based on their forecasts of their product needs.
     However, these forecasts do not represent binding purchase

                                       13
<PAGE>

     purchase commitments, and we do not recognize revenue for such products
     until the product is shipped to the OEM. As a result, we incur inventory
     and manufacturing costs in advance of anticipated revenue. As demand for
     our products may not materialize, this product delivery method subjects us
     to increased risks of high inventory carrying costs and obsolescence and
     may increase our operating costs. In addition, we may from time to time
     make design changes to our products, which could lead to obsolescence of
     inventory.

     We depend on sole source and limited source suppliers for certain key
     components, and if we are unable to buy these components on a timely basis,
     our delayed ability to deliver our products to our customers may result in
     reduced revenue and lost sales.

     We purchase a power module and a microprocessor for our products from sole
     sources. We do not have long-term contracts with most of our suppliers, and
     to date most of our component purchases have been made in relatively small
     volumes. As a result, if our suppliers receive excess demand for their
     products, we may receive a low priority for order fulfillment as large
     volume customers will receive priority. If we are delayed in acquiring
     components for our products, the manufacture and shipment of our products
     also will be delayed. We generally use a 12-month forecast of our future
     product sales to determine our component requirements. Lead times for
     ordering materials and components vary significantly and depend on factors
     such as specific supplier requirements, contract terms, the extensive
     production time required and current market demand for such components.
     Some of these delays may be substantial. As a result, we purchase these
     components in large quantities to protect our ability to deliver finished
     products. If we overestimate our component requirements, we may have excess
     inventory, which will increase our costs. If we underestimate our component
     requirements, we will have inadequate inventory, which will delay our
     manufacturing and render us unable to deliver products to customers on
     scheduled delivery dates. If we are unable to obtain a component from a
     supplier or if the price of a component has increased substantially, we
     will be required to manufacture the component internally, which will result
     in delays. Manufacturing delays could negatively impact our ability to sell
     our products and could damage our customer relationships.


     We depend on key personnel to manage our business and develop new products
     in a rapidly changing market, and if we are unable to retain our current
     personnel and hire additional personnel, our ability to develop and sell
     our products could be impaired.

     We believe our future success will depend in large part upon our ability to
     attract and retain highly skilled managerial, engineering and sales and
     marketing personnel. In particular, due to the relatively early stage of
     our business, we believe that our future success is highly dependent on
     Joseph F. Pinkerton, III, our founder, chief executive officer and
     president, to provide continuity in the execution of our growth plans.
     While we have severance arrangements in place with Mr. Pinkerton and with
     David S. Gino, our chief financial officer, we do not have long-term
     employment agreements in place with any of our employees. The loss of the
     services of any of our key employees, the inability to attract or retain
     qualified personnel in the future or delays in hiring required personnel,
     particularly engineers and sales personnel, could delay the development and
     introduction of, and negatively impact our ability to sell, our products.

                                       14
<PAGE>

     We have hired some of our employees from our current customers and from
     some of our competitors, which could damage our customer relationships and
     expose us to potential litigation.

     There is a limited supply of skilled employees in the power quality
     industry.  We have hired some of our current employees from our customers
     and our competitors.  As a result, some of our current customers might
     begin to view us as competitors in the future, and one or more of our
     competitors could file lawsuits against us alleging the infringement of
     their trade secrets and other intellectual property.  Although we do not
     believe we have infringed upon the intellectual property of our
     competitors, such lawsuits could divert our attention and resources from
     our business operations.


     We are a relatively small company with limited resources compared to some
     of our current and potential competitors, and competition within our
     markets may limit our sales growth.

     The markets for power quality and power reliability are intensely
     competitive. There are many companies engaged in all areas of traditional
     and alternative UPS and CPS systems in the United States, Canada and
     abroad, including, among others, major electric and specialized electronics
     firms, as well as universities, research institutions and foreign
     government-sponsored companies. There are many companies that are
     developing flywheel-based energy storage systems and flywheel-based power
     quality systems. We also compete indirectly with companies that are
     developing other types of power technologies, such as superconducting
     magnetic energy storage, ultra-capacitors and dynamic voltage restorers.

     Many of our current and potential competitors have longer operating
     histories, significantly greater resources, broader name recognition and a
     larger customer base than we have. As a result, these competitors may have
     greater credibility with our existing and potential customers. They also
     may be able to adopt more aggressive pricing policies and devote greater
     resources to the development, promotion and sale of their products than we
     can to ours, which would allow them to respond more quickly than us to new
     or emerging technologies or changes in customer requirements. In addition,
     some of our current and potential competitors have established supplier or
     joint development relationships with our current or potential customers.
     These competitors may be able to leverage their existing relationships to
     discourage these customers from purchasing products from us or to persuade
     them to replace our products with their products. Increased competition
     could decrease our prices, reduce our sales, lower our margins, or decrease
     our market share. These and other competitive pressures could prevent us
     from competing successfully against current or future competitors and could
     materially harm our business.


     If we are unable to protect our intellectual property, we may be unable to
     compete.

     Our products rely on our proprietary technology, and we expect that future
     technological advancements made by us will be critical to sustain market
     acceptance of our products. Therefore, we believe that the protection of
     our intellectual property rights is, and will continue to be, important to
     the success of our business. We rely on a combination of patent, copyright,
     trademark and trade secret laws and restrictions on disclosure to protect
     our intellectual property rights. We also enter into confidentiality or
     license agreements with our employees, consultants

                                       15
<PAGE>

     and business partners and control access to and distribution of our
     software, documentation and other proprietary information. Despite these
     efforts, unauthorized parties may attempt to copy or otherwise obtain and
     use our products or technology. Monitoring unauthorized use of our products
     is difficult, and we cannot be certain that the steps we have taken will
     prevent unauthorized use of our technology, particularly in foreign
     countries where applicable laws may not protect our proprietary rights as
     fully as in the United States. In addition, the measures we undertake may
     not be sufficient to adequately protect our proprietary technology and may
     not preclude competitors from independently developing products with
     functionality or features similar to those of our products.


     Our efforts to protect our intellectual property may cause us to become
     involved in costly and lengthy litigation, which could seriously harm our
     business.

     In recent years, there has been significant litigation in the United States
     involving patents, trademarks and other intellectual property rights.
     Although we have not been involved in intellectual property litigation, we
     may become involved in litigation in the future to protect our intellectual
     property or defend allegations of infringement asserted by others. Legal
     proceedings could subject us to significant liability for damages or
     invalidate our intellectual property rights. Any litigation, regardless of
     its outcome, would likely be time consuming and expensive to resolve and
     would divert management's time and attention. Any potential intellectual
     property litigation also could force us to take specific actions,
     including:

          .  cease selling our products that use the challenged intellectual
             property;
          .  obtain from the owner of the infringed intellectual property right
             a license to sell or use the relevant technology or trademark,
             which license may not be available on reasonable terms, or at all;
             or
          .  redesign those products that use infringing intellectual property
             or cease to use an infringing trademark.


     Any acquisitions we make could disrupt our business and harm our financial
     condition.

     Although we are not currently negotiating any material business or
     technology acquisitions, as part of our growth strategy, we intend to
     review opportunities to acquire other businesses or technologies that would
     complement our current products, expand the breadth of our markets or
     enhance our technical capabilities. We have no experience in making
     acquisitions. Acquisitions entail a number of risks that could materially
     and adversely affect our business and operating results, including:

          .  problems integrating the acquired operations, technologies or
             products with our existing business and products;
          .  potential disruption of our ongoing business and distraction of our
             management;
          .  difficulties in retaining business relationships with suppliers and
             customers of the acquired companies;
          .  difficulties in coordinating and integrating overall business
             strategies, sales and marketing, and research and development
             efforts;
          .  the maintenance of corporate cultures, controls, procedures and
             policies;
          .  risks associated with entering markets in which we lack prior
             experience; and

                                       16
<PAGE>

          .  potential loss of key employees.


     We may require substantial additional funds in the future to finance our
     product development and commercialization plans.

     Our product development and commercialization schedule could be delayed if
     we are unable to fund our research and development activities or the
     development of our manufacturing capabilities with our revenue, cash on
     hand and proceeds from our initial public offering. We expect that our
     current cash and investments, together with our other available sources of
     working capital, will be sufficient to fund development activities for at
     least 24 months. However, unforeseen delays or difficulties in these
     activities could increase costs and exhaust our resources prior to the full
     commercialization of our products under development. We do not know whether
     we will be able to secure additional funding, or funding on terms
     acceptable to us, to continue our operations as planned. If financing is
     not available, we may be required to reduce, delay or eliminate certain
     activities or to license or sell to others some of our proprietary
     technology.


     Our stock price may be volatile.

     Since our IPO in August 2000, we have experienced significant volatility in
     our stock price. The market price of our common stock may fluctuate
     significantly in response to numerous factors, some of which are beyond our
     control, including the following:

          .  actual or anticipated fluctuations in our operating results;
          .  changes in financial estimates by securities analysts or our
             failure to perform in line with such estimates;
          .  changes in market valuations of other technology companies,
             particularly those that Sell products used in power quality
             systems;
          .  announcements by us or our competitors of significant technical
             innovations, acquisitions, strategic partnerships, joint ventures
             or capital commitments;
          .  introduction of technologies or product enhancements that reduce
             the need for flywheel energy storage systems;
          .  the loss of one or more key OEM customers; and
          .  departures of key personnel.

                                       17
<PAGE>

PART II - OTHER INFORMATION

     Item 1.  Legal Proceedings.

          We are not currently a party to any material legal proceedings.

     Item 2.  Changes in Securities and Use of Proceeds.

          Our registration statement (Registration No. 333-36946) under the
     Securities Act of 1933, as amended, relating to our initial public offering
     of our common stock became effective on August 7, 2000.  A total of
     9,200,000 shares of common stock were registered.  We sold a total of
     8,900,000 shares of our common stock and a selling shareholder sold 300,000
     shares to an underwriting syndicate.  The managing underwriters were
     Goldman, Sachs & Co., Merrill Lynch, Pierce Fenner & Smith Incorporated,
     Morgan Stanley & Co. Incorporated and CIBC World Markets Corp.  The
     offering commenced and was completed on August 8, 2000, at a price to the
     public of $17.00 per share.  The initial public offering resulted in net
     proceeds to us of $138.4 million after deducting underwriting commissions
     of $10.6 million and offering expenses of $2.2 million.  The Company has
     used approximately $7.2 million of the net offering proceeds for capital
     expenditures and $20.1 million for operating activities. The remaining
     proceeds from the IPO were invested in government securities and other
     short-term, investment-grade, interest bearing instruments.

     Item 3.  Defaults Upon Senior Securities.

          Not applicable.

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

          At our annual meeting of stockholders held on April 26, 2001, our
     stockholders voted on the following matters:

     (1) The election of two Class I directors to serve until our 2004 annual
     meeting or until his or her successor has been elected and qualified. The
     nominees of the board of directors were elected by the following vote:

                                         Shares          Shares      Shares
     Class I Director                Voted in Favor  Voted Opposed  Withheld
     ----------------                --------------  -------------  --------
     Richard E. Anderson.......        29,336,767          0         439,842
     Rodney S. Bond............        29,336,717          0         439,892

     (2) Approve the appointment of Ernst & Young LLP as independent auditors
     for the fiscal year ending December 31, 2002. The appointment was approved
     by a vote of 29,660,880 shares in favor, 44,294 shares opposed and 71,435
     shares abstaining.

     Item 5.  Other Information.

          Not applicable.

     Item 6.  Exhibits and Reports on Form 8-K.

     (a)  Exhibit Index

                                       18
<PAGE>

     Exhibit
     Number    Description
     ------    -----------

      3.1*     Amended and Restated Certificate of Incorporation (filed as
               Exhibit 3.1 to Active Power's Registration Statement on Form S-1
               (SEC File No. 333-36496) (the "IPO Registration Statement)

      3.2*     Amended and Restated Bylaws (filed as Exhibit 3.2 to the IPO
               Registration Statement)

      4.1*     Specimen certificate for shares of Common Stock (filed as Exhibit
               4.1 to the IPO Registration Statement)

     ___________
     * Incorporated by reference to the indicated filing


     (b)  During the quarter ended June 30, 2001, Active Power did not file any
          current reports on Form 10-Q.

                                       19
<PAGE>

                                  SIGNATURES*

     Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

                                              ACTIVE POWER, INC.

                                 By:      /s/ Joseph F. Pinkerton, III
                                    -----------------------------------------
                                            Joseph F. Pinkerton, III
                                      President and Chief Executive Officer

          August __, 2001                 /s/ Joseph F. Pinkerton, III
                                    -----------------------------------------
                                            Joseph F. Pinkerton, III
                                      President and Chief Executive Officer
                                          (Principal Executive Officer)

          August __, 2001                       /s/ David S. Gino
                                    -----------------------------------------
                                                  David S. Gino
                                          Vice President of Finance and
                                             Chief Financial Officer
                                         (Principal Accounting Officer)


                                       20